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Financial Intermediaries
The word intermediary is self-explanatory. The role of a financial intermediary is to act as connect between the
providers of the funds and the people who lack such funds. In case of absence of such an intermediary, the
demand and supply would purely depend upon the sheer coincidence of wants or interest between two parties.
The coexistence of such interests is nearly impossible give the size of the population and the needs of the
people. The prominence of a financial intermediary is defined in the context of capital formation through its
ability to modify an existing obligation or contract into some other form of contract with completely varying
features from its pre existing form. This process has been termed as Transmutation Effect. A simple example of
this could be a Bank as intermediary which lends fund to a single large entity for long term with high interest
rate and provides him/her funds out of the savings collectivized from small depositors of short term funds at
lower interest rate. The obligation of bank is different as compared to the obligation it has enforced upon the
borrower and hence it manages to mitigate several risks and lags involved and also manages to earn profits.
They make different types of contracts with lenders and borrowers separately i.e. called Tailoring of Contracts.
Apart from the function of customization of contracts or claims, financial intermediaries also provide certain
other facilities which are equally important. Intermediaries make it convenient for a saver to park funds into
easily divisible forms of instruments. This gives a greater flexibility to a saver depending upon his needs and
quantum of surplus he/she has. Along with this the convenience is also in terms of maturity of such instruments
which vary from short term to long term again depending upon the customer’s needs.
Secondly, through financial innovation, intermediaries also help in lowering the extent of risk through their
ability of diversification of investment activities. Diversification helps in spreading the risk through multiple
investments or a portfolio of investments that are undertaken keeping in mind the risk and return attitude of each
such investment. Thirdly, intermediaries also possess the expertise of managing funds due to availability of vast
knowledge and trained staff. The expanse of transactions makes it possible for the financial intermediary to
reduce cost and economize which might not be possible for individual parties in absence of such intermediary.
Financial Markets
Other perspective to financial system is the organization in the form of markets of loanable funds. Markets cater
to both individual and institutional investors.
Financial Instruments/Assets
The third categorization is on the basis of instruments that are deals in the financial world. These instruments
form the basis of operation of financial intermediaries in the financial markets. It is these instruments which act
as a claim on an asset and also acts as a source of regular income.
Primary Securities
These are the securities issued by the non-financial institutions like companies in the form of equity
shares, debentures and preferential shares.
Indirect Securities
Indirect securities are issued by financial intermediaries. These include mutual funds units,Minsurance
policies, deposit certificates by banks and other instruments issued by asset securitization and
reconstruction companies.
Derivatives
Financial instruments are largely susceptible to price volatilities which thus cause a reduction in the
real return on such assets. The need for price discovery and to bring stability in return, financial
innovation led to the development of such instruments which derive a value form the value of asset
underlying. The underlying or the base could be equity, a foreign exchange or a physical commodity.
Common types of derivatives include:
o Forwards
o Futures
o Options
Financial intermediaries mediate between entities with surplus funds and those who need these
funds. In their role as a link between borrowers and savers, financial intermediaries create
liquidity, reduce transaction costs and minimize the asymmetric information problem prevalent in
the financial markets. There are two types of financial intermediaries, bank and non-bank
financial intermediaries. While bank financial intermediaries (BFIs) provide short term finance,
the non-bank financial intermediaries (NBFIs) cater to long term financial needs.
Financial intermediaries play an important economic function by facilitating a productive use of
the community's surplus money. Financial intermediaries perform the basicfunction of
transforming financial assets acquired through the market and constituting them into a different,
more preferable type of assets, which becomes their liabilities. The important functions of FIs
are:
1. Pooling of resources from small savers
Liquidity is a desirable property which refers to the ease and convenience with which an asset can
be converted to a means of payment. Financial intermediaries facilitate transformation of various
assets into a means of payment through ATMs, checking accounts, debit cards, etc. For
maintaining this, financial intermediaries must have smooth flow of funds so as to meet their
obligations while profiting from the spread between long and short term interest rates. Economies
of scale allows intermediaries to do this at minimum cost.
3. Diversification of risk
4. Facilitate portfolio creation
5. Reducing asymmetric information problem
6. Providing safekeeping, accounting, and payments mechanisms for resources
Banks are the safest place to keep money. Apart from this, banks keep the records of payments,
deposits and withdrawals and the use of debit/credit cards and checques as payment mechanisms.
Financial intermediaries can do all of this much more cheaply on account of economies of scale
in its operation. All of these services are standardized and automated on a large scale, so per unit
transaction costs are minimized.
7. Collecting and processing information
Role of Financial Intermediaries
1. Financial Intermediaries help reduce Poverty levels
Most formal financial institutions do not serve the poor because of perceived high risks, high
costs involved in small transactions, perceived low profitability, and probable inability to provide
the physical collateral required by such institutions.
FIs by providing efficient micro-finance to the poor can help in:
Enabling the poor to smoothen their consumption, manage risks better, gradually build assets,
develop micro-enterprises, enhance income earning capacity, and generally enjoy an improved
quality of life.
Improved resource allocation, development of financial markets and system, and ultimately
economic growth and development.
Active participation of vulnerable sections in benefitting from development opportunities.
Banks are one of the most important form of financial intermediary which perform the task of
transferring funds from people with excess towards people who want to borrow. Through
economies of scale, the banks are able to reduce the transaction cost and achieve greater
efficiency. The main functions of banks include credit creation, liquidity and profitability
management and management of reserves. Indian Banking System includes the central bank at
the top i.e. Reserve Bank of India followed by group of Scheduled and Non Scheduled Banks.
The scheduled banks include both Public Sector and Private Sector Banks. Liabilities of a Bank
includes Deposits received from public and assets include Loans and Advances generated using
the deposits of public through reserve system. Commercial Banks have diversified instruments
and mechanism to govern the inflow and outflow of funds. Commercial banks have seen a rise in
business which is visible through indicators like credit deposit ratios, investment deposit ratio,
Net Interest margin etc. The banks have also seen a rise in risk based assets and the introduction
of capital adequacy norms have led to greater arrangement for loss absorbing capital. The banks
have also witnessed the pressure of upsurge in NPAs.
The Basel Committee on Banking Supervision has said that
India is compliant regarding regulation on large exposures though, in some respects, regulations are
stricter than the Basel large-exposures framework.
Banking regulations in India are more stricter: Basel Accord
In some other respects, the Indian regulations are stricter than the Basel large exposures
framework.
For example, banks’ exposures to global systemically important banks are subject to stricter
limits in line with the letter and spirit of the Basel Guidelines.
The scope of application of the Indian standards is wider than just the internationally active
banks covered by the Basel framework.
What are Basel Norms?
Basel is a city in Switzerland. It is the headquarters of Bureau of International Settlement
(BIS), which fosters co-operation among central banks with a common goal of financial stability and
common standards of banking regulations.
Basel guidelines refer to broad supervisory standards formulated by this group of central
banks – called the Basel Committee on Banking Supervision (BCBS).
The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial
system are called Basel accord.
The purpose of the accord is to ensure that financial institutions have enough capital on
account to meet obligations and absorb unexpected losses.
India has accepted Basel accords for the banking system.
Basel I
In 1988, BCBS introduced capital measurement system called Basel capital accord, also
called as Basel 1.
It focused almost entirely on credit risk. It defined capital and structure of risk weights for
banks.
The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
RWA means assets with different risk profiles.
For example, an asset backed by collateral would carry lesser risks as compared to personal
loans, which have no collateral. India adopted Basel 1 guidelines in 1999.
Basel II
In June ’04, Basel II guidelines were published by BCBS, which were considered to be the
refined and reformed versions of Basel I accord.
The guidelines were based on three parameters, which the committee calls it as pillars:
Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy
requirement of 8% of risk assets.
Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risks that a bank faces, viz.
credit, market and operational risks.
Market Discipline: This need increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc to the central bank. Basel II norms in India and overseas are
yet to be fully implemented.
Basel III
In 2010, Basel III guidelines were released. These guidelines were introduced in response to
the financial crisis of 2008.
A need was felt to further strengthen the system as banks in the developed economies were
under-capitalized, over-leveraged and had a greater reliance on short-term funding.
Also the quantity and quality of capital under Basel II were deemed insufficient to contain any
further risk.
Basel III norms aim at making most banking activities such as their trading book activities
more capital-intensive.
The guidelines aim to promote a more resilient banking system by focusing on four vital
banking parameters viz. capital, leverage, funding and liquidity.
According to a report by the Basel Committee on Bank Supervision (BCBS), the Reserve Bank of
India has fallen short of meeting tougher requirements set by the Basel III norms.
The report looked at adoption status of Basel III standards by 30 global systemically important
banks (G-Sibs) as of end-May 2019.
The RBI is yet to publish the securitisation framework and rules on Total Loss-
Absorbing Capacity (TLAC) requirements.
Portfolio management refers to the prudent management of a bank’s assets and liabilities in order
to seek some optimum combination of income or profit, liquidity, and safety. When a bank
operates, it acquires and disposes of income-earning assets. These assets plus the bank’s cash
make up what is known as its portfolio. The manner in which banks manage their portfolios, that
is acquiring and disposing of their earning assets, can have important effects on the financial
markets, on the borrowing and spending practices of households and businesses, and on the
economy as a whole.
Objectives of Portfolio Management
1. Liquidity:
A commercial bank requires a higher degree of liquidity in its assets. Assets liquidity can be
defined as the certitude and ease with which assets can be converted into the most liquid asset i.e.
cash. The liabilities of a bank are large in relation to its assets because it holds a small proportion
of its assets in cash. But its liabilities are payable on demand at a short notice.
Therefore, the bank must hold a sufficiently large proportion of its assets in the form of cash and
liquid assets for the purpose of profitability. On the other hands, if liquidity is ignored and
earning more becomes focus, it will be catastrophic for it. Thus in managing its investment
portfolio a bank must strike a balance between the objectives of liquidity and profitability. The
balance must be achieved with a relatively high degree of safety. This is because banks are
subject to a number of restrictions that limit the size of earning assets they can acquire.
2. Safety:
A commercial bank always operates under conditions of uncertainty and risk. It is uncertain about
the amount and cost of funds it can acquire and about its income in the future. Moreover, it face
two types of risks. The first is the market risk which results from the decline in the prices of debt
obligations when the market rate of interest rises. The second is the risk by default where the
bank fears that the debtors are not likely to repay the principle and pay the interest in time. “This
risk is largely concentrated in customer loans, where banks have a special function to perform,
and bank loans to businesses and bank mortgage loans are among the high grade loans of these
types.”
In the light of these risks, a commercial bank has to maintain the safety of its assets. It is also
prohibited by law to assume large risks because it is required to keep a high ration of its fixed
liabilities to its total assets with itself and also with the central bank in the form of cash. But if the
bank follows the safety principle strictly by holding only the safest assets it will not be able to
create more credit.
It will thus lose customers to other banks and its income will also be very low. One the other
hand, if the bank takes too much risk, it may be highly harmful for it. Therefore, a commercial
bank “must estimate the amount of risks attached to the various types of available assets, compare
estimated risk differentials, consider both long-turn and short- run consequences, and strike a
balance.”
3. Profitability:
One of the principle objectives of a bank is to earn more profit. It is essential for the purpose of
paying interest to depositors, wage to the staff, dividend to shareholders and meeting other
expenses. It cannot afford to hold a large amount of funds in cash for that will mean forgoing
income. But the conflict between profitability and liquidity is not very sharp. Liquidity and safety
are primary considerations while profitability is subsidiary for the very existence of a bank
depends on the first two.
Thus, the three conflicting objectives of portfolio management lead to the conclusion that for a
bank to earn more profit, it must strike a judicious balance between liquidity and safety.
Co-operative Banks and their existence can be traced back to 1904 with the emergence of Cooperative
Societies Act of 1904. These institutions were setup with the intent of serving the rural institutions
engaged in productive activities. The main concern was to provide a setup to solve the issues related
to agricultural financing and credit and to eliminate the long existing unorganized money market
which exploited the rural poor by charging exorbitant rates of interest. The co-operative banks were
later introduced into the mainstream financial framework with the view to enhance development
through community based participation. These institutions today exist alongside the commercial
banking system and cater to both urban and rural credit requirements.
It has been said that there has been a direct link of prosperity and long term growth with the effective
and efficient financial system. A strong financial system results in good economic progress, reduction
in poverty, increase in the standard of living of the people. But there are many question marks to this
link. The role of financial system in the economic development depends upon happenings of many a
factors which, if does not happen, will not result into growth. Some of those factors are as follows:
(a) The financial system will help in the financial development if the financial system itself is
efficient. Thus, the development of economy based on financial system is possible only when
system works efficiently which in reality may not happen(b) There has been asymmetric
dissemination of information which does not lead to equitable gains for all.
(c) Stock market rarely depicts fundamental valuation efficiency.
(d) Good volumes at stock market have no necessary relation with real investment.
(e) Risk reduction and better risk management is also not assured even with multiple financial
instruments.
(f) Raising of funds from debt or new issue is also less and therefore, there is less funds for real new
investment.
(g) Market speculation leads to high volatility in share prices.
(h) Fluctuations in trade balances also result in high volatility in foreign exchange rates.
(i) Utilization of society’s resources into more productive channels is less facilitated by financial
markets. It has been seen that private benefit is more than public benefit.
Thus, it may be concluded that if financial system works efficiently, only then it results into long term
prosperity and growth of the economy.
The interrelationship of finance, financial system and economic development can be better understood
from some of the following theories.
The classical prior savings theory
Credit creation theory
Forced saving theory/Inflationary financing theory
Financial repression/Financial Regulation Theory and,
Financial liberalization theory
Efficient financial markets provide various other indirect benefits such as rapid accumulation of
physical and human capital, more stable investment financing, and faster technological progress.
3.1 Measures to develop a strong, vibrant and efficient financial market
There is no panacea for developing a strong and efficient financial market. A well-functioning financial
market with the required depth and liquidity requires various financial market reforms. Such reforms must be
implemented at an early stage to improve market infrastructure. Some of the measures are:
Macroeconomic stability
Reasonable/Tolerable government deficit, low and stable inflation rates and realistic exchange rates
Sound and efficient financial institutions and structure
Prudential regulation and supervision 3.2 Functions of a Financial Market
Financial markets serve six basic functions. These functions are briefly listed below:
1. Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to
another for either investment or consumption purposes.
2. Price Determination: Financial markets provide vehicles by which prices are set both for newly issued
financial assets and for the existing stock of financial assets.
3. Information Aggregation and Coordination: Financial markets act as collectors, aggregators, and coordinators
of information about financial asset values and the flow of funds from lenders to borrowers.
4. Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who
provide funds for those investments.
5. Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these
assets.
6. Efficiency: Financial markets reduce transaction costs and information costs and thereby increase efficiency
of the financial system.
In attempting to characterize the way financial markets operate, one must consider both the various types of
financial institutions that participate in such markets and the various ways in which these markets are structured.
4. Structure/Classification of Financial Markets
The financial markets can be classified in the following manner:
Functional classification
Institutional classification
Sectoral classification
Functional classification
It is based on the term of credit, whether the credit supplied is short term or long-term. Accordingly, markets are
called money markets or capital markets.
The institutional classification
It talks about the objectives of the institution. In other words, it indicates whether the financial institutions have
commercial objective or cooperative objective and whether they belong to organized or unorganized sector .
The sectoral classification
This classification is based on broad three sectors of the economy namely, agricultural industry, manufacturing
industry, and service industry and talks about their credit needs.
Various classifications are not mutually exclusive. Their aim is to give a broad view of the financial markets,
their several dimensions and functions. We combine all the above classifications together to explain every part
of the financial market. The diagram given below explains the various dimensions of the financial markets.
Strong creditor rights
Contract enforcements and appropriate legal framework
Non-Banking Financial Companies
NBFCs are doing functions similar to banks. What is the difference between
banks & NBFCs?
NBFCs lend and make investments, and hence their activities are akin to that of
banks; however, there are a few differences as given below:
Asset Finance AN AFC is a company which is a financial institution whose principle business is t
Company financing of physical assets such as automobiles, tractors, machines etc.
Infrastructure Finance IFC is an NBFC which deploys 75% of its total assets in infrastructure loans and h
Company a minimum net owned fund of Re 300 Crore.
Systematically CIC is an NBFC carrying on the business of acquisition of shares and securities. C
must satisfy the following conditions:
It holds not less than 90% of its Total Assets in the form of investment in
equity shares, preference shares, debt or loans in group companies;
Important Core
(c) it does not trade in its investments in shares, debt or loans in group
companies except through block sale for the purpose of dilution or
Investment Company
disinvestment;
(d) it does not carry on any other financial activity referred to in Section 45I
and 45I(f) of the RBI Act, 1934 except investment in bank deposits, money
market instruments, government securities, loans to and investments in de
issuances of group companies or guarantees issued on behalf of group
companies.
Infrastructure Debt IDF NBFC primary role is to facilitate long term flow of debt into infrastructure
Fund NBFC projects. Only Infrastructure Finance Companies can sponsor IDF.
Micro Finance NBFC MFI NBFC is a non-deposit taking NBFC having not less than 85% of its assets in
nature of qualifying assets which satisfy the following criteria:
b. loan amount does not exceed 50,000 in the first cycle and 1,00,000 in
subsequent cycles;
d. tenure of the loan not to be less than 24 months for the loan amount in
excess of 15,000 with prepayment without penalty;
f. aggregate amount of loans, given for income generation, is not less than
per cent of the total loans given by the MFIs;
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Banking Sector & NBFCs
The Reserve Bank of India (RBI) has decided to merge three categories of Non
Banking Financial Companies (NBFCs) into a single category to provide greater
operational flexibility to non-banking lenders.
Nabard
Sidbi
NHB
Primary Dealers (PD)
Non banking financial companies
Depends
Insurance Co. : IRDA
Merchant Banks : SEBI
All supervised by RBI
Microfinance Co. : State + RBI + NAB
Deposit insurance facility of DICGC applies Deposit insurance facility of DICGC does not
Depends
Gold Loans → risk factor (15%, 25%)
Shares: dividend
Loan rates linked with Base Rate system
Bonds: 8/12/16%
Loan recovery powers under SARFAESI SARFAESI applicable only for Housin
Gold loan: auction
Bonds holders of NBFC: first to get pa
Shares holders of NBFC: last to get pa
NBFC Classification
Regulated by Take “premium” from you; invest in
Insurance company IRDA
Examples include LIC, Bajaj Allianz
Infrastructure Finance
Company Gives loans for infra. Projects viz. roads, electricity etc.
Infrastructure Debt Fund Gives loans for infra. Projects, but give very long term
(IDF)
Can even raise money from abroad
Invest in securities
Investment Co.s
Examples include Muthoot finance, L & T finance etc
Long term investment in securities
Can accept public funds (NBFC-Deposit)
Cannot enter in insurance
Core Investment Co.s
E.g. Tata Capital, Birla Capital
SEBI Regulated
They help buying-selling of shares (of their clients)
Stock Brokers, Mutual Earn commission/brokerage) in between
Funds
Examples → Indiabulls, Sherkhan, IIFL
Venture Capital Fund They finance start-up companies via share in equity
Department of Company affairs Regulated
Form a group → Borrow money from members → le
Mutual benefit funds
Nidhi companies
Example → South Madras Benefit Fund ltd.
Focus on poor people, women clients, SHG
Provide loan without collateral
Borrower given flexibility to decide EMI and repaym
Actual interest rate: 26%
Microfinance company
Example → SKS (Andhra), Cashpor (UP), Ujjivan (K
1. NBFIs are those institutions which do not have a full banking license and supplement the
financial services along with banking financial institutions.
2. They have a key role in monetizing the economy and transferring unproductive financial assets
into productive assets, thereby contributing to the country’s economic development
3. Since 1997, extensive regulatory framework has been put in place to safeguard depositors’
interests and control the economic operations of NBFI
It is a type of bank that offers services like accepting deposits, making business loans, & offering
basic investment products. E.g. SBI, Indian Overseas bank.
Broad Objectives of Money Market
1. An equilibrating mechanism for evening out short term surpluses and deficiencies.
2. A focal point of RBI (central bank) intervention for influencing liquidity in the economy.
3. Access to the users of short term funds to meet their need at reasonable price and cost.
A company that provides insurance policies to the public, either by selling directly to an
individual or via another source such as an employee's benefit plan. An insurance company is
generally comprised of multiple insurance agents. An insurance company can specialize in one
type of insurance, such as life insurance, health insurance, or auto insurance, or offer multiple
types of insurance.
Foreign institutional investors
A hedge fund, pension fund manager, mutual fund, bank, insurance company, large corporate
buyer, or a representative agent for any of these parties that is registered to do business in a
country other than where the investment instrument is being purchased. The investor takes
positions in foreign financial markets on behalf of the institution in the home country.
Corporates and individuals
An instrument that signifies an ownership position (called equity) in a corporation, & signifies a
claim on its proportional share in the corporation's assets & profits. Ownership in the company is
determined by the no. of shares a person owns divided by the total no. of shares outstanding.
E.g., if a company has 1000 shares of stock outstanding & a person owns 50 of them, then he/she
owns 5% of the company.
Foreign exchange instruments
Any financial instrument that locks in a future foreign exchange rate. These can be used by
currency or forex traders, as well as large MNC’s. The latter frequently uses these products when
they presume to receive large sums of money in the future but want to hedge their exposure to
currency exchange risk. Financial instruments that are part of this group comprise: currency
options contracts, currency swaps, and forward contracts and futures contracts.
Hybrid instruments
An investment product that merges the attributes of an equity security with a debt security.
Generally, these instruments are considered as debt-type instruments with exposure to the equities
market. The examples of these instruments are convertible bonds, preferred stocks, equity default
swaps & structured notes linked to an equity index.
Nature of capital markets
It Has 2 segments
It Transacts in Long-Term Securities
It Accomplishes Trade-off Function
It Generates Dispersion in Business Ownership
It Benefits in Capital Formation
It Helps in creating Liquidity
The two components of capital market are: Primary market and Secondary market
PRIMARY MARKET/ New Issue Market (NIM)
The NIM deals in new securities, that is, securities which were not formerly accessible and are
offered to the investors for the first time. Capital formation take place in the NIM as it delivers
additional funds to the corporates directly.
It does not have any organisational setup located in any particular place and is recognized only by
the specialist institutional services that it tenders to the lenders/borrowers (buyers/sellers) of
capital funds at the time of any particular operation.
It performs triple-service, namely
1. Origination, that is, investigation & analysis & processing of new issue proposals.
2. Underwriting in terms of guarantee which states that the issue would be sold regardless of
public response.
3. Distribution of securities to the investors.
Issue of stock on a public market rather than being privately funded by the companies own
promoter(s), which may not be enough capital for the business to start up, produce, or continue
running. By issuing stock publically, this allows the public to own a part of the company, though
not be a controlling factor.
Private Placement
The sale of securities directly to an institutional investor, like a bank, mutual fund, insurance
company or foundation. Does not need SEC registration, as long as the securities are bought for
investment purposes instead of resale, as stated in the investment letter.
Right Issue
An issue of rights to a company's existing shareholders which enables them to buy additional
shares directly from the company in proportion to their existing holdings, within a fixed time
period.
Electronic-Initial Public Offer
It is the first sale of stock to the public by a company. Companies proposing an IPO are at times
new, young companies, or maybe companies which have been around for many years but have
lastly decided to go public. IPOs are often risky investments, but often have the potential for
noteworthy gains. IPOs are also used as a way for a young company to gain required market
capital.
Secondary Stock Market/Exchange (SE)
The SE is a market for old/existing securities, that is, those already issued and granted SE
quotation. It plays only an indirect role in industrial financing by providing liquidity to
investments already made. It has a physical existence and is located in a particular geographical
area.
Vital Functions Performed by SE are:
Nexus between savings and investments.
Liquidity to investors by offering a place of transaction in securities.
Continuous price formation.
Another type of classification for financial markets is based on the types of assets:
Debt versus Equity
The claim that the holder of a financial asset has may be either a fixed amount or varying/
residual amount. In the earlier case, the financial asset is stated as a Debt instrument while the
latter is stated as the equity. For example common stock is equity. Some securities fall into both
categories, example preferred stock.
4. Market Participants
Participants in national financial market and global financial markets are different. The national
participants as discussed are unique to money and capital market. In a global financial markets,
participants that issue and purchase financial claims include households, business entities
(corporations and partnerships), national government, national government agencies, state and
local governments, and supranationals such as the World bank, the European Investment Bank
and the Asian development bank. Money Market instruments essentially includes Government
securities, securities issued by
private sector & banking institutions—
1. Government Securities: RBI issues securities on behalf of the Government known as
Government Securities. It includes Central Govt Securities, State Govt Securities and Treasury
Bills. The various form of this Securities are given as following—The Government dated securities
can be bought for a minimum sum of Rs. 10,000/- and the
Treasury bills for a sum of Rs. 25,000/- & in multiples thereafter and the State Govt Securities
may be bought for a min. sum of Rs.1, 000/-.
2. Money at Call and Short Notice: Call money or call deposits is the amount of money that is
advanced on condition to repay on call. Notice money indicates the money that is advanced and
repaid on a certain day’s notification from the lenders. There are various reasons for this borrow
such as: to maintain their CRR, heavy payments etc. Money at short notice is meant for a
maturity of up to 14 days. RBI has permitted banks and all India FIs as the main participants.
At least a sum of Rs.20 crores for every transaction allowed the participation of the corporate in
the call money market. The DFHI upgraded the activity of Call Money Market and Short-term
Deposit Market. It allowed lending and borrowing of funds. Banks are the essential borrowers. It
can function outside the provision of the ceiling rates fixed by the Indian Banks Association.
GIC, IDBI, NABARD etc are the various participants along with the private Mutual Funds that
lends fund in the market. The DFHI determines the settlement among the lender and the borrower
about the accessibility of funds and the sum required for exchanges. It also provides an advice
regarding the interest rates appropriate to them.
Here, the call rates are highly unstable as they are estimated by the demand and supply of funds
in the market which is based on the maintenance of CRR by the banks. There are 2 call rates
sustained in India namely Inter-bank call rate & the lending rates of DFHI.
3. Bills Rediscounting Scheme: Under this scheme the banks may advance funds by issue of
issuance from issuing notes in appropriate lots and maturities matching the authentic trade bills
discounted by them. It promotes liquidity in the market. Here the seller draws a BoE and the
buyer accepts it. Suppose, Mr. X(seller) sells on credit and he wants money in the meantime, he
may approach the bank for discounting the bill and he acquires the money.
Now, the bank who has discounted the bill may need to get it ‘rediscounted’ with some other
bank to acquire the funds. This is referred to as ‘bill rediscounting’. The bank can rediscount the
bills with the RBI and other sanctioned institutions like LIC, GIC, etc.
4.Inter-Bank Participation Certificate: These are allotted by scheduled commercial banks only
to increase funds or to deploy short term surplus. It is issued as per the RBI guidelines on 2 basis:
a. on risk sharing basis
b. without risk sharing
Under risk sharing, the lender bank shares losses with the borrowing banks by conjointly
assessing the interest rate. The tenure in this case may be for 90 to 180 days.
There is a tenure of 90 days in case of Inter-Bank Participation without risk sharing where the
issuing bank is borrowing and the sum is lent by the participating banks.
5. Money Market Mutual Funds (MMMFs): MMMFs gather the small savings of a large no. of
savers and invest them in the capital market to
provide safety, liquidity and return. This concept is prolonged to money market. Hence, the
MMMF are coming up. The managing principle on MMMFs are revised from time to time by
SEBI relating to maximum limit of investment.
6. Treasury Bills: These are discounted securities issued at a discount face value as per the short
term requirement of the GOI. These are issued on a fixed day and at a fixed amount by RBI.
There are 4 types of TBs:
These money market instruments are extremely liquid and are zero default risk bearing paper. It
assists in placement of the idle funds for very short periods as well.
7. Certificates of Deposits:
This is issued as per the guidelines of the RBI in dematerialized form or Usance Promissory Note
for the funds deposited at a bank or other financial institution. This is a negotiable instrument
where the deposit should be at least of Rs.1 lakh and in the multiples of Rs. 1 lakh thereafter. The
maturity period should not be less than 15 days and exceed 1 year. But, for the financial
institution it should not be less than 1 year and not more than 3 years. 8. Inter-Corporate Deposits:
These are unsecured loan lent by 1 of the corporate to another. As the cost of funds for a
corporate is higher than a bank, the rates in this market are higher than those in the other market.
9. Commercial Bills:
These are the bills accepted by the buyer for those goods and services that are on credit from the
seller and these can be kept till the due date and encased by the seller or may be endorsed to a
third party. These bills can be discounted with the banks or financial institutions or can again be
rediscounted at the bank.
10. Commercial Papers (CP):
This instrument is meant as a source of short term borrowing. It is issued in the form of a
promissory note or dematerialized form. An Issuing & Paying Agent (IPA) is appointed for every
issuer for the issue of commercial papers and only a scheduled bank can act as an IPA for
issuance of CP. For crediting the CP into the investor’s account with a depository, the investor are
given the IPA certificate as well as issued physical certificates. The CP is issued for a maturity
period of minimum 7 days and till 1 year from the date of issue in the denomination of Rs. 5 lakh
or multiples thereof.
The main purposes of introducing CP are—
1. To allow the high levels of corporate borrowers such as leasing and financing of companies,
manufacturing and financial institutions etc.
2. To diversify the sources of short term borrowing
3. To provide tools for bank and financial institution in the money market.
11. Gilt-edged (Government) Securities:
These securities have huge demand by the banks to maintain the Net Demand & Time Liquidities
(NDTL) through its buying and selling. Govts such as Central & State Govts, Semi-Govt
Authorities, and Municipalities etc. issues these securities which are dated long before and are
with RBI. These issues are notified a few days before opening for subscription and offer remains
open for two to three days. The rate of interest is lower but it is payable on semi-annually basis.
12. Repo Market:
This tool helps in collateralised short- term borrowing & lending through purchase or sale
operation in debt instruments. The securities here are sold by the holders to the investors with a
promise to buy them again at a pre-fixed rate and date. Alternatively, under the reverse repo
transactions, the securities are bought with a promise to resell them at a pre-set rate and date.
5. Defects of Indian Money Market
A well-built money market signifies the operation of sound monetary policy. But the money
market in India suffers from many weaknesses.
1. Lack of integration: The Indian Money Market is separated into 2 sectors namely, the
organised and unorganised money market. But both the markets are completely separate
from one another. They are working independently and have little effect on each other. RBI has been
fully operative in monitoring the organised sector. But, in the unorganised
sector it has very less control.
2. Lack of rational interest rates structure: In the Indian Money Market there prevailed
several interest rates e.g. the deposit & lending rates of commercial banks, the borrowing
rate of Government etc. Formerly, these led to creation of excess demand for credit and
RBI had to depend on CRR. However, RBI has made effort to generate rationality in the
interest rates but the situation is not effective.
3. Existence of Unorganised Money Market: Due to the existence of the unorganised
sector in the Indian Money Market the banker makes no difference between short term
and long-term finance. They have no coordination with one another and have no link with
other banking sectors. They do not follow any sound banking regulations. There is no
control by RBI on these bankers.
4. Absence of an organised bill market: There is no sufficient bill market in the Money
Market in India. There is lack of commercial bill market or a discount for short term
commercial bills. The factors responsible for the underdeveloped bill market are (i)
relying more on cash transaction, (ii) cash credit of commercial bank, (iii) seller’s limited
use of bills, (iv) imposition of heavy stamp duty, (v) absence of acceptance houses etc.
5. Shortage of funds in the Money Market: A shortage of fund is created in the money
market due to the lack of banking habit and banking facility, little saving habit, etc. On
the other hand, the growing demand for loanable funds in the money market results in
inadequate supply.
6. Inadequate banking facility: Now-a-days, many new branches of banking facilities are
opened by the commercial banks. But, a much wider scope is available for further
development. In country like India which is still developing, there are people who live
below poverty line and have less saving habit as a result of which their savings are small
and they do not have much exposure to banking facilities till now.
7. Seasonal Stringency of Money: During some part of the year mainly from October to
June, the interest rate rises due to the rising demand for funds in the money market for the
even working of the agricultural sector.
6. Measures to Improve Indian Money Market
The major problem of India Money Market is its high instability. Gradually the money market
transaction is growing. But, on the commendation of the Sukhmoy Chakravarty Committee (on
the review of the working of the Monetary System) and the Narasimham committee (on the
Report on the working of the financial system in India, 1991), RBI has introduced change in
Indian Money Market. The following are some of the measures undertaken-
1. Introducing new money market instrument: Many new money market instruments are
introduced like Commercial Papers, Certificates of Deposits, 182-day Treasury, 364-day
Treasury etc. The Discount & Finance House is also established. These ensure various
short term borrowings to various borrowers to collect fund when required to preserve
their financial position.
2. Relaxation from interest rate regulations: RBI controls and regulate all types of interest
rates like lending as well as deposit rates of the banks and financial institution. But, progressively the
interest rates of the bank loans are regulated by the market forces which
result in decontrolling it.
3. Remitting the stamp duties: In Aug 1989, Govt remitted the stamp duty. But, it is not
effective until it reduces the cash credit system in favour of using the bill system.
4. Sector specific refinance: There are 2 refinance schemes namely export credit refinance
and general refinance that are active in the current financial system. The refinance is used
by the central bank to control credit conditions & the liquidity positions in the system.
But if the excessive funds supplies into the system do not result in any development then
it could be highly distorted one.
5. Introduction of repo: This is utilised by the banks for short term liquidity through sale or
purchase of debt instruments. It is an arrangement to re-buy them at a pre-set rate & date
between the RBI & commercial banks.
6. Introducing Money market Mutual Funds: These were announced in April’91. The pool
of the small savings invested generate short term avenues to the various investors.
7. Setting the Discount & Finance House in India: It equated the surplus of fund & the
deficit amounts of the banks. The DFHI assists in lending & borrowing of funds to
several banks and financial institutions. CAPITAL MARKET IN INDIA
a) Equity or Ordinary Shares:
It represents the ownership capital. It is of several types:
Authorized equity share capital: The maximum sum of share capital that a company can raise is
its authorized share capital.
Issued capital: It is that portion of the capital which offered by the company to the investors.
Subscribed capital: It is the part of issued capital which is subscribed by the investors.
Paid-up capital: It is the capital that paid by the shareholders. The main features include limited
liability, residual claim to income, right to control, pre-emptive
rights.
b) Preference Shares:
It has certain characters of equity share and debentures. It has a fixed rate of interest. It has
preferential right to get dividend in comparison to equity share. The preference shareholders can
get cumulative dividends i.e. all unpaid dividend are payable. They have no voting right. But, if
the preference shares are not paid for more than 2 years with regard to cumulative shares, the
preference shareholders permitted to vote.
c) Debentures or Bonds or Notes:
The debenture holders are long-term creditors. The debenture holders get a predetermined rate of
interest and the principal sum is refunded at specified time.
d) Innovative Debt or Instrument:
The debenture may be compulsorily, optional or convertible. Call option gives a chance to the
company to redeem the bonds prematurely. The firms issue su0236590c214\75h bonds and in
favourable condition, they refund it.
A warrant gives the right to subscribe the equity shares at a certain period. The zero coupon
bonds do not carry any coupon rate and sold at discount from their maturity value.
The deep discount bond issued at discount over its face value far below the yield to maturity.
Floating rate bonds are bonds whose interest rate are not predetermined and it is the percentage
point more than the benchmark rate. The benchmark rate is interest rate on treasury bills, bank
rate, and maximum rate on term deposit.
e) Forward Contracts:
It is the contract based on specified price to buy or sale at a definite future date of an asset. The
buyer assumes a long position and decides to buy at a definite future date at a definite price to
buy and the other party gets short position to sell the asset on the same date at specified price.
These are traded outside the stock exchange.
f) Futures or Future Contracts:
It is a contract between 2 parties to buy or sale an asset at a definite time in the future, at a
definite price. It solves the different issues related to the forward market. It reduces the counter
party risk as seen in forward contract.
The future contracts are traded in an organized stock market while forward contract are traded in
OTCEI. The future contracts are standardized contract which follow daily settlement. The
forward contracts are customized contract terms and settlement done at the conclusion of the
period. g) Options or Option Contracts:
In forward contract and future contract, the parties dedicated themselves to do something whereas
in case of option contract the parties get option the right to do something. The forward contract
and future contract does involve any charge any cost. But the option contract requires an up-front
payment. The option contracts are of two types, call option and put option. In case of call option
the holder get the right not obligation to buy an asset by a definite date for a definite price. In case
of put option the holder gets the right not the commitment to sell an asset on a pre-set date for a
pre-set price.
8. Capital Market Intermediaries
PRIMARYPRIMARY MARKET INTERMEDIARIES
The primary market deals with the sale of new securities. The following are the primary market
intermediaries:
A. MERCHANT BANKER OR LEAD MANAGERS:
Merchant bankers are corporate body who involve in issue of securities. It acts as
manager or advisor or consultant to issuing company. A merchant banker needs a
mandatory registration under the regulation 3 of SEBI (Merchant Bankers)
Regulations, 1992. These activities broadly involves defining the composition of
capital structure, compliance with procedural formalities , appointment of
registration , listing of securities, organisation of underwriting , selection of
brokers & bankers, publicity & advertisement agent , private placement of
securities, advisory services, etc. The merchant bankers are responsible to make
all attempts to safeguard the interest of investors. Due diligence, high standards
of integrity, dignity has to be applied by the merchant bankers. The merchantbankers are also
accountable in giving sufficient information without misleading
about the applicable regulations and guidelines. Now, it is obligatory for all
public issues to be managed by merchant bankers working as the leading
managers.
B. UNDERWRITER:
An underwriter may be an individual, broker, merchant banker, financial
institution or banks. The underwriting is an arrangement among the issuing
company & the assuring party via an agreement to take up shares or debentures
or other securities to a definite extent in case public subscription does not amount
to the expected level. Thus, in case of any shortage, it has to be made sufficient
by underwriting arrangements by the underwriter as per the agreement.
C. DEBENTURE TRUSTEES:
The issuing company has to make appropriate arrangements and fulfil the legal
necessities for the investor. The company provides these amenities to the
investors for a fee under a plan implementing as trust deed with the trustee who
are mainly banks and financial institutions and file the similar with the Registrar
of Companies. The chief responsibility of the debenture trustees is mainly the
ownership of trust property in agreement with the trust deed, taking periodical
report from the body corporate, enforce security of interest, protection of the
debenture holders, inspect books of a/c, notify SEBI if any breach of trust deed
etc.
D. REGISTRARS AND SHARE TRANSFER AGENTS:
These are very significant intermediaries in organizing new capital, keeping
records, determining the basis of allotment etc. for the investors. They are very
suitable in case of share transfer, sale, as it supports in liquidity to the investors
of their investment. They also offer this service to the existing companies. But
this responsibility decreases as depository system comes into play. But the share
transfer agents will have to work unless the old system is entirely abolished and
the shareholding completely switch over to dematerialized system, The ‘Registrar
to an issue means, any individual appointed by the company or group of
individuals transmit out such activities on its behalf i.e. collecting applications,
maintaining records, determining the basic for allotment of securities, finalizing
the list from the same, process & dispatch of allotment letters etc.
The ‘Share Transfer Agents’ means, any person who keep records of holder of
securities on behalf of any corporate. They manage all matters linked with it, like
redemption, transfer of securities etc. It can be a unit of a body corporate
performing the activities at any time the total no. of holders of its securities
issued is greater than one lakh.s.
The Chapter I of SEBI (Bankers to an Issue) Regulations, 1994, deals
with Banker to an issue.
The Banker to issue means a schedule bank performing on all or any of
the following activities:
A. Acceptance of application and application money.
B. Acceptance of allotment or call money.
C. Refund of application money
D. Payment of dividend or interest warrant. SECONDARY MARKET INTERMEDIARIES
The trading of securities that are initially offered is dealt by the secondary
market. The below mentioned are the secondary market intermediaries:
A. PORTFOLIO MANAGER:
The word ‘portfolio’ refers to the total sum of holdings of securities owned by
any person and the portfolio manager is the person who under an arrangement
with the client, instructs or guides the management and administration of such
portfolio of securities. The portfolio manager has to move into an agreement on
behalf of a client and it contains:
1. The investment objectives,
2. Area of investment,
3. Type of instrument,
4. Custody of securities,
5. Procedure of client’s account etc.
B. STOCK BROKERS:
Stock brokers are members of known stock exchanges who buy and sell or deals
in securities. For a broker to transact in the securities on a recognized stock
exchange, it is mandatory that he must be registered as a stock broker with SEBI.
They simplifies transaction of securities in the secondary market. The stock
broker has to engage into an agreement with his client before buying & selling of
securities. Person should have a client account with a registered broker or subbroker
to buy or sell securities and will have to do the transaction through such
broker or sub-broker. A brokerage commission is charged by the broker or subbroker
for enabling transaction.
C. CUSTODIAN:
It means any individual who delivers custodial services with respect to securities
of a client or safe keeping of gold or gold related instrument. They run their
purpose by opening custodial account which is an account of a client preserved
by a custodian of securities. Any individual who recommends to move such
business as custodian of securities will have to give an application to SEBI for
grant of a certificate for registration. The applicant satisfies the capitalrequirement specified under
regulation 7(1), a net worth of at least rupees 50
crore. The applicant should have the essential infrastructures and should follow
all rules and regulation approved under any law for the time being in force
relating to securities, gold or gold related instrument. The applicant should be
skilled person and the grant of certificate is in the interest of investor. Custodian
has the duty to examine their affairs through the inspecting officer such as books,
securities etc. Financial Regulators in India
The supervision and regulation of the Indian financial system is carried out by various regulatory
authorities; namely –
1. Securities and Exchange Board of India (SEBI)
2. Reserve Bank of India (RBI)
3. Ministry of Finance (MoF)
4. Ministry of Corporate Affairs (MCA)
5. Insurance Regulatory Authority of India (IRAI)
6. Pension Funds Regulatory and Development Authority (PFRDA)
The Reserve Bank of India (RBI) is the foremost authority that regulates & supervises the
important part of the financial system. The controlling role of the RBI covers commercial banks,
some financial institutions, urban cooperative banks (UCBs), and non-banking finance companies
(NBFCs). Moreover, some other financial institutions, in turn, supervises & regulates different
institutions in the financial sector, for example, National Bank for Agriculture and Rural
Development (NABARD) oversees Regional Rural Banks and the Co-operative banks; and
National Housing Bank (NHB) supervises housing finance companies.
Activities of corporate, like Deposit taking, other than NBFCS, registered under companies Act
are regulated by the Department of Company Affairs (DCA), Government of India (GoI), at the
same time not those which are under isolated statutes.
The Registrar of Cooperatives of various states on account of single state cooperatives and the
Central Govt in the case of multi-state cooperatives are joint controllers, with the RBI for UCBs,
and with NABARD for rural cooperatives. Whereas, RBI and NABARD sees the banking
functions of the co-operatives and the management control rests with the State/ Central Govt.
This “dual control” effects the supervision & regulation of the cooperative banks.
Securities and Exchange Board of India (SEBI) regulates the capital market, mutual funds, and
other capital market intermediaries are regulated. The insurance sector is regulated by the
Insurance Regulatory and Development Authority (IRDA); and the pension funds by the Pension
Funds Regulatory and Development Authority (PFRDA).
5. Salient features of the present Regulation
At present, financial regulation in India is product-oriented, i.e. each product is separately
regulated. For example, fixed deposits & other banking products are regulated by the RBI, small
savings products by the GoI, mutual funds and equity markets by the SEBI, insurance by the
IRDA and the New Pension Scheme (NPS) by the PFRDA. All these regulators have a key
mandate to safeguard the interests of customers - these may be investors, policy holders or
pension fund subscribers, depending on the product.
India has a bequest financial regulatory architecture. The present work division between RBI,
SEBI, IRDA, PFRDA, and Forward Market Commission (FMC) – was not designed; it has
evolved over the years, with a sequence of piecemeal decisions as a response to immediate
pressures from time to time.
Each regulator have their own rules on registration, code of conduct, commissions and fees to
monitor the product providers and distributors. RBI, SEBI & IRDA have grievance redress
procedures through sector financial Ombudsmen services.
5.1: SECURITIES AND EXCHANGE BOARD OF INDIA
SEBI is the apex body for regulating the securities market in India. It came into existence in 1988
and was given statutory powers on April 12, 1992 through the 1992 SEBI Act.
It has the following powers:
(a) Protection of the interests of investors in securities,
(b) Development and promotion of the securities market; and
(c) Regulating & controlling the securities market. The regulatory jurisdiction of SEBI covers
corporates on the factors relating to issue of capital & transfer of securities, in addition to all
intermediaries and persons associated with securities market.
It has powers for:
1. Regulating and controlling the business of stock exchanges and any other securities market
operating in India
5. Gathering information, undertaking inspection, conducting inquiries and auditing the stock
exchanges, intermediaries, self–regulatory organizations, mutual funds and other persons
associated with the securities market.
Maintaining confidence of public in the financial system, protect depositors' interest and
thereby, provide cost-effective banking services to the public.
The central board of directors govern the affairs of the Reserve Bank. The board of directors are
appointed by the GoI keeping in line with the Reserve Bank of India Act.
CENTRAL BOARD
Appointed/nominated for a period of 4 years
Constitution:
o Official Directors
Full-time : Governor and not more than four Deputy Governors
o Non-Official Directors
Nominated by Government: 10
Directors from various fields and 2 government officials
Others: 4 Directors - one each from four local boards
Main Functions
Monetary Authority:
Formulation, implementation and monitoring of the monetary policy.
Objective: maintaining the price stability and ensuring adequate flow of credit to productive
sectors.
Regulator and supervisor of the financial system:
Prescribing broad parameters of banking operations within which the country's banking and
financial system must function.
Objective: maintaining the public confidence in the system, protecting the depositors' interest and
providing cost-effective banking services to the public.
Manager of Foreign Exchange
Managing the Foreign Exchange Management Act, 1999.
Objective: facilitation of external trade & payment and promoting orderly development and
maintenance of foreign exchange market in India.
Issuer of currency:
Issuing and exchanging or destroying the currency & coins not fit for circulation.
Objective: giving the public satisfactory amount of supplies of currency notes & coins and also in
best quality.
Developmental role
Performing extensive range of promotional functions to support national goals.
Related Functions
RBI performs a function of being a banker to the Government whereby it performs merchant
banking function for the central and the state governments; and also acts as their banker.
28 Regional Offices and Branches: which are the operational arms and customer
interfaces of the Reserve Bank headed by Regional Directors. Additionally, the smaller
branches or sub-offices are headed by a General Manager / Deputy General Manager.
Training centres: The Reserve Bank Staff College at Chennai caters to the training
needs of the selected RBI officers; the College of Agricultural Banking at Pune trains staff
of co-operative and commercial banks, including regional rural banks. Moreover, the Zonal
Training Centres located at various regional offices, trains non-executive staff.
Research institutes: There are RBI-funded institutions to provide training and research
on banking issues, economic growth and banking technology, such as, National Institute of
Bank Management (NIBM) at Pune, Indira Gandhi Institute of Development Research
(IGIDR) at Mumbai, and Institute for Development and Research in Banking Technology
(IDRBT) at Hyderabad.
NPS consists of the income tax deduction that is available to the individuals when they make
their own contribution to the fund. There is an overall limit of INR 1 lakh for contributions under
eligible investments for Section 80C, pension fund contributions (Section 80CCC) and
contribution to NPS (Section 80CCD).
A flexible investment option:
NPS gives its subscribers the control on the choice of investment made by them and the fund
manager who manages the investments. Subscribers can switch over from one investment option
to another or from one fund manager to another subject, of course, to certain regulatory
restrictions.
Low Cost & Power of compounding:
NPS has the lowest account maintenance costs when contrasted with similar pension products
available in India, like retirement plans offered by Insurance companies and mutual funds. The
cost matters the most while saving for a long-term objective such as retirement. Till the
retirement pension wealth accumulation grows over a period of time with a compounding effect.
The account maintenance charges being low, the benefit of accumulated pension wealth to the
subscriber eventually become large.
Safe retirement fund:
This fund was introduced by GoI and regulated by the Pension Fund Regulatory & Development
Authority (PFRDA) and hence can be vouched as the safest retirement fund. Problems with
numerous regulators in India
There are differing regulatory pre-requistes because of numerous regulators in India which often
leads to regulatory arbitrage. Consider, for example, the similarity between mutual funds and
ULIPs. Mutual funds which is regulated by the SEBI and the ULIPS which are regulated by the
IRDA. For mutual funds, SEBI imposes very different levels of disclosure & there is ongoing
transparency on the outcomes of mutual funds as compared to the standards of disclosure
required by the IRDA. Consider another example on differing standards of regulation on
distributors. The bank employees, who come under regulation by the RBI, can distribute financial
products such as mutual funds & insurance products, without adhering to the rules & regulation
of SEBI and IRDA.
Hence, the present arrangement has gaps and there is no regulator who is in charge for them. The
numerous kinds of ponzi schemes that surface now and then in India, which are not regulated by
any of the existing agencies. Moreover, other organisations like the chit-funds appear to be
completely out of the purview of any of the financial sector regulator.
There is overlapping between laws and agencies of the existing financial agencies which leads to
incidences in which conflicts between regulators. This has consumed the energy of economic
policy makers & also held back market development.
Recent investigations on alleged money laundering by some banks using insurance products and
the litigation by SEBI against the Sahara group are good examples of regulatory gaps and
arbitrage opportunities.
Reflecting these difficulties, the present Indian financial regulatory architecture has, over the
years, been universally criticized.
7. Regulatory Reliance on credit Rating Agencies
Think –tanks such as the World Pension Council (WPC) has argued that most European
governments pushed dogmatically for adopting the Basel II recommendations. Basel II was
adopted in 2005, transported in the European Union Law via the Capital Requirements Directive
(CRD) in 2008. Essentially, European banks were forced e.g. when assessing the solvency of
European Union-based financial institutions, to rely more than ever on the standardized
assessments of credit risk marketed by two private US agencies –Moody’s and S&P, thus using
public policy and ultimate taxpayers’ money to strengthen an anti-competitive duopolistic
industry. Ironically European governments have abdicated a key component of their regulatory
authority in favour of a non-European, highly deregulated, private cartel. Financial Sector
during Pre-liberalization
Until the beginning of the 1990s, the state of the financial sector in India could be described as a
classic example of ‘financial repression’. The sector was characterized by 1) Administered
interest rates: Large pre-emption of resources by the authorities and extensive micro regulations
directing the major portion of the flow of funds to and from financial intermediaries. While the
true health of financial intermediaries, most of them public sector entities, was masked by
relatively
2) Opaque accounting norms and limited disclosure: There were general concerns about their
viability. Insurance companies both life and non-life were all publicly owned and offered very
little product choice.
3) Complex regulations and extensive restrictions: In the securities market, new equity issues
were governed by a plethora of complex regulations and extensive restrictions. There were very
little transparency and depth in the secondary market trading of such securities. Interest rates on
government securities, the pre-dominant segment of fixed-income securities, were decided
through administered fiat. The market for such securities was a captive one where the players
were mainly financial intermediaries, who had to invest in government securities to fulfill high
statutory reserve requirements. There was little depth in the foreign exchange market as most
such transactions were governed by inflexible and low limits and also prior approval
requirements.
Compartmentalization of activities of different types of financial intermediaries eliminated the
scope for competition among existing financial intermediaries. In addition, strong entry barriers
thwarted competition from new entrants. The end result was low levels of competition, efficiency
and productivity in the financial sector, on the one hand, and severe credit constraints for the
productive entities, on the other, especially for those in the private sector. The other major
drawback of this regime was the scant attention that was placed on the financial health of the
intermediaries.
4) Capitalization levels were low: The lack of commercial considerations in credit planning and
weak recovery culture resulted in large accumulation of non-performing loans. This had no
impact on the confidence of depositors, however, because of government ownership of banks and
financial intermediaries.
5) Predominance of government securities: In the fixed income securities market of India
mainly reflects the captive nature of this market as most financial intermediaries need to invest a
sizable portion of funds mobilized by them in such securities. While such norms were originally
devised as a prudential measure, during certain periods, such statutory norms pre-empted
increasing proportions of financial resources from intermediaries to finance high government
borrowings. The interest rate on government debt was administered and the rate of interest
charged by the Reserve Bank of India (RBI) for financing government deficit was concessional.
6) Limited external capital flows. Such a closed-economy set-up kept debt markets
underdeveloped and devoid of any competitive forces. In addition, there was hardly any
secondary market for government securities, and such transactions were highly opaque and
operated through over-the-telephone deals. The provision of fiscal accommodation through ad
hoc treasury bills led to high levels of monetization of fiscal deficit during the major part of the
1980s.
7) Phase of nationalization and ‘social control’ of financial intermediaries: however, was not
without considerable positive implications as well. The sharp increase in the rural branches of
banks increased saving and deposits growth considerably. There was a marked rise in credit flow
towards economically important but hitherto neglected activities, most notably agriculture and
small scale industries. The urban-bias and marked preference of banks to lend to the industrial
sector, especially large industrial houses, was contained. The implicit guarantee emanating from
public ownership created animpression of infallibility of these institutions and the expectation
was self-fulfilling- there was no major episode of failure of financial intermediaries in this period.
Starting from such a position, it is widely recognized that the Indian financial sector after 1991
has been transformed into a reasonably sophisticated, diverse and resilient system. However, the
transformation has been the culmination of extensive, well-sequenced and coordinated policy
measures aimed at making the Indian financial sector efficient, competitive and stable.
4. Approach of the Financial Sector Reforms
The initiation of financial reforms in the country during the early 1990s was to a large extent
conditioned by the analysis and recommendations of various committees and working group’s
setup to address specific issues. The process has been marked by ‘gradualism’ with measures
being undertaken after extensive consultations with experts and market participants. From the
beginning of financial reforms, India has resolved to attain standards of international best
practices but to fine tune process keeping in view the underlying institutional and operational
considerations [Reddy 2002a]. Reform measures introduced across sectors as well as within each
sector were planned in such a way so as to reinforce each other. Attempts were made to
simultaneously strengthen the institutional framework while enhancing the scope for commercial
decision-making and market forces in an increasingly competitive framework. At the same time,
the process did not lose sight of the social responsibilities of the financial sector. However, for
fulfilling such objectives, rather than using administrative fiat or coercion, attempts were made to
provide operational flexibility and incentives so that the desired ends are attended through broad
interplay of market forces.
The major aim in the early phase of reforms, known as first generation of reforms was to create
an efficient, productive and profitable financial service industry operating within the environment
of operating flexibility and functional autonomy. While these reforms were being implemented,
the world economy also witnessed significant changes. The focus of the second phase of financial
sector reforms starting from the second-half of the 1990s, therefore, has been the strengthening of
the financial system and introduction of structural improvements.
Two brief points need to be mentioned here. First, financial reforms in the early 1990s were
preceded by the measures aimed at lessening the extent of financial repression. However, unlike
in the latter period, the earlier efforts were not part of a well thought out and comprehensive
agenda for extensive reforms. Second, financial sector reform in India was an important
component of the comprehensive economic reform process initiated in the early 1990s. Whereas
economic reforms in India were also initiatedfollowing an external sector crisis, unlike many
other emerging market economies where economic reforms were driven by a boom-bust pattern
of policy liberalization, in India, reforms followed a consensus driven pattern of sequenced
liberalization across the sectors [Ahluwalia 2002]. That is why despite several changes in
government there has not been any reversal of direction in the financial sector reform process
over the last two decades.
An important salient feature of the move towards globalization of the Indian financial system has
been the intent of the authorities to move towards international best practices. This is illustrated
by the appointment of several advisory groups designed to benchmark Indian practices with
international standards in several crucial areas of importance like monetary policy, banking
supervision, data dissemination, corporate governance and the like. Towards the end, a Standing
Committee on International Financial Standards and Codes (chairman: Y.V Reddy) was
constituted and the recommendations contained therein have either been implemented or are in
the process of implementation.
5. Policy Reforms in the Financial Sector
The story of Indian financial reforms has been divided into four parts viz.
Banking reforms
Debt market reforms
Forex market reforms
Reforms in other segments of the financial sector
Banking Reforms
Commercial banking constitutes the largest segment of the Indian financial system. Despite the
general approach of the financial sector reform process to establish regulatory convergence
among institutions involved in broadly similar activities, given the large systemic implications of
the commercial banks, many of the regulatory and supervisory norms were initiated first for
commercial banks and were later extended to other types of financial intermediaries.
After the nationalization of major banks in two waves, starting in 1969, the Indian banking
system became predominantly government owned by the early 1990s. Banking sector reform
essentially consisted of a two-pronged approach. While nudging the Indian banking system to
better health through the introduction of international best practices in prudential regulation and
supervision early in the reform cycle, the idea was to increase competition in the system
gradually. The implementation periods for such norms, were, however, chosen to suit the Indian
situation. Special emphasis was placed on building upthe risk management capabilities of the
Indian banks. Measures were also initiated to ensure flexibility, operational autonomy and
competition in the banking sector. Active steps have been taken to improve the institutional
arrangements including the legal framework and technological system within which the financial
institutions and markets operate. Keeping in view the crucial role of effective supervision in the
creation of an efficient and stable banking system, the supervisory system has been revamped.
Unlike in other market countries, many of which had the presence of government owned banks
and financial institutions, banking reform has not involved large scale privatization of such banks.
The approach, instead, first involved recapitalization of banks from government resources to
bring them up to appropriate capitalization standards. In the second phase, instead of
privatization, increase in capitalization has been done through diversification of ownership to
private investors up to a limit of 49 per cent, thereby keeping majority ownership and control
with the government. With such widening of ownership most of these banks have been publicly
listed, this was designed to introduce greater market discipline in bank management, and greater
transparency through enhanced disclosure norms. The phased introduction of new private sector
banks, and expansion in the number of foreign bank branches, provided from new competition.
Meanwhile, increasingly tight capital adequacy, prudential and supervision norms were applied
equally to all banks, regardless of ownership.
Government Debt Markets Reforms
Major reforms have been carried out in the government securities (G-Sec) debt market. In fact, it
is probably correct to say that a functioning G-Sec debt market was really initiated in the 1990s.
The system had to essentially move from a strategy of pre-emption of resources from banks at
administered interest rates and through monetization to a more market oriented system.
Prescription of a ‘statutory liquidity ratio’ (SLR), i.e. the ratio at which banks are required to
invest in approved securities, though originally devised as a prudential measure, was used as the
main instrument of pre-emption of bank resources in the pre-reform period. The high SLR
requirement created a captive market for government securities, which were issued at low
administered interest rates. After the initiation of reforms, this ratio has been reduced in phases to
the statutory minimum level of 25 per cent. Over the past few years numerous steps have been
taken to broaden and deepen the government securities market and to raise the levels the
transparency. Automatic monetization of the government’s deficit has been phased out and the
market borrowings of the central government are presently undertaken through a system of
auctions at market-related rates.
The key lesson learned through this debt market reform process is that setting up such a market is
not easy and needs a great deal of proactive work by the relevant authorities. An appropriate
institutional framework has to be created for such a market to be built and operated in a sustained
manner. Legislative provisions, technology development, market infrastructure such as settlement
systems, trading systems and the like have all to be developed.
Forex Market Reforms
The Indian foreign exchange (forex) market had been heavily controlled since the 1950s, along
with increasing trade controls designed to foster import institution. Consequently, both the
current and capital accounts were closed and foreign exchange was made available by the RBI
through a complex licensing system. The task facing India in the early 1990s was therefore to
gradually move from total control to a functioning foreign exchange market. The move towards a
market-based exchange rate regime in 1993 and the subsequent adoption of current account
convertibility were the key measures in reforming the Indian foreign exchange market. Reforms
in the foreign exchange market focused on market development with prudential safeguards
without destabilizing the market [Reddy 2002a]. Authorized dealers of foreign exchange have
been allowed to carry on a large range of activities. Banks have been given large autonomy to
undertake foreign exchange operations. In order to deepen the foreign exchange market, a large
number of products have been introduced and entry of newer players has been allowed in the
market.
The Indian approach to opening the external sector and developing the foreign exchange market
in a phased manner from current account convertibility to the ongoing process of capital account
opening is perhaps the most striking success relative to other emerging market economies. There
have been no accidents in this process, the exchange rate has been market determined and flexible
and the process has been carefully calibrated. The capital account is effectively convertible for
non-residents but has some way to go for residents. The Indian approach has perhaps gained
greater international respectability after the enthusiasm for rapid capital account opening has
dimmed since the Asian crisis.
Reforms in Other Segments of the Financial Sector
Measures aimed at establishing prudential regulation and supervision and also competition and
efficiency enhancing measures have also been introduced for non-bank financial intermediaries as
well. Towards this end, non-banking financial companies (NBFCs) especially those involved in
deposit taking activities have been brought under the regulation of RBI. Development finance
institutions (DFIs), specialized term-lending institutions, NBFCs, urban cooperative banks and
primary dealers have all been brought under the supervision of the Board for Financial
Supervision (BFS). With the aim of regulatory convergence for entities involved in similar
activities, prudential regulationand supervision norms were also introduced in phases for DFIs,
NBFCs and cooperative banks.
The insurance business remained within the confines of public ownership until the late 1990s.
Subsequent to the passage of the Insurance Regulation and Development Act in 1999, several
changes were initiated, including allowing newer players/joint ventures to undertake insurance
business on risk-sharing/commission basis. The Insurance Regulatory and Development Agency
(IRDA) has been established to regulate and supervise the insurance sector.
With the objective of improving market efficiency, increasing transparency, integration of
national markets and prevention of unfair practices regarding trading, a package of reforms
comprising measures to liberalize, regulate and develop capital market was introduced. An
important step has been the establishment of the Securities and Exchange Board of India (SEBI)
as the regulator for equity markets. Since 1992, reform measures in the equity market have
focused mainly on regulatory effectiveness, enhancing competitive conditions, reducing
information asymmetries, developing modern technological infrastructure, mitigating transaction
costs and controlling of speculation in the securities market. Another important development
under the reform process has been the opening up of mutual funds to the private sector in 1992,
which ended the monopoly of Unit Trust of India (UTI), a public sector entity. These steps have
been buttressed by measures to promote market integrity.
The Indian capital market was opened up for foreign institutional investors (FIIs) in 1992. The
Indian corporate sector has been allowed to tap international capital markets through American
Depository Receipts (ADRs), Global Depository Receipts (GDRs), Foreign Currency Convertible
Bonds (FCCBs) and External Commercial Borrowings (ECBs). Similarly, Overseas Corporate
Bodies (OCBs) and non-resident Indians (NRIs) have been allowed to invest in Indian
companies. FIIs have been permitted in all types of securities including government securities
and they enjoy full capital convertibility. Mutual funds have been allowed to open offshore funds
to invest in equities abroad.
6. Recent Developments
From the vantage point of 2004, one of the successes of the Indian financial sector reform has
been the maintenance of financial stability and avoidance of any major financial crisis during the
reform period- a period that has been turbulent for the financial sector in most emerging market
countries.
While the basic objectives of monetary policy, namely, price stability and ensuring adequate
credit flow to support growth, have remained unchanged, the underlying operating environment
for monetary policy has undergone a significant transformation. An increasing concern is the
maintenance of financial stability. The basic emphasis of monetary policy since the initiation of
reforms has been to reduce market segmentation in the financial sector through increase in the
linkage between various segments of the financial market including money, government
securities and forex market.
The key policy development that has enabled a more independent monetary policy environment
was the discontinuation of automatic monetization of the government’s fiscal deficit through an
agreement between the government and the RBI in 1997. The enactment of the Fiscal
Responsibility and Budget Management Act (FRBM) has strengthened this further from 2006;
the Reserve Bank will no longer be permitted to subscribe to government securities in the primary
market. The development of the monetary policy framework has also involved a great deal of
institutional initiatives to enable efficient functioning of the money market: development of
appropriate trading, payments and settlement systems along with technological infrastructure.
7. Summary
Case Study: US Financial Crisis 2007-2009
Following the dot com bubble, US economy was already slumping into a recession and it was
then that the terrorist attack of 9/11 happened which stroked the ultimate symbol of global
economy, the twin towers of world trade centre. In the spring of 2001, Federal Reserve started
lowering interest rates from 6.5% to 1% till 2003 to keep employment down and to save
companies on a brink. Citizens were asked to shop more. Politicians encouraged home ownership
by creating subsidies and legislations that pushed lenders to lend. The low interest rate led to the
increase in the investment in the household sector and hence to the creation of the housing
bubble. Now bigger homes could be afforded via cheap loans (home acuity loans, also called as
NNA or no income, no asset loans). Government further introduced two home mortgage
financing companies, Fannie mae and Freddie mac, to encourage minority markets. These
companies donated more than 200 million dollars to the politicians and hence they played the role
of both a GSE And then a ESG afterwards. Lenders were carefree about their money. This in a
way created a situation of moral hazard for the borrowers. Banks started selling the mortgages
further to others, Germany, China and Norway, in the form of securities and everybody was
willing to buy them because the rating agencies gave them high and wrong ratings i.e AAA as
they were being paid by the sellers themselves for doing the same. But then in 2006, the spell was
broken as the interest rate realigned themselves to their normal value. People could no longer take
new loans to pay off old loans. The mortgages securities became increasingly worthless and
people with low income could not afford to live. Rating agencies removed the ratings and
investors stopped lending money.
The financial crisis in US economy starting with an economic crisis. To save the economy after
the 9/11 and dot com bubble collapse, govt. tried to save the economy by inflating another bubble
which on bursting led to the real estate credit crisis but then in order to get out of the financial
crisis a new rather big bubble was inflated, the global bubble. This was the bailout bubble. Seeing
the economy falling due to recession and no sales or exports in the economy, they decided to
stimulate packages. Money was fueled in the economy to keep it working. It was not only United
States but china, Australia, United kingdoms and many more economies.
By September 2008, US economy collapsed. Fannie mae and Freddie mac were taken over by the
govt. September 15, 2008 the lehman brothers collapsed resulting in near break down of the
world’s financial system. If not financed by the govt with $85 billion dollar, AIG, world’s biggest
insurer, would have collapsed which would have added to the global financial crisis and it could
have affected millions of lives. On October 13, congress agrees for the biggest financial bailout
that was $700 billion. But it was a waste of money as the objective for the bailout was not
specified which led to uneven distribution of money in the economy. By November 13, there was
a job holocaust in the economy and by December 16, interest was practically reduced to 0% by
the fed to restore investor’s confidence. The same mistake was repeated again but this time US
economy was not alone. This was a step taken at global level and it was a suicidal step. By the
end of the year, all major economies were in recession. Unemployment rate was around 7.2% in
December and US lost almost two million jobs in the last four months. Economic output fell by
0.5%. Alan Greenspan, former chairperson of the fed described the 2007-2009 financial crisis as
a “once in a century credit tsunami”.
Brian T. Moynihan, CEO and President, Bank of America said “Over the course of this crisis, we
as an industry caused a lot of damage. Never has it been clearer how mistakes made by financial
companies can affect Main Street, and we need to learn the lessons of the past few years.” One
must notice that it was the linient behavior of the govt. that indirectly led to the whole chaos. Had
it been the govt. was a little more careful with the policies and bail out the recession could have
been awarded.
Figure 3: Effects of Financial Reforms on the Economy
As discussed earlier, the working of the financial market can have adverse effects on the
economy as whole, sometimes might lead to a depression. So basically any changes in the
financial system will bring about prominent changes in every sector of the economy. Taking into
consideration a few financial reforms, we will discuss their effect on the financial markets and
hence the system.
1. Liberalization : financial liberalization can be referred to as deregulation of ‘control and
command’ system of govt. and the creation of a platform wherein the market forces provides the
price mechanism for the financial institutions. In other words, it is the removal of barriers
imposed by government. According to the financial liberalization theory, Shaw (1973) and
McKinnon (1973), financial liberalization increases savings which leads to increase investment
and hence economic growth. It provides foreign investors incentive to drive up local equity prices
permanently hence reducing the cost of capital. If not liberalization, the monetary policy
introduced in a financial repressed economy would have led to imposing high reserve
requirements or compulsory holdings of bonds which would have lowered interest rate,
discouraging savings and hence crippling down the investment. It has been claimed that it
generates tremendous booms and bursts in the short run and hence the macroeconomic effects of
the same remain controversial. But anyhow, it has become an important element in the economic
policies of all the developing and developed economy lately.
2. Privatization: As the name suggests privatization is the method of reallocating functions of
public assets to the private sector. It is the selling of state owned assets to the private sector. The
main benefit of privatization is the improved efficiency. Private companies have profit incentive
to cut costs, be more efficient and take into consideration the long run effects. The pressure
imposed by the shareholders and increase competitiveness in the market can be the greatest spur
to improvements in efficiency. But then the creation of private owned assets by the govt. itself
can lead to creation of a natural monopoly which might lead to exploitation of consumers due to
high prices charged by them. This type of ownership ignores public interest as their primary
objective is
profit maximization. So privatization, with its pros and cons, is also a major financial reform that
changes the face of the economy. Private companies not only easily raise investment in the
financial markets but also due to higher interest rates charged from them serve as a useful
constraint to promote efficient investments.
3. Globalization: Globalization refers to the integration of the world economies via ideas, views,
products and other aspects of culture. It creates a platform for financial markets to trade at
international level. Globalization of financial market gives financial institutions more
opportunities to extend their area of trade and offer diverse services to the consumers. It gives
access to capital flows, technology, human capital, cheaper imports and larger markets of exports
around the world in the form of FDI. It is even observed that globalization sometimes lead to
income inequalities, global instability due to interdependence. Kofi Annan said “it has been said
that arguing against the globalization is like arguing against the laws of gravity” that is
globalization might lead to few bumps in the short run but protection can make bad situation and
hence globalization is inevitable in the long run.
The introduction of liberalization, privatization and globalization led to a complete makeover of
many developed and developing countries, like USA and India.
Taking into consideration the case of the USA, one would notice that the impact of the economic
crisis of the great depression in the 1930s and the recent great recession of 2008 were very
different as great recession was a “global” crisis. It affected not only USA but also created a spill
over effect in other economies. Due to financial reforms that were introduced in the economic
policies of almost every developing and developed countries interconnected the financial
markets, so, not only USA but Mexico, Venezuela, Iceland, Ireland, Spain, United Kingdom,
Italy, Egypt etc were the victims of the crisis.
7. The Concept Of Capital Mobility And Financial Integration
Capital mobility is the easy and seamless movement of capital from one country to another. The
financial reforms encourage capital mobility but many did oppose free mobility of private capital
as it was observed to be behind the succession of crises during the 1990s. It can affect economic
performance in the following ways:
a. Via foreign savings: countries with more open capital account will be able to easily finance its
capital account deficit and hence increase volume of foreign savings that if not accompanied by
decline in domestic savings would increase aggregate savings and hence higher investment
followed by economic growth.
b. Via efficiency and productive growth: elimination of capital controls tend to result in high
return in investment and higher productive growth. So the ones with capital mobility will be
better than the ones with capital controls.
c. It may even inflict costs in countries with increased capital mobility which would limit the
benefit to the developing countries making them more vulnerable to the volatility of global
financial markets.
Financial integration, as the name suggests, is the process which interlinks different
financial markets irrespective of the political or economic boundaries. These integrated
economies have synchronized GDP fluctuations and even consumption patterns. It leads
to better capital flow and governance, high investment and also sharing of risks. But a
high degree of financial integration can also lead to economic instability and may lead to
inequality as capital scarce countries can be exploited by the capital rich ones.