FINANCIAL INSTITUTES AND MARKETS.

DEC 2018 EXAM

QUESTION 1  As a consultant suggest the various methods as to how ABC
fashion p ltd. Can raise funds through primary and secondary markets for their
business ?
Capital Markets are divided into
Primary Markets Secondary Markets

Definition of primary markets New shares are issued for first time to
investors

Example Launch of IPO by company

Sub category of primary markets instruments

Public Issue IPO Sale of securities to general public for

the first time via an IPO
Right Issue Issue of shares to existing shareholders
for raising supplementary capital
Private placement *Not for retail investor.
*Sale of share to venture capital fund;
mutual fund; etc.
Preferential allotment Sales of equity share to a selected no of
individual at a special price.

TYPE OF INSTRUMENTS WHICH ARE TRADED IN MARKET

FIXED INCOME SECURITIES VARIABLE INCOME SECURITIES

Bonds
Debentures
Mortgage backed Securities
Asset backed Securities
Here the company is bonded to give a
fix return to the investor. Hence the
name fined income. This is a debt for
the company.
Equities
Preference shares
Derivative securities
Here the returns are linked to the profit
made by the firm. The risk and reward
are shared with the stakeholders. Here
the shareholders of the firm become the
de facto partners of the firm.

SECONDARY MARKETS
 Definition :- It is the market wherein the securities are issued in primary
market are traded.
 Difference between primary and secondary market is that the company sells
securities to investor directly in a primary market. In a secondary market the
investor gets securities from the entity who want to dispense securities.
  Instrument traded in secondary markets are same as primary markets such as
equities, debentures, bonds and preference shares.
 The trading mechanism of secondary market is broker selection  open
demat account  order placement  settlement  execution of order.
 As a new company seeking funds the market regulator and relevant stock
exchange are to be approached first. All terms and conditions of the stock
exchange to be fulfilled and a IPO launched for sale of share in the company.
Typically in Indian markets the lauch price of IPO trades at a minimum P/E of
18. Thus company get a premium price as compared to the actual investment
of the promoters. The capital so raised by the company is to be utilized by the
firm for various objectives the end result of which should be generation of
appreciated income for shareholders in terms of increase in sales, profit which
is redistributed to them via dividends.
Question 2. You are a financial advisor in a financial advisory firm. Your client apart
from his existing investment; wants to diversify portfolio into MF. Help your client to
know about details of MF. Discuss various characteristics; advantages and
disadvantages of investing in the MF.
Definition  A Mutual Fund is a financial instrument in which investor and general
public can invests their savings in order to meet their investment objectives.
Features
Investment is done in a combination of securities. Diversification benefits are
incurred by the investors. And the investment can be started with a small
amount of money. This is in contrary to say real estate market. Here the
investment to be done is huge and also illiquid as compared to mutual funds.
The funds are managed by professional fund managers. Thus investors have
an advantage of expert opinion. These fund managers are alumni of
renowned institutes like IIM and have years of experience – thus the
investment is handled by experts of the field.
The mutual funds have Red Herring Prospectus. Here all the information
related to mutual funds are available and the objectives of the funds are also
well defined.
Mutual fund typically hold only 5 to 6 percent of total asset under
management in a particular company. Thus the risk faced by the investor is
heavily diversified.
Unit is the smalles element of MF. The investor buys units of MF. Much
similar to share bought in case of listed companies.
NAV (NETT ASSET VALUE) of the fund is calculated by subtracting the total
liabilities of the fund from the total value of all securities.
NAV of unit is the price paid by the investor to buy a unit.
Classification
GROWTH Here the objective is long term
appreciation of capital. Investment is
 predominantly in shares. Risk and
reward both are high.
DEBT These are fixed income securities
investment such as debentures and
debts. Their investment objective is
consistent income stream. Risk is less
and reward is less as well
MONEY MARKET Gilts – short term funds. Short term
income debts. These are utilized for
keeping finance for a short while and
earning interest on working money by
institutes.
BALANCE Here investment is done in a mix of
equity and debt. The risk and reward
both are average.

ADVANTAGES AND DISADVANTAGES OF MUTUAL FUNDS

ADVANTAGES DISADVANTAGES
Advance portfolio management High expense ratio and sales charges
Dividend reinvestment Management abuses
Reduce risk via diversification Tax inefficient if withdrawn before 12
months
Convenience and fair pricing Porr trade execution by handlers.

CONCLUSION :-
For an average investor – the available option of investment are
A) Traditional Bank FD, Post Office Schemes, Other Govt. Debt instruments.
These yield returns which are at time just beating inflation or even less. Hence
no real growth in terms of buying power.
B) Direct investment in shares – this is risky and time consuming. Rewards are
dependent on entry and exit points and no high skill manager services are
available for handling funds on day to day basis.
C) Real estate – low liquidity; lesser yields on rent; long term appreciation is
questionable; deliberate process of investment; huge amounts of funds to be
committed.
D) Gold – has seen low performance for many years now. Is not a preferred
investment option as Gold keeping is a costly affair.
E) Mutual funds – with an SIP can be probably the only solution for a retail
investor where funds are handled by professionals; with an SIP the entry / exit
risk are reduced; as a history the returns are higher than benchmark index for
most of the funds.
Q3. Arun has recently got placed in a public sector bank. His manager asks him to prepare a short presentation
on the following. Help Arun to prepare with his presentation.
A) Enumerate how Cash Reserve ratio (CRR) is used as a credit control tool by RBI.
(5 Marks)

When RBI raises Cash Reserve Ratio, banks will be left with lesser money to lend. Hence any raising of CRR will
lead to contraction in money supply. The effect will be reversed if CRR is reduced as any reduction in CRR will
leave more money in the hands of the Banks to lend.

As per the section 42 of the RBI Act, 1934, Cash Reserve Ratio (CRR) is an amount that all commercial banks

have to maintain with RBI. RBI publishes the CRR in a timely manner as a percentage of its total net demand and

time liabilities (NTDL) relative to the 2nd previous fortnight. As of March 7, 2017, CRR is 4% of NDTL. This basically

means that CRR is calculated as specified minimum percentage on the total amount of deposits that commercial

banks have from its customers. Commercial banks have to hold this fraction of total deposit of the customer

deposits as reserve at RBI, either in cash or as deposits.

CRR is set as per the guidelines of RBI. It is mandatory to maintain the Cash Reserve Ratio requirements as

prescribed by the RBI. Banks need to maintain a minimum 95% of the required CRR on a daily basis whereas on

an average 100% needs to be maintained fortnightly. Banks failing to maintain the CRR can attract penal charges

by RBI. CRR in India has hovered around an average of 5.61% for the last 18 years i.e. from 1999 to 2017.

During this period, it reached an all time high of 10.5% in March’ 1999 and touching the all time low in Feb 2013

at 4%.

The chart below shows the trend the CRR rate in India for the 18 years:
 Banks’ primary objective is to lend money. They earn profit from maximizing their lending power i.e. by giving loans.

For this, banks source their money from their depositors/customers in the form of deposits. Banks offer deposit

schemes to their customers which often attract healthy deposits and they, in turn, lends the same money to its

borrowers at a considerably higher rate of interest as compared to the rate of interest offered for deposits. The

difference between the rate of interest of deposits and loans is called the profit that a bank earns.

Now consider a scenario, let us assume Mr. Vaibhav has deposited Rs.100 with the bank, and the bank has lent

the same Rs.100 to XYZ Pvt. Ltd as a commercial loan on condition to repay the loan back after 2 years. Now after

6 months, Mr. Vaibhav wants Rs.10 to buy a vehicle out of his deposited amount. Now, the bank is in trouble as it

does not have the money that Mr. Vaibhav had kept with them. This is exactly the scenario that RBI and in turn

every bank wants to avoid. And this is where the Cash Reserve Ratio comes into picture. CRR plays an important

role to avoid this kind of scenario. Let us now understand how Cash Reserve Ratio rescues banks from such

undesirable circumstances.

As we know that all commercial banks accept deposits from its customer for a certain period by agreeing to pay

certain interest on them and use those deposits to give various loans. Now, CRR is that percentage of deposits

which all the Commercial Banks are liable to maintain as a reserve with the RBI. The money that is parked at RBI

cannot be used by banks to give loans. Let us now consider how CRR works with the above stated example:

consider bank CRR is 10%, then banks would have accepted Rs 100 from Mr. Vaibhav, kept Rs 10 as reserve and

would have given Rs 90 for loan purposes to XYZ Pvt. Ltd., so when Mr. Vaibhav suddenly demands a fraction of

his money, the bank would be having necessary cash to pay him. Thus, the aim of Cash Reserve Ratio is to ensure

that the banks never get out of money and can easily make payments of the cash demanded by its depositors.

Following are the key reasons why cash reserve ratio is a crucial and regulatory aspect for any bank:

 Cash Reserve Ratio is a crucial monetary policy tool used by RBI.

 It is used to control the supply of money in an economy.

 It aims at healthy banking channel and ensures that banks maintain some liquid funds to meet the demand

payments of its customers.

 It is used to control inflation or deflation prevalent in the economy.

 It is used as a tool either to inject money supply in the economy or drain excess funds from the economy.

 CRR as Monetary Policy Tool: Cash Reserve Ratio is considered as one of the most crucial and important tool

while structuring monetary policies by the RBI for Indian Economy. CRR is effectively used to adjust and control

the money supply in the economy. RBI resorts to CRR tool to effectively drain out the excess money out of the

economic system by lowering or raising the CRR rates.

 CRR and Banks: As we know CRR and Banking Channel work closely and are interdependent. The CRR and

availability of funds with the banks are inversely proportional to each other i.e. when RBI increases the Cash

Reserve Ratio, it leads to lesser funds at disposal with banks. Likewise decreased Cash Reserve Ratio means

increased funds at disposal with banks.

 CRR and Interest Rates on Loans: When there is increase in Cash Reserve Ratio, the loans become expensive

as the banks are forced to keep more money with the RBI, So, the amount of funds available with the bank for

disposal are decreased resulting into higher rate of interest as banks have less cash to give for loans and advances.

On the other hand when there is decrease in cash reserve ratio the loans become cheaper. This is because the

amounts of funds available with the banks for disposal have increased, resulting into lower rates of interest as

banks capacity to fund loans and advances increases. The relation between Cash Reserve Ratio and Interest

Rates are directly proportional to each other.

 Effects of CRR on Inflation and Deflation: Over the years, Cash Reserve Ratio has become an effective and

important tool for directly regulating and controlling the money supply in the economy. When the CRR increases,

there is a rise in the rate of interest so the bank’s lending capacity is reduced. This implies fewer new projects, new

and existing loans with floating rate of interest to become expensive, less investment opportunities, less spending

on luxuries etc. This will cause the prices to come down i.e. the inflation will come down. On the other hand, in

deflation, when the RBI reduces CRR, the money is pumped into the economy via banking channels and thus the

spending capacity increases and the deflation is curbed.

 CRR and Value of Money: When inflation decreases, the value of the money is depreciated and in the times of

deflation, the value of the money increases. So when the government wants to curb inflation or deflation and

correspondingly increase or decrease the value of money, it can be done by injecting or draining out money from

the economy. This can be attained with the help of cash reserve ratio as we have seen CRR helps forming monetary

policies of the economy.

B) Also discuss the contribution of statutory liquidity ratio (SLR) in Lowering Country’s Inflation. (5 Marks)
SLR is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form
of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved
liability (deposits). It regulates the credit growth in India.

The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are
also considered as time liabilities. The maximum limit of SLR is 40% and minimum limit of SLR is 0 In India,
Reserve Bank of India always determines the percentage of SLR.

There are some statutory requirements for temporarily placing the money in government bonds. Following this
requirement, Reserve Bank of India fixes the level of SLR. However, as most banks currently keep an SLR higher
than required (>26%) due to lack of credible lending options, near term reductions are unlikely to increase
liquidity and are more symbolic.[1][2]

The SLR is fixed for a number of reasons. The chief driving force is increasing or decreasing liquidity which can
result in a desired outcome. A few uses of mandating SLR are:

 Controlling the expansion of bank credit. By changing the level of SLR, the Reserve Bank of India can
increase or decrease bank credit expansion.
 Ensuring the solvency of commercial banks
 By reducing the level of SLR, the RBI can increase liquidity with the commercial banks, resulting in
increased investment. This is done to fuel growth and demand.
 Compelling the commercial banks to invest in government securities like government bonds

If any Indian bank fails to maintain the required level of the statutory liquidity ratio, then it becomes liable to pay
penalty to Reserve Bank of India. The defaulter bank pays penal interest at the rate of 3% per annum above the
bank rate, on the shortfall amount for that particular day. However, according to the Circular released by the
Department of Banking Operations and Development, Reserve Bank of India, if the defaulter bank continues to
default on the next working day, then the rate of penal interest can be increased to 5% per annum above the
bank rate. This restriction is imposed by RBI on banks to make funds available to customers on demand as soon
as possible. Gold and government securities (or gilts) are included along with cash because they are highly liquid
and safe assets.

The RBI can increase the SLR to control inflation, suck liquidity in the market, to tighten the measure to
safeguard the customers' money. Decrease in SLR rate is done to encourage growth. In a growing economy
banks would like to invest in stock market, not in government securities or gold as the latter would yield less
returns. One more reason is long term government securities (or any bond) are sensitive to interest rate changes.
However, in an emerging economy, interest rate change is a common activity.