FMI ASSIGNMENT

Ques 1: What is the role of financial system in economic development of a

nation? Explain major components of Indian Financial system.

The Indian Financial System is one of the most important aspects of the economic

development of our country. This system manages the flow of funds between the people

(household savings) of the country and the ones who may invest it wisely (investors/

businessmen) for the betterment of both the parties.

Components Of Indian Financial System

There are four main components of the Indian Financial System. This includes:

1. Financial Institutions

2. Financial Assets

3. Financial Services

4. Financial Markets

1) Financial Institutions

The Financial Institutions act as a mediator between the investor and the borrower. The

investor’s savings are mobilised either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows:

• A short term liability can be converted into a long term investment

• It helps in conversion of a risky investment into a risk-free investment

 • Also acts as a medium of convenience denomination, which means, it can match a

small deposit with large loans and a large deposit which small loans

The best example of a Financial Institution is Bank. People with surplus amounts of money

make savings in their accounts, and people in dire need of money take loans. The bank acts as

an intermediate between the two.

The financial institutions can further be divided into two types:

• Banking Institutions or Depository Institutions – This includes banks and other

credit unions which collect money from the public against interest provided on the

deposits made and lend that money to the ones in need

• Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual

funds and brokerage companies fall under this category. They cannot ask for

monetary deposits but sell financial products to their customers.

2) Financial Assets

The products which are traded in the Financial Markets are called the Financial Assets. Based

on the different requirements and needs of the credit seeker, the securities in the market also

differ from each other.

Some important Financial Assets have been discussed briefly below:

• Call Money – When a loan is granted for one day and is repaid on the second day, it

is called call money. No collateral securities are required for this kind of transaction.

• Treasury Bills – Also known as T-Bills, These are Government bonds or debt

securities with maturity of less than a year. Buying a T-Bill means lending money to

the Government.

 • Certificate of Deposits – It is a dematerialised form (Electronically generated) for

funds deposited in the bank for a specific period of time.

• Commercial Paper – It is an unsecured short-term debt instrument issued by

corporations.

3) Financial Services

Services provided by Asset Management and Liability Management Companies. They help to

get the required funds and also make sure that they are efficiently invested.

The financial services in India include:

• Banking Services – Any small or big service provided by banks like granting a loan,

depositing money, issuing debit/credit cards, opening accounts, etc.

• Insurance Services – Services like issuing of insurance, selling policies, insurance

undertaking and brokerages, etc. are all a part of the Insurance services

• Investment Services – It mostly includes asset management

• Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part

of the Foreign exchange services.

4) Financial Markets

The marketplace where buyers and sellers interact with each other and participate in the

trading of money, bonds, shares and other assets is called a financial market.

The financial market can be further divided into four types:

• Capital Market – Designed to finance the long term investment, the Capital market

deals with transactions which are taking place in the market for over a year.

 • Money Market – Mostly dominated by Government, Banks and other Large

Institutions, the type of market is authorised for small-term investments only. It is a

wholesale debt market which works on low-risk and highly liquid instruments.

Role of Financial system in Economic Development

1) Savings-investment relationship

To attain economic development, a country needs more investment and production. This can

happen only when there is a facility for savings. As, such savings are channelized to

productive resources in the form of investment. Here, the role of financial institutions is

important, since they induce the public to save by offering attractive interest rates. These

savings are channelized by lending to various business concerns which are involved in

production and distribution.

2) Financial systems help in growth of capital market

Any business requires two types of capital namely, fixed capital and working capital. Fixed

capital is used for investment in fixed assets, like plant and machinery. While working capital

is used for the day-to-day running of business. It is also used for purchase of raw materials

and converting them into finished products.

• Fixed capital is raised through capital market by the issue of debentures and shares.

Public and other financial institutions invest in them in order to get a good return with

minimized risks.

 • For working capital, we have money market, where short-term loans could be raised

by the businessmen through the issue of various credit instruments such as bills,

promissory notes, etc.

Foreign exchange market enables exporters and importers to receive and raise funds for

settling transactions. It also enables banks to borrow from and lend to different types of

customers in various foreign currencies. The market also provides opportunities for the banks

to invest their short term idle funds to earn profits. Even governments are benefited as they

can meet their foreign exchange requirements through this market.

3) Government Securities market

Financial system enables the state and central governments to raise both short-term and long-

term funds through the issue of bills and bonds which carry attractive rates of interest along

with tax concessions. The budgetary gap is filled only with the help of government securities

market. Thus, the capital market, money market along with foreign exchange market and

government securities market enable businessmen, industrialists as well as governments to

meet their credit requirements. In this way, the development of the economy is ensured by the

financial system.

4) Financial system helps in Infrastructure and Growth

Economic development of any country depends on the infrastructure facility available in the

country. In the absence of key industries like coal, power and oil, development of other

industries will be hampered. It is here that the financial services play a crucial role by

providing funds for the growth of infrastructure industries. Private sector will find it difficult

to raise the huge capital needed for setting up infrastructure industries. For a long time,

infrastructure industries were started only by the government in India. But now, with the

policy of economic liberalization, more private sector industries have come forward to start

 infrastructure industry. The Development Banks and the Merchant banks help in raising

capital for these industries.

5) Financial system helps in development of Trade

The financial system helps in the promotion of both domestic and foreign trade. The financial

institutions finance traders and the financial market helps in discounting financial instruments

such as bills. Foreign trade is promoted due to per-shipment and post-shipment finance by

commercial banks. They also issue Letter of Credit in favour of the importer. Thus, the

precious foreign exchange is earned by the country because of the presence of financial

system. The best part of the financial system is that the seller or the buyer do not meet each

other and the documents are negotiated through the bank. In this manner, the financial system

not only helps the traders but also various financial institutions. Some of the capital goods are

sold through hire purchase and instalment system, both in the domestic and foreign trade. As

a result of all these, the growth of the country is speeded up.

Ques 2: What is primary market? Explain the book building process of an

IPO.

Primary Market

In a Primary Market, securities are created for the first time for investors to purchase. New

securities are issued in this market through a stock exchange, enabling the government as

well as companies to raise capital.

For a transaction taking place in this market, there are three entities involved. It would

include a company, investors, and an underwriter. A company issues security in a primary

market as an initial public offering (IPO), and the sale price of such new issue is

determined by a concerned underwriter, which may or may not be a financial institution.

An underwriter also facilitates and monitors the new issue offering. Investors purchase the

newly issued securities in the primary market. Such a market is regulated by the Securities

and Exchange Board of India (SEBI).

The entity which issues securities may be looking to expand its operations, fund other

business targets or increase its physical presence among others. Primary market

example of securities issued includes notes, bills, government bonds or corporate bonds as

well as stocks of companies.

Book Building Process Of IPO

Book building is a process of price discovery.

he process of price discovery involves generating and recording investor demand for shares

before arriving at an issue price that will satisfy both the company offering the IPO and the

market. It is highly recommended by all the major stock exchanges as the most efficient way

to price securities.

The book building process comprises these steps:

1. The issuing company hires an investment bank to act as an underwriter who is tasked

with determining the price range the security can be sold for and drafting

a prospectus to send out to the institutional investing community.

2. The investment bank invites investors, normally large scale buyers and fund

managers, to submit bids on the number of shares that they are interested in buying

and the prices that they would be willing to pay.

3. The book is 'built' by listing and evaluating the aggregated demand for the issue from

the submitted bids. The underwriter analyses the information and uses a weighted

average to arrive at the final price for the security, which is termed the cut-off price.

 4. The underwriter has to, for the sake of transparency, publicize the details of all the

bids that were submitted.

5. Shares are allocated to the accepted bidders.

Ques 5: Discuss the functions of Commercial Banks. Explain products and

services offered by Commercial banks in India.

Commercial banks are financial institutions that accept demand deposits from the general

public, transfer funds from the bank to another, and earn a profit.

Commercial banks play a significant role in fulfilling the short-term and medium- term

financial requirements of industries. They do not provide, long-term credit, so that liquidity

of assets should be maintained. The funds of commercial banks belong to the general public

and are withdrawn at a short notice; therefore, commercial banks prefers to provide credit for

a short period of time backed by tangible and easily marketable securities.

Functions of Commercial Banks

1. Accept Deposits

The most important function of commercial banks is that it collects the surplus money or

saving of the people on accepting deposits. These deposits may be created in two ways, such

as by direct deposits, when a customer deposits their money in the bank by opening a bank

account such as current account, fixed account or saving account and secondly by indirect or

derivative deposits, which is credited by giving loans to their customers.

There are two types of deposits, which are discussed as follows:

(a) Demand Deposits:

Refer to kind of deposits that can be easily withdrawn by individuals without any prior notice

to the bank. In other words, the owners of these deposits are allowed to withdraw money

anytime by simply writing a check. These deposits are the part of money supply as they are

used as a means for the payment of goods and services as well as debts. Receiving these

deposits is the main function of commercial banks.

(b) Time Deposits:

Refer to deposits that are for certain period of time. Banks pay higher interest on lime

deposits. These deposits can be withdrawn only after a specific time period is completed by

providing a written notice to the bank.

2. Making Advances

The commercial banks provide loans and advances of various forms. It includes an overdraft

facility, cash credit, bill discounting, etc. They also give demand and demand and term loans

to all types of clients against proper security.

3. Credit creation

It is the most significant function of the commercial banks. While sanctioning a loan to a

customer, a bank does not provide cash to the borrower Instead it opens a deposit account

from where the borrower can withdraw. In other words, while sanctioning a loan a bank

automatically creates deposits. This is known as a credit creation from the commercial bank.

Commercial banks issue the loan in the form of cash credit, overdraft, and fixed loans and by

discounting of the bill of exchange. However, while making or advancing loans; banks

always take into consideration the creditworthiness of the applicants, i.e. four “C” of credit.

These are the “character”, “capacity”, “capital” and “collateral” which are always guidelines

to the bank for advancing loans.

4. Overdraft Facility

It refers to a facility in which a customer is allowed to overdraw his current account up to an

agreed limit. This facility is generally given to respectable and reliable customers for a short

period. Customers have to pay interest to the bank on the amount overdrawn by them.

5. Discounting Bills of Exchange

It refers to a facility in which holder of a bill of exchange can get the bill discounted with the

bank before the maturity. After deducting the commission, the bank pays the balance to the

holder. On maturity, the bank gets its payment from the party which had accepted the bill.

Products and Services offered by Commercial Banks

1. Industrial Loans

The primary business of commercial banks is to make loans to large industrial corporations.

Corporations in any nation are interested in obtaining debt at favourable terms. The bank is in

a position to fulfil this demand through the services that they offer.

Although with the evolution of the debt market, the idea of banks as the principal source of

debt has become outdated as far as mega corporations are concerned. Mega corporations are

in a position to raise funds directly from the markets. This proves cheaper since they do not

have to pay an intermediary i.e. the banks.

2. Project Finance

 Project finance is one type of loan for which mega corporations largely rely on banks till

date. In case of project finance, the banker finances the project as an individual entity. The

parent company that is sponsoring the project has a limited liability in case the loan goes bad.

For instance, if bank funds DEF project that was initiated by ABC Corporation and the

project goes bankrupt over time.

In this case, banks only have access to the assets owned by DEF project. ABC Corporation

does not have to assume any liability for the losses the bank incurred while financing the

project. The project is treated as a separate entity in its own right.

3. Syndicated Loans

One bank may play a lead role in coordinating with other banks and making the funds

available to the corporation. Hence, this bank would be called the “lead financier” and would

be entitled to a special fee over and above the regular interest that is earned on the loan. Also,

the corporation will service the loan i.e. pay the payments to this bank only. It is the lead

arranger that will have to create a mechanism to redistribute the monthly payments to the

other banks proportionately.

4. Leasing

With the advent of off balance sheet financing, a lot of companies have started using leasing

as a financing method. This is because it provides control of the said asset without leveraging

the balance sheet of the given corporation. Banks have become heavily involved in the

business of such financial leases. Financial leases are being signed by companies for

acquiring real estate, automobiles, factory equipment or such other major fixed assets. It

 needs to be noted that banks usually only fund financial leases and not pure play operational

leases.

5. Foreign Trade Financing

A lot of the corporations in the world today are multi-nationals. Thus their business interests

cross national borders. This means that foreign trade in rampant and has become the norm.

Now, foreign trade has some special financing needs. Banks have traditionally specialized in

such financing. In the modern world too, banks provide letters of credit, export financing,

bank guarantees and other such services to corporations which help them conduct foreign

trade in an efficient manner.

6. Bills of Exchange

Companies often use bills of exchange for accounts receivables and accounts payables

purposes. For instance if company A agrees to pay company B at a later date, they could sign

a bill of exchange for the same. Company A can then take this bill of exchange to the bank at

get the bill discounted.

This means that the bank will take over the right to collect receivables from B. They will do

so by purchasing the bill at a discount. This means that they will pay company A, a

discounted amount for the bill. The difference between the face value of the bill and the

discounted price for which the bank bought it is considered to be the interest earned by the

bank.

 Ques 6: Define Merchant Banking. Explain the role and functions of

merchant bankers. Discuss SEBI’s guidelines for merchant banking

institutions.

A merchant banker underwrites corporate securities and provides guidelines to clients on

issues like corporate mergers. The merchant banker may be in the form of a bank, a firm,

company or even a proprietary concern. It is basically service banking which provides non-

financial services such as arranging for funds rather than providing them.

The merchant banker understands the requirements of the business concerns and arranges

finance with the help of financial institutions, banks, stock exchanges, and money market.

Functions of Merchant Banking

1. Project Counselling: A project counselling basically by following three steps –

preparing the project reports, determining the right financing option, and assessing the

merit of the project reports with the banks and financial institutions. Project

counselling also involves filling up application forms and trying to fund the project

via banks or financial institutions.

2. Issue management: As the name suggests, this deals with issuing equity shares,

preference shares, and debentures. Acts as a partner to a high net-worth client

by issuing shares & debentures to the general public.

3. Underwriting services: One of the major services of a merchant bank is underwriting

services. Underwriting is a guarantee given to the client stating that if the subscription

is below a specified level, they will subscribe to the said amount.

 4. Portfolio management: As mentioned earlier, this bank invests in different kinds of

investments on behalf of clients; and then manages the whole investments as well.

5. Loan Syndication: Syndication of Loan in simple terms means, bankers provide term

loans to projects that need the money.

SEBI’s Guidelines

SEBI has made the following reforms for the merchant banker

1. Multiple categories of merchant banker will be abolished and there will be only one equity

merchant banker.

2.The merchant banker is allowed to perform underwriting activity. For performing portfolio

manager, the merchant banker has to seek separate registration from SEBI.

3. A merchant banker cannot undertake the function of a non-banking financial company,

such as accepting deposits, financing others’ business, etc.

4. A merchant banker has to confine himself only to capital market activities.

Ques 8: Write short note on the following:-

(a) Credit rating agencies

A credit rating agency is a private company whose purpose is to assess the ability of

borrowers, either governments or private enterprises, to repay their debt. To do this, these

agencies issue credit ratings based on the borrower’s solvency.

Credit rating agencies collect a fee either from the entity seeking to receive a rating (business

or government) or from the entity seeking to use and analyse the rating (the financial analysis

department of a bank, financial institution, etc.).

Along with other criteria, investors take credit ratings into account to help manage their

portfolios. A rating downgrade indicates a greater risk for the lender. Depending on the

sensitivity of the market, investors may require a higher return to protect against this risk,

which in turn raises financing costs for the borrower.

Many investors give credit ratings a lot of consideration in their investment decisions. This

has enabled credit rating agencies to play a central role in financial markets – a role that some

economists see as excessive.

(b) Venture capital

Venture capital is a form of private equity and a type of financing that investors provide

to start-up companies and small businesses that are believed to have long-term

growth potential. Venture capital generally comes from well-off investors, investment banks

and any other financial institutions. However, it does not always take a monetary form; it can

also be provided in the form of technical or managerial expertise. Venture capital is typically

allocated to small companies with exceptional growth potential, or to companies that have

grown quickly and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average returns

is an attractive payoff. For new companies or ventures that have a limited operating history

(under two years), venture capital funding is increasingly becoming a popular – even

essential – source for raising capital, especially if they lack access to capital markets, bank

 loans or other debt instruments. The main downside is that the investors usually get equity in

the company, and, thus, a say in company decisions.

(c) Leasing
Finance lease simply means a method of providing finance where the leasing company buys

the asset for the user and rents it to him for an agreed period. The leasing company is known

as the lessor, and the user is known as the lessee. A finance lease (also called capital lease)

substantially transfers all the risks and rewards of ownership of the asset to the lessee. It is

often used to buy leased assets for a major part of its economic life.

he basic criteria to classify a finance lease (also known as a capital lease under US GAAP) is

where the lessor remains the legal owner of the asset throughout the lease period, but all the

risk and rewards related to leased assets are transferred to the lessee. The, i.e., the lessee

records a liability and an asset related to leasing in its balance sheets; Additionally, legal

ownership of leased asset transfers from the lessor to lessee after the end of the lease.