GGSIPU (BCOM313) Financial Markets and

Institutions

UNIT 1

Financial Systems: Components, features

An overview of Indian Financial System

Financial instruments are tradable assets of any kind. They can be cash, evidence of an
ownership interest in an entity, or a contractual right to receive or deliver cash or
another financial instrument. It can also be classified generally as equity based, representing
ownership of the asset, or debt based, representing a loan made by an investor to the owner of the
asset.  Documents (such as a check, draft, bond, share, bill of exchange, futures or options
contract) come under this category.

Money Market Instruments: The money market can be defined as a market for short-term
money and financial assets that are near-substitutes for money. The term short-term means
generally a period up to one year and near substitutes to money is used to denote any financial
asset which can be quickly converted into money with minimum transaction cost.

Important Money Market Instruments are Briefed below:

Call/Notice-Money Market: Call/Notice money is the money borrowed or lent on demand for a

very short period. When money is borrowed or lent for a day, it is known as Call (Overnight)
Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money,
borrowed on a day and repaid on the next working day, (irrespective of the number of
intervening holidays) is “Call Money”. When money is borrowed or lent for more than a day and
up to 14 days, it is “Notice Money”. No collateral security is required to cover these transactions.

Inter-Bank Term Money: Inter-bank market for deposits of maturity beyond 14 days is referred
to as the term money market. The entry restrictions are the same as those for Call/Notice Money
except that, as per existing regulations, the specified entities are not allowed to lend beyond 14
days.

Treasury Bills: Treasury Bills are short term (up to one year) borrowing instruments of the
union government. It is an IOU of the Government. It is a promise by the Government to pay a
stated sum after expiry of the stated period from the date of issue (14/91/182/364 days, i.e. less
than one year). They are issued at a discount to the face value and on maturity the face value is
paid to the holder. The rate of discount and the corresponding issue price are determined at each
auction.

Certificate of Deposits: Certificates of Deposit (CDs) is a negotiable money market instrument

and issued in dematerialised form or as a Usance Promissory Note for funds deposited at a bank
or other eligible financial institution for a specified time period. Guidelines for issuance of CDs
are presently governed by various directives issued by the Reserve Bank of India as amended
from time to time. CDs can be issued by (i) scheduled commercial banks excluding Regional
Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial
Institutions that have been permitted by RBI to raise short-term resources within the umbrella
limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. A
Financial Institution (FI) may issue CDs within the overall umbrella limit fixed by RBI, i.e. issue
of CD together with other instruments viz., term money, term deposits, commercial papers and
inter-corporate deposits should not exceed 100 per cent of its net owned funds as per the latest
audited balance sheet.

Commercial Paper (CP): CP is a note in evidence of the debt obligation of the issuer. On
issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an
unsecured promissory note privately placed with investors at a discounted rate to face value
determined by market forces. CP is freely negotiable by endorsement and delivery. A company
shall be eligible to issue CP provided – (a) the tangible net worth of the company, as per the
latest audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based)
limit of the company from the banking system is not less than Rs. 4 crore and (c) the borrowal
account of the company is classified as a Standard Asset by the financing bank/s. The minimum
maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such
equivalent rating by other agencies.

Capital Market Instruments: The capital market generally consists of the following long term
period i.e., more than one year period, financial instruments; in the equity segment Equity shares,
preference shares, convertible preference shares, non-convertible preference shares etc. and in
the debt segment debentures, zero coupon bonds, deep discount bonds etc.

Hybrid Instruments: Hybrid instruments have both the features of equity and debenture. This
kind of instrument is called hybrid instruments. Examples are convertible debentures, warrants
etc.

Financial system and Economic Development

Financial System and Economic Development

The functioning of an economy depends on the financial system of a country. The financial
system includes banks as a central entity along with other financial services providers. The
financial system of a country is deeply entrenched in the society and provides employment to a
large population. According to Baily and Elliott, there are three major functions of the financial
system:

Credit Provision – Credit supports economic activity. Governments can invest in infrastructure
projects by reducing the cycles of tax revenues and correcting spends, businesses can invest
more than the cash they have and individuals can purchase homes and other utilities without
having to save the entire amount in advance. Banks and other financial service providers give
this credit facility to all stakeholders.

Liquidity provision – Banks and other financial providers protect businesses and individuals
against sudden cash needs. Banks provide the facility of demand deposits which the business or
individual can withdraw at any time. Similarly, they provide credit and overdraft facility to
businesses. Moreover, banks and financial institutions offer to buy or sell securities as per need
and often in large volumes to fulfil sudden cash requirements of the stakeholders.

Risk management services – Finance provides risk management from the risks of financial
markets and commodity prices by pooling risks. Derivative transactions enable banks to provide
this risk management. These services are extremely valuable even though they receive a lot of
flak due to excesses during financial crisis.

Savings-investment relationship

The above three major functions are important for the running and development activities of any
economy. Apart from these functions, an economy’s growth is boosted by the savings-
investment relationship. When there are sufficient savings, only then can there be sizeable
investment and production activity. This savings facility is provided by financial institutions
through attractive interest schemes. The money saved by the public is used by the financial
institutions for lending to businesses at substantial interest rates. These funds allow businesses to
increase their production and distribution activities.

Growth of capital markets

Another important work of finance is to boost growth of capital markets. Businesses need two
types of capital – fixed and working. Fixed capital refers to the money needed to invest in
infrastructure such as building, plant and machinery. Working capital refers to the money needed
to run the business on a day-to-day basis. This may refer to the ongoing purchase of raw
materials, cost of finishing goods and transport of finished goods to stores or customers. The
financial system helps in raising capital in the following ways:

Fixed capital – Businesses issue shares and debentures to raise fixed capital. Financial service
providers, both public and private, invest in these shares and debentures to make profits with
minimal risk.
Working capital – Businesses issue bills, promissory notes etc. to raise short term loans. These
credit instruments are valid in the money markets that exist for this purpose.

Foreign exchange markets

In order to support the export and import businessmen, there are foreign exchange markets
whereby businesses can receive and transmit funds to other countries and in other currencies.
These foreign exchange markets also enable banks and other financial institutions to borrow or
lend sums in other currencies. Moreover, financial institutions can invest and reap profits from
their short term idle money by investing in foreign exchange markets. Governments also meet
their foreign exchange requirements through these markets. Hence, foreign exchange markets
impact the growth and goodwill of an economy in the international markets.

Government securities

Governments use the financial system to raise funds for both short term and long term fund
requirements. Governments issue bonds and bills at attractive interest rates and also provide tax
concessions. Budget gaps are taken care of by government securities. Thus, capital markets,
foreign exchange markets and government securities markets are essential for helping
businesses, industries and governments to carry out development and growth activities of the
economy.

Infrastructure and growth

The economic growth depends on the growth of infrastructural facilities of the country. Key
industries such as power, coal, oil determine the growth of other industries. These infrastructure
industries are funded by the finance system of the country. The capital requirement for
infrastructure industries is huge. Raising such a huge amount is difficult for private players and
hence, traditionally, governments have taken care of infrastructure projects solely. However, the
economic liberalization policy led to the private sector participation in infrastructure industries.
Development and Merchant banks such as IDBI in India help fund these activities for the private
sector.

Trade development

Trade is the most important economic activity. Both, domestic and international trade are
supported by the financial system. Traders need finance which is provided by the financial
institutions. Financial markets on the other hand help discount financial instruments such as
promissory notes and bills. Commercial banks finance international trade through pre and post-
shipment funding. Letters of credit are issued for importers, thereby helping the country to earn
important foreign exchange.
Employment growth

Financial system plays a key role in employment growth in an economy. Businesses and
industries are financed by the financial systems which lead to growth in employment and in turn
increases economic activity and domestic trade. Increase in trade leads to increase in competition
which leads to activities such as sales and marketing which further increases employment in
these sectors.

Venture capital

Increase in venture capital or investment in ventures will boost growth in economy. Currently,
the extent of venture capital in India is less. It is difficult for individual companies to invest in
ventures directly due to the risk involved. It is mostly the financial institutions that fund
ventures. An increase in the number of financial institutions supporting ventures will boost this
segment.

Balances economic growth

The growth of different sectors of an economy is balanced through the financial system. There
are primary, secondary and tertiary sector industries and all need sufficient funds for growth. The
financial system of the country funds these sectors and provides sufficient funds for each sector –
industrial, agricultural and services.

UNIT 2 Financial Markets

Money markets: Functions, Organizations and

instruments

Indian Money Market: An Overview

The Indian money market cannot be considered as an integrated unit. It can be broadly divided
into two different parts, i.e., the unorganised and organised segments. There are lot of differences
between unorganised and organised segment of Indian money market.

While the unorganised sector is constituted by money lenders and the indigenous bankers but the
organised sector is again constituted by the nationalised and private sector commercial banks, the
foreign banks, co-operative banks and the Reserve Bank of India (RBI). The unorganised
segment of the Indian money market is not a homogenous and integrated sector but the organised
sector of the Indian money market is a fairly integrated one.
Unorganised Sector of Indian Money Market:

Unorganised segment of the Indian money market is composed of unregulated non-bank

financial intermediaries, indigenous bankers and money lenders which exist even in the small
towns and big cities. Their lending activities are mostly restricted to small towns and villages.
The persons who normally borrow from this unorganised sector include farmers, artisans small
traders and small scale producers who do not have any access to modern banks.

The following are some of the constituents of unorganised money market in India.

(i) Indigenous Bankers:

Indigenous bankers include those individuals and private firms which are engaged in receiving
deposits and giving loans and thereby acting like a mini bank. Their activities are not at all
regulated. During the ancient and medieval periods, these indigenous bankers were very active.
But with the growth of modern banking, particularly after the advent of British, the business of
the indigenous bankers received a setback.

Moreover, with the growth of commercial banks and co-operative banks the area of operations of
indigenous bankers has again contracted further. Even today, a few thousands of indigenous
bankers are still operating in the western and southern parts of the country and engaging
themselves in the traditional banking business.
Indigenous bankers are classified into four main sub groups, i.e., Gujarati Shroffs, Multani-or
Shikarpuri Shroffs, Chettiars and Marwari, Kayast. Gujarati Shroffs are mostly operating in
Mumbai, Kolkata and in industrial and trading cities of Gujarat. The Multani or Shikarpuri
Shroffs are operating mainly in Mumbai and Chennai. The Chettiars are mostly found in the
South.

The Marwari Shroffs are mostly active in Mumbai, Kolkata, tea gardens of Assam and also in
different other parts of North-East India. Among the four aforesaid groups, the Gujarati
indigenous bankers are considered as the most powerful groups in respect of its volume of
business.

The indigenous bankers are mostly engaged in both banking and non-banking business which
they do not want to separate. Their lending operations remain mostly unregulated and
unsupervised. They charge high rate of interest and they are not influenced by bank rate policy of
the Reserve Bank of India.

(ii) Unregulated Non-Bank Financial Intermediaries:

There are different types of unregulated non-bank financial intermediaries in India. They are
mostly constituted by loan or finance companies, chit funds and ‘nidhis’. A good number of
finance companies in India are engaged in collecting substantial amount of funds in the form of
deposits, borrowings and other receipts.

They normally give loans to wholesale traders, relailers, artisans, and different self-employed
persons at a high rate of interest ranging between 36 to 48 per cent.

There are various types of chit funds in India. They are doing business in almost all the states but
the major portion of their business is concentrated in Tamil Nadu and Kerala. Moreover, there
are ‘nidhis’ operating in South India which are a kind of mutual benefit funds restricted to its
members.

(iii) Moneylenders:

Moneylenders are advancing loans to small borrowers like marginal and small farmers,
agricultural labourers, artisans, factory and mine workers, low paid staffs, small traders etc. at
very high rates of interest and also adopt various malpractices for manipulating loan records of
these poor borrowers.

There are broadly three types of moneylenders:

(i) Professional moneylenders dealing solely with money lending;

(ii) Itinerant moneylenders such as Kabulis and Pathans and

(iii) Non-professional moneylenders.

The area of operation of the moneylenders is very much localised and their methods of operation
is also not uniform. The money lending operation of the moneylenders is totally unregulated and
unsupervised which leads to worst exploitation of the small borrowers.

Moneylenders have become a necessary evil in the absence of sufficient institutional sources of
credit to the poorer sections of society. Although various measures have been introduced to
control the activities of moneylenders but due to lack of political will, these are not enforced,
leading to a exploitation of small borrowers.

Organised Sector of Indian Money Market:

The organised segments of the Indian money market is composed of the Reserve Bank of India
(RBI), the State Bank of India, Commercial banks, Co-operative banks, foreign banks, finance
corporations and the Discount or Finance House of India Limited. The segment of Indian money
market is quite integrated and well organised.

Mumbai, Kolkata, Chennai, Delhi, Bangalore and Ahmedabad are the leading centres of the
organised sectors of the Indian money market. The Mumbai money market is a well organised,
having head offices of the RBI and different commercial banks, two leading well developed
stock exchanges, the bullion exchange and fairly organised market for Government securities.
All these have placed the Mumbai money market at par with New York money market of USA
and London money market of England.

The main constituents of the organised sector of Indian money market include:

(i) The Call Money Market,

(ii) The Treasury Bill Market,

(iii) The Commercial Bill Market,

(iv) The Certificates of Deposits Market,

(v) Money Market for Mutual Funds and

(vi) The Commercial Paper Market.

(i) Call Money Market:

The call money market is a most common form of developed money market. It is a most
sensitive segment of the financial system which reflects clearly any change in it. The call money
market in India is very much centred at Mumbai, Chennai and Kolkata and out of which the
Mumbai is the most important one. In such market, lending and borrowing operations are carried
out for one day.

The call money market in also termed as inter-bank call money market. Normally, scheduled
commercial banks, Cooperative banks and the Discount and Finance House of India (DFHI)
operate in this market and in a special situation; the LIC, UTI, the GIC, the IDBI and the
NABARD are permitted to operate as lenders in this call money market. In this market, brokers
usually play an important role.

(ii) Treasury Bill Market:

Treasury bill markets are markets for treasury bills. In India such treasury bills are short term
liability of the Central Government which are of 91 day and 364 day duration. Normally, the
treasury bills should be issued so as to meet temporary revenue deficit over expenditure of a
Government at some point of time. But, in India, the treasury bills are, nowadays, considered as
a permanent source of funds for the Central Government.

In India, the RBI is the major holder of the treasury bills, which is around 90 per cent of the total.
In India, ad-hoc treasury bills have now been replaced by ways and means Advances since April
1, 1997, so as to finance temporary deficits of the Central Government.

(iii) Commercial Bill Market:

The Commercial bill market is a kind of sub-market which normally deals with trade bills or the
commercial bills. It is a kind of bill which is normally drawn by one merchant firm on the other
and they arise out of commercial transactions.

The purpose for issuing a commercial bill is simply to reimburse the seller as and when the buyer
delays payment. But, in India, the commercial bill market is not so developed. This is mainly due
to popularity of the cash credit system in bank lending and the unwillingness on the part of large
buyer to bind himself to payment schedule related to the commercial bill and also the lack of
uniform approach in drawing bills.

Commercial bills are an instrument of credit which is very much useful to business firms and
banks. In India, the outstanding amount of commercial bills rediscounted by the banks with
different financial institutions at the end of March, 1996 was to the extent of only Rs 374 crore.

(iv) Certificate of Deposit (CD) Market:

The certificate of Deposit (CD) was introduced in India by the RBI in March 1989 with the sole
objective of widening the range of money market instruments and also to attain higher flexibility
in the development of short term surplus funds for the investors. Initially the CDs are issued by
scheduled commercial banks in multiples of Rs 25 lakh and also to the extent of a minimum of
Rs 1 crore.

Maturity period of CDs varied between three months and one year. In India, six financial
institutions, viz., IDBI, ICICI, IFCI, IRBI, SIDBI and Export and Import Bank of India were
permitted in 1993 to issue CDs for period varying between 1 to 3 years.

Banks normally pay high rates of interest on CDs. In 1995-96, the stringent conditions in the
money market induced the bankers to mobilise a good amount of resources through CDs.
Accordingly in recent years, the outstanding amount of CDs issued by the commercial banks has
almost been doubled from Rs 8,017 crore in March, 1995 to Rs 16,316 crore as on 29th March,
1996.

(v) Commercial Paper Market:

In India, the Commercial Paper (CP) was introduced in the money market in January 1990. A
listed company having working capital not less than Rs 5 crore can issue CP. Again the CP can
be issued in multiples of Rs 25 lakhs subject to a minimum of Rs 1 crore for a maturity period
varying between three to six months. CPs would be again freely transferable by endorsement and
delivery.

(vi) Money Market Mutual Funds:

In India, the RBI has introduced a scheme of Money Market Mutual Funds (MMMFs) in April
1992. The main objective of this scheme was to arrange an additional short term avenue for the
individual investors. This scheme has failed to receive much response as the initial guidelines
were not attractive. Thus, in November, 1995, the RBI introduced some relaxations in order to
make the scheme more attractive and flexible.

As per the existing guidelines, the banks, public financial institutions and the private financial
institutions are allowed to set up MMMFs. In the mean time, the limits of investment in
individual instruments by MMMF have already been deregulated. Since April 1996, the RBI has
allowed MMMFs to issue units to corporate enterprises and others at par with the mutual funds
introduced earlier.

As per the latest data available from Association of Mutual Funds, overall, the combined Assets
Under Management (AUM) of all the mutual fund houses in country stood at Rs 5,06,692.6
crore. The top five mutual funds of the country include—Reliance MF, ICICI Prudential MF,
UTI-MF, HDFC MF and Franklin Templeton MF. Reliance MF continued to be the most valued
fund house in the country with assets under management (AUM) of Rs 90,937.94 crore at the
end of March 31, 2008.

The industry body Assocham Chamber recently conducted a survey on “MF Growth Patterns”
and accordingly observed that the Mutual Fund industry has growth 25 per cent between 1999
and 2007 to stand at Rs 4,67,000 crore and the trend would improve as MFs are becoming a
preferred choice for both rural and urban retail investors.

The mutual fund sector would grow at compound annual rate of 30 per cent in next three years to
become Rs 9,50,000 crore industry as predicted by the survey. The share of privately managed
MF players in the total MF industry is expected to fall to 70 per cent from the current estimation
of 82 per cent. The reduction would result from the alliance of the private players with overseas
partners.

Recent development in Indian Money market

Indian Government appointed a committee under the chairmanship of Sukhamoy Chakravarty in
1984 to review the Indian monetary system. Later, Narayanan Vaghul working group and
Narasimham Committee was also set up. As per the recommendations of these study groups and
with the financial sector reforms initiated in the early 1990s, the government has adopted
following major reforms in the Indian money market.

Reforms made in the Indian Money Market are:

1. Deregulation of the Interest Rate: In recent period the government has

adopted an interest rate policy of liberal nature. It lifted the ceiling rates of the
call money market, short-term deposits, bills re-discounting, etc. Commercial
banks are advised to see the interest rate change that takes place within the
limit. There was a further deregulation of interest rates during the economic
reforms. Currently interest rates are determined by the working of market
forces except for a few regulations.
2. Money Market Mutual Fund (MMMFs): In order to provide additional short-
term investment revenue, the RBI encouraged and established the Money
Market Mutual Funds (MMMFs) in April 1992. MMMFs are allowed to sell
units to corporate and individuals. The upper limit of 50 crore investments has
also been lifted. Financial institutions such as the IDBI and the UTI have set up
such funds.
3. Establishment of the DFI: The Discount and Finance House of India (DFHI)
was set up in April 1988 to impart liquidity in the money market. It was set up
jointly by the RBI, Public sector Banks and Financial Institutions. DFHI has
played an important role in stabilizing the Indian money market.
4. Liquidity Adjustment Facility (LAF): Through the LAF, the RBI remains in
the money market on a continue basis through the repo transaction. LAF
adjusts liquidity in the market through absorption and or injection of financial
resources.
5. Electronic Transactions: In order to impart transparency and efficiency in the
money market transaction the electronic dealing system has been started. It
 covers all deals in the money market. Similarly it is useful for the RBI to
watchdog the money market.
6. Establishment of the CCIL: The Clearing Corporation of India limited
(CCIL) was set up in April 2001. The CCIL clears all transactions in
government securities, and repose reported on the Negotiated Dealing System.
7. Development of New Market Instruments: The government has consistently
tried to introduce new short-term investment instruments. Examples: Treasury
Bills of various duration, Commercial papers, Certificates of Deposits,
MMMFs, etc. have been introduced in the Indian Money Market.

These are major reforms undertaken in the money market in India. Apart from these, the stamp
duty reforms, floating rate bonds, etc. are some other prominent reforms in the money market in
India. Thus, at the end we can conclude that the Indian money market is developing at a good
speed.

Capital Markets: Functions

Mobilization of Savings: Capital market is an important source for mobilizing idle savings from
the economy. It mobilizes funds from people for further investments in the productive channels
of an economy. In that sense it activate the ideal monetary resources and puts them in proper
investments.

Capital Formation: Capital market helps in capital formation. Capital formation is net addition
to the existing stock of capital in the economy. Through mobilization of ideal resources it
generates savings; the mobilized savings are made available to various segments such as
agriculture, industry, etc. This helps in increasing capital formation.

Provision of Investment Avenue: Capital market raises resources for longer periods of time.
Thus it provides an investment avenue for people who wish to invest resources for a long period
of time. It provides suitable interest rate returns also to investors. Instruments such as bonds,
equities, units of mutual funds, insurance policies, etc. definitely provides diverse investment
avenue for the public.

Speed up Economic Growth and Development: Capital market enhances production and

productivity in the national economy. As it makes funds available for long period of time, the
financial requirements of business houses are met by the capital market. It helps in research and
development. This helps in, increasing production and productivity in economy by generation of
employment and development of infrastructure.

Proper Regulation of Funds: Capital markets not only helps in fund mobilization, but it also
helps in proper allocation of these resources. It can have regulation over the resources so that it
can direct funds in a qualitative manner.
Service Provision: As an important financial set up capital market provides various types of
services. It includes long term and medium term loans to industry, underwriting services,
consultancy services, export finance, etc. These services help the manufacturing sector in a large
spectrum.

Continuous Availability of Funds: Capital market is place where the investment avenue is

continuously available for long term investment. This is a liquid market as it makes fund
available on continues basis. Both buyers and seller can easily buy and sell securities as they are
continuously available. Basically capital market transactions are related to the stock exchanges.
Thus marketability in the capital market becomes easy.

Capital Markets: Organizations

Government Securities Market: This is also known as the Gilt-edged market. This refers to the
market for government and semi-government securities backed by the Reserve Bank of India
(RBI).

Industrial Securities Market: This is a market for industrial securities i.e. market for shares and
debentures of the existing and new corporate firms. Buying and selling of such instruments take
place in this market.

This market is further classified into two types such as the New Issues Market (Primary) and the
Old (Existing) Issues Market (secondary). In primary market fresh capital is raised by companies
by issuing new shares, bonds, units of mutual funds and debentures.
However in the secondary market already existing i.e old shares and debentures are traded. This
trading takes place through the registered stock exchanges. In India we have three prominent
stock exchanges. They are the Bombay Stock Exchange (BSE), the National Stock Exchange
(NSE) and Over The Counter Exchange of India (OTCEI).

Development Financial Institutions (DFIs): This is yet another important segment of Indian

capital market. This comprises various financial institutions. These can be special purpose
institutions like IFCI, ICICI, SFCs, IDBI, IIBI, UTI, etc. These financial institutions provide
long term finance for those purposes for which they are set up.

Financial Intermediaries: The fourth important segment of the Indian capital market is the
financial intermediaries. This comprises various merchant banking institutions, mutual funds,
leasing finance companies, venture capital companies and other financial institutions.

Capital Markets: instruments

The instruments issued in capital markets are listed below:

Shares:

Share is the share in the share capital of the company.Share is one of the units into which the
capital of company is divided. A person having the shares of the company is called as
shareholder of that company, He is regarded as the part of owner of the company.

There are 2 types of shares:

 Equity shares
 Preference shares

Debentures

Debentures are long term borrowed funds of the company. They have fixed maturity period as
well as fixed interest rate. These are the certificates issued under common seal of the company.

Bonds

Bonds are the long term borrowed funds of the government and also companies. Like debentures
have fixed maturity and fixed interest rate even bonds have. Here interest charged on bonds
termed as coupon rate.

Derivatives
These are instruments that derive from other securities, which are referred to as underlying
assets. The price, riskiness and function of the derivative depend on the underlying assets since
whatever affects the underlying asset must affect the derivative.

Some examples of derivatives are:

 Futures
 Options
 Swaps

Primary and Secondary Markets

PRIMARY MARKET

When a company publicly sells new stocks and bonds for the first time, it does so in the primary
capital market. This market is also called the new issues market. In many cases, the new issue
takes the form of an initial public offering (IPO). When investors purchase securities on the
primary capital market, the company that offers the securities hires an underwriting firm to
review it and create a prospectus outlining the price and other details of the securities to be
issued.

All issues on the primary market are subject to strict regulation. Companies must file statements
with the Securities and Exchange Commission (SEC) and other securities agencies and must wait
before their filings are approved before they can go public.

Companies that issue securities through the primary capital market may hire investment bankers
to obtain commitments from large institutional investors to purchase the securities when first
offered. Small investors are often unable to purchase securities at this point because the company
and its investment bankers want to sell all of the available securities in a short period of time to
meet the required volume, and they must focus on marketing the sale to large investors who can
buy more securities at once. Marketing the sale to investors can often include a road show or dog
and pony show, in which investment bankers and the company’s leadership travel to meet with
potential investors and convince them of the value of the security being issued.

Prices are often volatile in the primary market because demand is often hard to predict when a
security is first issued. That’s why a lot of IPOs are set at low prices.

A company can raise more equity in the primary market after entering the secondary market
through a rights offering. The company will offer prorated rights based on share investors
already own. Another option is a private placement, where a company may sell directly to a large
investor such as a hedge fund or a bank. In this case, the shares are not made public.

Capital or equity can be raised in the primary market by any of the following four ways-

(i) Public Issue

As the name suggests, public issue means selling securities to the public at large, such as IPO. It
is the most vital method to sell financial securities.

(ii) Rights Issue

Whenever a company needs to raise supplementary equity capital, the shares have to be offered
to present shareholders on a pro-rata basis, which is known as the Rights Issue.

(iii) Private Placement

This is about selling securities to a restricted number of classy investors like frequent investors,
venture capital funds, mutual funds, and banks comes under Private Placement.

(iv) Preferential Allotment

When a listed company issues equity shares to a selected number of investors at a price that may
or may not be pertaining to the market price is known as Preferential Allotment.

The primary market is also known as the New Issue Market (NIM) as it is the market for issuing
long-term equity capital. Since the companies issue securities directly to the investors, it is
responsible to issue the security certificates too. The creation of new securities facilitates growth
within the economy.
SECONDARY MARKET

The secondary market is where securities are traded after the company has sold its offering on
the primary market. It is also referred to as the stock market. The New York Stock Exchange
(NYSE), London Stock Exchange, and Nasdaq are secondary markets.

Small investors have a much better chance of trading securities on the secondary market since
they are excluded from IPOs. Anyone can purchase securities on the secondary market as long as
they are willing to pay the asking price per share.

A broker typically purchases the securities on behalf of an investor in the secondary market.
Unlike the primary market, where prices are set before an IPO takes place, prices on the
secondary market fluctuate with demand. Investors will also have to pay a commission to the
broker for carrying out the trade.

The volume of securities traded varies from day to day, as supply and demand for the security
fluctuates. This also has a big effect on the security’s price.

Because the initial offering is complete, the issuing company is no longer a party to any sale
between two investors, except in the case of a company stock buyback. For example, after
Apple’s Dec. 12, 1980, IPO on the primary market, individual investors have been able to
purchase Apple stock on the secondary market. Because Apple is no longer involved in the issue
of its stock, investors will, essentially, deal with one another when they trade shares in the
company.

The secondary market is further divided into two kinds of market:

(i) Auction Market

An auction market is a place where buyers and sellers convene at a place and announce the rate
at which they are willing to sell or buy securities. They offer either the ‘bid’ or ‘ask’ prices,
publicly. Since all buyers and sellers are convening at the same place, there is no need for
investors to seek out profitable options. Everything is announced publicly and interested
investors can make their choice easily.

(ii) Dealer Market

In a dealer market, none of the parties convene at a common location. Instead, buying and selling
of securities happen through electronic networks which usually fax machines, telephones or
custom order-matching machines.

Interested sellers deliver their offer through these mediums, which are then relayed over to the
buyers through the medium of dealers. The dealers possess an inventory of securities and earn
their profit through the selling. A lot of dealers operate within this market and therefore, a
competition exists between them to deliver the best offer to their investors. This makes them
deliver the best price to the investors. An example of a dealer market is the NASDAQ.

The secondary markets are important for price discovery. The market operations are carried out
on stock exchanges.

Financial Markets and institutions and its Components

The financial system of an economy provides the way to collect money from the people who
have it and distribute it to those who can use it best. So, the efficient allocation of economic
resources is achieved by a financial system that distributes money to those people and for those
purposes that will yield the best returns.

The financial system is composed of the products and services provided by financial institutions,
which includes banks, insurance companies, pension funds, organized exchanges, and the many
other companies that serve to facilitate economic transactions. Virtually all economic
transactions are effected by one or more of these financial institutions. They create financial
instruments, such as stocks and bonds, pay interest on deposits, lend money to creditworthy
borrowers, and create and maintain the payment systems of modern economies.

These financial products and services are based on the following fundamental objectives of any
modern financial system:

1. To provide a payment system

2. To give time value to money
3. To offer products and services to reduce financial risk or to compensate risk-
taking for desirable objectives
4. To collect and disperse information that allows the most efficient allocation of
economic resources
5. To create and maintain financial markets that provide prices, which indicates
how well investments are performing, determines the subsequent allocation of
resources, and to maintain economic stability in the markets

Components of Financial System

A financial system refers to a system which enables the transfer of money between investors and
borrowers. A financial system could be defined at an international, regional or organizational
level. The term “system” in “Financial System” indicates a group of complex and closely linked
institutions, agents, procedures, markets, transactions, claims and liabilities within an economy.
There are five components of Financial System which is discussed below:
1.Financial Institutions:

It ensures smooth working of the financial system by making investors and borrowers meet.
They mobilize the savings of investors either directly or indirectly via financial markets by
making use of different financial instruments as well as in the process using the services of
numerous financial services providers. They could be categorized into Regulatory,
Intermediaries, Non-intermediaries and Others. They offer services to organizations looking for
advises on different problems including restructuring to diversification strategies. They offer
complete series of services to the organizations who want to raise funds from the markets and
take care of financial assets, for example deposits, securities, loans, etc.

2. Financial Markets: 

A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
services, a financial transaction involves creation or transfer of a financial asset. Financial Assets
or Financial Instruments represent a claim to the payment of a sum of money sometime in the
future and /or periodic payment in the form of interest or dividend. There are four components of
financial market are given below:

(A) Money Market:

The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. 
Funds are available in this market for periods ranging from a single day up to a year.  This
market is dominated mostly by government, banks and financial institutions.

(B) Capital Market:

The capital market is designed to finance the long-term investments.  The transactions taking
place in this market will be for periods over a year.

(C) Foreign Exchange Market:

The Foreign Exchange market deals with the multicurrency requirements which are met by the
exchange of currencies.  Depending on the exchange rate that is applicable, the transfer of funds
takes place in this market.  This is one of the most developed and integrated markets across the
globe.

(D) Credit Market

Credit market is a place where banks, Financial Institutions (FIs) and Non Bank Financial
Institutions (NBFCs) purvey short, medium and long-term loans to corporate and individuals.
3. Financial Instruments:

This is an important component of financial system. The products which are traded in a financial
market are financial assets, securities or other types of financial instruments. There are a wide
range of securities in the markets since the needs of investors and credit seekers are different.
They indicate a claim on the settlement of principal down the road or payment of a regular
amount by means of interest or dividend. Equity shares, debentures, bonds, etc. are some
examples.

4. Financial Services

It consists of 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. They
assist to determine the financing combination and extend their professional services up to the
stage of servicing of lenders. They help with borrowing, selling and purchasing securities,
lending and investing, making and allowing payments and settlements and taking care of risk
exposures in financial markets. These range from the leasing companies, mutual fund houses,
merchant bankers, portfolio managers, bill discounting and acceptance houses. The financial
services sector offers a number of professional services like credit rating, venture capital
financing, mutual funds, merchant banking, depository services, book building, etc. Financial
institutions and financial markets help in the working of the financial system by means of
financial instruments. To be able to carry out the jobs given, they need several services of
financial nature. Therefore, financial services are considered as the 4th major component of the
financial system.

5. Money:

It is understood to be anything that is accepted for payment of products and services or for the
repayment of debt. It is a medium of exchange and acts as a store of value. It eases the exchange
of different goods and services for money.

UNIT 3 Financial Institutions

Indian Banking Industry

Structure and organization of banks

The existing banking structure in India evolved over several decades, is elaborate and has been
serving the credit and banking services needs of the economy. There are multiple layers in
today’s banking structure to cater to the specific and varied requirements of different customers
and borrowers. The structure of banking in India played a major role in the mobilization of
savings and promoting economic development. In the post-financial sector reforms (1991) phase,
the performance and strength of the banking structure improved perceptibly. Financial soundness
of the Indian commercial banking system compares favorably with most of the advanced and
emerging countries.

A bank is a financial institution that provides banking and other financial services to their
customers. A bank is generally understood as an institution which provides fundamental banking
services such as accepting deposits and providing loans. There are also nonbanking institutions
that provide certain banking services without meeting the legal definition of a bank. Banks are a
subset of the financial services industry.

Indian banking industry has been divided into two parts, organized and unorganized sectors. The
organized sector consists of Reserve Bank of India, Commercial Banks and Cooperative Banks,
and Specialized Financial Institutions (IDBI, ICICI, IFC etc).

1. Reserve banks of India.

2. Indian Scheduled Commercial Banks.
3. State Bank of India and its associate banks.
4. Twenty nationalized banks.
5. Regional rural banks.
6. Other scheduled commercial banks.
7. Foreign Banks
4. Non-scheduled banks.
5. Co-operative banks.

Banking System

The structure of banking system differs from country to country depending upon their economic
conditions, political structure, and financial system. Banks can be classified on the basis of the
volume of operations, business pattern and areas of operations. They are termed as a system of
banking. The commonly identified systems are:

Unit Banking

Unit banking is originated and developed in the U.S.A. In this system, small independent banks
are functioning in a limited area or in a single town . It has its own board of directors and
stockholders. It is also called as “localized Banking”.

Branch Banking

The Banking system of England originally offered an example of the branch banking system,
where each commercial bank has a network of branches spread throughout the country.

Correspondent Banking
The correspondent banking system is developed to remove the difficulties in the unit banking
system. The smaller banks deposit their cash reserve with bigger banks.

Therefore, correspondent banks are intermediaries through which all unit banks are linked with
bigger banks in financial centers. Through correspondent banking, a bank can carry-out business
transactions in another place where it does not have a branch.

Group Banking

Group Banking is the system in which two or more independently incorporated banks are
brought under the control of a holding company. The holding company may or may not be a
banking company. Under group banking, the individual banks may be unit banks, or banks
operating branches or a combination of the two.

Pure Banking and Mixed Banking

On the basis of lending operations of the bank, banking is classified into:

(a) Pure Banking: Under pure Banking, the commercial banks give only short-term loans to
industry, trade, and commerce. They specialize in short-term finance only. This type Of banking
is popular in U.K.
(b) Mixed Banking: Mixed banking is that system of banking under which the commercial ban s
perform the dual function of commercial banking and investment banking. Commercial banks
usually offer both short-term as well as medium-term loans. The German banking system is the
best example of mixed Banking.

Relationship Banking

It refers to the efforts of a bank to promote personal contacts and to keep continuous touch with
customers who are very valuable to the bank. In order to retain such profitable accounts with the
bank or to attract new accounts, it is necessary for the bank to serve their needs by maintaining a
close relationship with such customers.

Narrow Banking

A bank may be concentrating only on the collection of deposits and lend or invest the money
within a particular region or certain chosen activity like investing the funds only in Government
Securities. This type of restricted minimum banking activity is referred to as ‘Narrow Banking’.

Universal Banking

As Narrow Banking refers to restricted and limited banking activity Universal Banking refers to
broad-based and comprehensive banking activities.
Regional Banking

In order to provide adequate and timely credits to small borrowers in rural and semi-urban areas,
Central Government set up Regional Banks, known as Regional Rural Banks all over India
jointly with State Governments and some Commercial Banks.

Local Area Banks

With a view to bringing about a competitive environment and to overcome the deficiencies of
Regional Banks, Government has permitted the establishment of one type of regional banks in
rural and semi-urban centers under private sector known as “Local Area Banks”.

Wholesale Banking

Wholesale or corporate banking refers to dealing with limited large-sized customers. Instead of
maintaining thousands of small accounts and incurring huge transaction costs, under wholesale
banking, the banks deal with large customers and keep only large accounts. These are mainly
corporate customer.

Private Banking

Private or Personal Banking is banking with people — rich individuals instead of banking with
corporate clients. It attends to the need of individual customers, their preferences and the
products or services needed by them. This may include all-around personal services like
maintaining accounts, loans, foreign currency requirements, investment guidance, etc.

Retail Banking

Retail banking is a major form of commercial banking but mainly targeted to consumers rather
than corporate clients. It is the method of banks’ approach to the customers for sale of their
products.

RBI

Role and functions

The Reserve Bank of India is the central bank of India, was established on April 1, 1935 during
the British-Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The
Reserve Bank of India was set up on the recommendations of the Hilton Young Commission.
The commission submitted its report in the year 1926, though the bank was not set up for nine
years. The Central Office of the Reserve Bank was initially established in Kolkata, Bengal, but
was permanently moved to Mumbai in 1937. Though originally privately owned, the RBI has
been fully owned by the Government of India since nationalization in 1949. The Preamble of the
Reserve Bank of India describes the basic functions of the Reserve Bank as to regulate the issue
of Bank Notes and keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its advantage.

The Reserve Bank of India performs various traditional central banking functions as well as
undertakes different promotional and developmental measures to meet the dynamic requirements
of the Indian economy.

Role of RBI in Economic Development

1. Development of banking system

2. Development of financial institutions
3. Development of backward areas
4. Economic stability
5. Economic growth
6. Proper interest rate structure

Promotional Role of RBI

1. Promotion of commercial banking

2. Promotion of cooperative banking
3. Promotion of industrial finance
4. Promotion of export finance
5. Promotion of credit to weaker sections
6. Promotion of credit guarantees
7. Promotion of differential rate of interest scheme
8. Promotion of credit to priority sections including rural & agricultural sector

Functions of Reserve Bank of India

1. Monetary Authority: It controls the supply of money in the economy to

stabilize exchange rate, maintain healthy balance of payment, attain financial
stability, control inflation, strengthen banking system
2. The issuer of currency: The objective is to maintain the currency and credit
system of the country to maintain the reserves. It has the sole authority in India
to issue currency. It also takes action to control the circulation of fake currency.
3. The issuer of Banking License: As per Sec 22 of Banking Regulation Act,
every bank has to obtain a Banking license from RBI to conduct banking
business in India.
4. Banker’s to the Government: It acts as banker both to the central and the state
governments. It provides short-term credit. It manages all new issues of
 government loans, servicing the government debt outstanding and nurturing the
market for government’s securities. It advises the government on banking and
financial subjects.
5. Banker’s Bank: RBI is the bank of all banks in India as it provides the loan to
banks/bankers, accept the deposit of banks, and rediscount the bills of banks.
6. Lender of last resort: The banks can borrow from the RBI by keeping eligible
securities as collateral at the time of need or crisis.
7. Banker and debt manager of government: RBI keeps deposits of
Governments free of interest, receives and makes payment, carry exchange
remittances, and help to float new loans and manage public debt, act as an
advisor to Government.
8. Money supply and Controller of Credit: To control demand and supply of
money in Economy by Open Market Operations, Credit Ceiling, etc. RBI has to
meet the credit requirements of the rest of the banking system. It needs to
maintain price stability and a high rate of economic growth.
9. Act as clearinghouse: For settlement of banking transactions, RBI manages 14
clearing houses. It facilitates the exchange of instruments and processing of
payment instructions.
10.Manager of foreign exchange: It acts as a custodian of FOREX. It administers
and enforces the provision of Foreign Exchange Management Act (FEMA),
1999. RBI buys and sells foreign currency to maintain the exchange rate of
Indian rupee v/s foreign currencies.
11.Regulator of Economy: It controls the money supply in the system, monitors
different key indicators like GDP, Inflation, etc.
12.Managing Government securities: RBI administers investments in
institutions when they invest specified minimum proportions of their total
assets/liabilities in government securities.
13.Regulator and Supervisor of Payment and Settlement systems: The
Payment and Settlement systems Act of 2007 (PSS Act) gives RBI oversight
authority for the payment and settlement systems in the country. RBI focuses
on the development and functioning of safe, secure and efficient payment and
settlement mechanisms.
14.Developmental Role: This role includes the development of the quality of
banking system in India and ensuring that credit is available to the productive
sectors of the economy. It provides a wide range of promotional functions to
support national objectives. It also includes establishing institutions designed to
build the country’s financial infrastructure. It also helps in expanding access to
affordable financial services and promoting financial education and literacy
15.Publisher of monetary data and other data: RBI maintains and provides all
essential banking and other economic data, formulating and critically
 evaluating the economic policies in India. RBI collects, collates and publishes
data regularly.
16.Exchange manager and controller: RBI represents India as a member of the
International Monetary Fund [IMF]. Most commercial banks are authorized
dealers of RBI
17.Banking Ombudsman Scheme: RBI introduced the Banking Ombudsman
Scheme in 1995. Under this scheme, the complainants can file their complaints
in any form, including online and can also appeal to the RBI against the awards
and the other decisions of the Banking Ombudsman
18.Banking Codes and Standards Board of India: To measure the performance
of banks against Codes and standards based on established global practices, the
RBI set up the Banking Codes and Standards Board of India (BCSBI).

Commercial Banking: features, instruments

Structure of Commercial Banks in India:

The commercial banks can be broadly classified under two heads:

1. Scheduled Banks:

Scheduled Banks refer to those banks which have been included in the Second Schedule of
Reserve Bank of India Act, 1934.

In India, scheduled commercial banks are of three types:

(i) Public Sector Banks:

These banks are owned and controlled by the government. The main objective of these banks is
to provide service to the society, not to make profits. State Bank of India, Bank of India, Punjab
National Bank, Canada Bank and Corporation Bank are some examples of public sector banks.

Public sector banks are of two types:

(a) SBI and its subsidiaries;

(b) Other nationalized banks.

(ii) Private Sector Banks:

These banks are owned and controlled by private businessmen. Their main objective is to earn
profits. ICICI Bank, HDFC Bank, IDBI Bank is some examples of private sector banks.

(iii) Foreign Banks:

These banks are owned and controlled by foreign promoters. Their number has grown rapidly
since 1991, when the process of economic liberalization had started in India. Bank of America,
American Express Bank, Standard Chartered Bank are examples of foreign banks.

2. Non-Scheduled Banks:

Non-Scheduled banks refer to those banks which are not included in the Second Schedule of
Reserve Bank of India Act, 1934.

Commercial banks are of (3) Three Types:

(a) Public Sector Banks:

Refer to a type of commercial banks that are nationalized by the government of a country. In
public sector banks, the major stake is held by the government. In India, public sector banks
operate under the guidelines of Reserve Bank of India (RBI), which is the central bank. Some of
the Indian public sector banks are State Bank of India (SBI), Corporation Bank, Bank of Baroda,
Dena Bank, and Punjab National Bank.

(b) Private Sector Banks:

Refer to a kind of commercial banks in which major part of share capital is held by private
businesses and individuals. These banks are registered as companies with limited liability. Some
of the Indian private sector banks are Vysya Bank, Industrial Credit and Investment Corporation
of India (ICICI) Bank, and Housing Development Finance Corporation (HDFC) Bank.
(c) Foreign Banks:

Refer to commercial banks that are headquartered in a foreign country, but operate branches in
different countries. Some of the foreign banks operating in India are Hong Kong and Shanghai
Banking Corporation (HSBC), Citibank, American Express Bank, Standard & Chartered Bank,
and Grindlay’s Bank. In India, since financial reforms of 1991, there is a rapid increase in the
number of foreign banks. Commercial banks mark significant importance in the economic
development of a country as well as serving the financial requirements of the general public.

Development Financial Institutions (DFIs)

An Overview and role in Indian economy

Capital Formation:

The significance of Development Finance Institutions or DFIs lies in their making available the
means to utilize savings generated in the economy, thus helping in capital formation. Capital
formation implies the diversion of the productive capacity of the economy to the making of
capital goods which increases future productive capacity. The process of Capital Formation
involves three distinct but interdependent activities, viz., saving financial intermediation and
investment.

However, poor country/economy may be, there will be a need for institutions which allow such
savings, as are currently forthcoming, to be invested conveniently and safely and which ensure
that they are channeled into the most useful purposes. A well-developed financial structure will
therefore aid in the collections and disbursements of investible funds and thereby contribute to
the capital formation of the economy. Indian capital market although still considered to be
underdeveloped has been recording impressive progress during the post-interdependence period.

Support to the Capital Market

The basic purpose of DFIs particularly in the context of a developing economy, is to accelerate
the pace of economic development by increasing capital formation, inducing investors and
entrepreneurs, sealing the leakages of material and human resources by careful allocation
thereof, undertaking development activities, including promotion of industrial units to fill the
gaps in the industrial structure and by ensuring that no healthy projects suffer for want of finance
and/or technical services.

Hence, the DFIs have to perform financial and development functions on finance functions, there
is a provision of adequate term finance and in development functions there include providing of
foreign currency loans, underwriting of shares and debentures of industrial concerns, direct
subscription to equity and preference share capital, guaranteeing of deferred payments,
conducting techno-economic surveys, market and investment research and rendering of technical
and administrative guidance to the entrepreneurs.

Rupee Loans

Rupee loans constitute more than 90 per cent of the total assistance sanctioned and disbursed.
This speaks eloquently on DFI’s obsession with term loans to the neglect of other forms of
assistance which are equally important. Term loans unsupplemented by other forms of assistance
had naturally put the borrowers, most of whom are small entrepreneurs, on to a heavy burden of
debt-servicing. Since term finance is just one of the inputs but not everything for the
entrepreneurs, they had to search for other sources and their abortive efforts to secure other
forms of assistance led to sickness in industrial units in many cases.

Foreign Currency Loans

Foreign currency loans are meant for setting up of new industrial projects as also for expansion,
diversification, modernization or renovation of existing units in cases where a portion of the loan
was for financing import of equipment from abroad and/or technical know-how, in special cases.

Subscription to Debentures and Guarantees

Regarding guarantees, it is well-known that when an entrepreneur purchases some machinery or

fixed assets or capital goods on credit, the supplier usually asks him to furnish some guarantee to
ensure payment of installments by the purchaser at regular intervals. In such a case, DFIs can act
as guarantors for prompt of installments to the supplier of such machinery or capital under a
scheme called ‘Deferred Payments Guarantee’.

Assistance to Backward Areas

Operations of DFI’s in India have been primarily guided by priorities as spelt out in the Five-
Year Plans. This is reflected in the lending portfolio and pattern of financial assistance of
development financial institutions under different schemes of financing. Institutional finance to
projects in backward areas is extended on concessional terms such as lower interest rate, longer
moratorium period, extended repayment schedule and relaxed norms in respect of promoters’
contribution and debt-equity ratio.

Such concessions are extended on a graded scale to units in industrially backward districts,
classified into the three categories of A, B and c depending upon the degree of their
backwardness. Besides, institutions have introduced schemes for extending term loans for
project/area-specific infrastructure development.

Moreover, in recent years, development banks in India have launched special programmes for
intensive development of industrially least developed areas, commonly referred to as the No-
industry Districts (NID’s) which do not have any large-scale or medium-scale industrial project.
Institutions have initiated industrial potential surveys in these areas.
Promotion of New Entrepreneurs

Development banks in India have also achieved a remarkable success in creating a new class of
entrepreneurs and spreading the industrial culture to newer areas and weaker sections of the
society.

Special capital and seed Capital schemes have been introduced to provide equity type of
assistance to new and technically skilled entrepreneurs who lack financial resources of their own
even to provide promoter’s contribution in view of long-term benefits to the society from the
emergence of a new class of entrepreneurs. Development banks have been actively involved in
the entrepreneurship development programmes and in establishing a set of institutions which
identify and train potential entrepreneurs.

Again, to make available a package of services encompassing preparation of feasibility of

reports, project reports, technical and management consultancy etc. at a reasonable cost,
institutions have sponsored a chain of 16 Technical Consultancy organizations covering
practically the entire country.

Promotional and development functions are as important to institutions as the financing role. The
promotional activities like carrying out industrial potential surveys, identification of potential
entrepreneurs, conducting entrepreneurship development programmes and providing technical
consultancy services have contributed in a significant manner to the process of industrialization
and effective utilization of industrial finance by industry.

IDBI has created a special technical assistance fund to support its various promotional activities.
Over the years, the scope of promotional activities has expanded to include programmes for up
gradation of skill of State level development banks and other industrial promotion agencies,
conducting special studies on important issues concerning industrial development, encouraging
voluntary agencies in implementing their programmes for the uplift of rural areas, village an
cottage industries, artisans and other weaker sections of the society.

Impact on Corporate Culture

The project appraisal and follow-up of assisted projects by institutions through various
instruments, such as project monitoring and report of nominee directors on the Boards of
directors of assisted units, have been mutually rewarding.

Through monitoring of assisted projects, the institutions have been able to better appreciate the
problems faced by industrial units. It also has been possible for the corporate managements to
recognize the fact that interests of the assisted units and those of institutions do not conflict but
coincide.

Over the years, institutions have succeeded in infusing a sense of constructive partnership with
the corporate sector. Institutions have been going through a continuous process of learning by
doing and are effecting improvements in their systems and procedures on the basis of their
cumulative experience.

The promoters of industrial projects now develop ideas into specific projects more carefully and
prepare project reports more systematically. Institutions insist on more critical evaluation of
technical feasibility demand factors, marketing strategies and project location and on application
of modern techniques of discounted cash flow, internal rate of return, economic rate of return
etc., in assessing the prospects of a project.

This has produced a favorable impact on the process of decision-making in the corporate seeking
financial assistance from institutions. In fact, such impact is not continued to projects assisted by
them but also spreads over to projects financed by the corporate sector on its own.

The association of institutions in the management of corporate bodies has considerably

facilitated the process of progressive professionalism of the corporate management. Institutions
have been able to convince the corporate managements to appropriately re-orient their
organizational structure, personal policies and planning and control systems. In many cases,
institutions have successfully inducted experts on the Boards of assisted companies.

As part of their project follow-up work and through their nominee directors, institutions have
also been able to bring about progressive adoption of modern management techniques, such as
corporate planning and performance budgeting in the assisted units. The progressive
professionalism of industrial management in India reflects one of the major qualitative changes
brought about by the institutions.

Life and Non-life institutions in India

LIFE and NON-LIFE Insurance companies in India

A brief history of the Insurance sector

The business of life insurance in India in its existing form started in India in the year 1818 with
the establishment of the Oriental Life Insurance Company in Calcutta.

Some of the important milestones in the life insurance business in India are:

 1912: The Indian Life Assurance Companies Act enacted as the first statute to
regulate the life insurance business.
 1928: The Indian Insurance Companies Act enacted to enable the government
to collect statistical information about both life and non-life insurance
businesses.
  1938: Earlier legislation consolidated and amended to by the Insurance Act
with the objective of protecting the interests of the insuring public.
 1956: 245 Indian and foreign insurers and provident societies taken over by the
central government and nationalised. LIC formed by an Act of Parliament, viz.
LIC Act, 1956, with a capital contribution of Rs. 5 crore from the Government
of India.

The General insurance business in India, on the other hand, can trace its roots to the Triton
Insurance Company Ltd., the first general insurance company established in the year 1850 in
Calcutta by the British.

Some of the important milestones in the general insurance business in India are:

 1907: The Indian Mercantile Insurance Ltd. set up, the first company to transact
all classes of general insurance business.
 1957: General Insurance Council, a wing of the Insurance Association of India,
frames a code of conduct for ensuring fair conduct and sound business
practices.
 1968: The Insurance Act amended to regulate investments and set minimum
solvency margins and the Tariff Advisory Committee set up.
 1972: The General Insurance Business (Nationalisation) Act, 1972 nationalised
the general insurance business in India with effect from 1st January 1973.
 107 insurers amalgamated and grouped into four companies viz. the National
Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental
Insurance Company Ltd. and the United India Insurance Company Ltd. GIC
incorporated as a company.

Insurance sector reforms

In 1993, Malhotra Committee headed by former Finance Secretary and RBI Governor R.N.
Malhotra was formed to evaluate the Indian insurance industry and recommend its future
direction.

The Malhotra committee was set up with the objective of complementing the reforms initiated in
the financial sector. The reforms were aimed at “creating a more efficient and competitive
financial system suitable for the requirements of the economy keeping in mind the structural
changes currently underway and recognizing that insurance is an important part of the overall
financial system where it was necessary to address the need for similar reforms…”

In 1994, the committee submitted the report and some of the key recommendations included:

1) Structure
  Government stake in the insurance Companies to be brought down to 50%.
 Government should take over the holdings of GIC and its subsidiaries so that
these subsidiaries can act as independent corporations.
 All the insurance companies should be given greater freedom to operate.

2) Competition

 Private Companies with a minimum paid up capital of Rs.1bn should be

allowed to enter the industry.
 No Company should deal in both Life and General Insurance through a single
entity.
 Foreign companies may be allowed to enter the industry in collaboration with
the domestic companies.
 Postal Life Insurance should be allowed to operate in the rural market.
 Only One State Level Life Insurance Company should be allowed to operate in
each state.

3) Regulatory Body

 The Insurance Act should be changed.

 An Insurance Regulatory body should be set up.
 Controller of Insurance (Currently a part from the Finance Ministry) should be
made independent.

4) Investments

 Mandatory Investments of LIC Life Fund in government securities to be

reduced from 75% to 50%.
 GIC and its subsidiaries are not to hold more than 5% in any company (There
current holdings to be brought down to this level over a period of time).

5) Customer Service

 LIC should pay interest on delays in payments beyond 30 days.

 Insurance companies must be encouraged to set up unit linked pension plans.
 Computerisation of operations and updating of technology to be carried out in
the insurance industry The committee emphasized that in order to improve the
customer services and increase the coverage of the insurance industry should be
opened up to competition.

But at the same time, the committee felt the need to exercise caution as any failure on the part of
new players could ruin the public confidence in the industry. Hence, it was decided to allow
competition in a limited way by stipulating the minimum capital requirement of Rs.100 crores.
The committee felt the need to provide greater autonomy to insurance companies in order to
improve their performance and enable them to act as independent companies with economic
motives. For this purpose, it had proposed setting up an independent regulatory body.

MAJOR POLICY CHANGES

Insurance sector has been opened up for competition from Indian private insurance companies
with the enactment of Insurance Regulatory and Development Authority Act, 1999 (IRDA Act).
As per the provisions of IRDA Act, 1999, Insurance Regulatory and Development Authority
(IRDA) was established on 19th April 2000 to protect the interests of holder of insurance policy
and to regulate, promote and ensure orderly growth of the insurance industry. IRDA Act 1999
paved the way for the entry of private players into the insurance market which was hitherto the
exclusive privilege of public sector insurance companies/ corporations. Under the new
dispensation Indian insurance companies in private sector were permitted to operate in India with
the following conditions:

 Company is formed and registered under the Companies Act, 1956;

 The aggregate holdings of equity shares by a foreign company, either by itself
or through its subsidiary companies or its nominees, do not exceed 26%, paid
up equity capital of such Indian insurance company;
 The company’s sole purpose is to carry on life insurance business or general
insurance business or reinsurance business.
 The minimum paid up equity capital for life or general insurance business is
Rs.100 crores.
 The minimum paid up equity capital for carrying on reinsurance business has
been prescribed as Rs.200 crores.
The Authority has notified 27 Regulations on various issues which include Registration of
Insurers, Regulation on insurance agents, Solvency Margin, Re-insurance, Obligation of Insurers
to Rural and Social sector, Investment and Accounting Procedure, Protection of policy holders’
interest etc. Applications were invited by the Authority with effect from 15th August, 2000 for
issue of the Certificate of Registration to both life and non-life insurers. The Authority has its
Head Quarter at Hyderabad.

Protection of the interest of policy holders:

IRDA has the responsibility of protecting the interest of insurance policyholders. Towards
achieving this objective, the Authority has taken the following steps:

 IRDA has notified Protection of Policyholders Interest Regulations 2001 to

provide for: policy proposal documents in easily understandable language;
claims procedure in both life and non-life; setting up of grievance redressal
machinery; speedy settlement of claims; and policyholders’ servicing. The
Regulation also provides for payment of interest by insurers for the delay in
settlement of claim.
 The insurers are required to maintain solvency margins so that they are in a
position to meet their obligations towards policyholders with regard to payment
of claims.
 It is obligatory on the part of the insurance companies to disclose clearly the
benefits, terms and conditions under the policy. The advertisements issued by
the insurers should not mislead the insuring public.
 All insurers are required to set up proper grievance redress machinery in their
head office and at their other offices.
 The Authority takes up with the insurers any complaint received from the
policyholders in connection with services provided by them under the insurance
contract. 

General Insurance Companies:

Private Sector Companies

 Aditya Birla Health Insurance Co. Ltd.

 Bajaj Allianz General Insurance Co. Ltd.
 Bharti AXA General Insurance Co.Ltd.
 Cholamandalam General Insurance Co. Ltd.
 Future Generali India Insurance Co.Ltd.
 HDFC ERGO General Insurance Co. Ltd.
 ICICI Lombard General Insurance Co. Ltd.
 IFFCO-Tokio General Insurance Co. Ltd.
  Kotak General Insurance Co. Ltd.
 L&T General Insurance Co. Ltd.
 Liberty Videocon General Insurance Co. Ltd.
 Magma HDI General Insurance Co. Ltd.
 Raheja QBE General Insurance Co. Ltd.
 Reliance General Insurance Co. Ltd.
 Royal Sundaram Alliance Insurance Co. Ltd
 SBI General Insurance Co. Ltd.
 Shriram General Insurance Co. Ltd.
 TATA AIG General Insurance Co. Ltd.
 Universal Sompo General Insurance Co.Ltd.

Health Insurance Companies

 Apollo Munich Health Insurance Co.Ltd.

 Star Health Allied Insurance Co. Ltd.
 Max Bupa Health Insurance Co. Ltd.
 Religare Health Insurance Co. Ltd.
 Cigna TTK Health Insurance Co. Ltd.

This collaboration with the foreign markets has made the Insurance Sector in India only grow
tremendously with a high current market share. India allowed private companies in insurance
sector in 2000, setting a limit on FDI to 26%, which was increased to 49% in 2014. IRDAI states
–  Insurance Laws (Amendment) Act, 2015 provides for enhancement of the Foreign Investment
Cap in an Indian Insurance Company from 26% to an Explicitly Composite Limit of 49% with
the safeguard of Indian Ownership and Control.

Private insurers like HDFC, ICICI and SBI have been some tough competitors for providing life
as well as non-life products to the insurance sector in India.

The Future Of Insurance Sector In India

Though LIC continues to dominate the Insurance sector in India, the introduction of the new
private insurers will see a vibrant expansion and growth of both life and non-life sectors in 2017.
The demands for new insurance policies with pocket-friendly premiums are sky high. Since the
domestic economy cannot grow drastically, the insurance sector in India is controlled for a
strong growth.

With the increase in income and exponential growth of purchasing power as well as household
savings, the insurance sector in India would introduce emerging trends like product innovation,
multi-distribution, better claims management and regulatory trends in the Indian market.
The government also strives hard to provide insurance to individuals in a below poverty line by
introducing schemes like the

 Pradhan Mantri Suraksha Bima Yojana (PMSBY),

 Rashtriya Swasthya Bima Yojana (RSBY) and
 Pradhan Mantri Jeevan Jyoti Bima Yojana (PMJJBY).

Introduction of these schemes would help the lower and lower-middle income categories to
utilize the new policies with lower premiums in India.

With several regulatory changes in the insurance sector in India, the future looks pretty awesome
and promising for the life insurance industry. This would further lead to a change in the way
insurers take care of the business and engage proactively with its genuine buyers.

Some demographic factors like the growing insurance awareness of the insurance, retirement planning,
growing middle class and young insurable crowd will substantially increase the growth of the Insurance
sector in India.

Mutual Funds
A mutual fund scheme collects money from investors and buys and sell stocks collectively.

A mutual fund is a professionally managed investment fund that pools money from many
investors to purchase securities. These investors may be retail or institutional in nature.

Mutual funds have advantages and disadvantages compared to direct investing in individual

securities. The primary advantages of mutual funds are that they provide economies of scale, a
higher level of diversification, they provide liquidity, and they are managed by professional
investors. On the negative side, investors in a mutual fund must pay various fees and expenses.

Types of mutual funds in India Again, we are trying to make it as simple as possible in
explaining to you the different types of mutual funds.

 Equity Funds: Equity funds invest most of the money that they gather from
investors into equity shares. These are high risk schemes and investors can also
make losses, since most of the money is parked into shares. These types of
schemes are suitable for investors with an appetite for risk
 Debt Funds: Debt funds invest most of their money into debt schemes
including corporate debt, debt issued by banks, gilts and government securities.
These types of funds are suitable for investors who are not willing to take risks.
Returns are almost assured in these types of schemes
  Balanced funds: Balanced funds invest their money in equity as well as debt.
They generally tend to skew the money more into equity then debt. The
objective in the end is again to earn superior returns. Of course, they might alter
their investment pattern based on market conditions.
 Money Market Mutual Funds: Money market mutual funds are also called
Liquid funds. They invest a bulk of their money in safer short-term instruments
like Certificates of Deposit, Treasury and Commercial Paper. Most of the
investment is for a smaller duration.
 Gilt Funds: Gilt Funds are perhaps the most secure instruments that are
around. They invest bulk of their money in government securities. Since they
have backing of the government they are considered the safest mutual fund
units around.

Role in capital Market Development

 Investing in mutual funds have become hugely popular since 2003. To add to it and bring
awareness among investors and non-investors alike, AMFI (Association of Mutual Funds in
India) has started ‘Mutual Funds Sahi Hai’ campaign. It is interesting to see that majority of the
salaried population of India tends to invest in Mutual Funds. One of the major reason behind it is
the diversification of the fund schemes that allows more investors to come in and invest. Also,
investing Mutual funds provide tax exemption for the salaried class and thus, they opt towards
investing in Mutual funds.
 Non-Banking Financial Companies (NBFCs)
A Non – Banking Financial Corporation is a company incorporated under the Companies Act
2013 or 1956 which is engaged in the business of Loans and Advances, Acquisition of stocks,
equities, debt etc issued by the government or any local authority. The main objective of this
type of a company is to accept deposits under any scheme or manner.   

According to section 451(c) of the RBI Act, a Non – Banking Company carrying on the business
of a financial institution will be an NBFC. It is governed by the Ministry of Corporate Affairs as
well as the Reserve Bank of India.

The following NBFC’s are not required to obtain any registration with the Reserve Bank of
India:

1. Core Investment Companies – (assets are less than 100 crore or public funds
not taken)
2. Merchant Banking Companies
3. Companies which are engaged in the business of stock-broking
4. Housing Finance Companies
5. Companies engaged in the business of Venture Capital.
6. Insurance companies holding a certificate of registration issued by IRDA.
7. Chit Fund Companies as defined in the Sec 2 clause (b) of the Chit Fund Act,
1982
8. Nidhi Companies

Incorporate an NBFC

1. A company should first be registered under the Companies Act 2013 or under
Companies Act 1956.
2. The minimum net owned funds of the Company should be Rs. 2 Crore.
3. There should be a minimum of 1 Director from the same background or a
Senior Banker as a full-time director in the Company.
4. The CIBIL records of the Company should be clean
5. After all of the above conditions have been satisfied the online application on
the website of RBI should be filled and submitted along with the requisite
documents.
6. A CARN Number will be generated.
7. A Hard copy of the application also has to be sent to the regional branch of the
Reserve Bank of India.
8. After the application is properly scrutinized, the License will be given to the
Company.
NBFC Guidelines

The Company once it gets it license has to adhere to the following guidelines:

1. They cannot receive deposits which are payable on demand.

2. The public Deposits which the company can take should be for a minimum
time period of 12 months and a maximum time period of 60 months.
3. The interest charged by the Company cannot be more than the ceiling
prescribed by the Reserve Bank of India.
4. The repayment of any amount so taken by the Company will not be guaranteed
by the Reserve Bank of India.
5. All the information about the company as well as any change in the
composition of the Company has to be furnished to the Reserve Bank of India.
6. The deposits taken by the Public will be unsecured.
7. The Company has to submit its audited balance sheet every year.
8. A statutory return on the deposits taken by the company has to be furnished in
the form NBS – 1 every year.
9. A Quarterly Return on the liquid assets of the company has to be furnished.

 A certificate from the auditors had to be taken stating that the company is in a
position to pay back all the deposits or money taken from the Public.
 A half-yearly ALM return has to be given by the company which has a Public
Deposit of Rs. 20 Crore and above or has assets worth Rs. 100 Crore and
above.
 The credit rating has to be taken every 6 months and submitted to the RBI.
 A minimum level of 15% of the Public Deposits has to be maintained by the
Company in Liquid Assets.

If the NBFC defaults in the payment of any amount taken, the consumer can go to the National
Company Law Tribunal or the Consumer Forum to file a suit against the Company.

Following are the types of NBFC’s:

On the basis of the nature of Activity

On the basis of Deposits

UNIT 4 Financial Services

Merchant Banking
The term ‘merchant banking’ has been used differently in different parts of the world. While in
U.K. merchant banking refers to the ‘accepting and issuing houses’, in U.S.A. it is known as
‘investment banking’. The word merchant banking has been so widely used that sometimes it is
applied to banks who are not merchants, sometimes to merchants who are not banks and
sometimes to those intermediaries who are neither merchants not banks.

In India merchant banking services were started only in 1967 by National Grindlays Bank
followed by Citi Bank in 1970. The State Bank of India was the first Indian Commercial Bank
having set up separate Merchant Banking Division in 1972. In India merchant banks have been
primarily operating as issue houses than full- fledged merchant banks as in other countries.

A merchant bank may be defined as an institution or an organisation which provides a number of

services including management of securities issues, portfolio services, underwriting of capital
issues, insurance, credit syndication, financial advices, project counselling etc. There is a
distinction between a commercial bank and a merchant bank. The merchant banks mainly offer
financial services for a fee. while commercial banks accept deposits and grant loans. The
merchant banks do not act as repositories for savings of the individuals.
Functions of Merchant Banks:

The basic function of a merchant banker is marketing corporate and other securities. Now they
are required to take up some allied functions also.

A merchant bank now takes up the following functions:

1. Promotional Activities:

A merchant bank functions as a promoter of industrial enterprises in India He helps the

entrepreneur in conceiving an idea, identification of projects, preparing feasibility reports,
obtaining Government approvals and incentives, etc. Some of the merchant banks also provide
assistance for technical and financial collaborations and joint ventures

2. Issue Management:

In the past, the function of a merchant banker had been mainly confined to the management of
new public issues of corporate securities by the newly formed companies, existing companies
(further issues) and the foreign companies in dilution of equity as required under FERA In this
capacity the merchant banks usually act as sponsor of issues.

They obtain consent of the Controller of Capital Issues (now, the Securities and Exchange Board
of India) and provide a number of other services to ensure success in the marketing of securities.
The services provided by them include, the preparation of the prospectus, underwriting
arrangements, appointment of registrars, brokers and bankers to the issue, advertising and
arranging publicity and compliance of listing requirements of the stock-exchanges, etc.

They act as experts of the type, timing and terms of issues of corporate securities and make them
acceptable for the investors on the one hand and also provide flexibility and freedom to the
issuing companies.

3. Credit Syndication:

Merchant banks provide specialised services in preparation of project, loan applications for
raising short-term as well as long- term credit from various bank and financial institutions, etc.
They also manage Euro-issues and help in raising funds abroad.

4. Portfolio Management:

Merchant banks offer services not only to the companies issuing the securities but also to the
investors. They advise their clients, mostly institutional investors, regarding investment
decisions. Merchant bankers even undertake the function of purchase and sale of securities for
their clients so as to provide them portfolio management services. Some merchant bankers are
operating mutual funds and off shore funds also.

5. Leasing and Finance:

Many merchant bankers provide leasing and finance facilities to their customers. Some of them
even maintain venture capital funds to assist the entrepreneurs. They also help companies in
raising finance by way of public deposits.

6. Servicing of Issues:

Merchant banks have also started to act as paying agents for the service of debt- securities and to
act as registrars and transfer agents. Thus, they maintain even the registers of shareholders and
debenture holders and arrange to pay dividend or interest due to them

7. Other Specialised Services:

In addition to the basic activities involving marketing of securities, merchant banks also provide
corporate advisory services on issues like mergers and amalgamations, tax matters, recruitment
of executives and cost and management audit, etc. Many merchant bankers have also started
making of bought out deals of shares and debentures. The activities of the merchant bankers are
increasing with the change in the money market.

Underwriting

Underwriting of Shares and Debentures

‘Underwriting’ refers to the functions of an under-writer. An under-writer may be an individual,
firm or a joint stock company, performing the under-writing function. Under-writing may be
defined as a contract entered into by the company with persons or institutions, called under-
writers, who undertake to take up the whole or a portion of such of the offered shares or
debentures as may not be subscribed for by the public. Such agreements are called ‘Under-
writing agreement’.

A newly formed company enters into an agreement with an under-writer to the effect that he will
take up shares or Debentures offered by it to the public but not subscribed for in fully by the
public. Such an agreement may become necessary when a company issues shares or debentures
for the first time to the public, or subsequently when it is in need of working capital.

When the company does not receive 90 per cent of issued amount from public subscription,
within 120 days from the date of opening the issue, the company cannot proceed with allotment.
In such a case, the company must refund the amount of subscription. In the case of a new
company, it cannot obtain a certificate to commence function.
A company is not sure whether the shares or debentures offered for subscription may be taken up
by the public. There arises a risk to ensure the success of issue. Therefore, companies resort to
underwriting in order to ensure that sufficient number of shares or debentures would subscribed
for. Thus, risk-bearing or uncertainty bearing is an important function of an underwriter.

Thus, an underwriter is a person who undertakes to take up the whole or a portion of the shares
or debentures offered by a company to the public for subscription as may not be subscribed for
by the public, prior to making such an offer. The company has to pay a commission to such an
underwriter. It is known as underwriting commission. It is, of course, a type of insurance against
under-subscription.

Functions of a Broker in Underwriting:

Broker is a person who helps in subscribing the shares. A broker is one who finds buyers for the
shares or debentures of the company and gets the brokerage on the number of shares or
debentures subscribed by the public through him. Underwriter is different from a broker. An
underwriter is a person who agrees to take a specified number of shares or debentures, in case,
not subscribed by the public.

That is, an underwriter is liable to take up shares in case the public fails to subscribe whereas a
broker is not liable. Underwriter gets underwriting commission and a broker gets brokerage.
Underwriter gives a guarantee whereas a broker does the service of placing the shares.

Thus, the function of an underwriter is of great economic significance since he himself assumes
the risk of uncertainty on behalf of the company making public issue of shares or debentures. A
broker, on the other hand, does not assume any such risk. Underwriting acts as a sort of
insurance or guarantee against the danger of not receiving minimum subscription.

Sub Underwriting:

An underwriter may himself enter into a sub-agreement with other persons, called sub-
underwriters, whereby he transfers a part of his underwriting risk. Just like re-insurance, sub-
underwriting helps in spreading the risk. An underwriter may appoint several underwriters to
work under him. However, the sub-underwriters have no privacy of contract with the company.
They get their commission from the underwriter and are also responsible to him.

Underwriting Commission:

It is lawful for a company to pay commission to an underwriter, subject to the following

restrictions, according to Sec. 76 of the Companies Act of 1956.

(1) The payment of commission is authorised by the Article.

(2) The commission paid or agreed to be paid does not exceed in the case of shares, 5% of the
price at which the shares are issued or the amount or rate authorised by the Article, whichever is
less.

(3) The commission paid or agreed to be paid does not exceed in case of debentures, 2Vi% of the
price at which the debentures are issued or the amount or rate authorised by the Article,
whichever is less.

(4) The rate of commission and the number of shares which persons have agreed to subscribe
absolutely or conditionally are disclosed in the prospectus. However, brokerage can be paid in
addition to the payment of commission.

(5) Commission should not be given on those shares which are not issued to the public.

The Balance sheet of a company, prepared according to the prescribed form, should also
disclose, under the head ‘Miscellaneous Expenditure’ all sums payable by way of commission,
brokerage etc.

Pursuant to the guidelines issued by the Stock Exchange Division of the Department of
Economic Affairs, Ministry of Finance vide their letter of 7th May 1985; the following rates for
payment of under-writing commission, brokerage and managing broker’s remuneration are in
force:

Notes:

(i) The rates of under-writing commission given above are the maximum. The company is free to
negotiate such rates with the under-writers, subject to the ceiling.

(ii) Under-writing commission will not be payable on amounts taken up by the promoters group,
employees, directors, their friends and business associates.
Importance of Underwriting:

1. Underwriting acts as a sort of insurance or guarantee against the danger of not

receiving minimum subscription, in the absence of underwriting agreement,
there is always uncertainty regarding subscription of shares of debentures by
the public. The guarantee of the underwriters removes the uncertainty.
2. When shares or debentures are sold through underwriters, there arise more
confidence amongst the public. This is because underwriters undertake shares
or debentures of only those companies which are sound concerns and whose
future is bright.
3. Underwriting creates an impression regarding sound status of a company. It
increases the goodwill of the company.

Types of Underwriting:

An agreement to undertake the shares or debentures of a company are of the following

types:

(a) Complete Underwriting:

In case, the entire issue of shares or debentures of a company is undertaken, it is said to be full or
complete underwriting. Such an underwriting may be done by one underwriter or by a number of
underwriters. If the full issue is underwritten by one underwriter, then his liability will be equal
to the number of shares or debentures underwritten minus shares applied for.

Even if the issue is fully as subscribed or over-subscribed, the underwriter is eligible to get the
agreed commission on the issue of shares. In case less number of shares or debentures are
subscribed by the public, the underwriter is required to meet the deficiency in whole. In case, the
public response is good, the underwriter is at an advantage to get the underwriting commission,
without subscribing even a single share of debenture.

At the same time, if there are more than one underwriter, then allocation of unsubscribed shares
or debentures amongst themselves is made pro-rata, that is, in the ratio in which the number of
shares or debentures underwritten bear to the total number of shares or debentures offered for
subscription.

(b) Partial Underwriting:

If a part of the issue of shares or debenture of a company is underwritten, it is said to be partial

underwriting. Such an underwriting may be done by one underwriter or by a number of
underwriters. In case of partial underwriting, the company is treated as ‘underwriter’ for the
remaining part of the issue. For instance, a company issued 1,000 shares and 40% thereof is
underwritten by Nikhil. Out of 800 applications received, the marked applications are 350.
The liability of Nikhil is calculated as under:

Gross liability of Nikhil = 40% of 1,000 shares = 400

Less: Marked Applications = 350

Net liability of Nikhil = 50

It is to be noted that in case of partial underwriting, the underwriter does not get credit against
the unmarked applications.

(c) Firm Underwriting:

It is an underwriting agreement where the underwriter or underwriters agree to buy a certain

number of shares or debentures irrespective of the number of shares or debentures subscribed by
the public. Thus, in firm underwriting, the underwriters agree that a certain number of shares be
allotted to them, whether or not the issue is over subscribed.

An underwriting agreement may be open or firm. An agreement to take up shares or debentures

only when the issue is not subscribed in full is called open underwriting. For instance, if an
underwriter guarantees the issue of 1,00,000 shares and the public applied for 70,000 shares, then
the underwriter has to purchase the balance of 30,000 shares which are unsubscribed; in case, the
public applied for 80,000 shares, then the underwriter has to purchase the balance of 20,000
unsubscribed shares; in case the public applied for 90,000 shares, then the underwriter has to
purchase the balance i.e., 10,000 shares and in case the public applied for 1,00,000 or more
shares, the underwriter has no liability against the shares. Again, in case of under-subscription,
the underwriter is asked to purchase the deficiency of agreed shares, under open underwriting.

When an underwriter, enters into an agreement with the Company, to purchase certain number of
shares or debentures, irrespective of the public subscription, in addition to the open writing, is
known as firm underwriting. Thus, under firm underwriting, the underwriter agrees to take a
specified number of shares or debentures, in addition to the unsubscribed shares or debentures.
An underwriter through such an agreement with the Company gets priority over the public in
relation to the allotment, in case of over-subscription.

Firm applications are generally treated as direct applications from the public and are included
therein. If, however, the agreement specifically provides, personal relief is given for firm
applications also along-with the marked applications. Firm applications are added to the net
liability to find out the ultimate liability of an underwriter.
Marked or Unmarked Applications:

Generally, shares or debentures issued by a Company are usually underwritten by a number of

underwriters, in an agreed ratio of the whole issue. Each of the underwriter tries to sell the shares
or debentures at the maximum in order to reduce the risk of liability. Therefore, a method of
marking the application form with the stamp of the underwriters is adopted.

This facilitates to distinguish the forms of one underwriter from that of others and becomes clear
to the Company to know the exact number of applications received through a particular
underwriter. Such applications with stamp of an underwriter are called marked applications.

In some cases, public get the application form directly from the Company and such forms do not
bear the stamp of underwriters. Such applications, which do not possess the stamp of
underwriters, are called unmarked or direct applications.

Housing Finance
The Housing Finance Company is yet another form of non-banking financial company which is
engaged in the principal business of financing of acquisition or construction of houses that
includes the development of plots of lands for the construction of new houses.

The Housing Finance Company is regulated by the National Housing Bank. Any non-banking

finance company can operate as a housing finance company, subject to the fulfillment of basic
requirements as specified in the Companies Act, 1956.

 The company should have its primary business of providing finance for

housing, whether directly or indirectly.
 The company should obtain a certificate of registration (COR) from the
National Housing Bank (NHB). The company conducting such business
without a COR is an offense punishable under the provisions of the National
Housing Bank Act, 1987, also the NHB can demand the winding up of such
company.
 The company should have minimum Net Owned Fund of Rs 10 Crore.

Once these basic requirements are fulfilled, the company should comply with the following
conditions to get registered as a Housing Finance Company:

 The company shall be in such a position that it is able to meet the full claims of
its present as well as future depositors as and when these accrue.
 The affairs of the housing finance company should not be detrimental to the
interest of the present and future depositors.
  The management of the company should not be prejudicial towards public
interest or to the interest of its depositors.
 The Company should have an adequate capital structure and better income
prospects.
 The certificate of registration shall not be prejudicial to the operation and
growth of housing finance sector of the country.

All the above conditions must be met by the non-banking finance company to perform the
business of financing of houses (construction and acquisition).

Leasing
Parties to Lease Agreement:

There are two parties under any lease agreement:-

Lessor: – Owner of the asset is known as Lessor.

Lessee: – The party who uses the asset is known as Lessee.

Calculation of Equated Annual Install

When question specifies that loan is payable in Equal Installment then EAI should be calculated.

EAI = (Principle Amount)/PVAF(Interest  Rate, No. of Years)

Note: – Discount Rate or Interest for Calculation of EAI = Interest Rate on Loan amount without
taking any effect of Tax on it.

Tax Shield on Expenses done at zero period will be taken during first year (Leasing Topic Only).

Present Value Factor of Annuity when Inflow/Outflow is at beginning of Year then

PVAF(r,n) = PVAF[r, (n-1)] + 1

Calculation of Lease Rent

When a leasing company desires a certain percentage on gross value of assets then,

Lease Rent = (Cost of Assets)/Annuity factor at rate desire of leasing co.

When Value of Machine and other Expenses given then,

Lease Rent = [PV of Cash Out Flow – PV of Inflow (Tax Shield on

Depreciation/Expenses)]/Annuity Factor at Interest Rate

Salvage Value is deducted only when question specifies the method of depreciation as SLM.

Steps to Take Decision Whether Buy or at Assets on Lease by Lessee Point of view

Step I: – Calculate PV of Cash Outflow if Assets by Funding from Loan.

Step II: – Calculate PV of Cash Outflow if Assets is taken on Lease.

Step III: – Comparing PV Cash Outflow in both cases.

Step IV: – Decision: – Option which has lower Cash Outflow should be chosen.

Note: – Any Expenses which is common in both cases then those expenses is irrelevant for
decision making.

Steps to take Decision whether Assets should be leased out or not by Lessor Point of view

Step I: – Calculate PV of Cash Inflow (After Tax Lease Rent).

Step II: – Calculate PV of Cash Outflow (Initial Cash Outflow and Recurring Expenses)

Step III: – Calculate NPV (PV of Cash Inflow – PV of Cash Outflow).

Step IV: – Decision: – If NPV is positive then Assets should be leased out otherwise not.

Step to decision for which option to choose for Sale and Buy Back Case     

Step I: – Calculate NPV at each option.

Step II: – Compare NPV at each options.

Step III: – Decision: – Option which has Highest NPV should be chosen. 

Discount Rate to be used:

For Lessee: – Kd(1 – Tax Rate)

For Lessor: – Weighted Average Cost of Capital.

Venture Capital
Venture Capital is financing that investors provide to startup 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 just a monetary form; it can be provided in the form of technical or managerial expertise.

Though it can be risky for the investors who put up the 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.

In a venture capital deal, large ownership chunks of a company are created and sold to a few
investors through independent limited partnerships that are established by venture capital firms.
Sometimes these partnerships consist of a pool of several similar enterprises. One important
difference between venture capital and other private equity deals, however, is that venture capital
tends to focus on emerging companies seeking substantial funds for the first time , while private
equity tends to fund larger, more established companies that are seeking an equity infusion or a
chance for company founders to transfer some of their ownership stake.
Features of Venture Capital Investments

 High Risk
 Lack of Liquidity
 Long term horizon
 Equity participation and capital gains
 Venture capital investments are made in innovative projects
 Suppliers of venture capital participate in the management of the company

Methods of Venture Capital Financing

 Equity
 Participating debentures
 Conditional loan

Advantages of Venture Capital

 They bring wealth and expertise to the company.

 Large sum of equity finance can be provided.
 The business does not stand the obligation to repay the money.
 In addition to capital, it provides valuable information, resources, technical
assistance to make a business successful.

Disadvantages of Venture Capital

 As the investors become part owners, the autonomy and control of the founder
is lost.
 It is a lengthy and complex process.
 It is an uncertain form of financing.
 Benefit from such financing can be realized in long run only.

Angel Investors

For small businesses, or for up-and-coming businesses in emerging industries, venture capital is
generally provided by high net worth individuals (HNWIs) – also often known as ‘angel
investors’ – and venture capital firms. The National Venture Capital Association (NVCA) is an
organization composed of hundreds of venture capital firms that offer funding to innovative
enterprises.

Angel investors are typically a diverse group of individuals who have amassed their wealth
through a variety of sources. However, they tend to be entrepreneurs themselves, or executives
recently retired from the business empires they’ve built.
Self-made investors providing venture capital typically share several key characteristics. The
majority look to invest in companies that are well-managed, have a fully-developed business
plan and are poised for substantial growth. These investors are also likely to offer funding to
ventures that are involved in the same or similar industries or business sectors with which they
are familiar. If they haven’t actually worked in that field, they might have had academic training
in it. Another common occurrence among angel investors is co-investing, where one angel
investor funds a venture alongside a trusted friend or associate, often another angel investor.

Hire Purchase

Meaning of hire purchase contract

Hire purchase agreement or contract is an agreement of purchase where the goods or assets
are let out on hire by the seller/finance company (creditor) to the user of goods/ assets i.e. hire
purchase customer (Hirer). The hirer pays installments at regular intervals in the form of
consideration and gets the ownership of the asset after paying the last installment.

Hire purchase is a contract between two parties where a purchaser agrees to pay for goods in
parts. The hire purchase agreement was first initiated in the United Kingdom for situations where
the buyer could not afford to pay the required price for an item as a lump sum but could afford to
pay at regular intervals small amounts.

The seller asks for a sum equal to the original price of the asset plus interest to be paid in equal
installments. If the buyer defaults in paying the installments, the seller may repossess the goods.

Contents of Hire Purchase Agreement

1. The date on which the agreement is to be made.

2. The details of the seller/ finance company (of one part):

 Name
 Address
 Type of Business
 Type of organization like proprietorship/partnershipfirm/ Company etc.

3.  The details of the purchaser/ hirer (of the other part).

4. The date on which the asset is let out on hire and the period up to which it is let
out.
5. The name, type, model no. and make of the asset to be let out.
6. Details of installation expenses and the person who is going to bear it.
7. The cash price of the asset.
8. The hire purchase price i.e. (total of all installments + any deposit + any fees)
 9. The payment details:

 Amount of installment
 Time of payment i.e. first day / last day / any date of the month.
 Nature of interval i.e. monthly, quarterly etc.
 Mode of payment i.e. cash/ cheque.

10.The authority of inspection of the asset by the owner or a person assigned by

him.
11. Details of the rights of the hirer, in case he wants to terminate the
agreement.
12. Consequences when the hirer defaults in paying the installment amount or
breaches any point in the contract i.e. the owner has the rights to re-take
possession of the assets on these grounds.
13. A statement that the owner at his will can grant relaxation of any sort.

Points to be remember while preparing the hire purchase agreement

 One should pay extra care while selecting the asset. He should enquire whether
the asset he has asked for is not already owned by anyone else. It may so
happen that the person might not actually own it and therefore does not have
the right to sell it off.
 Secondly, keep a check on the cumulative installment amount to make sure it is
not unreasonably more than the value of the asset.
 The hirer should also possess the copy of hire purchase agreement.
 This mode is generally used for cars and high-value electrical goods where the
buyers are not able to pay for the goods directly.

After all, hire purchase agreement is also an agreement like any other agreement. There is no
fixed rule like 1+1=2. Any agreement cannot be said as the good or bad. The agreement can be
changed as per the convenience with the consent of both the parties i.e. hirer and the HP
company. The hirer should make sure that the agreement mentions the hire charges and other
terms of payment and their consequences in the manner he understands and interprets and the
terms are favorable as far as possible and agreeable. Similarly, the hire purchase company should
look for its interest in the agreement. In the end, the agreement should have clarity of terms
mutually agreeable to each party.

Factoring

Depositories, Factoring
A depository is a facility such as a building, office, or warehouse in which something is
deposited for storage or safeguarding. It can refer to an organization, bank, or institution that
holds securities and assists in the trading of securities. The term can also refer to a depository
institution that accepts currency deposits from customers.

A depository institution provides financial services to personal and business customers. Deposits
in the institution include securities such as stocks or bonds. The institution holds the securities in
electronic form also known as book-entry form, or in dematerialized or paper format such as a
physical certificate.

Institutions involved in Depository process

To have a better understanding of depository process, it is essential to study the institutions

interacting in a depository system.

1. The central depository,

2. Share registrar and transfer agent; and
3. Clearing and settlement corporations are the three institutions participating in
the depository process.
4. Central depository: The central depository keeps securities on behalf of the
investor and maintains records in electronic form. The statement given by the
depository is the evidence of the ownership of shares.
5. Share registrar and transfer agent: The ‘registrar’ is an institution which
controls the issuance of securities. The transfer agent retains the names and
addresses of the owners of registered securities.
6. Clearing house: The depository interacts with the clearing house during the
share transfer process. When the clearing house confirms that all funds have
been received, the depository will then transfer securities from the delivering
person to the receiver.

11 Most Important Functions of “Depository System”

The depository system functions as under:

1. The system envisages setting up of one or more depositories to hold securities

of investors in the electronic form.
2. The depository functions through its agents, who are called Depository
Participants (DP).
3. The investor, who wants to avail the services of the Depository, has to open a
beneficiary account with the Depository through a DP. The account known as
the “Demat” account can be opened with more than one DP also.
4 After opening the demat account, the investor is required to dematerialize the securities held by
him in the physical form. To dematerialize the securities, the investor has to fill the
Dematerialization Request Form (DRF) and submit the same to the DP along with the security
certificate.

The DP through the Depository will intimate the company/issuer and surrender the security
certificate. The process known as ‘dematerialization’ takes about 30 days.

5. The issuer/company on receipt of the intimation shall cancel the security

certificate and substitute the name of the Depository as the registered owner of
the security.
6. The Depository on being intimated by the company/issuer enters the name of
the investor in its record as the beneficial owner of the security.
7. Whenever any rights, bonus or dividend is announced by a company for its
particular security, the Depository would furnish all the details of the investors
having electronic holdings of that security on the record date. The disbursement
of the rights, dividends etc are, thus done by the company based on the
information provided.
8. In case of sale of the security under this mode, the investor/transferor (the
client) has to intimate the DP through issuing a Delivery Instruction Slip (DIS)
duly signed and containing the details of the security transaction.

In case of purchase, the client will send the intimation to the DP giving details of the security
purchased. The Depository on receiving the information through the DP will register the transfer
of securities in the name of the transferee in its record.

9. DP will also make book entries in the account of the investor to record
sale/purchase of securities.
10.DP is required to send statement of accounts to the clients at regular intervals,
and update the account after each transaction.
11.The client/ investor has to pay charges to the Depository and the DP for
availing the services.

FACTORING

Factoring is a financial transaction and a type of debtor finance in which a business sells its
accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will
sometimes factor its receivable assets to meet its present and immediate cash needs. Forfaiting is
a factoring arrangement used in international trade finance by exporters who wish to sell their
receivables to a forfaiter. Factoring is commonly referred to as accounts receivable factoring,
invoice factoring, and sometimes accounts receivable financing. Accounts receivable financing is
a term more accurately used to describe a form of asset based lending against accounts
receivable. The Commercial Finance Association is the leading trade association of the asset-
based lending and factoring industries.

Factoring is not the same as invoice discounting (which is called an assignment of accounts
receivable in American accounting – as propagated by FASB within GAAP). Factoring is the
sale of receivables, whereas invoice discounting (“assignment of accounts receivable” in
American accounting) is a borrowing that involves the use of the accounts receivable assets as
collateral for the loan. However, in some other markets, such as the UK, invoice discounting is
considered to be a form of factoring, involving the “assignment of receivables”, that is included
in official factoring statistics. It is therefore also not considered to be borrowing in the UK. In the
UK the arrangement is usually confidential in that the debtor is not notified of the assignment of
the receivable and the seller of the receivable collects the debt on behalf of the factor. In the UK,
the main difference between factoring and invoice discounting is confidentiality. Scottish law
differs from that of the rest of the UK, in that notification to the account debtor is required for the
assignment to take place. The Scottish Law Commission is[when?] reviewing this position and
seeks to propose reform by the end of 2017.