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Chap 1 Fina Inst
Chap 1 Fina Inst
INTRODUCTION:
Financial System of any country consists of financial markets, financial intermediation and
financial instruments or financial products. The term "finance" in our simple understanding
it is perceived as equivalent to 'Money'. We read about Money and banking in Economics,
about Monetary Theory and Practice and about "Public Finance". But finance exactly is not
money; it is the source of providing funds for a particular activity. Thus public finance does
not mean the money with the Government, but it refers to sources of raising revenue for
the activities and functions of a Government. Here some of the definitions of the word
'finance’ both as a source and as an activity.
MEANING:
‘Financial services’ refers to those services rendered by banks, FIs, insurance companies and
other intermediaries in the financial market. It include money management, portfolio
management, stock broking, custodian services, retail financing, credit rating services, credit
card services etc.
Thus, a financial system can be said to play a significant role in the economic growth of a
country by mobilizing the surplus funds and utilizing them effectively for productive
purposes.
Financial services are offered by the banks and other institutions are part of financial
system. A financial system is the subset of the economic system. In a broader framework,
Indian financial system comprises the banking sector, insurance sector, Fls, Non-Banking
Financial Companies (NBFCs) and the Housing Finance Companies (HFCs). The term 'financial
system' encompasses the financial institutions, the financial markets, financial instruments
and a host of financial services. It can be stated that a financial system comprises the
market, market participants, the financial instruments, the rules and procedures, and the
market regulator.
1. Regulators: The government of India, Reserve Bank of India (RBI), Securities &
Exchange Board of India (SEBI), Insurance Regulatory and Development Authority
(IRDA), The Ministry of Corporate Affairs (MCA) and The Ministry of Finance (MOF)
are some of the regulatory agencies that govern the functioning of the financial
system.
2. Commercial Banks: Commercial banks form the major segment of the financial
system. A strong network of commercial banks comprising of the public sector
banks, private sector banks, foreign banks and co-operative banks exists in the
Indian financial system. Banks facilitate the mobilisation of savings of individuals and
institutions and lend the same as loans and advances to the companies.
3. Financial institutions: Fls are non-banking and development oriented in nature, that
is, they do not engage themselves in the traditional banking job of mobilising
deposits for the purpose of operations. These institutions, started by the
government, serve as pillars of industrial and trade development. Therefore, these
institutions are described as the Development Finance Institutions (DFIS) which
include Industrial Finance Corporation of India (IFCI), Industrial Development Bank of
India (IDBI), Small Industries Development Bank of India (SIDBI), Infrastructure
Development Finance Company (IDFC), the National Bank for Agriculture and Rural
Development (NABARD), Export-Import Bank of India (EXIM Bank) National Housing
Bank (NHB), State Finance Corporations (SFCs) and Export Credit and Guarantee
Corporation (ECGC) are also included in this category.
4. NBFCs: The NBFCs are yet another segment of non-banking institution in the
financial system. Within this category there are deposit taking and non-deposit
taking NBFCs and Residuary Non-Banking Companies (RNBCs). NBFCs play a key role
in consumer credit, equipment leasing and vehicle financing through hire-purchase
finance. Eg. Bajaj Finance Ltd., Muthoot Finance Ltd., Cholamandalam Investment
and Finance Company Limited etc.
5. Insurance companies and the HFCs: Life Insurance Corporation (LIC), general
insurance companies and private sector insurance companies constitute the
insurance industry in India. This sector is currently emerging as an industry with high
potential for growth. With the IRDA at the helm as the regulator of the industry, the
insurance industry is on a growth path. More private insurance firms have entered
into insurance business due to the opening up of the sector. The HFCs provide long-
term housing finance for residential and commercial properties. The HFCs have
refinance facility from NHB.
6. Mutual Funds: These are investment institutions. Mutual funds enable the pooling of
savings of retail investors and channelize them for investment in capital market and
money market securities. The mutual fund industry in India is at a mature stage with
the number of funds being large and the Assets Under Management (AUM) have
also increased substantially.
STRUCTURE OF INDIAN FINANCIAL SYSTEM:
A) Financial Institutions:
Financial institutions are business organisations that act as mobilisers and depositories of
savings, and as sources of credit or finance. They also provide various financial services to
the community. They differ from non-financial (industrial and commercial) business
organisations in respect of their products, i.e., while the former deal in financial assets such
as deposits, loans, securities, and so on, the latter deal in real assets such as machinery,
equipment, stocks of goods, real estate, and so on.
B) Financial Markets:
Financial markets are the centres or place or arrangements that provide facilities for buying
and selling of financial claims (assets) and services. The corporations, financial institutions,
individuals, and governments trade in financial products on these markets either directly or
through brokers and dealers on organised exchanges or off-exchanges. The participants on
the demand and supply sides of these markets are financial institutions, agents, brokers,
dealers, borrowers, lenders, savers, and others.
i. Financial Assets
The financial asset represents a claim to the payment of a sum of money sometime in future
(repayment of principal) and/or a periodic (regular or not so regular) payment in the form of
interest or dividend. With regard to bank deposit or government bond or industrial
debenture, the holder receives both the regular periodic payments and the repayment of
the principal at a fixed date, whereas with regard to ordinary share only periodic payments
are received.
Financial instruments differ from each other in respect of their investment characteristics.
Among the investment characteristics of financial assets or financial products, the following
are important: (i) liquidity, (ii) marketability, (iii) reversibility, (iv) transferability, (v)
transactions costs, (vi) risk of default or the degree of capital and income uncertainty, and a
wide array of other risks, (vii) maturity period, (viii) tax status, (ix) options such as, call-back
or buy-back option, (x) volatility of prices, and (xi) the rate of return-nominal, effective, and
real.
The role of financial system in economic development has been a much discussed topic
among economists. Is it possible to influence the level of national income, employment,
standard of living, and social welfare through variations in the supply of finance? In what
way financial development itself is affected by economic development?
There is no agreement of views on such questions. A recent literature survey concluded that
the existing theory on this subject has not given any generally accepted model to describe
the relationship between finance and economic development. The importance of finance in
development depends upon the desired nature of development. In the environment-
friendly, appropriate-technology-based, decentralised Alternative Development Model,
finance is not a factor of crucial or critical importance. But even in a conventional model of
modern industrialism, the perceptions in this regard vary a great deal. One view holds that
finance is not important at all. The opposite view regards it to be very important. The third
school takes a cautionary view. It may be pointed out that there is a considerable weight of
thinking and evidence in favour of the third view also. Let us briefly explain these viewpoints
one by one.
In his model of economic growth, Solow has argued that growth results predominantly not
from the increase in labour and capital but from the technical progress, which is exogenous.
Therefore money and finance and the policies about them cannot contribute to the growth
process.
The financial system plays an important role in disciplining and guiding management
companies, leading to sound corporate governance practices. The domestic financial system
when linked to the international financial system increases capital flow with the help of
financial markets. This link reduces risk through portfolio diversification and helps in
accelerating economic growth.
REGULATORY INSTITUTIONS:
The RBI is the backbone of Indian economy and because of it, growth in Exports, FOREX,
Capital Markets and other sectors of the economy are all happening. It plays an important
role in strengthening, developing and diversifying the country’s economic and financial
structure. It is the apex bank in the Indian Banking System.
The Bank can issue notes against the security of gold coins and gold bullion, foreign
securities, rupee coins, Government of India securities, and such bills of exchange and
promissory notes as are eligible for purchase by the Bank. The proportional reserve system
of note issue existed in India till 1956. Thereafter, this system was abandoned and a
minimum value of gold coin and bullion and foreign securities as a part of total approved
assets came to be adopted as a cover for note issue.
2. Banker to the Government – The RBI is the banker to the Central and state governments.
It provides to the governments all banking services such as acceptance of deposits,
withdrawal of funds by cheques, making payments as well as receipts and collection of
payments on behalf of the government, transfer of funds, and management of public debt.
The Bank receives government deposits free of interest, and it is not entitled to any
remuneration for the conduct of the ordinary banking business of the Government. The
deficit or surplus in the Central government account with the RBI is managed by the
creation and cancellation of treasury bills (known as ad hoc treasury bills).
3. Banker’s Bank – The RBI, like all central banks, can be called a bankers' bank because it
has a very special relationship with commercial and co-operative banks, and the major part
of its business is with these banks. The Bank controls the volume of reserves of commercial
banks and thereby determines the deposits/credit creating ability of the banks. The banks
hold a part or all of their reserves with the RBI. Similarly, in times of need, the banks borrow
funds from the RBI. It is, therefore, called the bank of last resort or the lender of last resort.
On the whole, the RBI is the ultimate source of money and credit in India.
4. Supervising Authority – The RBI has vast powers to supervise and control commercial and
co-operative banks with a view to developing an adequate and sound banking system in the
country. It has, in this field, the following powers: (a) to issue licences for the establishment
of new banks; (b) to issue licences for the setting up of bank branches; (c) to prescribe
minimum requirements regarding paid-up capital and reserves, transfer to reserve fund,
and maintenance of cash reserves and other liquid assets; (d) to inspect the working of
banks in India as well as abroad in respect of their organisational set up, branch expansion,
mobilisation of deposits, investments, and credit portfolio management, credit appraisal,
region-wise performance, profit planning, manpower planning and training, and so on; (e)
to conduct ad hoc investigations, from time to time, into complaints, irregularities, and
frauds in respect of banks; (f) to control methods of operations of banks so that they do not
fritter away funds in improper investments and injudicious advances, (g) to control
appointment, re-appointment, termination of appointment of the Chairman and chief
executive officers of private sector banks; and (h) to approve or force amalgamations.
5. Promoters and Supervisor of the Financial System – Apart from performing the functions
already mentioned, the RBI has been rendering 'developmental' or 'promotional services
which have strengthened the country's banking and financial structure. This has helped in
mobilising savings and directing credit flows to desired channels, thereby helping to achieve
the objective of economic development with social justice. It has helped in deepening and
widening the financial system. As a part of its promotional role, the Bank has been pre-
empting credit for certain sectors at concessional rates.
a) Money Market – In the Money market, the RBI has continuously worked for the
integration of its unorganised and organised sectors by trying to bring indigenous
bankers into the mainstream of the banking business. In order to improve the
quality of finance provided by the money market, it introduced two Bill Market
Schemes, one in 1952, and the other in 1970. After the nationalisation of banks, the
RBI's responsibility to develop banking system on the desired lines increased. With
the help of a statutory provision for licensing the branch expansion of banks, the
RBI has been trying to bring about an appropriate geographical distribution of bank
branches.
b) Agriculture Sector – The RBI has rendered service in directing and increasing the
flow of credit to the agricultural sector. It has been entrusted with the task of
providing agricultural credit in terms of the Reserve Bank of India Act, 1934. As a
part of its efforts to increase the supply of agricultural credit, the Bank has been
working to strengthen co-operative banking structure through the provision of
finance, supervision, and inspection. It provides to co-operative banks (through
state co-operative banks), short-term finance at a concessional rate for seasonal
agricultural operations and marketing of crops. It operates the National Agricultural
Credit (long-term operations) Fund, and the National Agricultural Credit
(Stabilisation) Funds through which it provides long-term and medium-term finance
to co-operative institutions. It established the Agricultural Refinance Cooperation
(now known as NABARD) in July 1963 for providing medium term and long-term
finance for agriculture. It also helped in establishing an Agricultural Finance
Corporation.
c) Industrial Finance – The role of the Bank in diversifying the institutional structure
for providing industrial finance has been equally important. A number of
institutions providing financial and other services such as guarantees, technical
consultancy, and so on have come into being on account of the efforts of the RBI.
Through these institutions, the RBI has been providing short-term and long-term
funds to the agricultural and rural sectors, to small-scale industries, to medium and
large industries, and to the export sector. It has helped to develop guarantee
services in respect of loans to agriculture, small industry, exports and sick units. It
also co-ordinates the efforts of banks, financial institutions, and government
agencies to rehabilitate sick units.
d) Credit Delivery – The Bank has evolved and put into practice the consortium, co-
operative, and participatory approach to lending among banks and other financial
institutions. Through these, it has helped to upgrade credit delivery and service
capability of the financial system. It is observed that a substantial amount of funds
has been supplied by the RBI every year and the RBI provides most of these funds
at concessional rates of interest.
The instruments of monetary policy (method of credit control) may be broadly divided into:
1. General Credit Control or Quantitative Methods
2. Selective Credit Control or Qualitative Methods
The general methods affect the total quantity of credit and affect the economy generally.
The selective methods, on the other hand, affect certain sectors. In other words, under the
selective methods, certain qualitative distinctions are made between sectors and segments
of the economy; and selective is applied in regulating the flow of credit.
1. General Credit Control or Quantitate Methods
There are three general or quantitative instruments of credit control, namely, the Bank rate,
Open market Operation and Reserve Requirements (Cash Reserve Ratio and Statutory
Liquidity Ratio). All the three instruments affect the level of bank reserves. Open market
operation and the reserve requirements directly affect the reserve base, while the bank rate
produces its impact indirectly by variations in the cost of acquiring the reserve.
C. RESERVE REQUIREMENT:
Banks only maintain a small portion of their assets as cash available for immediate
withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the Reserve Bank changes the availability
of loanable funds. This acts as a change in the money supply.
Reserve requirements are a percentage of commercial banks', and other depository
institutions', demand deposit liabilities that must be kept on deposit at the Central Bank as a
requirement of Banking Regulations.
If the reserve requirement percentage were increased, this would reduce the money supply
by requiring a larger percentage of the banks, and depository institutions, demand deposits
to be held by the Central Bank, thus taking them out of supply. As a result, an increase in
reserve requirements would increase interest rates, as less currency is available to
borrowers. This type of action is only performed occasionally as it affects money supply in a
major way. Altering reserve requirements is not merely a short-term corrective measure,
but a long-term shift in the money supply.
There are two types of reserve requirements like Cash Reserve Ratio and Statutory Liquidity
Ratio.
Cash Reserve Ratio: It refers to a portion of deposits (as cash), which banks have to
keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank
deposits is totally risk-free and secondly it enables that RBI control liquidity in the system,
and thereby, inflation. Current CRR of India is 4.00%.
Commercial Banks in every country maintain, either by the requirement of law or custom, a
certain percentage of their deposits in the form of balance with the central bank. The
Central bank has the power to vary this reserved requirements; and the variation if the
reserve requirements affect the credit creating capacity of commercial banks.
Statutory Liquidity Ratio: Banks in India are required to maintain 18.00% of their demand
and time liabilities in government securities and certain approved securities. Action has also
been taken to prevent banks from offsetting the impact of variable reserve requirements by
liquidating their government security holding. This ensures that with every increase in the
cash reserve requirements, the overall liquidity obligations are also correspondingly raised.
2. Selective Credit Control or Qualitative Methods
Selective and qualitative credit control refers to regulation of credit for specific purposes or
branches of economic activity. Selective controls relate to the distribution or direction of
available credit supplies. It may be mentioned here that some element of selective can be
imparted to general credit controls also by giving concessions to priority or activities. This
has often been done in India.
Selective credit controls, many central banks have acquired powers of direct regulation of
the total magnitude, as also the distribution of advances and investments of individual
banks as well as entire banking system.
Selective credit controls are considered to be a useful supplement to general credit
regulation. They are designed specifically to curb excess in selected area without affecting
other types of credit. They attempt to achieve a reasonable stabilization of the price of
particular commodities on the demand side, by regulating the availability of bank credit for
purchasing and holding them. It should, however, be noted that price are determined by the
interaction of supply and demand, and that when supply is substantially short, what
selective credit controls are likely to accomplish is to moderate the price rise rather than
arrest the basic trend.
The techniques of selective credit controls used generally are:
1. Minimum margins for lending against specific securities;
2. Ceiling on the amounts of credit for certain purposes; and
3. Discriminatory rates of interest charged on certain types of advances.
The SEBI exercises powers under Sections 11 and 11B of the SEBI Act, 1992, and 17 other
regulations. The SEBI, with its powers, can carry out the following functions.
1. Regulations of the security market: The SEBI has powers to register and regulate all
market intermediaries. The SEBI has powers to penalise them in case of violations of
the provisions of the act, rules and regulations made thereunder. It can conduct
enquiries, audits, and inspection of all market intermediaries and adjudicate
offences under the SEBI Act, 1992. The SEBI registers and regulates the
intermediaries in the primary market. Some of the major intermediaries it regulates
are merchant bankers, underwriters, bankers to an issue, registrars to an issue and
share transfer agents and debenture trustees. The SEBI registers and regulates
various intermediaries in the secondary market such as brokers, sub-brokers, stock
exchanges, foreign institutional investors (FIIs) custodians, depositories, mutual
funds, and venture capital funds. All the above mentioned intermediaries can deal in
securities or operate in the securities market only after they obtain a certificate of
registration from the SEBI. The certificate of registration can be suspended or
cancelled by the SEBI in the manner prescribed in the regulations.
2. Supervision of security market: The SEBI supervises the securities market through
on-site and off-site inspections, enforcement, enquiry against violation of rules and
regulations, and prosecutions. It undertakes inspection of the books and records of
depository participants and registrar to an issue. It also issues show-cause notices to
companies on the basis of reports submitted by the depositories.
It also undertakes inspection of brokers/sub-brokers. It has initiated
cancellation of registration of broker declared defaulter or expelled from the
exchange as one-time exercise. It has devised a comprehensive disclosure
requirement framework for stock brokers which include information about the
registration details of the broker and his associates, their background, and history
including details of complaints/arbitration and regulatory action initiated. It is
planning to enhance the scope of audit of books of accounts and other records by
including reporting of information on collection of margins from clients, maintaining
segregation between client funds and arm funds, payment and deliveries to clients
and details of related party transaction. As a market supervisor SEBI undertakes
following activities:
o Inspection of depositories
o System audit
o Surveillance
o Investigation