(OMANIMAN YO FT © Choice Based Credit System TAXMANN"'S Financial Markets Institutions & Financial Services Dr. Vinod Kumar Department of Commerce SGTB Khalsa College University of Dethi Atul Gupta Department of Commerce Hindu College University of Dethi Manmeet Kaur Department of Commerce SGTB Khalsa College University of DelhiSYLLABUS FINANCIAL MARKETS, INSTITUTIONS AND FINANCIAL SERVICES. Paper: BCM [5.4(C)] DSE Group Duration: 3 hrs. Objective: To provide the student a basic knowledge of financial markets and institutions and to familiarize them with major financial services in India. Unit I: An Introduction to Financial System and its Components Financial markets and institutions. Financial intermediation, Flow of funds matrix. Financial system and economic development. An overview of Indian financial system. Unit II: Financial Markets Money Money market-functions, organization and instruments. Role of central bank in money market; Indian meney market —Anoverview: Capital Markets-functions, organization and instruments. Indian debt market; Indian equity market-primary and secondary markets; Role of stock exchanges in India. Unit I: Financial Institutions Depository and non-depository institutions, Commercial banking- introduction, its role in project finance and working capital finance. Development Financial Institutions (DFls)-An overview and role in Indian economy. Life and non-life insurance companies in India; Mutual Funds- Introduction and their role in capital market @evelopment. Non-banking financial companies (NBFCs). Unit IV: Overview of Financial Services Industry Fund based and fee based financial services, Merchant’ banking-pre and post issue management, underwriting, Regulatory ftamework relating to merchant banking in India.Tie SYEEARUS. UiCV: Leasing and hire purchase Consumer hnane« bonk puarantecs and lett and Portfolio and housing Venture capital nance. Facto Ing services, ler of credit: Credit 1 ating, Financial Counselling Management Services| Contents ABOUT THE AUTHORS ACKNOWLEDGEMENT SYLLABUS 1 CHAPTER 1 AN INTRODUCTION TO FINANCIAL SYSTEM I CHAPTER 2 MONEY MARKETS I CHAPTER 3 CAPITAL MARKETS INSTRUMENTS 1 CHAPTER 4 INDIAN DEBT MARKETS I CHAPTER 5 PRIMARY MARKETS I CHAPTERS “SECONDARY MARKETS I CHAPTER 7 _-SEBI AND INVESTOR PROTECTION I CHAPTER 8 FINANCIAL INSTITUTIONS 1 CHAPTER 9 COMMERCIAL BANKING ri a ral 108 ng112 CONTENTS 1 CHAPTER 10 DEVELOPMENT FINANCIAL INSTITUTIONS § CHAPTER 11 LIFE AND NON-LIFE INSURANCE COMPANIES IN wou fl CHAPTER 12 MUTUAL FUNDS “~~ I CHAPTER 13 NON-BANKING FINANCE COMPANIES. a CHAPTER 14 OVERVIEW OF FINANCIAL SERVICES INDUSTRY | CHAPTER 15 MERCHANT BANKING 4 T CHAPTER 16 LEASING AND HIRE PURCHASE I CHAPTER 17 VENTURE CAPITAL AND FACTORING SERVICES » I CHAPTER 18 — CREDIT RATING CHAPTER 19 CONSUMER AND HOUSING FINANCE CHAPTER 20 LETTER OF CREDIT AND BANK GUARANTEE I CHAPTER 21 FINANCIAL COUNSELLING AND PORTFOLIO MANAGEMENT SERVICES QUESTION PAPERS B.COM. (HONS.) GLOSSARY PAGE 135 140 156 168 17 180 212,/ aay 234/ 240 aa 257 264Introduction The resources required for developing any economy are generated through the process of savings. These savings remain unutilized or underutilized ifthe financial system of the economy is under developed. The size of the savings and its appropriate utilization for investment in industries can help economic growth. However, this channelizing of savings from savers to the industry requires the presence of vibrant, active and reliable financial markets system that aids in mobilization and appropriate channelization. The efficiency of the financial markets, decides the speed of the economic oo | Financial markets are markets through which funds required bythe users are supplied by the savers of funds. It helps in exchange of financial assets between those who have the funds and those who require these funds. Owners of funds would save more when they have incentive to save, which depends upon variety of financial instruments available and the return on the financial instruments. Savings can be easily multiplied if the savers or investors invest in different instruments ‘depending upon thereturn andthe corresponding risk. The efficiency in the creation of various instruments 1 ‘TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM ay Financial markets also help in providing {iabiaityrprice discovery and a mechanism through which the risk can be trans erred from hedgers to speculators. With the by S tunis 77 In a complex modern ec , inancial markets facifitates the transfer of resources from financi i developmentof the an economy. Development of an econom y is therefor: regulated and efficient finan jal syste ‘inancal system fe i structur i market. Exchange of e, When number of 3 rovided by intermediaries like bro. kers, underwriters, secondary market: ts, financial intermediaries (bankers, insurers, and mutual funds), information providers, and regulators I rests of users of funds and providers of funds, ‘i ediaries provide va aluableservices.Finan. cial intermed: chase the primary securities issued by the ultimate users and, in turn, acquire fu \ds for issuing their own securities, which are tailored to the needs of ulti late Savers, especially to relatively small savers. This is called Indirect Finance. Banks, insurance companies and mutual funds do this activity of conversion of direct securities into indirect securi- ties. These institutions help to channelize savings to high priority industries indirectly and in return make it safer for the savers to invest their money. In order to re -concile the int institutions: ‘ali = TAXMANN® { | |AN INTRODUCTION TO FINANCIAL SYSTEM 3 Cee ee eT ES cas of to conve! innov: ideas into pré which meet the needs of the markets. Existing-economic units need access to funds for expanding facilities, for fin \ 7 ci i , or for emergencies. They shall approach financial intermediaries to meet their requirement of funds. Financial markets also serve the function of providing financial surplus units like households theilgbesstrearrongassetsikeshares-bonds punts without requiring them to purchase real assets. If saving is increased by income generating financial claims, the accumulation of the plants, equip- ments, and materials that contribute to the growth, economies’ productive capacity gets enhanced. This results into economic growth. Indian Financial System Till the early nineties, the planned economic development in India had greatly influenced the course of financial development. In the post-1990s, the financial system that emerged was in response to the imperatives of a liberalized, globalised and deregulated economic era. This has helped the Indian economy to mobilize more funds for appropriate investments. The financial system of a country consists of financial institutions, instru- ments, services and markets. J 2 ER The evaluation of Indian Financial System can be divided into following three phases: TAXMANN®4 AN INTRODUCTION TO FINANCIAL SYSTEM The financial system up to 1951 (Phase {) ¢ The financial system from 1951 to mid-Fighties (Phase I) ¢ The financial System from 1990 onwards (Phase III) 1. The financial system up to 1951 (Phase I) . During this period the industrial sector was neglected by the government. ow slow growth of economic development reflected in low per capita income, savings, national income and purchasing capacity. 2. The financial system from 1951, mid-Eighties (Phase II) Post-1951 period evolved in response to the imperatives of planned economic development. Planning signified the distribution of credit and finance in conformity with the planned priorities, which, in turn, implied Government i 5S . The funds therefore, funneled towards the pr 's by the government. During this period the major characteristics of the financial system were: (a) Public ownership of financial institutions Public ownership of Financial Institutions was brought about pertly through nationalization of existing institutions {e.g State Bank of India (1956), LIC (1956), Commercial banks (1969) and GIC (1972)] and partly through the creation of the public sector new institutions, namely, special-purpose term-lending institutions (development banks) and UTL - (b) Fortification of the institutional structure The fortification of the institutional structure of the Indian Financial. System was partly the result of modification in the structure and policies of the existing Financial Institutions and also with the ad- ition of new insti = The nn a a Banks were encouraged to reorient their operational policies towards financing of industry, as against commerce and trade. They were also encouraged to enter into new forms of industrial financing, namely, underwriting and term-lending rather than lending for pure short term loan. TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 5 The banks also enlarged their functional coverage in terms of financ- ing of small scale industries, exports and agriculture. To expand the coverage and fill the credit gaps of the priority sector, a scheme of social control was introduced. This was followed up by nationalisa- tion of the banks to meet the needs of development of the economy in conformity with national priorities and objectives. (c) Protection to Investors Along with the measures being taken to strengthen and diversify the institutional structure of the Indian financial system, Ps reforms were carried out during this period to provide protection The main elements of the elaborate legislative code adopted by the Government were: Companies Act; Capital Issues (Control) Act (CCA), now repealed and replaced by the SEBI Act; Securities Contracts (Regulation) Act (SCRA); MRTP Act (now replaced by Competition Act) and; Foreign Exchange Regulation Act (FERA), now replaced by Foreign Exchange Management Act (FEMA). (d) Participation of Financial Institutions (FIS) in Corporate Management A significant feature of the Indian Financial System in this phase was the participation by the Financial Institutions in the management and control of companies to which finance was provided, in marked contrast to the time-honoured tradition of not getting involved in the control and management of assisted companies. This change in approach of the Fls‘could be ascribed to three factors: Government policy; structure of the industrial securities; and the deep involvement of the Financial Institutions in the fortune of the companies through lending operations for protecting their funding in these companies. 3. The Financial System from 1990 onwards (Phase III) The post-nationalization period yielded significant changes in the operational policies and practices of banks. This resulted in an acceleration of credit availability to the priority sector and consequent decline in the share of large industry in the total bank credit, due to regulations and credit rationing. The backbone of the institutional structure of the Indian Financial System during this phase was the variegated structure of development banks, namely, IDBI, SIDBI, IFCI, {CICI, SFCs, SIDCs, SIICs and so on. They were conceived as instruments of the State policy of directing capital into a chosen area of industry, in conformity with the planned priorities, and of ring the d p dustry al he desired blic control of priv erprise. They were also the agency through which specific socio-economic objectives of State TAXMANN®a 0 q 6 AN INTRODUCTION TO FINANCIAL SYSTEM policy, such as encouragement to new entrepreneurs and small enterprises and the development of backward regions to _ industry, were being realized. The setting up of the 1C;asa result'Of an’amalgamation of 245ilife in- psu ance companies into a single monolithic state-owned institution, was a ‘part of the deliberate and conscious attempt to mould the Indian Financial “System according to the’ It not only requirements of planned development. | transferred an important saving institution from private to public owner- ship, but also brought about a Bn oe g ne Trees in the hands of LIC, which emerged as the largest reservoir of long-term savings in the country. Similarly, the setting up of the UTI was the culmination of a long overdue need of the Indian Financial System to encourage indirect holding of secu- rities by the public by bolstering up the confidence of the investing public in the securities markets. An overview of Indian financial system Indian financial sector has undergone significant changes in during the past few decades with Private sector institutions growing rapidly in commercial banking and asset management business. The deregulation of the financial system and intensification of competition amongst financial intermediaries have led to a decline in interest rates. The regulators of the various segments of the market like The Securities and Exchange Board of India and the Insurance Regulatory and Development Authority (IRDA), PFRDA have become important institutions of the financial sector of India. Notwithstanding the dominance of the Public sector banks (PSBs), private sector banks are gradually gaining strong foothold in the financial sector of India. The Government is also eae to sede its ay stake in PSBs Der Cel Ss. As part of the liberalisation process, “new pri -Restruct of privat g ha was started with a few banks merging in order to form stronger entities. Bank of Rajasthan has been taken over by ICICI bank. Similarly Centurion Bank of Punjab has been taken over by HDFC bank. The existing private sector banks hav TAXMANN®f AN INTRODUCTION TO FINANCIAL SYSTEM 7 / | Development Finance Institutions (DF) DFls such as IDBI and ICICI which were largely knownvas developmental banks entered other segments of financial services such as commercial isset_ man: i venti This move to universal banking has really caught up with a majority of the banks now taking up short term as well as long term financing. Several measures have been initiated and include new money market instruments, strengthening of existing instruments and setting up of the Discount and Finance House of India (DFHI). The RBI conduets its sales of dated securities and treasury bills through its open market operations (OMO) window. Primary dealers bid for these “securities al 5 = alonii y market instruments and Government of India treasury bills. The RBI has introduced a liquidity adjustment facility (LAF) in which liquidity is influenced through repo and reverse repo auctions. On account of the substantial issue of government debt, the gilt-edged market occupies an important position in the financial set-up. SEBI has now decided to concentrate on the development of a long-term debt market which is crucial to the financing of infrastructure. The dema- terialisation of debt instruments in order to encourage paperless trading has helped in streamlining the debt markets. The number of shareholders in India is estimated in millions. However, only a very small number of an estimated two lakh persons actively trade in stocks. There has been a dramatic improvement in the country’s stock market trading infrastructure during thelast few years. Indian equity market has now become an attractive emerging market with tremendous potential. DV Ihdian Mutual Funds Market ~ Notwithstanding the fact that retail investor's participation in the markets for di i sor S Ba improved remarkably during the past few years. The mutual funds industry is now regulated under the SEBI (Mutual Funds) i is SEBI Rey ulsionsnloo4 guidelines, industry had a framework for the establishment of many more players, both Indian and foreign play. ya “- growthin th arkets and taxad antages granted forinvestment 7 in mutual fund units. TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM. th of Mutual fund segment got a further filip with the entry of dAMCs. They were instrumental with the introduction of new products, setting new standards of customer service, improved disclosure standards and experimenting with new types of distribution. The Indian insurance industry is the latest to be thrown open to competi- tion from the private sector including foreign players. As per rules, foreign companies can only enter joint ventures with Indian companies, with par- ticipation restricted to 49 per cent of equity. The major improvements in the working of various financial markets have been taken up gradually with a step-by-step approach, not a big bang one. The entry of foreign players has assisted in the introduction of interna- tional practices and systems. Technological developments have improved customer service. Some gaps, however, still remain like an active corporate debt market. On the whole, the cumulative effect of the developments since E too1 has be been quite encouraging. yl ls _ Foreign companies are already allowed to hold a majority stake in asset management companies and NBFCs; up to 49 per cent in banks and a “maximum of 49 per cent in insurance companies. io 5 ) wanting system An indication of the strength of the reformed Indian financial system can be seen from the wa CEL a eae R Spas Major minieieec in the banking system in recent years include the intro- duction of Prudential norms for income recognition, asset classification, provisioning for delinquent loans and capital adequacy. In order to reach the stipulated capital adequacy norms, substantial capital has been provided by the Government to PSBs. The Government pre-emption of banks’ resources through statutory liquidity ratio (SLR) and cash reserve ratio (CRR) was also brought down in two stages. Other prominent measures include: ° Interestrates ondeposit andlending sides almostentirely deregulated. PSBs were encouraged to approach the public to raise resources. Bank lending norms were liberalised and a loan system to ensure better control over credit was introduced. o co information bureau has been established to identify bad = TAXMANN®’ AN INTRODUCTION TO FINANCIAL SYSTEM 9 | | __ Derivative products such as forward rate agreements (FRAs) and interest Ve swaps (IRSs) and credit default swaps introduced, / Indian Capital Market significant changes were introduced for better reg- “ulation of the Thdian Capital Markets. Some of the prominent ones are the Capital Issues ;Control) Act, 1947 was repealed, Office of the Controller of Capital Tssues abolished and initial share pricing decontrolled. The SEBI, the capital market regulator, was established in1992, (I) - a Ta 0G) Foreign institutior utional investors (Fils) wereallowed to invest in Indian capital markets after regis: Me Or ens a oifecion companies pi 101 Ls mitiedtoaccessinlernationalcapitalarkts through }\) euro issues. a ee = The_National Stock Exchange (NSE), with nationwide stock trading and iy v) electronic display, clearing and settlement facilities was established. Several regional stock exchanges changed over from floor based trading to screen based trading. SEBI regulations governing substantial acquisition of shares and takeovers, 4) including concitions under which disclosures and mandatory public offers, i are to be made to shareholders were issued. yi Private mutual funds were permitted. The Depositories Act provides a legal framework for the establishment of yn leer torecord ownership deals in book entry form. Dematerialisation : lof stocks was introduced to encourage paperless trading. sos\Companies were required to disclose all material facts and specific risk vill factors associated with their projects while making public issues. app.) To recluceatinenpoatacbisemeaimnderyn tine sbysche issuergmadceopsionl, The practice o: making preferential allotment of shares at prices unrelated ~£) tothe prevailing market prices stopped and fresh guidelines issued by SEBI. - SEBI reconstitutes governing boards of the stock exchanges, introduces o,capital adequacy norms for brokers, and makes rules for making-client/ \Tproker relationship more transpazent, inckiding separation of client and broker accounts. 2) One time permission to stock brokers extended to corporatize their busi- |\ ness, without attracting capital gains tax. 7.) Buy-tack of sha (iu aa To introduce greater transparency of the country’s financial system and dealings, the SEBTts working to bring about greater corporate disclosures. TAXMANN®10 AN INTRODUCTION TO FINANCIAL SYSTEM, Steps are being taken to improve corporate governance of hsted companies based on the report of a commit? ssuance of detailed employee stock option scheme and employee stock purchase scheme for listed companies ; Standard denomination for equity shares of € 10 and % 100 and companies given the freedom to issue dematerialised shares in any denomination. _ _ Introduction of derivative trading with index options and stock futures and options Introduction of a system of rolling settlements. SEBI empowered to register and regulate venture capital funds. - The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial eyed ation. as defined by OECD is a productive activity in Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major fincions = 1. They provide a line of credit to qualified clients wh i struments such as loans for financing homes, education, auto, credit tards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2: Risk transformation: The financial institutions spread the risk by lending to multiple borrowers which helps them to convert risky investments into relatively less risky ones. 3. (Convenience denavnination: iis a function of transmutation which Inanci: ns underfake. It means combining small deposits . TAXMANN®4 to AN INTRODUCTION TO FINANCIAL SYSTEM Steps are being taken toimprove corporate governance of listed companies based on the report of a committee Issuance of detailed employee stock option scheme and employee stock purchase scheme for listed companies. Standard denomination for equity shares of 7 10 and % 100 and companies given the freedom to issue dematerialised shares in any denomination Introduction of derivative trading with index options and stock futures and options Introduction of a system of rolling settlements. SEBI empowered to register and regulate venture capital funds. The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. As per the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major functions: 1. They provide a line of credit to ) struments such as loans for financing homes, education, auto, credit " tards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2. Risk transformation: The financial institutions spread the risk by ending to multiple borrowers which helps them to convert risky investments i into relatively less risky ones. 3. Conveni nomination: It is a function of transmutation which nancial institutions underfake. It means combining small deposits TAXMANN®10 AN INTRODUCTION TO FINANCIAL SYSTEM Steps are being taken to improve corporate governance of listed companie based on the report of a committee Issuance of detailed employee stock option scheme and employee stock purchase scheme for listed companies Standard denomination for equity shares of 7 10 and 2 100 and companies given the freedom to issue dematerialised shares in any denomination Introduction of derivative trading with index options and stock futures and options. Introduction of a system of rolling settlements. SEBI empowered to register and regulate venture capital funds. The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. As per the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major functions: 1. They provide a line of credit to qualified clients who is: struments such as loans for financing homes, education, auto, credit Cards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2. Risk transformation: The financial institutions spread the risk by Tending to multiple borrowers which helps them to convert risky investments into relatively less risky ones. 3. Conveni lenomination: It is a function of transmutation which nancial institutions underfake. It means combining small deposits TAXMANN®10 AN INTRODUCTION TO FINANCIAL SYSTEM Steps ¢ c being taken to improve corporate governance of listed compari based on the report of a committee Issuance of detailed employee stock yption scheme and employer stock purchase scheme for listed companies Standard denomination for equity shares of 7 10 and & 100 and companies given the freedom to issue dematerialised shares in any denomination. Introduction of derivative trading with index options and stock futures and options Introduction of a system of rolling settlements SEBI empowered to register and regulate venture capital funds The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. As per the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major functions: sSsSSsSsSSSS—S 1. They provide a line of credit to qualified clients who i ins struments such as loans for financing homes, education, auto, credit Cards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2. Risk transformation: The financial institutions spread the risk by fending to multiple borrowers which helps them to convert risky investments into relatively less risky ones. 3. Conveni nomination: It is a function of transmutation which nancial institutions underfake. It means combining small deposits TAXMANN®MCIAL SYSTEM 10 AN INTRODUCTION TO FIN rove corporate governance of listed compantes cing taken tosmp the report of a commille® uance of detailed employee stock option scheme and employee stock irchase scheme for listed companies Standard denomination for equity shares of 7 10 and? 100 and companies given the freedom to issue dematerialised shares in any denomination. Introduction of derivative trading with index options and stock futures and options Introduction of a system of rolling settlements. gister and regulate venture capital Funds. lations, 1999 was issued for regu- as introducing a code of conduct SEBI empowered to re; The SEBI (Credit Rating Agencies) Regul lating new credit rating agencies as well t for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. As per the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major functions: . 1. They provide a line of credit to struments such as loans for ig tards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2: isk transformation: The financial institutions spread the risk by ending to multiple borrowers which helps them to convert risky investments into relatively less risky ones. 3 fonvenience denomination," is a function of transmutation which nancial institutions undertake. It means combining small deposits TAXMANN®0 AN INTRODUCTION TO FINANCIAL SYSTEM Steps are being taken toimprove corporate governance of listed companies based on the report of a commie Issuance of detailed employee stock option scheme and employee stock purchase scheme for listed companies Standard denomination for equity shares of f 10 and % 100 and companies. given the freedom to issue dematerialised shares in any denomination. Introduction of derivative trading with index options and stock futures and options. Introduction of a system of rolling settlements. SEBI empowered to register and regulate venture capital funds. The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. As per the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries functions: 1. They provide a line of credit to qualified clients who i: in= struments such as loans for financing homes, education, auto, credit tards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2. Risk transformation: The financial institutions spread the risk by ending to multiple borrowers which helps them to convert risky investments into relatively less risky ones. 3. Convenii lenomination: It is a function of transmutation which nancial institutions underfake. It means combining smalll deposits TAXMANN® perform offer the following three majorto AN INTRODUCTION TO FINANCIAL ‘SYSTEM Stepsare being taken toamprove corporate governance of listed companies based on the report of a committee sto Issuance of detailed employee stock option scheme and employee s ak purchase scheme for listed companies Standard denomination for equity shares of € 10 and & 100 and companies given the freedom to issue dematerialised shares in any denomination Introduction of derivative trading with index options and stock futures and options Introduction of a system of rolling settlements SEBI empowered to register and regulate venture capital funds. The SEBI (Credit Rating Agencies) Regulations, 1999 was issued for regu- lating new credit rating agencies as well as introducing a code of conduct for all credit rating agencies operating in India. Financial Intermediation Financial intermediation as defined by OECD is a productive activity in which an institutional unit incurs liabilities on its own account for the pur- pose of acquiring financial assets by engaging in financial transactions on the market; the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. Asper the economic view of monetary operations, the following institutions are or can act as financial intermediaries: Banks, Mutual savings banks, Savings banks, Building societies, Credit unions, Financial advisers or bro- kers, Insurance companies, Collective investment schemes, Pension funds, Cooperative societies, Stock exchanges. The financial intermediaries perform offer the following three major functions. OO 1. They provide a line of credit to qualified clients who i: i struments such as loans for financing homes, education, auto, credit tards, small businesses, and personal needs. Thus they convert short- term liabilities to long term assets. These intermediaries reconcile their conflicting needs by dealing with large number of lenders and borrowers. 2. Blsk transformation: The financial institutions spread the risk by lending to multiple borrowers which helps them to convert risky investments into relatively less risky ones.__osyi)AN INTRODUCTION TO FINANCIAL SYSTEM. in y . a C 0 its to make multiple small id meeting the requirements of both borrowers and lenders 7 fb interdependence of Financial Markets in Economic Development Industrialdevelopment s on Financial Markets. Th surplus funds and thos funds are obtained fro: household, business or by the economic unit purs economic development, which in turn depends hese markets intermediate among those who have ¢ who require and demand the funds, Investible m savings surplus economic units, Which can be a even Government. If the demand for funds are met C1 yi a own sai ‘ace tion among savers and users of funds would not be needed. Consequently there could be no incentive to save, and intermediaries who direct savings from saving entities to those who are in need of funds, would also not be required. The transition of savings into investment is facilitated by the reward of return, which becomes the cost for the user or borrower. If savings were not invested, it would remain dormant as idle cash, which would not earn any return, “Savings are invested in assets, depending on their risk-and return characteristics”. Any rational investor can realize that money not invested at a rate higher than the rate of inflation in the economy, would earn a negative real rate of return. Incentive to save depends on the level of income and the rate of return which savings can earn. In modern economy savings can multiply because of different investment schemes available, which offer different rates of return with corresponding risk profile. The need to grow at faster rate re- quires a country to seek resources from international market too because quantum of savings in domestic market proves inadequate. Thus at any point of time the domestic saving along with the funds from international capital market meet the need of funds in a country. At the other end of the spectrum demand for funds arise from the entre- preneurs or productive units, which cannot generate adequate resource from their currents revenues and remain saving deficit units. These corpo- rate or industrial units need funds for their present and future investment requirements. In a developing economy, the demand for funds is always more than supply of funds, hence leading to its scarcity. Consequently, al- location of scarce resources among different needs in the economy takes place either through, planned intervention, or is automatically adjusted through the forces of, demand and supply. Motives of those who save the funds and those who need the funds are always different. Risk and Return are the two important guide posts directing the savings. The maximization TAXMANN®12 AN INTRODUCTION TO FINANCIAL SYSTEM of return for a given level of risk particular use. Gap between internally generated funds and the need for funds for present and future expansion make companies demand funds. Corporate sector is the most important segment of the economy, which propels the demand for Funds. The growth of the economy is dependent on the growth of the corporate sector. Corporate as well as non-corporate individual units need funds for their continuing or new projects (capital expenditure), for their day-to-day needs (working capital) or for restructuring their balance sheets. In addition demand for funds may also come from non-industrial sector and government sector. Therefore, the pace of industrial growth and the economic development requires the development of a financial market, which provides long-term finance to entrepreneurs. The financial inarketis a wide term which includes alltransactions involving long-term and short-term funds. The development banks, commercial Banks, financial institutions and stock exchanges, SEBI, RBlare all important components of the financial markets. Financial mar- ket is an organized market for effective and efficient mobilization of funds from the numerous savers and their transfer to those who are in need of money to finance their business operations either in the private sector or in the public sector. guides a saver to direct his savings to Indian financial markets include both the unorganized and organized sector. Unorganized Sector mainly includes the indigenous bankers and moneylenders, while the organized sector consists of Banks, Stock markets and leading financial institutions. The public financial institutions are the most important ingredient of capital markets. To govern the mobilization of funds in the capital market government has established statutory bodies, which have framed a number of guidelines, rules and regulations. Some of the most important laws have been formed under the Companies Act, Securities Contract (Regulation) Act (SCRA). Securities Exchange Board of India (SEBN, RBI, IRDAI etc. The basic objective of these rules is to protect the interests of investors. The government has liberalized sever- al guidelines to aid the growth of financial markets in India during last few years. More especially with regard to dematerializations, buyback of shares, rolling settlements, and futures and options trading in the capital markets and many of the RBI guidelines for banking sector have lead to the economic development. ‘Several development banks which include IDBI, IFCI, ICICI, SFC, the in- vestment institutions which includes UTI, LIC and GIC, the commercial banks and the stock exchanges have been set-up to perform following major activities: TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 13 + Stirmtilate the capital markets * Provide the risk capital and seed capital. * Direct subscription 2 lerwriting of the public issues. ic nodernizing the existing industries the en y ° Promoting backward areas and regional levelopment. Providing safe environment ids and shares. alservices from the mutual through the insurance products. Development of an econo: ly is deeply dependent upon the availability of long term capital. Capital market provides long term resources which help in the long-term growth of the economy. Developed nations have healthy capital market which supplies funds to various sectors for different periods and varying requirements. It has been observed that those of the economies which could develop their financial markets earlier grew and developed long - long ago. The economies of USA, UK, France, Germany and Japan have sound, vibrant and active financial markets which aided their economic growth decades, ago. Although India’s financial markets have been in existence for quite a long time, it initiated the strong push towards the vibrant and reliable financial markets mainly after 1991. According to UNIDO Industrial Development Global Report 1997: “Finan- cial institutions which are an integral part of financial markets play crucial role in mobilizing domestic financial resources from savers and lending to Investors. The precise role of financial institutions depends, however, ~ on the stage of development of financial sector. In the early stages of de- velopment, Banks dominate the financial sector while financial markets and non-banking financial institutions play a more dominant role at a later stage. The process of evolution froma barter system to a money esonpmy is clearly confirmed by different characteristics pattern observed in the financial sector of countries at different levels of economic development. In Jow income developing countries and in economies in transition, the intermediation role of financial sector is limited. In more advanced cono- mies, Financial sector has deep and broadened financial system comprising of banking sector and rapidly developing financial institutions, especially stock-markets.” TAXMANN®14 AN INTRODUCTION TO FINANCIAL SYSTEM Role Played By Financial Markets in Allocation of Funds Ina free market where price system is the most efficient allocator of funds, financial markets are considered remarkable institutions. The rate of re. q ides the flow of funds ina fi i allocative function for the we: cha Ang the funds to the most efficient usage. ‘The above statement clearly highlights the importance of Financial Markets in the development of an economy. Moreover, the development of financial markets themselves is conditional on the economic development. In most of the under-developed and developing economies, the government role in pursuing the development of financial markets through legislation cannot be ignored; because a developed financial market is a sine -quo-non for the development of the economy. Efficient Financial Markets help in increasing the fund transfers in the right direction and also reduce their cost. As a result, financial markets increase the amount of c: i 7 y raising eco- nomic output. Producers and investors are able to transfer risk amongst them. These also help reduce income disparities, and increase production. Another way that financial markets improve living standards is by facili- tating the creation and exchange of money. By reducing the cost of trade, ‘money greatly increases the level of production. When the firms and individuals act to maximize their utility and wealth, through actions in their own self interest the sgciety stands to be benefited. Famous economist Adam Smith articulated this concept that the pursuit of individual interest leads to the best outcome for society as a whole. Financial markets increase the value of financial assets in several ways by: (@ Providing liquidity. inf a discovery (c) Facilitating capital budgeting decisions by the firms using above tion _ — os a ’ (@) Providing a mechanism thr which investors can transfer risk ng themselves to better accommodate their risk preferences. With the developmen f the financial markets the savings that accrue to units with financi uses can be allocated to preferred investment outlets. in this manner real resources are made available to those of the units which are efficient. In a complex modern economy, a system in which demands, production technologies, and the accessibility of various sorts of raw materials can change dramatically over time, a system of financial ‘TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 15 markets to facilitate the transfer of resources from financial surplus units to financial deficit units is essential to the common welfare. The innovative nature of financial markets allows the market participants to convert their innovative ideas into products which meet society's needs. Likewise existing economic units need access to funds for expanding fa- cilities, for financing inventories, for maintaining adequate cash reserves, or to repay existing high cost debt. Financial markets also serve the function of providing financial surplus units with access to earning assets without requiring them to purchase real assets. If saving is increased by income generating financial claims, the accumulation of the plants, equipment, and materials that contribute to the growth, economies productive capacity is also stimulated. Non-monetary financial claims make it possible to acquire consumer goods and services when they are wanted, so that households need not postpone their consumption for lack of savings. The services provided by brokers, underwriters, secondary markets, financial intermediaries, information providers, and regulators help the deepening of the financial system. In order to reconcile the interests of users of funds and providers of funds these institutions known as financial intermediaries provide valuable services. Financial intermediaries purchase the primary securities issued by the ultimate users and, in turn, acquire funds for issuing their own securities, which are tailored to be more attractive to ultimate savers, especially to relatively small scale savers. This is called Indirect Finance. These institution help to channel savings to high priority uses indirectly and in return make it safe for the savers to invest their money. Recent Reforms in the Financial Sector Financial sector is the mains! economy anditcontributesimmensely .es. Financial sector reforms in the mobilisation and distribu of resource: 0 have long been viewed as significant part of the program for policy reform in developing nations. Earlier, it was-thought thatéhey were expected to increase the efficiency of resource mobilization and allocation in the real economy to generate higher rates of growth. Recently, they are also seen to be critical for economic stability. r are Banks, Financial Institutions, ts of the financial secto1 tee ‘and markets which mobilise the resources from the surplus sector and channelize the same to the different needy sectors in the econo- The process of ‘accumulative capital growth through institutionalisation eresieet and investment fosters economic growth. Reform of the Indian financial sector was recognized, from the very ‘beginning, as an. integral part ‘TAXMANN®16 AN INTRODUCTION TO FINANCIAL SYSTEM of the economic reforms initiated in 1991. The economic reform process occurred amidst two serious crises involving the financial sector. First the balance of payments crisis that endangered the international credibility of the country and pushed it to the edge of default; and the second grave threat of insolvency confronting the banking system which had for years concealed its problems with the help of faulty accounting strategies. Furthermore, some deep rooted problems of the Indian economy in the eaily nineties were also strongly related to the financial sector such as large scale pre-emption of resources from the banking system by the government to finance its fiscal deficit. Excessive structural and micro regulation that inhibited financial innovation has increased transaction costs. The major goals of the financial sector reformsare to allocate the resources proficiently, increasing the return on investment and hastened. growthof the real sectors in the economy. The processes introduced by the Government of India under the reform process are intended to upturn the operational efficiency of each of the constituent of the financial sector. The major delineations of the financial sector reforms in India were found as under: Removal of the erstwhile existing financial repression. Creation of an efficient, productive and profitable financial sector. * Enabling the process of price discovery by the market determination of interest rates that improves allocate efficiency of resources. Providing operational and functional autonomy to institutions. * Preparing the financial system for increasing international compe- tition, Opening the external sector in a calibrated manner. . Promoting financial stability in the wake of domestic and external Financial and banking sector reforms are in following areas: Regulators The banking system * Non-banking finance companies The capital market Mutual funds Overall approach to reforms @ De-regulation of banking system Capital market developments * Consolidation imperative, To TAXMANN®17 AN INTRODUCTION TO FINANCIAL SYSTEM Regulators a - The Finance Ministry constantly formulated strategies in the nA d of financial sector of the country, The Government sclnosledged i of India (RBI) important role of regulators and made the Reserve Bank of more independent. The Securities and al the Insurance Regulatory and Development Authority (IRDA) emerg: as important regulatory institutions. Some people opine that there should be one super-regulator for the financialservices sector instead of multiplicity of regulators, Indian Banking Sector and Financial Reforms As carly as August 1991, the Indian government selected a high level Committee on the Financial System (1 i ittee) whose task was to look into all facets of the financial system and make compre- hensiverecommendations f The C dits report in November thet In India, around 80% of businesses are managed PSBs are still governing the commercial ba licenses to new private sector banks as part of the liberalizati ‘Fhe RBI has also beer granting lieensesvo industrial houses, Mae are effectively running in the retail and consumer segments but are yet to deliver’ services to industrial finance, retail trade, small business and agricultural finance. The reforms have focussed on eliminating financial ‘Ory pre-enptions, while st aged by public sector banks, nking system, The RBThas given TAXMANN®18 AN INTRODUCTION TO FINANCIAL SYSTEM Mbg,gieoeefonesrreturing wo the benlins Sere Capital base of the banks were strengthened by recapitalization, public equity issues and subordinated debt. Prudential norms were introduced and progressively tightened for income recognition, classification of assets, provisioning of bad debts, marking to market of investments. * Pre-emption of bank resources by the government was reduced sharply. @ New private sector banks were licensed and branch licensing restric- tions were relaxed. Similarly, several operational reforms were introduced in the area of credit policy: Detailed regulations relating to Maximum Permissible Bank Finance were abolished. Consortium regulations were relaxed substantially. Credit delivery was shifted away from cash credit to loan method. The banking system was expanded with many new banks allowed toset shop. Private Corporate, public sector entities and Non-Banking Finance Companies with a strong track record got permission to set up new banks. The addition of new banks will mean more competition for this sector in the country and it will lead to a development in services for the end customer. More and more people across the country would now be able to access banking facilities. In terms of reforms for the existing banks the public sector banks have been allowed to increase or decrease the authorised capital without the presence of an overall ceiling. This will provide greater flexibility to the banks to conduct their fund raising activities as per the requirements. The strict restriction of voting rights in banks has also been relaxed and this will aid the banking sector to develop. When evaluating banking sector reform, it can be identified that banks have experienced strong balance sheet growth in the post-reform period in an environment of operational flexibility. Enhancement in the financial health of banks, reflected in noteworthy improvement in capital adequacy and improved asset quality, is distinctly observable. It is striking that this progress has been realiscd despite the espousal of international best practices in prudential norms. Competitiveness and productivity gains have also been enabled by proactive technological deepening and flexible human resource management. These significant gains have been achieved even while renewing goals of social banking viz. maintaining the wide TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 19 reach of the banking system and directing credit towards important but underprivileged sectors of civilisation, FOREX market reforms: Forex market reform took place in 1993 and the successive adoption of current account convertibility was the acmes ie forex reforms intro: duced in the e foreign exchange as well as banks have been given greater sovereignty to perform in activities and numerous operations. Additionally, the entry of new companies has been allowed in the market. The capital account has become effective adaptable for non-residents but still has some reserva- tions for residents. Impact on the Reform Measures The broader objectives of the financial sector reform process are to ar- ticulate the policy to enhance the financial condition and to reinforce the iE Aspas oh s process, many private banks were granted licence to operate in India. This has led to a competitive environment in the banking industry which in turn has assisted in using the resources more competently. Conventionally, the industrial units were san ioned term velopme worki h ‘¢ reform process has transformed the pattern of financing and now both the institutions are willing to extend long term loan as well as working capital loans. Bs Capital Market Reforms The Capital market channelizes funds from savers and depository institu- tions (banks, credit unions, insurance companies, etc.) to borrowers and investees through a variety of financial instruments (bonds, notes, shares) called securities. A capital market is highly decentralized system made of three major parts that include stock market. It also works as an exchange for trading existing claims on capital in the form of shares or bonds. The Capital Market deals in the long-term capital Securities such as Equity and or Debt offered by the private business companies and also governmental undertakings of India. TAXMANN®20 AN INTRODUCTION TO FINANCIAL SYSTEM Structure of Capital Market of India Inthe agenda of financial sector reforms, improvement of the capital market is important area and suitable action has been taken in line with the overall reforms. Until 1980s, the volume of activity in the Indian capital market was relatively limited which extended rapidly in the 1980s and the market capitalization of companies registered in the BSE rose from 5 per cent of GDP in 1980 to 13 per cent in 1990. Indian capital market went through major reforms in the decade of 1990s and thereafter. The Government of India and SEBI took numerous measures to improve the working of the Indian stock exchanges and to make it more progressive and energetic. The ‘Securities and Exchange Board of India (SEBD was established in 1988. It got a legal status in 1992. Companies who wanted to access the capital market needed prior permis- sion of the government which also had to approve the price at which new equity could be raised. While new issues were strictly controlled, there was insufficient regulation of stock market activity and also of various market participants including stock exchanges, brokers, mutual funds, etc. The domestic-capital market was also closed to portfolio investment from. ‘TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 21 abroad except through a few closed ended mutual funds floated abroad by the Unit Trust of india (UTD which were committed to Indian investment. Capital market reforms started in 1992 along the lines recommended by the Narasimham Committee. The reform process was intended to remove direct governmentcontroland replacing it by a regulatory framework based on transparency and disclosure supervised by an independent regulator. The first step was taken in 1992 when the Securities and Exchange Board of India (SEBI), which was established as a non-statutory body in 1988, was raised to a complete capital market regulator with statutory powers in 1992. The requirement of prior government permission for accessing capital markets and for prior approval of issue pricing was stopped and companies were permissible to access markets and price issues freely, subject only to disclosure norms laid down by SEBI. Over a period of time, SEBIhas put inplacea modern regulatory framework with rules and regulations to control the behaviour of major market par- ticipants such as stock exchanges, brokers, merchant bankers, and mutual funds. It has also sought to control activities such as takeovers and insider trading which have implications for investor protection. The governing structure of stock exchanges has been changed to make the boards; of the exchanges more broad based and less dominated by brokers. The exchang- es have been converted from the association to demutualised carporate. The new regulatory framework is intended to control directly but provides support to investor protection by ensuring disclosure and transparency. Opening the Capital Market to Foreign Investors A significant policy initiative in 1993 was the o to foreign institutional investors (FIIs) and allowing Indian companies to raise capital abroad by issue of equity in the form of global depository re. ceipts (GDRs). Since the permission to FII’s major chunk of the blue chip companies’ equity has been taken up by them. FPI’s investments have been by now further relaxed by RBI. FPI's invest not only not only in equity markets they invest in Indian ‘bonds also. These foreign investors include sovereign wealth funds, pension funds and private central banks. pening of the capital market Modernization of Trading and Settlement Systems Several major developments occurred in trading antiquated earlier. The National Stock Exchange (NSE) was established in 1994 as an automated electronic exchange. It empowered brokers in 400 cities all over the country to link up with the NSE computers via VSATs methods which were highly ‘TAXMANN®22 AN INTRODUCTION TO FINANCIAL SYSTEM and trade in a unified exchange with automatic matching of buy and sell orders with price time priority, thus ensuring maximum transparency for investors. The initiation of electronic trading by the NSE generated com- petitive pressure for other exchanges to follow the suit. The old-fashioned settlement system involving delivery of sharecertificates has been substituted by the paperless trading by enacting a legislation which allowed dematerialization of share certificates with settlement by electronic transfer of ownership from one account to another within adepository. The National Securities Depository Ltd (NSDL) opened for business in 1996. It was followed by the establishment of Central Depository Securities Limited which has been promoted by the BSE. Futures Trading The permission for derivatives trading which was long pending was granted in year 2000. Majority of the Investors, particularly small investors who entered the market in the early stages of liberalization, did not get good value of their investments. It was perceived that many dishonest companies took advantage of the exclusion of government control over issue prices to raise capital at inflated prices, at the expense of inexperienced investors. Merchant bankers and underwriters were hand in glove with the unscru- pulous promoters of companies in duping gullible and novice investors who invested in these issues. Mutual Fund Presently, the Mutual Funds industry is controlled under the SEBI (Mutual Funds) Regulations, 1996 and amendments thereto. With the issuance of SEBI rules, the industry had a framework for the setting up of many more companies, both Indian and foreign firms. The foreign owned AMCs are the ones which are now setting the pace for the industry by introducing new products, setting new standards of customer service, improving disclosure standards and experimenting with new types of distribution. Reform of the Insurance Sector The Insurance sector in India directed by Insurance Act, 1938, the Life Insurance Corporation Act, 1956 and General Insurance Business (Nationalisation) Act, 1972, Insurance Regulatory and Development Authority (IRDA) Act, 1999 and other related Acts. The basis of liberalizing the banking system and encouraging competition among the three major participants’ viz. public sector banks, Indian private sector banks, and foreign banks, applied equally to insurance. There was a strong case for ending the ‘TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 23 public sector monopoly in insurance and opening it up to private sector participants subject to suitable prudential regulanion The AORTA PMENB op esing up the insurance sec torto new private companies as ca Thereafter, majority of the private sector insurance business moved to this segment. Foreign companies hav. been now permitted to 49% in the insurance company The reforms in the Indian financial system and its varied components led to increased efficiency of resource mobilisation and allocation in the real economy which in turn boosted the higher rates of growth in an economy and macro-economic stability. (i) Interest Rate Liberalisation Interest rates in the Indian banking system have been liberalised substantially compared to the situation prevailing before 1991. Prior tothe interest rate liberalisation the Reserve Bank of Indiacontrolled the rates payable on deposits of different maturities and also the rates which could be charged for bank loans which varied according to the sector of use and also the size of the loan. With effect from October 1997 interest rates on all time deposits, including 15 day deposits, have been freed. The rationale for liberalising interest rates in the banking system ‘was to allow the banks greater flexibility and encourage competition. Banks are now able to vary rates charged to borrowers according to their cost of funds and also to reflect the credit worthiness of different borrowers. (ii) Reserve Requirements Another important area where some liberalisation has taken place relates to the cash reserve requirement (CRR) and the separate requirement for mandatory investment in government securities through the statutory-liquidity ratio (SLR). At one stage, the CRR applicable to incremental deposits was as high as 25% and the SLR was 40%, thus pre-empting 65% of incremental deposits. These ratios were reduced in a series of steps after 1992. The statutory liquidity ratio is 25%, but its distortionary effect has been greatly reduced by the fact that the interest rate on government securities is increasingly market determined. In fact, most banks currently hold a higher vol- ume of government securities than required under the SLR reflecting the fact that the attractive interest rate on these securities combined with the zero risk-weight, makes it commercially attractive for banks to lend to the government. TAXMANN®24 AN INTRODUCTION TO FINANCIAL SYSTEM (iti) Directed Credit An area where there has been no liberalisation thus far relates | directed credit. Directed credit policies have been an importa: part of India's financial strategy under which commercial banks a1 required to direct 40% of their commercial advances to the priori sector which consists of agriculture, small scale industry, small sca’ transport operators, artisans etc. Within this aggregate ceiling the: are sub-ceilings for agriculture and also for loans to poverty relate target groups. The Narasinham Committee had recommended r ducing the 40% directed credit target to 10%, while simultaneous! narrowing the definition of the priority sector to focus on small farn ers and other low income target groups. This recommendation wz not accepted by the government and the directed credit requiremer continues unchanged. (iv) Government majority ownership of banks Perhaps the most difficult issue for the future is whether govern ment should retain majority control over public sector banks. Th: prevailing international consensus is definitely against it and man: developing countries are actively engaged in privatising governmen banks as part of financial sector reform. Privatisation is obviousl not a guarantee against bad banking, as is evident from the man) banking crises involving private banks in both developed and de veloping countries. However this argument is usually countered 6} conceding that while privatisation alone is definitely not sufficient and must be accompanied by improved regulation and supervision, itis nevertheless necessary because Government ownership involves “politicisation” and “bureaucratisation” of banking. Capital Market Reforms Reform of the capital market was an important part of the agenda of Indian financial sector reforms and action has been taken in this area parallel with reforms in banking. India has a long tradition of functioning capital markets - the Bombay Stock Exchange is over a hundred years old - but until the 1980s the volume of activity in the capital market was relatively limited. Capital market activity expanded rapidly in the 1980s and the market capitalisation of companies registered in the Bombay ‘Stock Exchange rose from 5% of GDP in 1980 to 13% in 1990. However the market remained primitive and poorly regulated. Companies wishing to access the capital market needed prior permission of the government which also had to approve the price at which new equity could be raised. While new issues were strictly controlled, there was inadequate regulation TAXMANN®AN INTRODUCTION TO FINANCIAL SYSTEM 25 of stock market 2 ity and also of various market participants including stock exchanges, brokers, mutual funds ete. The domestic capital market was also closed to portfolio investment from abroad except through a few closed ended mutual funds floated abroad by UTI which were dedicated to Indian investment. Following the recommendations of the Narasimham Committee the process of reform of the capital market was initiated aimed at removing direct government control and replacing it by a regulatory framework based on transparency and disclosure supervised by an independent regulator. The first step was taken in 1992 when the Securities and Exchange Board of India (SEBI), which was originally established as a non-statutory body in 1988, was elevated to a full fledged capital market regulator with statutory powers. The requirement of prior government permission for accessing capital markets and for prior approval of issue pricing was abolished and companies were allowed to access markets and price issues freely, subject only to disclosure norms laid down by SEBI ( calnsieninienieieniiniaeemieaitienteneimmnmmmmmiamemesnimammmrmesseese ee) Summary Development of an economy is linked to a well regulated and efficient financial system. Financial markets are markets through which funds required by the users are supplied by the saves of funds. It helps in exchange of financial assets between those who have the funds and those who require these funds, Indian financial markets include both the unorganized and organized sector. .”* Indian financial sector during the past few decadeshave been maturing with Private sector institutions growing rapidly in commercial banking and asset management business (mutual funds). An indication of the strength of the reformed Indian fi- nancial system can be seen from the way India was not affected by the Southeast Asian crisis and subprime crisis. : The reforms in the financial sector have brought India much closer to what is expected of developing countries as they integrate with the world economy. The reforms currently unde-way in the banking sector and in the capital market, com- bined with the agenda for reform identified for the insurance sector, represent a major structural overhaul of the financial system, As in so many other areas, reforms in the financial sector have been gradual, with changes being made only after much discussion and over a somewhat longer period then attempted in most other countries. However, the direction of change has been steady andin retrospect agreat deal has been accomplished in the past few years. It is essential to continue these reforms along the directions already indicated and to accelerate the pace of change as much as possible. It is important to recognize that financial sector reforms by themselves cannot guarantee good economic performance which depends upon a number of other ‘TAXMANN®26 AN INTRODUCTION TO FINANCIAL SYSTEM factors, including favourable macroeconomic environment and economic re- forms in other parts of the real economy. The impact of financial sector reforms in accelerating growth will be maximized if combined with progress in economic reforms in other areas. Review Questions Q.1 What are the i anctions ed by an efficient financial system inan economy Docs i helpintic coonomiedeeclopment of a county? 0. 2 Explain the relationship between financi Q. 3 Give a brief description of Financial Markets in India. Explain the role of " oo ‘financial intermediaries, Q. 4 Explain the impact of an efficient financial system on the economic develop- ment of the country with the help of examples of the Indian financial system. Q.5 Explain the recent reforms in the Indian financial System. Q. 6 What do you mean by financial system? Explain structure of the financial system? Tee Q.7 Give brief description of financial markets and financial institutions in India. TAXMANN®CHAPTER > Segments of, Financial Markets >> Difference Hetweett Capital Market and: rMoney Market + “Mongy Mate et (Wistfishents ge) > Shortcomings of indian’ Money Market Financial Markets Financial markets are markets through which funds required by the users are supplied by the savers of funds. With the development of the financial markets the savings that accrue to units with financial surpluses can be efficiently allocated to preferred investment outlets. In this manner real resources are made available to those who need them for the purpose of capital formation. In a complex modern economy, a system in which the demand, production technologies, and the accessibility of various sorts of raw materials can change dramatically over time, a system of financial markets facilitates the transfer of resources from financial surplus units to financial deficit units. The efficiency of the financial system lies not only in transfer of funds but the transmutation (conversion) too. The conversion of securities from direct securities into indirect securities according to the needs and requirements of savers as well as users help in enhancing the magnitude of financial flows. Financial market performs following functions: Helps in establishing fair prices of securities Enhancing the liquidity of the financial assets * Minimizing the transaction costs 27 TAXMANN®28 a: y «Helps in Diversification and reduction in Risk © Facilitates the better mode of operation of the payment mechanism. the better stode of operation of the Segments of Financial Markets Financial markets can be divided into two segments, depending on the maturities of the financial claims, traded therein: 1. Capital Markets. 2. Money Markets. Capital Markets The Capital marketisa vital segment of Financial Market and dealsin financial claims, which have, maturities of more than one year. It is a market for long-term debt and equity shares. These are typically expected to generate i turn to inves! (t is an institutional arrangement that facilitate the transfer of funds among investors. It not only represents those economic agents which are directly participating to raise resources or those who provide resources, but also those participants who execute the role of intermediaries like r iting institutions. It is wide enough to encompass the private placements of debt and equity as well as organized markets like stock exchanges. The.two types of capital markets are primary markets and secondary markets. Money Market- Money market can be defined as a market for short-term funds with aturities ov o one year and includes financial instruments that are considered to be close substitutes of money. It provides an equilibrating mechanism for demand and supply of short-term funds and in the process provides an avenue for central bank intervention in influencing both the quantum and cost of liquidity in the financial system, consistent with the overall stance of monetary policy. In the process, money market plays a central role in the monetary policy transmission mechanism by providing a key link in the operations of monetary policy to financial markets and ultimately, to the real economy. In fact, money market is the first and the most important stage in the chain of monetary policy transmission. Typically, the monetary policy instrument, effectively the price of central bank liquidity, is directly set by the central bank. in view of limited control over long-term interest rates, central banks adopt a strategy to exert direct influence on short-term interest rates. Changes in the short-term policy rate provide signals to financial markets, whereby ‘TAXMANN®MONEY MARKETS 2 different segments of the financial system respond by adjusting their i ae of return on various instruments, depending on their sensitivity an i efficacy of the transmission mechanism. How quickly and effectively t monetary policy actions influence the spectrum of market interest rates depends upon the level of development of various segments of financial markets, particularly the money market. : Money market is also an important funding market for banks and financial institutions, and at tinves, even for corporate. Stressed eondit in money markets could increase moralhazard with banks expecting central bank to function as the lender of first resort. aturity none yea meets the needs for short term funds for industry and banking sector. RBI defined the money market as “a market for short-term financial assets that are close substitutes for money, facilitates the exchange of money for the new financial claims in the primary market and also for the claims, already issued in the secondary market”. Money Market facilitates liquidity in market and also performs the role of a wholesale market of short term debt instrument The money markets securities are more liquid because of their short term nature. Money market encourages financial activity, by assuring borrowers (lenders) of the availability of short-term funds (returns) and lenders the avenues for deployment of the short term funds to create income. It also provides the regulators the information about the flow of funds in the economy which helps in the monetary adjustments to ensure stability in e economy. The ance _ ‘mutual funds and corporate. ‘TAXMANN®30 MONEY MARKETS Difference between Capital Market and Money Market [SNe "Capital Market Capital aad isa financial market where term borrowing and len ing of funds with maturity fpeed.ot more than one year take place. The d and ed secunites are used as ene in capital market. Money Market Money market is a financial-market where the short term borrowings and lending of funds with a maturity period of less than one year take _| place. 4] The instruments_ used in_money | markets-are treasury bills, comme! and certificates of deposits etc. 3. | Capital market investments carry | Money market investments are safe, | se [liquid and less risky. 4. |The regulator for Capital Market | The regulator for Money market is SEBT i 5. funds for fixed Capital market helps to generate | market facilitates funds for Features of Money Markets The following are salient features of money market: Money market deals with highly liquid and short term securities. It involves securities which are readily transferable.) Firms buy/sell securities in their own account and at their own risk. The money market is regulated by Reserve Bank of India. There is no well defined place where business is transacted in money market. It's a systerm of transactions between borrowers and lenders oor ° of short term funds. It provides trends in liquidity and interest rates. It is a wholesale market andsthe rolef individual is insignificant. The maturity period for most of the transaction in money market is overnight to one week. Instruments include Certificate of Deposit, T-Bills, Commercial Papers, Govt. Securities & others. The risk of investments in money market is low. = TAXMANN®MONLY MARKETS, 31 Objectives/Functions of the money market Money Market is a mechanism for movement of funds from short (crm surplus units to short term deficit units. 2. In money market the liquidity-isintused-by the interventions of Centrabbank 3. Money market enables the access of shortterm fundsataneasonable price inthe markety Need for Money Market Business needs working capital for day-to-day operations and the major component of that is Cash. Lack of adequate cash can lead to disruption in day-to-day activities of a business. The short term mismatch of funds requirement and availability is known as short term liquidity crisis, which leads to not meeting up of day-to-day operations and hence adds cost to the firm. Excess of cash too does not bring any yield. Hence Money Market is required to coordinate between borrowers and lenders. Thus transaction in money market is in high volumes and is less risky. Constituents of Money Market The Money market is a market where the financial institutions provide to the broad range of platform to borrowers and investors with an opportunity to trade in different forms of short term securities. Money market consist of three segments: 1. Borrowers of Funds 2. Intermediaries 3. Market Makers. ‘TAXMANN®32 MONEY MARKETS Money Market Participants Participants in Money Markets 4ssuers/ 3 A Market emt, | [oom | [tte Govt. Discount Banks Houses eee Acceptance Institutions Houses Corporate Houses Mutual Funds Fils Banks borrow in the money market to: « Fill the gaps or temporary mismatch of funds To meet the CRR and SLR mandatory requirements as stipulated by the central bank + To meet sudden demand for funds arising out of large outflows Call money market serves the role of equilibrating the short-term liquidity position of the banks. The institutions which deal with the short term borrowings and lending of funds are known as Money Market Institutions. The two sectors in which money market has been classified are as follows: organized sector and unorganized sector. The composition and rates of interest of both of these markets are different from each other. 1. Organised Sector: The organized sector of money market is integrated. It comprises of RBI, Mutual Funds, Public and Private sector banks, Cooperative Societies, can banks and Financial Institutions like IDBI, IFCI, 1CCI, LIC & 7 TAXMANN®MONEY MARKETS 33 2. Unorganised Sector: The unorganized sector of Money market is neither integrated nor homogencous. [tcomprises of the following institutions like Indigenous banks,_Chits, Nidhis_and Unregulated non-bank financial intermediaries. _ Money Market Instruments x The Money Market instruments have a maturity period of less than one year. The main money market instruments are as follows: Certificates of Deposit Commercial Paper . Inter-bank participation certificates . Inter-bank term money Treasury Bills Bill rediscounting . Call/Notice/Term money CBLO . Market Repo wo Onanrwn Certificates of Deposits34 MONEY MARKETS Certificate of Deposits (CDs) are negotiable money market instruments and-are also known as/Negotiable Certificate of Deposits. They are issued in dematerialized form by commercial banks and fi | institutions at ; i time period. Th “scone deposits accounts, are like bank term CDs are issued in th e form of Usance Promissory Note (UPN) by financial institutions and the titlesare easily transferable by endorsement and delivery. CDs Were introduced-in-1989 by Reserve Bank/of India with a maturity of rot ese toe OTD ess. Schedvled bonis ca issue CDs for a period ranging from year to 3 years) Theissuance of CDsin India is governed bythe Indian Negotiable Instruments Act, 1881. The issue of CDs attracts payment of stamp duty under the Indian ‘Stamp Act, 1899. There is no lock in period for CDs. They are generally issued to individuals, corporations, trusts, funds and associations. They are issued at a discountrate to the face value, determined by the investors. For the repayment of CDs no gi ice period is provided. However if there is a holiday on the date of maturity, the payment is to be made by the issuing bank on the immediate preceding working day. Buy- Back of CDs is also allowed >) Commercial Paper iS Commercial Paper (CP) is a short-term borrowing by corporate, financial institutions, primary dealers from the money market, It is an unsecured instrument issued in the physical form (Usance Promissory Note) or demat form. It was initiated by RBI in 1990. It enables the corporate borrowers to meet the n short term borrowings at competitive rates ug imarket. CP issued in physical form is freely transferable by endorsement and delivery. The credit rating companies in India like Credit Rating Information Services of India Ltd (CRISIL), the Investment Information and Credit Rating Agency TAXMANN®ne MONEY MARKETS 35 of India limited (ICRA), Credit analysis and research Ltd. (CARE) or the FITCH Rating India private limited provide ratings to the participants for issuing commercial paper. CP is issued as per the guidelines of RBI and with minimum denomination of €5 lacs and its multiples thereof. The rate of interest o' CP can be issued by the high rated corporate (corporate borrowers, primary dealers, satellite dealers and all-india financial institutions) whose tangible net worth is more than @ 4 crore. The investment in CP is as per ‘the limits set by Securities and Exchange Board of India and can be bought by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIs). Tl > thus it is a very bee y ca ro th The pratunity perit 1 Treasury Bills (T-Bills): T-Bills can be purchased by s, ni funds, financial institutions, i , NBFCs, FIs estor through the secondary (a market where it has been préviou u Presently in India the Government has issued the following types of treasury bills through auctions like, _T-Bills can also - be purchased at an auction where price is fixed tl rough a competitive bidding process generally at a discount and oe at par. For example: An investor buys T-Bills 0! liscount for 90. But at the time of maturity of T-Bills, it is redeemed at € 100. Thus investor gains z T-bills investments as an interest. have an option to issue any treasury bills. The State Government do ini e available in market is estm« £9 price and the discountare to becalculated at each auction The 91-day T-bills are auctioned by RBI weekly, whereas the Central Govérnment auctions the182-day T-bills and 364-days T-bills on a fortnightly basis. TAXMANN®) 3) Repos or Repurchase Agreements 36 MONEY MARKETS. BLO (Collateralized Borrowing and Lending Obligation) A CBLO is one of the mc i i i nic book entry form. Itrepresents an obligation between borrower and tenders as per the terms of the loans. The maturity period ranges from one day to "ninety days. As per RBI guidelines this can also be extended upto one year. They are approved and developed by RBI and Clearing Co! India(CCIL) in 2003 (It is an ere maj inthe lender-side arem BICBLO ike orrower has thblgation tora the money borowedst a i ture date. The lender has an authority to receive money lent at the predetermined future date. There is a charge on security held by CCIL. : By providing a dealing system, CCIL has an author le to borrow and lend funds. The dealing systems available are: @ Indian Financial Network (INFINET): This is a closed group formed by the members of the Negotiated Dealing System (NDS), who gen- + j¢rally have an account with RBL # Internet gateway: This enables the dealing system for those entities which do not maintain a Current accpunt with RB) and co-operative banks who are members of NDS can participate in CBLO ‘transactio (The Non-NDS members like corporates, co-operative banks, ‘Cs, Pension/Provident Funds, Trust: can, however, partici ly by obtaining the Associate Membership to the CBLO Segment epos are also known as repurchase agreement. It is a short t. 0g vhere one who sells the se ire. The securities for Repo transaction aré government approved securities like trea: ills, and Central/State Government securities. Repo (repurchase agreement) instruments enable collateralized short- term borrowing thror ents. For the seller the transaction is a repo as he agrees to repurchase it at a specified date and rate. Whereas for the buyer itis a reverse repo as he agrees to buy the The seller agrees to buyback the securities at a rate which includes the interest charged by the buyer for allowing purchasing securities from, the -TAXMANN®MONEY MARKETS 37 seller. The seller requires funds so he repurchases the securities by paying interest to the buyer. (C bawnoticer ‘erm Money Cail money is an important constituent of Indian Money Market. It is a lent on demand and has a maturity market where money is borrowed 01 y ranging between ont o nas Inter-ban! call money market/ The mais The difference among call money, notice money and term money is in terms of the period of maturity of the borrowed money, (Call money is defined as the money borrowed o1 je day and repaid on the nextsponiig ds) There is an exception of holiday or Sunday in this Case as the transaction is only for overnight basis. Notice money is defined as the money If the funds are transacted for more than 14 days then it is called as “Term MoneyRB! fixes the prudential limits for transaction in Call/Notice Market which keeps on changing from time to time. Scheduled Commercial Banks, Co-operative banks and Primary dealers are the borrowers in call/notice market. The non-banking financial institutions are not permitted totransact in the call/notice market since 2005. Important lenders in the call/notice market are commercial banks, cooperative banks and primary dealers. quired in call market and loans are made facilitates the redistribution of sunplus day to day funds among i 1 : 3. The call market enabl 4. Cail money market is a v« Call money helps toi financial institutions. n of banks and other w TAXMANN®38 MONEY MARKETS @® Commercial Bills Commercial bills facilitate short term liquidity to banks in need of funds. This Money market instrument isan important method of providing credit to customers by banks by discounting commercial bills at prescribed discount rates. The bill market scheme was introduced by RBI in 1952 and later a new scheme called bills rediscounting was introduced in 1970. [can bered inthe commercial bill rediscount Market. It helps the commercial banks to get money before the maturity date. According to RBI, only those commercial bills whose maturity period is not more than 90 days from date of rediscounting and which have been created out of a commercial transaction of sale of goods can be rediscounted. Role of a Central Bank The function of the central bank of a country is to control and monitor the banking and financial system of the country. In India, the Reserve Bank of India (RBI) is the Central Bank. The main role of RBI is related to the Indian economy, and the banks arean instrument tohelp RBImake changes according to different macroeconomic facets of the Indian economy. There are 3 ultimate goals of a central bank 1. Economic Growth - higher the better, but should be sustainable 2. Controlling Inflation. 3. Reducing Unemployment. The RBI was established in 1935. It was nationalized in 1949. The RBI plays role of regulator of the banking system in India. The Banking Regulation Act, 1949 and the RBI Act, 1953 have given the RBI the power to regulate the banking system. RBI : Controller and Supervisor of Banking Systems The RBI has been assigned the role of controlling and supervising the banking system in India. The RBI is responsible for controlling the overall operations of all banks in India. These banks may be: @ Public sector banks @ Private sector banks @ Foreign banks TAXMANN®MONEY MARKETS. 39 ¢ Co-operative banks, or # Regional rural banks The control and supervisory roles of the Reserve Bank of India is done through the following: Issue of Licence: Under the Banking Regulation Act, 1949, the RBI has been given powers to grant licenses to units to commence new banking operations. The RBI also grants licenses to existing banks for opening new branches. Under the licensing policy, the RBI provides banking services in areas that do not have this facility. ¢ Prudential Norms: The RBI issues guidelines for credit control and management. The RBI is a member of the Banking Committee on Banking Supervision (BCBS). As such, they are responsible for im- plementation of international standards of capital adequacy norms and asset classification. ¢ Corporate Governance: The RBI has power to control the appoint- ment of the chairman and directors of banks in India. The RBI has powers to appoint additional directors in banks as well. @ KYC Norms: To curb money laundering and prevent the use of the banking system for financial crimes, The RBI has “Know Your Customer“ guidelines. Every bank has to ensure KYC norms are applied before allowing someone to operl an account. ¢ Transparency Norms: This means that every bank has to disclose their charges for providing services and customers have the right to know these charges. ¢ Risk Management: The RBI provides guidelines to banks for taking the steps that are necessary to mitigate risk. They do this through risk management in basel norms. ¢ Audit and Inspection: The procedure of audit and inspection is con- trolled by the RBI through off-site and on-site monitoring system. On-site inspection is done by the RBI on the basis of “CAMELS”. Capital adequacy; Asset quality; Management; Earning; Liquidity; System and control. Major functions of the RBI are as follows: 1. Issue of Bank Notes: Section 22 of the RBI Act gives authority to the RBI to issue currency notes. The RBlalso takes action to control circulation of fake currency. The Reserve Bank of India has the sole right to issue currency notes except one rupee notes which are issued by the Ministry of Finance. TAXMANN®MONEY MARKETS Currency notes issued by the Reserve Bank are declared unlimited legal tender throughout the country. This concentration of notes issue function with the Reserve Bank has a number of advantages: {i) it brings uniformity in notes issue; (ii) il makes possible effective state supervision; (iii) it is easier to control and regulate credit in accordance with the requirements in the economy; and (iv) it keeps faith of the public in the paper currency. 2. Banker to Government: As the banker to the government the Reserve Bank manages the banking needs of the government. It has to-maintain and operate the government's deposit accounts. It collects receipts of funds and makes payments on behalf of the government. It rep- resents the Government of India as the member of the IMF and the World Bank. 3. Custodian of Cash Reserves of Commercial Banks: The commercial banks hold deposits in the Reserve Bank and the latter has the custody of the cash reserves of the commercial banks. 4. Custodian of Country's Foreign Currency Reserves: The Reserve Bank has the custody of the country’s reserves of in- ternational currency, and this enables the Reserve Bank to deal with crisis connected with adverse balance of payments position. 5. Foreign Exchange Control: The RBI plays a crucial role in foreign exchange transactions. It does due diligence on every foreign trans- action, including the inflow and outflow of foreign exchange. It takes steps to stop the [all in value of the Indian Rupee. The RBI also takes necessary steps to control the current account deficit. RBI gives support to promote exports from the country. 6. Lender of Last Resort: ‘The commercial banks approach the Reserve Bank of India in times of emergency to tide over financial difficulties, and the Central Bank comes to their rescue as a lender of last resort. 7. Central Clearance and Accounts Settlement: Since commercial banks have their surplus cash reserves deposited . in the Reserve Bank of India, it is easier to deal with each other and settle the claim of each on the’ other through book keeping entries in the books of the Central Baw... The clearing of accounts has now become an essential function of the Reserve Bank of India. 8. Controller of Credit: Credit is controlled by the Reserve Bank in accordance with the economic priorities of the government. RBI has a Control on bank TAXMANN®MONEY MARKETS 4 credit through Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) which commercial banks have to maintain. 9. RBI is the Regulator of Financial System through Monetary Policy The Government intervenes to control the interest rates and money supply in the economy through Fiscal and Monetary policy. A number of institutions can affect the supply of money but the greatest impact on the money supply is made by the Reserve Bank ard the commercial banks. The RBI formulates monetary policy twice a year. It reviews the policy every quacter as well. The main objectives of monitoring monetary policy are to control the Inflation by Monitoring different key indicators like GDP and inflation. The RBI undertakes Open market operations and Interest ratecontrol through repo rate, reverse Tepo rate, and bank rate. A repo transac- tion is one in which a bank or financial institution sells government securities or bonds to the RBI, which charges interest on it. Known as the repo rate, the RBI uses it to infuse liquidity in the system. In the reverse repo transaction, the RBI sells or releases bonds to drain ‘out excess liquidity. These transactions are carried out daily as part of the central bank's liquidity management operations, and are cur- rently not traded on the exchange. Another way in which the money supply can be affected by the cen- tral bank is through its operation of the interest rate. By raising or lowering interest rates the demand for money is respectively reduced or increased. The RBI regulates the Indian banking and financial system by issuing broad guidelines and instructions also. It helps in Maintaining peo. ple’s confidence in the banking and financial system, and Provides different tools for customers’ help, such as acting as the “Banking Ombudsman.” Menetary Policy Monetary policy refers to the use of certain regulatory tools under the control’at the RBI in order to regulate the availability, cost and use of money and credit. There are several direct and indirect tools which RBI can use to regulate the financial markets and maintain stability. Important ones are discussed below: Cash Reserve Ratio (CRR): CRR is the minimum amount of cash that commercial banks haveto keep with the RBI at any given point in time. RBI ‘TAXMANN®