Financial

Markets &
Institutions
F.Y.B.Sc. (Finance)
Module 1
An Introduction to Financial System and
its Constituents
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 Objective
• To understand Financial System
• Constituents of Financial System
• Need to Regulate Financial System
• Types of Financial Markets
• Functions of Financial Markets
• Role of Financial Markets in Economic Growth
• Types of Financial Institutions
• Role of Financial Institutions
• Types of Financial Instruments
• Need for Financial Services

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 Savings

For the household sector, savings are surplus of income over consumption expenditure
▪ Expenditure includes both consumer non-durables as well as consumer durables.
▪ Surpluses of the corporate sector, government sector and other institutions (such as
trusts/NGOs) also form part of the savings pool seeking investments.
▪ Savings, “if invested”, can grow due to returns earned from those investments.
▪ Savings which are not invested may reduce in “real” terms due to inflation.
▪ Savings => investments => growth of economy.

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 Investments
What is Investment?
• An investment is an asset or item that
is purchased with the hope that it will
generate income or will appreciate
in value in the future.
• In an economic sense, an investment
is the purchase of goods that are not
consumed today but are used in the
future to create wealth.
• In finance, an investment is a
monetary asset purchased with the
idea that the asset will provide
income in the future or will be sold at
a higher price for a profit.

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 Role of Financial System

Financial
Savings Investments
System

1.Collection of savings
2.Distribute the collected savings into various investments
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 What is Financial System

Need for a Sound Financial System

• Without financial system it is quite difficult and expensive to allocate resources where needed and
minimise risks for investors.
• It plays an important role in the economic development of the country
• It gathers or pools money from people and businesses that have more than they need currently and
transmit those funds to those who can use them for either consumption or investment.
• The larger the flow of funds and the more efficient their allocation is, the better the economic output
and welfare of the economy and society. A healthy economy is dependent on efficient transfers of
resources from people who are net savers (surplus) to firms and individuals who need capital.

• Importance of financial system - https://youtu.be/MsPgw4FodgE

• 6
 Capital flow between Savers & Borrowers through the financial system

• Financial markets are where people buy and sell, win and lose, bargain and argue about the
price and the product/services.
• Financial institutions, as part of financial system, they also play an important role in economic
development by facilitating the flow of funds from surplus unit (savers) to the deficit
unit(borrowers).
• Economic elements or parties that are involved can be divided into households, business
organizations, and government.
• Business often needs capital to implement growth plans; government requires funds to finance
building projects; and households frequently want loans for example to purchase homes, cars and
so on.
• Fortunately, there are other individuals or households and firms with incomes greater than their
expenditures (surplus budget position).
• Therefore financial systems bring together people and organizations needing money with those
having surplus funds. In other words, the purpose of the financial system is to transfer funds from
savers to the borrowers in the most effective and efficient possible manner. And that job can be
done by direct financing or by indirect financing. Despite the method of transferring the resources
the objective is to bring the involving parties together at the lowest possible cost.
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 Value addition by the
financial system
• Convenience
o Access : savers do not have to reach out to find the ultimate users of their
investments and vice-a-versa
o Divisibility : match the size needs of users of the funds ( ie the business units) and
savers by dividing a large investment into various size denominations
o Tenure : “matching” the tenure requirements of business units and savers

• Lowering of risk through diversification

o Large pool of funds available to a financial institution allows it to invest into
various investments.
o For a saver, it is difficult to achieve the same level of diversification
o By dividing large and diversified investments into small denominations (eg
mutual fund units); benefits of diversification are shared by the individual savers
How does diversification lower risk?
https://youtu.be/2NIIc-ZccLs
https://youtu.be/LU8tubkz_Fg
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 Value addition by the
financial system
• Expert management
o Trained, experienced and specialized managers
o Professionals who devote their full time to the investing activities
o Access to large information and data base

• Economies of scale
o Operating costs relating to investment get spread over large investment base (eg.
Mutual funds investing for large investors but time and efforts on research are limited
and cost of information also same for single or many investors. These costs thus get
divided over many investors)

• Boost to the economy

o Savers and borrowers of the funds get encouraged leading to greater levels of
investments
o Greater levels of productive investments lead to higher growth of the economy
• Provides price related information
o Such information enables quick valuation of financial assets and helps take financial
decisions of investment, disinvestment, reinvestment or holding a particular assets

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Constituents of Financial System

Financial
Institutions

Financial Financial Financial

Services System Markets

Financial
Instruments

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Regulating Financial System
Financial regulation is a form of regulation or supervision, which subjects
financial institutions to certain requirements, restrictions and guidelines,
aiming to maintain the integrity of the financial system. This may be handled
by either a goverment or non-government organization. Financial regulation
has also influenced the structure of banking sectors, by decreasing
borrowing costs and increasing the variety of financial products available.

The objectives of financial regulators are usually:

• market confidence – to maintain confidence in the financial system
• financial stability – contributing to the protection and enhancement of
stability of the financial system
• consumer protection – securing the appropriate degree of protection for
consumers.
• reduction of financial crime – reducing the extent to which it is possible
for a regulated business to be used for a purpose connected with
financial crime.
• regulating foreign participation in the
financial markets.

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Regulating Financial System
Regulators are the organizations entrusted with the task of implementing
such regulations and supervision of the financial sector
• Ministry of Finance
• Ministry of Corporate Affairs
• Reserve Bank of India (RBI)
• Securities and Exchange Board of India (SEBI)
• Insurance Regulatory and development Authority of India (IRDAI)
• Pension Fund Regulatory and Development Authority (PFRDA)

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Financial
Markets

13
 Financial Markets

• A Financial market is a market for creation and exchange of financial assets.

• Financial markets act as a forum to facilitate financial transactions through the
creation, sale and transfer of financial assets. If you buy or sell financial assets, you
will participate in financial markets in some way or the other.
• Financial markets play a key role in the economy by stimulating growth, influencing
economic performance of the factors, affecting economic welfare.
• This is achieved by financial infrastructure, in which entities with funds allocate
those funds to those who have potentially more productive ways to invest those
funds.
• A sound financial market facilitates efficient transfer of funds from savers to
borrowers.
What is financial market? - https://www.youtube.com/watch?v=MpZ1YY4IvzA

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 Functions of Financial
markets
1) Financial Markets facilitate Price Discovery: The continual interaction among numerous
buyers and sellers who throng financial markets helps in establishing the prices of financial
assets. Well organized financial markets seem to be remarkably efficient in price discovery.
That is why economists say: “If you want to know what the value of a financial asset is, simply
look at its price in the financial market”.

2) Financial Markets provide liquidity to financial assets: Investors can readily sell their
financial assets through the mechanism of financial markets. In the absence of financial
markets which provide such liquidity, the motivation of investors to hold financial assets will be
considerably diminished. Thanks to negotiability and transferability of securities through the
financial markets, it is possible for companies and other entities to raise long term funds from
investors with short term and medium term horizons. While one investor is substituted by
another when a security is transacted, the company is assured of long term availability of
funds.

3) Financial Markets considerably reduce the cost of transacting: The two major costs
associated with transacting are search costs and information costs. Search costs comprise
explicit costs such as the expenses incurred on advertising when one wants to buy or sell an
asset and implicit costs such as the effort and time one has to put in to locate a customer.
Information costs refer to costs incurred in evaluating the investment merits of financial assets.

15
 Functions of Financial
markets
4) Mobilisation of Savings and their Channelization into more Productive Uses: Financial
market gives impetus to the savings of the people. This market takes the idle cash to places
where it is really needed. Many financial instruments are made available for transferring
finance from one side to the other side. The investors can invest in any of these instruments
according to their wish.

5) Lowering of risk through diversification: Financial markets provide a variety of financial

products / instruments with varied of risk- return matrix. This provides the investor with the
choice of the right product to match his needs and thereby gives him the advantage of
diversification and reduced risk.

6) Easy transfer of financial asset: Financial markets facilitate ease in transferring financial
assets between investor and borrower through smooth and quick processes and easy
payment mechanisms.

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 Classification
There are different ways of classifying financial markets.
• Maturity : The market for short-term financial claims is referred to as Money Market and the
market for long-term financial assets is called as Capital market. Since short-term financial
assets are invariably debt claims, the money market is the market for short-term debt
instruments. The capital market is the market for long-term instruments and equity
instruments.
What are Capital Markets ?- https://www.youtube.com/watch?v=ujLFsZfa_MY

• Type of financial claim: The Debt market is the financial market for fixed claims of debt
instruments (principal and interest have to be paid) and the Equity market is the financial
market for residual claims (equity shareholders are paid profits or capital back only after
payment to all other creditors, lenders and stakeholders.)

• Market for new issues or outstanding issues: The market where issuers sell new securities
(issued for first time by the company) are referred to as the Primary market and the market
where investors trade outstanding securities is called the Secondary market (issuer
company is not a party to these transactions).

• Timing of delivery: A Cash or Spot market is one where the delivery occurs immediately
and a Forward or Futures market is one where the delivery occurs at a pre-determined
time in future.

• Nature of its organizational structure: An Exchange-traded market is characterized by a

centralized organization with standard procedures. An Over-the counter market is a
decentralized market with customized procedures. 17
 Capital Markets

Capital market refers to a type of financial market, where individuals and institutions are
trading in financial securities. Public and private institutions or organisations usually list their
securities for selling among investors and for raising their funds. This kind of a market is made
for both primary and secondary market. In this market, long term maturity instruments are
listed, which have a period of more than one year.

• Capital market is classified into two categories, first one is Primary market and second is
Secondary market.
• In primary market, the all new shares are traded in market and , on the other hand, in the
secondary market, the outstanding securities are traded.
• Capital market provides equity finance and long term debt to governments or
corporates.
Primary and Secondary Markets - https://www.youtube.com/watch?v=7S4jfCFkMoE
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 Money Market
Money Markets are markets where government and
other securities of very smaller time duration are
traded. India has a very active money market, where
a host of instruments are traded.
Here you have banks, mutual funds and various other
large domestic institutions like insurance companies
participating.

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 Foreign Exchange Market
• Forex is one of the most biggest investment markets in the world and
it is a huge platform for investors for their investment.
• There are various forms of currencies included for trading on
international level.
• The investors invest their money on the value of currencies
fluctuation because of variation in the economic position of
countries and entire world economy.

A price of one currency expressed in terms of the currency of another

country is called as the exchange rate. For example, the ratio INR/USD is
71, which implies that one unit of US Dollar can buy or equals 71 Rupees
of India. In that case, the US Dollar is a base currency and the Indian
Rupee is quote currency.

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 Role of Financial markets
in Economic Growth
• Mobilize savings for productive investments and facilitate capital inflows
• Financial Markets play an important role in promoting economic growth
• Strong Incentive for Investments
• Improved resource use and technological diffusion
• Collecting and Analysing information about investments
• Monitoring management and exerting corporate controls

Examples of Government, corporates, Investors and Individuals making optimum

use of financial markets to achieve economic growth

The Financial Market plays an important role in promoting economic growth. Thus,
by creating an efficient mechanism for transactions in long term financial
instruments, it provides a wide range of wealth creating opportunities for the
Government, Corporations, Private individuals, and other financial institutions..

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 Role of Financial markets in Economic Growth
• Financial Markets play an important role in promoting economic growth. It is commonly
argued in the economic literature that a well functioning financial sector creates strong
incentives for investment and also fosters trade and business linkages thereby facilitating
improved resource use and technological diffusion. By mobilizing savings for productive
investment and facilitating capital inflows, financial markets stimulates investments.
• The financial sector also channels savings to more productive uses by collecting and
analysing information about investment opportunities. It has also been argued that the
financial system can enhance efficiency in the corporate sector by monitoring
management and exerting corporate controls. Public as well as private sector operators
make use of various financial instruments to raise and invest short term funds which, if
need be, can be quickly liquidated to satisfy short-term needs.
• The Government, for instance, can borrow money from the general public to finance
long-term investment projects by issuing treasury notes or bonds. The proceeds from the
bonds issue can be used to build public hospitals, construct roads, provide public
transports, build airports, construct dams, or build other social infrastructures. This entails
national wealth creation for economic growth. The Government can mobilize a huge
amount of financial resources from the Capital Market to finance long term development
projects like the construction of public markets, recreational centres, roads, develop
efficient transport system, build Schools, hospitals and provide many other services from
which they can generate a regular source of income.
• Corporate bonds can be issued by public sector companies to finance long-term
development projects like the construction of new plants, expansion of existing plants,
construction of new buildings, introduction of new technology, purchase of new
equipments, etc.

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 Role of Financial markets in Economic Growth
• Corporates can also issue equities to raise additional financial resources for long term investment.
The proceeds from equities could be use to purchase new equipment, construct new factories,
expand operations etc. All these activities; the purchase of new equipments, expansion of existing
plants, construction of new buildings etc. entail wealth creation from the Capital Market by
corporates.
• Investors make money in the Capital Market through buying and selling of financial securities.
When investors buy debt instruments like government bonds or corporate bonds, they receive an
interest payment from the issuer of the debt security plus the principal amount at the end of the
loan period. The amount of interest payable to an investor holding a debt security depends on the
interest rate agreed by the loan contract. Thus, investors create wealth in the capital market by
investing in debt securities. Suppose an individual invests in equities, The investor in this case
becomes a shareholder or part owner of the company that issues the shares. As a shareholder, the
investor is entitled to receive a share of the Company’s annual profit which is distributed in the form
of dividend. The amount of dividend received by an investor depends on the number of shares
he/she holds as well as the dividend policy of the company. Sometimes the company may decide
not to pay dividend in cash but rather by issuing additional shares to the existing shareholders. An
investor may also decide to sell his/her shares to make a capital gain. The receipt of dividend,
bonus shares and capital gains from selling shares all amount to wealth creation by the investor
• The Financial Market plays an important role in promoting economic growth. Thus, by creating an
efficient mechanism for transactions in long term financial instruments, it provides a wide range of
wealth creating opportunities for the Government, Corporations, Private individuals, and other
financial institutions.
What do rising interest rates mean? - https://www.youtube.com/watch?v=4XYlQ_HbDTw
How do interest rates affect the stock market? - https://www.youtube.com/watch?v=Au_p_lSKV7A

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 Financial
Intermediaries

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 Financial Institutions

• Banking Institutions
• Non-Banking Institutions
• Asset Reconstruction
Companies
• Mutual Funds
• Insurance Companies
 Role of Financial Institutions
• Financial institutions facilitate smooth working of the
financial system by making investors and borrowers
meet.
• They mobilize the savings of investors either directly
or indirectly via financial markets, by making use of
different financial instruments as well as in the
process using the services of numerous financial
services providers.
• They offer complete array of services to the
organizations who want to raise funds from the
markets, or to those looking for advise relating to
restructuring or diversification strategies.

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 Banking
Non- Banking Institutions
Institutions
Commercial banks Non-banking Financial Companies (NBFC)
Asset
1. Public sector registered with RBI:
Reconstruction
2. Private Sector 1. Asset Finance Company (AFC)
Companies
3. Regional Rural 2. Investment Company (IC) (includes
Banks Primary dealer)
4. Foreign Banks 3. Loan Company (LC)
4. Infrastructure Finance Company (IFC)
Urban Co-operative 5. Infrastructure Debt Fund
Banks 6. Systemically important Core Investment
Company
7. NBFC- Microfinance (NBFC-MFI)
Housing
Payments Banks 8. NBFC – Factor
Finance
9. Mortgage Guarantee Companies (MGC)
Companies
10. NBFC- Non-operative Financial Holding
Small Finance Banks Company (NOFHC)
Development Finance Institutions
 Define Commercial Banks
• Commercial banks accept deposits and provide security and convenience to their
customers.
• Part of the original purpose of banks was to offer customers safe keeping for their money.
• Commercial banks also make loans that individuals and businesses use to buy goods or
expand business operations, which in turn leads to more deposited funds that make their
way to banks.
Banks also serve role as payment agents within a country and between nations. Not only do
banks issue debit cards that allow account holders to pay for goods with the swipe of a card,
they can also arrange wire transfers with other institutions. Banks essentially underwrite
financial transactions by lending their reputation and credibility to the transaction; a cheque
is basically just a promissory note between two people, but without a bank's name and
information on that note, no merchant would accept it. As payment agents, banks make
commercial transactions much more convenient; it is not necessary to carry around large
amounts of physical currency when merchants will accept the cheques, debit cards or credit
cards that banks provide.

If banks can lend money at a higher interest rate than they have to pay for funds and
operating costs, they make money.
What do banks do? - https://www.youtube.com/watch?v=sbvAAezbCKU

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 Comm. Banks Functions

Commercial banks are further classified in India as Public Sector Banks, Private
Sector Banks, Foreign Banks in India and Regional Rural Banks.
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 Urban Co-operative
Banks
• Urban co-operative banks usually meet the needs of specific
types or groups of members pertaining to a certain trade,
profession, community or even locality.
• They are also called Primary Co-operative Banks (PCBs) by the
Reserve Bank.
• The Reserve Bank of India defines PCBs as ‘small-sized co-
operatively organised banking units which operate in
metropolitan, urban and semi-urban centres to cater mainly
to the needs of small borrowers, viz., owners of small scale
industrial units, retail traders, professionals and salaried
classes’.
• The RBI grants licenses to co-operative banks based on certain
entry point norms (EPN). The RBI has revised these norms in
August 2000 prescribing 4 categories based on population
criterion.
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 Urban Co-operative
Banks
According to these new norms UCBs should have;
• A minimum share capital of INR 4 crore and membership of at
least 3,000 if the population is over 10 lakh;
• A minimum share capital of INR 2 crore and membership of at
least 2,000 if the population is between 5 to 10 lakh;
• A minimum share capital of INR 1 crore and membership of at
least 1,500 for population of 1 to 5 lakh and;
• A minimum share capital of INR 25 lakh and membership of at
least 500 for population less than 1 lakh
New UCBs have to achieve the prescribed share capital and
membership before the license is issued.

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 Payments Banks
The objectives of setting up of payments banks were to help financial inclusion by
providing (i) small savings accounts and (ii) payments/remittance services to
migrant labour workforce, low income households, small businesses, other
unorganised sector entities and other users.
• They can’t offer loans but can accept demand deposits of up to Rs. 2 lakhs
per individual customer and pay interest on these balances just like a savings
bank account does.
• They can enable transfers and remittances through their wide networks using
technological platforms (including mobile phones).
• They can offer services such as automatic payments of bills, and purchases in
cashless, cheque less transactions through a phone.
• They can issue debit cards and ATM cards usable on ATM networks of all
banks.
• They can transfer money directly to bank accounts.
• They can provide forex cards to travellers, usable again as a debit or ATM
card all over India.
• They can offer forex services at charges lower than banks.
• Payments Banks in India are : Airtel Payments Bank, India Post Payments Bank,
FINO Payments Bank Ltd, Paytm Payments Bank, Jio Payments Bank Ltd, NSDL
Payments Bank Limited
• Payments bank deposit limit doubled by RBI to Rs. 2 lakhs –
https://www.livemint.com/industry/banking/payments-bank-deposit-limit- 32
 Small Finance Banks
• Small finance banks are allowed to take deposits from customers.
• As against payments banks, small finance banks are also allowed to lend
money to people.
• Most customers of small finance banks account for small and medium
enterprises and small businesses. These banks are able to provide secured
and legal loans to small and medium enterprises, bringing them under the
ambit of the financial system.
• Small finance banks provide banking products to the unserved and
underserved sections of the country, which includes small and marginal
farmers, micro and small industries, and other organized sector entities, at an
affordable cost.

Small finance banks is another step to bring the unbanked under the ambit of the
banking system and helping financial inclusion.

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34
Capital Adequacy Norms for Banks

Need for Capital Adequacy Norms:

• Along with profitability and safety, banks also give
importance to solvency.
• Solvency refers to the situation where assets are equal to
or more than liabilities. A bank should select its assets in
such a way that the shareholders and depositors'
interest are protected.

Prudential Norms:
• The norms which are to be followed while investing funds
are called "Prudential Norms." They are formulated to
protect the interests of the shareholders and depositors.
• Prudential Norms are generally prescribed and
implemented by the central bank of the country.
• Commercial Banks have to follow these norms to protect
the interests of the customers.
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Capital Adequacy Norms for Banks

• For international banks, prudential norms were

prescribed by the Bank for International Settlements
popularly known as BIS.

• The BIS appointed a Basel Committee on Banking

Supervision in 1988.

• Basel committee has prescribed Capital Adequacy

Norms in order to protect the interests of the bank
customers.

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Capital Adequacy Ratio (‘CAR’)

• Capital Adequacy Ratio (CAR) is the ratio of a bank’s

capital in relation to its risk weighted assets and current
liabilities.
• It is decided by central banks and bank regulators to
prevent commercial banks from taking excess leverage
and becoming insolvent in the process.
• Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital
funds)) /Risk weighted assets
• The risk weighted assets take into account credit risk,
market risk and operational risk.
• The Basel III norms stipulated a capital to risk weighted
assets of 8%. However, as per RBI norms, Indian
scheduled commercial banks are required to maintain a
CAR of 9% while Indian public sector banks are
emphasized to maintain a CAR of 12%.
37
 Define NBFCs
• A Non-Banking Financial Company (NBFC) is a company registered
under the Companies Act, 2013.
• They are engaged in the business of loans and advances, acquisition
of shares/stocks/bonds/debentures/securities issued by Government
or local authority or other marketable securities of a like nature,
leasing, hire-purchase, insurance business, chit business.
• It does not include any institution whose principal business is that of
agriculture activity, industrial activity, purchase or sale of any goods
(other than securities) or providing any services and
sale/purchase/construction of immovable property.
• However, a company is said to be undertaking “financial activity” as
its principal business if :
o (a) the company’s financial assets constitute more than 50% of its total assets, and
o (b) income from financial assets constitutes more than 50% of its gross income
Such companies which are predominantly engaged in financial
activity would require to get registered with RBI and be regulated
and supervised by it.

38
 NBFCs vs. Banks

NBFCs lend and make investments and hence their activities are akin to
that of banks; however there are a few differences as given below:
i. NBFC cannot accept demand deposits;
ii. NBFCs do not form part of the payment and settlement system and
cannot issue cheques drawn on itself; and
iii. deposit insurance facility of Deposit Insurance and Credit Guarantee
Corporation is not available to depositors of NBFCs, unlike in case of
banks.

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 Types of NBFCs
Different types/ categories of NBFCs registered with RBI are
as follows;
NBFCs are categorized;
a) by the kind of activity they conduct
b) in terms of the type of liabilities into Deposit and Non-
Deposit accepting NBFCs,
non-deposit taking NBFCs by their size into systemically important
and other non-deposit holding companies
o Systematically Important: NBFCs whose asset size is of ₹ 500 cr or
more as per last audited balance sheet are considered as
systemically important NBFCs. The rationale for such classification
is that the activities of such NBFCs will have a bearing on the
financial stability of the overall economy.
o Others - with assets size of less than 500Cr : NBFC’s with assets of
less than Rs. 500 crores are exempted from the requirement of
maintaining Capital To Risk Weighted Asset Ratio (CRAR) and
complying with credit concentration norms.

https://www.rbi.org.in/commonman/English/Scripts/FAQs.aspx?Id=1167
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NBFCs registered with the RBI by nature of activity
• Asset Finance Company (AFC): An AFC is a company which is a financial
institution carrying on as its principal business the financing of physical assets
supporting productive/economic activity, such as automobiles, tractors, lathe
machines, generator sets, earth moving and material handling equipments,
moving on own power and general purpose industrial machines. Principal
business for this purpose is defined as aggregate of financing real/physical
assets supporting economic activity and income arising therefrom is not less
than 60% of its total assets and total income respectively.

• Investment Company (IC): IC means any company which is a financial

institution carrying on as its principal business the acquisition of securities.
These include Primary dealers (PDs), who deal in underwriting and market
making for government securities.

• Loan Company (LC): LC means any company which is a financial institution

carrying on as its principal business the providing of finance whether by
making loans or advances or otherwise for any activity other than its own but
does not include an Asset Finance Company.

Under the circular on “Harmonization of the Non-Banking Financial Companies

(NBFCs) Categories”, RBI merged three different categories of NBFCs - asset
finance companies, loan companies, and investment companies into one
named “NBFC - Investment and Credit Company (NBFC-ICC)”. 41
NBFCs registered with the RBI by nature of activity
• NBFC – ICC: Financial institution carrying on its principal business – asset
financing, the providing of finance whether by making loans or advances or
otherwise for any activity other than its own and the acquisition of securities.
The main object of merging three categories of NBFCs into one is to provide
greater operational flexibility to the NBFC sector.

• Infrastructure Finance Company (IFC): IFC is a non-banking finance company

a) which deploys at least 75 per cent of its total assets in infrastructure loans,
b) has a minimum Net Owned Funds of ₹ 300 crore, c) has a minimum credit
rating of ‘A ‘or equivalent d) and a Capital to Risk Weighted Assets Ratio
(CRAR) of 15%.
42
NBFCs registered with the RBI by nature of activity
• Infrastructure Debt Fund - Non-Banking Financial Company (IDF-NBFC): IDF-NBFC is a
company registered as NBFC to facilitate the flow of long term debt into infrastructure
projects. IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of
minimum 5 year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-
NBFCs.

• Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is a

non-deposit taking NBFC having not less than 85% of its assets in the nature of qualifying
assets which satisfy the following criteria:
a) loan disbursed by an NBFC-MFI to a borrower with a rural household annual income
not exceeding ₹1,00,000 or urban and semi-urban household income not exceeding
₹ 1,60,000;
b) loan amount does not exceed ₹ 50,000 in the first cycle and ₹ 1,00,000 in subsequent
cycles;
c) total indebtedness of the borrower does not exceed ₹ 1,00,000;
d) tenure of the loan not to be less than 24 months for loan amount in excess of ₹ 15,000
with prepayment without penalty;
e) loan to be extended without collateral;
f) aggregate amount of loans, given for income generation, is not less than 50 per cent
of the total loans given by the MFIs;
g) loan is repayable on weekly, fortnightly or monthly instalments at the choice of the
borrower

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NBFCs registered with the RBI by nature of activity
• Systemically Important Core Investment Company (CIC-SI): CIC-SI is an NBFC
carrying on the business of acquisition of shares and securities which satisfies the
following conditions:-
a) it holds not less than 90% of its Total Assets in the form of investment in equity
shares, preference shares, debt or loans in group companies;
b) its investments in the equity shares (including instruments compulsorily
convertible into equity shares within a period not exceeding 10 years from
the date of issue) in group companies constitutes not less than 60% of its Total
Assets;
c) it does not trade in its investments in shares, debt or loans in group
companies except through block sale for the purpose of dilution or
disinvestment;
d) it does not carry on any other financial activity referred to in Section 45I(c)
and 45I(f) of the RBI act, 1934 except investment in bank deposits, money
market instruments, government securities, loans to and investments in debt
issuances of group companies or guarantees issued on behalf of group
companies.
e) Its asset size is ₹ 100 crore or above and
f) It accepts public funds
Core Investment Companies with asset size of less than ₹ 100 crore,
and those with asset size of ₹ 100 crore and above but not accessing
public funds are exempted from registration with the RBI. 44
NBFCs registered with the RBI by nature of activity
• Non-Banking Financial Company – Factors (NBFC-Factors): NBFC-Factor is a
non-deposit taking NBFC engaged in the principal business of factoring. The
financial assets in the factoring business should constitute at least 50 percent
of its total assets and its income derived from factoring business should not be
less than 50 percent of its gross income.

• Mortgage Guarantee Companies (MGC) - MGC are financial institutions for

which at least 90% of the business turnover is mortgage guarantee business or
at least 90% of the gross income is from mortgage guarantee business and net
owned fund is ₹ 100 crore.

• NBFC- Non-Operative Financial Holding Company (NOFHC) is financial

institution through which promoter / promoter groups will be permitted to set
up a new bank .It’s a wholly-owned Non-Operative Financial Holding
Company (NOFHC) which will hold the bank as well as all other financial
services companies regulated by RBI or other financial sector regulators, to
the extent permissible under the applicable regulatory prescriptions.

45
 Primary Dealers (PDs)

• Primary dealers are registered entities with the RBI who have the license to
purchase and sell government securities.
• They are entities who buys government securities directly from the RBI (the RBI
issues government securities on behalf of the government), aiming to resell
them to other buyers. In this way, the Primary Dealers create a market for
government securities.
• The Primary Dealers system in the government securities market was
introduced by the RBI in 1995.

The PDs are thus created to promote transactions in government securities

market. A facilitating arrangement is essential for selling of government securities
as government is the single largest borrower in the market who borrows through
the issue of its securities – treasury bills and bonds.

46
 Primary Dealers (PDs)
• Central government and state governments periodically borrow funds to meet their
expenses.

• For amounts borrowed by the central government for a period less than 1 year, the
government issues “ T- bills” ( Treasury bills) and Cash Management Bills (CMBs).

• T bills have maturities of 91 days, 182 days and 364 days. CMBs are for less than 91 days.

• For borrowings beyond one year, the lenders get “G-Sec”, also called Gilt ( or Gilt edged
security).

• Likewise state governments issue state government securities.

• RBI offers these securities periodically through auctions and also buys them back from the
market when governments have excess liquidity.

• Role of the primary dealers is to help RBI distribute T bills and government securities. They
participate in the auctions along with the banks and thereafter sell these securities to
various investors.

• PDs are allowed to be active participants in the money markets.

47
 NBFCs
Methods of financing for purchase of assets
• Loans
• Hire purchase – purchasing in instalments
• Leasing – lease rental is the consideration for the
right to use a product ; the product is not sold. This
kind of lease is also known as operating lease and in
this the lessor has the obligation to maintain the
product.

48
 Loan V/s Lease V/s Hire
Purchase
Loan Lease Hire Purchase

Passes immediately to the Transfers to the hirer at

Title/ownership of asset Remains with the lessor
borrower end of HP contract

Interest expenses are tax

deductible. In India,
Complete lease rentals Only interest component
Tax treatment home loan principal
are tax deductible. is tax deductible.
repayments are also tax
deductible.

Borrower must pay some

Upfront payment by Lessor may collect 1 or 2 Owner may collect 1 or 2
amount as lender doesn’t
borrower/hirer/lessee lease rentals upfront instalments upfront
finance 100%

Higher as it is for the full Lower as it is for the part Higher than lease of loan
Installment payment
value of the asset value of the asset as HP charges are higher

Claimed by the hirer

Claimed by borrower as Claimed by the lessor as though not the owner
Tax depreciation
he is the owner he is the owner (ownership passes to him
after expiry of HP)

49
Development Finance Institutions
DFIs were started by the government to give sector-specific loans to
various sectors- industry, agriculture, housing, infrastructure, export
finance etc. The first DFI was the Industrial Financial Corporation of India
(IFC) that was launched in 1948.
Later several of them were converted into banks as industry got
opportunity to avail funds from the capital market (equity and debt) with
the development of the capital market.

Thus, DFIs are financial agencies that provide medium and long-term
financial assistance and engaged in promotion and development of
industry, agriculture and other key sectors.

Objectives of Development banks are as follows:

• To serve as an agent of development in various sectors and
international trade
• To accelerate economic growth
• To allocate resources to high priority areas
• To foster rapid industrialization
• To finance housing, small scale industries, infrastructure and social
utilities
50
 Some DFIs
• Industrial Finance Corporation of India Ltd. (IFCI)
• Industrial Development Bank of India (IDBI)
• Industrial Investment Bank of India Ltd. (IIBI)
• Small Industrial Development Bank of India (SIDBI)
• Export Import Bank of India (EXIM)
• National Bank For Agriculture & Rural Development
(NABARD)

51
Asset Reconstruction Companies (ARCs)
Sale Asset reconstruction
Banks Company (ARC)
Bad Loan / NPA

Borrower

An ARC is in the business of acquiring Non Performing Assets/ Loans which are not being
repaid by borrowers even after repeated notices/efforts of the Bank/financial institution.

So the Banks & an Asset reconstruction company get into an agreement whereby the
ARC agrees to take over the NPAs from the Banks Balance sheet at a certain amount
(Lower than the book value, of course) & then try to recover these amounts from the
Borrowers or if the borrowers are corporates then they can even offer them attractive
settlement terms for their loans.

For e.g., if there is a Rs. 40 cr NPA which an ARC purchased for 30 crores it can go back
to the borrower & offer them to settle the loan at 35 crores this way both parties benefit
from the arrangement.
Please refer to the Pre Read material shared for ARCs (PWC Report) 52
 ARCs
• ARCs acquire “non performing assets” in bulk on
attractive terms, work on them and generate incomes

• Usually ARCs issue “security receipts” to other investors

who share with the ARC the returns from the assets
acquired.

• They get the benefit of the SARFAESI Act (The

Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002); which allows
them to take possession of the secured assets of the
defaulting borrower without court or tribunal
intervention.

53
Investment Funds Financial Service Providers Others

1. Stock exchanges
2. Member brokers and sub-
1. Merchant Bankers
Mutual Funds brokers
(Investment Bankers)
3. Depositories & depository
2. Distributors
participants
3. Investment Advisors
4. Alternative Investment
4. Credit Rating Agencies
Funds
5. Custodians
5. Foreign Institutional
6. Registrars and transfer
Investors
agents
6. Debenture Trustees
Alternative 7. Portfolio Management
7. Self regulated
Investment Services
organisations such as
Funds Association of Mutual
Funds of India (AMFI)

Financial Intermediaries–Regulated by SEBI

 Mutual Fund
• A Mutual Fund is a mechanism for pooling money from a number of investors who share a
common investment objective and investing the money in instruments such as shares,
debentures and other securities in line with such objective.
• The Mutual Fund issues units to the investors in accordance with the quantum of money
invested by them, thereby each investor becomes a proportionate owner of the assets of
the Mutual Fund. Investors of mutual funds are known as a ‘unit holders’. For example, an
equity fund would invest in stocks and equity-related instruments, while a debt fund would
invest in bonds, debentures, etc.
• The profits or losses are shared by investors in proportion to the number of units owned by
them in the Mutual Fund.
• Income / gains generated from this collective investment is distributed proportionately
amongst the investors after deducting applicable expenses and levies, by calculating a
scheme’s “Net Asset Value” or NAV
• This Fund is managed by a professional fund manager.
• An average investor who lacks the knowledge of capital markets and does not have
large resources to invest, gets an opportunity to invest in a diversified, professionally
managed basket of securities.
• A mutual fund is required to be registered with Securities and Exchange Board of India
(SEBI) before it can collect funds from the public.
Advantages of investment through Mutual Fund
• Professional Management
• Fund Ownership through units
• Lowering risk through diversification
What are Mutual Funds? - https://www.youtube.com/watch?v=obDdWfsb9ww
55
How does a Mutual Fund work? https://www.youtube.com/watch?v=V-pQPCnfz_0
 Alternative Investment Fund
• Alternative Investment Funds:
Alternative Investment Fund or AIF means any fund established or
incorporated in India which is a privately pooled investment fund
which collects funds from large investors, whether Indian or foreign, for
investing it in accordance with a defined investment policy for the
benefit of its investors. AIFs do not cover Mutual Funds.

These funds can be classified into following different categories based

on the kind of assets in which they invest:
• AIFs which invest in start-up or early stage ventures or social
ventures or SMEs or infrastructure or other sectors or areas which the
government or regulators consider as socially or economically
desirable
• AIFs that make private equity investments or real estate investment
or invest in distressed assets
• AIFs that invest in derivatives (includes hedge funds)
What are hedge funds and how are they different from Mutual Funds?
https://youtu.be/xUa3BilLIrA
56
 Financial Services
Merchant
Banking / Investment
Distributors
Investment Advisory
Banking

Credit Custodial Brokers

PMS
Rating services

Factoring Forfaiting Leasing

Hire Housing
Purchase Finance
57
 Role of Financial Services
• Financial Service providers help to get the necessary funds from savers and also
make sure that they are efficiently deployed in the financial system.

• Financial institutions and financial markets help in the working of the financial
system by means of financial instruments. To be able to carry out the jobs given,
they need several services of financial nature. Therefore, Financial services are
considered as the 4th major component of the financial system.
• Functions of Financial Service providers:
o Facilitating transactions through exchange of goods and services
in the economy.
o Mobilizing savings for which the outlets would otherwise be much
more limited
o Allocating capital funds notably to finance productive
investment.
o Monitoring managers so that the funds allocated will be spent as
envisaged.
o Transforming risk by reducing it through aggregation and
enabling it to be carried by those more willing to bear it.
58
 Types of Financial Services
Merchant Banks / Investment Banks:
Institutions that provide fund-raising services (including underwriting) and financial
advisory services (as under) to large companies and high-net worth individuals for a fee
o Issue management services (equity shares):
Assist in conducting a public offer of equity shares in the capital market to raise
funds by selling the shares to public and other large investors as under:
– Preparing and reviewing public offer document to be filed with regulator
– Marketing the public offer and assessing the demand in the market
– Arriving at an appropriate pricing for the offer based on market knowledge and
consultation with the issuer company
– Running the entire process of issue of shares & collection of sales proceeds
– Taking care of all compliances required by regulators
o Issue management for sale of debt securities or preference shares
o Underwriting (as required) – commitment to get the issue subscribed either by
others or by themselves
o Providing advise and facilitating mergers and acquisitions (includes buying or
selling of companies / divisions / assets / bulk shares in companies)
o Advising & facilitating corporate re-organisations & complex financial transactions
It is mandatory for Merchant bankers to be registered with SEBI
What are investment bankers? https://youtu.be/Lfbb4oeyeHk
Due to the important role played by merchant bankers in public issue process and
the expertise that they provide, SEBI made it compulsory for every company to
appoint a Merchant banker for undertaking a public issue of securities 59
 Types of Financial Services
• Distributors: Distribute various investment products such as mutual funds, IPOs to the
savers (commonly called investors). They earn commission from the mutual funds, IPO
issuers, however, they do not provide any investment advice.

• Investment Advisor: Their role is to provide investment advice to the investors. They earn
fee from the investors. They are not allowed to distribute investment products and earn
commission from the mutual funds and other investment product companies or from the
issuing companies of the IPOs.

• Credit rating: Credit rating means giving an expert opinion by a rating agency on the
relative willingness and ability of the issuer of a debt instrument to meet the financial
obligations in time and in full. It measures the relative risk of an issuer’s ability and
willingness to repay both interest and principal over the period of the rated instrument. It
is a judgement about a firm’s financial and business prospects. In short, credit rating
means assessing the creditworthiness of a company by an independent organisation.

• Custodial services:
o Custodian is an institution or a person who is handed over securities by the security
owners for safe custody. For rendering these services, he gets a remuneration called
custodial charges.
o Custodian is a caretaker of a public property or securities. Custodians are
intermediaries between companies and clients (i.e. security holders) and institutions
(financial institutions and mutual funds).
o There is an arrangement and agreement between custodian and real owners of
securities or properties to act as custodians of those who hand over it.
60
 Types of Financial Services
• Factoring: Factoring is an arrangement under which the factor purchases the
account receivables (arising out of credit sale of goods/services) and makes
immediate cash payment to the supplier or creditor. Thus, it is an arrangement in
which the account receivables of a firm (client) are purchased by a financial
institution or banker. Thus, the factor provides finance to the client (supplier) in
respect of account receivables. The factor undertakes the responsibility of
collecting the account receivables. The financial institution (factor) undertakes the
risk. For this type of service as well as for the interest, the factor charges a fee for
the intervening period. This fee or charge is called factorage.

• Forfaiting: Forfaiting is a form of financing of receivables relating to international

trade. It is a non-recourse purchase by a banker or any other financial institution of
receivables arising from export of goods and services. The exporter surrenders his
right to the forfaiter to receive future payment from the buyer to whom goods
have been supplied. Forfaiting is a technique that helps the exporter sells his goods
on credit and yet receives the cash well before the due date. In short, forfaiting is a
technique by which a forfaitor (financing agency) discounts an export bill and pay
ready cash to the exporter. The exporter need not bother about collection of
export bill. He can just concentrate on export trade.

61
 Types of Financial Services
• Leasing: Leasing is a process by which a firm can obtain the use of a
certain fixed assets (equipment, machinery etc.) for which it must
pay a series of contractual, periodic, tax deductible payments. The
lessee is the receiver of the services or the assets under the lease
contract and the lessor is the owner of the assets. The payments or
consideration for the lease is called rent.
Lease can be defined in the following way:
➢ A contract by which one party (lessor) gives to another (lessee)
the use and possession of equipment for a specified time and for
fixed payments.
➢ A great way companies can conserve capital.
➢ An easy way vendors can increase sales.
In other words, lease is a contract between the owner of an asset (the
lessor) and its user (the lessee) for the right to use the asset during a
specified period in return for a mutually agreed periodic payment (the
lease rentals). The important feature of a lease contract is separation of
the ownership of the asset from its usage.

62
 Types of Financial Services
• Hire Purchase: Hire purchase is a type of instalment credit under which the hire
purchaser, called the hirer, agrees to take the goods on hire at a stated rental,
which is inclusive of the repayment of principal as well as interest, with an option to
purchase. Under this transaction, the hire purchaser acquires the property (goods)
immediately on signing the hire purchase agreement but the ownership or title of
the same is transferred only when the last instalment is paid.

The hire purchase system is regulated by the Hire Purchase Act 1972. This Act
defines a hire purchase as “An agreement under which goods are let on hire and
under which the hirer has an option to purchase them in accordance with the
terms of the agreement and includes an agreement under which:
➢ The owner delivers possession of goods thereof to a person on condition that
such person pays the agreed amount in periodic instalments.
➢ The property in the goods is to pass to such person on the payment of the last
of such instalments, and
➢ Such person has a right to terminate the agreement at any time before the
property so passes”.

63
 Types of Financial
Services
• Housing Finance: Housing finance is a business of financial intermediation wherein
the money raised through various sources such as Public Deposits (which are
subject to the regulatory stipulations of RBI), institutional borrowings from banks,
refinance from NHB and their own capital, is lent to borrowers for purchasing a
house. These intermediaries lend money by accepting mortgage by deposit of title
deeds of the residential property.

• Portfolio Management Services (PMS):

• Portfolio management Services popularly known as PMS are provided through a
specialized investment vehicle managed by a portfolio manager.
• A portfolio manager is a person who, pursuant to a contract or arrangement
with a client, advises or directs or undertakes on behalf of the client, the
management or administration of a portfolio of securities or the funds of the
client.
• The portfolio manager invests the money in shares and other securities in line
with the investment objectives of the client as stated in the portfolio
management agreement and charges fees for such services.
• Portfolio manager needs to obtain registration with SEBI before providing any
such services.

64
 Types of Financial Services
• Broker: A broker is an individual or firm that acts as an intermediary between an
investor and a securities exchange. Because securities exchanges only accept
orders from individuals or firms who are members of that exchange, individual
traders and investors need the services of exchange members. Brokers provide that
service and are compensated in various ways, either through commissions, fees or
through being paid by the exchange itself.
• As well as executing client orders, brokers may provide investors with research,
investment plans and market intelligence.
• Brokers have to register themselves with SEBI and obtain membership with stock-
exchanges where they plan to operate, before they start business.

65
 Financial services providers – Rules for conducting business
• With development of capital markets, Intermediaries play a critical role in :-

o Providing expert advise to investors - on purchase or sale of securities of companies

o Protecting investors – ensuring companies disclose all important information correctly

o Assisting companies - with filings and to comply regulations relating to issue of securities

o Facilitating purchase and sale – Documentation and paperwork relating to sale /

purchase of securities

o Building confidence in participants - for dealing in the financial markets

• Some Ground rules for intermediaries have been set by SEBI to ensure credibility & proper
conduct:

o SEBI has issued regulations for every intermediary, with regard to:

1. Registration certificate – Compulsory to obtain before starting operations

o Certificate is issued only after all required conditions of SEBI are fulfilled

2. Capital adequacy – Paid-up capital + free reserves should meet the minimum
amount specified by SEBI for each intermediary (refer table in subsequent slide)

3. Obligations and responsibilities – Each intermediary must understand and adhere

to its duties

66
 Minimum capital or capital adequacy requirement
Sr. Financial services provider Minimum net worth required to obtain registration
No, registered with SEBI certificate
(paid up capital + free reserves should be equal to or more
than min amount specified by SEBI)

1 Merchant banker INR 5 crores

2. Investment Adviser INR 25 lakhs

3. Custodians INR 50 crores

4 Portfolio Managers INR 5 crores

67
 Insurance
• Life Insurance Companies
• General Insurance Companies
• Health Insurance Companies
• Reinsurance Companies
• Insurance Agents and Brokers

Financial Intermediaries - Regulated by IRDAI

 Insurance

• A promise of compensation for specific potential future losses in exchange for

a periodic payment.
• Insurance is designed to protect the financial well-being of an
individual, company or other entity in the case of unexpected loss.
• Some forms of insurance are required by law, while others are optional.
• Agreeing to the terms of an insurance policy creates a contract between
the insured and the insurer.
• In exchange for payments from the insured (called premiums), the
insurer agrees to pay the policy holder a sum of money upon the occurrence of
a specific event.
• Insurance works on the principle of Utmost Good Faith.
• Insurance companies are regulated by Insurance Regulatory and Development
Authority of India (IRDAI)

69
 Types of Insurance

• Life Insurance: Life Insurance is a contract providing for payment of a sum of

money to the person assured or after him, to the person entitled to receive the
same, on the happening of certain event. It is a good method to protect your
family financially, in case of death, by providing funds for the loss of income.

• General Insurance: Insurance other than ‘Life Insurance’ falls under the category of
General Insurance. General Insurance comprises of insurance of property against
fire, burglary etc. personal insurance such as Accident and Health Insurance, and
liability insurance which covers legal liabilities. There are also other covers such as
Errors and Omissions insurance for professionals, etc.

• Health Insurance: Health insurance is a type of insurance coverage that covers the
cost of an insured individual's medical and surgical expenses. Depending on the
type of health insurance coverage, either the insured pays costs out of his pocket
and is then reimbursed, or the insurer makes payments directly to the provider
In health insurance terminology, the "provider" is a clinic, hospital, doctor,
laboratory, health care practitioner, or pharmacy. The "insured" is the owner of the
health insurance policy; the person with the health insurance coverage.

70
 Insurance
• Reinsurance companies: Insurance companies “sell” their insurance covers to large
overseas reinsurers as a measure of risk management.

• Insurance agents: Entities (individuals as well as companies) which sell insurance products
of only one insurance company in a category.

• Insurance brokers: Organizations which are allowed by IRDAI to sell insurance products of
more than one insurance company in a category.

71
 Financial
Instruments

72
 Financial Instruments
• This is an important component of financial system.
• The products which are traded in a financial market are financial assets,
securities or other type of financial instruments.
• There is a wide range of securities in the markets since the needs of investors
and credit seekers are different.
• They indicate a claim on the settlement of principal down the road or
payment of a regular amount by means of interest or dividend.
Money Market Instruments Capital Market Instruments
Treasury Bills Shares
Cash Management Bills Debentures (including bonds)
Certificate of Deposit
Derivatives (Futures, forward,
Repurchase Agreements (Repo) options)
Commercial Paper Fixed Deposits
Call Money, Notice Money and Gold ETFs
Term Money (sub-markets in
money market) Government Securities

73