Financial Institutions and Markets WDaWxoRBI6

Financial Institutions and Markets
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COURSE DESIGN COMMITTEE
TOC Reviewer Content Reviewer

Ms. Manisha Mishra Ms. Manisha Mishra
Visiting Faculty, NMIMS Global Access - Visiting Faculty, NMIMS Global Access -
School for Continuing Education School for Continuing Education
Specialization: Wealth Management, Specialization: Wealth Management,
Financial Accounting, Banking & Insurance Financial Accounting, Banking & Insurance
and Business Communication and Business Communication
Chief Academic Officer

Dr. Sanjeev Chaturvedi
NMIMS Global Access – School for Continuing Education
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Author: Sanjive Saxena

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Reviewed By: Ms. Manisha Mishra
Copyright:
2015 Publisher
ISBN:
978-93-5119-867-3
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
NMIMS Global Access - School for Continuing Education School Address
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NMIMS Global Access - School for Continuing Education

CONTENTS
CHAPTER NO. CHAPTER NAME PAGE NO.
1 Financial System: An Overview 1
Regulation in Indian Financial Market – Regulators and

2 25
their Roles
3 Money Market 43
4 Capital Market 63
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Primary, Secondary and Debt Market 85
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6 Currency Market 109
Institutions in the Financial Market—

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Banking Institutions
8 Non-banking Financial Institutions (Nbfis) 147

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9 Development Financial Institutions 163
10 Mutual Funds, Insurance and Venture 181
11 International Financial Institutions 205
12 Efficient Market and Market Anomalies 225
13 Risk Management in Financial Institutions 243
14 Case Studies 265

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F i na nc i a l I ns t i t u t i o n s a n d M a r k e t s
c u r r i c u l u m
Financial System – An Overview: Introduction to Financial System, Indian Financial System and
its Functions, Structure of Indian Financial System and its Segments, International Financial Sys-
tem, International Financial System vs. Indian Financial System, Impact of Liberalisation on Fi-
nancial Institutions and Markets, Impact of New Initiatives in Indian Financial System
Regulation in Indian Financial Market – Regulators and their Roles: Regulatory Theory, State
Intervention in Financial Markets, Regulatory Institutions, Types of Regulatory Institutions (Reg-
ulatory, Funding and Mixed), Important Regulators in India and their Functions (RBI, SEBI, IRDA
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and FMC)
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Money Market: Money Markets, Indian Money Market, International Money Markets, Money Mar-
ket Instruments, Treasury Bills, Bills of Exchange, Promissory Notes, Commercial Papers, Certifi-
cate of Deposits, Bill Market in India, Issues in Indian Money Market, Unorganised Money Market
in India
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Capital Market: Capital Market, Roles of Capital Market, Composition and Structure of Indian
Capital Market, Scams and Reforms in the Indian Capital Market, Capital Market Instruments,
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Capital Market Regulation, Control of Capital Issues, Securities and Exchange Board of India,
Securities Contracts (Regulation) Act, 1956, Monopolies and Restrictive Trade Practices (MRTP)
Act, 1969, Foreign Exchange Regulation Act (FERA), 1973, Foreign Exchange Management Act
(FEMA), 1999
Primary, Secondary and Debt Market: Primary Market, Functions of Primary Market, Listing of
Securities—Methods of Floatation of New Issues, Operators in Primary Market, Problems of Pri-
mary Market, Secondary Market and the National Stock Market System, Trading Mechanism in
the Secondary Market, National Stock Market System, Over-the-Counter (OTC) Markets, Depos-
itory System, Stock Holding Corporation of India Limited (SHCIL), Stock Exchanges and Their
Functions, Stock Exchanges in India, Commodity Exchanges
Currency Market: Roles of Foreign Exchange Market, Participants in Foreign Exchange Market,
Balance of Trade (BOT) and Balance of Payments (BOP), Monetary Policy and Foreign Exchange,
Interest Rate and Exchange Rate, Exchange Rate Dynamics

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Institutions in the Financial Market—Banking Institutions: History and Evolution of Banking Insti-
tutions in India, Commercial Banking, Functions of Commercial Banking, Services Offered by Banks,
Commercial Banking Principles, Concept of Central Banking and India’s Central Bank (RBI), Evolu-
tion of Central Banking, Functions of a Central Bank
Non-banking Financial Institutions (NBFIs): NBFI– An Introduction, Types of NBFIs, Importance of

Industrial Financial Institutions, Major NBFIs in India, Non-banking Financial Companies (NBFCs),
Major NBFCs in India, Regulatory Norms of NBFCs
Development Financial Institutions: History and Evolution of Development Financial Institution in
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India, Importance of DFI in Economy, Land Development: NABARD, Industrial Development: SIDBI,
Export and Import Development: EXIM Bank, Housing Development: NHB, New Initiative of GOI:
MUDRA Bank
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Mutual Funds, Insurance and Venture: Concept and Origin of Mutual Funds, Mutual Funds in India,
SEBI Requirements for AMC, Functions and Working of AMC, The Unit Trust of India, Regulatory
Structure of Mutual Funds, Concept and Principles of Insurance, Reinsurance, General Insurance, Life
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Insurance, Concept of Venture Capital, Stages of Venture Capital Financing, Venture Capital in India,
Deal Structure, Registration of Venture Capital Fund (VCF), Application for Venture Capital
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International Financial Institutions: IMF, World Bank, IBRD, IDA, IFC, MIGA, ICSID
Efficient Market and Market Anomalies: Efficient Market, Historical Evolution of EMH, Characteris-
tics of Efficient Market, Degree of Efficiency, Tests for Market Efficiency, Market Anomalies, Earnings
Announcement, Price/Earnings Ratio, Firm Size Effect, January Effect, Monday Effect, Bubbles, St.
Petersburg Paradox, Information Economics
Risk Management in Financial Institutions: Risks in Financial Market, Systematic and Unsystemat-
ic Risks, Concept of Hedging, Hedging Techniques—Derivatives, Forwards, Futures, Options, Swaps,
Basel Norms

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Ch a
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FINANCIAL SYSTEM: AN OVERVIEW
CONTENTS
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1.1 Introduction
1.2 Introduction to Financial System
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Self Assessment Questions
Activity
1.3 Indian Financial System and its Functions
1.3.1 Structure of Indian Financial System and its Segments
Activity
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1.4 International Financial System

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1.5 International Financial System vs. Indian Financial System
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Activity
1.6 Impact of Liberalisation on Financial Institutions and Markets
1.6.1 Impact of New Initiatives in Indian Financial System
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1.7 Summary
1.8 Descriptive Questions
1.9 Answers and Hints
1.10 Suggested Readings for Reference

2 Financial Institutions and Markets
Introductory Caselet
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SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
SEBI was established in 1988 as a regulator for the Indian secu-

rities market. Prior to this, the Indian economy faced several se-
curities scams, which shook the confidence of Indian investors in
the Indian financial framework. For getting that trust back, the
Government of India (GOI) felt a need of establishing a statutory
body with as intense power to regulate the securities market of
India.
SEBI performs a number of functions so that the financial system

of India can contribute significantly to the growth of the country’s
economy. It provides a healthy and amicable financial framework
by ensuring the availability of accurate and correct information.
This helps issuers to raise finance easily, investors to make right
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investment decisions and intermediaries to play their roles fairly
in any transaction that takes place between issuers and investors.
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OBJECTIVES OF SEBI
The prime objective of SEBI is to protect the interests of inves-

tors and promote the development of the stock exchange by reg-
ulating the activities of the stock market. The other objectives of
SEBI are to:
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Regulate the functioning of the stock exchange

Protect the rights of investors by ensuring safety against their
investment
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Prevent fraudulent practices by implementing various rules

and regulations
Develop a code of conduct for various participants of the fi-
nancial system that includes companies, brokers and under-
writers

FINANCIAL SYSTEM: AN OVERVIEW 3
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learning objectives
After studying this chapter, you will be able to:

>> Describe the concept of financial system
>> Explain the Indian financial system and its functions
>> Discuss the role of international financial system
>> Distinguish between international financial system and
Indian financial system
>> State the impact of liberalisation on financial institutions
and markets
1.1 INTRODUCTION
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Financial system refers to the financial framework of an economy
that enables lenders and borrowers to exchange funds in a systematic
manner. An effective financial system ensures the availability of suffi-
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cient funds for economic activities with comparatively low transaction
costs. The enhancement of economic activities leads to increased pro-
duction of goods and services, improved level of national income and
enhanced living standards of individuals in a country.
The financial system of a country is divided into various segments such

as financial institutions, financial markets, financial instruments and
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financial services. The efficiency of each segment adds to the efficien-

cy of the whole financial system of an economy. In the globlised today,
every economy needs to have an effective financial system in place to
come out as an emerging economy. This requires adoption of a more
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liberalised approach towards the financial framework of an economy.

A liberalised financial system helps in attracting international inves-
tors, which increases money supply in the domestic economy.
The most prominent factor of ensuring the efficiency of the finan-

cial system is investors’ confidence that encourages them to spend
their savings in financial markets. Such confidence can be fostered
if a country has a well-established financial framework that is able
to protect the interests of investors. At the same time, the financial
framework has to be rigid enough to face all the challenges that could
impact its smooth functioning.
In this chapter, you learn about the concept of financial system. The
chapter explains all the components of financial system in detail.
The Indian financial system and international financial system are
discussed in detail. In addition, all the major reforms that took place
to smoothen the complexities of Indian financial framework are ex-
plained in detail.

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1.2 INTRODUCTION TO FINANCIAL SYSTEM

A financial system acts as an intermediary between borrowers and
lenders of an economy. The concept of financial system can be de-
fined at different levels, such as organisation-specific level, regional
level and global level. At the organisational level, the financial system
encompasses all financial activities of an organisation. The financial
system at the regional level serves as a platform for exchanging funds
between lenders and borrowers. The concept of financial system gets
broader when it is discussed at the global level that encompasses fi-
nancial activities between borrowers, lenders and various financial
institutions such as International Monetary Fund (IMF), World Bank,
central banks and other major banks of countries. The following are
some definitions of financial system:
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In the words of Van Horne, Financial system allocates savings effi-
ciently in an economy to ultimate users either for investment in real
assets or for consumption.
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According to Prasanna Chandra, financial system consists of a variety
of institutions, markets and instruments related in a systematic manner
and provide the principal means by which savings are transformed into
investments.
The prime motive behind the functioning of a financial system is to

move funds across the economy. Funds are moved from sectors having
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surplus funds to sectors having the shortage of funds. Thus, it can be

said that a financial system acts like a gateway that channelises the
flow of funds. The following points explain the importance of a finan-
cial system:
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A financial system creates a link between borrowers and lenders

by mobilising funds from one sector (having surplus) to others
(having a shortage).
It acts as a tool to monitor the performance of an organisation. For
instance, a company that is able to manage funds easily is certainly
the one that gains the trust of investors. This further boosts the
market image of that particular company.
A financial system provides a platform that facilitates the invest-
ment process. Investors can put in their money by purchasing
various kinds of securities such as shares, debentures and fixed
deposit as per their convenience.
From the discussion so far, it can be said that the financial system
plays a crucial role in maintaining the health of an economy by facili-
tating the movement of funds. Apart from this, the following are some
other functions of an economy:
Reducing information cost: Rational investment decision making
largely depends on accurate and timely information related to the
financial system.

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The financial system creates a platform where the various types of

information related to different securities can be disseminated at
a lower cost. High information cost may obstruct the smooth flow
of funds to the most productive use. Without financial system, the
investment-related information can be difficult to access at lower cost.
For instance, in the absence of financial intermediaries, every inves-
tor needs to incur a huge cost to obtain information for evaluating the
worth of an investment proposal.
Lowering transaction cost: A large number of transactions take
place in the financial system on a day-to-day basis. A certain cost is
associated with each transaction for its processing. A large number
of transactions by financial intermediaries help them to achieve
economies of scale, thereby reducing transaction costs.
Facilitating trade activities: The financial system smoothens
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trade-related activities by ensuring the availability of adequate
funds across the economy.
Diversifying and managing risk: There are a number of securi-
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ties available in the financial system. An investor can diversify his/
her risk by investing in more than one security.
Maintaining liquidity: The most important function of a financial
system is to maintain enough money for the production of goods
and services. A business firm needs adequate finance for long and
short-term purposes. Finance raised by a firm for long term is
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called capital, while finance raised for short term is called work-
ing capital. The financial system ensures liquidity across business
firms by providing them capital and working capital.
Regulating financial framework: It is the duty of a financial
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system to regulate the functioning of the financial framework of

an economy by introducing standardised rules and instruments
(securities).
self assessment Questions
1. A financial system smoothens trade-related activities by

ensuring the availability of adequate funds across the economy.
(True/False)
2. A ________ provides a platform that facilitates the investment
process. Investors can put in their money by purchasing
various kinds of securities such as shares, debentures and
fixed deposit as per their convenience.
Activity
With the help of the Internet, collect information on how the finan-
cial system helps in reducing the transaction and information costs.
Prepare a report based on your findings.

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INDIAN FINANCIAL SYSTEM AND ITS

1.3
FUNCTIONS
As already discussed, the prime function of a financial system is to mo-
bilise the savings of individuals so that capital formation can take place
in an economy. The Indian financial system works on the same princi-
ple and ensures the smooth flow of money across the Indian economy.
In the post-liberalisation era (after 1991), India came out as an open
economy as it allowed the flow of money across the country with com-
paratively lesser restrictions. This resulted in the enhanced flow of
foreign capital into the Indian economy, which further increased var-
ious dynamics and complexities in the Indian financial market. Now,
let us discuss the structure of the Indian financial system.
1.3.1 STRUCTURE OF INDIAN FINANCIAL SYSTEM AND ITS
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SEGMENTS
The Indian financial system is considered to be a complex system as

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it involves a large number of participants dealing in various financial
instruments and services. The structure of the Indian financial system
is shown in Figure 1.1:
Indian
Financial
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System
Financial Financial Financial Financial

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Institutions Markets Instruments Services
Figure 1.1: Structure of the Financial System of India
Let us discuss the structure and segments of the Indian financial sys-
tem in the next sections.
FINANCIAL INSTITUTIONS
A financial institution refers to an intermediary that mobilises sav-

ings done by one section of an economy and allocates that to another
section of the economy requiring funds for accomplishing economic
activities. The following are some major financial institutions:
Regulatory and promotional institutions: Like any other system,
the financial system also needs regulatory authorities to make
rules and guidelines for governing the financial framework of an
economy. In India, there are many regulatory bodies that are re-
sponsible for managing the activities of financial institutions and
markets and the issuing of financial instruments and services.

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These bodies are the Ministry of Finance of India, Company Law

Board, Reserve Bank of India (RBI), Securities and Exchange
Board of India (SEBI), Insurance Regulatory and Development
Authority (IRDA), Department of Economic Affairs, Department
of Company Affairs, etc.
Out of these bodies, two prime regulators of the Indian financial
system are RBI and SEBI. They are responsible for administering,
legislating, supervising, monitoring and controlling the financial
system. All financial institutions in India are governed by RBI,
whereas financial markets are under the control of SEBI.
Banking institutions: Banking institutions ensure the mobilisa-
tion of the savings of people. They accumulate the savings of one
sector of an economy and provide credit to another section of the
economy. The banking sector can be classified into three catego-
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ries—commercial banks, co-operative banks and developmental
banks. Banking institutions accumulate the savings of individuals
and provide a wide range of financial services like bank accounts,
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loans, D-MAT accounts, mutual funds, etc.
Non-Banking Financial Institutions (NBFIs): It is a financial in-
stitution that is not regulated under any banking regulatory agen-
cy. Services provided by NBFIs include credit facilities, retirement
planning, money markets, underwriting and merger activities.
The examples of NBFIs include insurance firms, cashier’s check
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issuers and microloan organisations. The major NBFIs in India

include Unit Trust of India (UTI), General Insurance Company of
India (GIC) and Life Insurance Corporation (LIC).
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FINANCIAL MARKETS
The term market refers to a place where interaction between the buy-
ers and sellers of a certain good or service takes place. A financial
market is a place where people make transactions of financial securi-
ties, commodities and other items. Here, the term securities comprise
a wide range of investment such as shares and debentures, and com-
modities include precious metals or agricultural goods.
Investors can invest their money in the financial market by purchas-

ing any securities, and the lender can borrow money by issuing/selling
any securities. A financial market acts as a platform where financial
institutions provide financial instruments and services in the econo-
my. Therefore, the growth of financial market is directly related to the
growth of an economy.
Major participants in the financial market include corporations, fi-

nancial institutions, individuals and the government. They facilitate
the movement of funds across the economy by trading either direct-
ly or indirectly with the help of brokers and dealers. Financial mar-

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kets can be classified based on various factors. Figure 1.2 shows this
classification:
Classification of
Financial Markets
Based on Based on Based on

Based on Based on
Structural Issuance of Maturity of
Securities Delivery
Framework Securities Securities
Figure 1.2: Classification of Financial Markets
Let us discuss this classification in detail.
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BASED ON STRUCTURAL FRAMEWORK
There are two categories of a financial market based on the structural

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framework. These two are:
Organised markets: As the name suggests, an organised market is
followed by well-established rules and regulations.
Unorganised markets: In this market, financial transactions take
place in the absence of prescribed rules and regulations and stan-
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dards.
BASED ON SECURITIES
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A financial market is classified on the basis of the types of securities

dealt in it. Based on securities, the following is the classification of a
financial market:
Debt market/Debenture market: A debenture is a kind of a secu-
rity that is characterised by fixed interest, fixed tenure of maturity
and security of return. The market where all the transactions per-
taining to debentures take place is called debt market.
Equity market: Equity is a type of security that is characterised
by dividend, voting right and decision making power in a business
firm. A market whereby transactions related to equity take place
is called equity market.
BASED ON ISSUANCE OF SECURITIES
The classification of a financial market can also take place on the basis
of the issuance of new and old securities, which is as follows:
Primary market: It is a market where transactions related to new
securities (shares and debentures) take place. For instance, if a
business firm comes with new securities to be sold to investors, the

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firm would be issuing its new securities in the primary market. In

simple words, if a security is being sold for the first time, the trans-
action would take place in the primary market. Therefore, primary
market is also known as the new issue market. This market helps
in mobilising savings and supplying fresh or additional capital to
business firms.
Secondary market: In this market, the transaction of existing se-
curities takes place. After being issued for the first time in the pri-
mary market, the subsequent transaction of a particular security
takes place in the secondary market. A stock exchange is an exam-
ple of the secondary market. There are two main stock exchang-
es in India, namely Bombay Stock Exchange (BSE) and National
Stock Exchange (NSE).
BASED ON MATURITY OF SECURITIES
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Money can be invested in the market for long term and short term.
Based on this, the financial market can be segregated as follows:
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Capital market: This market deals in long-term securities such as
debentures and shares with a maturity period of more than one
year. The long-term finance raised from the capital market is used
for industrial purposes.
Money market: In this market, an investor can invest money for
a short duration that is less than a year. A wide range of securities
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are traded in the money market such as T-bills, call money, com-
mercial bills, etc.
BASED ON DELIVERY
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Every transaction of financial markets includes two main compo-

nents. One is security (instruments) and the other is fund. Sometimes,
the delivery of securities/underlying goods and commencement of
contract take place at different points of time. Based on this, the seg-
regation of financial market can be as follows:
Cash/Spot market: In this market, a security is delivered immedi-
ately at the time of the contract to the other party.
Forward/Future market: In this market, the delivery of underly-
ing goods/securities does not take place immediately. The transac-
tion is completed on a pre-determined time in the future as men-
tioned in the contract by delivering the security.
Other Types of Financial Markets
In addition to the above categorisation, there are few other types of

financial markets that exist in the economy. Some of these are:
Foreign exchange market: The currency of one country is called
foreign currency by another country. The foreign exchange mar-

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ket is a place where the currency of one country is traded for an-
other currency.
Derivatives market: A derivative can be defined as a modern and
dynamic financial instrument that contributes significantly in
hedging risk. The important types of derivatives are forwards, fu-
tures, options, swaps, etc. A market in which derivatives are dealt
with is called derivative market.
FINANCIAL INSTRUMENTS
Every market is operated based on two components, namely money

and objects/commodities. A transaction can take place in any market
if both of these components are present. An object or commodity of
the financial market is called financial instrument. These instruments
(securities and claims) are issued for raising money in the market. For
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a lender, financial instruments are financial liabilities, while for the
borrower, they are financial assets. Lenders invest their money by
purchasing financial instruments for earning economic returns in the
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future in the form of interests and dividends.
Financial instruments can be classified on several aspects such as

transferability, associated risks and return. Some of the financial in-
struments that are tradable/ transferable include equity shares, de-
bentures, government securities and bonds. Others are non-tradable/
non-transferable and include banks deposit, post office deposit, insur-
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ance policies, National Savings Certificates (NSCs), provident funds

and pension funds. Financial instruments available in the capital mar-
ket include equity shares, preference shares, warrants, debentures
and bonds. These instruments are characterised by comparatively a
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low degree of associated liquidity as the maturity period of these in-

struments is more than a year. On the other hand, the instruments
of the money market include treasury bills, commercial papers, call
money, short notice money, certificates of deposits and commercial
bills. Securities of the money market are associated with a high degree
of liquidity as the maturity period of these instruments is less than
a year. There is one more concept that is hybrid instruments, which
have the mixed features of equity and debt instruments such as con-
vertible debentures and warrants.
Financial instruments can also be categorised as cash instruments

and derivative instruments. Cash instruments refer to financial assets
whose values are determined directly by the market mechanism. On
the other hand, derivative instruments refer to financial assets whose
values are driven by some other financial instruments.
FINANCIAL SERVICES
Over the years, the service sector of the Indian economy has emerged
as the major contributor to the Gross Domestic Product (GDP) of In-

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dia. Almost every industry is coming out with a wide range of services
designed for customers in order to meet their expectations. The fi-
nancial sector has also come up with an array of financial services
that integrates the domestic economy with the global economy in a
systematic and efficient manner.
The prime objective of this financial service sector is to intermediate

and facilitate financial transactions of individuals and institutional in-
vestors. Some of the main financial services include lease financing,
banking, hire purchase, insurance, merchant banking, factoring, for-
faiting, etc.
3. Major participants in the financial market include corporations,

financial institutions, individuals and the government.
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(True/False)
4. Which of the following can be classified on several aspects
such as transferability, associated risks and return?
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a. Financial instruments
b. Financial market
c. Financial services
d. Financial regulatory bodies
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Activity
With the help of various sources, find information on investment

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trends of the Indian financial system. Also analyse which of the fi-
nancial instruments is the most preferred in the Indian financial
market.
1.4 INTERNATIONAL FINANCIAL SYSTEM

With the advent of globalisation, economies are integrated with each
other. This integration has resulted in huge fund flow across the globe
that further leads to the financial dependence of one economy on
another economy. The international financial framework started gain-
ing attention after the inception of the Bretton Woods system. After
the Second World War, when almost every economy was suffering
from a major financial crisis, the conclusion made in Bretton Woods
Conference came as a game changer for building a globalised econ-
omy on the basis of financial aspects. The concept of International
Monetary Fund (IMF) and International Bank for Reconstruction and
Development (IBRD) was developed to provide financial support to
the global economy.

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INTERNATIONAL MONETARY FUND (IMF)
IMF, established in 1945, is an international apex body that regulates

the international financial framework. IMF works to foster growth
and stability of the global economy by making policies and provid-
ing financial assistance to the member countries. The main aim of
the IMF is to provide financial support to developing nations so that
they can achieve macroeconomic stability. The following are the main
functions of the IMF:
Facilitating international monetary cooperation by easing money
flow across the globe
Maintaining the exchange rate stability so that international busi-
ness can be protected from fluctuations in the currency rate
Helping member countries so that adverse balance of payment
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can be adjusted by providing financial assistance
Assisting all member countries through international financial co-
ordination
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The inefficiency of local financial systems of different nations is con-
sidered a reason of limited access to financial markets by the individ-
uals of an economy. These market imperfections are well managed by
the IMF as it acts as an alternate source of financing so that the global
economy can be developed with a consistent growth rate.
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INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT (IBRD)
IBRD is a development finance institution established in 1945. It was

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the second main concept that was introduced in the Bretton Woods
Conference along with IMF. Today, IBRD is known as the World Bank.
Here, it is important to differentiate between World Bank and World
Bank Group. The World Bank Group refers to the integration of five
international organisations that together provide financial assistance
to developing nations.
IBRD is one of the five international organisations of the World Bank

Group. The main role of the World Bank is to provide loans for de-
velopment purpose to underdeveloped member countries. Long-term
loans are provided for financing development projects for the dura-
tion of 5 to 20 years. Financial assistance provided by the World Bank
helps in assuring a favourable condition of the Balance of Payments
(BoP) of member countries that in a way facilitates the balanced de-
velopment of international trade.
Let us now discuss other four international organisations of the World

Bank Group.
International Development Association (IDA): This segment of
the World Bank Group provides concessional loans to the poorest

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developing countries. IDA works on the World Bank Group’s mis-

sion of reducing poverty across the poorest nations.
International Finance Corporation (IFC): This segment of the
World Bank Group is associated with the development of the pri-
vate sectors of developing countries. It provides financial assis-
tance to private sectors of member countries without government
interference.
Multilateral Investment Guarantee Agency (MIGA): The invest-
ment in the developing countries is usually followed by a political
risk for the investor nation. MIGA is an international financial in-
stitution that provides insurance against the political risk in devel-
oping countries. This insurance provides assurance to the inves-
tor nation and helps in facilitating the Foreign Direct Investment
(FDI) across the globe.
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International Centre for Settlement of Investment Dispute (IC-
SID): This is the fifth component of the World Bank Group. ICSID
acts like an international arbitration institution. The prime mo-
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tive of ICSID is to facilitate a resolution against legal disputes that
may occur during international investment process among various
nations.
5. _____, established in 1945, is an international apex body that

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regulates the international financial framework.
Activity
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Visit the website of the IMF. Find information on the latest policies
of the IMF for improving the economic position of developing na-
tions.
INTERNATIONAL FINANCIAL SYSTEM

1.5
VS. INDIAN FINANCIAL SYSTEM
As already discussed, a financial system facilitates the movement
of money/funds across as economy. The financial system operating
within an economy is called the local financial system of that nation.
On the other hand, the financial system operating at a global level
is known as the international financial system. Although they seem
different systems, they are directly related to each other. In fact, the
financial system of every country is a part of the international finan-
cial system.
Every country has a central bank to govern its financial system. The
Indian financial system is governed by RBI, which is the central bank
of India. The central bank of a nation ensures that the domestic fi-

n o t e s
nancial framework works as per the requirement of the international

financial framework. International financial governing bodies such as
the IMF and World Bank issue guidelines from time to time. Mem-
ber nations are required to follow these guidelines so that the stan-
dardised financial framework can be built across the global economy.
In this globalised economy, almost every economy is integrated with

other economies, thereby affecting the globalised financial framework
by making changes in their domestic financial frameworks. For exam-
ple, a country providing high interest rates on domestic instruments
may fetch foreign funds in huge quantum. This would further impact
the flow of money in different countries.
6. In this globalised economy, almost every economy is integrated
S
with other economies, thereby affecting the globalised
financial framework by making changes in their domestic
financial frameworks. (True/False)
IM
Activity
With the help of various sources, find out any three countries hav-
ing a strong position in the international financial system.
M
IMPACT OF LIBERALISATION ON
1.6 FINANCIAL INSTITUTIONS AND
MARKETS
N
India was facing an adverse balance of payment since 1985, which led
to a major economic crisis during the 1990s. At that time, the foreign
exchange reserves of India got reduced to the point that the country
could barely finance imports for a few weeks. The condition of Indian
financial framework got more complex when the Indian government
decided to pledge the country’s gold reserve to IMF for availing finan-
cial assistance to cover the BOP deficit. This was the time when the
Indian government realised the need of adopting a dynamic econom-
ic policy to support the economic instability of the Indian financial
system. The newly appointed Prime Minister of India, P.V. Narasimha
Rao with Finance Minister Manmohan Singh decided to introduce the
New Economic Policy in 1991.
IMF provided financial assistance to India based on certain conditions

related to the implementation of economic reforms. The basic objec-
tive of the new economic policy of India was to transform the complex-
ity of Indian financial framework by introducing more liberal policies
to facilitate FDI. The liberalisation resulted in innovation in financial
instruments and processes, which further led to increased capital flow
in India. In other words, liberalisation created an open environment

n o t e s
for investment and improved the functioning of financial institutions

by eliminating all constraints faced by the Indian financial system.
Let us now understand the impact of liberalisation of various financial
markets.
MONEY MARKET
As already discussed, the money market ensures the movement of

funds for short term and thus facilitates the liquidity factor in the
economy. After liberalisation, many instruments/services/institutions
have been introduced for enhancing the strength of the financial sys-
tem with the help of the money market. Some of these instruments
include Certificates of Deposit (CDs) and Commercial Papers (CPs).
Internal Working Group and Narasimham Committee were formed to
supervise the development of the Indian financial system. They pro-
S
vided the following recommendations:
To bring advantages of the auction system for T-bills
To ensure the gradual movement from the loan-based system to
IM
the cash credit system
To abolish the ad hoc T-bills that result in the elimination of the
automatic monetisation of fiscal deficit
In January 2003, a new instrument Collateralised Borrowing and

Lending Obligation (CBLO) was developed by the Clearing Corpora-
M
tion of India Limited (CCIL). It is a collateralised instrument that car-

ries a lower interest rate as compared to the call money rate. There-
fore, quantum of transaction pertaining to CBLO increased from a
tremendous number that is 22.4% in 2004–2005 to 53.2% in 2012–2013.
N
GOVERNMENT SECURITIES MARKET
The interest rate on government securities has always been low so

that the government can ensure low-cost on government borrowing.
Therefore, the Government Securities Market (GSM) remained un-
derdeveloped. Although due to low interest rate, individual investors
were lacking interest in government securities. However, the guaran-
tee of return made GSM the safest place of investment. Banks and
insurance companies are the major participants in GSM.
In 1992, the introduction of auction of T-bills initiated the price discov-

ery process, which helped in determining an optimal price of T-bills
and made investment in T-bill lucrative comparatively. In 1997, the ab-
olition of ad hoc T-bills helped in eliminating automatic monetisation.
In addition, the Ways and Means Advances (WMA) mechanism was

introduced. With the help of this mechanism, RBI provides short-term
funding to state banks so that temporary mismatch in the cash flow
(receipts and payment of banks) can be met.

n o t e s
Moreover, the Statutory Liquidity Ratio (SLR) declined considerably

from 38.5 % of the net demand and time liabilities in 1992 to 21.5 % in
2015. This led to the fact that the RBI wanted to enhance the money
supply into the economy.
FOREX MARKET
This market remained inactive till the time India was following a fixed
exchange rate. After 1991, for integrating the Indian economy with
the global economy, the flexible, market-based exchange rate was ad-
opted. In addition, the adoption of current account convertibility took
place in 1994, which further helped in making the Indian currency
flexible.
EQUITY MARKET
S
The equity market is seen as a more complex and dynamic market due
to the higher sensitivity of the return attached to equity. The following
measures introduced during liberalisation affected the equity market:
IM
The establishment of SEBI was done to ensure the regulatory ef-
fectiveness and competitiveness in the Indian financial market.
SEBI also facilitates the application of modern technological infra-
structure so that informational asymmetries and transaction costs
can be reduced.
M
The concept of FII was introduced to increase foreign equity in-

vestments in the form of FIIs in 1992.
The permission of Indian companies was given to raise foreign
capital. For this purpose, a wide range of instruments introduced
N
such as American Depositary Receipts (ADRs), Global Depository

Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs)
and External Commercial Borrowings (ECBs). Companies are now
allowed to raise capital internationally by issuing these securities.
The National Stock Exchange (NSE) was established in 1994 as
a platform to make the transaction of old shares. This further in-
creased the competitiveness of the equity market in India.
BANKING SECTOR
Before the implementation of reforms in 1991, the Indian banking sys-

tem had been facing many issues such as small capital base, low prof-
itability and less competition in the banking sector as a whole. Post
1991, many structural reforms took place on the basis of recommen-
dations provided by the Narasimham Committee. There were many
reforms that were introduced to increase the efficiency and competi-
tiveness of the banking industry:
The capital base of the Indian Bank was enhanced by infusing the
capital of approximately ` 20,000 crores.

n o t e s
Initially, banks were required to keep a major portion of deposit as

Cash Reserve Ratio (CRR) and SLR in accordance with the strin-
gent guidelines of RBI. The introduction of financial reforms also
resulted in the provision of reduction in the reserve ratio, which
further led to the enhancement of the money supply in the Indian
economy. For instance, banks used to keep 63.5 per cent of their re-
sources as CRR and SLR in the early 90s that reduced drastically
around 25.5 per cent in 2015.
The complex structure of administering interest rates had been
almost totally eliminated. Now, most of the instrument-derived in-
terest values are based on the demand and supply mechanism.
Public sector banks were allowed to approach the capital markets
for collecting equity capital, provided that the government owner-
ship would remain at least at 51 per cent.
S
Establishment of internationally acceptable prudential norms
such as asset classification and capital adequacy to improve the
low profitability of the Indian banking system
IM
Establishment of a debt recovery mechanism by establishing 29
Debt Recovery Tribunals (DRTs) and five Debt Recovery Appel-
late Tribunals (DRATs).
Enhancement in the role of Lok Adalats so that disputes between
banks and small borrowers can be settled in a timely manner.
M
Credit data sharing between banks for guarding against defaulters.
Introduction of measures to reduce the quantum of non-perform-

ing assets (NPAs). New measures helped significantly in reducing
the percentage of NPAs to gross advances from 23.2 per cent in
N
March 1993 to 16 per cent in March 1998.

The monopoly of public banks was removed by providing a license
to private banks to increase the competitiveness of the banking
industry.
The second phase of reforms was introduced with another Nara-
simham Committee report in April 1998.
The concept of asset reconstruction companies was introduced so
that the process of debt recovery can be smoothened.
Enactment of Securitisation and Reconstruction of Financial As-
sets and Enforcement of Security Interest Act (SARFAESI), 2002,
with a motive to empower the banks to recover their Non-Perform-
ing Assets (NPAs) without the intervention of the courts.
Establishment of Credit Information Bureau (India) Ltd. (CIBIL)
as India’s first credit information company in 2000 that further
paved the way for the enactment of the Credit Information Act in
May 2005, for providing credit information of borrowers. This led
to the drastic reduction in the quantum of NPAs.

n o t e s
Participation of foreign players was enhanced by allowing FDI lim-

it in the banking sector under the automatic route. The limit was
revised from 49 per cent to 74 per cent for international players for
entering the Indian banking industry under the automatic route.
Establishment of the Basel Committee as banking supervisory that
provides a forum for regular cooperation on banking supervisory
matters. The prime motive behind the setting up of this committee
is to improve the quality of banking supervision worldwide.
The liberalisation process changed the complete outlook of the Indian

economy in the global market. Now, it is no more a closed economy, it
is an open economy with more liberal policies so that the flow of mon-
ey/fund can take place across the globe smoothly. The aforesaid points
are well discussed as to how the Indian economy came up with a more
liberal financial framework. These reforms contributed significantly
S
for transforming Indian economy from a poor economy to an emerg-
ing economy.
IM
1.6.1 IMPACT OF NEW INITIATIVES oN INDIAN FINANCIAL
SYSTEM
Financial inclusion is one of the most important objectives of every

economy as this adds to the economic value of the country. Financial
inclusion is all about providing financial services at affordable costs
to low-income segments of society. The concept of financial inclu-
M
sion results in the additional flow of money into the economy. It is

important to note that this concept ensures the mobilisation of house-
hold savings into the economy through financial intermediaries,
thereby increasing the money supply in the economy for the produc-
N
tive means.
It is a universal truth that each section of the economy does saving

according to the level of their income. Although the level of saving
depends on the level of income, but every individual and household
try to save some portion of their earning. The various schemes under
financial inclusion target to flow those small savings into the economy.
It is important to note that this kind of small chunk of saving plays
a dynamic role in the economy when it comes from countless indi-
viduals and households. These savings are further used in productive
means that result in increased Gross Domestic Product (GDP) and
further leads to the improved status of the economy. In India, there
are several schemes that are run for financial inclusion. Let us now
discuss about some of these schemes in detail.
PRADHAN MANTRI JAN DHAN YOJANA (PMJDY)
PMJDY is a national mission for financial inclusion so that various

financial services, including bank savings, deposit accounts, remit-
tance, credit, insurance, pension, can be provided to the disadvan-

n o t e s
taged section of the economy in an affordable manner. This campaign

was launched by Prime Minister Narendra Modi on 28 August 2014.
The scheme is run by the Department of Financial Services, Ministry

of Finance. On the very first day, 1.5 crore (15 million) bank accounts
were opened under this scheme, which was recognised under the
Guinness World Records. Majority of Indians opened there accounts
under this scheme.
Exhibit
Milestones Achieved Under Pmjdy

Banks have opened 17.74 crore accounts under PMJDY with
deposit of more than 22000 crores.
Aadhaar has been seeded in 41.82% of account opened under
S
PMJDY.
To ensure universal banking access more than 1.26 lakhs Bank
Mitras have been deployed with online devices capable of
IM
e-KYC based account opening and interoperable payment
facility.
131012 Mega Financial Literacy camps were organized by banks
under PMJDY ‘in coordination with various agencies and 89876
Financial Literacy counters, to spread awareness on PMJDY,
use of RuPay cards etc.
M
147418 students in 2567 schools/collage were imparted training

on Financial literacy from September 2014 to April 2015
More than 10 lakhs accounts have been found eligible for Over-
N
draft facility. Out of these overdrafts facility has been availed

by 164962 account holders.
847 Claims of Life cover of ` 30000 and 389 Claims of accident
insurance cover of ` 1 lakh have been successfully paid.
As on 22nd August, 2015, 8.17 crore beneficiaries have been
enrolled under the Pradhan Mantri Suraksha Bima Yojana
and 2.76 crore have been enrolled under Pradhan Mantri Je-
evan Jyoti Bima Yojana. 6.83 lakh account holders have been
enrolled under Atal Pension Yojana.
Zero balance accounts in PMJDY have declined from 76% to
45.74% from September 2014 to 19th August 2015
(Source: http://pib.nic.in/newsite/PrintRelease.aspx?relid=126439)
LICENSES FOR NEW BANKS
The main motive of reopening the window for providing licenses to

commercial and development banks by RBI is to achieve financial in-
clusion. India is considered a country having the world’s largest un-

n o t e s
banked population. According to IMF, out of the two, only one Indian
has a savings account and out of seven Indians’ only one has access to
bank credit. Table 1.1 shows the IMF survey about the availability of
the banking facility in India and China:
TABLE 1.1: IMF SURVEY 2011

Parameter India China
Bank branches per 1000 km 30.43 1428.98
ATMs per 1000 km 25.43 2975.05
Bank branches per 100000 people 10.64 23.81
ATMs per 100000 people 8.9 49.56
Bank deposits to GDP (%) 68.43% 433.96%
Bank deposits to Total Credit (%) 51.75% 287.89%
(Source: http://www.imf.org/external/pubs/ft/survey/so/2012/NEW031612A.htm)
S
RBI has granted licenses to 23 banks since April 2014. More banks
mean more ways to channelise the savings of various sections of the
country into the Indian economy.
IM
MICRO FINANCE/MICRO CREDIT
Microfinance refers to a source of financial services that ensures the

accessibility of banking and related services for entrepreneurs and
small businesses. The concept of microcredit is based on the premise
M
that skills of poor people usually remain unutilised or underutilised

due to the lack of adequate finance. Microfinance/microcredit firms
act as one of the main sources of eliminating poverty. This in a way
affects the economic standard of the economy.
N
PAYMENT BANKS
Unlike traditional banks, payment banks do not have any physical lo-
cation and reach their customers primarily through mobile phones.
Payment banks are not allowed to offer loans. They can only raise
deposits of up to ` 1 lakh and pay interest on the balance just like a
savings bank account does. All the services offered along with a sav-
ings account remain as it is. These include transfers and remittances
through mobile phones, automatic payments of bills, cashless pur-
chases, debit cards and ATM cards. RBI recently granted approval to
be a payment bank to several organisations such as Aditya Birla Nuvo
Ltd., Airtel M Commerce Services Ltd., Cholamandalam Distribution
Services Ltd. and Vodafone m-pesa Ltd.
7. ______ refers to a source of financial services that ensures the

accessibility of banking and related services for entrepreneurs
and small businesses.

n o t e s
Activity
Make a critical analysis on the measures taken by the Government

of India to liberalise various norms of the Indian financial system.
1.7 SUMMARY
A financial system acts as an intermediary between borrowers and
lenders of an economy.
The prime motive behind the functioning of a financial system is to
move funds across the economy.
A financial institution refers to an intermediary that mobilises sav-
ings done by one section of an economy and allocates that to an-
other section of the economy requiring funds for accomplishing
S
economic activities.
Like any other system, the financial system also needs regulatory
authorities to make rules and guidelines for governing the finan-
IM
cial framework of an economy.
A financial market is a place where people make transactions of
financial securities, commodities and other items.
Major participants in the financial market include corporations,
financial institutions, individuals and the government.
M
Financial instruments can be classified on several aspects such as

transferability, associated risks and return.
The prime objective of the financial service sector is to intermedi-
ate and facilitate financial transactions of individuals and institu-
N
tional investors.
IMF, established in 1945, is an international apex body that regu-
lates the international financial framework.
IBRD is a development finance institution established in 1945. It
was the second main concept that was introduced in the Bretton
Woods Conference along with IMF.
In today’s globalised economy, almost every economy is integrat-
ed with other economies, thereby affecting the globalised financial
framework by making changes in their domestic financial frame-
works.
Indiawas facing an adverse BoP since 1985, which led to a major
economic crisis during the 1990s.
IMF provided financial assistance to India based on certain condi-
tions related to the implementation of economic reforms.
The basic objective of the new economic policy of India was to
transform the complexity of Indian financial framework by intro-
ducing more liberal policies to facilitate FDI.

n o t e s
key words
American depositary receipts: These are negotiable certifi-

cates issued by a US bank that represent a specified number of
shares (or one share) in a foreign stock that is traded on a US
Exchange.
Cash reserve ration: It is the percentage of money that needs to
be deposited by a commercial bank to RBI.
External commercial borrowings: These are instruments used
in India to get access to foreign money by Indian corporations
and Public Sector Undertakings (PSUs).
Fiscal deficit: The borrowing of a government is called fiscal
deficit.
S
Foreign Currency Convertible Bonds (FCCBs): These are is-
sued in currencies different from the domestic currency of the
issuing company. Corporates issue FCCBs to raise funds in for-
eign currencies.
IM
Foreign Institutional Investor (FII): It refers to an outside
company investing in the Indian financial markets. FII must be
registered with the SEBI to participate in the market.
Global Depository Receipts (GDRs): These are bank certifi-
cates issued in more than one country for shares in a foreign
M
company. The shares are held by the foreign branch of an in-

ternational bank. The shares are traded as domestic shares but
can be sold out globally through various bank branches.
Monetisation: It refers to a process of converting or establish-
N
ing something into a legal tender, which implies deriving value

for something on a legal basis.
Statutory Liquidity Ratio (SLR): It refers to the portion of
commercial banks’ net deposit that is kept by banks themselves
as per the monetary policy of the RBI in the form of gold, cash
or other securities.
Treasury bills (T-bills): They are issued by the Government of
India for a maturity period of 91 days, 182 days and 364 days.
They are issued at discounted price value and redeemed at par/
face value. The difference between par value and discounted
value is the return earned by an investor.
1.8 DESCRIPTIVE QUESTIONS

1. Discuss the significance of the financial system of an economy.
2. Explain the structure and segments of the financial system.
3. Elaborate on the role of international financial system.

n o t e s
1.9 ANSWERS AND HINTS
ANSWERS TO SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

Introduction to Financial 1. True
System
2. Financial system
Indian Financial System 3. True
and its Functions
4. a. Financial instruments
International Financial 5. IMF
System
International Financial 6. True
S
System vs. Indian Financial
System
Impact of Liberalisation on 7. Microfinance
IM
Financial Institutions and
Markets
HINTS FOR DESCRIPTIVE QUESTIONS

1. The prime motive behind the functioning of a financial
system is to move funds across the economy. Refer to Section
M
1.2 Introduction to Financial System.

2. The structure and segments of the financial system include
financial institutions, financial markets, financial instruments
and financial services. Refer to Section 1.3 Indian Financial
N
System and its Functions.

3. The international financial framework started gaining attention
after the inception of the Bretton Woods system. After the Second
World War, when almost every economy was suffering from a
major financial crisis, the conclusion made in Bretton Woods
Conference came as a game changer for building a globalised
economy on the basis of financial aspects. Refer to Section
1.4 International Financial System.
SUGGESTED READINGS FOR

1.10
REFERENCE
SUGGESTED READINGS
Bhole, L., & Mahakund, J. (2015). Financial institution and Mar-
kets (5th ed.). New Delhi: Tata McGraw-Hill.
Pathak, B. (2008). The Indian Financial System (3rd ed.). New Del-
hi: Dorling Kindersley.

n o t e s
E-REFERENCES
Jadhav, N. (2013). Liberalising India’s Financial Sector: Con-
straints, Challenges and Prospects.
Ghosh, J. (2005). The Economic and Social Effects of Financial
Liberalization: A Primer for Developing Countries.
(2015). Retrieved from http://www.business-standard.com/arti-
cle/news-ians/banking-sector-reforms-and-india-s-competitive-
ness-column-active-voice-115011200825_1.html
S
IM
M
N

Ch a
2 p t e r
regulation in indian financial market –

regulators and their roles
CONTENTS
S
2.1 Introduction
2.2 Regulatory Theory
IM
Activity
2.3 State Intervention in Financial Markets
Activity
2.4 Regulatory Institutions
M
2.4.1 Types of Regulatory Institutions (Regulatory, Funding and Mixed)

2.4.2 Important Regulators in India and their Functions (RBI, SEBI, IRDA and
FMC)
N
Activity
2.5 Summary

n o t e s
Sebi to keep a close tab on price cartels

in commexes
Price cartels, which were enjoying the status of not being moni-
tored thoroughly till recently, will soon be put on the radar. The
Securities and Exchange Board of India (SEBI), which recent-
ly undertook the task of regulating the decade-old commodity
futures market, has decided to modify its Integrated Market Sur-
veillance System—a widely used tool in the equity market—to
track down the unusual increase in prices and also to determine
the trends and patterns that suggest the existence of manipula-
tion of futures on bourses like the National Commodity and De-
rivatives Exchange (NCDEX) and Multi Commodity Exchange
(MCX). In addition, the SEBI wishes to conduct a risk profiling
of brokers trading in the commodity markets through the system.
S
There have been several incidents of manipulation and attempted
cartelisation, especially in narrow farm futures like castor, pep-
IM
per, jeera, mentha, guar and coriander. The NCDEX in associa-
tion with the Forward Markets Commission, which was merged
with the SEBI, had undertaken several measures to tackle the
problem of cartelisation and the manipulation of the prices of
commodities.
Some measures that were adopted included staggering the deliv-

M
ery of commodities across 10-15 days from a day before the expiry
of the contract and increasing the margins for trading so as to
deter manipulators who worked on borrowed finance.
SEBI, in turn, intends to adopt a pro-active approach, wherein

N
real time and online data would be available so that pro-active

action can be taken immediately.
However, in order to implement this measure, SEBI will have to

face certain challenges, such as fragmentation of the commodity
market and variation of price across several segments.
(Source: http://articles.economictimes.indiatimes.com/2015-11-03/news/67987310_1_com-
modity-futures-market-market-surveillance-system-imss)

regulation in indian financial market – regulators and their roles 27
n o t e s
learning objectives

>> Explain the regulatory theory
>> Discuss state intervention in the regulation of financial
market
>> Identify various regulatory institutions
2.1 INTRODUCTION
The previous chapter discussed the importance and functions of the
financial system. It also discussed the Indian and international finan-
cial systems while emphasising the comparison between both these
systems. Moreover, it discussed the impact of liberalisation of finan-
S
cial institutions and markets. This chapter will focus on the regulatory
aspect of the Indian financial market, including regulators and their
roles.
IM
The Indian financial market needs to be regulated by authorised in-
stitutions to prevent illegal money exchange, fraudulent activities, etc.
In the absence of any control measures, several complications and is-
sues are bound to occur, which will have a cascading effect on the
economy of the country. In the Indian financial system, markets are
regulated by certain designated regulators, such as the Reserve Bank
M
of India (RBI), the Securities and Exchange Board of India (SEBI),

the Insurance Regulatory and Development Authority (IRDA) and the
Forward Markets Commission (FMC). These regulators are a set of
independent bodies that operate in various domains, such as banking,
insurance, commodity market and capital market.
N
The Government of India also plays a significant role in ascertain-

ing that the regulators play an active role in monitoring the activi-
ties of financial markets. In general, the RBI acts as the ultimate de-
cision-making authority in a case of severe disputes or issues in the
country’s financial market.
In this chapter, you learn about the regulatory theory. Further, you
learn about state intervention in the regulation of the financial mar-
ket. Towards the end of the chapter, you learn about various regulato-
ry institutions.
2.2 regulatory theory

Financial markets are centres that provide various services in the
form of purchase and sale of financial claims and services, which are
conducted through the agents and brokers on organised exchanges.
The players in the financial market are financial institutions, agents,
brokers, etc., whose activities when suitably regulated will ensure
transparency.

n o t e s
Of late, there has been considerable debates on the issue of regulatory

controls versus liberalisation of the financial system. This is because
there have been several incidents of failure owing to gaps in the regu-
latory model and liberalisation issues, such as the global recession in
2008, which resulted from failure of the regulatory model of sub-prime
lending of American banks. American banks took a liberal approach
in issuing finances to various entities, whereas regulatory controls did
not focus on the drawbacks of the issue of finances with the exercise
of adequate controls on any entity’s repayment capacity.
Some of the theories that pertain to regulation of the financial system

are as follows:
Free markets outperform regulated markets: This theory is
based on the concept of the fundamental theorem of welfare of
people. In essence, this is related to the assumption that a com-
S
petitive environment must exist for financial markets to perform,
by promoting issues, such as promotion of service quality through
economies of scale and prevention of discriminatory pricing.
IM
Regulation is inefficient: This theory is based on the concept that
regulation is bound to increase the costs of providing financial ser-
vices to various entities.
The stock market works as a fair play field where fair game is
the norm: This is another theory wherein the information pertain-
ing to various companies is viewed as the true value in the market,
M
which forces investors to make instant decisions. While this may

be true to some extent, it may not genuinely reflect the company’s
performance in the long term. In essence, this translates to the fact
that regulation is unnecessary, as it does not reflect the true value
N
of the company in the stock market.

Regulation of innovation can result in social costs: This theory
emphasises the fact that regulation of innovation in financial prod-
ucts and services can increase social costs.
Regulatory capture occurs as public or private groups manipu-
late regulation for personal benefits: This theory is based on the
concept that whenever regulations are imposed, it always produc-
es a cascading effect on the operations of public or private finan-
cial firms.
Regulators must regulate themselves more than agents or bro-
kers: This theory is based on the fact that regulators themselves
must follow the regulatory process and procedures so that agents,
brokers, etc., follow and implement the regulatory practices in the
earnest. In general, it is observed that regulators themselves fail to
adhere to the necessary rules and apply certain approaches that
suit their interests and benefits.
Therefore, from the above-mentioned, it is observed that several reg-

ulatory theories have been proposed. However, there is always a need

n o t e s
for the existence of some sort of regulation which at least will provide
confidence to the investors and other entities that their finances are
safe. The economy of a country will be majorly affected in the absence
of appropriate regulations.
1. Financial markets are centres that provide various services in

the form of purchase and sale of financial claims and services,
which are conducted through agents and brokers on organised
exchanges. (True/False)
2. Regulation of __________ in financial products and services
can result in increase in social costs.
S
Activity
Conduct research on various other regulatory theories. Prepare a

report on your findings.
IM
State intervention in financial
2.3
marketS
The 2008 global recession occurred as a result of banks being too lib-
eral in providing credit to various entities without having appropri-
M
ate regulatory controls in place. In other words, the banks dispensed

money without taking into consideration the entities’ repayment ca-
pacity. This led to a financial crisis, which in effect led to the global
recession, resulting in loss of jobs and destabilisation of economies of
N
several countries across the world. Thus, it has brought back to light
the role of state intervention in regulating the financial market.
Some of the reasons for state intervention in the regulation of the

financial market are as follows:
State intervention is required for regulating the financial system
so as to maintain the balance between the needs of the financial
market and the needs of the economic scenario of the country. In
other words, state intervention ensures that this balance is main-
tained. The main aim of financial markets is to garner as much
profit as possible. However, the benefits arising out of the profits
may not contribute to the economic growth of the country. In oth-
er words, the financial market may under-report the profits, which
will have severe repercussions on the economy of the country.
The provision of financial security and risk-taking aptitude is an-
other reason why the state should intervene for the efficient func-
tioning of financial markets. The creditor the investor always want
to seek their own benefits, and during the process, they are prone to
excessive risk-taking measures, such as investing in schemes that

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promise high interest rates, various Ponzi schemes like Speakasia,

etc. Therefore, the investor needs to be provided with as adequate
financial security.
The other reason that calls for the need for state intervention is
the fact that the cyclic occurrence of recessions in the banking sec-
tor needs to be carefully monitored, and this can only be achieved
by the existence of a proper regulatory mechanism. For exam-
ple, banks took excessive risk, which resulted in the recessions of
1930 and 2008. Although there have been some minor recessions
in between these periods, they have been effectively managed by
the state due to suitable regulatory mechanisms in place. For ex-
ample, Indian banks operated well as compared to Morgan Stan-
ley or American Express, as the regulatory mechanism of Indian
banks, governed by the RBI, ensured that Indian banks continued
to thrive despite the severe effects of the global recession in the
S
year 2008.
Thus, from the above discussions, it becomes imperative that there

is an inevitable need for state intervention in regulating the financial
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market.
In the Indian context, the level of state intervention can be understood

from the following measures that were identified and implemented
from time to time. These measures include identifying the trends and
patterns of financial markets, establishing control measures and de-
M
ciding whether implementation of these measures is feasible or not.
The following points highlight the importance of state intervention in

the Indian context:
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Liberalisation of the financial system: The focus of the state to-

wards liberalisation and regulation led to the development of an
efficient and effective financial system. The Government of India
has already launched the liberalisation programme, wherein sev-
eral controls were eliminated from the public sector banks. The
objective of this elimination was to encourage the entry of private
sector banks so that more capital inflow can take place in the Indi-
an financial sector.
Need for regulatory controls: This is another level of intervention,
wherein the Government of India formed several regulatory bod-
ies to prevent the misuse of the liberalisation programme. For ex-
ample, SEBI was established to prevent the unethical functioning
of financial markets. Furthermore, the IRDA was established to
prevent the insurance companies from charging huge premiums
and misleading insured entities through false claims of the policy.
Need for liberalising the interest rate: This is another level of
state intervention, wherein the interest rates offered by the banks
have been liberalised, that is, banks are free to take decisions re-

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garding the interest rates on various types of financial dealings by

the customers. Earlier, the interest rate was fixed by the central
controlling body, that is, the RBI.
Maintenance of cash reserve ratio: Another area wherein state
intervention was necessary was related to the process of manda-
tory maintenance of the cash reserve ratio. This implies that the
banks are currently required to maintain mandatory reserves of
cash with the RBI so that they are able to sustain any financial
fallout that may arise due to an economic crisis.
Opening up capital markets to foreign investors: This is another
level of state intervention, wherein the state allowed foreign inves-
tors to invest their money in the Indian capital market under the
regulatory framework of the SEBI and other regulatory bodies.
Modernisation of trading and settlement systems: This is anoth-
S
er area wherein state intervention has formulated the modernisa-
tion process of trading and settlement systems with the usage of
Information Technology.
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Promotion of futures trading: In the year 1999, the Government
of India proposed trading in the futures market, as it assists in
overcoming the problems related to liquidity and better manage-
ment of risks in the Indian financial market.

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3. The provision of __________ and risk-taking aptitude is

another reason that the state should intervene for the efficient
functioning of financial markets.
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4. In the year 1999, the Government of India proposed trading in

the futures market, as it assists in overcoming the problems
related to __________ and better management of risks in the
Indian financial market.
Activity
Using the Internet, find a recent case that required state interven-
tion in regulating financial activities. Write a brief note on the same.
2.4 Regulatory institutions

Regulatory institutions are generally part of the executive section of
the government or have statutory authority to carry out their opera-
tions with oversight from a legislative department. Their actions are
usually open to legal review. Some of the regulatory institutions are
RBI, SEBI, IRDA and FMC.

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Regulatory institutions are needed because of the following reasons:

Heterogeneous nature of financial markets: This implies that the
components of financial markets are varied. For example, there
is insurance market, capital market, money market, foreign ex-
change market, etc., all of which need to be monitored by regula-
tory institutions.
Diverse organisational structure and functioning: Various seg-
ments of the financial market have different organisational struc-
tures and styles of working. This is another reason for having dif-
ferent sets of regulatory controls. For example, the functioning of
the insurance market segment is different from that of the foreign
exchange market.
Market dynamics: The market dynamics are also responsible for
the varied nature of the regulatory mechanisms. For example, in
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the case of slow economic growth, regulatory mechanisms attempt
to increase the circulation of money from the public or various en-
tities by increasing the interest rate. This will also enable more
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entities to invest their money, which drives the economy.
From the above discussions, it becomes imperative that regulatory

mechanisms are implemented to ensure that there is always a balance
between the inflow of money and the outflow of funds so that the fi-
nancial markets are able to function efficiently and effectively. Regu-
latory institutions are also varied due to the different nature of various
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segments of the financial market.
In general, we have SEBI, which is the regulatory institution, that

deals with the various types of securities in the market. Similarly,
IRDA is the regulatory institution that deals with the insurance seg-
N
ment. There are other regulatory bodies that will be covered in detail
in the subsequent sections.
2.4.1 Types of Regulatory Institutions

(Regulatory, Funding AND MIXED)
The type of regulatory institution depends on the nature of work done

by the regulatory bodies.
Based on this, regulatory institutions can be of the following types, as

shown in Figure 2.1:
Types of Regulatory
Institutions
Regulatory Funding Mixed
Figure 2.1: Types of Regulatory Institutions

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Let us now study these types in detail:

Regulatory: These are the institutions that regulate the financial
market. Their primary role is to ensure that financial institutions
comply with the established procedures and rules of the regulato-
ry bodies.
Funding: These are the institutions that provide funds to the fi-
nancial institutions. In general, the primary role of funding institu-
tions is to provide funds to various entities, which must be carried
out in accordance with the established rules and procedures of the
regulatory authorities.
Mixed: These are the regulatory institutions that regulate the fi-
nancial institutions as well as provide funds to various entities.
In general, there are some establishments that act as regulatory as
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well as funding institutions. These are depicted in Figure 2.2:
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Commercial Banks
Investment Banks
Insurance Companies
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Investment Companies
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Figure 2.2: Types of Mixed Institutions
Let us now study these types in detail:

Commercial banks: These are the banks that accept deposits and
provide some sort of security to the entities that ensure the safe
guarantee of their money. The securities provided include fixed
deposit certificates, loans and advances to the concerned entities,
credit card facilities, etc. These commercial banks operate un-
der the regulatory mechanism of the RBI. Examples of commer-
cial banks include the State Bank of India (SBI), the Corporation
Bank, etc.
Investment banks: These banks differ from commercial banks
in the sense that they have a different business model. In other
words, they function differently from the commercial banks. While
the main clientele in the case of commercial banks is the general
public, in the case of investment banks, the main clientele is the
government and large corporate houses. Investment banks are in-
volved in the Initial Public Offerings of the company. Examples of
investment banks include Goldman Sachs, Kotak Mahindra Bank,

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HSBC Bank, BNP Paribas, etc. Investment banks are subjected to

less regulatory mechanisms than commercial banks.
Insurance companies: These are the companies that collect pre-
miums for insurance from various entities. These companies are
operated under the regulatory authority of IRDA. The main focus
of these companies is to offer accidental and other insurance cov-
ers to individuals as and when required. Examples of insurance
companies include the Life Insurance Corporation of India (LIC),
Star Health, etc.
Investment companies: These are the companies that are oper-
ated by a professionally qualified group of people who invest the
money of various entities in different portfolios so that the returns
are maximum with a low risk profile. They are regulated by SEBI.
Examples include mutual fund schemes.
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2.4.2 Important Regulators in India and Their
Functions (RBI, SEBI, IRDA and FMC)
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The Indian financial system is regulated and controlled by some im-
portant regulators. Figure 2.3 shows some key Indian financial regu-
lators:
Reserve Bank of India (RBI)

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Securities and Exchange Board of India (SEBI)
Insurance Regulatory and Development Authority (IRDA)

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Forward Markets Commission (FMC)
Figure 2.3: Important Regulators in India
Let us now study about these regulators in detail:

RBI: This is the central banking institution of India, which was
established in the year 1935. The main purpose of establishing the
RBI was to regulate the financial system of the country. This bank
is fully owned by the Government of India even though in the ini-
tial stages, it was under the domain of the British Government.
The main functions of the RBI include:
Issuing of currency notes and coins: Section 22 of the RBI
Act 1934 has the provision that the RBI has the sole right to
issue notes and currency coins of all denominations. This, in
essence, translates to the fact that the RBI is responsible for
designing, producing and managing the Indian currency. It is

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further entrusted with the responsibility of ensuring adequate

supply of genuine notes. The RBI frequently addresses issues
related to security concerns and regularly enforces preventive
measures to ensure that counterfeit currency does not come
into circulation.
Managing the balance of payments position of various
entities: The RBI efficiently and effectively manages the bal-
ance of payments of different entities through credit control;
thus, enabling decrease in the money supply in the country.
This measure of the RBI ensures that imports decline and thus
the outflow of foreign currency is reduced.
Managing the resources of the government: The RBI is re-
sponsible for managing the public debt of the government,
such as payment of interest and repayment of loans, and other
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operational matters like debt certificates and registration. It
also acts as a cash manager for the Government of India.
Regulating and monitoring various operations of commer-
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cial banks: The RBI is responsible for fulfilling the role of
being the bankers’ bank. It is responsible for regulating and
monitoring the liquidity position and cash reserve ratio of the
banks and their dealings in foreign exchange markets.
Reviewing and updating various credit policies at different
points of time due to market dynamics: The credit position of
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the country is monitored by the RBI. It is responsible for decreas-

ing credit supply so as to reduce the imports and thus preventing
the outflow of foreign currency. The RBI is also responsible for
increasing the credit supply so that exports increase, thereby al-
lowing the inflow of foreign currency in the country.
N
Managing the value of the rupee with respect to other cur-

rencies of the world: The RBI determines the value of the ru-
pee according to the position of foreign currencies. The fixa-
tion of the value of the rupee assists the RBI in controlling the
credit position of the country, which in turn, affects the balance
of trade and balance of payment position of the country.
SEBI: This regulatory body was established in 1992 to ensure that
the investors’ interest is protected when dealing with the securi-
ties of various companies. In addition, SEBI is responsible for reg-
ulating, maintaining and developing various market opportunities
of the securities. Some of the key functions of SEBI are as follows:
Regulating transactions in the stock market exchange: SEBI
is responsible for regulating different transactions that take
place in various stock exchanges of the country. In particular,
SEBI closely monitors a certain stock and takes preventive
measures against any unethical practice. SEBI is thus entrust-
ed with the powers to ensure that an efficient financial market
system prevails in the country.

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Admitting and registering various stock brokers: SEBI is re-

sponsible for admitting and registering a broker who would be
allowed to carry out trading in the stock market where that
broker is registered. Prospective stock brokers are scrutinised
thoroughly, and depending upon their eligibility, they are al-
lowed to register by paying a certain registration fee.
Regulating the functioning of sub-brokers, agents, share
transfer agents, etc.: SEBI also regulates the functioning of
brokers, sub-brokers, transfer agents and the like. It also brings
out improvements in these regulations from time to time so as
to prevent any malpractices, which they may adopt.
Registering and regulating the working of depositories and
depository participants: The functions related to depositories
and depository services are regulated, monitored and tracked
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by SEBI for any malpractices being adopted by the deposito-
ry agents. The functions of the agents are regulated, and im-
provements in their working methodology are implemented
from time to time.
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Promoting investor education and providing various train-
ing programmes to intermediaries for performing day-to-
day operations: SEBI conducts frequent training and aware-
ness sessions for investors, brokers, agents, etc., so that they
remain informed and are thus able to take decisions based on
the latest facts.
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Regulating various public issues of shares and debentures:

Any public issue of shares and debentures must necessarily
fulfil the requirements of SEBI. In other words, no public is-
sue can be floated in the market unless and until it has been
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cleared by the SEBI in accordance with its established practic-

es and procedures.
IRDA: This regulatory body, established in 1999, ensures that var-
ious insurance companies are regulated and monitored efficiently
and effectively. The basic objective of establishing the IRDA was to
ensure that various entities, which are holders of different policies,
get their claim genuinely. Hence, in order to meet this objective,
the IRDA is required to maintain a stipulated deposit with the RBI
which is a certain percentage of the total premium collected from
different entities. In addition, every insurer is required to main-
tain a minimum paid-up share capital of ` 100 crores with the pro-
moters’ quota not exceeding 26 per cent thereof.
Some of the key functions of IRDA are as follows:
Specifying code of conduct for surveyors and loss assessors:
The code of conduct is prescribed by the IRDA when the sur-
veyors and the loss assessors visit the site so as to process the
claim of the insured person.

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Protecting the interests of various policy holders: The IRDA

actively improvises various processes to ensure that the inter-
est of the policy holders is sustained and maintained effectively.
This is achieved through several measures, which are adopted
regularly so as to ensure that no unethical practices take place.
Promoting awareness and education to various entities: The
IRDA helps in educating policy holders, as well as agents and
brokers who actually deal with the policy holders. The main
purpose is to prevent the occurrence of any unhealthy practic-
es, wherein the interest of the policy holder is compromised.
Controlling and regulating various companies in the insur-
ance sector: This is another important function of the IRDA,
which it frequently undertakes to ensure that the insurance
sector of the country is operating at an optimum level.
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FMC: This is the chief regulator of the commodity market in
India, which was established in the year 1953. The Ministry of Fi-
nance oversees various operations of this body in its day-to-day
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transactions. This body allows commodity trading in various ex-
changes of India. FMC was merged with SEBI in the year 2015.
Some of the main functions of FMC are as follows:
To assist the government in respect of the recognition from any
association or any matter that may arise out of the adminis-
tration of the Forward Contracts Act, 1952. Thus, it assists the
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Government of India in the formulation of policies and pro-

cesses, which will help in the smooth functioning of the for-
wards market.
To keep a check on the forwards market and take necessary
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actions. To do so, the FMC conducts studies of the latest trends

and patterns and any indicators that depict any unethical prac-
tices.
Topublish various reports regarding the functioning of com-
modity markets
To identify and support any measures and make recommenda-
tions so as to improve the operations of the FMC as well as the
functioning of the market
To review and inspect the various accounts and other docu-
ments of recognised associations. The FMC also identifies
trends and patterns so that improvements can be made.
5. __________ are generally part of the executive section of the

government or have statutory authority to carry out their
operations with oversight from a legislative department.
6. List the three types of regulatory institutions.

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7. Which types of institutions accept deposits and provide some

sort of security to the entities that ensure the safe guarantee
of their money?
a. Commercial banks
b. Investment banks
c. Insurance companies
d. Investment companies
8. Which types of institutions offer accidental and other
insurance covers to individuals as and when required?
a. Investment banks
b. Investment companies
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c. Insurance companies
d. Commercial banks
9. RBI, SEBI, IRDA and FMC are some of the important
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regulators in India. (True/False)
10. __________ is the central banking institution of India, which
was established in the year 1935.
11. SEBI frequently addresses issues related to security concerns
and regularly enforces preventive measures to ensure
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that counterfeit currency does not come into circulation.

(True/False)
12. The basic objective of establishing the IRDA was to ensure
that various entities, which are holders of different policies,
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get their claim genuinely. (True/False)

13. __________ helps in educating policy holders, as well as agents
and brokers who actually deal with the policy holders.
14. __________ is the chief regulator of the commodity market in
India, which was established in the year 1953.
Activity
Find out other types of regulatory institutions in India. Prepare a

report on your findings.
2.5 SUMMARY
Financial markets are centres that provide various services in
the form of purchase and sale of financial claims and services
which are conducted through agents and brokers on organised
exchanges.

n o t e s
The regulation of innovation in financial products and services

can result in social costs.
The provision of financial security and risk-taking aptitude is an-
other reason as to why the state should intervene for the efficient
functioning of financial markets.
In the year 1999, the Government of India proposed the trading of
the futures market, as it assists in overcoming the problems relat-
ed to liquidity and better management of risks in the Indian finan-
cial market.
Regulatory institutions are generally part of the executive section
of the government or have statutory authority to carry out their
operations with oversight from a legislative department.
The three types of regulatory institutions are regulatory, funding
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and mixed.
RBI, SEBI, IRDA and FMC are some of the important regulators
in India.
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key words
Credit: It is the sum of money that is required to be returned

with interest.
Financial asset: It is an intangible asset whose value is derived
M
from a contractual claim like stocks, bonds, deposits, etc.

Financial institutions: These are establishments that act as en-
hancers and depositories of savings.
Financial market: These are centres or arrangements that
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facilitate the sale and purchase of financial claims and services.

Liquidity: It refers to the availability of liquid assets to a market
or organisation.

1. What are the various regulatory theories? Explain with examples.
2. Discuss the reasons for state intervention in the regulation of
financial markets.
3. Explain the concept of regulatory institutions.
4. Describe the various types of regulatory institutions. Support
your answer with examples.
5. Explain the functioning of RBI as a regulatory body.
6. Discuss the functions of SEBI in regulating the capital market of
the country.

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answers for SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

Regulatory Theory 1. True
2. Innovation
State Intervention in Financial 3. Financial security
Markets
4. Liquidity
Regulatory Institutions 5. Regulatory institutions
6. Regulatory, funding and
mixed
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7. a. Commercial banks
8. c. Insurance companies
9. True
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10. RBI
11. False
12. True
13. IRDA
14. FMC
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hints for DESCRIPTIVE QUESTIONS

1. One of the regulatory theories is that the regulation of innovation
in financial products and services can result in social costs. Refer
N
to Section 2.2 Regulatory Theory.

2. The provision of financial security and risk-taking aptitude
is one of the reasons why the state should intervene for the
efficient functioning of financial markets. Refer to Section
2.3 State Intervention in Financial Markets.
3. Regulatory institutions are generally part of the executive section
of the government or have statutory authority to carry out their
operations with oversight from a legislative department. Refer to
Section 2.4 Regulatory Institutions.
4. The various types of regulatory institutions are regulatory,
funding and mixed. Refer to Section 2.4 Regulatory Institutions.
5. The RBI is the centralised and regulatory bank of India for
commercial banks. Refer to Section 2.4 Regulatory Institutions.
6. SEBI is responsible for regulating the different transactions that
take place in the various stock exchanges of the country. Refer to
Section 2.4 Regulatory Institutions.

n o t e s

2.8
REFERENCE
SUGGESTED READINGS
Bhole,M., L., and Mahakud, J. (2009). Financial institutions and
markets: Structure, growth and innovations. 5th ed. New Delhi: Tata
McGraw-Hill Education Private Limited
Pathak, B. (2014). Indian financial system. 4th ed. Noida: Dorling
Kindersley (India) Pvt. Ltd.
E-REFERENCES
AllBanking Solutions (2015). Retrieved 30 November 2015, from
http://www.allbankingsolutions.com/Banking-Tutor/Regulato-
S
ry-Bodies-in-India-RBI-SEBI-IRDA.shtml.
Economywatch.com. (2015). Regulatory Body- Financial Regulato-
ry Bodies in India | Economy Watch. Retrieved 30 November 2015,
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from http://www.economywatch.com/financial-regulatory-body.
Sree V., Pandian, K. (2014). Understanding Financial Regulatory
Bodies in India. Marketcalls.in. Retrieved 30 November 2015, from
http://www.marketcalls.in/market-regulations/understanding-fi-
nancial-regulatory-bodies-in-india.html.
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Ch a
3 p t e r
money market
CONTENTS
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3.1 Introduction
3.2 Money Markets
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3.2.1 Indian Money Market
3.2.2 International Money Markets
Activity
3.3 Money Market Instruments
3.3.1 Treasury Bills
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3.3.2 Bills of Exchange

3.3.3 Promissory Notes
3.3.4 Commercial Papers
3.3.5 Certificate of Deposits
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Activity
3.4 Bill Market in India
Activity
3.5 Issues in Indian Money Market
Activity
3.6 Unorganised Money Market in India
Activity
3.7 Summary

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GOVT WANTS SEBI, NOT RBI, TO REGULATE MONEY MARKET
The proposal has been made by the Government of India for mod-
ifying the Reserve Bank of India (RBI) Act that takes away money
market regulatory powers from the RBI and brings it under the
purview of the Securities and Exchange Board of India (SEBI).
This proposal wasn’t mentioned in Budget speech made by Fi-

nance Minister Arun Jaitley, but the Finance Bill proposes to
amend Sections 45U and 45W of the RBI Act, which effectively
takes away the central bank’s powers to regulate government se-
curities and other money market instruments.
The amendment to Section 45W says, “Any direction issued by

the Reserve Bank of India, in respect of security, under chapter
S
III D of the Reserve Bank of India Act, shall stand repealed.”
Usha Thorat, former deputy governor of RBI, said, “Certain pow-

ers in relation to regulating money market instruments and prod-
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ucts and derivatives based on these instruments were given to
RBI in 2005-06 by amending the RBI Act and this happened after
a lot of discussion. Now, with this amendment in the finance bill,
all these provisions are proposed to be withdrawn. RBI was given
the responsibility for financial stability and the power to regulate
forex and money markets was given to RBI to enable it to fulfil its
M
mandate for financial stability.
Before such sweeping changes are brought about through the Fi-
nance Bill, there has to be an understanding of the purpose for
such changes and whether these are indeed in the interest of finan-
N
cial stability. It has to go through a lot of discussion and dialogue.”
If the proposed amendments go through, regulations relating to

the issuance and investment of commercial papers, inter-bank
repo or any other repo and reverse repo used as instruments to
raise liquidity by keeping these as collateral as government secu-
rities will no longer be in RBI’s hands.
To be sure, these amendments are not an extension of the Pub-

lic Debt Management Act, which essentially deals with primary
issuances of government securities. After the proposal is enact-
ed, public debt management will be under the purview of Public
Debt Management Agency, not RBI.
Speaking to analysts, RBI Governor Raghuram Rajan had said

the proposed amendments weren’t part of the finance minister’s
Budget speech. Answering a question on the shifting of regula-
tory powers over debt markets from RBI, Rajan said he expect-
ed the proposed changes wouldn’t take place. “On the shifting of
regulatory powers over debt markets from RBI, there are some

money market 45
n o t e s
clauses in the Finance Bill referring to this. But the finance min-
ister’s speech did not contain any reference to this; the speech
generally flags the important actions of the government. I am not
worried this will happen,” Rajan had said.
The proposal to shift the power to regulate money market opera-

tions from RBI was made by the Financial Sector Legislative Re-
forms Commission. Though there were exhaustive discussions on
most other proposals by the council, the proposal to shift money
regulations from RBI wasn’t discussed.
(Source: Adapted from http://www.business-standard.com/article/economy-policy/fi-
nance-bill-wants-sebi-to-regulate-money-market-115030600506_1.html)
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learning objectives

>> Describe money markets
>> Explain money market instruments
>> Discuss the bill market in India
>> Describe the issues in Indian money market
>> Explain unorganised money market in India
3.1 INTRODUCTION
The previous chapter discussed about the role of regulators in the In-
dian financial market. This chapter relates to the role of money mar-
S
ket in India. We know that the financial market is a place where in-
vestors trade securities and commodities. Financial market provides
numerous services, such as fund raising, risk distribution, interna-
tional trade and capital formation. It is divided into capital market and
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money market to differentiate the sources of long-term and short-term
finance. Capital market is regulated by SEBI and the money market is
regulated by Reserve Bank of India (RBI).
The instruments traded under the money market are treasury bills,
bills of exchange, promissory notes, commercial papers and certifi-
M
cate of deposits. Indian money market is divided into organised money

market, unorganised money market and cooperative sector. The var-
ious challenging issues in the money market are limited instruments,
multiplicity of the interest rates, lack of integration etc.
N
International financial markets have developed extensively due to an

increase in international business. These markets facilitate the smooth
flow of cross-border business transactions. International money mar-
kets are also developed for enabling the nations to trade among them-
selves at pre-determined rates at a free traded exchange market.
This chapter discusses about money markets, money market instru-

ments such as treasury bills, bills of exchange, promissory notes, com-
mercial papers and certificate of deposits. The chapter further covers
bill market in India and issues in the Indian money market. It also
explores the role of unorganised money market.
3.2 MONEY MARKET

Money market is an important component of the financial system of the
country wherein monetary assets (or financial assets which are close
substitutes of money) are traded in the market. It is a part of financial
market in which short-term loans are raised. The nature of the trading
is restricted to a period of less than one year. In other words, whatever
the borrowing and lending that takes place in the market it has to be

money market 47
n o t e s
closed within one year from its inception date. Money markets possess
the characteristics of high liquidity and low transactions cost.
Money market includes sundry institutions and agencies such as com-

mercial banks, savings institutions, investment houses, government,
etc. that operate in it, to facilitate the process of short-term lending
and borrowing.
The features of money market are discussed as follows:

The money market is wholesale market with large volumes of trad-
ing. In general the transactions are settled on day to day basis.
Trading in money market is conducted telephonically which is fol-
lowed by written confirmation from both the parties, i.e., borrow-
ers and lenders regarding the terms and conditions of the trading
deal and other associated issues which include the time period by
S
which the deal has to be closed. This time period has to be less
than a year.
The number of participants in the money market is large with the
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Reserve Bank of India carefully monitoring the various operations
of money market trading. The reserve bank ensures that liquidity
and the interest rates are maintained with respect to the objectives
of the money market, i.e., maintaining the interest rates as well as
the price of the monetary asset.
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3.2.1 INDIAN MONEY MARKET
In general, the structure of the Indian Money Market is divided into

two distinct components viz. organised money market, unorganised
money market and co-operative sector. Figure 3.1 provides the basic
N
structure of Indian Money market:
Indian Money Market
Organised money Unorganised Co-operative

market money market sector
RBI Indigenous State cooperative

banks
DFHI (Discount State Land
and Finance Development
Money lenders
House of India) Banks
Commercial
Nidhis
Banks
Development
Chits
Bank
Figure 3.1: Indian Money Market Structure

n o t e s
Let us discuss about the money market in India:

Organised money market: This market comprises various com-
mercial banks in India. Public sector, private sector and foreign
commercial banks are components of this organised money mar-
ket sector. The following are some of sub money markets of organ-
ised money sector:
Call money: This involves the process of borrowing or lending
the funds for a day.
Notice money: This involves the process of borrowing or lend-
ing of funds from 2 days to 14 days.
Term money: This involves the process of borrowing or lend-
ing of funds for a period of more than 14 days.
Interest rates in the sub money markets is determined by the mar-
S
ket dynamics, i.e., demand and supply of short-term funds. Also, in
the Indian context, 80% of the demand is received from the public
sector funds and the remaining 20% comes from the foreign sector
IM
and private sector banks. In the process of supply of funds around
80% of the funds are supplied by the financial institutions such as
IDBI, LIC and the like. Call Money is the most liquid money mar-
ket and is the prime driver of day to day interest rates in the mar-
ket. In case if the call money rates fall there is a rise in the liquidity
and if the call money rate increases, the liquidity falls.
M
Unorganised money market: This market comprises various mon-

ey lenders, chit funds, and other entities who have surplus amount
of money. Entities such as real estate builders, property dealers
having surplus money fall into this category. Examples of unorgan-
N
ised money markets in Indian context are Nidhi which is a form of

mutual benefit society. This type of money market is very popular
and widely operates in Southern India. In the case of Nidhi’s the
funds are given to members only at a very reasonable low rate. The
funds are accumulated by the contributions of the members only.
Nidhis are also the constituents of Non Banking Financial Compa-
ny (NBFC), which is under the ambit of RBI. Worth mentioning is
the fact that when it comes to unorganised money markets there
are certain advantages and disadvantages as compared to organ-
ised money markets. For example, the process of disbursing the
loan such as gold loan may be done within 3 minutes in unorgan-
ised money market whereas for the organised sector it may take
up to 10 days.
Table 3.1 shows the difference between the organised and unor-
ganised money market:

money market 49
n o t e s
Table 3.1: Difference between the Organised

Money Market and Unorganised Money
Market
Organised Money Market Unorganised Money Market
Organised money market finances Unorganised market finances
the short term needs of govern- the short-term financial needs of
ment and financial institutions. farmers and small businessmen.
RBI is active in organised money RBI is not active in the unorgan-
market. ised money market.
The institutions under organised The institutions under unorgan-
money market include the follow- ised money sector include the
ing: following:
zz Reserve Bank of India zz Moneylenders,
zz Private banks zz Indigenous bankers,
S
zz Public sector banks zz Unregulated Non-Bank Finan-
zz Development banks cial Intermediaries.
zz Non-Banking Financial Com-

IM
panies (NBFCs) such as Life
Insurance Corporation of In-
dia (LIC), the International Fi-
nance Corporation, IDBI, and
the co-operative sector.
The instruments under organised The instruments under unorgan-
money market include the follow- ised money market include the
M
ing: following:
zz Call and Notice Money Market zz Chit Funds
zz Treasury Bill Market (T – Bills) zz Nidhis
Commercial Bills
N
zz
zz Certificate Of Deposits (CDs)

zz Commercial Papers (CP)
zz Money Market Mutual Funds
Co-operative sector: Money market comprises state co-operatives
and state land development banks. In the case of state co-oper-
atives, central co-operative banks are participants in the money
market whereas in the case of state land development banks cen-
tralised development banks and primary land development banks
are the participants in the money markets.
3.2.2 INTERNATIONAL MONEY MARKETS
The international money market was introduced in the year 1971 and
was implemented in the year 1972. The primary purpose of formula-

n o t e s
tion of International Financial markets was the trading of currency

futures which was a new instrument to facilitate trading among the
nations. International money market was formulated to enable the
nations to trade among themselves at pre-determined rates at a free
traded exchange market. On an experimental basis the US dollar was
traded against the British Pound, Swiss Franc and other currencies of
the world.
However, there were certain challenges in adopting this approach viz.

how to link the interbank rate with the International Money Market.
The Continental Bank of Chicago was hired to act as a delivery agent
for the parties involved in the entire process. The success started a
sort of intense competition among the nations each vying for their
currency to be included as a part of international trading. Thus, with
the rise of the competition there was a desperate need to bring in the
transparency in the nature of the various transactions which were tak-
S
ing place across the globe. This transparency aspect was created with
the formulation of post market trade, currently known as Globex. This
post market trade was designed to facilitate global automatic transac-
IM
tion system to act as a single point for clearing and linking the world’s
financial trading centers such as Tokyo and London.
With the passage of time, the role of international money market also
changed from playing the role of facilitator to a profit making enti-
ty having shareholders and stakeholders. The trading at the Interna-
tional Markets begins at a fixed time wherein several central bankers,
M
multinational corporations, traders etc. borrow, lend and trade on the

various entities at the international markets.
Different nations may need foreign currencies while importing/export-

N
ing goods from/to other countries. Besides the foreign currency that is
needed for imports and exports, countries also need foreign exchange
for various other purposes. Firstly, the countries need funds denomi-
nated in foreign currency having a lower rate of interest, so that they
can take loans at a lower rate for their different needs and can easily
repay the loans, and secondly, the countries may consider borrowing
in a currency that will depreciate against their home currency, as they
would be able to repay the loan at a more favourable exchange rate.
Therefore, the actual cost of borrowing would be less than the interest
rate of the currency. Besides countries, there are some organisations
and institutional investors which also intend to invest in foreign cur-
rency rather than in their home currency. Firstly, the interest rate they
earn from investing in their home currency may be lower than what
they can gain on short-term investments denominated in some other
currencies.
New York Money Market
New York money market is an international money market where-

in national and international surplus funds operate to seek short run

money market 51
n o t e s
investments and borrowing takes place. The New York International

Money Market is one of the biggest financial center in the world. In
US, there are basically two types of money markets viz. Federal mar-
ket and Call money market.
The federal funds market transaction is any transaction which takes
place between the lenders and borrowers of banks deposits at Feder-
al Reserve Banks at a specified rate of interest. The prime purpose
of various transactions in this market is to adjust or balance out the
reserves or excess of funds to the supply of funds to the needs of the
market with the centralised banking system. The Federal funds mar-
ket provide the maximum flexibility so as to adjust the reserve posi-
tions or requirements of the banks stipulations.
Call money market is the market which is used to perform a specific
and different function. The call loans are the short-term loans which
S
are used by the banks to lend the funds to security brokers and deal-
ers for the purpose of financing their customer’s purchases of stock in
the generalised or the common category. Call loans are secured loans
IM
and can be called off within a day’s notice.
UK Money Market
In UK, the money market comprises components viz. clearing banks,

inter banks, and discount houses where mobilisations of surplus funds
take place among themselves before they approach the banks for fi-
M
nancial assistance.
Clearing banks in UK provide loans to the various discount houses on
call basis. These loans are in general secured loans against treasury
bills or other bills of exchange. These loans are highly liquid due to the
N
fact that they can be repaid whenever demanded and moreover the
discount houses have an access to the Bank of England and if needed
this bank provides assurance to security of the loan. Hence, these al-
low to balance their excess funds with the deficit funds in the process
and allow them to maintain their reserve balance.
Thus, there is a marked difference between the UK and US money
market in the sense that in US the transactions are between banks
while in the UK the transactions are between the banks and the dis-
count houses.
InterBank Call Money Market is the market wherein the borrowing
and lending takes place among banks such as merchant banks, Scot-
tish banks, foreign banks, all of which are outside the purview of the
commercial banks of UK. The clearing banks do not participate in this
market.
Euro Money Market
Euro money market is a market that includes all the European Union
Member Countries which use the currency, the Euro. The European

n o t e s
Central Bank is the main central bank of the Euro market. This mar-
ket is also called common bank.
The euro money market consists of unsecured euro money market,
secured euro money market, short-term securities market and over
the counter derivatives market.
In addition to the above, the euro money market comprises the follow-
ing products:
Short-term deposits
Repos swaps
Eonia swaps
Foreign swaps
The following are some of the features of euro money market which
S
have been witnessed in the recent years due to changing market dy-
namics across the globe:
The increased usage of electronic transactions has become more
IM
and more screen based. This is due to the fact that the nations
have realised the importance in terms of transparency of dealings,
cost savings and the other issues related to electronic transactions.
Further, some players are sharing more than one platform even
this may affect the fragmentation of global liquidity. This may be
explained on the basis that some participants do not want to post
M
their information on a single platform as it may reveal their trans-

action patterns.
The euro money market is characterised by increasing importance
of indexation to one specific reference interest rate commonly
N
known as Euro overnight Index average (EONIA). This is mostly

marked in the interest rate swap market wherein few of the major
participants put the functioning of the cash market at a huge risk
due to indexation issues.
1. Money markets possesses the characteristics of high liquidity

and low transactions costs. (True/False)
2. _______________ market includes sundry institutions and
agencies such as commercial banks, savings institutions,
investment houses, government, etc.
3. What are the components of organised money market sector?
Activity
Research about various other money markets in the world. Prepare

a report on your findings.

money market 53
n o t e s
3.3 MONEY MARKET INSTRUMENTS

Instruments which are traded in the money markets are known as
money market instruments. Each of these instruments have a face
value which represents the amount of money that is depicted on the
instrument. In addition to the face value depicted on the instrument,
there is another value which is known as issue price. This represents
that the lender is willing to sell the instrument to the borrower at the
lower price of the face value. The difference between the issue prices
and the face value is the interest component which is also known as
the discount.
Let us discuss the money market instruments in detail.
3.3.1 TREASURY BILLS
S
Treasury bills are the government securities that are issued to raise
fund for financing short-term government projects. Treasury bills are
issued by the Reserve Bank of India to raise funds for the government.
IM
These are issued as a promissory note at a discounted price. Further,
as mentioned above the difference between the issue price and the
redemption price is the interest. The yield in the case of treasury bill
is assured yield and the risk of default is almost zero or negligible.
Treasury bills are issued as T-91 or T-182 or T-364. The ‘T’ represents
the treasury bill while the number represents the number of days of
M
maturity. Reserve Bank of India issues only T-91 Day and T-364 Day
Treasury Bills. Also, treasury bills are transferable by proper endorse-
ments. Treasury bills are issued at a discounted price and are later re-
deemed at their face value like the other money market instruments.
N
T-Bills are of two types, namely, regular and ad hoc bills. The regular
T-bills are sold to the general public and the various banks. The ad hoc
bills are issued by the state government, semi-governments and other
government agencies for temporary investment as they are not sold to
the general public and banks. As of late, ad hoc bills were abolished in
the year 1997.
3.3.2 BILLS OF EXCHANGE
According to the Negotiable Instrument Act, A bill of exchange is de-

fined as a written unconditional order wherein the drawee orders the
payment of certain money to the another person known as drawee or
to the holder of the instrument.
There are three parties to a bill of exchange as under:

a. Drawer: The person who draws a bill of exchange.
b. Drawee: The person on whom the bill of exchange is drawn. He
is also called as an acceptor of the bill.

n o t e s
c. Payee: The person named in the instrument to whom or to whose

order the money is directed to be paid by the instrument.
There are various types of bills of exchange. Some of them are as

follows:
Inland bill: These are the bills which are drawn in India on a per-
son residing in India whether it is payable in India or outside India.
For example, a bill drawn by a merchant in Delhi on a merchant in
Chennai. It is payable in Bengaluru.
Foreign bill: It is the bill which is not an inland bill. This bill is
drawn in one country and payable in another.
Trade bill: This is the bill which is drawn and accepted for a gen-
uine trade transaction.
Accommodation bill: This is the bill which is drawn and accepted
S
but it is not backed up by genuine transactions in trade. In this bill,
no consideration is given by drawer to the acceptor for purpose of
accommodating some other party who is to use it and expected to
IM
pay it when due. The party accommodating it is called the “accom-
modation party” and the party that is accommodated is called the
“accommodated party”.
3.3.3 PROMISSORY NOTES

M
A promissory note is a financial instrument or a money market instru-

ment wherein one party (known as the issuer or the maker) promises
to pay in writing a certain sum of money to another person (usually
the bearer of the instrument) at a future date under specific terms. An
example of a promissory note is the bank note or the currency note
N
through which we purchase goods and services.
The following are the features of promissory notes:

The promissory note is always a written instrument
The promissory note is signed by the maker
The promissory note is an unconditional instrument. In case the
instrument is conditional then it is not promissory note
The promissory note is either payable on demand or at a fixed pe-
riod time
The amount mentioned in the promissory note is certain and definite
The promissory note may be made by more than one person who
are then required to pay the amount of money jointly
3.3.4 COMMERCIAL PAPERS
Commercial papers in essence are unsecured financial instruments

of the money markets. These are issued by larger corporate houses in

money market 55
n o t e s
the form of promissory notes and their duration is very short. Com-
mercial papers are issued by well-reputed organisations that carry
high credit ratings. It is regulated by the guidelines issued by RBI on
October 10, 2000. In money market, commercial paper is a negotiable
instrument with a fixed maturity of 1 to 270 days. It is sold and pur-
chased at discounted price and has higher interest payment rate as
compared to bonds.
As commercial papers are issued by large corporate houses there are

certain terms and conditions on the basis of which they can issue com-
mercial papers. The conditions are as follows:
The company issuing the commercial paper must have net worth
of ` 4 crores as well as working capital to the tune of ` 4 crores too.
The company should have the minimum rating of P2 or A2 or PR2
S
from Credit rating information services of India or ICRA or CARE
or from any other credit rating agency as specified by Reserve
Bank of India from time to time
IM
The said rating should not be more than 2 months old on the date
of issue of CP
In addition to the above the company can issue commercial papers of

varying maturity periods of 7 days to 12 months from the date of issue.
Financial institutions are an exception to this rule in the sense that
M
they can issue certificate of deposit for a period not less than 1 year
and not exceeding 3 years.
3.3.5 CERTIFICATE OF DEPOSITS
N
Certificate of deposits are negotiable financial instruments which

have a term based maturity value. These are short-term promissory
notes having a maturity period of not less than three months and not
more than one year. The various banks offer interest on certificate of
deposits at the prevailing market rates. There is a sharp distinction
between fixed deposit of the commercial banks and certificate of de-
posits. While the fixed deposits are non-transferable, the certificate
of deposits are transferable and therefore they can be traded in the
secondary market.
Certificate of deposit can be used at a discount price on the face value

of the certificate deposit. The discount may be either at the front end
or rear end. In case the discount is at the front end the effective rate of
discount is more than the quoted rate whereas in the case of rear end
the rate of discount is lower than the quoted price.
Also, there is no lock in period for Certificate of Deposits. Therefore,

the banks on the other hand cannot grant loans on the basis of certif-
icate of deposits.

n o t e s
4. Treasury bills are issued by the Reserve Bank of India.

(True/False)
5. ____________ is the person on whom the bill of exchange is
drawn.
6. ________________ are issued by larger corporate houses in the
form of promissory notes and their duration is very short.
7. _________________ is the bill which is drawn and accepted but
it is not backed up by genuine transactions in trade.
Activity
S
Research about various other instruments of money markets. Pre-
pare a report on your findings.
IM
3.4 BILL MARKET IN INDIA
The segment of the money market whereby the transactions of bills
take place is called bill market. The players of bill market comprise
various commercial banks, discount houses and brokers. Various
kinds of bills can be transacted in the market that includes Bills of
Exchange or Commercial Bills or Treasury Bills. The bill market has
M
strived to make an important place in the money market segment on

account of the following reasons. As already discussed, the Commer-
cial Bills or Bills of Exchange carries a promise for making payment of
a specified amount by a particular firm or the government.
N
Following are the composition of the bill market:

Commercial bills are considered as an important source of avail-
ing finance for the firms. The firms use commercial bill for buying
and selling of materials. It helps in maintaining the comparatively
less quantum of liquid resources for making various payments.
The surplus funds with the commercial banks are usually invested
by them in commercial bills. Commercial banks prefer to do this
because of the short-term duration of the commercial bills. In a
return they earn interest income on their surplus funds.
One of the major functions of RBI is controlling credit in the econ-
omy. This becomes possible with the help of the bill market. The
monetary policy of RBI largely depends on the volume of credit
that is controlled by the bill market.
The enhanced importance of the bill market has made it necessary for
the RBI to govern it with more efforts. Therefore, the Reserve Bank
adopted for the two bill market schemes that are as follows:

money market 57
n o t e s
Bill Market Scheme, 1952
Initially, a Bill Market Scheme was implemented by The Reserve

Bank in January 1952. This scheme allowed Scheduled Banks to avail
demand loans against their promissory notes. These promissory notes
were supported by the security of bills having maturity of 90 days or
less. These promissory notes were lodged as collateral for taking ad-
vance from the banks from the Reserve Bank of India.
Not a big difference was created by this scheme as the amount bor-
rowed by banks under this scheme used to be a small proportion of
their borrowings taken from the RBI. It was observed that this scheme
was not contributing significantly in the development of the bill mar-
ket. According to the Banking Commission, the Bill Market Scheme of
1952 was primarily a scheme for accommodation of banks, the scheme
did not bother to develop a market in genuine bills.
S
New Bill Market Scheme, 1970
IM
The failure of the Bill Market Scheme, 1952 raised a need for another
scheme for developing the bill market of India. Therefore, a New Bill
Market Scheme was implemented by the RBI in November 1970. Fol-
lowing are the main features of the New Scheme:
a. The genuine trade bill would be covered under the scheme.
Genuine bills refer that the bill is supported by the evidence of
M
sale or dispatch of goods.

b. The scheme was also known as Bills Rediscounting Scheme as
this scheme made the rediscounting of these bills by the RBI
mandatory.
N
The second scheme was an improvement over the previous scheme.

The New Bill Market Scheme, 1970 made a successful attempt in in-
tegrating the credit structure of the country so that the monetary con-
trol can take place in an effective manner.
8. Bill Market Scheme, 1952 allowed Scheduled Banks to avail

demand loans against their promissory notes. (True/False)
9. New Bill Market Scheme, 1970 is also known as _______.
Activity
With the help of the Internet, find information on the various schemes
of bill market run under the following developing countries:
1. Pakistan 2. Sri Lanka
3. Bangladesh 4. China
Analyse which of them is having the most developed bill market.

n o t e s
3.5 ISSUES IN INDIAN MONEY MARKET

Every economy has its money market for meeting the short-term re-
quirements of the funds. The difference among these various money
markets depends on the development of the respective country and
Indian money market is not an exception to it.
Following are the issues pertaining to the Indian money market:

Dichotomous structure: The Indian money market is divided into
two segments viz. organised money market and the unorganised
money market. The organised money market is under the ambit
of Reserve Bank of India while the unorganised money market
is under the control of money lenders and other individuals who
have surplus funds. These entities are responsible for bringing in
several issues wherein the borrower is at a great disadvantage as
S
compared to organised money market.
Multiplicity of interest rates: The Indian money market is char-
acterised by the different level of interest rates. The interest rate
IM
differs from bank to bank, from period to period and even from
borrower to borrower. In addition, the interest rate offered by the
organised and unorganised segment also differs.
Lack of organised bill market: Bill market is one of the important
segments of the money market. Even after the introduction of new
scheme in 1970, the establishment of the the organised bill market
M
was not obtained by the Indian economy.

Lack of integration: The Indian money market comprises a wide
range of the products that are offered by the organised and unor-
ganised sector of the money market. The organised sector is con-
N
trolled by RBI but the uncordinated moves of the organised mon-

ey market are difficult to conrol.
High volatility in call money market: The call money market is
one of the most volatile segment of the Indian money market. The
call money is characterised by the maturity in the very short peri-
od that is of few hours.
Limited instruments: As compared to developed economy’s mon-
ey market the Indian money market comprises comaparatively
less number of the financial instruments. Every investor comes
with a different requirement that must be catered by different fi-
nancial instruments.
Lack of organised banking system: Indian banking sector is one
of the emerging economic sector of the country. But there are lots
of issues faced by Indian banking system as well that includes Non
Performing Asset (NPA) and lack of efficiency. These weaknesses
of the Indian banking system add on the issues for the Indian mon-
ey market.

money market 59
n o t e s
10. The call money is charecterised by the maturity in the very

__________ period that is of few hours.
Activity
With the help of the Internet find the information and analyse why the
multiplicity of the interest rate occurs in the Indian money market.
3.6 UNORGANISED MONEY MARKET IN INDIA

As mentioned above, the Indian money market is divided into two seg-
ments viz. organised and unorganised segments. While the organised
segment is under the ambit of Reserve Bank of India the unorganised
S
segment of the money market is under the ambit of indigenous banks
and influential entities having surplus funds to lend.
IM
The following are the main components of the unorganised Indian
money market.
Indigenous banks: These are the bankers who are individual en-
tities or private firms who receive deposits and provide loans. The
deposits and advances operations of these banks are completely
unsupervised and unregulated by any authorised agency. Over the
passage of time their importance has declined considerably due to
M
growth of organised money market.

Money lenders: The money lenders are popular in both the urban
and non urban areas of the country. The interest charged by these
entities is generally very high. With the passage of time their im-
N
portance has gone down considerably due to the fact that organ-
ised banking is able to provide the loan at a much cheaper rate.
Still the unprivileged section of the society prefers these sources to
avail finance because they provide funds on reasonable term that
includes less amount of paper work.
Non-Banking Finance Companies: Non-banking financial com-
panies (NBFCs) refer to those entities that are not banks yet they
demonstrate the capabilities of banking. They comprise privately
owned and decentralised intermediaries. NBFCs have emerged
as a vital part of the Indian financial system by serving the credit
requirements of the unorganised sector such as wholesale and re-
tail traders, small-scale industries and small local borrowers. The
examples of NBFCs include equipment leasing company, hire pur-
chase finance company and chit fund company.
11. ______ refer to those entities that are not banks yet they
demonstrate the capabilities of banking. They comprise
privately owned and decentralised intermediaries.

n o t e s
Activity
With the help of the various sources, find information of the top five
NBFCs of India and comment how does their functioning is differ-
ent from the banking organisation.
3.7 SUMMARY
Money market is an important component of the financial system
of the country wherein monetary assets (or financial assets which
are close substitutes of money) are traded in the market.
Money market includes sundry institutions and agencies such as
commercial banks, savings institutions, investment houses, gov-
ernment, etc. that operate in it, to facilitate the process of short-
term lending and borrowing.
S
Instruments which are traded in the money markets are known
as money market instruments. Each of these instruments have a
face value which represents the amount of money that is depicted
IM
on the instrument. Money market instruments include Treasury
Bills, Bills of Exchange, Promissory Notes, Commercial Papers
and Certificate of Deposits.
The segment of the money market whereby the transactions of
bills take place is called bill market.
M
The Reserve Bank adopted for the two bill market schemes that in-
cludes Bill Market Scheme, 1952 and New Bill Market Scheme, 1970.
Issues in Indian Money Market include dichotomous structure,
multiplicity of interest rates, lack of organised bill market and lack
N
of integration.
The main components of unorganised money market in India in-
clude indigenous banks, money lenders and non-banking finance
companies.
key words
Chit fund company: It operates on the basis of agreement that

binds each member to pay instalments of a fixed amount for a
certain time period. As a reward, every member gets benefitted
with a monetary reward declared by auction or random selection
in the end.
Equipment leasing company: It is a company that provides
funds for purchasing industrial equipment on lease. These com-
panies raise funds from the deposits of other companies, banks
and financial institutions.
Hire purchase finance company: It is a company that provides
funds to borrowers. These funds are paid by borrowers within a
fixed time in the form of instalments.

money market 61
n o t e s
Non-transferable: It refers to an object/security/asset that is

unable to get transferred or made over to the possession of an-
other person.
Secondary market: It refers to a market whereby the selling
and buying transitions of the existing securities take place.

1. What do you mean by Indian money market? Explain the
structure of Indian money market.
2. Describe the money market instruments in detail.
3. Write a short note on bill market in India.
4. What challenges can be seen in the Indian Money market.
S
IM
Topic Q. No. Answer

Money Market 1. True
2. Money
3. Public sector, private sector
M
and foreign commercial banks

are components of this organ-
ised money market sector.
Money Market Instruments 4. True
N
5. Drawee
6. Commercial Papers
7. Accommodation Bill
Bill Market in India 8. True
9. Bills Rediscounting Scheme.
10. Short
11. Non-banking Financial Com-
panies (NBFCs)

1. Money market is a part of financial market in which short-term
loans are raised. Refer to Section 3.2 Money Market.
2. Instruments which are traded in the money markets are known
as money market instruments. Refer to Section 3.3 Money
Market Instruments.
3. The segment of the money market whereby the transactions
of bills take place is called bill market. Refer to Section 3.4 Bill
Market in India.

n o t e s
4. The Indian money market is followed by the various issues such

as dichotomous structure, multiplicity of interest rates and lack
of organised bill market. Refer to Section 3.5 Issues in Indian
Money Market.
Suggested Readings for

3.10
Reference
SUGGESTED READINGS
Bhole, L.M., Jitendra, (2015), Financial Institutions and Markets,
Structure, Growth and Innovations, McGraw Hill Publishing Com-
pany Limited.
Pathak, B. (2008). The Indian Financial System (3rd Ed.). New Del-
S
E-REFERENCES
IM
Imf.org,. (2015). Finance & Development, June 2012 - Back to Ba-
sics: What Are Money Markets?. Retrieved 1 December 2015, from
http://www.imf.org/external/pubs/ft/fandd/2012/06/basics.htm
Inc.com,. (2015). Money Market Instruments. Retrieved 1 Decem-
ber 2015, from http://www.inc.com/encyclopedia/money-mar-
ket-instruments.html
M
The Economic Times,. (2015). Money Market Definition | Money

Market Meaning - The Economic Times. Retrieved 1 December
2015, from http://economictimes.indiatimes.com/definition/mon-
ey-market
N

Ch a
4 p t e r
capital market
CONTENTS
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4.1 Introduction
4.2 Capital Market
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4.2.1 Roles of Capital Market
4.2.2 Composition and Structure of Indian Capital Market
4.2.3 Scams and Reforms in the Indian Capital Market
Activity
4.3 Capital Market Instruments
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Activity
4.4 Capital Market Regulation
4.4.1 Control of Capital Issues
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4.4.2 Securities and Exchange Board of India

4.4.3 Securities Contracts (Regulation) Act, 1956
4.4.4 Monopolies and Restrictive Trade Practices (MRTP) Act, 1969
4.4.5 Foreign Exchange Regulation Act (FERA), 1973
4.4.6 Foreign Exchange Management Act (FEMA), 1999
Activity
4.5 Summary

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CAPITAL MARKET SCAMS AND MEASURES TAKEN BY SEBI
(Source: www.asian-news-channel.tv)
Sir Winston Churchill had once famously remarked that an opti-

mist sees opportunity in every difficulty. The same can be said for
the Securities and Exchange Board of India (SEBI), which was
established on 12 April 1992 and is headquartered at Mumbai.
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SEBI is the chief regulator for the securities market in India. It
has recently enhanced its mechanisms after facing some severe
capital market scams.
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Within a few weeks of the establishment of SEBI, a securities
market scam perpetrated by the late Indian stockbroker Harshad
Mehta affected Dalal Street, the location of the Bombay Stock Ex-
change and several premier financial firms. This led to the intro-
duction of several regulatory changes in primary and secondary
markets. The need of restricting insider trading and making it a
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criminal offence was also felt.
During 1999-2001, the country’s capital market was majorly af-

fected by the Ketan Parekh Scam. Ketan Parekh, a former Mum-
bai-based stockbroker, was involved in the stock market manip-
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ulation scam and is since debarred from trading in Indian stock

exchanges till 2017. After this scam surfaced, SEBI entirely dis-
carded account settlement, and rolling settlement was intro-
duced. In addition, forward trading was officially introduced in
the form of exchange-traded derivatives. Moreover, short selling
in spot markets was banned.
Another learning curve for SEBI was the Initial Public Offering
(IPO) Scam, 2005. The result of this scam was further tightening
of the implementation of Know Your Customer (KYC) norms and
ensuring that Permanent Account Number (PAN) card is made
compulsory for all the categories of investors.
Recently, a report published by the International Organisation of

Securities Commissions (IOSCO) under its Financial Sector As-
sessment Programme (FSAP) recognised that the comprehensive
risk management framework approved by SEBI is one of the pil-
lars of the Indian securities settlement system. As per the report
further, the Indian capital market’s regulator has been effective in

capital market 65
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preventing any key defaults in the last decade. SEBI has accept-
ed the recommendations in the report and agreed that it must
emphasise more on strengthening the regulation of securities
market intermediaries including fund managers. Moreover, SEBI
has focussed on enhancing the liquidity risk management. With
an appropriate legal support, SEBI also intends to enhance the
clearing and settlement process by resolving the issues of finality
and netting at the level of law.
(Source: http://newsonair.com/SEBI-A-CREDBLE-AND-EFFECTIVE-
REGULATOR.asp)
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learning objectives

>> Describe the concept of capital market
>> Explain about various capital market instruments
>> Discuss various regulations in the capital market
4.1 INTRODUCTION
In the previous chapter, you studied about money markets and their
instruments like treasury bills, promissory notes, commercial papers,
etc. You also studied about the bill market of India, issues in the In-
dian money market and unorganised money markets in India. This
chapter will focus on the capital market.
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The financial markets of a country cannot survive only through mon-
ey markets, that is, short-term trading cycles. They also need long-
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term trading cycles, the need for which is fulfilled by capital mar-
kets. Capital markets help in addressing the needs of individuals,
small investors, etc. They stand in sharp contrast to money markets,
which involve large corporate houses or entities, having an excess of
surplus funds.
Capital market is a market where buyers and sellers participate in

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the trading of financial securities like bonds, stocks, etc. The buy-
ing or selling activities are conducted by individuals and institu-
tions both. Capital markets help channelise excess funds from sav-
ers to institutions, which are then invested for productive use.
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The capital market comprises primary markets and secondary mar-

kets. Primary markets involve trading of new issues of stocks and oth-
er securities, whereas secondary markets involve exchange of current
or previously-issued securities. Further, the capital market can be
classified depending upon the nature of the securities traded in equity
markets and debt markets.
Capital markets also need to be regulated and monitored effectively to

prevent scams, unethical practices, fraudulent activities, etc. In India,
for example, the capital market is regularised by SEBI and through
various acts like the Securities Contracts (Regulation) Act, 1956, Mo-
nopolies and Restrictive Trade Practices (MRTP) Act, 1969.
In this chapter, you learn about the role of capital markets. Further,
you learn about various capital market instruments. Towards the end
of the chapter, you learn about capital market regulations.

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4.2 capital market

Capital market refers to that part of the financial market where the
buying and selling of long-term equity and debt securities take place.
It provides a platform whereon a small investor stands to gain good
returns on his/her money invested in the market.
Financial instruments, equity, debt, etc., in particular, are issued to in-

vestors, and the money collected is invested in the assets of capital na-
ture such as machinery, land and other forms of capital. Thus, a capi-
tal instrument, such as an equity, bond or debenture, is different from
revenue instruments such a Commercial Paper (CP) or Certificate of
Deposit (COD). It is so because companies use revenue instruments
to meet their short-term requirements such as paying to suppliers or
paying salaries, whereas capital market instruments, such as equity,
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are issued to meet long-term requirements such as setting up of new
production units or modernisation of the existing facilities.
4.2.1 roleS of capital market

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The capital market is an important segment of the financial market
because it helps in pooling and attracting investments from various
sources and diverts them towards long-term productive use. The roles
of a capital market can be explained as follows:
It plays a crucial role in providing financial assistance to sick units
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and other non-performing assets of a country.

Itassists a country in promoting its industrial growth. It is so be-
cause capital market investments provide growth impetus to vari-
ous industries as investors are motivated to invest their money in
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potential industries or companies. For example, investors put their

money in IT companies in the hope of getting better returns be-
cause, historically, the IT industry has demonstrated its potential.
It provides assistance in the mobilisation of foreign capital. For
example, Indian companies are able to generate capital funds from
foreign markets through bonds, equity and various other securi-
ties as the Indian government has liberalised the Foreign Direct
Investment (FDI) sector in the country. Due to this initiative, for-
eign capital is brought into the country along with new and ad-
vanced technologies, which results in economic growth providing
thrust for the development of the country.
Itis quite liquid, i.e., investors can liquidate all or part of their eq-
uity as per their needs. They may also liquidate foreseeing market
conditions. This helps them to plan their finances.

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It enables regulators in framing various policies that would assist

stakeholders in managing resources effectively and efficiently.
This is necessary to ensure that provisions are made for dealing
with various gaps and unethical practices, which arise or have be-
come part of trading practices and mechanism.
It provides assistance in the mobilisation of the savings that are
lying idle with banks. These monies can be deployed to generate
greater returns for investors and consequently act as a catalyst for
the development of an economy.
It ensures continuous availability of funds. As capital markets are
meant for long-term investments, there is a continuous supply of
funds for both the buyer and the seller.
It indirectly leads to the generation of various associated avenues/
career options such as consultancy services. Consultancy services
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means that an individual or a company assists investors in parking
their excess funds in the shares or equities of various companies.
It is responsible for the development of backward areas of a coun-
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try because some funds are also deployed in the setting up of vari-
ous production units or companies in the rural areas of the country.
4.2.2 Composition and Structure of Indian

Capital Market
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Every market has a unique structure and different types of market

participants specific to it. Similarly, capital markets also differ with
a distinctive structure and composition. The Indian capital market is
basically divided into two parts viz. primary market and secondary
market. The classification of markets is done on the basis of the nature
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of the financial instruments that are traded in a particular market.

Whenever a new company wants to introduce its financial instruments
such as equity and debentures in a capital market, it introduces them
in the primary market. It means that the market in which financial in-
struments are introduced for the first time is the primary market. The
primary market is also known as the new issues market. On the other
hand, the trade of financial instruments that have already been in-
troduced in the primary market takes place in the secondary market.
Therefore, the secondary market is the market for successive buying
and selling of financial instruments that have been bought and/or sold
before. This market is also called the old issues market. For example,
a new company wants to issue equity shares to general public through
its Initial Public Offering (IPO). The market in which these shares are
introduced for the first time and bought by investors will be the pri-
mary market. Let us assume that Mr. A bought 100 shares of this com-
pany during the IPO. Now, he places an order for selling these stocks
with his broker. Such selling will be done in the secondary market.
Another type of classification is done on the basis of the types of insti-

tutions present in the capital market.

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This classification is shown in Figure 4.1:
India Capital market
Government Industrial Securities Development Financial

Securities Market Financial Intermediaries
Institutions
New Issues Old Issues
Market Market
IFCI ICICI SFCs IDBI IIBI UTI
Merchant Mutual Leasing Venture Capital Others

Banks Funds Companies Companies
Figure 4.1: Classification of the Capital Market on

the Basis of Institutions
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This classification is explained in detail as follows:
1. Government securities market: Apart from the private sector, the
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government also issues some bonds and other securities known
as ‘gilt-edged securities’ or market instruments. The market
in which these gilt securities are traded is called government
securities market. This market is regulated and controlled by the
Reserve Bank of India (RBI).
2. Industrial securities market: The private sector issues securities
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such as equity shares and debentures in the market known as

industrial securities market. Industrial securities including both
new and old securities are traded in this market. This market is
divided into new issues and old issues markets.
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3. Development Financial Institutions (DFIs): DFIs are another

component of the capital market, including various financial
institutions that work for the development of a country by
providing finance to development projects. Major DFIs in India
are ICICI, IFCI, IDBI, UTI, etc.
4. Financial intermediaries: The capital market also comprises
various financial intermediaries such as mutual funds, merchant
banking firms and banks, venture capitalists, insurance
companies, etc.
4.2.3 Scams and reforms in the Indian Capital

Market
The capital market in India was present in an unorganised form until

the end of 19th century. During that time, India was not independent
and the securities of the East India Company were traded. Howev-
er, the market got its first formal component in the form of Bombay
Stock Exchange, which was recognised in May 1927. From that time
until today, the Indian capital market has undergone various chang-

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es and grown into a market that is accessible to almost every citizen

of India and is quite technology-oriented. The Indian capital market
keeps an important position among the capital markets of the world,
specifically among the emerging market economies. However, there is
still an absence of three important factors, namely adequate supervi-
sion, accountability and appropriate punishment in the Indian capital
market.
The present form of the capital market has been achieved through
successful implementation of various controls and regulations over a
period of time. However, a lot of scams have also taken place in the
capital market during this time period. Each scam necessitated the
exercising of better control and regulation mechanisms over the Indi-
an capital market.
Some of the scams that have been recorded in the capital market of
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India are as follows:
Securities Scam, 1992: This was the first financial scandal regis-
tered in the Indian capital market. This scam brought into focus
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the absence of adequate and necessary regulations and control in
the Indian capital market. Huge sums of money from banks were
made to move in and out of brokers’ bank accounts without any
restrictions. For investigating such scams, a special court was set
up and about 70 cases were registered by the Central Bureau of
Investigation (CBI). However, not even one individual was convict-
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ed. The negligence of RBI was also a reason behind the scam as it
intentionally did not take any action even in the presence of super-
vision reports that showed inconsistency.
IPO Bubble Scam: This was another scam in which various mar-
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ket players devised mechanism to bypass the regulations and con-

trols that were implemented after the Scam of 1992. In this scam,
the existing companies had raised equity at huge premiums to raise
funds for new projects. Most of these projects did not take off or
were not growing as expected. Also, some individuals and entities
such as chartered accountants, small traders and businessmen tied
up with investment bankers to float new companies and raise new
funds through IPO (this was the historic case of vanishing compa-
nies). The scam lasted for three years, from 1993 to 1996, when in-
vestors understood that they were being duped. Due to this scam,
the primary market remained almost dead till the early 1999.
Preferential Allotment Scam: In this scam, the companies de-
vised means to allot shares to themselves on preference basis at
heavy discounts as compared to the market prices. Companies
such as Colgate and Castrol started this trend. SEBI discovered
this scam and put in various controls to streamline the processes.
This scam was worth ` 5000 crores.

capital market 71
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Plantation Companies’ Puffery Scam: In this scam, companies

followed a strategy similar to the strategy adopted by vanishing
companies. The investors were promised returns as high as 1000%.
These companies introduced themselves as part IPO and part mu-
tual fund companies. They ran extensive television ad campaigns
and full-page advertisements to dupe investors. However, due to
the absence of any regulations or controls, these companies ceased
to exist and hence all the money of the investors was wasted, but
these companies made huge money.
note
Vanishing companies are those companies which raised funds from

public through initial public offers (IPOs) and subsequently failed, in-
ter-alia, to comply with the listing/ filing requirements of Registrar of
Companies (ROC) and the stock exchanges for a period of two years
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and were not found at their registered office address at the time of
inspection done by authorities / Stock Exchange.
(Source: http://www.arthapedia.in/)
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Some other important scams in the Indian capital market include C R
Bhansali Scam, Mutual Funds Disaster, Satyam Scam, etc.
REFORMS IN THE CAPITAL MARKET

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We discussed some of the major scams in the history of the capital

market in India. These scams have forced the authorities to bring in
reforms in the market from time to time. The various reforms and
measures have been implemented in this segment to regulate it and
leave little or no room for scams. These reforms can be categorised
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as primary capital market reforms and secondary capital market re-

forms. Some of the important primary capital market reforms include
the following:
Setting up of Securities Exchange Board of India (SEBI): SEBI
was set up in 1988 and given statutory status in 1992. This was
a major reform in the capital market. SEBI was entrusted with
the powers to regulate trading in stock exchanges. It was provided
with immense powers to ensure that the confidence of investors is
maintained and that companies, brokers and other entities do not
carry out any unethical practices in order to avoid any scams.
Diversification of primary market infrastructure: This was an-
other reform that involved the setting up of a large number of mer-
chant banks, investment banks and various consulting agencies.
They were responsible for educating investors and maintaining
their confidence by assisting them in the planning and utilisation
of surplus funds.

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Institutionalisation of the market: This was achieved by setting

up various institutions such as stock exchanges, depositories,
SEBI, etc.
Withdrawal of requirements to issue shares at par value of ` 10
and ` 100: Earlier, companies were required to issue shares with
the face value of ` 10 or ` 100 only. Shares with any other face value
could not be issued. However, this requirement was withdrawn.
Allowing foreign investments: Foreign investors were allowed to
invest in the financial markets (capital as well as money markets)
and hence to invest in government securities and treasury bills,
and equity.
Allowing Indian companies to raise foreign funds: Indian com-
panies have now been allowed to raise funds from international
capital markets by issuing American and Global Depository Re-
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ceipts (ADRs, GDRs).
Information disclosure: Another reform was introduced that ne-
cessitated that the companies disclose all the information includ-
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ing the risk factors and other details of their projects to investors
along with IPO.
Establishment of code of conduct: Investment companies, es-
pecially mutual fund companies, must not disclose any informa-
tion that could mislead or provide false information to investors
through advertisements or any public announcements.
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SEBI’s DIP: SEBI’s DIP (Disclosure and Investor Protection)

Guidelines were introduced in 2000 and amended in 2005-06.
Dematerialisation of shares: Now, the shares of companies can be
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bought and sold only in demat form (electronically). Paper-based

trading has been eliminated.
Minimum prescribed shareholding: SEBI has prescribed that
at least 25% of the total shares of a company must be floated on
a stock exchange for the company to stay listed on the stock ex-
change (as per the listing requirements).
Allotment of shares on proportionate basis: This reform neces-
sitated that shares be allotted on the basis of the proportion of the
money invested by investors.
Setting up of Electronic Clearing System (ECS): ECS was intro-
duced for trading processes. It was designed to ensure faster clear-
ing of refunds to be made in respect of public issues.
Allowing buy-back of shares: Companies were allowed to buy
back their own shares under certain conditions.

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Some of the important secondary capital market reforms include the

following:
In1995, the open outcry trading system was replaced by screen-
based trading.
Over-the-Counter Exchange of India (OTCEI) was established in
1992, National Stock Exchange (NSE) in 1994 and Interconnected
Stock Exchange (ISE) in 1999.
The T+5 rolling settlement system was adopted in 1998 and was
revised to T+3 system in 2002.
The badla system of trading was banned in 1994. It was later al-
lowed in 1996, but this time, safeguards measures were attached
with this system on the recommendations made by the Patel Com-
mittee (1995) and Varma Committee (1996). However, badla was
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again banned in 2001 after the Scam of March 2001.
The corporate governance programme was introduced to protect
the interest of investors. The K R Managalam Birla Committee
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was constituted to provide recommendations on corporate gover-
nance in India.
SEBI has been authorised to regulate stock exchanges, brokers
and sub-brokers.
Derivatives trading was introduced in 2000 when futures were al-
lowed to be traded on stock exchanges.
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It is necessary for all brokers to provide information regarding

block deals.

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1. A capital market plays a crucial role in providing financial

assistance to sick units. (True/False)
2. The Indian capital market is principally divided into two
parts, namely ______ and ______.
3. A new company wants to issue its equity shares to general
public. The shares of the company will be introduced in the
______________ market.
4. List the four segments of the capital market.
5. In this scam, companies followed a strategy similar to the
strategy adopted by vanishing companies. The investors were
promised returns as high as 1000%, and these companies
presented themselves as part IPO and part mutual fund
companies. Which scam is being referred to here?

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Activity
Find out about various financial scams that have taken place in the
history of India since the beginning of 20th century. Highlight the
capital market scams out of these and prepare a report.
4.3 Capital Market Instruments

You have already studied the concept of the capital market and its
role in the entire financial system (refer to Figure 4.1). There are two
important segments of the capital market: the primary market and the
secondary market, which together constitute the industrial securities
markets. Another segment of the capital market is the government
securities market in which gilt-edged securities are traded. Other
segments of the capital market include financial intermediaries and
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various Developmental Financial Institutions (DFIs). Each market in
the capital market has its own set of instruments for trading. Various
types of instruments traded in each segment of the capital market are
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Capital Market
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Government Industrial Financial

Securities Market Securities Market DFI Instruments Intermediaries’
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Instruments Instruments Instruments
Ordinary Shares,
Preference Soft Loans for Mutual Funds,
Bonds
Shares, Microfinance Venture Capital
Debentures
Figure 4.2: Different Instruments in Each Segment of Capital Market
Let us now discuss all the above mentioned types of instruments in

detail.
Bonds: Bonds or government bonds or gilt-edged securities are
long-term debt securities that offer fixed or floating coupons or
interest rates. The interest is paid on the face value at which the
bond is issued and this is payable at regular time periods usually
on a half-yearly basis. It is issued for a fixed period of time called
the maturity period. After the maturity period is over, the security
is redeemed at its face value.

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Ordinary shares and preference shares: Shares are equity instru-

ments used in capital markets. A share is a part in the ownership
of a company. Shares that do not have any special rights attached
with them are called ordinary shares. Preference shares are those
shares that have a certain privilege over ordinary shares. A com-
pany is required to pay dividends to preference shareholders at a
fixed rate before paying any dividend to ordinary shareholders.
Debentures: Debentures are similar to bonds but the only differ-
ence is that the bonds are issued by government, whereas deben-
tures are issued by corporates.
Soft loans for microfinance: DFIs grant loans at minimal rates
(soft loans) to individuals. Additionally, DFIs also invest in various
development projects.
Mutual funds: Mutual fund companies are important financial in-
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termediaries in financial markets. These companies roll out sev-
eral mutual fund schemes which may include investments being
made in shares, bonds and debentures along with other types of
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investment instruments.
Venture capital: Venture capital companies have grown tremen-
dously during the last 10-15 years. Venture capitalists provide risk
capital to new start-up companies which would otherwise not have
been possible for these start-ups to raise capital from conventional
sources of finance.
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6. Each sub-market or segment of the capital market has its own

set of instruments that are traded in it. (True/False)
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7. Mention one capital market instrument used by DFIs.
Activity
Write a short note on how microfinance forms an important part of

a capital market.
4.4 Capital Market Regulation

Regulations are extremely important for ever-widening capital mar-
kets globally. The growth of an economy relies on the development of
its capital market. A well-regulated market has the potential to moti-
vate more investors to partake and contribute towards the economic
growth of a country. Rules and regulations allow the capital market to
function more efficiently. In capital markets, rules and regulations are
laid regarding the issuance of securities, interest rate, rights of inves-
tors and so on.

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The capital market in every country is controlled by some regulato-

ry authority. Some of the main capital market regulatory authorities
globally are as follows:
US Securities and Exchange Commission
Canadian Securities Administrators, Canada
Australian Securities and Investments Commission
Securities and Exchange Commission, Pakistan
Securities and Exchange Board of India
Securities and Exchange Commission, Bangladesh
Securities and Exchange Surveillance Commission
Securities And Futures Commission, Hong Kong
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Financial Supervision Authority, Finland
Financial Supervision Commission, Bulgaria
Financial Services Authority, UK
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Comision Nacional Del Mercado De Valores, Spain
4.4.1 Control of Capital Issues
A company needs to take permission of the Controller of Capital Is-

sues when it is:
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Issuing capital outside India

Issuing shares in India
Renewing or postponing the date of maturity or repayment of se-
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curity maturing for payment in India

Issuing any prospectus for subscription of any security in India
According to the Capital Issues (Control) Act, 1947, capital issue is de-
fined as issue of any securities whether for cash or otherwise, and in-
cludes capitalisation of profits or reserves for the purpose of converting
partly paid shares into fully paid shares or increasing the par value of
shares already issued. As per the Act:
Companies are required to take consent of the central government
when they make an issue of the capital outside the state in which
they are located. This is necessary as companies take advantage of
the investors’ confidence.
Any company shall not extend or postpone the payment of any secu-
rity except with the permission of the central government.
Companies shall not present any false information when dealing
with securities.

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Itshould be noted that this Act covers all citizens of India and
non-resident Indians, except the State of Jammu and Kashmir.
4.4.2 Securities and Exchange Board of India
The Securities and Exchange Board of India (SEBI), headquartered

in Mumbai, was established in the year 1988 with the objective of reg-
ulating the functions of capital and money markets. Initially, SEBI
was unable to completely exercise the control over the functioning of
the stock market due to limitations in terms of authority. Later, con-
sidering the indispensable role of SEBI in controlling and maintain-
ing transactions in the stock market, the central government granted
SEBI a legal status and the required authority to ensure the effective
functioning of various operations of the stock exchange. Some of the
key functions of SEBI are as follows:
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SEBI helps to prevent the usage of unethical and malpractices,
which are prevalent in the stock market.
It helps to build confidence of investors and ensure that transac-
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tions are done efficiently by exercising various controls and regu-
lations.
SEBI aids in streamlining various activities of stock markets.
Ithelps to regulate and develop a code of conduct for various bro-
kers and intermediaries.
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SEBI aims to prevent insider trading, price rigging and other mal-
practices which companies, brokers and agents may resort to.
Itconducts audits and other inspections with respect to various
activities of stock exchanges.
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SEBI helps in framing policies, guidelines and other aspects of the

functioning of the stock exchange.
4.4.3 Securities Contracts (Regulation) Act, 1956
The Securities Contracts (Regulation) Act, 1956 was enacted with

the basic purpose of preventing the undesirable transactions that
were taking place in various stock exchanges of the country. The Act
came into force in the year 1957. The Securities Contracts (Regula-
tion) Act, 1956 included the following:
Defining various terms for the purpose of identifying different
control measures that were required for the efficient functioning
of stock exchanges in the country.
Developing the process and formulating policies of various stock
exchanges in the country.
Reviewing various reports related to the functioning of various
stock exchanges in the country.

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Drafting rules and regulations and implementing various correc-

tive measures so as to ensure that the exchanges function accord-
ing to the defined rules.
Applying power to suspend the business of the stock exchange if
gross irregularities are observed.
Enforcing authority to impose penalties and other corrective mea-
sures to various stock exchanges.
Thus, the Securities Contracts (Regulation) Act, 1956 was estab-

lished to provide umbrella cover to stock exchanges. In other words,
this Act was enacted to ensure that stock exchanges do not resort to
any unethical practices, which will impact the confidence of investors.
4.4.4 Monopolies and Restrictive Trade Practices
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(MRTP) Act, 1969
The Monopolies and Restrictive Trade Practices (MRTP) Act, 1969,

was enforced to prevent organisations from resorting to unethical and
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malpractices wherein companies make a cartel and manipulate pric-
es of goods and services. Thus, this Act was enacted to prevent these
practices. Some of the main objectives of this MRTP Act are:
To prevent companies from distortion or restriction of trade prac-
tices so as to gain advantage in a competitive market.
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To prevent companies from obstructing the flow of capital or re-

source into the production cycle.
To prevent companies from manipulating prices or conditions or
supplies in the market to gain a competitive advantage.
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To impose a fine or restriction on companies who make false offer

and other unethical practices to gain an advantage in a competi-
tive market.
To conduct an enquiry into unfair and unethical practices.
To ensure that companies do not fix prices at unreasonable levels
by preventing the flow of goods into the market.
To ensure that companies do not unreasonably prevent or lessen
the production or supply of goods.
To prevent companies from limiting technical development or cap-
ital investment to generate a competitive advantage.
4.4.5 Foreign Exchange Regulation Act (FERA), 1973
The Foreign Exchange Regulation Act (FERA) was legislation enacted

in 1973. The Act imposed strict regulations regarding certain kinds
of payments and dealings in foreign exchange and securities. This is
because these transactions had an indirect impact on the foreign ex-
change and the import and export of currency.

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The main features of the Act are as follows:

The operations pertaining to MNCs are clearly defined.
Companies having more than 40 per cent equity are required to
take permissions to invest in new firms.
Allforeign companies are required to work as Indian companies
with minimum 60 per cent of the equity.
Companies are allowed to retain foreign equity holdings above
40 per cent and up to 74 per cent if they are engaged in core
industries.
The focus is on activities requiring specialised skills and those
which are export-oriented.
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4.4.6 Foreign Exchange Management Act (FEMA), 1999
In 1991, market liberalisation reforms allowed multinational compa-

nies (MNCs) to enter the Indian market. In fact, MNCs controlled 53.7
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per cent of the assets of major sectors in India. Thus, with the rise in
the number of MNCs investing in India, these companies started to
adopt unethical practices by diverting their profits to their home land
and at the same time resorting to collect most of the capital from India
only. The existing FERA, 1973 was incompatible with the pro-liber-
alisation policies of the Government of India. Hence, a need was felt
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to exercise some degree of control over these MNCs. As a result, the

Foreign Exchange Management Act (FEMA), 1999 was passed.
The FEMA, 1999 was enacted through the Indian Parliament in the
year 1999 replacing the existing FERA, 1973. FEMA is applicable to
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the entire country. Under this Act, the offences pertaining to foreign
exchange are treated as civil offences. The main objective of this Act
is to facilitate trading in foreign exchange markets in an orderly and
systematic manner.
The following are some to the main features of the FEMA, 1999:
Payments or receipts made to any person outside India which is
concerned with foreign exchange and security is restricted under
this Act.
Impositions of restrictions on the residents of India who perform
foreign exchange transactions.
Exporters are required to furnish their details to the Reserve Bank
of India (RBI) if they are dealing in foreign exports involving for-
eign currency.
RBI has the power to impose limitations on the number of foreign
transactions.

n o t e s
8. Regulations are extremely essential in the face of increasing

importance of capital markets globally. (True/False)
9. __________ was established in the year 1988 with the objective
of regulating the functions of the capital and money market.

10. Market liberalisation allowed multinational companies
(MNCs) to enter the Indian market. (True/False)
11. The FEMA, 1999 was enacted through the Indian parliament in
the year 1999 in order to replace the existing __________ which
was becoming ineffective due to changing market dynamics.
Activity
S
Find information on other regulatory controls which are applied in
the capital markets. Prepare a report on your findings.
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4.5 SUMMARY
Capital market refers to that part of the financial market where the
buying and selling of long-term equity and debt securities take place.
The capital market is an important segment of the financial market
because it helps in pooling and attracting investments from vari-
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ous sources and diverts them towards long-term productive use.

Every market has a unique structure and different types of market
participants specific to it.
The capital market is basically divided into two parts viz. the pri-
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mary market and the secondary market.

Primary market is also known as new issues market.
Secondary market is also called old issues market.
If a new company wants to issue equity shares to general public, it
does so through an Initial Public Offer (IPO).
Classification of the capital market is also done on the basis of the
types of institutions, such as government securities market, indus-
trial securities market, DFIs and financial intermediaries.
The Indian capital market has undergone various changes and
grown into a market that is accessible to almost every citizen of
the country and is quite technology-oriented.
The present form of capital market has been achieved through
successful implementation of various controls and regulations
over a period of time.
Some of the scams that have been recorded in Indian capital mar-
ket are Securities Scam 1992, IPO Bubble Scam, Preferential Al-
lotment Scam and Plantation Companies’ Puffery Scam.

capital market 81
n o t e s
Some of the important primary capital market reforms include:

setting up of SEBI, diversification of primary market infrastruc-
ture, allowing foreign investments, etc.
Some of the important secondary capital market reforms include:
banning the badla system of trading in 1994, introduction of the
corporate governance programme, etc.
Each sub-market or segment of the capital market has its own set
of instruments that are traded in it.
Different types of instruments used in each segment of the capi-
tal market are bonds, ordinary and preference shares, debentures,
soft loans for microfinance, mutual funds and venture capital.
The regulation of a capital market comprises the regulation of se-
curities.
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Companies are required to take consent of the central government
when they make an issue of the capital outside the state in which
they are located. This is necessary as companies take advantage of
the investors’ confidence.
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The Securities and Exchange Board of India (SEBI), headquar-
tered in Mumbai, was established in the year 1988 with the objec-
tive of regulating the functions of the capital and money market.
The Securities Contracts (Regulation) Act, 1956 was enacted with
the basic purpose of preventing the undesirable transactions that
were taking place in the various stock exchanges of the country.
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The Monopolies and Restrictive Trade Practices (MRTP) Act,

1969, was enforced to prevent organisations from resorting to un-
ethical and malpractices, wherein companies try to dominate com-
petition in the market by preventing other competitive companies
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from participating.
The Foreign Exchange Management Act (FEMA), 1999 was en-
acted through the Indian parliament in the year 1999 in order to
replace FERA, 1973 which was becoming ineffective due to chang-
ing market dynamics.
key words
Cartel: It refers to an agreement between competing compa-

nies to manipulate prices and exclude the entry of new compet-
itors in a market.
Gilt-edgedsecurities: These refer to bonds that are issued by
the government of a country.
Market dynamics: It refers to changes between interdependent
market factors, such as demand, supply and pricing.
Sick units: These refer to those units of a business that have
accumulated losses equal to or exceeding its entire net worth at
the end of a financial year.

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Soft loans: These refer to the loans that are offered at rates well
below the rates offered by commercial banks.
Stock exchange: It is an organisation or place where stock trad-
ers (people and companies) can trade stocks.

1. Describe the various capital market reforms that have taken
place after the 1990s.
2. Explain the various types of capital market instruments.
3. Explain the functions of Securities and Exchange Board of India
(SEBI).
4. Write a short note on the Foreign Exchange Management Act
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(FEMA), 1999.

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Topic Q. No. Answer

Capital Markets 1. True
2. Primary market and secondary
M
market
3. New issues market
4. Government securities market,
industrial securities market, De-
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velopment Financial Institutions

(DFIs) and financial intermediaries
5. Plantation Companies’ Puffery
Scam
Capital Market Instruments 6. True
7. Soft loans for microfinance
Capital Market Regulation 8. True
9. Securities and Exchange Board of
India (SEBI)
10. True
11. Foreign Exchange Regulation Act

1. Some of the important capital market reforms include: setting up of
Securities Exchange Board of India (SEBI), diversification of primary
market infrastructure, allowing foreign investments, banning
the badla system of trading in 1994, introduction of the corporate
governance programme. Refer to Section 4.2 Capital Market.

capital market 83
n o t e s
2. Various types of capital market instruments include bonds,

ordinary and preference shares, debentures, soft loans for
microfinance, mutual funds and venture capital. Refer to Section
4.3 Capital Market Instruments.
3. The Securities and Exchange Board of India (SEBI),
headquartered in Mumbai, was established in the year 1988 with
the objective of regulating the functions of capital and money
markets. Refer to Section 4.4 Capital Market Regulation.
4. The Foreign Exchange Management Act (FEMA), 1999 was
enacted through the Indian parliament in the year 1999 replacing
FERA, 1973. Refer to Section 4.4 Capital Market Regulation.

4.8
REFERENCE
S
SUGGESTED READINGS
Bhole,M., L., and Mahakud, J. (2009). Financial institutions and
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markets: Structure, growth and innovations. 5th ed. New Delhi: Tata
McGraw-Hill Education Private Limited
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E-REFERENCES
Newsonair.com,.
(2015). SEBI: A CREDIBLE AND EFFECTIVE
REGULATOR. Retrieved 1 December 2015, from http://newsonair.
com/SEBI-A-CREDBLE-AND-EFFECTIVE-REGULATOR.asp
N
Pnbgilts.com,. (2015). Retrieved 1 December 2015, from http://

pnbgilts.com/sublinks/g1.html
The Economic Times,. (2015). Capital Market Definition | Capi-
tal Market Meaning - The Economic Times. Retrieved 1 December
2015, from http://economictimes.indiatimes.com/definition/capi-
tal-market
World Finance,. (2015). Capital Market Regulations. Retrieved
1 December 2015, from http://finance.mapsofworld.com/capi-
tal-market/regulations.html

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M
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Ch a
5 p t e r
PRIMARY, SECONDARY AND DEBT MARKET
CONTENTS
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5.1 Introduction
5.2 Primary Market
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5.2.1 Functions of Primary Market
5.2.2 Listing of Securities—Methods of Floatation of New Issues
5.2.3 Operators in Primary Market
Activity
5.3 Problems of Primary Market
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Activity
5.4 Secondary Market and the National Stock Market System
5.4.1 Trading Mechanism in the Secondary Market
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5.4.2 National Stock Market System

Activity
5.5 Over-the-Counter (OTC) Markets
Activity
5.6 Depository System
5.6.1 Stock Holding Corporation of India Limited (SHCIL)
Self Assessment Question
Activity
5.7 Stock Exchanges and Their Functions
5.7.1 Stock Exchanges in India
Activity
5.8 Commodity Exchanges
Self Assessment Question
Activity

CONTENTS
5.9 Summary
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PRIMARY, SECONDARY AND DEBT MARKET 87
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INDIGO IPO
(Source: 50skyshades.com)
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InterGlobe Aviation Ltd, the owner of IndiGo, launched its Ini-
tial Public Offering (IPO) on 26th October, 2015 and the three-day
IPO closed on 29th October, 2015. IndiGo is the only domestic air-
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line in India that has been constantly profitable since 2009.
Demand for the shares reached as high as 6.14 times the num-
ber of shares issued by the company. The demand was mainly
spurred by the active participation of financial institutions and
rich individual investors. A total of 90% shares were set apart for
retail investors that were brought in the IPO.
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According to stock exchange data, shares set aside for Qualified

Institutional Buyers (QIB) was subscribed 17.79 times. In addi-
tion, the shares set aside for the High Net worth Individuals (HNI)
was subscribed 3.57 times, whereas the employees of the airline
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bought 12% of the shares. Stock exchange data also show that the
IPO values IndiGO at USD 4 billion and most of the bids came at
the upper end of the ` 700–765 price band.
According to Aditya Ghosh, President and whole-time Director

of IndiGo, We are overwhelmed with the response. Many of these in-
vestors are the very best of the best. We take a lot of pride in the fact
that we have put the Indian airline industry back on the global map.
But you know, that’s in the past now. Our track record has brought
them to us. But now it’s up to me and my team to deliver on their
trust and thank them for their faith with our future performance.
On 26th October, InterGlobe Aviation finalised the allocation of

10.87 million equity shares at ` 765 apiece, the upper end of the
price band, aggregating to ` 832.03 crore, to anchor investors.
These anchor investors included Fidelity Investments, GIC Pte
Ltd, Acacia Partners LP, HDFC Trustee Co. Ltd, DB Internation-
al (Asia) Ltd, DSP BlackRock India Tiger Fund, Kuwait Invest-
ment Authority Fund, Merrill Lynch Capital Markets Espana SA

n o t e s
SV, Credit Suisse Singapore Ltd, Harvard Management Co. Inc.,

Sundaram Mutual Fund and Goldman Sachs India Fund.
The anchor book is the share of the IPO that bankers allot to spe-
cific institutional investors on a discretionary basis. Subscription
of anchor book starts one day before the launch of the IPO and
serves as an indicator of the interest of institutional investors in
the IPO.
According to an investment banker involved in the IPO, The in-

stitutional demand was driven mostly by the anchor investors of the
issue, which is a set of very high quality investors who understand
the low-cost carrier model. Overall, around 70–75% institutional
demand is from long-only investors, with remaining coming from
hedge funds. Demand from the big-name institutional investors also
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drew high net-worth individuals and retail investors to the share
sale.
The success of the IPO points towards the abundance of liquidity

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in the Indian capital market.
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n o t e s
learning objectives

>> Discuss the concept and functions of the primary market
>> Explain the role of operators in the primary market
>> Discuss the problems in the primary market and national
stock market system
>> Describe the functions of the secondary market
>> Explain the functions of the OTC market
>> Describe the concept of the depository system
>> Discuss the functions of stock exchanges
>> Describe the functions of commodity market
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5.1 INTRODUCTION
In the previous chapter, you were introduced to the concept of cap-
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ital market along with its functions. In this chapter, we will focus
on primary and secondary markets, commodity market and stock
exchanges.
Companies need capital to run or expand their business operations.

Capital market is a very important source of capital for companies.
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The capital market has two main segments—primary market and

the secondary market. In general, the primary market is a part of the
capital market in which new securities are issued for the first time
in the market. Therefore, in simple words, if a private firm wants to
raise funds for some purpose, say for expansion into new markets,
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it can issue its shares in the primary market and get access to fresh
capital. Different specialised financial institutions, such as investment
banking firms, brokers and dealers manage the process of issuing new
shares and distributing these shares to the investors. The securities
issues in the primary market are traded in the secondary market.
Both the primary and the secondary market have significant role in
mobilisation of capital and the economic growth of the country. The
depository systems and stock exchanges facilitate the functions of the
primary and secondary markets.
In this chapter, you will be introduced to the concept of primary and

secondary markets of the capital market. Next, the chapter will ex-
plore the issues faced by the primary market. In addition, the chapter
will discuss the functions of the secondary market, the National Stock
Market System, Over-the-Counter (OTC) markets and depository sys-
tems. Some of the other concepts to be discussed in the chapter in-
clude stock exchanges and their functions and commodity exchanges.

n o t e s
5.2 PRIMARY MARKET

The capital market is divided into two broad categories—primary
market and secondary market. In simple words, primary market re-
fers to the market in which new shares are issued for the first time.
This is why the primary market is also known as the ‘new issue mar-
ket’. The securities issued in the primary market are traded in the
secondary market. In this section, we will discuss the primary market
and its functions; whereas in the next segment, we will discuss the
secondary market.
Companies can raise fresh capital by issuing shares in the primary

market. For example, companies launch Initial Public Offering (IPO)
in the primary market. In this, the company offers its shares to the
public for the first time. One important point to remember is that in
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the primary market, securities are directly purchased from the issuer.
Companies raise fresh capital from the primary market using a num-
ber of techniques as shown in Figure 5.1:
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Public Issue
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Right Issue
Private Placement
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Preferential Allotment
Figure 5.1: Techniques of Raising Capital from the Primary Market
Let us discuss these techniques as follows:

Public issue: It refers to the sale of securities to the general public.
An IPO is an example of a public issue. Public issue is one of the
most important methods of raising capital through issuing shares
in the primary market.
Right issue: It refers to the issue of shares to existing sharehold-
ers for raising supplementary capital. Right issue is offered by the
companies whose shares are already being traded in the second-
ary market.

n o t e s
Private placement: It refers to the sale of shares to a limited

number of special investors, such as venture capital funds, mu-
tual funds, frequent investors, etc. Therefore, private placement
of shares is not issued to the general public. Private issue offers
quicker access to capital than in the public issue. In addition, pri-
vate issue is relatively inexpensive.
Preferential allotment: It refers to the issue of equity shares to a
selected number of investors at a special price (a price that may
not be pertaining to the market price).
From our discussion so far, you must have got some idea of the im-
portance of primary market as an important source of fresh capital
for companies. Now, let us study the main functions of the primary
market.
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5.2.1 FUNCTIONS OF PRIMARY MARKET
In the previous sections, we have had a general overview of the pri-

mary market and its importance in the financial system of the country.
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The primary market is responsible for encouraging investors to invest
their money in the new issues floated by the companies. The primary
market is responsible for providing thrust to new and upcoming seg-
ments of the economy. For example, it was the IPO of several IT com-
panies, which ensured that the Indian IT sector gets the necessary
thrust for growth. The three main functions of the primary market are
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The three main functions of the primary market are:

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Origination
Underwriting
Distribution
Figure 5.2: Functions of the Primary Market
Let us discuss the functions of the primary market as follows:

Origination: In a primary market, origination involves inves-
tigation and evaluation of a new project proposal in terms of its
economic, legal, technical and financial aspects. The process of
origination begins before a new issue is launched in the market.
Origination takes place with the help of merchant bankers, which

n o t e s
can include banks, financial institutions or private investment

firms. In origination, various sponsoring institutions are involved.
These provide advisory services, such as reduction of the price
and the methods of issue.
Underwriting: It refers to guaranteeing the sale of a fixed amount
of shares at a particular price. Generally, a group of financial insti-
tutions underwrite a new issue. In case, the underwriter is unable
to sell shares to the public, it has to purchase the shares by itself.
Therefore, as you can see, underwriters basically ensure the suc-
cess of a new issue by ensuring a minimum level of subscription of
the issue. Underwriters are paid a commission for underwriting a
new issue.
Distribution: The success of a new issue depends on the level of
subscription of the issue. Various primary market participants,
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such as brokers and agents to distribute shares to the investors
through their networks.
5.2.2 LISTING OF SECURITIES—METHODS OF
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FLOATATION OF NEW ISSUES
Listing of the securities in the Indian stock exchanges comes under

the provisions contained in the Companies Act, 1956, rules and regu-
lations of the particular stock exchange, and the rules and regulations
formulated by the central government, the RBI, the SEBI and the like.
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The following steps outline the process of listing of new securities in

the stock market:
Preliminary discussion with the concerned stock exchanges
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wherein the company is to be listed.

Fulfillment of the requirement for articles of association, which is
the main document for the companies to be listed.
Approval of the draft prospectus of the company. This is the basic
pre-requisite, which must be done before any company can be list-
ed on the stock exchange. The prospectus contains the informa-
tion, such as the name of the regional stock exchange, the date of
opening and closing of the issue and the like.
Listing of the application, wherein the company applies to the con-
cerned stock exchange in which the shares are to be listed. The
application also contains other documents, such as certified copies
of the memorandum and articles of association, copies of the pro-
spectus, copies of balance sheet, valuation reports, court orders
and the like.
Listing agreement regarding the projections of the profitability of
the company.
Listing agreement regarding the details of the cash and fund flow
statements.

n o t e s
Payment of listing fees and the collection of the proof of the listing
fee from the bank.
Obtaining trading permission by the SEBI regulatory authorities.
Payment of 1% security with the concerned stock exchange.
Floating an advertisement in the radio, newspapers and the like.
Having understood the basic steps for the floatation of new issues,
let us now dwell on the methods that can be adopted for floating new
issues. The methods for floating new issues are described as follows.
Publicissue: In this, the company raises funds by issuing shares,
bonds or debentures to the public through the issue of an offer
document, which is known as a prospectus.
IPO: In this, an unlisted company makes a public issue for the first
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time to get the shares listed on the stock exchange.
Follow-on public offer: In this, the listed company makes another
public issue to raise capital.
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Offer for sale: In this, the institutional investors, such as venture
funds, private equity funds and the like after having invested their
funds in a small unlisted company decide to sell their shares to the
public. This is done through the offer document as the company’s
shares are listed on the stock exchange.
Private placement: In this, the securities are sold to a relatively
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small number of selected investors for raising capital. In this case,

investors that are involved generally include large banks, mutual
funds, insurance companies and the like. You should note the fact
that the private placement is opposite to public issue wherein the
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securities are made available for sale in the open market.

Issue of Indian Depository Receipt (IDR): In this, a foreign com-
pany that has been listed in a foreign stock exchange can raise
money from the Indian public by issuing shares. These shares are
held in trust by a custodian foreign bank against which a domestic
custodian bank issues an acknowledgement instrument, known as
Indian Depository Receipt (IDR). This IDR can be traded in the
stock exchange just like any other share.
Rights Issue (RI): In this, the company raises funds from its exist-
ing shareholders by issuing them new shares. The existing share-
holders are entitled to apply for new shares in direct proportion to
the number of shares held by them.
Bonus issue: In this, the company issues new shares to its existing
shareholders. Since these new shares are issued out of the accu-
mulated profits, the shareholders need not pay any money to the
company for receiving the new shares.

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5.2.3 OPERATORS IN PRIMARY MARKET
In the previous section, we have discussed the process of listing se-

curities in the stock exchange. However, in case of primary markets,
trading is done on the basis of the following operators, i.e., the kinds
of instruments, which are traded in the market.
Fixed income securities: These are those securities that are fixed
and the returns are guaranteed irrespective of the financial posi-
tion of the company. In this category, the operators are:
Bonds: These constitute loans advanced to the company and
the interest is assured by the company that raises the bond.
Debentures: These are debt instruments that are not backed
by any specific security.
Mortgage backed securities: These are a type of asset-based
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security, which are secured by a mortgage or a collection of
mortgages.
Asset-backed securities: These are the securities that are
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backed by financial assets of the company or the issuer.
Variable income securities: These are the operators wherein the
investors receive a variable amount of income. Variable income
securities include:
Equities: These are also known as equity shares or variable
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income securities. Equities are also called as perpetual capital

of the companies as equities can be traded for no fixed time
frame. Investors have a claim on the residual profits of the
company as they are part owners of the company.
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Preference shares: These are the securities in which dividends

are paid to the investors at a fixed rate. These preference share-
holders do not have the voting rights in normal circumstances.
These shares can be converted into equity.
Derivative securities: These are the securities that derive val-
ue from the underlying asset. In other words, they derive their
value or are betted for being traded at a future date or a future
price.
Let us now discuss the means and mechanism as to how various enti-
ties or players play a crucial role in the primary stock market. The list
of players in a primary market is given as:
Issuers: These may be a domestic company, foreign company or
investment trust. Issuers are responsible for reporting financial
conditions and other requirements of the regulatory bodies. These
issuers belong to the demand side category of the new issue pro-
cess. The demand side means the entity that requires long-term
capital. The issuer possesses a legal entity that is responsible for

n o t e s
developing, registering and selling the securities to finance its var-

ious operations.
Investors: These are the buyers or sellers of the securities that are
floated by the company. The investor can be a long-term investor
or a short-term investor. The investor can also be an impulsive in-
vestor or a prudent investor. An investor needs to consider sever-
al fundamental aspects. These include the financial performance
of the company, type of business, prospect of the industry, etc., to
make effective investment strategies.
Regulators: They are responsible for supervising various opera-
tions of the stock exchanges, issuers and various agencies that are
associated with the stock market operations. Their main role is
to ensure that investors’ confidence is maintained in the financial
system. Further, they are required to bring an improvement in the
system of various operations of the stock markets by studying the
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trends and patterns of various operations of the market.
Custodians: These are financial institutions that have a special
role to play and are responsible for safeguarding the issuer’s in-
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terest or the individual’s financial assets. They may or may not be
necessarily involved in the ‘traditional’ commercial or consumer/
retail banking operations of day-to-day functioning. In general,
the custodian banks are responsible for holding the assets of large
institutions, which have a considerable amount of money invested.
These include banks, insurance companies, mutual funds and the
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like.
Brokers and dealers: These are the agents that are responsible for
executing the buying and selling processes of the entities. When
they execute the process on behalf of the customer, they are known
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as brokers or agents. Similarly, when they execute the process

from their own investment, they are said to be acting as a dealer.
Depositories: A depositor is a specialised form of financial organ-
isation that is responsible for holding securities, such as shares
either in electronic form or in non-electronic form, i.e., demate-
rialised form. In the case of depositories, the ownership is trans-
ferred easily as it is carried out by book entry rather than the phys-
ical trans-shipment of documents.
Clearing agents: These are financial institutions that are respon-
sible for providing clearing and settlement services for the finan-
cial market, commodities market, and derivatives and securities
transactions.
1. __________ are the financial institutions that are responsible

for supervising various operations of the stock exchanges,
issuers and various agencies that are associated with the stock
market operations.

n o t e s
2. Preference shares are the securities in which dividends are

paid to the investors at a fixed rate. (True/False)
Activity
Make a group of your friends and discuss the functions of the pri-
mary market.
5.3 PROBLEMS OF PRIMARY MARKET

Primary market plays a very crucial role in an economy in terms of
mobilising savings into long-term investments. However, the function-
ing of primary market is not always very smooth and faces several
problems and challenges. Let us discuss some of these challenges as
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follows:
Withdrawal of IPOs: This happens when a company is no more
willing to proceed with its proposed security offerings. Primary
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market is responsible for building investors’ confidence in the fi-
nancial system of a country. Therefore, withdrawal of an IPO is
generally viewed as a failure of the primary market. In FY 2010–
2011, a total of 72 companies cancelled their IPO plans and 58 com-
panies allowed their regulatory approval to lapse in FY 2011–2012
(George, 2012).
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Shrinking retail investor base: This is a significant problem faced

by the Indian primary market, because of which the corporate sec-
tor depends more on the bank funding and promoter capital. Re-
duction in the number of retail investors creates scarcity of funds
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in the IPO market (George, 2012).

Manipulation of grey markets: This happens in case of over-sub-
scription of the shares, when the grey market shares were sold
at a very high rate. These shares show a steep fall when they are
listed on the stock exchange. Thus, this reflects that manipulations
were being carried out in the grey market by parties with vested
interests.
Different processes for different categories of investors: This is
one of the biggest problems of the Indian primary market wherein
there are separate processes for separate class of investors. This
approach limits the small investors. Ideally, there should be a uni-
form process for all investor classes.
Volatility in the market: Globalisation and global financial inte-
gration cause volatility in the capital market. Volatility reduces in-
vestors’ confidence in the market, which in turn crashes funds in
the primary market.

n o t e s
3. Mention two challenges faced by the primary market in India.

4. Fall in the numbers of retail investors create scarcity of funds
in the IPO market. (True/False)
Activity
Using the Internet, study the launch of some recent IPOs in India
and the issues faced by them. Make a list of your findings.
SECONDARY MARKET AND THE

5.4
NATIONAL STOCK MARKET SYSTEM
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Secondary market is the market wherein the securities issued in the
primary market are traded. In terms of functionality, there is no dif-
ference in the primary market and the secondary market. This is ow-
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ing to the fact that both markets deal with the same type of security.
However, there is a fundamental difference between the two. In case
of primary market, the investor directly gets the securities from the
company in the form of an IPO. On the other hand, in case of second-
ary markets, the investor gets securities from the entities who want to
dispense their securities.
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The instruments that are traded in the secondary market include eq-
uities, debentures, bonds, preference shares, etc. Similar to the pri-
mary market, various operations in the secondary markets are con-
trolled and regulated by the SEBI.
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The main function of the secondary market is to ensure that liquidity

is maintained. This is due to the fact that in the case of secondary mar-
ket the greater the number of investors in the given market the better
is the liquidity of the market. The other function of the secondary mar-
ket is to ensure that the investors do not have to tie up their money for
a long time as this violates the most important principle of generating
liquidity. The secondary market also ensures stability in the price as
the trading continues. This is one of the most important functions of
the secondary market. If the prices are unstable, appropriate mea-
sures and control must be deployed. Moreover, the secondary market
maintains continuity of various operations of the stock market.
5.4.1 TRADING MECHANISM IN THE SECONDARY MARKET
The process for carrying out trading in stock market operations is de-
scribed as follows:
Selectionof the broker: This is the first step as any trading in the
secondary market can be performed only by SEBI-registered bro-

n o t e s
ker. The broker is responsible for advising, buying and selling of

securities in the stock exchange.
Opening Demat account with the depository: This is another
step that calls for opening of a Demat account wherein the securi-
ties are stored in an electronic form.
Order placement: This is the step wherein the investor places the
order through the broker. This instruction to the brokers may be
given through telephone or e-mail, with clear instructions. Occa-
sionally, the investor may personally place the order to the broker.
Execution of the order: The broker executes the order that the
investor has placed. The broker prepares the contract note and
hands it over to the investor.
Settlement: This is the step wherein payment is made to the broker
for the concerned transaction of securities and the securities are
S
transferred to the buyer through an entry in the book of accounts.
5.4.2 NATIONAL STOCK MARKET SYSTEM

IM
To meet the requirement of the need for having a screen-based on-
line trading that will conform to the need of the international require-
ments and standards, the idea of having a national market system was
floated. The main reason for this was the highly fragmented second-
ary market and issues, such as lack of liquidity, inability to provide
M
impetus for the development of debt markets, inefficient and outdat-

ed trading systems and the lack of a single market due to inability of
various stock exchanges in terms of regulation and uniformity in the
trading practices.
N
Thus, with this background, the concept of a National Market system

was established with the formulation of the National Stock Exchange
in the year 1991.
The basic objective of the formulation of the national stock market

system was:
To provide a completely automated system in terms of trading and
the settlement process that is performed through the Securities
Facilities Support Corporation. This need was felt as the stock ex-
changes were using outdated methods and there was no uniformi-
ty among different stock exchanges.
To provide liquidity and ready market so that trading can be done
on continuous basis. This was another reason that the brokers and
jobbers were entrusted to ensure that trading was done on a con-
tinuous basis.
To provide a large number of corporate and institutional mem-
bers. The members must also be the representative entities across
the country on All India basis. Large membership ensures more
liquidity.

n o t e s
To have separate trading time for debt instruments. This was the
concept to promote debt market.
To help in privatisation of the public sector units through the list-
ing of their shares. This was done to ensure that private sector
players come into the picture in various public sector entities.
To assist in developing the investment habit, especially in the rural
and semi-rural areas. This was done to ensure that people develop
the habit of saving and investment.
To create more employment opportunities in the service sector
within the capital market. This was another reason as it assists
in the creation of more job opportunities pertaining to the capital
market.
S
5. The secondary market also ensures stability in the price as the
trading continues. (True/False)
IM
Activity
Make a group of your friends and discuss the importance and func-
tions of the secondary market.
M
5.5 OVER-THE-COUNTER (OTC) MARKETS

OTC markets are the spot markets that are locally situated for specific
commodities. All trading conducted through OTC markets is deliv-
ery-based. Stocks, bonds, commodities, etc., are traded in the OTC
N
market and the transactions happen directly between two parties, i.e.,
the buyers and sellers. Therefore, OTC trading is significantly differ-
ent from exchange trading, which takes place in futures exchanges or
stock exchanges.
All OTC transactions are bilateral transactions in which two parties

agree on the settlement of transactions. In the OTC market, buyers
and sellers have their set of brokers who negotiate the price of the
underlying assets.
Let us take an example to understand the concept of OTC market.

Suppose a farmer produces castor and he wants to sell his produce. In
this case, he will approach a local mandi and contact his broker who
in turn will negotiate with the broker of the buyer. Generally, buyer
in this case will be a wholesaler or a refiner. In case, the negotiation
between the two parties is successful, the exchange will take place on
the spot. Therefore, you can see, in the OTC market, the transaction
is done directly between the buyer and the seller and the transaction
takes place on the spot.

n o t e s
A stock is generally traded in the OTC market when the company is

very small and is unable to meet the listing criteria of exchanges. Such
stocks are called ‘unlisted stocks’.
6. The _______ are the spot markets that are locally situated for
specific commodities.
7. All OTC transactions are bilateral transactions in which two
parties agree on the settlement of the transactions. (True/
False)
Activity
Make a group of your friends and discuss the concept of OTC mar-
S
ket.
5.6 DEPOSITORY SYSTEM

IM
A depository system is an organisation responsible for allotting, trans-
ferring and lending securities. A depository stores securities in the
electronic form and operates on the basis of paper transfer of secu-
rities between buyers and sellers. Therefore, an efficient depository
system is crucial for smooth operations of the stock markets. In the
M
primary market, the depositories connect the issuers and the pro-
spective shareholders. In the secondary market, the depository links
the investor and the exchange and help in the settlement of security
transactions. In addition, a depository provides various other services,
N
such as collection of dividends and interest and reporting of corporate

information. Therefore, as you can see an efficient depository system
is crucial for smooth functioning of the stock markets.
In India, the requirement of a depository was realised after the short-

comings of the prevailing settlement systems were exposed in 1992. In
addition, the requirement of the depository was also necessitated for
the improvement in the primary market. The earlier system of settle-
ment of security transactions involved a huge amount of paper work.
This exposed the system to the risk of stolen shares, fakes certificates,
etc.
Therefore, the idea of developing a depository system for scrip less

trading was required in India. This improved the efficiency of the
trading settlement in India and eliminated the issues related to deal-
ing with physical certificates.
The first step towards setting up a depository system in India was ini-
tiated by the Stock Holding Corporation of India Limited (SHCIL) in
July 1992. It presented the concept paper on ‘National Clearance and

n o t e s
Depository System’ in collaboration with Price Waterhouse under a

programme sponsored by the US Agency for International Develop-
ment. After this, the government of India set up a technical group un-
der Shri R. Chandrasekaran, the then Managing Director of SHCIL,
who was appointed as its Chairman. Thereafter, a seven-member ac-
tion squad was developed by the SEBI to work on the structural and
operational parameters of the depository system. Depository Ordi-
nance was promulgated by the government of India in 1995. This was
a major thrust towards setting up the depository system in India. The
Depositories Act was passed in 1995, to provide a legislative frame-
work for the depository system.
The National Securities Depository Limited (NSDL), promoted by

IDBI, UTI and NSE was the first depository in India. NSDL started its
operation in 1996. At present, SHCIL is the largest depository partic-
ipant in India.
S
5.6.1 STOCK HOLDING CORPORATION OF INDIA LIMITED
(SHCIL)
IM
Stock Holding Corporation of India Limited was established in the
year 1986. SHCIL was established as a public limited company under
the government of India. It is owned by various banks and other finan-
cial institutions, such as LIC, GIC and the like. It is an online trading
portal with investors and traders.
M
SHCIL is responsible for e-stamping across the country. SHCIL is the

custodian of all e-stamping documents, including the keeper for vari-
ous securities across different exchanges of India.
The main custody services provided by SHCIL are given as:

N
Custodial services: It provides first-rate custodial services to In-

dia’s leading financial institutions, insurance companies, mutual
funds, Foreign Institutional Investors (FIIs), banks, Indian and for-
eign venture capital companies, funds, PF trusts and corporates.
Clearing and settlement services (cash segment): It provides the
following:
Smooth Straight Through Processing (STP) systems with a
choice of two reputed service providers, enabling the competi-
tive advantage of efficient settlements.
Seamless monitoring and constant updates on failed trades
and status (T+2 basis).
Daily verification of settlements (normal/auction), thus miti-
gating systemic risks.
Efficient fund transfer facilities are offering flexibility of settle-
ment of funds through a wide panel of banks having Real Time
Gross Settlement (RTGS) capabilities.

n o t e s
Effortless handling of residual trades in physical mode, since it

has the necessary infrastructure in place.
Electronic and physical safekeeping services: It provides the fol-
lowing:
Operations on both Depositories, National Securities Deposito-
ry Limited and Central Securities Depository Limited, manned
by qualified, certified and experienced staff, complemented by
cutting-edge back-office processes.
Comprehensive document tracking and storage systems that
enable instant tracking of status of any investment in physical
custody.
S
8. A depository system is responsible for allotting, transferring
and lending securities. (True/False)
IM
Activity
Visit the official website of SHCIL and study the e-stamping ser-
vices provided by it. Make a note of your findings.
STOCK EXCHANGES AND THEIR

5.7
M
FUNCTIONS
Stock exchange can be defined as an organised market where selling
and buying transactions of various securities take place. These secu-
N
rities include government securities, shares, bonds and debentures.

It acts as a platform where an interaction of the demand and supply
of shares and securities take place. Stock exchange is also known as
stock market.
The stock market can be categorised into two markets—primary mar-

ket and secondary market. The primary market includes transactions
pertaining to new shares that are first sold through an IPO. Many in-
stitutional investors purchase new securities from investment banks.
After that, all subsequent trading takes place in the secondary market
where participants include both institutional and individual investors.
The functions performed by a stock exchange are:
It provides a ready market for all participants that include specu-
lators and investors.
It works on the price mechanism and evaluates the price of secu-
rities on the basis of demand and supply. The constant quoting of
the market price by stock exchanges allows investors to be aware
of the current market values of the security. On this basis, the pro-
duction of various indexes takes place. This further indicates the

n o t e s
market and economy trends. Therefore, it is also termed as a ba-

rometer of the economy.
It provides a rigid set of rules for all participants to safeguard the
investor’s trust. This helps investors in making a fair judgement of
securities. Therefore, the company is required to disclose all mate-
rial facts to their shareholders.
Allnew securities listed in the stock market are evaluated on vari-
ous criteria before being approved by the stock market.
Many institutional investors, such as banks and insurance com-
panies invest their money in large number of securities. These se-
curities can be converted into cash as and when required by the
intuition. Thus, it adds liquidity to the economy by providing mar-
ketable securities.
S
Stock exchange plays a major role in facilitating money movement
for productive purpose across the economy. Thus, it plays a pivotal
role in the growth of the economy.
IM
Itsatisfies the investing need of a wide range of investors that in-
clude small investors to the government by providing various se-
curities.
Let us discuss some of the main stock exchanges in India.
5.7.1 STOCK EXCHANGES IN INDIA

M
In India, there are 21 stock exchanges that facilitate the transaction of

various securities. Out of these, the Bombay Stock Exchange (BSE)
and National Stock Exchange (NSE) are the largest Indian exchanges
N
that majorly satisfy the needs of nearly all foreign investors.
BOMBAY STOCK EXCHANGE (BSE)
It was established in 1875 as Asia’s first stock exchange. It is the larg-

est stock exchange of India. More than 6,000 companies are listed by
BSE. This makes it one of the largest stock exchanges in the world.
BSE plays a significant role in developing India’s capital markets, in-
cluding the retail debt market. This has resulted in enhanced growth
rate of Indian corporate sector.
With the passage of time, the traditional way of working has been
transformed. In 1995, BSE switched over from an open-floor to an
electronic trading system. A wide range of securities are traded by the
BSE that include stocks, stock futures, stock options, index futures, in-
dex options and weekly options. The overall performance of the BSE
is measured by the BSE’s index that is known as Sensex, compiled in
1986. The Sensex comprises 30 largest and most actively traded stocks.
Based on the Sensex, the performance of the BSE is measured. This,
in a way, illustrates the performance of the Indian economy.

n o t e s
NATIONAL STOCK EXCHANGE (NSE)
It is India’s first demutualised electronic exchange that was estab-

lished in 1992. As a result, it was the first stock exchange of India to
provide a modern, fully automated, screen-based electronic trading
system. It introduced ease in the trading facility for the investors.
Like BSE, the NSE also has an index that denotes its performance.
This is known as Nifty. It comprises 50 largest and most actively trad-
ed stocks in NSE.
In the year 2015, NSE was registered as the world’s 12th largest stock
exchange by having the market capitalisation of more than US$1.65
trillion. The continuously improving market capitalisation of the NSE
also indicates enhanced trust of domestic and international investors.
As a result, investors extensively started using Nifty as a barometer of
S
the Indian capital markets and economy.

IM
9. Stock market works on the _____ and evaluates the price of
securities on the basis of demand and supply.
10. BSE was the first stock exchange of India to provide a modern,
fully automated, screen-based electronic trading system.
(True/False)
M
Activity
Utilising the Internet, find information on the companies that are

included in both indices—Sensex and Nifty. Out of these, pick any
N
three companies and make a report on their contribution to the

Indian economy.
5.8 COMMODITY EXCHANGES

Commodity exchange works in the same way as the stock exchange
does. It is defined as an incorporated non-profit association that de-
velops and maintains the regulatory and operational framework for
trading commodities and related investments. It is also known as the
physical centre for trading.
The transactions of various commodities and derivative products take

place in the commodities exchange. Most commodity markets trade in
agricultural products and other raw materials including wheat, sugar,
cocoa, coffee, milk products, oil, metals, etc., and in contracts that are
based on underlying assets (commodities). There is a wide range of
these kinds of contracts that take place in the commodity exchange.
These include forwards, futures and options. In addition, these com-

n o t e s
modity exchanges also deal in various sophisticated and dynamic

products that include interest rates and swaps.
Usually, the futures contracts traded in commodities exchanges are

based on some commodities.
In addition to farmers, the futures contracts are also traded by specu-

lators and investors in an attempt to make profit followed by a fluctu-
ation in the price during the respective period.
In all, there are 24 commodity exchanges in India. Few of the major

commodity exchanges are as follows:
Multi-Commodity Exchange of India Ltd, Mumbai (MCX): It is
an independent commodity exchange of India that was established
in 2003. The turnover of this exchange for the fiscal year 2014–1015
was ` 51.84 lakh crore (Source: MCX AR 2014–15) and it was the
S
world’s sixth largest commodity exchange on the basis of the con-
tracts traded. It offers futures trading in bullion, non-ferrous met-
als, energy and a number of agricultural commodities.
IM
Its key shareholders are Financial Technologies (I) Ltd., State
Bank of India and its associates, National Bank for Agriculture
and Rural Development (NABARD), National Stock Exchange of
India Ltd (NSE), Fid Fund (Mauritius) Ltd—an affiliate of Fideli-
ty International, Corporation Bank, Union Bank of India, Canara
Bank, Bank of India, Bank of Baroda, HDFC Bank and SBI Life
M
Insurance Co. Ltd.

Originally, it was regulated by Forward Markets Commission
(FMC), but after the merger of FMC with SEBI, it came under the
regulation of SEBI.
N
National Commodity and Derivative Exchange, Mumbai (NC-

DEX): It is an online commodity exchange of India that has an
independent Board of Directors. It was incorporated on 23 April,
2003, as a public limited company under the Companies Act, 1956.
It began its operations on 15 December, 2003. It is regulated by
SEBI and is subject to various Acts and laws that include the Com-
panies Act, 2013, Stamp Act, Contracts Act and Forward Commis-
sion (Regulation) Act.
It is promoted by a consortium of institutions that include the ICI-

CI Bank Limited (ICICI Bank), Life Insurance Corporation of India
(LIC), NABARD and NSE.
11. NCDEX is an independent commodity exchange of India.

(True/False)

n o t e s
Activity
With help of the Internet, collect information on the various com-

modity exchange in the following countries:

1.
China 2.
US

3.
UK 4.
Pakistan
5.9 SUMMARY
The primary market is responsible for encouraging investors to in-
vest their money in new issues floated by companies. This market
is responsible for providing thrust to new and upcoming segments
of the economy.
S
Listing of securities in Indian stock exchanges comes under the
provisions contained in the Companies Act, 1956, rules and reg-
ulations of the particular stock exchange and the rules and regu-
lations formulated by the central government, the RBI, the SEBI
IM
and the like.
Some of the methods of floatation of new issues in the primary
market include IPO, follow-on public offer, offer for sale, private
placement, IDR, rights issue, bonus issue, etc.
The fixed income securities in the primary market include bonds,
M
debentures, mortgage-backed securities and asset-backed securi-

ties.
Variable income securities in the primary market include equities,
preference shares and derivative securities.
N
The main players in the primary market include issuers, investors,

regulators, custodians, brokers and dealers, depositories, clearing
agents.
The main issues faced by the Indian primary market are with-
drawal of IPOs, shrinking the investor base, manipulation of the
grey markets, different processes for different categories of inves-
tors and volatility in the market.
Secondary market is the market wherein the securities issued in
the primary market, are traded. In terms of functionality, there is
no difference in the primary market and the secondary market as
both markets deal with the same type of security.
The instruments that are traded in the secondary markets include
equity, debentures, bonds, preference shares, etc. Similar to the
primary market, various operations in the secondary markets are
controlled and regulated by the SEBI.
Thus, with this background, the concept of a national market sys-
tem was established with the formulation of the National Stock
Exchange in the year 1991.

n o t e s
OTC markets are the spot markets that are locally situated for spe-
cific commodities. All trading conducted through OTC markets
are delivery-based. Stocks, bonds, commodities, etc., are traded
in the OTC market and the transactions happen directly between
two parties—buyers and sellers.
A depository system is an organisation responsible for allotting,
transferring and lending securities. A depository stores securities
in the electronic form and operates on the basis of paper transfer
of securities between buyers and sellers. Therefore, an efficient
depository system is crucial.
The Stock Holding Corporation of India Limited (SHCIL) was es-
tablished in the year 1986. SHCIL was established as a public lim-
ited company under the government of India. It is owned by var-
ious banks and other financial institutions, such as LIC, GIC and
S
the like. It is an online trading portal with investors and traders.
key words
IM
Debentures: These are the securities issued by corporate enti-
ties and the government acknowledging the loans advanced by
investors.
Money market: This is the platform wherein entities such as
banks, financial institutions and corporate houses gather to
raise short-term loans to meet their business requirements.
M
Stock exchange: The platform wherein trading activities relat-

ed to securities take place.

N
1. Discuss the role of the primary market.

2. Elaborate on the methods of floatation of new issues in the
primary market.
3. What do you mean by a depository system? What is its role?
4. What are the functions of stock exchanges? List the major stock
exchanges in India.

ASNWERS FOR SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

Primary Market 1. Regulators
2. True
Problems of Primary Market 3. Withdrawal of IPOs and mar-
ket volatility

n o t e s
Topic Q. No. Answer

4. True
Secondary Market and the Na- 5. True
tional Stock Market System
Over-the-Counter (OTC) Mar- 6. OTC markets
kets
7. True
Depository System 8. True
Stock Exchanges and Their 9. Price mechanism
Functions
10. False
Commodity Exchanges 11. True
S
1. In the primary market, new securities are issued for the first
time. Refer to Section 5.2 Primary Market.
IM
2. Some of the important methods of floatation of new issues in the
primary market include offer for sale, IPO, private placement
and public issue. Refer to Section 5.2 Primary Market.
3. A depository system stores securities in the electronic form.
Refer to Section 5.6 Depository System.
M
4. Stock exchanges provide a platform for the trading of securities.

Refer to Section 5.7 Stock Exchanges and Their Functions.

5.12
N
REFERENCE
SUGGESTED READINGS
Pathak B. (2011). The Indian financial system. New Delhi: Pearson.
Bhatia A. (2013). Indian financial system. New Delhi: Black Prints

India.
E-REFERENCES
Nigudkar A. (2012). What is primary and vs. secondary market?
Differences. Financewalk. Retrieved 2 December 2015, from http://
www.financewalk.com/2012/primary-market-secondary-market/.
Indianmba.com (2015). An overview of Indian financial system.
Retrieved 2 December 2015, from http://www.indianmba.com/Fac-
ulty_Column/FC177/fc177.html.
Ncdex.com (2015). Live quotes—Commodity futures market. Re-
trieved 2 December 2015, from http://www.ncdex.com/marketdata/
livefuturesquotes.aspx#.

Ch a
6 p t e r
currency market
CONTENTS
S
6.1 Introduction
6.2 Foreign Exchange Market
IM
6.2.1 Roles of Foreign Exchange Market
6.2.2 Participants in Foreign Exchange Market
Activity
6.3 Balance of Trade (BOT) and Balance of Payments (BOP)
M
Activity
6.4 Monetary Policy and Foreign Exchange
Activity
N
6.5 Interest Rate and Exchange Rate

Activity
6.6 Exchange Rate Dynamics
Activity
6.7 Summary

n o t e s
CURRENCY WAR BETWEEN US AND CHINA
After 2010, the use of phrases ‘currency war’ and ‘currency ma-
nipulation’ has increased significantly. The term currency war
was coined by the International Monetary Fund (IMF) in October
2010. This term refers to a situation wherein two or more curren-
cies are engaged in deliberate monetary policy reforms in order to
increase their global competitiveness.
The United States of America claims that China intentionally ma-

nipulates its monetary policy and has been doing so for quite a
long time now. Further in the claim, China maintains the value
of its currency, the Chinese Yuan (CNY), at low levels vis-à-vis
the US Dollar (USD). The Chinese monetary authority achieves
this by creating artificial demand for other currencies. This way
S
the exchange value of those currencies increases, giving a boost
to the exporters and international competitiveness of China. The
US, on the other hand, started printing the currency in order to
IM
infuse liquidity in the market that led to the depreciation of USD
and appreciation of other major currencies against the USD. To
counter this problem created by USA, countries such as China,
Brazil and Korea have started intervening directly in Foreign Ex-
change (forex or FX) markets and keeping their currency values
low. The US trade deficit data with China is shown in table below:
M
Table: US trade deficit data with China for the period 2005–2015
Year Exports Imports Balance of Trade (BOT)
2005 41,192.0 243,470.1 –202,278.1
N
2006 53,673.0 287,774.4 –234,101.3

2007 62,936.9 321,442.9 –258,506.0
2008 69,732.8 337,772.6 –268,039.8
2009 69,496.7 296,373.9 –226,877.2
2010 91,911.1 364,952.6 –273,041.6
2011 104,121.5 399,371.2 –295,249.7
2012 110,516.6 425,619.1 –315,102.5
2013 121,721.1 440,434.3 –318,713.2
2014 123,675.7 466,754.5 –343,078.8
2015 83,993.5 357,566.9 –273,573.4
Total 932,970.90 3,941,532.50 –3,008,561.60

currency market 111
n o t e s
The following figure presents the movements of USD-Yuan cur-

rency pair between 2011 and 2015:
Figure: Movements of USD-Yuan Currency

Pair between 2011 and 2015
On 15 September 2010, the exchange rate of USD/CNY was 6.74,
S
and on 14 October 2015, it was 6.65. It means that the yuan had
been depreciating during those 30 days. Exactly after five years,
on 15 September 2015, the exchange rate of USD/CNY was 6.368.
On 24 September 2015, the USD/CNY value was 6.382. On 30 No-
IM
vember 2015, it was 6.400. A deep analysis of such exchange rate
movements by researchers reveals that China has been devalu-
ating its currency deliberately against the USD. All this has led
to an increasing trade deficit of the US with China as can be ob-
served from the table given above. US exporters are facing crisis
due to cheap Chinese products, and they are finding it difficult
M
to remain competitive in the domestic and international markets.
International agencies such as IMF have been pressurising China

to let its currency appreciate against the dollar as per the free
market. However, China follows a policy that allows its currency
N
to appreciate vis-à-vis the USD but only for short periods of time,
and after that, it again starts devaluating its currency intention-
ally. For example, China allowed the yuan to appreciate by 2%
during June-July 2010. However, after this, China again started
depreciating the yuan.
China and USA are two of the most powerful and largest econo-
mies in the world. Therefore, such invisible battles or currency
wars that they fight with each other is not a good indicator for the
world economy as a whole. Ideally, the determination of exchange
rates must be left wholly to the market forces rather than central
bank interventions.
(Sources:
Business Today,. (2015). Currency War – The Clash of Two Economic Superpowers.
Retrieved 30 November 2015, from http://www.businesstoday-eg.com/case-studies/
case-studies/currency-war-the-clash-of-two-economic-superpowers.html
Branch, F. (2015). Foreign Trade - U.S. Trade with China. Census.gov. Retrieved 30 Novem-
ber 2015, from https://www.census.gov/foreign-trade/balance/c5700.html
Ycharts.com,. (2015). US Dollar to Chinese Yuan Exchange Rate (Market Daily, CNY to 1
USD). Retrieved 30 November 2015, from https://ycharts.com/indicators/chinese_yuan_
exchange_rate)

n o t e s
learning objectives

>> Discuss the role of foreign exchange markets in the financial
system
>> Describe the concept of Balance of Trade (BOT) and Bal-
ance of Payments (BOP)
>> Explain the relationship between the monetary policy of a
country and the exchange rates of its currency vis-à-vis oth-
er currencies
>> Examine the relationship between foreign exchange rates
and interest rates
>> Identify various factors behind exchange rate dynamics
S
6.1 INTRODUCTION
In the previous chapter, you studied about three important types of fi-
IM
nancial markets that exist in the financial system, namely, the primary
market, the secondary market and the debt market. You studied that
the primary market refers to the new issues market where companies
issue their first ever public offers. The secondary market refers to the
markets where the trade of already issued securities takes place. The
debt market refers to the market in which loans are issued through
M
various financial instruments such as debentures, bonds, etc. This

chapter will introduce you to another important type of financial mar-
ket called currency market.
The currency market refers to that part of the financial market in

N
which the currency of one country is traded for the currency of an-
other country. This trade takes place at the existing exchange rate.
The currency market, also known as foreign exchange market, helps
countries to trade with each other by facilitating imports, exports and
capital transfers in a common currency. In addition, the forex market
provides arbitrage and speculation opportunities to arbitrageurs and
speculators, respectively. The forex market and exchange rates are
affected by a number of factors such as interest rates, monetary policy
of the country, inflation rates, levels of employment, and political and
economic stability of the country. In a forex market, each currency
pair represents a trading product.
In this chapter, you learn about the basic concepts of the forex market,
the roles played by it in the international financial market along with
the major participants that exist here. After that, the chapter discuss-
es the concepts of BOT and BOP. The later sections of the chapter
discuss exchange rate dynamics; relationship between interest rates,
exchange rates, inflation and unemployment, etc.

currency market 113
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6.2 Foreign Exchange Market

You must be aware by now about the various types of financial markets
such as primary markets, secondary markets, equity markets, debt
markets, etc. However, apart from these markets, there exists another
type of market called currency market or foreign exchange market.
A forex/FX market is the market in which individuals and corporates
can trade their currency in exchange for an equivalent amount of an-
other currency. Forex markets work in accordance with the rules and
regulations of the controlling authorities (such as RBI and SEBI) and
various related laws (such as FEMA and PML). The characteristics of
a forex market are described as follows:
Ithas lower trading costs as compared to the other types of mar-
kets because there is no brokerage or commission fee involved in
the case of forex markets. Trading of one currency for another is
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done on the basis of exchange rates. For example, an individual
having an amount of USD 250 can exchange it to get ` 15,000/-,
provided the exchange rate is USD 1 = ` 60.
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Transactions here are very transparent, and all the information re-
lated to buying and selling rates is available with investors. There
is no scope of any manipulation as it is controlled by the regulatory
authorities of various countries. With an increased use of Informa-
tion Technology (IT) in various forex transactions, operations have
become streamlined.
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It is quite liquid as compared to other markets. For example, a

person can easily convert his/her USD into INR by simply walking
into any authorised dealer’s centre or through money changers
such as the Western Union.
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Itstrends are easily available to investors, and they can monitor

the same as and when required.
Fluctuations here are reflected in the exchange values of curren-
cies on a day-to-day basis.
The international trade and capital activities have gone up tremen-
dously during the past five-six decades. For international trade
(import and export) and international capital activities, individ-
uals (such as overseas travellers) and corporates require certain
foreign currency that leads to a continuous demand and supply of
foreign exchange.
The forex market is an Over-the-Counter (OTC) market as there
is no permanent physical space where investors meet and trade.
Most of the forex trades are carried out through retail Authorised
Dealers (ADs) that act as representatives of the controlling and
regulatory authorities. For example, Western Union and Thomas
Cook are two agents through which an individual or corporate can
exchange one currency for another.

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The forex market is the largest financial market by volume of the

transactions among all financial markets.
The market works on a 24x7 basis throughout the year. It means
that there are no holidays in forex markets!
6.2.1 ROLES OF FOREIGN EXCHANGE MARKET
Why the foreign exchange market is the largest financial market in the
world is because of the various significant roles it plays, some of which
are as follows:
The market facilitates the transfer of purchasing power among
countries.
It provides credit for foreign trade.
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Its instruments are used for hedging against foreign transaction
risks.
In it, there are certain currencies that are used most widely. These
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currencies serve as the standard currency of trade and exchange.
For example, import and export usually takes place in currencies
such as USD, CHF, etc. The advantage with such currencies is that
they are readily exchangeable in forex markets.
It is also used to regulate the
Balance of Payments (BOP) and Bal-
ance of Trade (BOT) of an economy.
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Foreign exchange serves different purposes for various foreign mar-

ket participants such as governments, traders, corporations, invest-
ment funds and banks. This is represented in Figure 6.1:
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Traders
Short term system followers
with a wide range of skill,
knowledge, resources, and
commitment, Risk takers.
Governments Corporations
Long term enablers of national, Long term players who seek
regional, or global economic goals, profit protection through treasury
Market disruptors. management, Active hedgers.
FOREX
Investment Funds Banks

Long term trend followers Credit suppliers to
with high levels of skill, resources, corporation, governments, banks,
knowledge, and commitment, funds, and ancillary forex
Risk avoiders players, Market makers.
Figure 6.1: Role of the Forex Market for Various Market Participants
(Source: http://www.fxsforexsrbijaforum.com/t743-the-whos-who-of-forex)

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6.2.2 PARTICIPANTS IN FOREIGN EXCHANGE MARKET
As mentioned in the preceding section, there are various participants

in the forex market, and the market serves different purposes for dif-
ferent participants.
The various forex market participants are shown in Figure 6.2:
Corporates
Consumers and Travellers
Investors, Speculators and Arbitrageurs
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Commercial and Investment Banks
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Governments and Central Banks
Figure 6.2: Participants in the Forex Market
Let us now discuss each of these market participants:

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Corporates: Large corporate houses are one of the major users

of foreign exchange; therefore, they are a key participant in the
forex market. These houses require forex for their business deal-
ings such as imports, exports and capital flows. In addition, the
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employees of MNCs may also require visiting overseas for busi-

ness purposes. Frequent travelling by corporate employees and
corporates’ business dealings involve foreign exchange for which
corporates require the foreign exchange market. An MNC, such
as Infosys, Tata, etc., converts tens of millions of rupees each year.
Consumers and travellers: Whenever a purchase is made from
the home country for a product or service belonging to a company
located abroad, the buyer needs to pay for that product or ser-
vice in terms of the related country’s foreign currency, and for this,
the buyer needs to access a forex market. Whenever an individu-
al needs to travel to an overseas location, he/she requires foreign
exchange in the local currency for which he/she needs to access a
forex market.
Investors, speculators and arbitrageurs: Speculators and arbi-
trageurs require foreign currency in order to take advantage of the
exchange rate fluctuations in the forex market and derive some
profit from it. Investors also require forex when they want to in-
vest in securities such as equities or commercial papers that are
denominated in some foreign currency.

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Commercial and investment banks: Banks are key players in

the foreign exchange market. They are responsible for buying
and selling of currencies of different countries in accordance with
the rules and regulations of the governing bodies. Commercial
banks are important because they streamline the process of for-
eign exchange for their clients that comprise both individuals and
corporates.
Governments and central banks: Every country has its own cen-
tral bank that is responsible for effective and smooth functioning
of the financial system of the country. In particular, central banks
are responsible for implementing the monetary policy and fiscal
policy for their respective countries. These banks also regulate the
foreign exchange market by taking appropriate measures when-
ever required. Additionally, the banks determine the interest rate
that directly or indirectly affects the foreign exchange market. The
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value of a currency is determined by the supply and demand of
foreign exchange. Central banks intervene in the foreign exchange
market by buying the home currency when it wants to increase
IM
the value of the home currency (currency appreciation). Similarly,
central banks may decide to sell the home currency when it wants
to decrease the value of the home currency (currency deprecia-
tion). These banks also have the power to intentionally depreciate
the home currency.
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1. Which of the following individuals do not require foreign

exchange?
a. Overseas travellers b. MNC employees
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c. Housewives d. All of the above

2. Most of the forex trades are carried out through retail ADs
that act as representatives of the controlling and regulatory
authorities. (True/False)
3. List any three important participants in the currency market.
Activity
Prepare a report on the importance of INR as a foreign currency in

the world. What is the value of transactions that take place in terms
of INR on an average daily basis?
Balance of Trade (BOT) and

6.3
Balance of Payments (BOP)
Ever since the opening up of economies, almost every nation of the
world now maintains trade relations with various other nations. For

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example, the basmati rice of India is exported to more than 150 coun-
tries. Similarly, oil, petrol and petroleum products are exported from
oil-producing countries to all the countries of the world, especially
those that do not have their own oil reserves or do not produce oil.
It is evident that goods and services are traded between various coun-
tries. Such trade is completed with the help of imports and exports.
Import and export between countries requires that the importer pays
the exporter in a particular currency. Since each country has exports
and imports both, it is a rare possibility that the amount of revenue
generated as a result of exports and the amount of expenses incurred
on imports would ever be equal.
The difference between the amount of revenue generated from ex-

ports and the amount of expenses incurred on imports is known as
the Balance of Trade (BOT). If the amount of revenue generated from
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exports is more than the amount of expenses incurred on imports, the
BOT would be positive. Such a situation is called trade surplus. On
the contrary, if the amount of revenue generated from exports is less
IM
than the amount of expenses incurred on imports, the BOT would be
negative. Such a situation is called trade deficit. Various factors that
impact the BOT include:
Cost and availability of raw materials
Costof production in the exporting country as against the cost of
production in the importing country.
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Exchange rate fluctuations

Agreements, quotas and restrictions related to trade
Foreign exchange adequacy or level of forex reserves in the
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country
Prices of the goods manufactured domestically
In the preceding paragraphs, you studied that the difference between

the value of exports and imports of goods and services is known as
the balance of trade. The trade in goods is called trade in visibles or
merchandise trade, whereas trade in services is known as trade in in-
visibles. However, apart from these, there are other types of economic
transactions (involving transfer of economic value from one entity to
another) as well. These include capital transfers, unilateral transfers
and gifts.
All the countries of the world keep a detailed record of all their trans-
actions with each other, which is known as the Balance of Payments
(BOP). BOP is a structured and systematic accounting record of all the
economic transactions carried out between the residents and non-res-
idents of a country for a specified period. Non-residents are referred to
as the Rest of World (ROW). All economic transactions mean exports,
imports, capital flows, unilateral transfers, exchanges, etc.

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A BOP statement is prepared for a particular period, usually a year.

All the transactions having impact of bringing certain foreign curren-
cy into the country are called credit transactions, whereas the trans-
actions having impact of the domestic currency moving out of the
country are called debit transactions. Economic transactions in the
BOP can be categorised into visible items, invisible items and capital
transfers.
Factors that affect the BOP are as follows:

Inflation
Exchange rates
Interest rates
Economic policies of the government
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The difference between BOT and BOP is shown in Table 6.1:
Table 6.1: Difference between BOT and BOP

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S. No. BOT BOP
1. Includes economic transac- Includes economic transactions
tions related to export and related to export and import of
import of goods and services goods and services and capital
transfers
2. BOT is a part of overall BOP. BOP includes BOT.
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3. BOT is favourable if exports BOP is favourable when the

are greater than imports. sum total of exports and capital
inflows is greater than sum
total of imports and capital
outflows.
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4. The difference between the amount of revenue generated

from exports and the amount of expenses incurred on imports
is known as the Balance of Payments (BOP). (True/False)
5. Capital transfers are a part of BOT/BOP.
Activity
Examine the trend of BOT and BOP of India in the last twenty
years. Analyse the data and prepare a report on the same includ-
ing your findings and suggestions. Your suggestions should include
ways in which India can reduce its trade deficits. What steps can
be taken by the Indian government to achieve a trade surplus and
approximately how much time would it take?

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Monetary Policy and Foreign

6.4
Exchange
You are already aware about the concept of exchange rates. Let us now
define monetary policy. It is a policy that is usually made by the cen-
tral bank of a country to regulate the supply of money and credit in the
economy. The monetary policy affects the availability and cost of mon-
ey in the economy. The central bank achieves this by controlling the
interest rates that ultimately impact the prices and economic growth.
Two important considerations in a monetary policy are employment
and inflation, which are both affected by exchange rates. Therefore, it
can be said that there exists a relationship between the monetary poli-
cy of a country and the exchange rates. Both of these affect each other.
The monetary policy of a country includes decisions such as whether
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exchange rates should be fixed or kept floating or whether the central
bank should take any measures to manage exchange rates or not.
As mentioned before, exchange rates affect the inflation levels and

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employment in a country. Assume that the exchange rate of a home
currency is low and the foreign currency is expensive. In such a case,
if the economy is a heavy importer, the import of goods becomes more
expensive, and this will lead to increased levels of inflation in the
country due to price increase.
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The low exchange rate of the home currency will also lead to higher
levels of exports because domestic goods become cheaper for foreign
individuals. This means that the work of exporters will increase, and
it leads to employment generation. On the contrary, when the value
of the home currency appreciates against the foreign currency (ex-
N
change rate of home currency is high), it leads to the loss of employ-

ment because the levels of exports decrease.
All countries have mechanisms to help them in controlling their re-

spective monetary policies and exchange rates. Some countries have
adopted fixed exchange rates by imposing restrictions on the move-
ment of money (capital transfers) and on imports and exports. Some
countries let exchange rates float freely as they do not impose any
trade restrictions nor do they resort to any provisions for managing
exchange rates in their monetary policies. However, majority of the
countries allow exchange rates to float freely but maintain a certain
degree of control.
Central banks have the power to manage exchange rates by intention-

ally appreciating or depreciating their currencies or by buying and
selling foreign currencies. However, the banks need to do this only
in some critical cases such as shocks, wherein the central bank may
adopt an expansionary monetary policy or quantitative easing.

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Whenever governments and central banks observe that inflation lev-

els, employment levels and exchange rates are not in harmony, they
consider reviewing their monetary policies.
6. _______ policy affects the availability and cost of money in an

economy.
7. Assume that the exchange rate of a home currency is low.
Which of the following is an implied effect?
a. Imports will rise b. Exports will decrease
c. Exports will increase d. Inflation will increase
Activity
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Find out when India last implemented an expansionary monetary
policy.
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6.5 Interest Rate and Exchange Rate
In the previous section, we discussed the relationship between the
monetary policy and exchange rates of a country. However, another
important aspect of monetary policy is interest rates. There exists a re-
M
lationship between the interest rates and exchange rates of a country.
The exchange rate of a currency depends on various factors. However,

one important factor is the interest rate offered by a country. Assume
that all the factors apart from interest rates remain unchanged. In
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such a case, if the country offers higher interest rates, the value of the
home currency would increase as against the currencies offering low
interest rates. Similarly, if lower interest rates are offered, the value
of the home currency would decrease. As mentioned earlier, exchange
rates are impacted by a number of inter-related factors. However, in-
terest rates are a major factor that influence the exchange rate of the
home currency as against other currencies.
When the interest rate offered by a country is high, it attracts foreign

investments. Foreign investors require to get their home currency
converted into the currency of the country in which they want to in-
vest, which increases the demand for that currency leading to its ap-
preciation. Similarly, if the interest rate offered by a country is low, the
demand for its currency will also be low leading to its depreciation.
The above scenarios are ideal to explain the relationship between in-
terest rates and exchange rates, but the fact is that there are various
affecting factors that make predicting the relation between the two
very complex.

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One factor that affects the relationship between exchange rates and
interest rates is the relation between high interest rates and inflation.
High interest rates lead to increased inflation as the borrowing in
the domestic market decreases and the economy slows down. High-
er inflation therefore leads to currency depreciation. However, if the
central bank is able to strike a balance between the increase in in-
terest rates and the increase in inflation, the currency value would
appreciate.
The second factor relates to the political and economic stability of a

country. Foreign investors do not consider it wise to invest in the coun-
tries that are politically and economically fragile or instable because
of high uncertainty associated with their investments. They know that
the economy may stumble or political leadership of the country may
change anytime. In such a scenario, investors are faced with the risk
of losing their entire principal investment amount, nor can they fore-
S
see receiving any interest.
The third factor is related to the demand for a country’s goods and
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services reflected in its BOT. BOT and Gross Domestic Product (GDP)
are two important factors for determining the exchange rate. This is
so because the positive BOT implies greater demand for goods and
services, which leads to currency appreciation.
The fourth factor is related to the amount of debt a country owes to

outsiders. High level of debts leads to high inflation levels that, if un-
M
checked, may lead to depreciation of the home currency. In India, the

Reserve Bank sets the base rate. Base rate refers to the interest rate
below which commercial banks cannot lend. If this rate is increased,
the average risk-free interest rates will also go up, and consequently,
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businesses will have to offer higher rates to investors. Such higher

rates of interest also attract foreign investments, which in turn in-
creases the demand for the INR. The increased demand leads to the
appreciation of INR.
8. If a country offers higher interest rates, the value of its home

currency would ________ as against the other currencies
offering lower rates.
9. Higher inflation leads to currency depreciation. (True/False)
Activity
Collect the exchange rate (average for USD/INR) and interest rate
data offered in India as per the monetary policy for the last two years.
What kind of trend do you observe? Prepare a chart for this data.

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6.6 EXCHANGE RATE DYNAMICS

It is well-known that the exchange rates of currencies are very volatile
and so they change on a daily basis. The change in the exchange rate
depends on the demand and supply of a currency. High demand gen-
erally leads to currency appreciation, whereas low demand leads to
currency depreciation. The change in demand and supply of a curren-
cy is reflected in the exchange rate of the currency. When an economy
slows down, consumer spending decreases leading to the depreciation
of the home currency. On the other hand, when an economy is boom-
ing, consumer spending increases, and it leads to the appreciation of
the home currency.
Let us know the working of exchange rates in the markets.

Fixed Exchange Rate System: In a fixed exchange rate system, the
S
exchange rates are determined by the interventions of the central
banks and the government of nations. We can demonstrate how
the fixed exchange rate system worked, that is how the exchange
IM
rates used to remain constant, given in Figure 6.3:
Consider that the exchange rate between the dollar and the pound
is: $4=£1 and then try to understand the concept of the fixed ex-
change rate.
On x-axis >price per pound in dollars.
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On y-axis >quantity of pounds
S1
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S2
$4
D2
D1
Figure 6.3: Mechanism of the Fixed Exchange Rate System

Suppose there are two different currencies, that is, pounds and
dollars. Let the supply of pound increase, then the dollar would
appreciate against the pound and the pound will depreciate. Then
the Central Bank of England will start buying the pounds and
selling dollars so that the supply of dollars increase, and its sup-
ply would be limited thereby shifting the demand curve in such a
manner that the equilibrium price of $4=£1 is regained.
Free Floating Exchange Rates: This is an exchange rate system
in which exchange rates are determined by the forces of demand
and supply. The free floating exchange rates can be achieved in

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two different ways. The difference is only based on one parameter,

that is, government intervention. In one system, the government
does not interfere at all. But in the second system the government
takes part in the currency market or it can also affect the market
by use of some policy measures.
The two varieties of floating exchange rate are as follows:
Freely Floating Exchange Rate System: This is the system in
which the exchange rate determination is left solely dependent
on the market forces. The Government and the Central Bank
do not participate in the operations of the market. The only role
that the Government and the Central Bank of the concerned
country play is to regulate and monitor the market so that no
illegal activities take place and no scams or frauds occur. In
reality, such a system is not possible but the U.S. has adopted
S
the system of minimum interference in the currency market;
therefore, it is the only nation which is closest to being called as
an economy that follows a freely floating exchange rate deter-
mination system. The primary disadvantage of adopting such a
IM
mechanism is that uncertainty is associated with the exchange
rates and the exchange rates can be highly unpredictable.
Therefore, it means that international transactions and trade
become much more risky.
Managed Float System: This is the system in which the ex-
change rates are determined by the operation of the market
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forces, but the Central Banks and the Governments of the

concerned countries interfere in the operations of the market.
These bodies can buy or sell their own currencies or foreign
currencies to increase or decrease the price of its own currency.
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Each country’s exchange management interventions can only

have a negligible effect on the world foreign exchange market.
The dynamic nature of exchange rates is due to the factors as shown

in Figure 6.4:
Interest Rates
Employment Levels
Economic Growth
BOT
Central Bank Measures
Figure 6.4: Factors Affecting Exchange Rates

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Let us now discuss all the factors that affect exchange rate dynamics:
Interest rates: Every central bank fixes a rate of interest called
the benchmark rate. This rate affects the lending rates of various
financial institutions. In India, this rate is called the base rate and
is decided by the Reserve Bank. When the economy is under-per-
forming and growth is slow, the central bank lowers the interest
rates. Similarly, when the economy is growing excessively and in-
flation levels increase, the central bank raises the base rate. Due
to increased rates, borrowing becomes expensive. Increased rates
lead to greater demand for the currency due to which the currency
appreciates, and vice versa for decrease in interest rates.
Employment levels: When the level of unemployment in a coun-
try is high, the overall economic growth is low because the unem-
ployed have little amounts to spend. Additionally, all the employed
people also live under a constant fear of job loss and so they tend
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to save more. Therefore, as unemployment increases, there will
be a decrease in economic activities. All this leads to depreciation
or devaluation of a currency. In case of increasing unemployment,
IM
the demand for currency and general consumer confidence in cur-
rency also decrease. When the demand slows down, it is also likely
that the supply of currency will pile up leading to further depreci-
ation of the currency.
Economic growth: It is necessary for an economy to grow because
in case of little or no growth, the economy would stagnate and
M
would not be able to keep pace with the rest of the world. It is also
possible that an economy grows so rapidly that the prices increase
at alarming rates. In such cases, the percentage of price rise is usu-
ally higher than the percentage of increase in individual wages. It
N
means that individuals may be earning more than what they used
to earn earlier, but the increase is not sufficient to beat the infla-
tion. When high interest rates lead to higher inflation levels, the
central bank may attempt to lower the interest rates to slow the
economy, and this change impacts the exchange rates. During pe-
riods of recession, deflation (lowering of prices in general) takes
place, but consumers do not have money to spend. The central
bank, in such cases, lowers the interest rates in order to encourage
public spending and reviving the economy.
Balance of Trade (BOT): As discussed earlier, the BOT refers to
the balance generated after deducting the value of imports from
the value of exports. If the value of BOT is positive (trade surplus),
it is favourable for a country. On the contrary, if the value of BOT
is negative (trade deficit), it is unfavourable for a country. A trade
surplus means that the demand for the home currency is more,
and it leads to currency appreciation. On the other hand, a trade
deficit means that demand for the home currency is low, and it
leads to currency depreciation.

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Central bank measures: At times, it becomes necessary for the

government and central bank of a country to directly intervene in
the forex market to have a desired impact on the economic growth
of the country. Under such measures, the central bank involves
itself in the buying and selling of government securities and oth-
er instruments such as foreign exchange, which results in either
increase or decrease in the demand of the currency, leading to ap-
preciation or depreciation of the same. Such measures typically
include expansionary monetary policy and quantitative easing.
Exhibit
Shocks and Quantitative Easings
An economic shock refers to an unexpected or unpredictable event,

the occurrence of which affects an economy either positively or
S
negatively. An economic shock may take the form of a supply shock
as in the case of commodities such as oil and petrol. A shock may
also occur when there is continuing and rapid devaluation of a cur-
IM
rency as this would impact imports and exports.
Supply shocks may also occur when the supply of a commodity de-
creases along with increase in the price that is a negative supply
shock; on the other hand, there may be a supply shock wherein the
supply of a commodity increases and the prices decrease leading
to a positive supply shock. Similarly, demand shocks occur owing
M
to steep changes in the demand of a commodity. In case the de-

mand decreases drastically, the prices will also decrease, and when
the demand for a commodity increases drastically, the prices will
increase generally (plus owing to hoarding and black marketing).
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Inflationary shock occurs when the prices of commodities increase

rapidly.
The expansionary monetary policy is adopted by the central banks

of countries when the usual monetary policy of a central bank fails
to achieve its intended objectives of maintaining price stability and
increasing economic growth. The expansionary monetary policy is
implemented when the interest rate on short-term securities tends
to approach zero percent. Under this policy, the central bank buys
government and other securities (short-term as well as long-term)
from the open market (banks and FIs) in order to lower the inter-
est rates and also to increase the money supply into the financial
system. When the financial systems (comprising banks and FIs)
have access to funds, they also boost up their lending activities to
individuals, companies and other banks. A very elaborate type of
expansionary monetary policy is Quantitative Easing (QE). Under
a QE, the central bank of a country buys government and other se-
curities, usually long-term, from the open market (banks and FIs)
in order to further lower the interest rates and also to increase the
money supply into the financial system. QE may lead to increase

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in inflation; therefore, it is necessary to ensure that inflation levels

do not fall below a certain level.
For example, after the subprime crisis of 2007–08 that affected the
whole world, the Bank of England (central bank of England) had
to roll out a QE programme. It is because banks and FIs make new
money when they lend loans. However, after the crisis, the exist-
ing borrowers were paying their loans from the already existing
sources or funds. The banks were not lending, and as a result, the
economy was shrinking for which the Bank of England rolled out
the QE scheme and created new money worth £375 billion under it.
10. Mention any two factors that majorly affect exchange rates.
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11. A trade deficit means that the demand for a home currency is
more, leading to currency appreciation. (True/False)
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Activity
Apart from the factors mentioned in the above text, prepare a list of
the other factors that affect exchange rate dynamics.
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6.7 SUMMARY
The FX market is the market in which individuals and corporates
can trade their currencies in exchange for an equivalent amount
of another currency.
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Foreign exchange serves different purposes for different foreign

market participants such as governments, traders, corporations,
investment funds and banks.
Various forex market participants are corporates, consumers and
travellers, investors, speculators and arbitrageurs, commercial
and investment banks, and governments and central banks.
The difference between the amount of revenue generated from ex-
ports and the amount of expenses incurred on imports is known as
the Balance of Trade (BOT).
BOP is a structured and systematic accounting record of all the
economic transactions carried out between the residents and
non-residents of a country for a specified period.
Monetary policy is a policy that is usually made by the central
bank of a country to regulate the supply of money and credit in the
economy.
Exchange rates affect the inflation levels and employment in a
country.

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All countries have mechanisms to help them in controlling their

respective monetary policies and exchange rates. Majority of the
countries allow exchange rates to float freely but maintain a cer-
tain degree of control.
There exists a relationship between the interest rates and ex-
change rates of a country.
Assume that all the factors apart from interest rates remain un-
changed. In such a case, if the country offers higher interest rates,
the value of the home currency would increase as against the cur-
rencies offering low interest rates and vice versa.
Change in the exchange rate depends upon the demand and sup-
ply of a currency. High demand generally leads to currency ap-
preciation, whereas low demand leads to currency depreciation.
S
The change in demand and supply of a currency is reflected in the
exchange rate of the currency.
The dynamic nature of exchange rates is due to the factors such
IM
as interest rates, employment levels, economic growth, BOT and
central bank measures.
key words
Authorised Dealer (AD): It refers to a bank that has been au-

M
thorised by the central bank to deal in foreign currencies.

Deflation: It refers to the general decrease in the price of goods
and services in a country. It occurs when inflation rates fall be-
low zero percent.
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Employment level: It refers to the percentage of population out

of the total population of a country that is employed or engaged
in some productive activity, which generates income.
Inflation: General increase in the price of goods and services in
a country over a period of time.
Interest rate: It refers to the rate that is charged by financial
institutions such as banks for granting loans to borrowers.
Market participant: It refers to the individual/entity that takes
part in a market.
Non-residents: It refers to all those individuals/entities whose
economic interest does not lie in a country.

1. Describe in detail the concept of foreign exchange market.
2. Write a detailed note on BOT and BOP.

n o t e s
3. How are monetary policy and foreign exchange related to each

other?
4. List and explain the various factors that affect exchange rate
dynamics.
Topic Q. No. Answer

Foreign Exchange Market 1. c. Housewives
2. True
3. Corporates, commercial and
investment banks, and govern-
S
ments and central banks
Balance of Trade (BOT) and 4. False
Balance of Payments (BOP)
IM
5. BOP
Monetary Policy and Foreign 6. Monetary
Exchange
7. c. Exports will increase
Interest Rate and Exchange 8. Increase
Rate
M
9. True
Exchange Rate Dynamics 10. Inflation level and employ-
ment level
11. False
N

1. For international trade (import and export) and international
capital activities, individuals (such as overseas travellers) and
corporates require certain currency that leads to a continuous
demand and supply of foreign exchange. Refer to Section
6.2 Foreign Exchange Market.
2. The difference between the amount of revenue generated from
exports and the amount of expenses incurred on imports is
known as the Balance of Trade (BOT). All the countries of the
world keep a detailed record of all their transactions with each
other, which is known as the Balance of Payments (BOP). Refer
to Section 6.3 Balance of Trade (BOT) and Balance of Payments
(BOP).
3. Two important considerations in a monetary policy are
employment and inflation, which are both. Exchange rates
affect both the employment and inflation. Refer to Section
6.4 Monetary Policy and Foreign Exchange.

currency market 129
n o t e s
4. The dynamics of exchange rates are affected by the following

factors: interest rates, employment levels, economic growth,
BOT and central bank measures. Refer to Section 6.6 Exchange
Rate Dynamics.

6.10
REFERENCE
SUGGESTED READINGS
Bhole, L., & Mahakud, J. (2009). Financial institutions and mar-
kets. New Delhi: Tata McGraw-Hill.
Pathak, B. (2011). The Indian financial system. New Delhi: Pearson.
E-REFERENCES
S
Risksandrewards.org.uk,.(2015). Foreign Exchange Market - Risks
and Rewards. Retrieved 30 November 2015, from http://www.risk-
IM
sandrewards.org.uk/background_city_116.html
(2015).Retrieved 30 November 2015, from http://www.icmrindia.
org/casestudies/catalogue/Finance/Securities%20and%20Ex-
change%20Board%20of%20India.htm
Fxtrade.oanda.com,. (2015). Exchange Rate Factors | Exchange
Rate Dynamics | OANDA fxTrade. Retrieved 30 November 2015,
M
from http://fxtrade.oanda.com/learn/top-5-factors-that-affect-ex-
change-rates
N

N
M
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S
Ch a
7 p t e r
institutions in the financial market—

banking institutions
CONTENTS
S
7.1 Introduction
7.2 History and Evolution of Banking Institutions in India
IM
Activity
7.3 Commercial Banking
7.3.1 Functions of Commercial Banking
7.3.2 Services Offered by Banks
M
Activity
7.4 Commercial Banking Principles
Activity
N
7.5 Concept of Central Banking and India’s Central Bank (RBI)

7.5.1 Evolution of Central Banking
7.5.2 Functions of a Central Bank
Activity
7.6 Summary

n o t e s
MODERNISATION OF FINANCIAL INSTITUTION: AN

EXAMPLE OF YES BANK
Yes Bank marks a departure from other banks when it comes to

growth, innovation and marketing strategy. It was founded in No-
vember 2003, by Rana Kapoor and Ashok Kapoor, with an initial
capital base of $ 45 million. This amount was modest when com-
pared with new banks, which were set up by financial institutions
or existing banks with high capital base. The birth of Yes Bank is
unique as it was set up by the first generation entrepreneur. In
fact, Yes Bank is the only greenfield bank to be approved by the
central bank, Reserve Bank of India (RBI), in the last 15 years.
When Yes Bank started its operations, it decided to focus on agri-

culture and infrastructure services. It opened 100 branches with-
S
in 3–4 years. The bank decided to offer corporate banking, finan-
cial market services, investment banking and special schemes for
small companies.
IM
In a very short time, Yes Bank established a high quality, custom-
er-centric, service-driven private Indian bank. The bank believes
that its differentiator begins with its service and trust mark, ‘Yes’.
Yes, by its very name, represents the bank’s true spirit of being af-
firmative, positive and service-driven. The major strength of Yes
Bank is a sharp, motivated and young team. Various focused cam-
M
paigns combined with the bank’s excellent service delivery makes

it a highly recognised brand.
Quality service and technology continue to be the key differentia-

tor for Yes Bank. It helps in attracting and retaining the discern-
N
ing customers.

institutions in the financial market— banking institutions 133
n o t e s
learning objectives

>> Describe the evolution of banking institutions in India
>> Explain the concept of commercial banking
>> Discuss commercial banking principles
>> Explain the concept of central banks
7.1 INTRODUCTION
In the previous chapter, you have studied about the currency market.
This chapter is related to banking institutions in the financial market.
Every country needs to have a strong financial system in place so that
S
it is able to meet the demand and supply of financial requirements of
the country. In order to ensure that this requirement is met, the coun-
try seeks the services of several types of financial institutions, such as
banks. A bank is a financial institution that carries out lending and
IM
borrowing activities in an economy.
The economic condition of any country is closely related to the effi-

ciency of its banking system. Banks in India are broadly categorised
into two types, namely, central bank and commercial banks. Central
banks act as the banker’s bank and regulate the whole banking sys-
M
tem. Commercial banks accept deposits, transfer funds from one bank
to another and create money by advancing loans.
In this chapter, you will study the evolution of banking institutions in

India. The chapter explains the concept and functions of commercial
N
as well as central banks in the country.
istory and Evolution of Banking

H
7.2
Institutions in India
The banking system in India is not a new concept. It has progressed
from a licensed raj business to a modernised technological business.
In fact, the origin of banking goes back to the days of Lord Buddha
wherein evidences have been found in the form of an existence of
some form of money economy or banking economy at that time. Also,
there have been evidences in the Maurya Dynasty period wherein
there was an existence of an instrument called Adesha. It represented
some form of an order to pay money to the third person. This rep-
resents the modern form of bill of exchange. Further, during that pe-
riod there have been evidences wherein merchants used instruments,
which represented a letter of credit.
Similarly, institutions, such as temples represented the role of the

modern banks wherein they accepted donations and other instru-
ments. These donations or entities were used to provide some sort of

n o t e s
loans and advances. Even some traders followed the same mechanism.
Traders, who had excess of these instruments with a monetary value,
used to lend the same with some form of added value. This added
value represented the interest factor of the modern form of banking.
Further, down the ages, Muhammad Bin Tughlaq, the ruler of Delhi,
issued copper coins. These coins were used by traders to carry out
their business. Thus, this issue represented the authority of the Cen-
tral Banks or the RBI to issue new coins. With the coming down of the
British rule in the Indian subcontinent, the concept of banking insti-
tutions improvised with the establishment of the East India Company.
This represented the start of commercial banks wherein earning prof-
it was the main motive. This was similar to modern-day commercial
banks of the country.
Thus, banking operations evolved in stages with each stage being an
S
improvement over the previous stage. Let us learn about these stages
in detail:
Early phase (1786–1947): This was an evolutionary phase. The first
IM
banks started in India were the General Bank of India and Bank
of Hindustan in 1786. The Bank of Bengal in 1809 was established
as Presidency Bank. After this, the Bank of Bombay and the Bank
of Madras were established in 1840 and 1843, respectively. During
this period, many banks leaped up and failed due to various issues,
such as mismanagement, fraud, speculation, etc. Thus, the bank-
M
ing system during this phase grew at a slow pace. Before the First
World War, Swadeshi Movement influenced the opening of banks,
such as People Bank of India, Central Bank of India, Bank of In-
dia and Bank of Baroda. However, these banks became unstable
after the First World War. The Government of India established the
N
Imperial Bank of India in 1921 by merging three banks, namely,

Bank of Bengal, Bank of Bombay and Bank of Madras. In 1935,
the RBI was established to manage the currency of the country.
This bank acted as the banker to the commercial banks as well as
government.
The outbreak of the Second World War also disrupted the econom-
ic development in the Indian banking sector. However, it was fol-
lowed by the emergence of rebuilding the economy. In 1948, RBI
was nationalised by enacting the Banking Companies Act, 1949,
for an amendment related to the banking companies.
Expansion phase (1950–1990): We can link this phase with the
broadening of the banking system. It led to the expansion of bank
branches and penetration of banking in the rural sector. In 1969,
Indian government nationalised several banks, such as the Union
Bank, the Bank of Maharashtra, the Punjab National Bank, the
Indian Bank, the United Bank of India, the Bank of India, etc. This
nationalisation was done because of the following reasons:

n o t e s
Failure to achieve the social and developmental goals of banking
Exclusion of the rural sector from lending

To make available more funds for agricultural development
Nationalisation led to enhanced bank credit to the agricultural sec-
tor. This also helped in improving the deposits and more savings,
leading to increased supply of money. Apart from this, National
Bank for Agricultural and Rural Development (NABARD) was set
up in 1982 for agricultural and rural credit.
Modern phase (from 1991 till date): This is the phase of moderni-
sation in the banking system. The Narasimhan Committee played
a great role in this phase. This committee reviewed the progress
of the banking sector reforms for six years and gave recommenda-
tions to strengthen the financial system. Another turning point in
this phase was that of economic liberalisation. It suggested reduc-
S
tion in tariffs, duties and taxes. The Indian economy was opened
to investment by foreign players that revitalised the banking sec-
tor in India. This has also given rise to various tech-savvy meth-
IM
ods of banking. The information technology revolution has further
brought many changes in the banking industry in the form of net
banking, m-banking, etc.

M
1. In 1809, the Bank of Bengal was established as ___________.

2. In ________________, the Reserve Bank of India was established
to manage the currency of the country.
3. In the modern phase, which committee reviewed the
N
progress of the banking sector reforms for six years and gave
recommendations to strengthen the financial system?
Activity
Using the Internet, find out about various other evidences, which
are available for existence of banking institutions in India. Prepare
7.3 Commercial Banking

Commercial banking is the most important component of the whole
banking system. Commercial banks are a profit-based financial insti-
tution. These banks take deposits from the customers, provide loans
to the borrowers by charging an interest rate and earn profit through
these interest rates or otherwise, such as commissions on making the
draft, electronic transfer of funds, selling and buying of currency, etc.
Like the investment banks, commercial banks are regulated strongly

n o t e s
by regulatory authorities, such as the RBI, banking ombudsman, etc.

These banks prefer to provide credit for a short period of time backed
by tangible and easily marketable securities. Some of the important
features of a commercial bank include the following:
Safeguards important documents and other deposits
Offers financial assistance in the form of bank loans, installment
credit and overdraft
Issues bills of exchange, such as bank drafts and checks
Accepts cash, gold and other financial securities
Assists organisations in underwriting, selling and distributing se-
curities
Plays the role of merchant banker and finance equity
S
Generally, there are three types of commercial banks. These are ex-
plained as follows:
Public sector banks: These banks are nationalised by the govern-
IM
ment of a country where the major stake is held by the govern-
ment. These banks operate under the guidelines of the RBI, which
is the central bank. Some examples are State Bank of India (SBI),
Corporation Bank, Bank of Baroda, Dena Bank and Punjab Na-
tional Bank.
Private sector banks: These are the banks in which the major part
M
of the share capital is held by private businesses and individuals.

These are registered as companies with limited liability. Some ex-
amples are Vysya Bank, Industrial Credit and Investment Corpo-
ration of India (ICICI) Bank and Housing Development Finance
N
Corporation (HDFC) Bank.

Foreign banks: These banks are headquartered in a foreign coun-
try, but operate branches in different countries. Some examples in
India are Hong Kong and Shanghai Banking Corporation (HSBC),
Citibank, American Express Bank, Standard & Chartered Bank
and Grindlay’s Bank.
7.3.1 Functions of Commercial Banking
The functions of a commercial bank can be divided into primary func-

tions and secondary functions. The primary functions comprise the
basic or core functions of a commercial bank, while the secondary
functions relate to other functional aspects of a commercial bank.
The following points cover the primary functions of the commercial banks:
Accept deposits from the customers: This is one of the basic func-
tions of the commercial banks in India. As commercial banks oper-
ate on the basic objective of a profit motive and maximisation of the
profits, the acceptance of deposits is invariably the core function

n o t e s
of the commercial banks. This is due to the fact that commercial

banks make advances or provide loans to borrowers through these
deposits only. The deposits which are accepted by these commer-
cial banks include term deposits, such as fixed deposits, recurring
deposit, cash certificates, gold deposits, etc.
Provide loans and advances to the borrower: This is another ma-
jor function of commercial banks. The prime motive for the com-
mercial banks is to make profits, which come only when the banks
make advances or loans supplemented with the interest factor.
Commercial banks grant loans in the form of overdraft, cash cred-
it, discounting bills of exchange, etc.
Secondary functions include the following:

Act as collecting agents: This is another important function of
commercial banks wherein they collect cheques, drafts, promisso-
S
ry notes on behalf of the customers and credit them directly into
their accounts.
Make payment of rent, insurance premium and other utility func-
IM
tions, such as telephone bills and electricity bills: This is another
major function of the commercial banks wherein they make pay-
ments on behalf of the customers through the standing instructions.
Act as a dealer in foreign securities: This is another major func-
tion of the commercial banks wherein they buy and sell foreign
M
currencies. The commission that is charged during this process

provides the avenue to profit motive.
Act as a dealer in the sale and purchase of various types of se-
curities: This is another function, which is performed by the com-
N
mercial banks. They buy and sell various types of securities on

behalf of the customers.
Advise the customer on various avenues for saving and mobil-
isation of funds: This is another function, which is performed by
the commercial banks to advise and guide customers in the pro-
cess of effective utilisation of funds.
Provide various utility services, such as an ATM, safe deposit
lockers and credit cards: This is another function of the banks to
provide several utility services to assist customers in the process of
carrying out various operations effectively and efficiently.
7.3.2 Services offered by Banks
The other services performed by the commercial banks include the

following:
Funds-based services: The commercial banks provide funds to
the borrowers on the basis of the assets that the borrower owns.
Some examples include provision of funds against the asset home,
i.e., loan against property, provision of funds against fixed deposit,

n o t e s
equipment leasing, underwriting shares, debentures and bonds,

hire purchase, venture capital, insurance services, etc. In case of
fund-based services, the difference between the interests paid and
the interest earned is the income of the bank. Also, there is a large
amount of expenditure in the form of interest and brokerage. In
fund-based services, the risk exposure is quite high due to the fact
that the borrower may not be able to repay the amount that he has
borrowed.
Fee-based services: These services are provided by the commer-
cial banks. Like the fund-based services of the commercial banks,
these types of services do not carry much risk. However, the moot
question is the fact that it requires a lot of expertise and judgement
on the part of banks to dispense these services. Some examples of
fee-based services include corporate advisory services, bank guar-
antees, loan syndication, credit rating, etc.
S
Modern services: With the advent of information technology, the
commercial banks too have upgraded their banking operations by
closely integrating technology into their business process. Some
IM
examples of modern services offered by commercial banks include
net banking, mobile banking, RTGS and NEFT for the transfer
of funds electronically, banking from the convenience of home,
24x7x365 days banking operations and the like. Other modern
services offered by commercial banks include payment of bills for
utility services, such as telephone bills, electricity bills, etc.
M
4. Fee-based services are not provided by the commercial banks.

(True/False)
N
5. Public sector banks are the banks in which the major part of
the share capital is held by private businesses and individuals.
(True/False)
6. Commercial banks grant loans in the form of overdraft, cash
credit, discounting bills of exchange, etc. (True/False)
7. Give examples of public sector banks.
Activity
Using the Internet, research about various other functions of com-

mercial banks. Prepare a report on your findings.
7.4 Commercial Banking Principles

The success of commercial banks depends on the principles that they
follow. These principles are important for maintaining stability in the
market.

n o t e s
Some of the principles followed by the commercial banks include:

Principle of safety: Safety implies when the borrower is not at
default and he/she is able to pay the loan amount on time at regu-
lar intervals. Nature of security, credibility position of the borrow-
er and financial standing are the important factors that affect the
safety. The ability of the borrower to repay the funds depends on
his/her capacity and willingness to buy. Capacity to pay depends
on the success of the borrower’s business while willingness to buy
depends on his/her personal characteristics that include honesty
and reputation. Thus, a banker should ensure while lending that
the business for which the loan is being sought is successful and
that the borrower is a person of good character. This ensures that
the funds are safe.
Principle of liquidity: This is an important principle on the ba-
S
sis of which any bank operates. Banks lend public money that the
depositors can withdraw any time. If banks are unable to provide
liquidity in a short time, then they stand to lose out to the compet-
itor banks. For example, customers are hesitant to open a deposit
IM
in a post-office banks due to problems in liquidity. Therefore, they
resort to commercial banks that are able to provide easy liquidity
in a short span of time. Commercial banks always choose the secu-
rities that provide easy liquidity.
Principle of secrecy: This is a basic principle that is strictly en-
forced by all commercial banks. This principle deals with the se-
M
crecy of the transactions and other details pertaining to the cus-

tomers who avail the services. This translates to the fact that the
customers must feel assured that the details are not divulged to
any unauthorised person or authority.
N
Principle of profitability: The main objective of commercial banks

is to earn maximum profit. Profits are necessary for paying sala-
ries, interest to the depositors, dividend to the shareholders, etc.
For earning high profits, banks should not lend to unsound parties
with suspicious repaying capacity. To earn profits with liquidity,
the banks should invest in short notice, bills discounted, loans and
advances, etc.
Saleability of securities: This implies that the banks should invest
in those securities that are easily marketable, when required. A
bank cannot invest its funds in long-term or unsalable securities.
Therefore, it is important for the bank to invest its funds in the
government sector or reputed organisations.
8. The capacity to pay depends on the success of the borrower’s

business while willingness to buy depends on his/her personal
characteristics that include honesty and reputation. (True/False)

n o t e s
Activity
Using the Internet, find out about various other principles of com-
mercial banks. Prepare a report on your findings.
Concept of Central Banking and

7.5
India’s Central Bank (RBI)
A central bank is an institution that is entrusted with the responsibil-
ity of controlling the supply of money in the market to meet the ob-
jectives of the financial system. In other words, the central bank is the
custodian of the money that floats in the market. This helps in meeting
the needs of various stakeholders and shareholders. These banks pro-
vide specialised activities, such as supervising and regulating banking
S
institutions, managing payments and developing the monetary poli-
cy for the economy. As compared to the commercial banking, central
banking enjoys monopoly as it oversees the commercial banking sys-
IM
tem in a country. Central banking objectives of the RBI can be stated
as follows:
Monetary policy objectives: These objectives relate to promoting
economic growth, maintaining inflation and ensuring money sup-
ply in the economy.
Financial sector objectives: These objectives relate to supervising
M
commercial banking systems and assisting banking and financial

institutions.
Organisational development objectives: These objectives relate
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to economic research facilities and creating an information system

to support economic decision-making, and financial and human
resource management.
Let us study the evolution of central banking in India in the following

section.
7.5.1 Evolution of Central Banking
The concept of central banking was introduced in the 20th century.

It came into existence to regulate the flow of money in the market
through an authorised body. This body was proposed to be entrusted
with the task to regulate the flow, form policies and guidelines, and
implement management controls to make the financial system of the
country effective. The RBI came into existence in 1935 under the Re-
serve Bank of India Act, 1934, as a banker to the central government
to respond to the economic effects after the First World War. The Hil-
ton Young Commission provided a base for the establishment of the
RBI to handle the financial and economic environment of India.

n o t e s
This was established because of the following reasons:

Separating the control of currency and credit from the government
Increasing banking facilities throughout the country
The RBI launched its operations on April 1, 1935. It started as a pri-

vate shareholder bank with a paid up capital of ` 5 crore. The RBI
was nationalised in 1949 and started working as a government-owned
central bank of India.
7.5.2 Functions of a Central Bank
The central bank protects the financial stability and economic devel-
opment of a country. It deals with commercial banks and does not
deal with the general public directly. The RBI as India’s central bank
avoids the cyclical fluctuations by controlling monetary policy of the
S
economy. It acts as a monetary authority to supervise the financial
system. The functions of the central bank are to:
Monitor the key indicators that directly or indirectly affect the flow
IM
of funds into and out of the country.
Maintain the confidence of the people of the country in the bank-
ing and financial system as it is the custodian of various banking
operations of the country in addition to performing the core func-
tions of the financial management system.
M
Resolve various problems of the public and draft new policies and
procedures in the form of banking ombudsman. The banking om-
budsman is responsible for resolving the conflicts and issues that
the public faces when they interact with the banking officials re-
garding their work.
N
Let us study the functions of the central bank in detail.
ISSUE OF NOTE
The central bank is responsible for ensuring that the financial system
of the country is working in an efficient manner. One of the major
functions performed by the central bank is the issue of note (curren-
cy). The RBI has an exclusive right to issue notes (currency). The issue
of notes by one bank is necessary for the uniformity in note circulation
and equilibrium between money demand and money supply.
The reasons for the concentration of the right of issue by the central
bank are as follows:
The centralised and monopolistic function of the central banks en-
sures that circulation, issue and withdrawal of currency notes and
coins is controlled in a systematic manner. This directly and in-
directly provides the thrust for maintaining an effective financial
system of the country.

n o t e s
The efficient and effective functioning of the central banks in terms

of controlling the currency note issue and withdrawal ensures that
public confidence is maintained with respect to the financial sys-
tem of the country.
The central bank of the country has complete information regard-
ing the economy. Thus, it can formulate policies as to when the
new currency notes are required to be floated or issued in the mar-
ket and when the currency notes are required to be withdrawn.
GOVERNMENT’S BANKER, AGENT AND ADVISOR
Apart from issuing currency, one of the important functions of the

central bank is to act as a banker, agent and advisor to the government
and commercial banks. As a banker, the central bank indulges in var-
ious banking operations related to deposits and loans to the govern-
S
ment. As an agent, the banks manage the public debt. As an advisor,
the central bank advices on the matters related to monetary policy,
fiscal policy, inflation, etc. Let us study in detail:
IM
As a banker: The central bank performs the role of a banker to the
government just as the commercial banks play the role for the end
customers. It is responsible for maintaining the accounts of central
as well as state governments and other public sector enterprises.
It is responsible for the collection of drafts, cheques, treasury bills,
etc., on behalf of the government and depositing the same in the
M
government accounts. It is also responsible for the repayment of

external debts or for purchasing foreign goods and making other
payments on behalf of the government.
As an agent: The central bank acts as an agent to the government.
N
It is responsible for collecting several types of taxes, such as in-

come tax, sales tax, VAT, etc. It is responsible for representing the
government at several international events and conferences and
in announcing the policies of the government with respect to the
financial system of the country.
As an advisor: The central banks are responsible for advising the
government on economic, fiscal and monetary policies, devalua-
tion and appreciation of the currency based on the international
market dynamics across the world.
Custodian of Foreign Balances of a Country
In addition to acting as an advisor to the government, the central banks

are also responsible for acting as the custodian of foreign balances of
a country. Central banks must maintain foreign exchange reserves to
ensure that trading in international markets remains uninterrupted.
If the foreign exchange balances are not maintained by the central
banks, several issues and problems may arise when deals are required
to be performed at an international level.

n o t e s
Thus, in order to manage the foreign exchange reserve, the central

bank buys and sells gold at fixed prices to several countries, thereby
regulating the inflow and outflow of foreign currency in the country.
In addition to buying and selling of gold, the central banks are also re-
sponsible for buying and selling of foreign currencies at international
levels. Also, the central banks are responsible for fixing the buying
and selling rates of currencies of different countries.
Further, keeping in mind the regulations and policies of the Internation-

al Monetary Fund, World Bank and WTO, the central bank tries to man-
age the financial stability of the international currencies. This is done as
per the directions or guidelines provided by these international bodies
as well as the directions of the government of the respective country.
Central Clearance, Settlement and Transfer
S
Being the bankers’ bank to several commercial as well as other banks,
the central bank plays the role of a clearing agent for transfer and
settlement of various claims for several types of commercial banks.
IM
The central bank sets a clearing house under it where mutual indebt-
edness between banks is settled. Representatives of different banks
meet in the clearing house for clearance of inter-bank payments. This
also helps the central bank to know the liquidity state of the commer-
cial banks. As the central bank holds the reserve capital of several
banks, it does so by transferring funds from the account of one bank
to the account of another to facilitate the clearing of the cheques de-
M
posited by the account holders.
Credit Control
N
Credit control assumes great importance in managing the financial

system of a country in the sense that it is responsible for inflation and
deflation rate of the country which has the tendency to affect the econ-
omy. In order to control the credit, the central banks resort to quanti-
tative as well as qualitative methods.
Quantitative methods are implemented with the aim of controlling the

cost and quantity of credit on the basis of bank rate policy and open
market operations. It also takes into account the varying reserve ra-
tios of different commercial banks in the country.
The usage and application of qualitative methods is performed with the

aim to control the usage of credit. This involves the identification and
selection of selective credit controls. By using these methods, the cen-
tral banks try to influence and control the credit creation by commercial
banks to maintain stability in various economic activities of the country.
In addition to credit control, the central banks are also entrusted with
other powers. They have been empowered to issue licenses and to reg-
ulate the expansion of the branch and to ensure that every bank and

n o t e s
every branch maintains the minimum paid up capital and reserves as

provided by the rules and regulations of the country.
9. _________________ has an exclusive right to issue notes.

10. The banking ombudsman is responsible for resolving the
conflicts and issues that the public faces when they interact
with the banking officials regarding their work. (True/False)

11. ________________ relate to supervising the commercial
banking systems and assisting the banking and financial
institutions.
Activity
S
Using the Internet, find out various roles of the central bank
through which the public is indirectly benefitted. Prepare a report
on your findings.
IM
7.6 SUMMARY
The origin of banking in India goes back to the days of Lord Bud-
dha wherein evidences have been found in the form of an exis-
tence of some form of money economy or banking economy at that
M
time. Also, there have been evidences in the Maurya Dynasty peri-
od wherein there was an existence of an instrument called Adesha.
It represented some form of an order to pay money to the third
person. This represents the modern form of bills of exchange.
N
Commercial banks are a profit-based financial institution. These

banks take deposits from customers, provide loans to the borrow-
ers by charging an interest rate and earn profits through these in-
terest rates or otherwise, such as commissions on making the draft,
electronic transfer of funds, selling and buying of currency, etc.
The primary functions of the commercial banks comprise the ba-
sic or core functions, while the secondary functions relate to other
functional aspects of the commercial banks.
A central bank is an institution that is entrusted with the respon-
sibility of controlling the supply of money in the market to meet
the objectives of the financial system. As compared to commercial
banking, central banking enjoys the monopoly as it oversees the
commercial banking system in a country.
The principles of commercial banking include the principle of
safety, the principle of liquidity, the principle of secrecy, principle
of profitability and salability of securities.
The central bank protects the financial stability and economic de-
velopment of a country. It deals with commercial banks and does

n o t e s
not deal with the general public directly. The RBI, as India’s cen-
tral bank, avoids the cyclical fluctuations by controlling monetary
policy of the economy.
key words
Bank: It is a financial institution that deals in money.

Commercial bank: It is a profit-based financial institution that
grants loans, accepts deposits and offers other financial services,
such as overdraft facilities and electronic transfer of funds.
Liquidity: It refers to the capability of an organisation to meet
short-term financial needs.
Private sector banks: These are commercial banks in which
the major part of the share capital is held by private businesses
S
and individuals.
Public sector banks: These are commercial banks that are na-
tionalised by the government of a country.
IM
1. Explain the evolution of the banking system in India.
2. What are the functions of commercial banking?
M
3. Explain the principles of commercial banking.

4. Describe the functions of a central bank.

N
Topic Q. No. Answer

History and Evolution of 1. Presidency Bank
Banking Institutions in India
2. 1935
3. Narasimhan Committee
Commercial Banking 4. False
5. False
6. True
7. Examples are State Bank of
India (SBI), Corporation Bank,
Bank of Baroda, Dena Bank
and Punjab National Bank
Commercial Banking Princi- 8. True
ples

n o t e s
Topic Q. No. Answer

Concept of Central Banking 9. RBI
and India’s Central Bank
(RBI)
10. True
11. Financial sector objectives

1. Banking in India has progressed from a licensed raj business to a
modernised technological business. Refer to Section 7.2 History
and Evolution of Banking Institutions in India.
2. Commercial banks take deposits from the customers and
provide loans to the borrowers. Refer to Section 7.3 Commercial
S
Banking.
3. The principles of commercial banking include the principle
of safety, principle of liquidity, principle of secrecy, principle
IM
of profitability and salability of securities. Refer to Section
7.4 Commercial Banking Principles.
4. The central bank is the custodian of money that floats in the
market so that the needs of various stakeholders and shareholders
are adequately met. Refer to Section 7.5 Concept of Central
Banking and India’s Central Bank (RBI).
M

7.9
REFERENCE
N
SUGGESTED READINGS
Bhole L.M., Jitendra (2015). Financial institutions and markets,
structure, growth and innovations. McGraw-Hill.
Pathak B. (2014). Indian financial system. 4th ed. India, Noida:
Dorling Kindersley.
E-REFERENCES
Economictimes.indiatimes.com (2015). The Economic Times.
Retrieved 28 November 2015, from http://economictimes.india-
times.com/central-bank-of-india/infocompanyhistory/companyid-
11944.cms.
Encyclopedia Britannica (2015). Bank | finance. Retrieved 28 No-
vember 2015, from http://www.britannica.com/topic/bank.
Nanda S. (2015). 8 most important functions of a Central Bank of
India. Preservearticles.com. Retrieved 28 November 2015, from
http://www.preservearticles.com/201102083964/functions-of-a-
central-bank.html.

Ch a
8 p t e r
NON-BANKING FINANCIAL INSTITUTIONS (NBFIs)
CONTENTS
S
8.1 Introduction
8.2 NBFI– An Introduction
IM
8.2.1 Types of NBFIs
8.2.2 Importance of Industrial Financial Institutions
8.2.3 Major NBFIs in India
Activity
8.3 Non-banking Financial Companies (NBFCs)
M
8.3.1 Major NBFCs in India

8.3.2 Regulatory Norms of NBFCs
Activity
N
8.4 Summary

n o t e s
SMALL NBFCs PLAN TO BUILD SALES TEAMS TO

DRAW CUSTOMERS
Small and mid-sized non-banking financial companies (NBFCs)

contribute significantly in lending money to small and medium
enterprises (SMEs). Nowadays, NBFCs have started moving away
from third-party agencies so that they can explore new customer
segments on their own.
Unlike banks, NBFCs do not have a large distribution network.

Therefore, NBFCs depend on services provided by third-par-
ty agents who get them customers from tier-II and tier-III cities,
where financing companies are not available as they are in tier-I
cities. However, over the years, NBFCs have felt a need of finding
their own customers by investing in hiring the right kind of sales
S
talent and technology. Bajaj Finserv, IndoStar Capital and Dewan
Housing Finance Ltd. are some of NBFCs that have started explor-
ing their customer segments without the help of third-party agents.
IM
Vimal Bhandari, the Managing Director and Chief Executive Of-
ficer at IndoStar Capital (an NBFI that offers property, consumer
durable and business loans to SME customers), said the NBFC
plans to hire young graduates from business schools and reputed
colleges to deal with customers as the firm is focusing on increasing
direct acquisition to complement the business contributed by DSAs.
M
The firm has already started to build teams across locations to can-
vas business directly for the company and the number of field offi-
cers and area managers will go up to 100 shortly.
Ashish Kohli, the Head of SME Business at IndoStar Capital,

N
said the company is targeting building at least 25% of its total reve-
nue from this new stream. The company’s total asset base stands at
around `4,000 crore.
According to Harshil Mehta, Chief Executive Officer at Dewan

Housing Finance Ltd (DHFL), by slowly moving to their own re-
sources, NBFCs can cut turnaround time on loan applications by
10-25%. Since internal teams are able to do basic due diligence
themselves, the quality of the leads are much better than those gen-
erated by DSAs. This helps the company identify the right kind of
customers and approve loans faster. The housing finance company
started its SME business in December last year and currently has a
loan book of about `1,000 crores. While the company depended en-
tirely on DSAs for sourcing customers when the SME lending busi-
ness started, the share of leads generated by internal teams is about
20-25% now. We also save on the cost when leads are generated by
internal teams, since there is no third-party fee involved. This re-
flects in our operational expenditure, since the cost of generation of
loans works out lower.

NON-BANKING FINANCIAL INSTITUTIONS (NBFIs) 149
n o t e s
It is also important to note that the commission charged third-par-

ty agencies will get higher in the future as NBFCs are coming up
with a wide range of products for SME borrowers.
(Source: http://www.livemint.com/Companies/LgOeYKret9LSKesPRFzbXL/Small-
NBFCs-plan-to-build-sales-teams-to-draw-customers.html)
S
IM
M
N

n o t e s
learning objectives

>> Explain the concept of NBFIs
>> Discuss the role of NBFCs in an economy
8.1 INTRODUCTION
In the previous chapter, you have studied about various banking in-
stitutions. However, the growth of an economy also depends on the
functioning of Non-banking Financial Institutions (NBFIs). In this
chapter, you will study about (NBFIs).
An NBFI is an institution that provides an array of bank-related ser-
S
vices, such as investment, risk pooling, contractual savings and mar-
ket brokering. However, it is not licenced to carry on full-time bank-
ing services. An NBFI is not controlled by a national or international
IM
banking regulatory agency. Development banks, insurance companies
and mutual funds are the examples of NBFIs.
The main aim of any NBFI is to provide finance to small-scale busi-

nesses that cannot raise funds through stocks and bonds due to high
transaction costs. By availing adequate finance, small businesses can
carry out their operations smoothly. For this, NBFIs encourage inves-
M
tors to invest their savings in various financial schemes and transfer

those savings to borrowers.
In this chapter, you will study the role and importance of NBFIs in
N
detail. In addition, you will study some of the major NBFIs in India.
The chapter also discusses the concept of NBFCs and their regulatory
norms.
8.2 NBFI– AN INTRODUCTION

A non-banking financial institution (NBFI) is a body that provides fi-
nancial products and services but is not regulated under any bank-
ing regulatory agency. Some of these financial services include cred-
it facilities, retirement planning, underwriting, etc. The examples of
NBFIs include insurance firms, cashier’s check issuers and microf-
inance organisations. The important functions performed by NBFIs
are explained as follows:
Financial intermediation: Like other financial institutions, NBFIs
also act as intermediaries that channelise the savings of investors
for economic activities. Small businesses can raise funds through
these intermediaries at comparatively lesser cost. NBFIs help in

n o t e s
the diversification of risk by pooling the funds of investors in dif-

ferent securities. A wide range of services is provided by NBFIs,
which result in the economics of scales. The economies include
comparatively less administrative cost of large loans and low costs
of establishment, information and transactions.
Savings inducement: The savings in a country get promoted
through the intermediation of NBFIs. A wide range of financial
services and products are provided by them that induce individu-
als to save. This further leads to the growth of economy.
Savings mobilisation: The movement of savings takes place
when individuals invest their savings in various financial instru-
ments such as bank deposits, post office savings, life insurance
policies, equity shares, etc. The savings accumulated in various
forms is further invested by NBFIs in different economic activities
S
that help in the capital formation of the economy.
Exhibit
IM
NBFC Companies Are Game Changers
In a speech, P Vijaya Bhaskar, Executive Director of the Reserve

Bank of India, explained NBFC companies are game changers that
are very important to the economy. Here’s how:
Size of sector: The NBFC sector has grown considerably in the
M
last few years despite the slowdown in the economy. As of March

2013, it accounted for 12.5% of the country’s Gross Domestic
Product (GDP) – a measure of the size of the economy. This is
up from 8.4% in March 2006. However, this only counts NBFCs
with assets more than ` 100 crore. “If the assets of all the NBFCs
N
below ` 100 crore are reckoned, the share of NBFCs’ assets to

GDP would go further,” Bhaskar said in his speech.
Growth: In terms of year-over-year growth rate, the NBFC
sector beat the banking sector in most years between 2006 and
2013. On an average, it grew 22% every year. Even when the
country’s GDP growth slowed to 6.3% in 2011-12 from 10.5% in
2010-11, the NBFC sector clocked a growth of 25.7%. This shows
that it is contributing more to the economy every year.
Profitability: NBFCs are more profitable than the banking sec-
tor because of lower costs. This helps them offer cheaper loans
to customers. As a result, NBFCs’ credit growth – the increase
in the amount of money being lent to customers – is higher than
that of the banking sector. Credit grew an average 24.3% per
year for NBFCs as against 21.4% for banks. This shows that
more customers are opting for NBFCs.

n o t e s
Infrastructure lending: NBFCs contribute largely to the economy

by lending to infrastructure projects, which are very important to
a developing country like India. But they require large amount of
funds, and earn profits only over a longer time-frame. As a result,
these are riskier projects. This deters a lot of banks from lending
to infrastructure projects. In the last few years, NBFCs have con-
tributed more to infrastructure lending than banks. NBFCs lent
over one-third or 35.8% of their total assets to infrastructure sec-
tor as of March 2013. In contrast, banks lent only 7.6%.
Promoting inclusive growth: NBFCs cater to a wide variety of
customers – both in urban and rural areas. They finance projects of
small-scale companies, which is important for the growth in rural
areas. They also provide small-ticket loans for affordable housing
projects. All these help promote inclusive growth in the country.
S
(Source: https://www.kotaksecurities.com/ksweb/Meaningful-Minutes/Why-are-Non-Bank-
ing-Financial-Companies-important)
IM
8.2.1 TYPES OF NBFIs
NBFIs can be categorised on the basis of the types of products ser-

vices provided by them. Figure 8.1 lists the types of NBFIs:
Risk-pooling Institutions
M
Contractual Savings Institutions
Market Makers
N
Specialised Sectorial Financiers
Financial Service Providers
Figure 8.1: Different Types of NBFIs
Let us discuss about these NBFIs in detail.

Risk-pooling institutions: Insurance companies are called risk
pooling institutions that provide coverage against various adverse
situations such as illness, death, property damage and other risks
of loss. An insurance company collects premium from individu-
als or companies (called insured) and provides compensation (as
promised in an insurance contract) in case of any loss occurs.
Two main types of insurance companies include general insurance
and life insurance. Health insurance, motor insurance, home insur-
ance, etc. are examples of general insurance. On the other hand,
life insurance provides coverage against the life of an individual.

n o t e s
Contractual savings institutions: These institutions provide an

opportunity to individuals for investing in collective investment
vehicles (CIVs) as a fiduciary. Investors do not play a principal role
in CIVs as they invest their savings through contractual savings
institutions. Pension funds and mutual funds are the examples of
contractual savings institutions.
Market makers: These are institutions that facilitate transactions
for financial assets by quoting a buy and sell price. All securities
(equities, debentures, derivatives and currencies) transacted in
capital and money markets are dealt by market makers.
Specialised sectorial financiers: As the name suggests, a limited
range of financial services is provided by these NBFIs to a tar-
geted sector. For example, real estate financiers provide loans to
prospective homeowners.
S
Financial service providers: These include various brokers that
work on a fee-for-service basis for improving the functional effi-
ciency of the financial system. These providers include manage-
IM
ment consultants and financial advisors.
8.2.2 IMPORTANCE OF INDUSTRIAL FINANCIAL

INSTITUTIONS
From the discussion so far, it can be said that NBFIs play a crucial
M
role in mobilising the savings of investors so that various sectors in an

economy can access to the required finance. The development of each
sector is directly dependent on the availability of the required finance.
The industrial sector is another sector that is vital to the growth of any
N
economy; thus, requires continuous finance for supporting its activi-

ties. NBFIs largely contribute in fulfilling the need of industrial finance.
Industrial finance encompasses funds for different industries, such

as the manufacturing industry, service industry or any other industry.
This finance can be provided for medium (1-3 years) or long (more
than 3 years) terms. In order to streamline the sources of industrial
finance post-independence, the government established special indus-
trial financial institutions both at the national and state levels. National
level institutions include the Industrial Finance Corporation of India,
the Industrial Credit and Investment Corporation of India, National
Industrial Development Corporation of India, the Industrial Develop-
ment Bank of India and the Industrial Reconstruction Corporation of
India. On the other hand, State Financial Corporations and State In-
dustrial Development Corporations are established at the state level.
The following points explain the importance of industrial finance in-

stitutions in an economy:
They play a major role in the development of the capital market by
providing direct financial assistance to industries.

n o t e s
They assist different industries in raising long-term loans by in-

ducing saving.
They assist organisations in underwriting new issues of industrial
security.
They work in reducing the regional disparity by providing assis-
tance and support to industries having insufficient financial sup-
port as compared to other industries having sufficient support.
They are responsible for mobilising various resources of a country
into profitable avenues by keeping in mind the balanced develop-
ment of the country.
They provide assurance and guarantee of deferred payment
against the import of capital goods into the country. Thus, they
try to bring together foreign and local entrepreneurs on the same
S
platform.
They are responsible for maintaining liquidity and managing the
price mechanism in markets. Thus, they help in managing risks
IM
associated with fluctuations in price levels.
8.2.3 MAJOR NBFIs IN INDIA
In India, there are a number of NBFIs that play a crucial role in the
growth of the country’s economy by providing comparatively low-cost
funds for various economic activities. The following are the major
M
NBFIs in India:
The Unit Trust of India (UTI): This is an investment company
that was established under the Unit Trust of India Act, 1963. The
company comprises several trustees who hold the money of inves-
N
tors in trust and then invest this money in various securities. UTI
is managed by the board of trustees headed by a chairman, who
is appointed by the central government in association with IDBI
Bank. Each trustee is nominated by the Reserve Bank of India
(RBI), Life Insurance Corporation of India (LIC) and State Bank of
India (SBI). Four trustees are nominated by IDBI Bank along with
one executive trustee. Two members are elected by the contrib-
uting banks and financial institutions. The board must meet once
in two months. UTI is regulated by the Securities and Exchange
Board of India (SEBI).
Investment and trading are done by UTI Asset Management Com-
pany Ltd. (UTI AMC), which started its operations from February
1, 2003. UTI AMC is promoted under the sponsorship of the SBI,
LIC, Bank of Baroda and Punjab National Bank. Each of the spon-
sor contributes 25% of the paid-up capital of UTI AMC. A detailed
explanation on UTI is given in the upcoming chapters on the book.
Industrial Finance Corporation of India (IFCI): This was estab-
lished in 1948 when there was as ardent need to provide financial

n o t e s
assistance to the industrial sector after World War II. In 1999, the
IFCI was granted the power to raise funds from capital markets.
Now, it avails finance for various industries, such as textiles, paper
and sugar, hospitality, power generation and telecommunication
industries. In 1973, IFCI sponsored a management development
institute for enhancing the managerial and entrepreneurial skills
of managers.
Life Insurance Corporation (LIC) of India: It was established in
1956 as a public statutory body fully owned by the Government of
India. LIC was the amalgamation of several insurance companies
and provident fund societies that were operating in the private
sector. Before the formation of LIC, most private companies were
charging huge premiums from insured. Thus, the main of estab-
lishing LIC was to prevent the fraudulent settlement of claims and
other activities which were not in the interests of investors. LIC
S
plays a major role in the capital market by mobilising the savings
of investors into life insurance policies and invest those savings for
development functions.
IM
General Insurance Corporation of India: In India, till the 1970s,
there was no instrument that could provide the Indian people pro-
tection against various types of risks. In order to provide a possible
solution to this problem, the General Insurance Company (GIC)
was established in 1972 when the general insurance business was
nationalised. GIC carried out its business smoothly till the year
M
1999. However, in 1999, IRDA was established. This was intro-

duced as a regulatory body for the insurance sector. IRDA diluted
the working and the functioning of GIC. Therefore, in 2000, the
government notified GIC as being the “Indian Reinsurer” under
Section 101A of the Insurance Act, 1938. You will study in detail
N
about GIC about the upcoming chapters on the book.

National Bank for Agriculture and Rural Development
(NABARD): It is an apex development bank that was established
in 1982. NABARD is a financing agency that provides credit for
agriculture and rural development. It also provides financial help
to the cottage and handicrafts industries. NABARD is sponsored
by RBI and the World Bank.
1. A non-banking financial institution (NBFI) is a body that

provides financial products and services but is not regulated
under any _____regulatory agency.
2. Insurance companies are called risk-pooling institutions that
provide coverage against various adverse situations such
as illness, death, property damage and other risks of loss.
(True/False)

n o t e s
3. Investors do not play a principal role in ________________

as they invest their savings through contractual savings
institutions.
a. CIVs b. Banks
c. Chit fund company d. Insurance company
4. ______________ is a financing agency that provides credit for
agriculture and rural development.
Activity
With the help of various sources, find information on different in-

dustrial financial institutions. Analyse which of them holds the
largest share in industrial financing in India.
S
Non-Banking Financial Companies
8.3
(NBFCs)
IM
In the Indian context, non-banking financial companies (NBFCs) re-
fer to those entities that are not banks yet they demonstrate the capa-
bilities of banking. They comprise privately owned and decentralised
intermediaries. These intermediaries are relatively small-sized as
compared to NBFIs. NBFCs have emerged as a vital part of the Indian
M
financial system by serving the credit requirements of the unorgan-

ised sector such as wholesale and retail traders, small-scale industries
and small local borrowers. The following are different types of NBFCs:
Equipment leasing company: It is a company that provides funds
N
for purchasing industrial equipment on lease. These companies

raise funds from the deposits of other companies, banks and finan-
cial institutions. An equipment leasing company provides funds
on two types of lease, namely operating lease and capital lease.
The operating lease is provided for short term, while capital lease
is long term in nature.
Hire purchase finance company: It is a company that provides
funds to borrowers. These funds are paid by borrowers within a
fixed time in the form of instalments.
Housing finance company: It provides finance for the purchase
of house. These companies are regulated by the National Housing
Bank (NHB).
Investment company: It deals in the selling and purchasing of
financial instruments/securities. An investment company mainly
provides finance to large business houses.
Loan company: It provides loans for any generalised activities
which may include education loan, vehicle loan, construction loan,
property renovation loan and so on.

n o t e s
Chit fund company: It operates on the basis of agreement that

binds each member to pay instalments of a fixed amount for a cer-
tain time period. As a reward, every member gets benefitted with
a monetary reward declared by auction or random selection in
the end.
8.3.1 MAJOR NBFCs IN INDIA
In the present scenario, the share of NBFCs has been rapidly increas-
ing in the Indian industry. As per the statistics, the share of NBFCs
has grown from 10.7 per cent of the banking assets in 2009 to 14.3 per
cent in 2014. This resulted into the revised regulation for NBFCs by
RBI in November 2014. Some major NBFCs of India are as follows:
Housing Development Finance Corporation (HDFC): It was es-
tablished in 1977. HDFC is one of the India’s largest mobilisers of
S
public deposits outside the banking system. HDFC provides hous-
ing finance to individuals in developing countries in Asia and Afri-
ca at comparatively lower cost.
IM
Power Finance Corporation: The company was established in
1986. It works as a financial backbone of the power sector. It is
an ISO-certified company having a status of Navratna. It provides
financial consulting, investment banking and loan management
services to power corporations.
Reliance Capital: The company was established in 1986. It pro-
M
vides core services that include asset management, insurance,

broking and distribution, commercial finance and mutual funds.
Infrastructure Development Finance Company (IDFC): The
company was incorporated in 1997. IDFC provides finance for in-
N
frastructure projects, corporate finance, mutual funds and invest-

ment banking.
Rural Electricity Corporation: The company was established in
1969. The core services provided by the company include invest-
ment and private banking and asset management.
Infrastructure Leasing & Financial Services Limited (IL&FS):
It is an Indian Infrastructure Development and Finance company
for promoting the infrastructure in the country. It is promoted by
Central Bank of India, Housing Development Finance Corpora-
tion Limited (HDFC), and Unit Trust of India (UTI). It focuses on
commercialisation of infrastructure projects and creation of value
added financial services. It works in sectors such as transporta-
tion, Power, e-Governance, water, education, tourism, etc.
8.3.2 REGULATORY NORMS OF NBFCs
NBFCs play a crucial role in enhancing the growth rate of an economy

by moving the savings of one section having surplus to another section

n o t e s
having a shortage. This movement of money across the economy takes

place till the time the investor has trust in the financial system of the
country. Thus, the regulatory framework of the economy should be
sound enough to facilitate the movement of money by ensuring the
safety of money invested by investors. The new regulatory norms for
NBFCs have been notified by the RBI. These norms are related to net
owned funds, deposit acceptance ratio, capital norms, asset classifica-
tion rules and corporate governance.
The following are some important regulatory norms of NBFCs:

NBFCs in operation before April 1999 are to raise their minimum
net owned funds (NOF) to ` 1 crore by March 2016 and further to ` 2
crore by March 2017 from ` 25 lakhs currently or risk cancellation of
their permits.
NBFCs are now required to mark a loan as bad debt if the inter-
S
est has not been paid for 90 days or three months. Till now, NBFCs
marked a loan as bad loan only if the interest was not paid for six
months while for banks it was three months. Provisions for standard
IM
assets have also been raised from 0.25 per cent of the loans outstand-
ing to 0.40 per cent of loans.
For deposit-taking NBFCs, the revised norms have made it mandato-
ry to get an investment grade rating by March 2016 or stop accepting
deposits.
Moreover, till March 2016, the unrated asset finance companies
M
which are sub-investment grade can only renew deposits on maturity

and not accept fresh deposits till they get an investment-grade rating.
All assets financing NBFCs are now allowed to accept deposits up
to 1.5 times their net owned funds, down from four times their net
N
owned funds earlier.

Previously, non-deposit taking NBFCs with assets over ` 100 crore
were considered systemically important, but this cut-off has now been
increased to ` 500 crore “in light of the overall increase of growth of
the NBFC sector.”
RBI has also asked all non-deposit taking NBFCs with an asset size of
` 500 crore to streamline the core capital adequacy ratio of 10 per cent,
compared with a range of 7.5 per cent to 12 per cent at present. NBFCs
have been given time till March 2017 to comply with the norms.
RBI said that an NBFC registering as NBFC-Factor is required to
ensure that its financial assets in the factoring business constitute
at least 50 per cent of its total assets and its income derived from
the factoring business is not less than 50 per cent of its gross income.
This was 75 per cent earlier.
(Source: http://www.vccircle.com/news/finance/2015/03/30/rbi-notifies-revised-regulato-
ry-norms-nbfcs)

n o t e s
5. The operating lease is provided for _____, while capital lease is

long term in nature.
6. Power Finance Corporation works as a financial backbone of
the power sector. (True/False)
7. NBFCs in operation before April 1999 are to raise their
minimum net owned funds (NOF) to ` 1 crore by March 2016
and further to ` 2 crore by March 2019 from ` 25 lakhs currently
or risk cancellation of their permits. (True/False)
Activity
With the help of the Internet, find information on loan schemes
S
of various housing finance companies in India. Analyse which of
them provides loans at reasonable cost. Prepare a report on your
findings.
IM
8.4 SUMMARY
An NBFI is a body that provides financial products and services
but is not regulated under any banking regulatory agency.
Examples of NBFIs include insurance firms, cashier’s check issu-
M
ers and microfinance organisations.

Insurance companies are called risk-pooling institutions that pro-
vide coverage against various adverse situations such as illness,
death, property damage and other risks of loss.
N
Contractual savings institutions provide an opportunity to individu-

als for investing in collective investment vehicles (CIVs) as a fiduciary.
Industrial finance encompasses funds for different industries,
such as the manufacturing industry, service industry or any other
industry. This finance can be provided for medium (1-3 years) or
long (more than 3 years) terms.
Themajor NBFIs of India include UTI, LIC, GIC, IFCI and NAB-
ARD.
NBFCs refer to those entities that are not banks yet they demon-
strate the capabilities of banking.
Major NBFCs in India include Housing Development Finance
Corporation (HDFC), Power Finance Corporation, Reliance Cap-
ital, Infrastructure Development Finance Company (IDFC) and
Rural Electricity Corporation.

n o t e s
The new regulatory norms for NBFCs have been notified by the RBI.
These norms are related to net owned funds, deposit acceptance ra-
tio, capital norms, asset classification rules and corporate governance.
key words
Collective Investment Vehicles (CIV): It is an entity that collects

the money of individual investors and invests the pooled funds
on the behalf of them.
Derivatives: It is a security whose the price of which is depen-
dent is derived from the underlying assets.
Fiduciary: It is a person holding a legal or ethical relationship of
trust for taking care of money or other assets for another person.
Hire-purchase: It refers to a method by which goods are pur-
S
chased by making instalments over time.
Risk-pooling: It is a tool of risk management that is practiced by
insurance companies to diversify and mitigate the risk.
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1. What is NBFI? Also, explain the functions performed NBFIs.
2. Discuss the role of some major NBFIs in India.
M
3. What do you understand by the term NBFC? Explain the new

revised regulatory norms for NBFCs by RBI.

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Topic Q. No. Answer

NBFI– An Introduction 1. Banking
2. True
3. a. CIVs
4. NABARD
Non-banking Financial 5. Short term
Companies (NBFCs)
6. True
7. False
Hints for DESCRIPTIVE QUESTIONS

1. A NBFI is a body that provides financial products and services
but is not regulated under any banking regulatory agency. Refer
to Section 8.2 NBFI–An Introduction.

n o t e s
2. Major NBFIs of India include UTI, LIC, IFCI, GIC and NABARD.
Refer to Section 8.2 NBFI– An Introduction.
3. NBFCs refer to those entities that are not banks yet they
demonstrate the capabilities of banking. Refer to Section
8.3 Non-banking Financial Companies (NBFCs).

8.7
REFERENCE
SUGGESTED READINGS
Bhole, L.M., Jitendra, (2015), Financial institutions and markets,
structure, growth and innovations, McGraw Hill Publishing Com-
pany Limited
S
Pathak, B. (2008). The Indian financial system (3rd Ed.). New Del-
hi: Dorling Kindersley
IM
E-REFERENCES
CARMICHAEL, J. (1992). THE NBFI REFORMS. Economic Pa-
pers: A Journal Of Applied Economics And Policy, 11(4), 36-40.
http://dx.doi.org/10.1111/j.1759-3441.1992.tb00059.x
Dr. M.S. Meiyappan, D., & Dr. S. Annamalai, D. (2011). Financial Im-
pact of Microfinance on The NbFc-MFI borrowers in Kanchipuram
M
District. IJAR, 4(7), 310-317. http://dx.doi.org/10.15373/2249555x/

july2014/98
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Ch a
9 p t e r
Development financial institutions
CONTENTS
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9.1 Introduction
9.2 History and Evolution of Development Financial Institution in India
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9.2.1 Importance of DFI in Economy
Activity
9.3 Land Development: NABARD
Activity
M
9.4 Industrial Development: SIDBI

Activity
9.5 Export and Import Development: EXIM Bank
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Activity
9.6 Housing Development: NHB
Activity
9.7 New Initiative of GOI: MUDRA Bank
Activity
9.8 Summary

n o t e s
NABARD’S INITIATIVES IN PROMOTING SHORT ROTATION

FOREST SPECIES UNDER AGROFORESTRY
National Bank for Agriculture and Rural Development (NAB-

ARD) is an apex development bank that aids credit flow for pro-
motion and development of agriculture, cottage and village in-
dustries, small-scale industries, handicrafts, etc. It also supports
various economic programmes in rural areas and promotes inte-
grated and sustainable rural development. Recently, it undertook
initiatives in promoting short rotation forest species under agro-
forestry.
NABARD, together with the Western India Match Company

(WIMCO) had promoted Poplar (Populus deltoides) clones under
agroforestry in the 1980s in the North Indian States of Punjab,
S
Haryana and Uttar Pradesh. Further, in order to promote new
agroforestry projects in other areas of the country, NABARD con-
ducted a research in Prakasam and Krishna districts of Andhra
IM
Pradesh. It observed that these two districts had great poten-
tial for promoting Subabul (Leucaena leucocephala) agroforest-
ry plantation under short rotation of 3 to 5 years. For this, credit
linked agroforestry projects were promoted in both these districts
and the tree successfully produced pulp-wood for supply to paper
mills. Moreover, the State Government of Andhra Pradesh has
liberalised its agriculture policy by establishing agriculture-mar-
M
keting committees for efficient marketing of Subabul woods.
After the research, NABARD has also liberalised its own policies
and has incorporated Subabul and Casuanna plantations under
N
Automatic Refinance scheme. In addition, it has also given special

status to such schemes by lowering the rate of interest on re-fi-
nance. Currently, NABARD is trying to promote new agro-for-
estry projects throughout the country under its short rotation
agroforestry programmes by collaborating with wood-based in-
dustries and conducting seminars, workshops, etc. in various In-
dian states.
(Source: http://www.cabdirect.org/abstracts/20073293517.html;jsession-
id=6C76FD3368982D4B1C848A523317A00F)

Development financial institutions 165
n o t e s
learning objectives

>> Explain the history and evolution of development financial
institutions in India
>> Discuss the role of NABARD in land development
>> Explain the role of SIDBI in industrial development
>> Describe the role of EXIM bank in export and import devel-
opment
>> Discuss the role of NHB in housing development
>> Explain the new initiative of GOI - MUDRA bank
9.1 INTRODUCTION
S
In the previous chapter, you have studied about industrial finance and
institutions, development banking in India, major NBFIs in India and
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Non-Banking Financial Companies (NBFCs). This chapter will focus
on the development financial institutions (DFIs).
DFIs are those which are responsible for providing the financial assis-
tance towards the development activities. In particular, the DFIs are
segregated into various domains, such as banks providing the financ-
es for development of housing sector, banks providing the finances for
M
the development of exports and imports; banks providing the finances

for the development of land, etc.
DFIs play an important role in the financial system of the country as

they are responsible for providing long-term financing requirements
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of different sectors as compared to traditional banks, which are main-

ly focussed on meeting the short-term capital requirements.
This chapter explores the history and evolution of DFIs in India, the
role of NABARD in land development and the role of EXIM bank in
export and import development. Moreover, this chapter also focuses
on housing development by NBH. Towards the end it discusses about
the new initiatives of GOI - mudra bank.
ISTORY AND EVOLUTION OF

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9.2 DELOPMENT FINANCIAL INSTITUTION
IN INDIA
DFIs are an alternative financial institution comprising community
DFIs, microfinance institutions, etc. These institutions offer credit in
the form of high risk loans, private sector investments, etc. to devel-
oping countries like India. Traditional banks have focused on meeting
short-term working capital requirements of industry whereas DFIs

n o t e s
have mainly emphasised on meeting the medium and long-term fi-

nancing requirements.
Industrial Finance Corporation of India (IFCI) was the first DFI set
up to provide long-term finance to industry. Thereafter, several public
and private sector DFIs were established. DFIs are categorised as:
1. Term lending institutions: These offer financial services to
several sectors and include Industrial Investment Bank of India
(IIBI) Ltd., Export–Import Bank of India (EXIM) and Tourism
Finance Corporation of India (TFCI) Ltd.
2. Refinance institutions: These offer financial services, banking
services, non-banking financial intermediaries, etc. and
include National Bank for Agriculture and Rural Development
(NABARD), Small Industries Development Bank of India
(SIDBI) and National Housing Bank (NHB).
S
Most of these DFIs were government-owned and their operations
were marked by near absence of competition up to 1990. In addition,
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DFIs were provided funds at concessional rates in the form of Long-
Term Operations Fund of the Reserve Bank of India (RBI) and gov-
ernment guaranteed bonds on a long-term basis, with their maturity
being between 10 and 15 years. However, the operations of these DFIs
became less profitable over the years. Therefore, in order to incorpo-
rate market orientation to operations of DFIs, different reform initia-
tives, such as gradual phase out of the market borrowing allocations
M
of government guaranteed bonds and ceasing the access to low cost

funds of RBI were announced in 1990s. Besides, prudential norms re-
lated to, income recognition, capital adequacy, asset classification and
provisioning were recommended in 1994.
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From 1993 to 1998, DFIs undertook several initiatives, such as provid-

ing innovative products and diversification of activities into new areas
of business, namely, stock broking, investment banking, and custodi-
al services to deal with enhanced competition. However, decreasing
interest rates and slowdown in industrial activity in the latter half of
1990s had adverse impact on the asset quality of DFIs. With decreasing
interest rates, high cost of funds raised by DFIs previously became an
issue. In spite of rise in cost of funds, DFIs had to lend at competitive
rates because of enhanced competition from banks that forayed into
project financing, in turn, leading to decline in profitability of DFIs.
Further, in January 2001, the RBI allowed reverse merger of ICICI with
its commercial bank subsidiary. Thereafter, the transformation of IDBI
into a banking company occurred on October 1, 2004. These banking
conversions resulted in the decline in shares of DFIs in infrastructure
project finance. Such developments led to significant decline in finan-
cial assistance sanctioned and disbursed by DFIs during initial years
of the current decade. On an average, the financial aid sanctioned and
disbursed by DFIs decreased to ` 389.1 billion during FY02–FY07 as

n o t e s
compared with ` 836.8 billion during FY96–FY01. However, the finan-

cial aid sanctioned by DFIs, highlighted an upturn during FY08–FY09
due to enhanced sanction by investment institutions, such as the Life
Insurance Corporation of India (LIC). During FY09, the financial aid
sanctioned by DFIs depicted an increase of 70.2 per cent (y-o-y) while
disbursements increased by approximately 93.3 per cent.
The increase in global financial crisis and consequent liquidity crunch

in the domestic financial system led the RBI to incorporate certain
approaches to offer liquidity support to DFIs. For example, the RBI of-
fered refinance facility of ` 160 billion (comprising ` 70 billion for SID-
BI, ` 50 billion for EXIM Bank and ` 40 billion for NHB) to DFIs to aid
on-lending to Housing Finance Companies (HFCs), NBFCs, mutual
funds and exporters. In addition, under the refinance facility, ` 213.98
billion was drawn up to June 26, 2009, while total disbursements
amounted to ` 153.12 billion (up to June 26, 2009). The refinance fa-
S
cility had 5,283 beneficiaries, including 33 State Finance Corporation
& Banks, 22 NBFCs and 14 HFCs. Moreover, the ceiling on aggregate
resources mobilised by SIDBI, NHB and EXIM Bank was increased
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to 12 times of Net Owned Funds (NOF) for SIDBI & NHB and 13 times
of NOF for EXIM Bank. This resulted in 9.1 per cent rise in resource
mobilisation by DFIs during FY09. In addition, the ‘umbrella limit’
was increased for EXIM Bank and NHB and only certain DFIs were
allowed to provide marker related yield to maturity.
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9.2.1 IMPORTANCE OF DFI IN ECONOMY
The DFIs play a key role in addressing various global issues, such
as financial crisis and global security through constantly innovating
their means and mechanism to provide finances for the development
N
of the country’s economy. The DFIs were created to act as intermedi-

aries between the government financial agencies and the commercial
banks. While commercial banks have focussed on meeting the short-
term requirements, DFIs were established to cater to medium and
long-term needs of the private sector. Thus, this role of the DFIs en-
sures that economic growth is possible across weaker and backward
sectors of the country. For example, the financial problems pertaining
to the modernisation of cotton based industries were addressed by
these DFIs. Thus, DFIs play an important role in the development of a
country’s economy, some of which are detailed as follows:
DFIs play a crucial role in providing assistance to the new and upcom-
ing entrepreneurs to start their business ventures by providing finan-
cial assistance. The new start-ups are likely to contribute towards the
economic growth of the country.
DFIs are involved in the operations of underwriting and direct sub-

scription in the issue of shares and debentures, which have an im-
portant role to play in the capital market. Thus, these DFIs contribute
towards the economic growth.

n o t e s
DFIs have been providing assistance in the establishment of business

units which require large finance for their projects. The financial as-
sistance leads to the development of these projects, thereby impacting
the economic growth of the country.
DFIs have been aiding the process of allocation of funds to industry

through optimum utilisation of the available resources, thereby con-
tributing towards the economic development of the country.
DFIs provide financial, technical, legal, marketing and administrative

assistance to several industrial establishments for their promotion
and expansion of services. This, in turn, enhances the productivity
and management levels of these establishments, which will have a sig-
nificant impact on the economy of the country.
DFIs grant finances for the modernisation, expansion, diversification
S
of industries in both corporate and co-operative sectors, thereby im-
pacting the economy of the country.
DFIs provide both imported and indigenous equipment to various in-

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dustrial establishments, under the ‘equipment leasing scheme’, there-
by impacting the economy of the country.
1. The DFIs were created to act as intermediaries between the

M
government financial agencies and the commercial banks.

(True/False)
Activity
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Using the Internet, find out the important functions of DFIs. Pre-
pare a report on your findings.
9.3 LAND DEVELOPMENT: NABARD

DFIs were created with the aim of providing finance towards the de-
velopment of various sectors of the country, such as development of
rural sector, providing thrust for the growth of new industry or to bud-
ding entrepreneurs.
Thus, in order to provide thrust and growth impetus to the ru-

ral sector, National Bank for Agriculture and Rural Development
(NABARD) bank was established in the year, 1982. The NABARD
bank is headquartered in Mumbai and has several branches across
the country. The main objective of establishing the NABARD bank
was to provide finances for the development and promotion of agricul-
ture, small-scale industries, cottage and handicrafts industry, etc. In
other words, the prime reason for the establishment of NABARD was
to aid the growth and development of the rural sector.

n o t e s
Some of the important functions of the NABARD bank are as follows:
The NABARD bank provides the means and mechanism for the de-
velopment of the rural sector. This includes various financial pro-
grammes, which highlight the process of taking credit from the banks
for different schemes that can be implemented in the rural sector. For
example, financially aiding a farmer who wants to buy modern equip-
ment so as to produce the enhanced yield for the crop.
The NABARD bank serves as the top financing agency for various
institutions working towards the development of the rural sector.
The NABARD bank monitors and controls activities of various in-
stitutions that have implemented rural development projects. This
is to ensure that they are not adopting any unethical or fraudulent
practices.
S
The NABARD bank aids in re-financing the various institutions
that work towards the development and growth of the rural sector.
The NABARD bank promotes the concept of participatory culture
IM
for the development of watershed agriculture and thereby enhanc-
es the productivity in a sustained manner.
The NABARD bank provides direct credit to any institution that
has been approved by the Government of India for the develop-
ment and growth of the rural sector.
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Thus, the NABARD bank is responsible for playing the role of credi-
tor, that is, providing credit facilities for the growth and development
of the rural sector; providing the re-finance for the development of the
rural sector, that is, ensuring that the credit allocated for the develop-
ment of the rural sector is effective and efficacious; playing the role of
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supervisor, that is, monitoring the performance of several institutions

which are responsible for the development of the rural sector.
Exhibit
“On Farm Development Works” In Command Area of Rural

Infrastructure Development Fund (Ridf) Assisted Irrigation
Projects
INTRODUCTION
A number of irrigation projects have been financed under various

tranches of RIDF in the Country. Some of the projects have recent-
ly been completed while some are under implementation. Once the
head works and distribution network under an irrigation project
are constructed and water released to the command area for use by
the farmers, the land in the command area needs to be developed
and prepared for receiving the water to practice irrigated farming

n o t e s
so that the irrigation facility is used efficiently and the productivity

of the land is kept high on sustainable basis.
ON FARM DEVELOPMENT WORKS
On Farm Development (OFD) works are required to be taken up in

the command area of these projects to facilitate efficient use of the
water provided by these projects. The OFD works include levelling
the land into suitable size plots, bunding, construction of semiper-
manent unlined water channels and water flow control structures
for distribution of water within each holding. As there is no provi-
sion under the irrigation project sanctioned under RIDF for car-
rying out these works with project funds, farmers have to get the
OFD works done with their own resources. While some farmers
may have adequate financial resources of their own, some of the
S
farmers necessarily have to depend on the financial institutions for
credit support. As the source of irrigation and distribution system
are created at project cost and the net incremental income would
be sufficient to repay the bank loan available for carrying out the
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OFD works leaving adequate surplus with the farmers to meet their
requirements, such projects are financially viable and bankable
without any subsidy.
ABOUT THE MODEL

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A general bankable model scheme has been prepared for under-

taking OFD Works by the farmers in the command areas of RIDF
assisted irrigation project areas based on a study in Jhansi district
of Uttar Pradesh. The illustrations made in the model scheme are
area specific which requires to be modified according to the require-
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ment of a particular area, cropping pattern etc. in other areas/states.
The land in the command area villages has an average slope of one
percent and farmers level the land using tractor-drawn levelling
equipment. The bunds around the individual plots having an av-
erage cross section of 0.2 m2 are formed by manual labour and the
hire charges of the tractor are about ` 250 to ` 300 per hour depend-
ing on the horsepower of the tractor. Manual labour cost is ` 100/-
per labour day. According to the farmers, the holdings need to be
levelled into plots with an average size of 0.4 ha (80 m × 50 m).
CROPPING PATTERN
Without project the crops raised in the command area in-

clude blackgram and gingelly (Til) during kharif and Chick-
pea and mustard during Rabi under rain fed conditions.
With the availability of water in the project area and execution of
the OFD works, the cropping pattern would be blackgram, gingelly,

n o t e s
groundnut and soybean during Kharif and chickpea, pea, wheat

and mustard during Rabi. Accordingly, raising of blackgram and
gingelly in 0.35 ha each and groundnut and soybean in 0.15 ha each
during kharif under irrigation and raising of chickpea, pea, mus-
tard and wheat in 0.25 ha each under irrigation during rabi is con-
sidered for working out economics (post project).
FINANCIAL ASPECTS UNIT COST
The OFD works required to be undertaken include levelling, bund-

ing and formation of field channels and flow control structures. In
arriving at the cost of levelling, the average plot size of 0.4 ha (80 m
× 50 m) and average land slope of 1% are assumed. Bunds of cross
section of 0.2 m2 are considered. The total cost of levelling works
out to ` 18000/- per ha. Annual maintenance cost of 5% of the unit
cost is considered. The details of unit cost including the assump-
S
tions made for working out unit cost and financial analysis of the
project are given in Annexure I.
IM
MARGIN
The margin money / down payment prescribed is 5%, 10% and 15%
for small, medium and other farmers, respectively. The rest of the
cost of development will be provided as bank loan. However, in the
present model, 10% of the unit cost, i.e., ` 7700 has been considered
as margin money.
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(Source: https://www.nabard.org/english/farm_development_works.aspx)

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2. The NABARD bank is responsible for playing the role of

__________, that is, providing credit facilities for the growth
and development of the rural sector.
Activity
Using the Internet, find some other important functions of NAB-

ARD. Prepare a report on your findings.
9.4 INDUSTRIAL DEVELOPMENT: SIDBI

Small Industries Development Bank of India (SIDBI), headquartered
in New Delhi, was set up on 2nd April, 1990 as wholly owned subsid-
iary of Industrial Development Bank of India (IDBI) under the small
Industries Development of India Act 1989. It is the main establish-
ment for promotion, financing and development of industries in the
small-scale sector. It also coordinates the operations of establishments
involved in similar activities. For this purpose, SIDBI helps in admin-
istrating Small Industries Development Fund and National Equity
Fund from IDBI.

n o t e s
SIDBI began its operations with an initial authorised capital of ` 250

crore, which increased to ` 1000 crore over the years. Moreover, it also
took over the IDBI’s outstanding small-scale sector portfolio.
In establishing SIDBI, the main objective of the government was to

ensure provision of greater aid to the small-scale organisations. In or-
der to meet this objective, the immediate thrust of the SIDBI was on
the following measures:
Formulating steps for technological upgradation and modernisa-
tion of current organisations
Expanding the distribution channels for marketing products of
the small-scale sector
Promoting industries in semi-urban areas to create greater em-
ployment opportunities. This is intended to reduce people migrat-
S
ing to urban areas in search for jobs.
SIDBI aids the small-scale industries sector in the country via the cur-
rent banks and other financial establishments, such as State Financial
IM
Corporations, State Industrial Development Corporations, commer-
cial banks, cooperative banks, etc. Some of the important functions of
SIDBI are as follows:
SIDBI refinances loans and advances offered by the current lend-
ing institutions to small-scale organisations.
M
Itdiscounts and rediscounts bills from sale of machinery to and

manufactured by small-scale industrial organisations.
It offers seed capital/soft loan aid under National Equity Fund,
Mahila Udyam Nidhi and Mahila Vikas Nidhi and seed capital
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schemes.
It provides direct aid and refinance loans extended by primary
lending establishments for financing export of products, manufac-
tured by small-scale organisations.
SIDBI offers various services, such as factoring, leasing, etc. to
small-scale organisations.
It offers financial aid to State Small Industries Corporations for
providing scarce raw materials to and marketing the products of
It offers financial assistance to National Small Industries Corpo-
ration for providing leasing, hire purchase and marketing help to
3. SIDBI helps in administrating Small Industries Development

Fund and National Equity Fund from __________.

n o t e s
Activity
List some objectives of SIDBI focussing on industrial development

in the country. Use the Internet to avail the necessary information.
EXPORT AND IMPORT DEVELOPMENT:

9.5
EXIM BANK
The Export–Import (EXIM) bank, headquartered in Mumbai, was
established on 1st January, 1982. The bank consists of a 17-member
Board of Directors, with Chairman and Managing Director as the chief
executive and full-time director. The Board of Directors comprises the
representative of the Government of India, RBI, IDBI, ECGC, com-
mercial banks and the exporting community.
S
The authorised capital of EXIM Bank is ` 200 crores, of which ` 75
crores is paid up. The bank has obtained a long-term loan of ` 20
crores from the Government of India. Moreover, it can also borrow
IM
from the RBI. It can also acquire resources from both domestic and
international markets.
The main objective of the bank is to provide financial assistance to

various exporters and importers who want to carry out business with
international clients. Some other important objectives include:
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Ensuring and integrating a co-ordinated approach in addressing

the allied issues, often faced by exporters in India
Focussing on the export of capital goods
Aiding and encouraging joint ventures and export of technical ser-
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vices and foreign and merchant banking

Offering buyers’ credit and lines of credit
Exploring both domestic and foreign markets for resources for un-
dertaking development and financial activities in the export sector
In addition to providing assistance to exporters and importers, the

EXIM Bank is also responsible for providing financial aid and guid-
ance to various establishments who are in the same domain and ca-
pacity. The EXIM Bank plans and promotes exports and imports,
offers technical, administrative and managerial aid for promotion,
management and expansion of exports. It also conducts market and
investment surveys and techno-economic studies associated with the
development of export of goods and services. Some other functions of
the EXIM bank are as follows:
It provides assistance to exporters of plant, machinery and other
related services in the form of credit. The duration of credit is usu-
ally between 1 and 3 years.

n o t e s
It is responsible for underwriting of the issue of shares and stocks

for the organisation involved in the export of goods and products.
It facilitates provision for credit to overseas buyers and foreign im-
porters.
The EXIM bank is responsible for the development and financing
of export-oriented industries.
The EXIM bank is responsible for identifying, collecting and com-
piling the data pertaining to market and credit information about
trade.
It helps in raising additional funds and financial resources from
the Government of India, the RBI and the market through bonds,
shares, etc.
The EXIM bank is also responsible for financing several com-
S
mercial banks, which are helping the financial activities of the ex-
port-oriented customers or dealers.
IM
4. The EXIM Bank conducts market and investment surveys and

techno-economic studies associated with the development of
export of goods and services. (True/False)
M
Activity
Write a brief note on a recent initiative undertaken by EXIM Bank

towards export and import development in the country. Use the In-
ternet to avail the necessary information.
N
9.6 HOUSING DEVELOPMENT: NHB

The National Housing Bank (NHB), headquartered in New Delhi, was
established on July 9, 1988, under the National Housing Bank Act,
1987. NHB is wholly owned by the RBI, which contributed the entire
paid-up capital.
The vision of NHB is as follows:

Promoting inclusive expansion with stability in housing finance
market.
The mission of NHB is as follows:

To harness and promote the market potentials to serve the hous-
ing needs of all segments of the population with the focus on low
and moderate income housing.
The main objective to establish the NHB was to provide financial as-
sistance to entities who want to avail the finances for buying a house.

n o t e s
In other words, this was established to provide support for the growth
and the development of the housing sector. Some of the other import-
ant objectives of establishing NHB are as follows:
To promote an efficient and cost-effective housing finance system
to meet the requirements of all segments of the population and
to integrate the housing finance system with the overall financial
system
To create a network of housing finance establishments to effective-
ly serve different locations and people in various income groups
To supplement resources for the housing sector and channelise
them for housing
To ensure housing credit can be obtained conveniently
Tomonitor and control the functions of housing finance establish-
S
ments depending on regulatory and supervisory authority derived
under the Act
To augment supply of buildable land and also provide materials
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for housing and upgradation of housing stock in the country
To ensure public agencies work as facilitators and suppliers of ser-
viced land, for housing
Figure 9.1 depicts the important functions of NHB:

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Functions of
NHB
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Regulation and Promotion and

Finance
Supervision Development
Figure 9.1: Functions of NHB
Let us now study these functions in detail.

Regulation and supervision: As per the National Housing
Bank Act, 1987, NHB is expected to monitor and control the
housing finance system of the country to avoid the opera-
tions of any housing finance institution being conducted in a
way that is detrimental to the interest of the depositors or in a
manner prejudicial to the interest of the housing finance in-
stitutions. For this, NHB formulates the policy and provides di-
rections to the housing finance institutions and their auditors.
Besides, NHB has issued the housing finance institutions guide-
lines for Asset Liability Management System in their organisa-
tions. These are regularly updated via circulars and notifications.

n o t e s
In terms of supervision, an entry level regulation is in place togeth-

er with a system of registration of housing finance institutions. NHB
supervises the housing sector via a system of on-site and off-site sur-
veillance.
Finance: NHB provides support to housing finance sector by:
Offering refinance to various primary lenders
Providing eligible housing loans to individual beneficiaries
Providing project loans to different implementing agencies
Lending directly in terms of projects undertaken by public
housing agencies for housing construction and development of
housing-related infrastructure
Guaranteeing the repayment of principal and interest payment
on bonds issues by housing finance institutions
S
Acting as ‘Special Purpose Vehicle’ for securitising the housing
loan receivables
IM
Promotion and development: NHB works towards the promotion
of housing finance institutions. It helps these institutions by en-
hancing or strengthening the credit delivery network for housing
finance in the country. NHB plays a facilitator role and has issued
the Model Memorandum and Articles of Association. In addition,
NHB has also issued guidelines for participating in the equity of
M
housing finance institutions. All housing finance institutions, reg-

istered with NHB u/s 29A of the National Housing Bank Act, 1987
and scheduled commercial/co-operative banks, can avail refinance
support, subject to terms and conditions as highlighted under the
respective refinance schemes.
N
As a part of its promotional role, NHB has also formulated a

scheme for guaranteeing the bonds to be issued by the housing
finance institutions.
NHB has also identified the need to have trained personnel for the
housing sector. For this, it has designed and conducted different
training and development programmes.
Activity
Find information on the project lending activities of NHB. Prepare

9.7 NEW INITIATIVE OF GOI: MUDRA BANK

In order to provide impetus to the Indian financial system, the Gov-
ernment of India (GOI) has recently launched the Micro Units Devel-
opment and Refinance Agency (MUDRA) Bank. The main objective
for the launch of the MUDRA bank is to ensure that entrepreneurship

n o t e s
is promoted by encouraging micro units. The MUDRA bank offering

includes refinance offering for micro units having loan requirement
in the range of ` 50,000 to ` 10 lakh and aid to microfinancing institu-
tions for onlending, etc. This refinancing support will be offered to mi-
cro businesses under the Scheme of Pradhan Mantri MUDRA Yojana.
The other MUDRA bank offering includes development and financial
literacy support. Figure 9.2 depicts the various MUDRA offerings in
detail:
MUDRA Offerings
S
Refinance of
Micro Units to
Development and
Commercial Banks/
Financial Literacy
NBFCs/RRBs/
IM
Support
Cooperative Banks/
MFIs
Manufacturing and Skill Development,

Service Enterprises Entrepreneurship,
Small Retailers/
WomenPreneurs in Rural, Semi- Marketing
Shopkeepers
urban and Urban Training, Financial
M
Areas Literacy
Figure 9.2: MUDRA Offerings

N
Under the Scheme of Pradhan Mantri MUDRA Yojana, MUDRA bank

has already created its primary products/schemes. The interventions
have been termed ‘Shishu’, ‘Kishor’ and ‘Tarun’ to highlight the stage
of growth/development and funding requirements of the beneficiary
micro unit/entrepreneur and also offer a reference point for the next
phase of graduation/growth to look forward to:
Shishu: covering loans upto ` 50,000
Kishor: covering loans above ` 50,000 and upto ` 5 lakh
Tarun: covering loans above ` 5 lakh and upto ` 10 lakh
MUDRA Bank will ensure that at least 60 per cent of the credit flows
to Shishu category and the balance to Kishor and Tarun categories.
Within the framework and overall objective of growth and develop-
ment of Shishu, Kishor and Tarun categories, the products being of-
fered by MUDRA at the rollout stage have been designed under differ-
ent schemes to meet the needs of entrepreneurs and business sectors.
Some of these schemes are:
Sector/activity specific schemes

n o t e s
Micro Credit Scheme (MCS)

Refinance Scheme for Regional Rural Banks (RRBs)/Scheduled
Co-operative Banks
Mahila Uddyami Scheme
Business Loan for Traders & Shopkeepers
Missing Middle Credit Scheme
Equipment Finance for Micro Units
Some of the benefits of having the MUDRA Bank are as follows:

Easy financial access for micro enterprises
Lower cost of finance
Credit plus approach
S
Mass entrepreneurship growth and development
Higher GDP growth leading to employment generation
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Activity
List the market stakeholders of MUDRA Bank. Write a brief expla-

nation on the activities of these stakeholders.
9.8 SUMMARY
M
DFI is an alternative financial institution comprising community

development financial institutions, microfinance institutions, etc.
These institutions offer credit in the form of high risk loans, pri-
N
vate sector investments, etc. to developing countries like India.

Traditional banks have focused on meeting short-term working
capital requirements of industry whereas DFIs have mainly em-
phasised on meeting the medium and long-term financing require-
ments.
The main objective of establishing the NABARD bank was to pro-
vide finances for the development and promotion of agriculture,
small-scale industries, cottage and handicrafts industry, etc.
SIDBI aids the small-scale industries sector in the country via the
current banks and other financial establishments, such as state fi-
nancial corporations, state industrial development corporations,
commercial banks, cooperative banks, etc.
The EXIM Bank plans and promotes exports and imports, offers
technical, administrative and managerial aid for promotion, man-
agement and expansion of exports.
The main objective to establish the NHB was to provide financial
assistance to entities who want to avail the finances for buying a
house.

n o t e s
The main objective for the launch of the MUDRA bank is to ensure
that entrepreneurship is promoted by encouraging micro units.
key words
Microcredit: It is a small financial loan given to impoverished

people to enable them to become self-employed, that is start
their own business.
Microfinance: It is a type of banking service offered to unem-
ployed or low-income people who has problems obtaining fi-
nancial services.
Onlending: It refers to organisations lending money which they
have borrowed from a third party, that is a person or another
firm.
S
Refinance: It is basically financing once again, usually with new
loans at a lower interest rate.
Working capital: It is the capital of a business that is used in
IM
day-to-day trading operations, determined as current assets mi-
nus current liabilities.

1. What are the functions of SIDBI?
M
2. Discuss the functions of NHB.

N
Topic Q. No. Answer

History and Evolution of Development 1. True
Financial Institution (DFI) in India
Land Development: NABARD 2. Creditor
Industrial Development: SIDBI 3. IDBI
Export and Import Development: EXIM 4. True
Bank

1. SIDBI aids the small-scale industries sector in the country via
the current banks and other financial establishments, such as
State Financial Corporations, State Industrial Development
Corporations, commercial banks, cooperative banks, etc. Refer
to Section 9.4 Industrial Development: SIDBI.

n o t e s
2. Regulation and supervision, finance, promotion and development

are the functions of NHB. Refer to Section 9.6 Housing
Development: NHB.

9.11
REFERENCE
SUGGESTED READINGS
Bhole, L., M., and Jitendra. (2015). Financial institutions and mar-
kets, structure, growth and innovations. McGraw-Hill Publishing
Company Limited
S
E-REFERENCES
Dnb.co.in. (2015). BFSI Sector in India. Retrieved 26 November
IM
2015, from http://www.dnb.co.in/bfsisectorinindia/NonBankC1.asp
Nabard.org. (2015). Nabard - On Farm Development Works. Re-
trieved 26 November 2015, from https://www.nabard.org/english/
farm_development_works.aspx
Sinha, A. (2015). What are the objectives and functions of Small In-
dustries Development Bank of India (SIDBI) ? Preservearticles.com.
M
Retrieved 26 November 2015, from http://www.preservearticles.

com/201012291886/objectives-functions-of-sidbi.html
N

Ch
10 a p t e r
Mutual Funds, Insurance and Venture
CONTENTS
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10.1 Introduction
10.2 Concept of Mutual Funds
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10.2.1 Origin of Mutual Funds
10.2.2 Mutual Funds in India
10.2.3 SEBI Requirements for AMC
10.2.4 Functions and Working of AMC
10.2.5 The Unit Trust of India
10.2.6 Regulatory Structure of Mutual Funds
M

Activity
10.3 Concept of Insurance
10.3.1 Principles of Insurance
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10.3.2 Reinsurance
10.3.3 General Insurance
10.3.4 Life Insurance
Activity
10.4 Concept of Venture Capital
10.4.1 Stages of Venture Capital Financing
10.4.2 Venture Capital in India
10.4.3 Deal Structure
10.4.4 Registration of Venture Capital Fund (VCF)
10.4.5 Application for Venture Capital
Activity
10.5 Summary

n o t e s
HDFC ASSET MANAGEMENT COMPANY LIMITED
The growth of capital market depends on the savings of people in

the country. Indian people are generally least interested in invest-
ing in capital markets; instead most of the population prefers in-
vesting in real estate, gold, secure savings such as fixed deposits.
The prime reasons for investing in such instruments are guaran-
teed returns and no major risks.
Markets need to encourage people to invest in non-traditional

and capital markets. For this, investors must be ensured that their
money is invested in safe instruments. They must also be con-
vinced that their money is professionally managed especially in
case of a huge amount.
S
HDFC Mutual Fund was constituted as a trust under the Indian
Trusts Act, 1882. The trust deed was issued on June 8, 2000 under
the sponsorship of Housing Development Finance Corporation
IM
Limited (HDFC) and Standard Life Investments Limited. HDFC
Trustee Company Limited was made the trustee. The trust deed
was registered under the Indian Registration Act, 1908. The mu-
tual fund got registered with SEBI in June 2000. The HDFC Asset
Management Company Ltd. (AMC) was established in 1999 and
got approval from SEBI for acting as AMC for the HDFC Mutual
Fund in July 2000.
M
HDFC Group conducts various businesses such as banking, home

finance and insurance. The group’s AMC company has been edu-
cating investors regarding investments in mutual funds and capi-
N
tal markets. It offers long-term benefits to its customers, constant-

ly reviews markets for new trends, identifies new growth sectors
and accordingly rolls out different mutual funds schemes for in-
vestors. The AMC shares all this information with investors and
develops new product offerings that are a combination of various
assets and risk categories. This helps investors to achieve their
investment objectives.
(Source: http://www.hdfcfund.com/aboutus/why-hdfc-mutual-fund)

Mutual Funds, Insurance and Venture 183
n o t e s
learning objectives

>> Describe the regulatory structure of mutual funds
>> Discuss the concept of insurance
>> Explain the concept of venture capital
10.1 Introduction
In the previous chapter, you have studied the concept and role of De-
velopment Financial Institutions (DFIs), which are responsible for the
development of rural sectors of the country. In this chapter, you will
study about some important financial markets: mutual funds, insur-
ance and venture capital.
S
There are various components of the financial system that facilitate the
efficient flow of money and ensure the development of a country. Such
IM
components include: mutual funds, insurance and venture capital. A
mutual fund is a financial instrument collects a pool of money from in-
vestors and invests this amount in various kinds of securities having dif-
ferent maturities and nature. In this way, it serves diverse investment
goals of investors. Small investors resort to mutual funds as an invest-
ment option wherein they get the benefit of professional management
of their funds along with the diversification of risk. This is because in-
M
vestments in mutual funds involve a combination of various securities.
Insurance, on the other hand, serves as a risk management tool and an

investment option that provides coverage against various risks. Some
N
of the common insurance policies include general insurance and life

insurance. Lastly, venture capital is a start-up or growth equity capital
or loan capital invested in firms that have a high probability of success
but do not have access to conventional sources of funds.
In this chapter, you will study in detail the concept and features of mu-
tual funds. After that, the chapter discusses the concept of insurance
and its importance for investors. Towards the end, you will study the
concept of venture capital.
10.2 CONCEPT OF MUTUAL FUNDS

As discussed in the previous chapters, a strong financial system is vi-
tal to a sound economy. An effective financial system is one that facil-
itates a smooth transfer of money from investors to borrowers. The
financial system of a country comprises various financial markets (se-
curities markets), financial instruments (mutual funds, shares, bonds,
fixed deposits, etc.) and financial intermediaries (private and nation-
alised banks, insurance companies, central banks of the countries, de-
velopment financial institutions, non-banking financial institutions,

n o t e s
regulatory and supervisory authorities and so on). In this section, you

will study in detail about mutual funds, which are one of the most im-
portant categories of financial instruments.
A mutual fund can be defined from two perspectives. It may refer to a

mutual fund trust or a particular scheme rolled out by a mutual fund
company. A mutual fund trust is a professionally managed body that
pools in the money (investment) of various investors and invests the
entire money collected (corpus) into various securities such as stocks,
bonds, money market securities, gilt securities, commodities, precious
stones, etc. In this way, it acts as a financial intermediary between
financial markets and investors. On the other hand, in the context of
a scheme, a mutual fund is a type of financial instrument in which
investors and the general public can invest their savings in order to
meet their investment objectives.
S
Just like investment instruments such as Fixed Deposits (FDs) or eq-
uities have their specific features related to their rate of return, matu-
rity period etc.; a mutual fund also has certain features. Some of these
IM
features are:
Investments in mutual funds are invested in a combination of se-
curities. Thus, an investor receives the benefit of diversification.
Even small amount of money can be invested in mutual funds.
Mutual funds are managed by professional fund managers; there-
fore, investors can get benefit of well-managed securities even if
M
only a small amount of money is invested.

Each mutual fund scheme has a particular objective which is de-
fined in the fund’s prospectus known as Red Herring Prospectus.
This prospectus contains all information related to the mutual
N
fund scheme such as the name of the concerned fund manager,

securities in which the investment is to be made, expenses, oper-
ating policies, etc.
Mutual funds usually do not hold more than 5-6% of shares of a
particular company. They invest in hundreds of companies; thus,
the risk is truly diversified.
A unit is called the smallest element of a mutual fund. When an in-
vestor is investing in a particular scheme, he/she is basically buy-
ing the units of a mutual fund.
A unit’s value is determined by calculating its Net Asset Value
(NAV), which is calculated by subtracting the total liabilities of the
mutual fund from the total value of all the securities (in which in-
vestment is made). The NAV of a single unit is calculated by divid-
ing the NAV of the whole mutual fund by the number of outstand-
ing mutual fund units.
NAV is the value at which each unit of a mutual fund is bought.
NAV of units is calculated on a daily or weekly basis.

n o t e s
Investors get a proportional share of gains, losses, expenses and

income related to their investment in mutual funds.
As discussed earlier, each mutual fund has a fixed objective. The main
objective of a mutual fund may be to achieve long term growth or to
provide current income to the investor or a combination of growth
and income. Based on their objectives, mutual funds can be classified
into the following types:
Growth funds: These are mutual funds whose objective is to pro-
vide long-term growth of investments made by investors. Such
funds invest the entire corpus of money in high growth securities
such as stocks.
Debt funds: These mutual funds provide a consistent stream of
income to investors. Such funds invest the entire corpus only in
debt or fixed income securities such as debentures.
S
Money market funds: These mutual funds provide short-term, fixed
income to investors. Such funds invest the entire corpus in short-term
debt or short-term, fixed income securities such as gilt securities.
IM
Balanced funds: These are hybrid mutual funds whose objective
is to provide investors with optimised returns. Such funds usually
invest the entire corpus in a mix of long and short-term debt and
equity instruments.
During the last two decades, mutual funds have gained wide ac-
M
ceptance because investments in mutual funds do not require

investors to keep a constant watch over their investments. Apart
from this, mutual funds are also an important investment alterna-
tive for investors who lack time and/or knowledge to make invest-
N
ment decisions. This is because when an investor invests his/her

money in mutual funds, he/she empowers the fund manager and
the mutual fund company to take decisions on his/her behalf. Mu-
tual funds lower the risks of investors as professionals and experts
work on the best course of actions to ensure that investors get the
best return on their savings and investments. Further, in order to
protect the interests of investors, mutual funds are regulated and
controlled by SEBI.
10.2.1 ORIGIN OF MUTUAL FUNDS
The history of mutual funds in India dates back to 1963. In this

year, the Unit Trust of India (UTI) was established through the con-
tinued efforts of the Government of India and the Reserve Bank of
India (RBI). The history and growth of mutual funds can be divided
into four phases, which are explained as follows:
Phase I (1964-87): This stage began with the setting up of UTI in
1963 as a result of a special act of the Parliament. In 1964, the Unit
Scheme of the UTI was launched. UTI launched its first offshore
fund in 1986.

n o t e s
Phase II (1987-92): UTI enjoyed monopoly till 1987 until SBI’s

Mutual Fund and Canbank mutual funds were introduced. UTI
also launched a second offshore fund in 1988. During this period,
many insurance and banking companies started entering the mu-
tual fund business. In 1989, RBI issued first guidelines for mutual
funds. This was followed by the issuance of comprehensive guide-
lines for all mutual funds by the Indian government in 1990.
Phase III (1992-97): Mutual fund regulations were issued by SEBI
in 1993. All mutual funds except UTI were brought under regu-
latory control. In addition, foreign and domestic private players
were allowed entry in mutual funds.
Phase IV (1997-till date): In this phase, the popularity of mutual
funds has increased manifold due to positive changes in capital
markets, associated tax benefits and improvement in the quality of
S
investor services provided by Asset Management Company (AMC).
With the growth of the market for mutual funds and foreseeing the
possibility of unethical practices, SEBI established the Association of
IM
Mutual Funds in India (AMFI) in 1995. It is the body for all mutual
fund companies.
10.2.2 MUTUAL FUNDS IN INDIA
You have already studied the history and development of mutual

M
funds in India. Currently, there are more than 45 mutual fund com-
panies operating in India which including private and government
sector companies. In India, mutual funds work in accordance with
the SEBI Mutual Fund Regulations, 1996. Under these regulations, a
mutual fund can be formed as a public trust under the Indian Trusts
N
Act, 1882. According to these regulations, a mutual fund must follow a

three-tier structure, which is shown in Figure 10.1:
Fund Sponsor
Trustees
Asset Management
Company
Figure 10.1: Structure of Mutual Funds in India

n o t e s
Let us discuss the three-tier structure of mutual funds in detail.

Fund sponsor: A fund sponsor is a person who establishes mutual
funds either alone or in association with an individual/body. The
sponsor establishes a subsidiary company for the purpose of man-
aging funds. The sponsor is eligible for setting up the public trust
and getting it registered with SEBI. In addition, he/she also has to
appoint trustees with the approval of SEBI. He/she then sets up an
AMC under the Companies Act, 1956.
Trustees: The sponsor creates a trust by executing a trust deed in
favour of trustees. Trustees manage the trust along with acting as
the guardian of unit funds and assets. The trustee is responsible
for acting as the internal regulator of the system of handling the
various operations pertaining to mutual funds.
Asset management company (AMC): It is a company that is
S
formed by the trust or the sponsor and acts as the investment man-
ager of mutual funds. All this is done after the execution of the
investment management agreement. The AMC charges the requi-
IM
site fee from investors for managing the money that is invested in
various securities.
10.2.3 SEBI REQUIREMENTS FOR AMC
AMC is responsible for managing various assets and portfolios of in-

vestors in the mutual fund market. It manages the investor’s money on
M
a day-to-day basis and in turn charges a fee for its services. This fee is
deducted from the money collected from investors. AMC appoints the
board of directors. At least 50% of its directors must be independent
directors. AMC works as per the directions of the board, trustees and
N
SEBI. The AMC must be approved by SEBI. It launches and manages

all the schemes under the mutual fund. For launching any new scheme,
the AMC requires to submit a draft offer to the SEBI. If the draft offer
is approved by SEBI, the AMC can introduce the scheme in markets.
It must be ensured that the AMC operates ethically. For this, SEBI
has formulated certain guidelines for AMCs so that the interests of
investors remain protected. Some of these guidelines are explained
as follows:
Itmust take necessary actions to protect the interests of investors
in all circumstances.
Itmust adhere to the guidelines and policies issued by SEBI from
time to time. These guidelines can be related to the preparation of
sales, promotional or any other material about schemes.
Itmust provide updated information related to its various mutual
fund offerings to investors. It should also recommend specific of-
ferings to investors keeping in perspective their risk profile, needs
and requirements.

n o t e s
It must provide information regarding various types of risks in-

volved in its offerings. An AMC should not misrepresent any in-
formation.
It should provide quality services to its investors by maintaining
the necessary infrastructure for carrying out operations.
It should keep all details of investors (including their transactions)
secured and confidential.
10.2.4 FUNCTIONS AND WORKING OF AMC
An AMC acts as an investment manager for a mutual fund trust. It em-

ploys a team of professionally qualified individuals who are responsi-
ble for managing various mutual fund schemes. The following are the
main functions of an AMC:
S
Receiving, validating and processing application forms of various
investors whenever mutual funds are floated in the market
Issuing unit certificates to investors
IM
Preparing, validating and returning refund orders to investors
Providing approvals for all the transfer of units requested by in-
vestors and maintaining all such records
Repurchasing units and redeeming units to investors
M
Issuing dividend or income warrants to investors

Calculating the NAV for each unit of mutual fund on a weekly basis
Ensuring the compliance of various schemes as per regulations

imposed by SEBI and other regulatory bodies
N
Preparing and distributing reports on the scheme for various unit

holders
Monitoring the performance of various mutual funds
Carrying out advertising and promotional campaigns related to
various schemes to attract investors
Performing market analysis in addition to security and risk analy-
sis of various schemes
10.2.5 THE UNIT TRUST OF INDIA
The Unit Trust of India (UTI) is a public sector institution that was
set up in 1964 after the enactment of the Unit Trust of India Act, 1963.
The main purpose for setting up UTI was to provide opportunities to
small investors wherein they can park their funds in investment in-
struments, which offer the diversification of risk.

n o t e s
UTI enjoyed maximum market share till 1987-90 where there were
very few players. However, as of 2015, UTI now has only 9.6% market
share in the mutual fund industry. The market share of various mutu-
al funds is shown in Table 10.1:
TABLE 10.1: Market Share of Mutual Fund Players

Major Players in the Mutual Market Share as of September
Funds Market 2015
HDFC Mutual Fund 15.9032
ICICI Prudential Mutual Fund 15.3252
Reliance Mutual Fund 14.2351
Birla Sun Life Mutual Fund 12.4185
UTI Mutual Fund 9.68847
Axis Mutual Fund 2.95922
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DSP Black Rock Mutual Fund 3.47587
Kotak Mahindra Mutual Fund 5.26058
IDFC Mutual Fund 5.28506
IM
Franklin Templeton Mutual Fund 7.19842
SBI Mutual Fund 8.25033
(Source: http://www.moneycontrol.com/mutual-funds/amc-assets-monitor)
UTI is managed by the board of trustees headed by a chairman, who is

appointed by the central government in association with IDBI Bank.
M
Each trustee is nominated by the Reserve Bank of India (RBI), Life

Insurance Corporation of India (LIC) and State Bank of India (SBI).
Four trustees are nominated by IDBI Bank along with one executive
trustee. Two members are elected by the contributing banks and fi-
N
nancial institutions. The board must meet once in two months. The
objectives of UTI are to:
Encourage small investors to pool and invest their savings in mu-
tual fund offerings of UTI.
Enable small investors enjoy the benefits derived from the indus-
trial development of the country.
Grant loans and advances and provide merchant banking, adviso-
ry and investment services to investors.
Provide portfolio management services to individuals residing
outside India.
Provide forex services such as buying and selling of foreign cur-
rency.
Invest in securities issued by the Government of India, RBI or for-
eign banks
Sell and buy the units issued by UTI.

n o t e s
Investing in the UTI has certain advantages, which are discussed as

follows:
Safety of investment because the risk is spread in a range of secu-
rities
The unit holders get regular income distributed over a period of time
Dividends given by UTI are not taxable
Liquidity of investments is high as the units can be sold at any time.
Some important schemes introduced by the UTI include:

Unit scheme, 1964
Unit Linked Insurance Plan (ULIP), 1971
Children Gift Growth Fund Unit Scheme, 1986
Rajyalakhmi Unit Scheme, 1992
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Senior Citizen’s Unit Plan, 1993
Monthly Income Unit Scheme
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Each of the above scheme has a specific purpose or objective for being
floated. For instance, the Monthly Income Unit Scheme is designed to
provide a regular monthly income to investors based on the number
of units purchased by them.
10.2.6 REGULATORY STRUCTURE OF MUTUAL FUNDS

M
With the growth of economy and increase in the purchasing power of

small investors, mutual funds have witnessed a remarkable growth in
India. Such growth may also provide scope for unethical practices in
this sector. Therefore, to ensure adherence to ethical practices in the
N
mutual funds sector, regulatory bodies such as SEBI have issued reg-
ulations that must be followed by every mutual fund company so that
the interests of investors are protected.
SEBI and RBI regulate mutual funds in India. The RBI regulates a
mutual fund in case the AMC is promoted by any commercial bank.
SEBI is the main authority that formulates policies and regulates mu-
tual funds. SEBI notified regulations in 1993 which were later revised
in 1996. It also issues guidelines for mutual funds on a regular basis.
It must be noted that SEBI has the authority to regulate all mutual
funds, whether they are issued by a public or a private player.
SEBI MUTUAL FUNDS REGULATIONS, 1996
In the year 1993 and 1996, SEBI came out with mutual funds regula-
tions to ensure that various dealings in mutual funds are performed
in an ethical manner. The following are regulations issued by SEBI in
1996 are as follows:
An AMC must get the approval of trustees for issuing mutual fund
schemes.

n o t e s
The document offer of all proposed schemes must also be sent to

SEBI for its approval without which schemes cannot be launched
in markets.
The document offer must contain all relevant disclosures related
to the risk and return of the scheme. It is important to enable in-
vestors in taking a decision as to whether they should invest in the
scheme or not.
AMC must roll out advertisements and promotions related to
schemes in conformance with the guidelines issued by SEBI.
It must get all closed-ended schemes listed on a recognised stock ex-
change within six months after the scheme subscription has ended.
Listing is not mandatory if the scheme provides for monthly in-
come to senior citizens, women, children and physically handi-
S
capped persons.
Units pertaining to a close-ended scheme can be opened for sale
or redemption only at a predetermined fixed interval.
IM
Units of a close-ended scheme can be converted into the units of an
open-ended scheme if a majority of unit holders give their consent.
An AMC must refund the application money to all investors if the
scheme fails to collect minimum subscription within six weeks af-
ter the closure of subscription.
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THE ASSOCIATION OF MUTUAL FUNDS IN INDIA (AMFI)
AMFI is a body that comprises various AMCs (of mutual funds) regis-
tered with SEBI. It was established in August, 1995 as a non-profit or-
N
ganisation. Presently, about 44 AMCs are registered with SEBI and all
of these are the members of AMFI. AMFI was established when vari-
ous mutual funds except UTI realised the need for having a platform
wherein various issues related to the functioning of mutual funds can
be addressed. Additionally, AMFI was also introduced to provide a
mechanism to ensure that fair and ethical practices related to mutual
are implemented. This helps in protecting the interests of investors
and other stakeholders. The major objectives of AMFI are as follows:
To define and maintain high professional and ethical standards in
all areas of operation of the mutual fund industry.
To recommend and promote best business practices and code of con-
duct to be followed by members and others engaged in the activities
of mutual fund and asset management including agencies connected
or involved in the field of capital markets and financial services.
To interact with the Securities and Exchange Board of India (SEBI)
and to represent to SEBI on all matters concerning the mutual fund
industry.

n o t e s
To represent to the Government, Reserve Bank of India and other

bodies on all matters relating to the Mutual Fund Industry.
To undertake nation-wide investor awareness programme so as to pro-
mote proper understanding of the concept and working of mutual funds.
To disseminate information on Mutual Fund Industry and to under-
take studies and research directly and/or in association with other
bodies.
To take regulate conduct of distributors including disciplinary ac-
tions (cancellation of ARN) for violations of Code of Conduct.
To protect the interest of investors/unit holders.
(Source: https://www.amfiindia.com/know-about-amfi)
The regulatory features of AMFI are as follows:
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AMFI has always played an important role in setting parameters
based on which the mutual fund market can be regularised. For
example, AMFI recommended the valuation of unlisted equity
shares and later SEBI issued the same.
IM
In the year 2002, AMFI launched the registration of AMFI-certified
intermediaries. Additionally, distributor agents were also recognised.
The AMFI body works closely with other regulators such as In-
surance Regulatory and Development Authority (IRDA), SEBI and
RBI to prevent gaps in the regulations or the possibility of overreg-
M
ulation, which can hinder growth and the working of mutual funds.
AMFI has launched certain appropriate market indices using
which investors can compare returns on their investments and
take appropriate decisions.
N
It conducts awareness programs to educate and inform investors

about the regulatory requirements of the mutual fund industry.
1. Mutual funds act as a financial intermediary between financial

markets and investors. (True/False)
2. In the case of mutual fund investments, an investor receives
the benefit of __________ due to investments made in a
combination of securities.
3. If the objective of an investor is to get optimised returns from
his investment, he should invest in _________.
a. Growth funds b. Debt funds
c. Balanced funds d. Money market funds
4. UTI enjoyed monopoly till 1987 until ________ and ______ were
introduced.

n o t e s
5. SEBI established the Association of Mutual Funds in India

(AMFI) in 1990. (True/False)
6. The three-tier structure of mutual funds in India comprises
___________, _____________ and ____________.
7. Trustees manage the trust along with acting as the guardian
of unit funds and assets. (True/False)
8. Receiving, validating and processing application forms of
various investors whenever mutual funds are floated in the
market is the responsibility of __________.
9. The chairman of UTI is appointed by central government in
association with __________.
Activity
S
Find information on the current scenario of foreign mutual funds
in India. Also, find which investors generally invest in these foreign
funds.
IM
10.3 CONCEPT OF INSURANCE
Insurance can be defined as an agreement or contract between an
insurance company (insurer) and a client (insured). As per this con-
tract, the insurance company agrees to pay or compensate a particu-
M
lar percentage of damage that may occur to the client or any of his/her
properties in case any emergency arises. When a client enters into an
insurance agreement, he/she has to pay a particular amount of money
for a fixed period of time. The amount that has to be paid by the client
N
is called the premium amount. The premium is to be paid annually or

semi-annually or quarterly or monthly or as per the terms of the insur-
ance agreement. Therefore, insurance serves as a risk management
tool as it transfers a certain amount of risks from one entity to another.
The insurance sector plays an important role in the financial system of

a country. This is because it is the insurance sector that provides risk
coverage and minimises the impact of risks in the case of any casualty.
Insurance is based on the fact the probability of the actualisation of
any adverse situation is very high for an individual or any individual
entity. On the contrary, the probability of the actualisation of any ad-
verse situation for a population or a group of entities is comparatively
very low. For example, it is difficult to predict whether one individual
will face any risk of accident in the coming future or not (please note
most individuals purchase accidental policies). On the other hand, it
is fairly easy to anticipate that 1000 individuals cannot meet an ac-
cident at the same time. In this case, the insurance company needs
to compensate for the claims of only those individuals who have met
accidents and not to all 1000 policy holders.

n o t e s
Let us understand the concept of insurance with the help of an exam-

ple. Assume that there are about 10,000 houses in City A. Now, assume
that about 8,000 house owners in City A want to secure their hous-
es against fire by purchasing fire insurance. Assume that all house-
holders purchase insurance from the same insurer. Each owner of the
house pays a premium towards fire insurance say INR 1000 per year.
It means that the insurer receives INR 80, 00, 000 as premium. Now,
within a period of one year, say five houses faced cases of fire acci-
dents. The insurer paid each house owner an amount of (say) INR 2,
00, 000 as damage claims. Therefore, the insurer paid a total of INR
10, 00, 000 out of the entire INR 80, 00, 000 it had received. This is the
mechanism of insurance.
10.3.1 PRINCIPLES OF INSURANCE
S
An insurance agreement is signed between two entities based on cer-
tain principles. These principles are explained as follows:
Insurance is an activity in the form of a legal and documented
IM
agreement.
Insurance is between two or more entities/ parties/individuals.
The party who signs the agreement is known as the insured while
the other party (insurance company) is known as the insurer.
The insurance agreement contains details related to coverage of
risks, type (s) of risk covered, the percentage of damages to be cov-
M
ered, etc.
The agreement is signed and accepted by the insurer only when
the prospective insured has made the payment known as the pre-
mium. Premium has to be paid on a timely basis.
N
The insurance mechanism works on the concept of pooling, which

implies that several individuals/entities share money to prevent them-
selves from risks, which may or may not actualise. In case the risks
actualise, the pooled amount is used to compensate for the losses.
There are various insurance policies available in the market providing

coverage against different risks, such as aviation insurance, general
insurance, earthquake insurance, health insurance and reinsurance.
Among them, there are three major types of insurance namely rein-
surance, life insurance and general insurance. Let us discuss these
three types of insurance in the next sections.
10.3.2 REINSURANCE
Reinsurance plays a crucial role in the financial system of a country

as it is a means of transferring risks. When an insurer approaches a
prospect for selling an insurance policy, it should be ensured that the

n o t e s
insurer is able to pay for all the claims that the insured files. This pro-
tects the insured against an emergency; on the other hand, it creates
a burden for the insurance company as it needs to maintain a fixed
amount of capital. Thus, to reduce the amount of capital that is re-
quired to be maintained by the insurer; the insurer transfers part of
its risk to another insurer. This is called the concept of reinsurance. In
India, General Insurance Corporation (GIC) is the only company that
provides reinsurance services.
10.3.3 GENERAL INSURANCE
General insurance can be any kind of insurance except for life insur-
ance. Thus, it is also called non-life insurance. Insurance that covers
risks related to homes, offices, any building facilities, vehicles, disas-
ters, theft, fires, terrorism, accidents, etc. come under the category
S
of general insurance. Also, general insurance includes health insur-
ance. Health insurance typically includes compensation for the cost
of hospitalisation, cost of surgery and cost of medicines. These differ-
ent general insurance policies may offer different percentage of risk
IM
cover. Moreover, the terms and conditions also vary for every type of
insurance policy.
In India, till the 1970s, there was no instrument that could provide
the Indian people protection against various types of risks. In order
to provide a possible solution to this problem, the General Insurance
M
Company (GIC) was established in 1972 when the general insurance

business was nationalised. GIC was primarily created because there
were more than 107 private domestic and foreign general insurers
present in India. Many cases were reported regarding the unethical
practices adopted by these companies for the settlement of claims and
N
collection of premium.
Thus, a need was felt to have a regulatory body in place that would
monitor and control the activities of all these companies. To achieve
this, all the 107 companies were merged and four new companies,
namely National Insurance Company Ltd, Oriental Insurance Com-
pany Ltd, The New India Assurance Pvt Ltd. and the United India In-
surance Company Ltd. were created. GIC was created as the holding
company of all these four companies.
GIC carried out its business smoothly till the year 1999. However, in
1999, IRDA was established. This was introduced as a regulatory body
for the insurance sector. IRDA diluted the working and the function-
ing of GIC. Therefore, in 2000, the government notified GIC as being
the “Indian Reinsurer” under Section 101A of Insurance Act, 1938.
Since 2000, GIC has been transformed into a full-time reinsurer and
provides services to direct general insurance companies.

n o t e s
At present, there are about 16 general insurance companies in India.

Out of these 16, four companies are wholly owned by the Indian gov-
ernment and are known as the public sector general insurance com-
panies, namely National Insurance Company Ltd., Oriental Insurance
Company Ltd., The New India Assurance Pvt Ltd. and United India
Insurance Company. On the other hand, other 12 companies are pri-
vately owned and operated. Some private general insurance providers
include: Kotak Mahindra Old Mutual Life Insurance ltd., ICICI Pru-
dential Life Insurance, Bajaj Allianz Insurance Co. Ltd, Star Health &
Allied Insurance Co. Ltd., etc.
10.3.4 LIFE INSURANCE
Life insurance is an insurance agreement in which the insurer agrees

to pay a certain amount to the insured (or his/her nominee) after the
death of the insured or after a particular time period. It is used basi-
S
cally in two scenarios. In the first scenario, the insured may die young
leaving behind dependants; while in the second scenario, the insured
may live long but has no financial support.
IM
In 1956, the government took over 154 Indian insurers, 16 foreign in-
surers and 75 provident societies that were operating in India. All these
were nationalised. As a result of this nationalisation drive, Life Insur-
ance Corporation of India (LIC) came into existence on 1st September
1956. It was set up as a public body fully owned by the Government
of India. During this time, most insurance companies were charging
M
hefty premiums and were resorting to unethical practices. Thus, a need

was felt to regulate these private insurance companies by nationalising
them and bringing them under an umbrella organisation LIC. With
the passage of time, LIC became a key player in the capital market.
N
Life insurance policies can be of the following types:

Endowment plans: In this type of insurance, the insurer has to
compulsorily pay the sum assured to the insured or his/her nomi-
nee at the time of maturity or death of the insured.
Term plans: This type of policy is generally issued at very low pre-
miums and a good amount of the sum assured is paid to the nom-
inee of the insured if he/she dies during the policy term. However,
if the insured has paid all premiums in the policy term but he/she
remains alive, no amount is paid to him/her. This type of plan is
bought only to manage risks and not for an investment purpose.
Whole life policy: In this type of insurance, the insured has to pay
a premium throughout his/her life but his/her family receives the
amount of sum assured only after the insured’s death.
Money-back policy: In this type of insurance, the insured receives
the lump sum amount of money at regular intervals.

n o t e s
10. The ________ policy is generally issued at very low premiums

and a good amount of the sum assured is paid to the nominee
of the insured if he/she dies during the policy term.
11. In India, _____________ is the only company that provides
reinsurance services.
Activity
Find information on Unit Linked Insurance Plans (ULIPs). Prepare

a detailed report on the advantages of ULIPs.
10.4 CONCEPT OF VENTURE CAPITAL
S
Venture capital refers to money (capital) provided by a company (ven-
ture capital company) or an individual (venture capitalist) to new
IM
entrepreneurs having new business ideas. A venture capital firm or
venture capitalist usually provides financial, technical and manage-
rial assistance to new entrepreneurs. Venture capital is important for
budding entrepreneurs as they may not have access to the traditional
sources of finance or may not be eligible to raise finances through
these sources. Venture capitalists invest in novel and unique ideas and
companies in which other investors may never invest. Since the risk
M
involved in this type of business is very large, it is also known as risk

capital. The following are the features of venture capital:
Venture capital is always associated with new and innovative proj-
ects. In other words, venture capitalists invest in projects that are
N
highly risky and there is also a high probability of their growth.

Venture capital is based on an assumption that investments made
today would realise in the long run as new and innovative proj-
ects require time to mature. Additionally, there is also a possibility
that the project/company may or may not even reach the maturity
phase.
Venture capitalists have presence in the management of the com-
pany in which they have invested. Therefore, all decisions that are
taken in the company’s board meetings are taken with the consent
of venture capitalists.
Venture capital funding must be based on the knowledge of com-
petition and ever-changing market dynamics.
Venture capital funding involves analysing future trends and is-
sues related to the project.

n o t e s
10.4.1 STAGES OF VENTURE CAPITAL FINANCING
Each start-up company is unique and may require investment during

different stages of its life cycle. Therefore, it is not possible to decide
investment stages for a start-up. However, investment stages in a
start-up can be broadly divided into three parts, which are shown in
Figure 10.2:
Early Stage Financing
Start-up Stage Financing
Later Stage Financing
S
Figure 10.2: Stages of Venture Capital Financing
IM
Let us discuss these three stages of financing in detail.
1. Early stage financing: A venture capitalist first performs a
detailed study on the project. In the study, the capitalist takes
into account the technical, operational and functional feasibility
of the project. The capitalist may also seek the help of consultants
to ascertain strategic constraints related to the project and the
M
expected benefits of the project. Considering all these details,

the venture capitalist makes a decision whether or not to invest
in a project under consideration.
2. Start-up stage financing: This is the stage where the project
N
is launched in the market and is expected to be stabilised. This

stage carries a high degree of risk as once the project is launched;
it may or may not be much successful. In the case of slow sales
growth or no growth at all, certain other measures must be
adopted as early as possible to prevent the failure of the project.
However, after the project starts generating revenues; the project
may require more investment (additional investment) to provide
stability to marketing campaigns running for the product. Such
additional investments are known as booster investments.
3. Later stage financing: This is the stage when the project
expands. At this stage, the focus of project/company remains on
increasing its presence and operations throughout the country
or across the border. For achieving expansion goals, the company
requires more funds which are provided by venture capitalists.
10.4.2 VENTURE CAPITAL IN INDIA
Initially, the venture capital in India was provided by Developmen-

tal Financial Institutions (DFIs) such as IDBI Bank and ICICI Bank.

n o t e s
They provided funds to companies in the form of debt. At that time,

the concept of venture capital was not recognised formally. R.S. Bhatt
Committee was formed in 1973 for making recommendations for the
development of small and medium enterprises. This report provided
by the committee stated that venture capital in India must grow. The
need for venture capital was introduced formally in the seventh Five
Year plan (1985-90) and the fiscal policy of the Indian government.
However, in 1988, the Technology Development and Information Com-

pany of India (TDICI) Ltd. was formed. This company was promoted
by ICICI and UTI. Till 2008, there were 105 domestic companies and
97 foreign companies which were providing venture capital. However,
as the market for venture capital has gained significance, the num-
ber of venture capitalists has risen. In fact, venture capital is no more
considered as risk capital and has been given a new name i.e. private
equity (PE). The functioning and regulation of the venture capital
S
companies (known as Venture Capital Funds or VCFs) is under SEBI.
10.4.3 DEAL STRUCTURE
IM
A venture capitalist or venture capital firm provides capital for start-
ing a new project or expanding a newly established project. While do-
ing so, the firm/venture capitalist must take into account the process
of structuring the capital or the deal. For financing the project, the
venture capital firm/venture capitalist can use various instruments,
M
which can be broadly divided into debt and equity. They may also use
a combination of debt and equity called hybrid instruments. Let us
now study various types of instruments.
N
EQUITY INSTRUMENTS
The most popular equity instruments adopted by venture capitalists

include ordinary shares, non-voting equity shares, deferred ordinary
shares, preference shares, equity warrants and convertible warrants.
Venture capitalists may also develop specific kinds of instruments
that combine the features of various types of equity instruments. For
example, a venture capitalist may use convertible preference shares,
which may have an option of converting into ordinary shares.
DEBT INSTRUMENTS
In the case of equity instruments, a venture capitalist loses control as

all equity holders become partial owners of the company. However, in
the case of debt instruments, the capitalist may exercise better control
over the management of the company (in which investment is made).
The company that takes debt is required to pay interest at fixed in-
tervals along with the principal amount of money borrowed. The two
major types of debt instruments include:

n o t e s
Conditional loans: These types of loans have no fixed schedule

for the repayment of interest and the principal amount. The terms
and conditions of financing dictate the nature of repayment instal-
ments. The repayment towards interest and principal is recovered
by charging a certain percentage of the sales company has made.
This instrument is also called quasi-equity instrument.
Income notes: These are loans that have a fixed schedule of re-
payment for the principal amount. The repayment is in the form
of charging a certain percentage on sales in addition to a low rate
of interest.
10.4.4 REGISTRATION OF VENTURE CAPITAL FUND
Any company that wants to conduct the business of venture capital

needs to register itself with SEBI under SEBI (Venture Capital Funds)
S
Regulations, 1996. Any company that operates the business of venture
capital funding is called a Venture Capital fund (VCF). The process of
registration of a venture capital fund has been specified by SEBI. A
IM
venture capital needs to follow guidelines and procedures as laid out
by SEBI. The process for registering a venture capital fund involves
the following steps:
Submission of application to the SEBI in the specified form A.
Submission of relevant documents along with the application form.
M
Submission of the requisite application fee with the application

form.
Submission of the requisite registration fee once the application
is accepted.
N
10.4.5 APPLICATION FOR VENTURE CAPITAL
A venture capitalist must make an application to SEBI in a specified

form called Form A for setting up the VCF The application must be
accompanied by all necessary documents required for processing the
application. On submitting the application to SEBI, the applicant re-
ceives a reply from SEBI regarding the status of its application (ap-
proved/rejected) within 21 days. However, SEBI does not grant regis-
tration until and unless it is satisfied that all the required documents
have been submitted as required.
Some of the documents that are required for the registration of a VCF
with SEBI include:
Form A along with the requisite application fee (` 1, 00,000)
Copy of memorandum and Articles of Association
Copy of registered trust deed
Copy of investment management agreement

n o t e s
Details of the sponsor

Details of the trustees/trust
Details of the investment manager/investment advisor/ AMC
Details of the investment strategy
Declarations to be submitted by the applicant include undertaking as

per the regulation of 11(3) of SEBI Regulations 1996; undertaking of
the third schedule to SEBI Regulations 1996; and a declaration in re-
spect of being fit and proper.
Once all these documents are submitted, SEBI processes the appli-
cation. If all the conditions are met, registration is granted. The SEBI
grants the applicant certificate of registration as a SEBI registered
VCF.
S
12. Risk capital is another name for ________.

IM
13. After a project starts generating revenues; the project may
require more investment or additional investment, known as
_________.
Activity
M
Prepare a list of venture capital funds that were granted certificate

of registration by SEBI in the past two years. Also, find if there are
any funds whose registration has been revoked by SEBI in the re-
cent past.
N
10.5 SUMMARY
A mutual fund trust is a professionally managed body that pools in
the money (investment) of various investors and invests the entire
money collected (corpus) into various securities such as stocks,
bonds etc.
A mutual fund is a type of financial instrument in which investors
and the general public can invest their savings in order to meet
their investment objectives. Based on their objectives, mutual
funds can be classified into: growth funds, debt funds, balanced
funds, money market funds.
The history of mutual funds in India dates back to 1963. In this
year, the Unit Trust of India (UTI) was established through the
continued efforts of the Government of India and the Reserve
Bank of India (RBI).
A mutual fund must follow a three-tier structure that comprises of
fund sponsor, trustees and Asset Management Company.

n o t e s
SEBI is the main authority that formulates policies and regulates

mutual funds. SEBI notified regulations in 1993 which were later
revised in 1996.
RBI regulates a mutual fund in case the AMC is promoted by any
commercial bank.
Insurance can be defined as an agreement or contract between an
insurance company (insurer) and a client (insured).
The insurance agreement contains details related to coverage of
risks, type (s) of risk covered, the percentage of damages to be cov-
ered, etc.
When an insurer approaches a prospect for selling an insurance
policy, it should be ensured that the insurer is able to pay for all
the claims that the insured files. This protects the insured against
S
an emergency; on the other hand, it creates a burden for the in-
surance company as it needs to maintain a fixed amount of capital.
General insurance can be any kind of insurance except for life in-
IM
surance. Thus, it is also called non-life insurance. Insurance that
covers risks related to homes, offices, any building facilities, vehi-
cles, disasters etc.
Life insurance is an insurance agreement in which the insurer
agrees to pay a certain amount to the insured (or his/her nominee)
after the death of the insured or after a particular time period.
M
A venture capital firm or venture capitalist usually provides finan-

cial, technical and managerial assistance to new entrepreneurs.
Venture capital is important for budding entrepreneurs as they
may not have access to the traditional sources of finance
N
Investment stages in a start-up can be broadly divided into three

parts: early stage financing, start-up stage financing, later stage
financing.
key words
Financial market: It refers to an arrangement in which finan-

cial institutions are engaged in selling and buying of financial
instruments and services.
Giltsecurities: It refer to bonds that are issued by the govern-
ment of a country.
Net Asset Value (NAV): It is a measure of the value of a mutual
fund. It is calculated by subtracting the total liabilities of the
mutual fund from the total value of all the securities (in which
investment is made).
Preference shares: It refer to shares that have fixed dividends.
Venture capitalist: It refers to an individual that offers venture
capital.

n o t e s

1. Explain the concept of mutual funds in detail.
2. What are the functions of an AMC?
3. Discuss in detail the regulatory structure of mutual funds in India.
4. What do you understand by the term insurance? Explain various
types of insurance.
5. Write a short note on venture capital.
ANSWERS FOR SELF ASSESSMENT QUESTIONS
S
Topic Q. No. Answers
Mutual Funds 1. True
2. Diversification
IM
3. c. Balanced funds
4. SBI’s Mutual Fund, Canbank
mutual funds
5. False
6. Fund Sponsor, Trustees , Asset
Management Company
M
7. True
8. Asset Management Company
9. IDBI Bank
N
Insurance 10. Term plan

11. General Insurance Corporation
(GIC)
Venture Capital 12. Venture capital
13. Booster investment

1. A mutual fund is a type of financial instrument in which investors
and the general public can invest their savings in order to meet
their investment objectives. Refer to Section 10.2 Concept of
Mutual Funds.
2. An AMC acts as an investment manager for a mutual fund trust.
It employs a team of professionally qualified individuals who are
responsible for managing various mutual fund schemes. Refer to
Section 10.2 Concept of Mutual Funds.
3. SEBI and RBI regulate mutual funds in India. The RBI regulates
a mutual fund in the case an AMC is promoted by any commercial
bank. Refer to Section 10.2 Concept of Mutual Funds.

n o t e s
4. Insurance can be defined as an agreement or contract between

an insurance company (insurer) and a client (insured). As per this
contract, the insurance company agrees to pay or compensate a
particular percentage of damage that may occur to the client or
any of his/her properties in case any emergency arises. There are
three types of insurance: reinsurance, general insurance and life
insurance. Refer to Section 10.3 Concept of Insurance.
5. Venture capital refers to money (capital) provided by a company
(venture capital company) or an individual (venture capitalist) to
new entrepreneurs having new business ideas. Refer to Section
10.2 Concept of Mutual Funds.

10.8
REFERENCE
S
SUGGESTED READINGS
Bhole, L., & Mahakud, J. (2009). Financial institutions and mar-
IM
kets. New Delhi: Tata McGraw-Hill.
Pathak, B. (2011). The Indian financial system. New Delhi: Pearson.
E-REFERENCES
Amfiindia.com,. (2015). Retrieved 27 November 2015, from https://
M
www.amfiindia.com/downloads/revised-code-conduct-of-inter-mf
Gruenden.ch,. (2015). Different types of insurance :: gruenden.ch.
Retrieved 27 November 2015, from http://www.gruenden.ch/en/
founding-process/preparation/insurance-and-social-security/
N
Sebi.gov.in,. (2015). Retrieved 27 November 2015, from http://www.

sebi.gov.in/vc/vcregistration.html

Ch
11 a p t e r
International Financial Institutions
CONTENTS
S
11.1 Introduction
11.2 IMF
IM
Activity
11.3 World Bank
11.3.1 IBRD
11.3.2 IDA
11.3.3 IFC
M
11.3.4 MIGA
11.3.5 ICSID
Activity
N
11.4 Summary

n o t e s
ACTIVITIES OF ICSID
The International Centre for Settlement of Investment Disputes

(ICSID) is an international arbitration institution, which was es-
tablished in 1966. The ICSID is a part of the World Bank Group
that aids in legal dispute conciliation and resolution between in-
ternational investors. Although, the recourse to ICSID concilia-
tion and arbitration is entirely voluntary, once the parties have
consented to arbitration under the ICSID Convention, neither can
unilaterally withdraw its consent. In addition, every ICSID Con-
tracting State, whether or not a party to the dispute is needed by
the Convention to recognise and enforce ICSID arbitral awards.
Since 1978, there have been a set of Additional Facility Rules au-
thorising the ICSID Secretariat to administer specific types of
S
proceedings between states and foreign nationals that are outside
the range of the Convention. Such proceedings are related to con-
ciliation and arbitration where either the state party or the home
IM
state of the foreign national is not a member of ICSID. Additional
Facility conciliation and arbitration can also be availed in cases
where the dispute is not an investment dispute, provided it con-
cerns a transaction, which has “features that segregates it from a
traditional commercial transaction”.
Further, the Additional Facility Rules enable ICSID to incorporate

M
a type of proceeding not included in the Convention, for instance,

fact-finding proceedings to which any state and foreign national
may have recourse, if they wish to set up an inquiry “to examine
and report on facts”.
N
In terms of settlement of disputes, the Secretary-General of IC-

SID plays the role of appointing authority of arbitrators for ad hoc
(that is, non-institutional) arbitration proceedings. Quite often,
this is done in the context of arrangement for arbitration under
the Arbitration Rules of the United Nations Commission on Inter-
national Trade Law (UNCITRAL), which is specially designed for
ad hoc proceedings.
Provisions on ICSID arbitration are mostly present in investment

contracts between governments of member countries and inves-
tors from other member countries. Advance consent by govern-
ments to submit investment disputes to ICSID arbitration are
also present in approximately 20 investment laws and in over 900
bilateral investment treaties.
Arbitration under the auspices of ICSID is similarly one of the

main mechanisms for the settlement of investment disputes un-

International Financial Institutions 207
n o t e s
der four recent multilateral trade and investment treaties, which

are:
The North American Free Trade Agreement
The Energy Charter Treaty
The Cartagena Free Trade Agreement
The Colonia Investment Protocol of Mercosur
ICSID also conducts advisory and research activities, publishes

investment laws of the World and Investment Treaties and col-
laborates with other World Bank Group units. Since April 1986, a
semi-annual law journal has been published, entitled ‘ICSID Re-
view-Foreign Investment Law Journal’.
(Source: http://www.yourarticlelibrary.com/organisation/international-centre-for-settle-
S
ment-of-investment-disputes-icsid/23535/)
IM
M
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n o t e s
learning objectives

>> Explain the functions of IMF
>> Describe the functions of the World Bank
11.1 INTRODUCTION
In the previous chapter, you have studied the concept of mutual funds,
insurance and venture capital. This chapter will focus on internation-
al financial institutions.
The financial system of a country cannot survive only on the basis of

the domestic financial system. It needs the support and assistance of
S
international financial institutions. The international financial insti-
tutions provide assistance for the growth and development of devel-
oped as well as developing countries. For example, the International
IM
Monetary Fund (IMF) provides funding for the development of the
infrastructure in many African countries. Further, the international fi-
nancial institutions are responsible for assisting the countries that are
affected by natural disasters, such as earthquakes, floods, etc. Thus,
they provide assistance and help to the residents of those countries
that face the consequences of the disaster.
M
The international financial institutions provide assistance to the de-

velopment of various sectors, such as healthcare, transportation, etc.,
so that the specific sector can aid in the economic growth of the coun-
try. For instance, there are several World Bank-funded projects that
N
are going on in India. An example includes Nai Manzil project, which

is aimed at the education and skill training for the minorities. In the
similar way, IMF has assisted India in the development of the securi-
ties market. These institutions are also responsible for easing out the
balance of payment issues, which the countries regularly face when
dealing in international matters.
In this chapter, you will study about IMF and World Bank, along with
other international financial institutions.
11.2 IMF
The International Monetary Fund (IMF), headquartered in Washing-
ton, DC, USA, was set up in the year 1945, when several countries
were affected as a result of the world war. At that time, a need was
felt to have an organisation wherein the countries would be provided
funds to ensure financial stability and help them towards growth and
development. In addition to achieving this objective, the IMF was re-

n o t e s
quired to facilitate international trade amongst the member countries.

It also aimed at providing assistance to the process of generating em-
ployment in the countries affected due to the world war.
The aims of IMF are to:

Promote international monetary cooperation
Aid the expansion and balanced growth of international trade
Promote foreign exchange stability
Aid in setting a multilateral system of payments
Provide sufficient resources to member countries facing balance
of payment problems
The IMF was set up to perform the following functions:
S
Help in providing surveillance, lending and technical assistance to
foster global growth and economic policies of the member coun-
tries.
IM
Ensure that economic stabilities are achieved by providing advice,
drafting policies and ensuring support and co-operation in pover-
ty eradication in member countries.
Help to ease out the balance of payments issue involving the mem-
ber countries.
M
Evaluate the economies of various countries around the world and

provide innovative solutions to maintain economic growth.
Help to regulate and fix the exchange rate mechanism of member
countries. This also helps in addressing issues with the balance of
N
payments.
Extend loans to various countries to meet their needs and require-
ments and ensure that the amount of the loan sanctioned is prop-
erly utilised for the intended purpose.
In recent times, several countries have been facing severe financial

crisis due to global recession. The IMF has helped various countries
to overcome such critical financial issues. For example, the IMF was
responsible for bailing out Greece, the country was severely affected
due to financial crisis. Therefore, countries can become a member of
the IMF and seek financial assistance when required. Currently, the
IMF comprises 188 member countries. Other nations can also become
its member by applying to the IMF and paying a certain membership
fee. Presently, the IMF is mobilising efforts of the member countries
in meeting the challenges of climate changes through the financials
involved in the pricing of carbon credits of these countries. This is
carried out through technical and advisory consultants of the IMF.

n o t e s
Exhibit
History of IMF
The IMF has played a part in shaping the global economy since the
end of World War II. Some of the instances in history where the IMF
has helped rejuvenating economies in various ways are as follows:
Cooperation and Reconstruction (1944–1971)
As the Second World War ended, the job of rebuilding national econ-
omies began. The IMF was involved in overseeing the international
monetary system to ensure exchange rate stability and encourag-
ing members to eliminate exchange restrictions that hinder trade.
The End of the Bretton Woods System (1972–1981)
S
After the system of fixed exchange rates collapsed in 1971, coun-
tries were free to choose their exchange arrangement. Oil shocks
occurred in 1973–1974 and 1979, and the IMF stepped in to help
IM
countries deal with the consequences.
Debt and Painful Reforms (1982–1989)
The oil shocks led to an international debt crisis, and the IMF
assisted in coordinating the global response.
M
Societal Change for Eastern Europe and Asian Upheaval

(1990–2004)
The IMF played a central role in helping the countries of the for-
mer Soviet bloc transition from central planning to market-driven
N
economies.
Globalisation and the Crisis (2005–Present)
The implications of the continued rise of capital flows for economic

policy and the stability of the international financial system are still
not clear completely. The current credit crisis and the food and oil
price shock are clear indications of the new challenges that the IMF
will face in future.
(Source: http://www.imf.org/external/about.htm)
1. The IMF was established in the year __________.

2. The IMF helps in providing surveillance, lending and technical
assistance to foster global growth and economic policies of the
member countries. (True/False)

n o t e s
Activity
Using the Internet, find information on the organisation and gover-

nance structure of the IMF. Prepare a report on your findings.
11.3 World Bank

The World Bank, headquartered in Washington, DC, USA, was estab-
lished in July, 1944. It operates as an important source of financial and
technical assistance to developing countries around the world. The
bank aims to reduce poverty and support development globally. The
goals set by the World Bank for countries to achieve by 2030 are:
End extreme levels of property by minimising the percentage of
people earning less than US$ 1.25 per day, to no more than 3 per
S
cent.
Promote shared prosperity by enhancing the income growth of the
bottom 40 per cent for each country.
IM
The World Bank is like a cooperative, comprising 188 member coun-
tries, which are represented by the Board of Governors, who are the
ultimate policymakers at the World Bank. Usually, the governors are
finance or development ministers of the member country. They meet
once a year at the Annual Meeting of the Boards of Governors of the
World Bank Group and the IMF.
M
The governors assign certain duties to 25 executive directors, who

work on-site at the Bank. The five largest shareholders appoint an
executive director, while other member countries are represented
N
by the elected executive directors. Jim Yong Kim, President of the

World Bank Group, chairs meetings of the Boards of Directors and
is responsible for entire management of the Bank. The President is
chosen by the Board of Executive Directors for a five-year, renewable
term. The Executive Directors represent the Board of Directors of the
World Bank. They usually meet at least twice a week to monitor and
review the Bank’s business, including approval of loans and guaran-
tees, new policies, the administrative budget, country aid strategies
and borrowing and financial decisions. The World Bank functions on
a day-to-day basis under the leadership and direction of the president,
management, senior staff and the vice-presidents in charge of Global
Practices, Cross-Cutting Solution Areas, regions and functions.
Some of the main functions of the World Bank are as follows:

Financial products and services: The World Bank offers low-in-
terest loans, zero to low-interest credits and grants to developing
countries. These support a wide range of investments in various
sectors, such as education, healthcare, public administration, in-
frastructure, financial and private sector development, agricul-
ture, and environmental and natural resource management. Some

n o t e s
of the projects of the World Bank are co-financed with govern-

ments, various multilateral institutions, commercial banks, export
credit agencies and private investors. The World Bank also offers
financial assistance via trust fund partnerships with bilateral and
multilateral donors.
Innovative knowledge sharing: The World Bank aids developing
countries in different ways, such as policy advice, research and
analysis, and technical assistance. The World Bank also helps in
capacity development in member countries and sponsor, host or
participates in various conferences and forums related to the is-
sues of development, often in collaboration with the partners.
In order to ensure that countries can access the best global skills and
help generate cutting-edge knowledge, the World Bank is regularly
working towards enhancing the manner in which it shares its knowl-
S
edge and communicates with clients and the public. Some of the main
priorities include:
Results: The World Bank emphasises on helping developing coun-
IM
tries to deliver measurable results.
Reform: The World Bank continuously works towards the im-
provement of project design and suitability of access to informa-
tion. It also works to bring operations closer to member govern-
ments and communities.
M
Open development: The World Bank provides a range of free,

easy-to-access tools, and research and knowledge opportunities to
aid people manage the global development challenges. For exam-
ple, the Open Data website of the World Bank offers free access to
detailed, downloadable indicators about development in countries
N
around the world. Moreover, the World Bank has started ‘World
Bank Live’, which is a live discussion forum, open to participants
globally. It is a vital component of the bank’s Spring and Annual
Meetings with the IMF.
Exhibit
History of the World Bank
Since the inception in 1944, the World Bank has expanded from
a single institution to a closely associated group of five develop-
ment institutions. The World Bank’s mission evolved from the
International Bank for Reconstruction and Development (IBRD)
as a facilitator of post-war reconstruction and development to the
present-day mandate of worldwide poverty alleviation in close co-
ordination with the bank’s affiliate, the International Development
Association, and other members of the World Bank Group, that is,
the International Finance Corporation (IFC), the Multilateral Guar-
antee Agency (MIGA), and the International Centre for the Settle-
ment of Investment Disputes (ICSID).

n o t e s
Once, the World Bank had a homogeneous staff of engineers and

financial analysts, based solely in Washington, DC. Currently, the
bank has a multi-disciplinary and diverse staff that includes econo-
mists, public policy experts, sector experts and social scientists and
at present, more than a third of the bank’s staff is based in country
offices.
Reconstruction remains an important part of the World Bank’s

work. However, poverty reduction through an inclusive and sus-
tainable globalisation remains the overarching goal of the bank’s
work.
(Source: http://www.worldbank.org/en/about/history)
The World Bank Group comprises five organisations, as shown in

Figure 11.1:
S
IM
World Bank Group
International Bank International International Multilateral International

for Reconstruction Development Finance Investment Guarantee Centre for
and Development Association Corporation Agency Settlement of
Investment
Disputes
M
Figure 11.1: The World Bank Group

(Source: www.fin.gc.ca)
N
It is important to note that the International Bank for Reconstruction

and Development (IRDA) and International Development Associa-
tion (IDA) together comprise the World Bank. Let us now study these
organisations of the World Bank Group in detail in the subsequent
sections.
11.3.1 IBRD
The International Bank for Reconstruction and Development (IBRD),

created in 1944, is an international financial institution that is a com-
ponent of the World Bank. The main purpose for the establishment of
IBRD was to provide financial assistance in the reconstruction of sev-
eral countries that were facing economic crisis as a result of the World
War. As an institution, the IBRD provides financial services as well
as other technical, financial and operational knowhow to the various
member countries so that a concerted effort can be implemented to
eradicate poverty and lead the countries towards growth and devel-
opment.

n o t e s
The following points enumerate the functions of IBRD:

It provides support for long-term human and social development
to countries in which the private creditors are unwilling to provide
finance for reasons pertaining to default.
It provides support to borrowers who have taken loans and ad-
vances when they are impacted by the financial crisis, wherein the
poor people are affected significantly.
IBRD promotes key policies and other institutional financial re-
forms that require utmost attention, such as reforms pertaining to
anti-corruption and so on.
It helps in creating a favourable environment that will invite ade-
quate investment and will thus provide the impetus and thrust for
the private investors towards funding entrepreneurship.
S
It provides financial advice, consultancy and initiates various
developmental programmes so as to enable them to operate as
self-independent entities.
IM
In addition to providing financial support to various countries, the
IBRD also provides knowledge and advisory services. For example,
financial packages of the IBRD are designed to address the issues of
financial crisis of a nation.
Exhibit
M
Financing of Ibrd
IBRD raises most of its funds in the world’s financial markets. In

fact, in these markets, IBRD is simply known as the World Bank.
N
This practice has allowed IBRD to provide more than US$ 500 bil-
lion in loans to alleviate poverty around the world since 1946, with
its shareholder governments paying in about US$ 14 billion in cap-
ital.
IBRD has maintained a triple-A rating since 1959. Its high cred-
it rating allows it to borrow at low cost and offer middle-income
developing countries an access to capital on favourable terms—in
larger volumes, with longer maturities and in a more sustainable
manner than world financial markets typically provide.
IBRD earns income every year from the return on its equity and
from the small margin it makes on lending. This pays for IBRD’s
operating expenses, goes into reserves to strengthen the balance
sheet, and provides an annual transfer of funds to IDA, the fund for
the poorest countries.
(Source: http://www.worldbank.org/en/about/what-we-do/brief/ibrd)

n o t e s
11.3.2 IDA
The International Development Association (IDA), established in

1960, is a component of the World Bank. It is responsible for pro-
viding help and assistance to the under-developed countries of the
world. The main aim of the establishment of the IDA was to reduce
poverty by providing loans and advances. It also aims at implement-
ing programmes that are designed to boost economic growth, reduce
inequalities and improve the general living and working conditions of
the people in under-developed countries.
The IDA is the single source of donor funds in meeting the basic social
needs of the people in under-developed countries. The IDA provides
loans on concessional terms to various countries that require the help
of IDA. Like the IRDA, the IDA is also involved in several develop-
ment activities, such as primary education, basic healthcare services,
S
clean water and improvement in sanitation services. The IDA has
been working towards addressing the current global challenges, such
as financial crunch, climate changes, harmful diseases, etc.
IM
Some of the key functions of the IDA are as follows:
It is actively involved in managing the challenges of climate change
by conducting awareness programmes and other financial packag-
es that are designed to address the related issues.
Itworks towards addressing the issues related to gender inequali-
M
ty and empowering the women of poor countries to undertake the

development and growth of the society.
Itprovides financial assistance to under-developed countries as
well as developing nations to foster their economic growth and de-
N
velopment.
IDA offers financial assistance, advice and consultancy services to
under-developed countries as well as developing nations to enable
them to efficiently and effectively conduct programmes related to
eradication of poverty.
Exhibit
Ida Financing
IDA funds are allocated to the recipient countries in relation to

their income levels and a record of success in managing their econ-
omies and their on-going IDA projects. IDA’s lending terms are
highly concessional, meaning that the IDA credits carry no or low
interest charges.
The lending terms are determined with reference to recipient coun-

tries’ risk of debt distress, the level of GNI per capita, and credit-
worthiness for the IBRD borrowing. Recipients with a high risk of

n o t e s
debt distress receive 100 per cent of their financial assistance in

the form of grants and those with a medium risk of debt distress
receive 50 per cent in the form of grants. Other recipients receive
IDA credits on regular or blend and hard-terms with 38-year and
25-year maturities, respectively.
In fiscal year 2015 (which ended June 30, 2015), IDA commitments
totalled US$ 19 billion (including IDA guarantees), of which 13
per cent was provided on grant terms. New commitments in FY15
comprised 191 new operations. Since 1960, IDA has provided US$
312 billion to 112 countries. Annual commitments have increased
steadily and averaged about US$ 19 billion over the last three years.
(Source: http://www.worldbank.org/ida/financing.html)
S
11.3.3 IFC
International Finance Corporation (IFC), established in July 1956,

is a part of the World Bank Group. IFC was set up to offer advisory
IM
and investment services to the private sector in the developing coun-
tries. It provides assistance and advice to the commercial projects that
are undertaken by the private sector in various countries around the
world. These projects are undertaken to address the issues related to
the eradication of poverty and provide development opportunities for
the people of the developing countries.
M
Some of the main objectives of IFC are as follows:

To invest in productive private firms, together with private inves-
tors, and without government guarantee of repayment, in cases
where adequate private capital is not present on reasonable terms.
N
To serve as a clearing house to bring together investment opportu-

nities, foreign and domestic private capital and experienced man-
agement.
To stimulate productive investment of foreign and domestic pri-
vate capital.
WORKING
The IFC takes into consideration only a specific investment proposal

that aims to establish, expand or enhance productive private enter-
prises towards contributing to the development of the economy of the
country concerned. Industrial, financial, agricultural, commercial and
other private enterprises can apply for IFC financing, provided their
operations are productive.
The IFC can invest its funds in several forms, with the exception of
capital stocks and shares. It does not have a policy of uniform interest
rates for its investments. The interest rate needs to be determined
according to various factors, such as risks involved and any right to

n o t e s
participation in profits, etc. IFC invests only when it is sure that the
enterprise has the necessary experience and competent management
to successfully conduct the day-to-day business of the enterprise. The
IFC does not itself takes responsibility of managing the enterprise. In
India, the IFC has made six investment commitments till date, total-
ling over US$ 7 million.
Although there is great scope for IFC to broaden its operations, as

reflected through its resources and investment portfolios, the overall
working has been extremely slow. In future, it is expected that the
IFC will be more capable of playing a dynamic investor’s role in the
economic development of developing and under-developed countries.
Exhibit
Ifc Financing
S
IFC virtually raises all funds for lending activities through the issu-
ance of debt obligations in international capital markets. IFC’s bor-
rowings are diversified by country, currency, source and maturity
IM
in order to provide flexibility and cost effectiveness.
A consistent triple-A credit rating based on conservative policies

and excellent financial performance has assisted in building sig-
nificant and distinct name recognition in the market place for the
IFC. Since first being rated in 1989, IFC has been rated triple-A
M
every year by Standard and Poor’s and by Moody’s. Our high cred-
it rating is essential for maintaining our ability to access markets
globally and to maintain our low cost of funding.
Under IFC’s funding programme, IFC issues bonds in a variety

N
of markets and formats, including US dollar benchmarks bonds,

themed bonds that support a specific programme, such as green
bonds, uridashi notes, private placements and discount notes. In
addition, IFC issues local-currency bonds to develop domestic cap-
ital markets and facilitate local-currency lending. In the fiscal year
2014, IFC borrowed an amount equivalent to US$ 16 billion in 17
different currencies.
Besides raising capital through bond issuance, IFC invests its liq-
uid assets globally and manage them with respect to recognised
industry benchmarks. IFC aims to outperform those targets while
preserving capital and ensuring that funds are available as needed
for its private sector investments in developing countries.
IFC also manages currency and interest rate risks of assets and
liabilities on its funded balance sheet within prudent risk limits.
This allows IFC to tailor risk management and loan products to the
needs of its clients while hedging the resulting market risks.
(Source: http://www.ifc.org/wps/wcm/connect/corp_ext_content/ifc_external_corporate_site/
about+ifc_new/ifc+governance/funding/ourfunding)

n o t e s
11.3.4 MIGA
Multilateral Investment Guarantee Agency (MIGA), established in

1988, is another component of the World Bank Group. The mission of
the MIGA is to promote Foreign Direct Investment (FDI) in develop-
ing countries to support their economic growth, minimise poverty and
enhance the standard of living. The main aim for the establishment
of the MIGA is to promote investment in the developing countries by
offering a variety of services, such as risk insurance against foreign
exchange regulations, outbreak of political disturbance in the coun-
try, several impositions on the spending limits and restrictions on the
assets of the company and so on.
In addition to providing a risk cover, as in the case of political dis-

turbances, MIGA also provides help to the developing countries by
providing advisory and technical services so as to attract more foreign
S
investments. This is achieved by assisting the government in the for-
mulation of policies and procedures that are best suited for attracting
foreign investment.
IM
Some of the functions of MIGA are as follows:
Conducting research and knowledge-sharing sessions with the
purpose of attracting foreign investments.
Providing risk cover to the private sector investors against any po-
litical insurgency.
M
Monitoring, evaluating and tracking the investment patterns and

discussing the trends and patterns that can be optimised to attract
foreign capital.
N
Exhibit
Miga Products, Team and Shareholders
Miga Products
MIGA fulfils its mission by providing political risk insurance guar-

antees to private sector investors and lenders. MIGA’s guarantees
protect investments against non-commercial risks and can help in-
vestors obtain access to funding sources with improved financial
terms and conditions. MIGA’s unique strength is derived from its
standing as a member of the World Bank Group and its structure as
an international organisation with its shareholders including most
countries of the world. Since MIGA’s inception in 1988, it has issued
more than US$ 28 billion in political risk insurance for projects in a
wide variety of sectors, covering all regions of the world.
MIGA also conducts research and shares knowledge as part of its

mandate to support foreign direct investment in emerging markets.
This underscores its position as a thought leader and a source of
pertinent information for the political risk insurance community.

n o t e s
Miga Team
MIGA team members have extensive experience in political risk in-

surance, with backgrounds including banking and capital markets,
environmental and social sustainability, project finance and sector
specialties, and international law and dispute settlement.
Miga Shareholders
Council of Governors and a Board of Directors representing its

member countries guide the programmes and activities of MIGA.
Its corporate powers are vested in the Council of Governors, which
delegates most of its powers to the Board of Directors. Voting pow-
er is weighted according to the share of capital each director rep-
resents. The directors meet regularly at the World Bank Group
headquarters in Washington, DC, where they review and decide on
S
investment projects and oversee general management policies.
(Source: https://www.miga.org/who-we-are)
IM
11.3.5 ICSID
The International Centre for Settlement of Investment Disputes

(ICSID), established in 1966, is an autonomous international institu-
tion and a component of the World Bank Group. It was set up under
the Convention on the Settlement of Investment Disputes between
M
states and nationals of other states (the ICSID of the Washington Con-
vention) with over 140 member states.
The Convention has detailed ICSID’s mandate, organisation and core

functions. The main purpose of ICSID is to offer facilities for concilia-
N
tion and arbitration of international investment disputes. The ICSID

Convention is a multilateral treaty formulated by the Executive Direc-
tors of the International Bank for Reconstruction and Development
(the World Bank). It was opened for signature on March 18, 1965, and
got implemented on October 14, 1966. The Convention intended to
eradicate issues to the free international flows of private investment
posed by non-commercial risks and the absence of specialised inter-
national methods for investment dispute settlement. The Convention
formed ICSID so that it can play a key role in the field of international
investment and economic development. Currently, ICSID is regarded
as the leading international arbitration institution for investor–state
dispute settlement.
At present, there are 155 signatory states to the ICSID Convention. Of

these, 143 states have deposited their instruments of ratification, ac-
ceptance or approval of the Convention to become ICSID contracting
states.

n o t e s
ICSID has a simple organisational structure, as depicted in

Figure 11.2:
Organisational
Structure of ICSID
Administrative
Secretariat
Council
S
Figure 11.2: Organisational Structure of ICSID
Let us now study the composition and functions of the administrative

IM
council and the secretariat in detail.
Administrative council: It is the governing body of the ICSID and
comprises one representative of each of the ICSID contracting
states. The administrative council convenes every year together
with the joint World Bank/IMF annual meetings. All representa-
tives have equal voting powers. The President of the World Bank
M
is ex-officio Chairman of the ICSID administrative council, but has

no vote. Some of the key functions of the administrative council
are to elect the Secretary-General and the Deputy Secretary-Gen-
eral, implement rules and regulations for the institution and con-
duct ICSID proceedings, adopt the ICSID budget and approve the
N
annual report on the operation of ICSID.

Secretariat: It comprises a Secretary-General, a Deputy Secre-
tary-General and staff. The Secretary-General is the legal repre-
sentative of the ICSID, the registrar of the ICSID proceedings and
the principal officer of the Centre.
The Deputy Secretary-General is responsible for the daily functioning

of the Secretariat and acts for the Secretary-General in cases of his ab-
sence or inability to carry out duties and during any vacancy in the of-
fice of Secretary-General. Some of the key functions of the Secretariat
are to offer institutional support for the initiation and conduct ICSID
proceedings; aid in the constitution of conciliation commissions, ar-
bitral tribunals and ad-hoc committees and support their operations;
and administer the proceedings and finances of each case. The Sec-
retariat also offers support to the administrative council and ensures
the functioning of ICSID as an international institution and a centre
for publication of information and scholarship.
Secretariat maintains the ICSID Panels of Conciliators and of Arbitra-

tors to which each contracting state may appoint four persons and the

n o t e s
Chairman of the administrative council may designate 10 people. The

ICSID Panels offer a source from which the parties to ICSID proceed-
ings may choose conciliators and arbitrators. Further, in the event the
Chairman of the administrative council is called upon to appoint con-
ciliators, arbitrators or ad-hoc committee members in ICSID proceed-
ings, his appointees must be selected from the Panels. The Secretari-
at’s administrative costs are financed out of the World Bank’s budget;
the expenses of ICSID proceedings are borne by the disputing parties.
Exhibit
Institutional Arrangements of Icsid
As a general rule, ICSID proceedings are held at the Centre’s head-

quarters in Washington, DC. However, the parties may agree to hold
their proceeding at any other place, subject to certain conditions.
S
The ICSID Convention contains provisions that facilitate advance
stipulations for such other venues when the place chosen is the seat
of an institution with which the Centre has an arrangement for this
IM
purpose.
ICSID has to date concluded such arrangements with the following

institutions:
1. The Permanent Court of Arbitration at The Hague;
M
2. Regional Arbitration Centres of the Asian-African Legal

Consultative Committee at Cairo, at Kuala Lumpur and at
Lagos;
3. Australian Commercial Disputes Centre at Sydney;
N
4. Australian Centre for International Commercial Arbitration

at Melbourne;
5. Singapore International Arbitration Centre;
6. Gulf Cooperation Council Commercial Arbitration Centre at
Bahrain;
7. German Institution of Arbitration.
(Source: http://www.yourarticlelibrary.com/organisation/international-centre-for-settle-
ment-of-investment-disputes-icsid/23535/)
3. The World Bank offers high-interest loans, zero to high-

interest credits and grants to developing countries. (True/
False)
4. __________ works towards addressing the issues related
to gender inequality and empowering the women of poor
countries to undertake the development and growth of the
society.

n o t e s
5. The IFC does not have a policy of __________ interest rates for
its investments.
6. The mission of __________ is to promote Foreign Direct
Investment (FDI) in developing countries to support their
economic growth, minimise poverty and enhance the standard
of living.
7. The ICSID Convention is a __________ formulated by
the Executive Directors of the International Bank for
Reconstruction and Development (the World Bank).
8. __________ is the governing body of ICSID and comprises one
representative of each of the ICSID contracting states.
S
Activity
Using the Internet, find information on the dispute settlement facil-

ities of ICSID. Prepare a report on your findings.
IM
11.4 SUMMARY
The IMF helps in providing surveillance, lending and technical as-
sistance to foster global growth and economic policies of the mem-
ber countries.
M
The World Bank operates as an important source of financial and

technical assistance to developing countries around the world. The
bank aims to reduce poverty and support development globally.
N
The main purpose for the establishment of IBRD was to provide

financial assistance for the reconstruction of several countries that
were facing an economic crisis as a result of the World War.
IDA is the single source of donor funds in meeting the basic social
needs of the people in under-developed countries.
IFC was set up to offer advisory and investment services to the pri-
vate sector of the developing countries. It provides assistance and
advice to commercial projects that are undertaken by the private
sector of various countries around the world.
The mission of MIGA is to promote Foreign Direct Investment
(FDI) in developing countries to support their economic growth,
minimise poverty and enhance the standard of living.
The organisational structure of ICSID includes the administrative
council and the secretariat.

n o t e s
key words
Ad hoc committee: It is set up for a certain task or objective

and dissolved on completion of the task or attainment of the
objective.
Arbitrator: It refers to an independent person or group nomi-
nated to settle a dispute.
Conciliator: It refers to an individual who acts as a mediator
between two disputing individuals or groups.
Investment portfolio: It is a collection of assets owned by a per-
son or an organisation.
Multilateral treaty: It is a written agreement between two or
more sovereign states setting the rights and obligations be-
S
tween the parties.

IM
1. What are the functions of the IMF?
2. Discuss the functions of the World Bank.
3. Explain the organisational structure of ICSID.
M

N
Topic Q. No. Answer

IMF 1. 1945
2. True
World Bank 3. False
4. IDA
5. Uniform
6. MIGA
7. Multilateral treaty
8. Administrative Council

1. The IMF helps in providing surveillance, lending and technical
assistance to foster global growth and economic policies of the
member countries. Refer to Section 11.2 IMF.

n o t e s
2. The World Bank offers low-interest loans, zero to low-interest

credits and grants to developing countries. Refer to Section
11.3 World Bank.
3. The organisational structure of ICSID comprises the
administrative council and the secretariat. Refer to Section
11.3 World Bank.

11.7
REFERENCE
SUGGESTED READINGS
Bhole L.M., Jitendra (2015). Financial institutions and markets,
structure, growth and innovations. McGraw-Hill.
S
Pathak B. (2014). Indian financial system. 4th ed. India, Noida:
Dorling Kindersley.
IM
E-REFERENCES
Imf.org (2015). IMF—About. Retrieved 28 November 2015, from
http://www.imf.org/external/about.htm.
Miga.org (2015). Who we are. Retrieved 28 November 2015, from
https://www.miga.org/who-we-are.
M
Worldbank.org (2015). About. Retrieved 28 November 2015, from

http://www.worldbank.org/en/about.
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Ch
12 a p t e r
EFFICIENT MARKET AND MARKET ANOMALIES
CONTENTS
S
12.1 Introduction
12.2 Efficient Market
IM
12.2.1 Historical Evolution of EMH
12.2.2 Characteristics of Efficient Market
12.2.3 Degree of Efficiency
12.2.4 Tests for Market Efficiency
Activity
M
12.3 Market Anomalies

12.3.1 Earnings Announcement
12.3.2 Price/Earnings Ratio
12.3.3 Firm Size Effect
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12.3.4 January Effect

12.3.5 Monday Effect
Activity
12.4 Bubbles
Activity
12.5 St. Petersburg Paradox
Activity
12.6 Information Economics
Activity
12.7 Summary

n o t e s
CHINA TIGHTENS MARGIN LOANS TO CURB STOCK BUBBLE
(Source: ejinsight.com)
China is cracking down on leveraged bets in its stock market,

telling investors that it won’t tolerate bubbles. The country has
S
raised the margin requirement to 100 per cent from 50 per cent,
starting from November, 2015. This will discourage investors to
borrow for investing in stocks.
IM
The rule change means that the investors with 1 million Yuan
(US$156,895) in their account are limited to borrowing another 1
million Yuan from a broker to buy more shares.
Previously, they could borrow as much as 2 million Yuan. The

US-listed Chinese companies and exchange-traded funds, which
M
tracked mainland shares, slumped on the concern that the curbs

will hurt investor confidence in the world’s second largest stock
market.
However, Hermes Investment Management Ltd and Union Ban-

N
caire Privee say that limiting speculative activities will provide a

stronger foundation for the nation’s equities to extend a bull mar-
ket rebound, according to Bloomberg.
According to Gary Greenberg, who oversees USD 1.8 billion worth

of investment as the head of emerging market equities at Hermes
Investment Management in London, this is a very responsible
step on the part of the authorities to nip the growing bubble in
the bud.
“In very short term, it might have a negative effect, but in the long
term it will increase the robustness of the Chinese market.”
The Shanghai bourse said that the restrictions will help in pre-
venting systemic risks from building in China’s financial system.
Margin financing, which shrank by more than half during the

rout, rose for the past six weeks as the Shanghai Composite Index
rallied more than 20 per cent from its August low.

EFFICIENT MARKET AND MARKET ANOMALIES 227
n o t e s
Surging margin debt helped to amplify the record-breaking

boom—and subsequent bust—in Chinese stocks earlier this year.
This was owing to the fact that easy access to leverage gave the
country’s millions of individual investors an increased buying
power.
“The Chinese acted preemptively to stop the rally from being un-
controlled,” Koon Chow, senior macro and currency strategist at
Union Bancaire Privee in London, said in an e-mail on Friday.
“I think the move happened at a very good time—before specu-

lative and margin-fueled trading drove the equity market higher
again.”
Margin debt and volume rose “rapidly” in recent weeks as some
S
investors bought shares that were trading at high valuations. The
Shanghai exchange said this in a post on its Weibo account ex-
plaining the rule change. This move will help reduce leverage and
ensure “healthy development” of the market, it said.
IM
(Source: EJ Insight (2015). China tightens margin loans to curb stock bubble. Retrieved
28 November 2015, from http://www.ejinsight.com/20151116-china-tightens-margin-loans-
to-curb-stock-bubble/.)
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N

n o t e s
learning objectives

>> Discuss the concept of efficient market
>> Explain different types of market anomalies
>> Describe the causes of bubble in the market
>> Explain St. Petersburg paradox
>> Discuss the concept and applications of information eco-
nomics
12.1 INTRODUCTION
In the previous chapter, you have studied the various aspects of the
S
financial system and financial institutions. The chapter also discussed
issues concerning the regulatory authorities and the role of various
institutions responsible for ensuring the effectiveness and efficiency
in the functioning of the market.
IM
A stock market is called an efficient market, if it quickly reflects and
reacts to new information. Suppose you are reading the latest edition
of the Economic Times, which covers a news story that a particular
company is going to launch a new product that will have good market
potential. You may consider this to be a step that will increase the pric-
M
es of the shares of the company. You might decide to call a broker and
buy stocks of the company immediately before the prices go up. The
efficient market theory states that even if you buy the stock immedi-
ately after reading the article, you are still too late because many sav-
vy investors and traders, who got hold of the information much ahead
N
of you, bought the stock and drove the prices up. The one who buys
the stock first wins. Market changes with time and so do the prices of
stocks in the market. Thus, smart traders always keep an eye on the
changes in the market and recognise the difference between the mar-
ket value and the ideal value of the stock before other investors do.
With the emergence of these opportunities, a powerful motivation for
seizing such opportunities also arises with the same speed. For exam-
ple, when arbitrageurs start buying an underpriced asset, the value of
the asset rises in the market. As a result, the arbitrageur is not able to
make the amount of money he wants to.
An efficient market is the one that rapidly and completely possesses

all the information related to the prices of the assets. In such a market,
it is impossible to make money through underpriced or overpriced
assets. In addition, in these markets, the stock prices cannot be in-
creased on the basis of rumours that have not been verified by inves-
tors. The price of assets in such markets can only be moved by authen-
tic and valid information.

n o t e s
In an efficient market, stock prices should always reflect the available

information. However, in real life, markets do not always work in the
most efficient way because of various market anomalies. As a result,
‘bubbles’ are formed in the stock market.
In this chapter, you will study the concept of an efficient market and var-
ious market anomalies that cause market inefficiency. Further, you will
study how bubbles are formed in the market. Further ahead, the chap-
ter will discuss St. Petersburg Paradox and information economics.
12.2 EFFICIENT MARKET

According to Louis Bachelier, a French mathematician, an efficient
market is one where the market price is an unbiased estimate of the
true value of investment. Therefore, in simple words, an efficient mar-
ket refers to that market in which the existing stock prices always in-
S
corporate and reflect all the relevant information available in the mar-
ket. For example, in an efficient market, the stock price of a company,
say Reliance Industries, reflects all available information related to
IM
the stock. The theory that propagates that the market is efficient is
known as Efficient Market Hypothesis (EMH).
According to EMH, an investor cannot outperform or ‘beat the mar-

ket’ because all stocks are bought and sold at their fair or real value.
Therefore, in the efficient market, it is not possible to buy underval-
ued stocks or sell overvalued stocks.
M
12.2.1 HISTORICAL EVOLUTION OF EMH
EMH has created financial economics as a sub-field of economics. It is

N
a result of historical investigation of the causes of random movement

in stock prices, which dates back to 1863. Towards the end of the 19th
century, many economists observed the fact that fluctuations in the
stock prices were random. It was Regnault who first hypothesised,
empirically validated and theoretically interpreted the random com-
ponent of stock market fluctuations. In 1900, Louis Bachelier used
Regnault’s hypothesis and the empirical framework for developing
the mathematical model of Brownian motion. He applied the model to
price futures and options. Presently, it is recognised that Bachelier’s
doctoral dissertation is the first major work in mathematical finance.
However, financial economics was non-existent at that time because
the scientific field and the scientific community did not show much in-
terest in the work of Regnault and Bachelier. Their work was formally
recognised only in the 1960s. However, EMH in its present form was
formulated between 1959 and 1976 to provide an explanation for the
random character of stock price movement.
The origin of EMH can be traced back to the work of Regnault and
Bachelier in the 19th century. However, their work was isolated in

n o t e s
nature and was not a part of the mainstream scientific community

involved in financial research. Further, the foundation of EMH was
strengthened by the work of Cowles, Working and Kendall from 1933
to 1959. Next, the most revolutionary work on EMH was done between
1959 (Roberts) and 1976 (Fama’s reply to LeRoy; Franck Jovanovic,
Efficient markets theory).
The intellectual base of EMH was complete in the 1960s to suggest

that stock market reflects all available information and the market
price of stocks equals their intrinsic values. Another important sug-
gestion was that as the arrival of new information is random in the
market, the fluctuation of stock prices should also be random.
12.2.2 CHARACTERISTICS OF EFFICIENT MARKET
In order to understand the concept of efficient market, you need to
S
explore its characteristics with diligence. Some of the important char-
acteristics of the efficient market are as follows:
It is not necessary that the market price of an asset is always equal
IM
to its actual value. However, the changes in the asset price should
be valid and unbiased. In other words, any deviation of the market
price from the true value of an asset should be random.
In case the deviation in the price of an asset from its true value is
random, the price can be either undervalued or overvalued any-
M
time. These deviations have no correlation with any observable

variable. For example, the price of an asset having a low P/E ratio
is not undervalued than the price of an asset with a high P/E ratio.
It is not possible for investors to identify either undervalued or
N
overvalued assets to which the rest of the market is unfamiliar,

using any of the investment strategies.
12.2.3 DEGREE OF EFFICIENCY
EMH suggests that the market is efficient and the market price of
stocks reflects the intrinsic value of stocks. However, in real life, mar-
ket exhibits different degrees of efficiency discussed as follows:
Weak efficiency: In this form of market efficiency, the current
price of stocks reflects information of all past prices of the stock.
Therefore, in weak efficiency, investors will not be able to find un-
dervalued stocks by using past price charts or technical analysis
using past price data.
Semi-strong efficiency: Under this form of market efficiency, the
current stock prices assimilate and reflect not only all past prices
but all public information, such as financial statements and news-
paper reports. Therefore, neither fundamental analysis nor tech-
nical analysis can be used to identify undervalued stocks.

n o t e s
Strong efficiency: Under this form of efficiency, the current stock

prices reflect not only the public information but also private infor-
mation. Therefore, investors cannot identify undervalued stocks
by using any approach—not even by having an access to the insid-
er information.
12.2.4 TESTS FOR MARKET EFFICIENCY
Tests of market efficiency try to find out if specific investment strat-

egies earn excess returns and may also account for transaction costs
and execution feasibility. Some important points related to the testing
of market efficiency are given as follows:
In every case, a test of market efficiency is a joint test of market
efficiency and the efficacy of the model used for expected returns.
S
When there is an evidence of excess returns in a test of market ef-
ficiency, it indicates that markets are inefficient or that the model
used to compute expected returns is wrong, or both.
IM
There are a number of different ways of testing for market effi-
ciency, and the approach used depends on the investment scheme
being tested.
As an excess return on an investment is the difference between the

actual and expected returns on that investment, every test of mar-
ket efficiency has an implicit model for the expected return. In some
M
cases, the expected return takes into account the returns on similar
or equivalent investments, while in others it also adjusts for risk us-
ing the Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing
Model. However, as stated earlier, a test of market efficiency combines
N
the testing of market efficiency and the efficacy of the model used for
expected returns. If the conclusions of a study are insensitive with
respect to different model specifications, it is likely that the outcomes
are being controlled by true market inefficiencies and not just by the
model mis-specifications.
There are a number of ways to test market efficiency, as shown in

Figure 12.1:
Random Walk Test
Weak Form Tests
Semi-strong Form Tests
Strong Form Tests
Figure 12.1: Types of Market Efficiency Tests

n o t e s
Let us discuss these different forms of tests for market efficiency as

follows:
Random Walk Test (RWT): This is a financial theory, which states
that stock market prices evolve based on a random walk and hence
cannot be predicted. The concept was first given in 1863, in the
book of a French broker, Jules Regnault. Later, in 1990, Louis
Bachelier, in his thesis titled, The Theory of Speculation included
some remarkable insights and commentary on the theory.
According to the Random Walk Theory, stock price changes have
the same distribution and are independent of each other. There-
fore, the past movement or trend of a stock price or market has
nothing to do with its future movement. In short, the test states
that stocks take a random and unpredictable path. The theory be-
lieves that it is not possible to outperform the market without as-
S
suming additional risk. Critics of the theory; however, resist that
stocks do maintain price trends over time. In other words, as per
critics, it is possible to outperform the market by carefully select-
ing entry and exit points for equity investments.
IM
Weak form tests: The weak form of EMH implies that the market
is efficient and is reflecting all information about the market. It
assumes that the rates of return in the market are independent.
The rates of return in the past have no impact on the rates in
the future.
M
The weak form tests of EMH can be categorised as follows:

Statistical tests for independence: As the weak form tests as-
sume that the rates of return in the market are independent,
the tests used to examine the weak form of the efficient mar-
N
ket are the tests for market independence. The following tests
elaborate this in detail:
99 The auto-correlation tests: These tests check if the returns
are significantly correlated over time.
99 The runs tests: These tests check if the stock price changes
are independent over time.
99 Trading tests: These are based on the fact that the past
returns are not indicative of future rates. For example, the
filter rule, which tests that after the transaction cost, an in-
vestor cannot earn an above-average return.
Semi-strong form tests: This form implies that the market is re-
flective of all publicly available information. The semi-strong form
tests of EMH are of the following types:
Event tests: An event test analyses the security, both before
and after an event, such as earnings. The basic idea behind
the event test is that an investor will not be able to draw an
above-average return by trading through an event.

n o t e s
Regression/time series tests: Time series tests are used to fore-

cast returns based on historical data. As a result, an investor is
not able to achieve an above-average return using this method.
Strong form tests: The strong form of market implies that it is
efficient and is reflective of all information—public or private. The
tests for the strong form are dependent on a group of investors
who hold excess information. These investors are as follows:
Insiders: They have access to all inside information and there-
fore, Securities and Exchange Board of India (SEBI) forbids them
from using this information to achieve above-average returns.
Exchange specialists: They can recall runs on the orders for a
specific equity. They can earn above-average returns with this
specific order information.
Analysts: Equity analysts provide opinion and suggestions
S
that can help an investor to achieve above-average returns.
They can cause significant movements along the equities they
focus on.
IM
Institutional money managers: They work for mutual funds,
pensions and other types of institutional accounts. They sel-
dom perform above the overall market benchmark.

M
1. According to EMH, an investor cannot outperform or ‘beat

the market’ because all stocks are bought and sold at their fair
or real value. (True/False)
2. Under the ______ form of efficiency, the current price of a
N
stock reflects information about all past prices of the stock.

3. Under semi-strong efficiency, the current stock prices reflect
not only the public information but also private information.
(True/False)
4. Mention at least two tests for EMH.
Activity
Make a group of your friends and discuss the concept of an efficient

market.
12.3 MARKET ANOMALIES

An anomaly refers to the occurrence of an unusual event. In the lan-
guage of finance and investment, anomalies refer to the instances in
which a particular security or a portfolio shows opposite performance
with respect to the postulates of EMH. We have studied earlier in

n o t e s
the chapter that according to the EMH, the performance of securi-

ties should reflect the available information of the market. However,
anomalies take place when the market price of securities does not re-
flect the intrinsic value of the stocks. In an efficient market, anomalies
should not occur and these should not definitely persist. There is no
unanimous conclusion on why anomalies take place. There are many
opinions regarding the occurrence of anomalies.
An ‘efficient market’ is more of a theoretical concept. However, in

practice, it is hard to achieve an efficient market because of constant
release and dissemination of new information in the market. Many
market anomalies take place once and then they disappear. On the
other hand, there are anomalies that are observed continuously.
Therefore, investment professionals study these recurring anomalies
to find a pattern and exploit them while investing.
S
12.3.1 EARNINGS ANNOUNCEMENT
Companies periodically announce their earnings reports and other

IM
corporate reports that are important to the stakeholders. Earning an-
nouncements are made on certain dates. These announcements cause
various market anomalies, such as:
Stock split effect: In this, the number of outstanding shares is in-
creased and the values of outstanding shares are decreased. How-
ever, stock split does not have any effect on market capitalisation
M
of a company. However, it has been empirically seen that the stock

price of companies goes up after the announcement of a stock
split. This increase in the stock price after the announcement of
stock split is known as a stock split effect. Therefore, investors
N
take stock split as a signal that the share price of the company will
continue to go high.
Short-term price drift: After companies make an announcement,
the stock price also immediately reacts in the same direction. For
example, in case of the announcement of positive news, such as
higher earnings, there may be an immediate movement in stock
prices in the positive direction. However, in case of short-term
price drift, the stock price movement continues to take place quite
a long time after the announcement of the news. This is because
information does not always immediately reflect in the stock pric-
es of the companies.
Merger arbitrage: It has been seen that in the case of the an-
nouncement of mergers and acquisitions, the value of stocks of the
acquired company tends to go high while the value of the acquirer
goes down. This phenomenon is known as merger arbitrage.

n o t e s
12.3.2 PRICE/EARNINGS RATIO
Price/earnings ratio refers to the ratio of the price of a stock and its
earnings. It has been observed that portfolios consisting of low P/E
securities perform better than those consisting of high P/E securities.
This is because many investment professionals, on the basis of CAPM
and other portfolio models, have concluded that low P/E stocks pre-
sumably involve greater risks; therefore, they have more potential to
give better returns.
12.3.3 FIRM SIZE EFFECT
Empirical studies have shown that small-sized firms or firms with low
market capitalisation, outperform large companies. Therefore, this
theory is also known as ‘Small Firm Effect’. The theory that smaller
companies possess a higher growth potential than larger companies
S
gives rise to various market anomalies. The theory is rooted to the
facts that small companies tend to operate in a relatively volatile mar-
ket. Therefore, correction of problems causes share price to appreci-
IM
ate. In addition, the price of small cap stocks tends to be low. There-
fore, the price appreciations taking place in small cap stocks tend to
be higher than the same for the large cap stocks.
12.3.4 JANUARY EFFECT

M
Stock prices have a general tendency to go up in the month of January.

Generally, this appreciation in the stock prices happens because of an
increase in buying followed by a drop in stock prices in the month of
December. It has been observed that small caps are more affected by
the January effect than the mid or large caps. However, the January
N
effect has been less prominent in the recent years because markets
have adjusted for it to a great extent.
12.3.5 MONDAY EFFECT
This effect is also known as ‘Weekend Effect’. It has been seen that there
is a general tendency of the stock prices to go down on Mondays. In oth-
er words, investment experts have observed that returns in the market
on Mondays is mostly lower than those on other days of the week. An
example of average rate of return on weekdays is shown in Table 12.1:
Table 12.1: An Example Of Average Rate

Of Return On Weekdays
Years Monday Tuesday Wednesday Thursday Friday
1950–2004 –0.072% 0.032% 0.089% 0.041% 0.080%
(Source: Fundamentals of Investments, McGraw Hill, 2006)

n o t e s
5. Market anomalies are in accordance with the postulates of

EMH. (True/False)
6. Stock prices generally go down after the announcement of a
stock split. (True/False)
7. It has been seen that in the case of the announcement of
mergers and acquisitions, the value of stocks of the acquired
company tends to go high while the value of the acquirer goes
down. This phenomenon is known as:
a. Merger effect
b. Merger and acquisition effect
c. Merger windfall effect
S
d. Merger arbitrage
8. Generally, portfolios consisting of high P/E securities perform
IM
better than those consisting of low P/E securities. (True/False)
9. Owing to the ‘Monday Effect’ prices of stocks tend to go down
on Mondays. (True/False)
Activity
M
Make a group of your friends and discuss the concept of market

anomalies and their effects on investment decision making.
12.4 BUBBLES
N
In the context of stock markets, bubble refers to the phenomenon of

the exorbitant rise in the price of stocks of a company or sector or the
market as a whole, which is out of proportion to the intrinsic value of
the stock. Stock bubble, like bubbles in the water, grows up temporar-
ily and bursts in some time. Stock bubble bursts when stock prices go
on declining compounded by panic selling.
note
Panic selling refers to mass selling of a stock when investors want

to get rid of the stock regardless of the selling price. Panic selling
results in the stock market crash.
Stock market bubbles are formed when investors’ demand for a par-
ticular stock increases so much that the excessive demand causes the
price of the stock to skyrocket. In a bubble, the stock price is many
times over and above the intrinsic price of the stock.

n o t e s
One highly cited example of stock market bubble is the dotcom bub-
ble, which formed between 1995 and 2000. In the dotcom bubble, the
stock prices of Internet-based companies rose rapidly and caused the
technology-dominated NASDAQ index to rise from below 1000 in 1995
to 5000 in 2000. The factors that gave rise to this bubble include specu-
lative investment and abundance of venture funding. Eventually, the
bubble burst in between March 2000 and October 2002 and the NAS-
DAQ composite index lost 78% of its value from 5046.86 to 1114.11.
Therefore, bubbles do not provide any substantial return to the inves-

tors in the long run.
10. In stock bubble, the price of a stock goes down, which is out of
proportion to its intrinsic value. (True/False)
S
Activity
IM
With the help of the Internet, conduct research on at least two in-
stances in which stock market bubbles took place and the market
eventually crashed. Make a note of your findings.
12.5 ST. PETERSBURG PARADOX

M
St. Petersburg paradox is a paradox related to decision making un-

der uncertainty. The paradox is based on a gamble that has potential
infinite payoff; however, the return seems to be worth a very small
amount to the participants. The paradox presents a situation in which
a real investor hardly takes a course of action that is suggested based
N
only on the expected value. Let us understand the paradox with an

example. Suppose someone asks you about the amount that you will
be willing to pay to participate in the following gamble:
A fair coin would be tossed continuously until it turns up tails. If the

coin comes up tails on the nth toss, you would receive $2n, i.e., if it
comes up tails on the 6th toss, you would receive $26 = $64.
How much will your answer be?
Before investing money, you would like to know the expected payoff
of the gamble. So, let us calculate the payoff of this gamble as follows:
The probability of a coin turning up tails in the nth toss (which equals
the probability of the coin turning up heads in the nth toss) is (1/2)n.
Therefore, the expected value of the gamble would be = (1/2) × 2 +
(1/4) × 4 + (1/8) × 8 + (1/16) × 16 + ... ∞
= 1 + 1 + 1 + 1 + ... ∞

n o t e s
Therefore, the expected payoff of this gamble is infinity, which is a lot

more than an investor would like to pay to participate in the gamble.
In fact, an average investor would not be willing to pay even $2 to par-
ticipate in the gamble that has infinite expected payoff. This puzzle
deeply troubled Nicholas Bernoulli, a Swiss mathematician, who lived
in the Russian city of Petersburg. The name of the paradox comes
from this city. In 1738, Nicholas Bernoulli approached his cousin and a
famous mathematician Daniel Bernoulli to solve this paradox. Daniel
Bernoulli introduced the concept of ‘utility’ to solve the paradox. Dan-
iel Bernoulli suggested that the marginal utility of money to a person
depends on how much money he already has. According to Daniel
Bernoulli, the determination of the value of an item must not be based
on the price, but on the utility it yields. There is no doubt that a gain
of one thousand ducats is more significant to a pauper than to a rich
man; though, both gain the same amount.
S
Therefore, according to the suggestion of Daniel Bernoulli, each dol-
lar of additional return is worth less to an investor than the previous
dollar. This is how the notion of diminishing marginal utility, a very
important decision-making criterion in economics was born.
IM
11. The solution to the St. Petersburg paradox gives rise to the
concept of utility. (True/False)
12. The paradox is based on a gamble that has potential infinite
M
payoff; however, the return seems to be worth a very small

amount to the participants. (True/False)
N
Activity
With the help of the Internet, explore some real-life scenarios that
relate to the St. Petersburg paradox.
12.6 INFORMATION ECONOMICS

Availability of information plays a crucial role in decision making. If
information is partially available or becomes available at a time when
it has lost its value, then the loss suffered by the lack of information
would be tremendous. This role of information on real-life decision
making gives rise to the discipline of Information Economics. In sim-
ple terms, information economics or the economics of information is
a component of microeconomic theory that studies how information
and information systems affect economies and economic decisions.
The starting point of information economics as a subject of scientific

enquiry is the recognition of the fact that information has an economic
value. The economic value of information arises from the fact that in-
formation allows individuals to make decisions that yield a higher ex-
pected payoff than the amount derived in the absence of information.

n o t e s
Information economics has significant application in the stock mar-

ket where the availability of information can help investors in making
sound investment decisions. For example, information regarding the
fundamentals of business of a company or its latest earnings reports
help investors in timing their purchase or sale of stocks. In addition, in
the stock market, information asymmetry creates market anomalies,
in which one party has more amount of information or more inaccu-
rate information than another party.

13. Information economics pertains to the application of
information in economic decision making. (True/False)
14. Information economics is based on the fact that the availability
of information has an economic value. (True/False)
S
Activity
IM
With the help of the Internet, conduct research on various applica-
tions of information economics. Prepare a report on your findings.
12.7 SUMMARY
An efficient market refers to that market where existing stock
M
prices always incorporate and reflect all the relevant information

available in the market.
According to EMH, an investor cannot outperform or ‘beat the mar-
ket’ because all stocks are bought and sold at their fair or real value.
N
EMH has created financial economics as a sub-field of econom-

ics. It is a result of historical investigation of the causes of random
movement in stock prices, which dates back to 1863.
The origin of EMH can be traced back to the work of Regnault and
Bachelier in the 19th century.
The intellectual base of EMH was complete in the 1960s. It sug-
gests that the stock market reflects all available information and
the market price of stocks equals their intrinsic values.
In an efficient market, it is not necessary that the market price of
an asset is always equal to its actual value. However, the changes
in the asset price should be valid and unbiased. In other words, the
deviation of market price from the true value of an asset should be
random.
EMH suggests that market efficiency and market price of stocks
reflect the intrinsic values of stocks.
Inreal life, market exhibits different degrees of efficiency, such as
weak efficiency, semi-strong efficiency and strong efficiency.

n o t e s
Tests of market efficiency try to find out if specific investment

strategies earn excess returns and may also account for transac-
tion costs and execution feasibility. Important tests for market effi-
ciencies include Random Walk Test (RWT), weak form tests, semi-
strong form tests and strong form tests.
In the language of finance and investment, anomalies refer to the
instances in which a particular security or a portfolio shows oppo-
site performance to the postulates of EMH.
Some of the generally observed anomalies in the stock market in-
clude stock split effect, short-term price drift, merger arbitrage,
the firm size effect, January effect and Monday effect.
In the context of stock markets, bubble refers to the phenomenon
of the exorbitant rise in the price of stocks of a company or sector
S
or the market as a whole, which is out of proportion to the intrinsic
value of the stock.
St. Petersburg paradox is a paradox related to decision making un-
IM
der uncertainty. The paradox is based on a gamble that has poten-
tial infinite payoff; however, the return seems to be worth a very
small amount to the participants.
Availability of information plays a crucial role in decision making.
The tremendous role of information on real-life decision making
gives rise to the discipline of Information Economics.
M
In simple terms, information economics or the economics of in-

formation is a component of microeconomic theory that studies
how information and information systems affect economies and
economic decisions.
N
key words
Arbitrage Pricing Model (APM): An asset pricing model that

has been developed on the basis of the assumption that the re-
turns on an asset can be predicted using the relationship of the
asset with other risk factors.
Arbitrageurs: An investor who tries to make profits out of price
differences of assets in different markets arising out of market
inefficiencies.
Bull market: The market in which share prices are rising.
Capital Asset Pricing Model (CAPM): A model describing the
relation between risks and expected rerun of securities.
Paradox: A situation or statement that seems to be improbable,
but found to be valid when investigated.
Venture funding: A type of funding extended to the emerging
growth companies.

n o t e s

1. Explain the concept of an efficient market. What are the different
degrees of efficiency observed in the market?
2. Describe the characteristics of an efficient market.
3. Explain some of the tests for market efficiency.
4. What do you mean by ‘market anomalies’? Explain some of the
market anomalies observed in the stock market.
5. Explain the concept of the St. Petersburg paradox.
6. What is information economics? Why is it important?
S
ANSWERS FOR SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

IM
Efficient Market 1. True
2. Weak
3. False
4. Random Walk Test (RWT) and
strong-form tests
M
Market Anomalies 5. False

6. False
7. d. Merger arbitrage
8. False
N
9. False
Bubbles 10. False
St. Petersburg Paradox 11. True
12. True
Information Economics 13. True
14. True

1. An efficient market refers to that market in which the
existing stock prices always incorporate and reflect all the
relevant information available in the market. Refer to Section
12.2 Efficient Market.
2. In an efficient market, it is not necessary that the market price
of an asset is always equal to its actual value. However, changes
in the asset price should be valid and unbiased. Refer to Section
12.2 Efficient Market.

n o t e s
3. Some of the tests for market efficiency are Random Walk Test
(RWT), weak form tests, semi-strong tests and strong form tests.
Refer to Section 12.2 Efficient Market.
4. In the language of finance and investment, anomalies refer to
the instances in which a particular security or a portfolio shows
opposite performance to the postulates of EMH. Refer to Section
12.3 Market Anomalies.
5. St. Petersburg paradox is a paradox related to decision making
under uncertainty. The paradox is based on a gamble that
has potential infinite payoff; however, the return seems to be
worth a very small amount to the participants. Refer to Section
12.5 St. Petersburg Paradox.
6. Availability of information plays a crucial role in decision making.
The tremendous role of information on real-life decision making
S
gives rise to the discipline of Information Economics. Refer to
Section 12.6 Information Economics.
IM
12.10
REFERENCE
SUGGESTED READINGS
Bianconi M. (2003). Financial economics, risk and information.
M
Singapore: World Scientific.

Bodie Z., Merton R., Cleeton D., Bodie Z. (2009). Financial eco-
nomics. Upper Saddle River, NJ: Pearson/Prentice Hall.
Keane S. (1980). The efficient market hypothesis. Published for the
N
Institute of Chartered Accountants of Scotland. UK, London: Gee

& Co.
E-REFERENCES
Econport.org (2015). EconPort—Handbook—Decision-making
under uncertainty—St. Petersburg Paradox Experiments. Re-
trieved 1 December 2015, from http://www.econport.org/econport/
request?page=man_ru_experiments_stpetersburg.
Investorhome.com (2015). Investor home—The efficient market
hypothesis. Retrieved 1 December 2015, from http://www.investo-
rhome.com/emh.htm.
Forbes.com (2015). Forbes welcome. Retrieved 1 December 2015,
from http://www.forbes.com/sites/investopedia/2011/01/12/efficient
-market-hypothesis-is-the-stock-market-efficient/.

Ch
13 a p t e r
Risk Management in Financial Institutions
CONTENTS
S
13.1 Introduction
13.2 Risks in Financial Market
IM
13.2.1 Systematic and Unsystematic Risks
13.2.2 Concept of Hedging
Activity
13.3 Hedging Techniques—Derivatives
13.3.1 Forwards
M
13.3.2 Futures
13.3.3 Options
13.3.4 Swaps
N
Activity
13.4 Basel Norms
Activity
13.5 Summary

n o t e s
RBI asks banks to encourage hedging of

agri products
The RBI has initiated the programme of promoting commodity

derivatives market with involvement of banks. As a first major
move the RBI asked the banks to encourage borrowers of agricul-
tural products to move towards commodity derivative exchanges
for hedging their risk. The large agricultural products’ borrowers
include commodity processors, traders, millers, aggregations etc.
In India, National Commodity & Derivatives Exchange (NCDEX)

is the largest exchange whereby the trading in agri commodity
derivatives and forward trading takes place. Currently few banks
are having the association with NCDEX or its subsidiary so that
they can trade in spot markets for lending against stocks deposit-
S
ed in recognised warehouses. This move allowed banks to direct-
ly encourage hedging by their borrowers so that the risk can be
managed in an effective manner.
IM
For keeping the cost in check the borrowers who have taken loans
for processing are allowed to buy the raw material from futures
exchange.
According to RBI circular, generally, this risk is more pronounced

in cases where agri borrowers do not hedge the underlying com-
M
modity price risk. Hedging of this risk is beneficial to both borrow-

ers and banks and, hence, it is desirable that a risk management
culture is fostered among the stakeholders, including agri-bor-
rowers and banks.
N
A government official said, “RBI has ultimately recognised the im-

portance of hedging commodity price risk and shown confidence in
the commodity derivative system.
However, experts also say that in many agri commodity deriva-

tives traded on an exchange platform, the liquidity is not enough
to accommodate large numbers. In reply, a sector official said,
“With banks encouraging their borrowers to hedge the risk of com-
modity prices, a different kind of players will come on the exchang-
es, automatically imparting depth to the market.”
The Forward Markets Commission (FMC) has already liberalised

the margin structure for hedgers on comexes.
RBI has asked banks to educate borrowers about hedging the

price risk of agri commodities, though, it added, banks must keep
the sophistication, understanding of, scale of operation and re-
quirements of their agriborrower in mind while advising on the
availability and use of these instruments.
(Source: Adapted from: http://www.business-standard.com/article/finance/rbi-asks-
banks-to-encourage-hedging-of-agri-products-115052801307_1.html)

Risk Management in Financial Institutions 245
n o t e s
learning objectives

>> Discuss the concept of risk
>> Explain the concept of hedging techniques
>> Discuss the Basel norms
13.1 INTRODUCTION
In the last chapter we have studied the concept of efficient market and
market anomalies. Let us move ahead with one of the most prominent
topic related to financial system that is risk management.
A large number of financial transactions take place in the financial
S
system and each transaction is associated with expected amount of
return. It is important to note that the return depends on the various
factors that may add the component of uncertainty with the expect-
IM
ed risk and this uncertainty is called the risk. Therefore, to manage
the risk present in the financial system for all the players of financial
system that includes government, financial institutions and individual
investors is of prime importance.
Risk management can be defined as a process that aims to minimise

the impact of risk by forecasting and evaluating the risk present in
M
the existing procedures. Thus, risk management is an important as-

pect and it must be managed in an efficient and effective manner. In
other words, the financial institutions must develop a system in which
the risks are defined, identified, documented and their probability of
N
occurrence must be determined accordingly. Further, the damages

which are likely to arise due to the occurrence of the risk must be as-
sessed and mitigation plans must be developed to minimise the risks
involved.
This chapter covers the concept of various kinds of risk in the finan-
cial system and it also explains risk management with the help of
hedging. In addition, it also explores various hedging techniques and
Basel norms.
13.2 RISKS IN FINANCIAL MARKET

The financial market is a place where all the financial transaction
takes place between the buyers and lenders. All these financial trans-
actions are done by investors to earn economic returns. It is important
to note that each transaction that results into the expected return is
also associated with the expected risk.
Risk and return are two sides of a coin that could not be segregated.
Risk can be defined as the probability of happening or not happening

n o t e s
of an event. Apart from the government securities, each type of secu-

rity is followed by the uncertainty of expected returns that resulted
into the risk.
Every one dealing in the financial market is bound to be exposed to

the various kinds of risks in financial market. The financial institu-
tions that facilitate the movement of money across economy have high
financial risk based on the amount they are dealing in as compared to
the small investor.
To deal with these risks in a better way the participants of the finan-
cial market are required to manage their risk. Risk management can
be defined as the process of mitigating risk through forecast and eval-
uation of financial risks at the right time.
There is long list of the financial risk that includes credit risk, interest
S
risk, liquidity risk and operational risk. All these risk comes under two
major categories of risk. These two main categories are systematic and
unsystematic risks. Let us discuss both of them in the next section.
IM
13.2.1 SYSTEMATIC AND UNSYSTEMATIC RISKS
As already discussed, all the financial risks are broadly categorised

into two main categories. This includes systematic and unsystematic
risks:
M
Systematic risk
It can be defined as an inherent risk to the entire market that cannot

be mitigated or eliminated. It is also known as non-diversifiable risk,
N
volatility or market risk that not only affects any specific organisation
or industry but it also affects the overall market. It is important to note
that this type of risk is difficult to predict and impossible to avoid. In
other words if this risk hits the economy, then it would be affecting the
entire economy. This risk is macro in nature and cannot be controlled
by an organisation even through risk management.
The following risks come under the systematic risk:

Interest rate risk: Variability in the interest rate resulted into the
interest rate risk.
Market risk: There are many instruments that are characterised
by the continuous fluctuations in their trading prices. It is known
as market price. The equity is the appropriate example of these
kind of instruments characterised by the market risk.
Purchasing power/inflationary risk: When price level in an econ-
omy increases and makes the product and service comparatively
costlier than before.

n o t e s
Non-diversifiable risks are measured in terms of the beta coefficient.

The level of volatility is measured with the help of Beta. Beta denotes
the volatility of the given stock as compared to the market as a whole.
In simple words beta is the sensitivity of returns pertaining to a secu-
rity in response to swings in the market.
A security having beta 1 refers that the price of security moves
with the market.
A security having beta less than 1 indicates that the security is less
volatile than the market.
A security having beta greater than 1 shows that the price of secu-
rity is more volatile than the market.
Unsystematic risks
S
These risks are also known as residual risk. This risk is associated
with particular company and industry that does not affect the entire
economy. The reduction of this risk can take place with the process of
IM
diversification. An investor can reduce or eliminate the unsystematic
risk by investing in different companies and industries. For example,
entry of a new competitor, change in management and any change in
the regulatory framework specific to an industry or a company. Fol-
lowing risks fall under the category of unsystematic risk:
Business or liquidity risk: If a firm does not have the sufficient
M
funds to meet the ongoing business transaction, then it is called

the liquidity risk.
Financial or credit risk: The change in capital structure of the
firm leads to the financial risk.
N
Operational risk: It occurs due to the technical failure or human

error in the functional framework of a firm.
13.2.2 CONCEPT OF HEDGING
In the previous section we have discussed the concept of systematic

and unsystematic risks. In this section we will study about hedging, a
technique of risk management that helps in reduction of the risk level.
Hedging can be defined as an investment that is done by investor so

that he/she reduces the risk of adverse price movement in an asset.
There are various tools that are used by an investor to hedge the risk.
These tools are called derivatives. They mainly perform three func-
tions that include hedging speculation and price discovery but the
prime function performed by them is hedging.
Hedging generally refers to managing, mitigating, reducing or offset-

ting a risk by taking an exposure on the opposite side of the concerned
transaction. For example, consider an exporter with an exposure to
foreign currency (i.e., he/she has export receivables in a foreign cur-

n o t e s
rency) and he/she is expecting to receive the proceeds after three

months. He/she is not sure about the exchange rate that will be appli-
cable after three months when he/she will be converting the foreign
currency into home currency. Thus, he/she faces the exchange rate
risk. Suppose the current exchange rate is INR 65/USD. Let this also
be the rate he/she used to convert his/her INR invoice amount into
USD amount. If the exchange rate becomes INR 60/USD after three
months, he/she will lose three rupees for every dollar worth of goods
exported. There is an uncertainty with regard to the total amount of
INR proceeds he/she can realise after three months. In this case, his
exposure is the expected receipt of the foreign currency for the men-
tioned time period of three months. His/her loss due to the exposure
depends on the exchange rate after three months. If he/she wants to
eliminate the exchange rate risk, he/she can resort to a hedging trans-
action, i.e., take an exposure on the opposite side. Since his current
exposure is of receipt of USD after three months, he can take an expo-
S
sure on the opposite side by a contract to sell USD after three months.
Suppose that he/she could find some other importer who expects to
pay an equivalent amount of USD to his/her exporter. He/she faces
IM
the risk that the exchange rate could become, say, INR 67/USD, which
means his cost would increase by two rupees for every dollar worth of
goods imported. He/she faces an uncertainty that the exchange rate
could turn adverse similar to the case of exporter. Suppose that the ex-
porter can enter into an agreement with the importer to sell USD after
three months for INR 65/USD irrespective of future spot exchange
M
rates. This means the exporter takes an opposite exposure of com-

mitment to sell USD after three months, while the importer would
face the opposite exposure of receipt of USD after three months. By
this contract, both of them can eliminate the exchange rate risk. The
transaction or contract by which they take the opposite position in the
N
future spot market for eliminating the risks involved in their current
exposure is termed a hedging transaction.
1. It is important to note that each transaction that results into

the expected return is also associated with the expected
_______.
2. Risk can be defined as probability of happening or not
happening of an event. (True/False)
3. Apart from the ______ securities, each type of security is
followed by the uncertainty of expected returns that resulted
into the risk.
a. Government b. Public
c. Private d. Hybrid
4. ______ can be defined as the process of mitigating risk through
forecast and evaluation of financial risks at the right time.

n o t e s
5. ________ can be defined as an inherent risk to the entire

market that cannot be mitigated or eliminated.
6. The equity is characterised by the market risk. (True/False)
7. Non-diversifiable risks are measured in terms of the ____
coefficient.
a. alpha b. gamma
c. theta d. beta
8. ________ risk is associated with particular company and
industry that does not affect the entire economy.
Activity
With the help of the Internet, find out the information on the IT in-
S
dustry of India and find out which of the unsystematic risk hit this
industry largely.
IM
13.3 HEDGING TECHNIQUES—DERIVATIVES
The derivative products can be used for hedging risks and for specula-
tion of price movements of the underlying asset. They also play signifi-
cant role in price discovery. As already discussed, derivatives play main-
ly three roles that include hedging, speculation and price discovery. Out
M
of them, hedging is already discussed in detail in the previous section.

The following are the remaining roles played by the derivatives:
Speculation: Derivatives markets are also a great place for spec-
ulation. In the above example, we assumed that there would be
N
another importer who would have an exactly opposite exposure.

This ensures that banks can offset exposures by performing the
function of an intermediary. However, it is possible that there is no
counterparty having an opposite exposure. In financial markets, it
is still possible to hedge transactions.
Financial markets have participants with differing risk capabili-
ties and risk averseness. Some investors would like to completely
eliminate all risks, while some may be interested in taking on addi-
tional risks if higher returns are possible. Let us say that the future
spot rate expected by market participants after three months is
INR 68/USD. This means if an investor purchases USD now at INR
65/USD and sells it after three months, he will gain three rupees
per USD (ignoring the interest he will receive on USD). However,
there is a risk that the exchange rate may turn adverse to INR 60/
USD. However, if an investor is interested in taking risks as he is
confident about the exchange rate to be above INR 68/USD, he
might decide to purchase. Thus, he is trying to make profits by
speculating on the movement of exchange rates. Such an inves-
tor might be interested in entering into a forward contract with

n o t e s
the exporter above to purchase, say, at INR 65/USD after three

months. After three months, he will purchase USD at the stated
rate of INR 65/USD and sell it in a spot market. If the future spot
exchange rate turns out to be, say, INR 68/USD, he will sell USD
and make a profit of three rupees per USD. This transaction of en-
tering into a contract to buy or sell the underlying asset at a future
date on a price fixed now, without having any current exposure to
the underlying asset, is termed a speculative transaction.
Note the difference between hedging and speculation. In the case
of hedging, the exporter already had a risk exposure that he want-
ed to eliminate or reduce. In the case of speculation, there is no
underlying asset involved. Thus, hedging is for the purpose of mit-
igating risks, while speculation is meant for making profit by un-
dertaking risks.
S
Price discovery: Derivatives markets are supposed to help in
the price discovery process of financial markets. Price discovery
means a process by which underlying assets are priced according
to their actual intrinsic value. Through hedging, speculating and
IM
arbitrage transactions, market participants are involved in pre-
dicting the future spot prices of underlying assets. In the above ex-
ample, the speculator expects the exchange rate to be above INR
65/USD. However, another speculator may expect the exchange
rate to be at INR 70/USD based on his/her own fundamental anal-
ysis and exchange rate forecasting on which he/she is willing to
M
take risk. Similarly, different market participants can have differ-

ent expectations about the movement of exchange rates. Suppose
many people expect the exchange rate to be at INR 69/USD, then
the future exchange rate at which the exporter can sell his/her ex-
N
port proceeds increases. Thus, possible higher profit out of spec-

ulation due to higher demand for USD in a three-month maturity
will affect both the three-month forward rate and the spot rate of
USD against INR.
note
Forward rates are determined by the covered interest rate parity

theorem that is based on the currently prevailing interest rates in
any of the two countries. However, as we discussed in the previous
chapter, it is not necessary that the future expected spot rate will
be the same as the current forward rate. The actual spot rate after
three months will be determined by several other factors prevailing
after that period. Speculation involves predicting these factors and,
hence, the future expected spot rate.
13.3.1 FORWARDS
A forward can be defined as a customised contract that takes place be-

tween two parties pertaining to buying and selling an asset at a spec-

n o t e s
ified price on a future date. It is used for hedging or speculation. The

non-standardised nature of forwards makes them particularly apt for
hedging.
Transaction exposures pertain to specific and quantifiable foreign

exchange exposures and hence can be easily hedged using financial
derivatives. The simplest case of transaction exposures are the expo-
sures arising out of exports and imports where the receivables and
payables, respectively, might lead to transaction exposures if the in-
voice currency is not in home currency. In both these cases, there is
an uncertainty with regard to the exchange rate being applicable at a
future date when the foreign exchange is purchased or sold.
One simple and straightforward way to remove this uncertainty is to

undertake the future transaction now itself. For example, if an import-
er has an exposure to pay $1 mn after three months, his/her problem
S
will be the exchange rate that will be available for purchasing the dol-
lar after three months. He/she can remove this uncertainty by pur-
chasing USD now itself. He/she can then invest it in money markets at
IM
applicable US money market interest rates. His/her borrowal amount
should be such that the maturity amount of the investment matches
the USD payables occurring after three months. He/she might need
to borrow in rupee in order to make the USD purchase in spot mar-
kets. However, the interest he/she needs to pay for rupee loan would
be compensated by the interest he/she gets in the USD investment,
which reduces the amount that needs to be borrowed. Alternatively,
M
he/she can borrow the exact USD amount of payables and convert the
USD interest into rupee after three months to pay for the rupee loan
at the future spot rate. If the uncovered interest parity theorem holds
good, the interest he/she needs to pay for the rupee loan will be the
N
same as the amount received by converting the interest received from

USD investment.
A similar process can also be adopted for the exporter expecting mon-
ey from the receivables. Suppose that a corporate expects to receive
USD receivables after three months. His/her problem will be the un-
certainty regarding the exchange rate at which he/she will be able to
convert the USD receivables after three months. To remove this un-
certainty, he/she can borrow in USD for an amount whose maturity
value is exactly equal to the dollar receivables such that when the re-
ceivables are realised, they can be used to pay off the USD loan along
with the interest payable. The dollar amount borrowed can be sold
in spot markets, and the resulting rupee proceeds can be invested in
money markets. If the uncovered interest parity theorem holds good,
the maturity amount received from his/her rupee investment will be
exactly equal to the amount that would have been received if the USD
receivables had been converted into the future spot exchange rate.
You must have understood by now that the above process of resorting
to the two money markets of the two currencies is cumbersome and

n o t e s
not required if there exists an active forward market for the maturity
and currency pair. If the forward market exists, the importer would
simply enter into a forward purchase contract for USD at the forward
rate. Similarly, the exporter would enter into a forward sale contract
for USD on a three-month maturity. The resultant effect on their real-
isation of rupee proceeds/payables will be the same as that achieved
through the money market hedge discussed above, if the covered in-
terest parity theorem holds good.
13.3.2 FUTURES
The forward contracts discussed above are tailor-made contracts that

are entered into by corporate clients with their bankers. These are not
derivative instruments that can be sold in secondary markets. Sup-
pose an exporter entered into a forward purchase contract with the
S
maturity date being after 3 months. If his/her underlying exposure
was not applicable any more (i.e., the export transaction was cancelled
or he/she was unlikely to receive the foreign currency amount after 3
months), in the case of forward contracts, he/she would have to ask his
IM
banker to cancel the forward contract. The forward contract would be
cancelled, and the required adjustments would be done based on the
prevailing exchange rates on the date of cancellation. Another way to
cancel a forward purchase is to square off the forward position with
counter-exposure. For example, the exporter can square off the for-
ward purchase with a forward sale contract with the same amount
M
and maturity date. This is theoretically same as selling the forward

purchase contract already entered into. Such things are not possible
in forward markets as forward contracts are not really instruments
that can be traded and also because these contracts are tailor made
N
to meet the individual requirements that makes squaring off with the
opposite transaction difficult.
If the contracts can be standardised in terms of all applicable parame-

ters like contract amount, maturity period, future price, etc., it will be
easy to trade these contracts with other counterparties. Derivative ex-
changes serve this need of standardising derivative contracts so that
they can be traded easily in derivatives exchanges. This also allows
buying or selling derivative contracts for speculative purposes as dis-
cussed in the previous section. The standardised forward contracts
are the currency futures in derivatives exchanges. Table 13.1 differen-
tiates between forwards and futures:
TABLE 13.1: DIFFERENCE BETWEEN FORWARDS

AND FUTURES
Characteristics Forward Contracts Currency Futures
Contract type Can be tailor-made to Standardised contracts;
suit corporate needs may not match exactly with
corporate exposure

n o t e s
Characteristics Forward Contracts Currency Futures

Trading No secondary market Can be traded in derivatives
trading exchange
Counterparty Banks are counter Derivatives exchange is the
parties to forward con- counterparty; actual coun-
tracts terparty is anonymous.
Settlement Daily settlement by Settlement on maturity
Mark to Market (MTM)
mechanism
Expiration date Standard contracts Standardised delivery dates
available, but it is
possible to meet the
specified date require-
ment.
Delivery Delivery of underlying No delivery of underlying
S
is common asset; only cash settlement
Trading costs Bid-ask spread plus Bid-ask spread and broker-
commissions charged age for trading in exchange
IM
by the bank
The very nature of standardisation and exchange trading leads to sev-

eral other differences between how hedging can be done with forward
contracts and futures contracts. In order to understand the same, let
us further study the characteristics of currency futures.
M
A currency futures contract (also termed FX futures) is a contract to

exchange one currency for another at a specified future date at an
exchange rate (price) that is fixed on the trade date. A futures con-
tract is applicable between the market participant and the exchange,
with exchange acting as the intermediary to both the counterparties
N
so that the trades are anonymous. Thus, when you purchase a futures
contract from the exchange, there will be another market participant
that will be selling the same futures contract through the exchange.
The buying or selling of a futures contract is done through brokers
who are members of the derivatives exchange. The settlement of the
contract is done through a clearing house attached to the derivatives
exchange. The broker may also act as the clearing member or may
clear through another broker who is a member of the clearing house.
13.3.3 OPTIONS
When hedging with currency future, we see that there could be a no-
tional loss or profit depending upon the actual exchange rate move-
ments. If an exporter sells currency future to hedge his/her receivables,
and on the maturity date, if the home currency depreciates against the
foreign currency more than that accounted for in the futures price
contracted, the exporter cannot exploit the currency depreciation be-
cause his/her effective exchange rate will be the same as the rate at

n o t e s
which he/she has contracted the currency futures irrespective of the

spot exchange rate on the contract’s expiry date.
For example, if the current exchange rate is INR 65/USD and the ex-
porter has receivables in six months, he/she will sell currency future
because he/she faces uncertainty with regard to the exchange rate
on the expiry date. Suppose that he/she expects the future spot ex-
change rate to be INR 68/USD and the futures price for six months
is also around that range. If he/she decides not to leave the position
uncovered (because it is also possible that the rupee might appreciate
and the future spot rate could be INR 60/USD, which he/she would
like to avoid), he/she will hedge the uncertainty by selling currency
future at INR 68/USD. However, if on the contract’s expiry date, the
spot exchange rate turns out to be INR 72/USD, he/she loses INR 4/
USD because he/she has an obligation to sell currency futures at INR
68/USD. If he/she had left the position uncovered, he/she would have
S
been able to sell his/her export proceeds at INR 72/USD. Hence, there
is a notional loss of INR 4/USD.
IM
Ideally, the exporter would like to keep an option of exercising the
currency future on the expiry date or ignore the futures contract and
buy the foreign currency in the spot market so that he/she can exploit
any favourable currency movement. In other words, hedging should
be applicable only if the currency turns unfavourable. If the exchange
rate turns favourable, he/she should be able to transact in the spot
market and should have no obligation to exercise the futures contract.
M
In the above example, the exporter would be interested in not set-

tling his/her futures contract and would allow it to expire without any
transaction and sell export proceeds in the spot market at INR 72/
USD. However, this is not possible because currency future is a con-
N
tract to purchase or sell currency at a future date, and every buy/sell

transaction will have a counterparty that would like to close its posi-
tion on the expiry date.
It is possible, however, to purchase ‘right but not obligation’ to buy

currency in a spot market or currency future in a futures market of
the derivatives exchange. A derivative instrument that gives market
participants the right to purchase or sell a currency (or currency fu-
tures) but does not involve an obligation to do the same is called op-
tions. If the underlying asset is a currency, it is known as a currency
option, and if the underlying is currency futures, it is a currency fu-
tures option.
Options exist in both Over-the-Counter (OTC) markets and derivatives

exchanges. OTC options are generally created tailor-made by banks to
meet specific corporate needs. It is important to note that the market
for OTC derivatives is bigger than that for exchange-traded options.
An option can be defined as a contract that gives the owner the right,
but not the obligation, to buy or sell a given quantity of an asset at a

n o t e s
specified price at some future date. It is a derivative instrument, and

the underlying asset could be equity, commodities, currencies, etc. An
option to buy an underlying asset is known as call option, and the
option to sell an underlying asset is called put option. The option pur-
chaser is called the option buyer, and the option seller is called the
option writer. The price at which the option allows the buyer to buy
the asset is called exercise price or strike price. The price of the option
is called option premium.
It is not necessary that the right can be exercised only on the expira-
tion date of an option contract. There are options that allow exercising
before the maturity date. The options that can be exercised only on
the expiry date of the contract are called European options, and the
options that can be exercised any time before the contract’s expiry
date are known as American options. However, it is not necessary that
an option can be settled only by exercising it (i.e., buying or selling
S
the underlying asset). Like futures, it is possible to sell/buy options in
derivatives exchange and thus an option can be settled by a reverse
transaction or squaring off transaction. Similarly, margins are appli-
IM
cable for options as well.
Options are traded at an option price or option premium. It is the pre-

mium that the option writer gets for giving the right to buy or sell the
underlying asset. There are financial models that can value options
based on volatility of prices of the underlying asset.
M
The first exchange-traded currency options came into existence in

December 1982 at Philadelphia Stock Exchange (PHLX) in the United
States. Currently, it is one of the largest option exchanges in the world
trading in seven major currencies. Currency future options are traded
N
at Chicago Mercantile Exchange (CME). The underlying asset is the

currency future contract.
In India, currency future began to be traded in NSE in August 2008

and currency options in USD in October 2010.
13.3.4 SWAPS
The next major derivative products, after futures and options, are
swaps. A swap is a different kind of derivative instrument compared
to both a future and an option in terms of its structure and utility. In
case of swap futures and options can only be used for hedging a single
transaction exposure, swaps deal with several cash flows over a period
of time. The structure of swaps differs accordingly. The underlying as-
set in a swap can be interest-bearing instruments, currencies, equity,
commodities, etc. All of these swaps have a role in international finan-
cial management for tackling different kinds of risks. In this section,
you will study the most important type of swap from the perspective of
managing foreign exchange risk, viz., currency swaps.

n o t e s
A swap can be defined as a contract in which two parties exchange

their cash flows based on a predetermined series of payments. The
exchange of cash flows can be with regard to:
Series of interest payments on a notional principal
Series of interest payments with differing characteristics like fixed
to floating, etc.
Series of payments denominated in different currencies
Depending upon the nature of exchange of cash flows, swaps can be

classified into interest rate swaps and currency swaps. Interest rate
swaps might involve only exchange of interest with no principal ex-
change in the same currency. In the case of currency swaps, exchange
of principal and interest takes place between two different currencies.
S
Swaps thus involve several cash flows over a period of time and can
be used for hedging multiple transaction exposures resulting out of
an asset or liability unlike futures and options. The maturity period of
swaps can extend even beyond five years.
IM
9. Price discovery means a process by which underlying assets

are priced according to their actual premium value. (True/
False)
M
10. A _____ can be defined as a customised contract that takes

place between two parties pertaining to buying and selling an
asset at a specified price on a future date.
11. OTC options are generally created tailor-made by banks to
N
meet specific corporate needs. (True/False)

12. Options exist in both Over-the-Counter (OTC) markets and
_____.
13. An ____ can be defined as a contract that gives the owner the
right, but not the obligation, to buy or sell a given quantity of
an asset at a specified price at some future date.
14. A swap is a different kind of derivative instrument compared
to both a future and an option in terms of its structure and
utility. (True/False)
15. Depending upon the nature of exchange of cash flows, swaps
can be classified into interest rate swaps and _______.
16. Currency swaps involve only exchange of interest with no
principal exchange in the same currency. (True/False)

n o t e s
Activity
With the help of various sources, find the information on the finan-
cial market and analyse which hedging tool is used largely by an
Indian investor.
13.4 BASEL NORMS

With the enhanced pace of globalisation, the need for strengthening the
banking system was realised so that the domestic banking structure
can integrate with the international banking structure. This integra-
tion was required to make the banking system more transparent and
safe. For fulfilling the same need, the Basel norms were established in
India. It was done so that the competitiveness of Indian baking system
can be enhanced so that it can compete with the international bank-
S
ing system. India has implemented the Basel norms in three phases:
Basel I, Basel II and Basel III. Let us discuss these phases in detail.
IM
Basel I
Basel I was introduced in 1988 by the Basel Committee on Banking

Supervision (BCBS) as a system of capital measurement. The aim of
Basel I is to minimise credit risk by defining capital structure so that
the effective risk measurement can take place for banks.
M
The credit risk was considered mainly by Basel I. Based on the credit
risk, the classification of assets was done in the following five catego-
ries:
0% – It includes the safest instruments such as cash, central bank
N
and government debt and any OECD government debt.

0%, 10%, 20% or 50% – It includes public sector debt.
20% – It includes development bank debt, OECD bank debt, OECD
securities firm debt, non-OECD bank debt (under one year matu-
rity) and non-OECD public sector debt.
50% – It includes residential mortgages.
100% – It includes securities characterised by the highest level of
credit risk such as private sector debt, non-OECD bank debt (ma-
turity over a year), real estate, plant and equipment, and capital
instruments issued at other banks.
Basel I requires banks to meet the minimum capital (Tier 1 and Tier
2) requirement of 8% of risk-weighted assets (RWA). RWA means as-
sets with different risk profiles. This illustrates that loans backed by

n o t e s
collateral would carry lesser risks as compared to personal loans that

are unsecured and have no collateral. India adopted Basel 1 guide-
lines in 1999 that differentiated risks very well and promoted the loan
securitisation resulting to the unwinding in the subprime market. For
example, if a bank has risk-weighted assets of 1 crore, then it is re-
quired to maintain the capital of at least 8 lakh.
Basel II
Basel II refers to the new capital adequacy framework that replaced

the 1988 Basel Accord in June 2004. The revised framework was set
basically on three pillars, namely, minimum capital, supervisor review
and market discipline. The main aim of Basel II is to integrate Basel
capital standards with national regulations. It was achieved by setting
the minimum capital requirements to be maintained by financial in-
S
stitutions so that the required level of liquidity can be ensured. Mini-
mum capital that banks must hold should be 8% of their assets, after
adjusting risk.
IM
The core objectives of Basel I and II are same. However, Basel II is
different from Basel I on the basis of the approach it follows. Basel I
primarily focuses on the credit risk. However, the focus of Basel II is
on the creation of standards and regulations deciding the quantum of
the capital that should be kept aside by the financial institutions. The
capital put aside acts as a safeguard cover that helps in reducing the
M
risks associated with the investing and lending practices of various

banks.
Basel III
N
Basel III was introduced in 2009 to further strengthen the norms made
under Basel II framework. Basel III norms were set to help the bank-
ing sector in combating the financial crisis on account of high leverage
and inadequate liquidity buffers. Basel III issued regulatory norms for
sound liquidity risk management and supervision to mitigate risk fac-
tors associated with banking business. The norms were set to simplify
the certain complex securitisation positions, off-balance sheet vehi-
cles and trading book exposures.
Certain changes in the regulatory norms were made in September

2010 pertaining to higher global minimum capital standards for com-
mercial banks and overall design of the capital and liquidity. These
reform packages also form a part of Basel III regulatory norms.
It is important to note that Indian banking system follows regulatory

norms set under Basel II. The full implementation of the Basel III cap-
ital regulations is expected by March 31, 2019.

n o t e s
17. Basel I was introduced in 1988 by the Basel Committee

on Banking Supervision (BCBS) as a system of capital
measurement. (True/False)
18. The credit risk was considered mainly by Basel I. Based on
the credit risk, the classification of assets was done in the
_____ categories.
19. The Basel norm requires bank to meet the minimum capital
(Tier 1 and Tier 2) requirement of ___ of risk-weighted assets
(RWA).
a. 7% b. 8%
c. 9% d. 10%
S
20. The focus of Basel II is on the creation of standards and
regulations deciding the quantum of the capital should be
kept aside by the financial institutions. (True/False)
IM
21. Basel III norms were set to help the banking sector in
combating the financial crisis on account of high leverage and
inadequate liquidity buffers. (True/False)
Activity
M
With the help of various sources, collect information on the per-

formance of Indian banks before and after the implementation of
Basel norms. Make a report on the findings.
N
13.5 SUMMARY
Itis important to note that each transaction that results into the
expected return is also associated with the expected risk.
Risk management can be defined as the process of mitigating risk
through forecast and evaluation of financial risks at the right time.
There is long list of the financial risk that includes credit risk, in-
terest risk, liquidity risk and operational risk. All these risk comes
under two major categories of risk. These two main categories are
systematic and unsystematic risks.
Systematic risk can be defined as an inherent risk to the entire
market that cannot be mitigated or eliminated. It is also known as
non-diversifiable risk, volatility or market risk that not only affects
any specific organisation or industry but also affects the overall
market.

n o t e s
Unsystematic risks are also known as residual risk. This risk is as-
sociated with particular company and industry that does not affect
the entire economy.
Hedging can be defined as an investment that is done by investor
so that he/she reduces the risk of adverse price movement in an
asset.
The derivative products can be used for hedging risks and for
speculation of price movements of the underlying asset.
A forward can be defined as a customised contract that takes place
between two parties pertaining to buying and selling an asset at a
specified price on a future date.
Future contracts are standardised contracts that may not match
exactly with corporate exposures.
S
An option can be defined as a contract that gives the owner the
right, but not the obligation, to buy or sell a given quantity of an
asset at a specified price at some future date.
IM
A swap can be defined as a contract in which two parties exchange
their cash flows based on a predetermined series of payments.
With the enhanced pace of globalisation, the need for strengthen-
ing the banking system was realised so that the domestic banking
structure can integrate with the international banking structure.
M
Basel I was introduced in 1988 by the Basel Committee on Bank-

ing Supervision (BCBS) as a system of capital measurement.
Basel II refers to the new capital adequacy framework that re-
placed the 1988 Basel Accord in June 2004. The revised framework
N
was set basically on three pillars, namely minimum capital, super-

visor review and market discipline.
Basel III was introduced in 2009 to further strengthen the norms
made under Basel II framework.
key words
Bid-ask: It is an amount by which the ask price exceeds the bid.
Mark to Market (MTM): It is an accounting act of recording

under which the value of a security is considered on the basis of
current market value rather than its book value.
Over-the-Counter (OTC): This term is associated with the secu-
rities which are traded in the absence of a centralised exchange
with the help of the dealer network.
Secondary market: A market where the selling and purchasing
transaction of existing securities takes place.
Volatility: It refers to the variation in the trading price.

n o t e s

1. Define risk and risk management.
2. Write a short note on the systematic risk.
3. Explain the various types of unsystematic risks.
4. Discuss the concept of hedging.
5. Elaborate the roles played by derivatives.
6. Differentiate between the forward and future contracts.
7. Write a short note on option.
8. Write a short note on swap.
9. Explain the significance of Basel norms.
S
IM
Topic Q. No. Answer

Risk in Financial Market 1. Risk
2. True
3. a. Government
M
4. Risk management
5. Systematic risk
6. True
N
7. d. beta
8. Unsystematic risks
Hedging Techniques— 9. True
Derivatives
10. Forward
11. True
12. Derivatives exchanges
13. Option
14. True
15. Currency swaps
16. False
Basel Norms 17. True
18. Five
19. b. 8%
20. True
21. True

n o t e s

1. Risk can be defined as the probability of happening or not
happening of an event. Risk management can be defined as the
process of mitigating risk through forecast and evaluation of
financial risks at the right time. Refer to Section 13.2 Risk in
Financial Market.
2. Systematic risk can be defined as an inherent risk to the entire
market that cannot be mitigated or eliminated. Refer to Section
13.2 Risk in Financial Market.
3. The various types of unsystematic risks include Business or
liquidity risk, Financial or credit risk and Operational risk. Refer
to Section 13.2 Risk in Financial Market.
4. Hedging can be defined as an investment that is done by investor
S
so that he/she reduces the risk of adverse price movement in an
asset. Refer to Section 13.2 Risk in Financial Market.
5. The role played by derivatives includes hedging, price discovery
IM
and speculation. Refer to Section 13.3 Hedging Techniques—
Derivatives.
6. Forward contract can be tailor-made to suit corporate needs.
Future contracts are standardised contracts. Refer to Section
13.3 Hedging Techniques—Derivatives.
7. An option can be defined as a contract that gives the owner the
M
right, but not the obligation, to buy or sell a given quantity of an

asset at a specified price at some future date. Refer to Section
13.3 Hedging Techniques—Derivatives.
8. A swap can be defined as a contract in which two parties exchange
N
their cash flows based on a predetermined series of payments.

Refer to Section 13.3 Hedging Techniques—Derivatives.
9. With the enhanced pace of globalisation, the need for
strengthening the banking system was realised so that the
domestic banking structure can integrate with the international
banking structure. Refer to Section 13.4 Basel Norms.

13.8
REFERENCE
SUGGESTED READINGS
Bhole, L.M., Jitendra, (2015). Financial institutions and markets,
structure, growth and innovations, McGraw Hill Publishing Com-
pany Limited.
Pathak, B. (2008). The Indian financial system (3rd Ed.). New Del-

n o t e s
E-REFERENCES
Davies, T. (1993). Derivative? What do you mean “Derivative”?. NIR
News, 4(1), 10. http://dx.doi.org/10.1255/nirn.199
Scholtz, H. Is Systematic Risk Diversifiable? Presentation of a
Portfolio Model that Eliminates Systematic Risk. SSRN Electronic
Journal. http://dx.doi.org/10.2139/ssrn.2533943
Suthaharan, R. Derivative Instruments. SSRN Electronic Journal.
http://dx.doi.org/10.2139/ssrn.1264324
Madsen, C. Hedging med Obligations-Optioner (Hedging
with Bond-Options). SSRN Electronic Journal. http://dx.doi.
org/10.2139/ssrn.1490928
S
IM
M
N

N
M
IM
S
Ch
14 a p t e r
CASE STUDIES
CONTENTS
S
Case Study 1 Rbi Grants 10 Small Finance Bank Licenses
Case Study 2 Sebi Allows Vadodara Stock Exchange to Exit the Capital Market
IM
Case Study 3 Treasury Bills to Retail Investors
Case Study 4 Us$580mn Worth Of Black Money Declared as the Black Money Act
Comes Into Force
Case Study 5 India to Become a Us$ 6 Trillion Economy
Case Study 6 Regulation of Regional Commodity Derivatives Exchanges by Sebi
Case Study 7 Rbi Steadies Interest Rates to Keep Rate of Inflation in Check
M
Case Study 8 Evolution of Agricultural Nbfcs in India

Case Study 9 Development of Msme Sector by Sidbi
Case Study 10 Sebi Advises to Limit Risk Exposure of Mutual Funds
Case Study 11 World Bank’s Strategy to Counteract Climate Change in Africa
N
Case Study 12 Stock Market Efficiency and Financial Crisis – An Indian Perspective

Case study 1
n o t e s
RBI GRANTS 10 SMALL FINANCE BANK LICENSES
This Case Study discusses the granting of licenses by RBI to finan-

cial entities to operate as small finance banks. It is with respect to
Chapter 1 of the book.
The Reserve Bank of India (RBI) has licensed ten financial enti-
ties to begin operations as small finance banks. This move is de-
signed to expand the availability of financial services in rural and
semi-urban regions of the country.
The ten financial entities that have been granted the license are
Disha Microfin Private Limited, Janalakshmi Financial Services
Private Limited, RGVN (North East) Microfinance Limited, Equi-
tas Holdings Limited, Suryoday Micro Finance Private Limited,
S
Ujjivan Financial Services Private Limited, ESAF Microfinance
and Investments Private Limited, Au Financiers (India) Limited,
Capital Local Area Bank Limited and Utkarsh Micro Finance Pri-
IM
vate Limited.
There were also other financial services firms that had applied for
the license but were denied due to their being deemed too large
to function as a small finance bank. These firms were SKS Mi-
crofinance Limited, IIFL Holdings Limited, UAE Exchange and
Financial Services Limited and Dewan Housing Finance Limited.
M
RBI stated that these small finance banks would have to follow
guidelines stipulated by it such as accepting deposits, offering
rudimentary banking services and providing loans to overlooked
sections like micro and small industries, small business units, en-
N
tities in the unorganised sector, and small and marginal farmers.
This license provided by RBI would be valid for a period of 18

months. Moreover, out of the 10 finance institutions that have
been granted the license, 8 are microfinance institutions. The ex-
ceptions to these are Au Financiers and Capital Local Area Bank
Limited. Capital Local Area Bank Limited is currently operating
in 5 separate districts of Punjab.
These microfinance firms are turning into small finance banks

to be able to gain access to deposits and the ability to maintain a
complete treasury department and provide an extensive range of
loan products and services to their customers.
RBI revealed in a statement that it had carefully chosen the ten

candidates after an exhaustive study of each applicant had been
conducted by three different committees.
Going forward, the Reserve Bank intends to use the learning from
this licensing round to appropriately revise the guidelines and move

Case study 1: RBI GRANTS 10 SMALL FINANCE BANK LICENSES 267
Case study 1
n o t e s
to giving licences more regularly, that is, virtually ‘on tap.’ Samit
Ghosh, founder and managing director, Ujjivan Financial Ser-
vices, stated that it would take at least a period of two years to
stabilise the bank operations after it has been set up. Current-
ly, Ujjivan has provided loans for an amount worth about ` 3,300
crores, and it plans to keep its focus on providing services to
smaller borrowers.
The next 18 months are going to be a lot of hard work. We have to

figure out ways to bring down the 90% foreign shareholding in the
company since RBI has strict guidelines for it. We will be looking at
various options including private placements, said Ghosh.
In accordance with the current policy of RBI, the cumulative for-

eign investment is limited to 74 per cent of the paid-up capital in
S
a private sector bank.
Disha Microfin stated that it would be operating in the central

and western parts of India where there is a massive number of
IM
customers who don’t have bank accounts or have not availed any
kind of banking services.
The initial challenge will be to restructure and transform into a bank

from a non-banking financial institution and offer multiple banking
products, said Rajeev Yadav, director of Disha group, which runs
M
the Ahmedabad-based microfinance company.
RBI stated that 72 financial institutions had applied for the small
finance bank licence. Usha Thorat, who had formerly served as
an RBI deputy governor, headed a committee that reviewed these
N
applications.
It is clear from the list (of licensees) that the RBI’s bias is towards
people who have proved themselves in the priority lending space.
Since larger banks have always felt it to be a drag on their books,
these entities will be able to fill that gap and serve smaller custom-
ers, said Abizer Diwanji, partner and national leader, financial
services, EY. But these will also be the biggest challenges, since these
are players who have not had much experience in these services,
Diwanji said.
It has been understood that the transformation of these institu-

tions into small finance banks would not be easy.
For the initial few years, lives are going to be difficult for the licens-
ees. Some extremely large challenges include the ability to form a
sustainable business model and gaining trust from the depositors.
However, this sector is capable of achieving these things, said Alok
Prasad, industry expert and former chief executive officer of Mi-

Case study 1
n o t e s
crofinance Institutions Network, an industrial body for micro

lenders.
These small finance banks would be liable to follow several reg-

ulations that are adhered to by scheduled commercial banks as
well. For example, small finance banks would need to maintain
cash reserve ratio and statutory liquidity ratio similar to commer-
cial banks.
These small finance banks would need to advance 75 per cent of

their credit provided to priority sectors. These priority sectors
include low-income earners, agriculture and small business en-
terprises. On the other hand, commercial banks are mandated to
lend 40 per cent of their net credit to these priority sectors.
S
Moreover, these small finance banks would also have to guaran-
tee that 50 per cent of their loan portfolio includes advances of
value ` 25 lakhs as stated by RBI.
IM
These banks can in due course apply for transition into universal
banks when they have developed an acceptable track record. This
transition would be at the discretion of RBI after it has verified
with requisite due diligence.
(Source: Adopted from: Nair, Vishwanath. ‘RBI Issues 10 Small Bank Licences’. http://
www.livemint.com/.)
M
questions
1. Why did the financial entities switch to small finance

banks?
N
(Hint: to gain access to deposits and the ability to maintain

a complete treasury department and provide an extensive
range of loan products and services to their customers.)
2. Which stipulations the new small finance banks would
have to adhere to?
(Hint: maintain a cash reserve ratio and statutory liquidity
ratio similar to commercial banks, advance 75 per cent of
their credit provided to priority sectors, guarantee that 50
per cent of their loan portfolio includes advances of value
` 25 lakhs.)

Case study 2
n o t e s
SEBI ALLOWS VADODARA STOCK EXCHANGE TO

EXIT THE CAPITAL MARKET
This Case Study discusses the exit of Vadodara Stock Exchange

from the Indian capital market in compliance with regulations of
SEBI. It is with respect to Chapter 2 of the book.
SEBI has permitted the departure of the Vadodara Stock Ex-

change from the stock exchange business. It is one of the two doz-
en stock exchanges that have been permitted to leave the capital
market by SEBI.
The stock exchanges included in this list are the Cochin Stock
Exchange, Madhya Pradesh Stock Exchange, Hyderabad Securi-
ties and Enterprise, Uttar Pradesh Stock Exchange, Coimbatore
Stock Exchange, Ludhiana Stock Exchange, Madras Stock Ex-
S
change and several others.
A stock exchange can apply for exit of its own will if its annu-
IM
al trading turnover is less than ` 1000 crores according to SEBI
regulations. SEBI affirms that Vadodara Stock Exchange had
conformed to SEBI`s norms in relation to exit from the capital
market. Moreover, it confirms that Vadodara Stock Exchange had
made the necessary payment in relation to its dues plus ten per
cent listing fee along with the regulatory fee that is charged on an
annual basis.
M
SEBI in its recent statement said, “From the valuation report and
undertaking of the Vadodara Stock Exchange Limited, it is ob-
served that all the known liabilities have been brought out and
that there is no other future liability that is known as on date”.
N
SEBI however, had laid out conditions to the Vadodara Stock Ex-
change like it could not use the term “stock exchange” or any oth-
er form similar to it and to change its present name. Moreover, it
would refrain from publicising that it was earlier a stock exchange
in any form of media.
(Source: Adopted from: Moneycontrol.com. ‘Sebi Allows Vadodara Stock Exchange To
Exit Bourse Biz’.)
questions
1. What are the conditions needed to exit the capital market

needed by a stock exchange?
(Hint: if stock exchanges annual trading turnover is less
than ` 1000 crores.)
2. Which conditions did Vadodara Stock Exchange have to
fulfil before its exit was approved by SEBI?
(Hint: could not use the term “stock exchange” or any other
form similar to it and had to change its present name.)

Case study 3
n o t e s
TREASURY BILLS TO RETAIL INVESTORS
This Case Study discusses the plans of the Reserve Bank of India
(RBI) to offer T-bills to retail investors. This is with respect to chap-
ter 3 of the book.
Treasury bills are one of the most important short-term money

market instruments. These bills are a way for the Indian govern-
ment to raise money from the public. In 2002, the RBI introduced
a scheme for non-competitive bidding of dated government se-
curities to retail investors. This allowed retail investors to par-
ticipate directly in the auction process. This bidding was opened
to individuals, co-operative banks, companies, institutions, provi-
dent funds and trusts. Under this scheme, investors can apply for
a certain amount of securities in an auction without detailing the
S
specific price or yield.
In 2015, RBI also plans to offer T-bills to retail investors through

IM
non-competitive bidding. Till now, T-bills are issued at compet-
itive bidding. In competitive bidding, investors have to specify
the amount of the return they would like to receive. In countries
such as the US, retail investors are active in T-bills. For instance,
Bureau of Fiscal Service, a T-bill issuer, has four retail securities
programmes for investors. This allows users to go online and
open their accounts, purchase savings bonds and manage their
M
holdings. Till now, in India, non-competitive bidding is permitted

only for state governments, specific foreign central banks, eligible
provident funds and sovereign wealth funds. As RBI Governor
Raghuram Rajan says, “details of the facility will be worked out
N
and implemented in consultation with the government of India”.
RBI is also taking various steps for promoting retail investments

by providing access to the Negotiated Dealing System-Order
Matching (NDS-OM). In addition, Web-based services are also ex-
tended for gilt account holders. RBI is also planning to introduce
a similar Web-based solution for the participation of retail inves-
tors with government sector accounts on the e-Kuber platform
(part of the e-payment revolution in India).
According to Killol Pandya, a senior debt fund manager at LIC

Nomura Mutual Fund, “A very robust working mechanism will be
required to provide liquidity to individual investors. If individuals
are convinced that they will not be stuck buying sovereign papers, it
will work. Investors do not get a yield benefit by investing in these
sovereign instruments. They look for capital gains. Those get real-
ised only when you exit, as a result of which a liquidity mechanism
is critical,”

Case study 3: TREASURY BILLS TO RETAIL INVESTORS 271
Case study 3
n o t e s
questions
1. How can RBI benefit from retail investment in T-bills?

(Hint: The amount raised by RBI through T-bills is used
for making investment in the economy and financing the
national debt.)
2. What is non-competitive bidding of T-bills?
(Hint: An auction where the specific price or yield is not
detailed.)
S
IM
M
N

Case study 4
n o t e s
Us$580MN WORTH OF BLACK MONEY DECLARED AS

THE BLACK MONEY ACT COMES INTO FORCE
This Case Study discusses the declaration of black money held by

Indian citizens under a compliance window before the Black Mon-
ey (Undisclosed Foreign Income and Assets) and Imposition of Tax
Act, 2015 came into force. It is with respect to Chapter 4 of the book.
The Indian government declared that 638 people had disclosed

assets of value ` 3,770 crores (US$580mn) after the closing of the
compliance window in September 30th 2015 and before the Black
Money (Undisclosed Foreign Income and Assets) and Imposition
of the Tax Act, 2015 came into force. The government cautioned
that it would take action against those who had not declared their
foreign assets and investments within the stipulated deadline.
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“Whatever has come, we accept it and now onwards we would
start the action against those people who have not declared any
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asset and about whom the information would come to us,” Reve-
nue Secretary Hasmukh Adhia told reporters here.
“In order to give them an opportunity, this compliance window

was there up to September 30th 2015 and the figures we have re-
ceived so far are that 638 people have announced their foreign
investment or foreign assets including bank account balances and
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the total amount coming to ` 3,770 crores,” he added.
Under the law, a compliance window is to be provided so that the

citizens can declare and pay the penalty as required by law. If
the time limit of the compliance window is not met, then those
N
citizens who failed to comply would be liable to pay an addition-

al penalty of 90 per cent. This would make them liable to pay a
full tax liability of 120 per cent on the total foreign assets held by
them.
Under the compliance window, September 30th 2015 was the last
date for the declaration of foreign assets on which a 30 per cent
tax was required to be paid along with an equivalent sum to be
paid before 31st December 2015.
The Indian government’s official statement said that the actual

sum of declaration, under the Black Money (Undisclosed Foreign
Income and Assets) and Imposition of the Tax Act, 2015, was like-
ly to be revised for a final agreement.
The statement also declared that “the officer designated to receive

the declarations worked till midnight on September 30, 2015,” as
the number of people who declared their black money peaked.

Case study 4: Us$580MN WORTH OF BLACK MONEY DECLARED AS
THE BLACK MONEY ACT COMES INTO FORCE 273
Case study 4
n o t e s
Anita Kapur, who is the chairperson of the Central Board of Di-

rect Taxes (CBDT), said that the Indian government had taken all
the requisite steps to ease the declaration of black money.
“We clarified a lot of queries of people. We also facilitated their fil-

ing till midnight, as we got some last minute requests from places
other than Delhi,” she said. “Once the window is closed, the act
with all its provisions will be enforced on defaulters,” she added.
The finance ministry had reaffirmed that it would provide full

confidentiality for information related to hoarding of black mon-
ey in foreign countries. It also provided flexibility to people who
could not provide their foreign bank statements in time by giving
them the opportunity to give their “best estimate” declarations.
However, if the estimates provided were found to be untrue, then
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they would be liable to be charged with a penalty.
Furthermore, the income tax department had reiterated that

disclosures made under the Black Money (Undisclosed Foreign
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Income and Assets) and Imposition of Tax Act, 2015 would have
“immunity from prosecution under the Foreign Exchange Man-
agement Act (FEMA), Prevention of Money Laundering Act
(PMLA), Income Tax Act, Wealth Tax Act, Companies Act and
Customs Act”. However, immunity from prosecution is not pro-
vided under any other statute of Indian law.
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Even Swiss and other European banks were urging their Indian
customers to declare their assets in order to benefit from this one
time opportunity for giving full disclosure of their foreign assets.
It has been revealed by sources that few Swiss and British banks
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have requested their Indian customers to present renewed un-

dertakings stating that they have paid the due taxes on the mon-
ies deposited by them with the banks. These undertakings have
been requested from wealthy individuals as well who have a high
net worth and corporate clients who handle wealth and portfolio
management.
Black Money (Undisclosed Foreign Income and Assets) and Im-

position of Tax Act, 2015 has made it possible to impose tax on
foreign assets in India.
Acting on the information revealed by the HSBC Geneva Bank

list, the Indian Income Tax department has initiated proceedings
against 121 entities for their prosecution. These cases have been
registered before the 31st March 2016 deadline since if the dead-
line would have been missed then these cases would have been
time-barred and the income tax department would have been un-
able to prosecute them.
(Source: Adopted from: Business-standard.com. ‘Black Money Act Comes Into Force, 638
Declare Assets Of $580 Mn (Roundup)’.)

Case study 4
n o t e s
questions
1. What would be the consequences if an Indian citizen does

not declare his foreign assets or investments under the
compliance window?
(Hint: liable to pay an additional penalty of 90 per cent
plus it would make them culpable to pay a full tax liability
of 120 per cent on the total foreign assets held by them.)
2. How are the European banks helping the Indian
government?
(Hint: urging their Indian customers to declare their
assets, requesting their Indian customers to present
renewed undertakings stating that they have paid the due
S
taxes on the monies deposited by them with the banks.)
IM
M
N

Case study 5
n o t e s
INDIA to become a US$ 6 TRILLION ECONOMY
This case study discusses the impending revival of the Indian equity
market and how the Indian economy will grow to become a US$ 6
trillion economy. It is with respect to Chapter 5 of the book.
The Indian domestic equity market would be revitalised by sig-

nalling of a recovery in the economy spurred by the investment
cycle and earnings revival, acting as its substantial trigger.
Analysts believe that India, which is the third largest economy of

Asia, can potentially reach double digit growth rate figures in the
next few years. In that scenario, India’s GDP would rise to US$
5-6tn from the current US$ 2tn in a period of five to ten years.
S
Since an equity market discounts its securities well in advance,
it is estimated that the prices would quickly start mirroring the
recovery made by the economy. Furthermore, the analysts opine
that the stock market would also begin reflecting the economic
IM
growth and equities would be well placed to take advantage of
that said growth.
“The broad hypothesis is that equity market tends to have a cor-

relation with GDP in a longer time horizon. We are roughly $2
trillion of GDP now, and if I assume that you can have 13 per cent
M
kind of notional GDP growth rate over the next 10 years, then you
could be somewhere between say $6 trillion and $8 trillion de-
pending on what kind of growth you are assuming,” says Madhu-
sudan Kela, Chief Investment Strategist, Reliance Capital AMC.
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“There is a gigantic opportunity if you take a time frame of 5-10

years. People should not feel left out. Over the next 10 years, there
is going to be wealth creation to the extent of $5-$6 trillion. Some
of it will happen in the private domain and some of it will happen
in a public market domain,” he said.
Over the past year, the equity market has been stagnant, with only
the pharmaceuticals, healthcare and consumer durables sector
performing at a good level.
Analysts are of the opinion that realty and infrastructure stocks

may begin to gain back market value because of the recent an-
nouncement made by the government about reform measures
related to the real estate sector. The government had recently
relaxed the regulations in foreign direct investment (FDI) in the
construction sector by discarding two primary conditions that are
in relation to minimum built-up area and capital needs.
Experts suggest that by spinning their non-core assets, the ma-

jority of realty firms would be able to fortify their balance sheets

Case study 5
n o t e s
and raise sufficient cash. It is believed by experts that the equity

market would reward patience even though the market has been
quite weak in the past few months.
“Nothing moves in a straight line, especially in equity market. So

investors should use every dip to accumulate quality stocks for
long-term time horizon,” the realty firms say.
“The market is likely to witness high volatility during the rest of

this year and early part of 2016 due to slow earnings revival, a mis-
match between expectations and delivery from the government
and global factors like slowing China and the impending US Fed
rate hike,” said Amar Ambani, Head of Research, IIFL.
“But it would also present a golden opportunity to accumulate
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quality stocks. The year 2016 has a lot to offer, which could well
lay the foundation for a big bull run,” he added. A further vital
trigger could be a decrease in interest rates. It has been projected
by some analysts that interest rates would decrease by 100 basis
IM
points in the year 2016.
The sentiment on Dalal Street is that despite the creation of an

atmosphere of uncertainty because of US Fed interest rate in-
crease and slowdown being experienced by the Chinese economy,
India would be able to rejuvenate its GDP growth and outdo other
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emerging market economies.
“We are passionate India bulls and we speak by heart. We genu-

inely believe that India is going to be a $4 trillion economy in the
next seven to eight years and there is going to be big returns on
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stocks,” Sunil Singhania, CIO- equity, Reliance Mutual Fund, said

in an interview with ET Now.
“India is doing relatively better than a number of other countries,

and finally, it has reached a size which the world cannot ignore.
That way India definitely stands out,” he said.
Singhania was of the opinion that the macro story for India was a
big positive when compared to other large economies. “So, while
everyone else is fighting deflation, we are still fighting inflation.
Things can only improve from here,” he said.
Retail investors who have been investing via mutual funds are
believed to be a major factor that would contribute in carrying
on the momentum in the equity market. The investors have been
advised to believe in the power of compounding which would help
them in increasing their wealth.
“The stock market requires discipline, time commitment and ef-

fort. Making money is not easy. So try to do investment either on

Case study 5: INDIA to become a US$ 6 TRILLION ECONOMY 277
Case study 5
n o t e s
your own, when you have the time commitment and energy, or
come via the mutual fund route,” said Nilesh Shah, MD, Kotak
Mutual Fund.
“If you are coming via the mutual fund route, try to invest on a
regular basis. Every month save something and invest something.
That small amount you save over a period of time will end up be-
coming quite large,” he added.
Shah advised investors not to discontinue their Systematic In-

vestment Plan (SIP) account even if the market corrects itself in
a sharp manner. “In fact, those are the times when you should al-
locate a higher amount to SIP and let the India growth story take
its own turn. Eventually, this long-term investment will help you
create a lot of wealth,” he said.
S
(Source: Adopted from: timesofindia-economictimes. ‘India To Be $6 Trillion Economy,
Buy Stocks To Capture That Growth’.)
questions
IM
1. Why would the realty and infrastructure stocks gain back
market value?
(Hint: the government relaxed the regulations in foreign
direct investment (FDI) in the construction sector by
discarding two primary conditions that are in relation to
M
minimum built-up area and capital needs.)

2. Why is the equity market likely to witness high volatility?
(Hint: due to slow earnings revival, a mismatch between
expectations and delivery from the government and
N
global factors like slowing China and the impending US

Fed rate hike.)

Case study 6
n o t e s
REGULATION OF REGIONAL COMMODITY

DERIVATIVES EXCHANGES BY SEBI
This case study discusses the new regulations enforced by SEBI

with relation to the demutualisation and corporation of the regional
commodity derivatives exchanges. It is with respect to Chapter 6 of
the book.
The Securities and Exchange Board of India (SEBI) has recently

ordered the regional commodity derivatives exchange to submit
a proposal for approval for demutualisation and corporation by
September, 2017. These regional commodity derivatives exchange
would have to observe the guidelines of the Securities Contracts
(Regulation) Act, 1956 (SCRA) within a 3 year period starting from
28th September, 2015.
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Due to differences amid the promoters and the necessary migra-
tion from regional exchanges to national ones, demutualisation
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and corporatisation for most of the six regional commodity ex-
changes would be difficult. This would result in merging the com-
modity exchange business.
Moreover, SEBI has directed national-level commodity exchange

to adhere with its guidelines by September, 2016. However, all of
these commodity exchanges would be required to install adequate
M
surveillance systems for the monitoring of positions, prices and

volumes of the commodities for assuring market integrity. This
would be followed until online real-time surveillance systems
would be installed and ready for operations.
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SEBI has further pointed out that the regional commodity deriv-
atives exchange would have to transfer the rights of clearing and
handling of trade to a distinct clearing corporation within a pe-
riod of three years. Moreover, the national commodity exchange
would need to begin complying with these guidelines within the
next year. Until that time, the commodity exchanges have been di-
rected to continue dealing with clearance and settlement of trade
in the present arrangement.
SEBI has taken strict action and is enforcing tough guidelines re-
quiring any national exchange that does not have a net worth of
` 100 crore to achieve it by 5th May, 2017. However, within a peri-
od of 6 months, these exchanges would need to submit an exhaus-
tive plan detailing how they will achieve their target.
SEBI has directed the commodity exchange to refrain from profit

distribution to their shareholders till the time they reach their tar-
get. These exchanges would be mandated to present an audited

Case study 6: REGULATION OF REGIONAL COMMODITY DERIVATIVES EXCHANGES BY SEBI 279
Case study 6
n o t e s
net worth certificate each year which would have to be certified

by a statutory auditor.
SEBI has given time to national commodity exchange to address

issues related to shareholding limits till 5th of May, 2019. Under
the new regulations, the commodity exchange would have to keep
their regulator departments, that would be formed within a peri-
od of 3 months, separate along with an oversight committee for
“product design” which would be overseen by a Public Interest
Director.
SEBI has also mandated the national and regional commodity ex-
changes to establish advisory committees within a period of 1 and
3 years.
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These commodity exchanges are obligated to select a compliance
officer similar to equity exchanges. These exchanges are recom-
mended to transmit all penalties to their designated funds, name-
ly, settlement guarantee fund and investor protection fund. SEBI
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has authorised exchanges to retrieve dues from the members who
had been released from the clearance and settlement functions
from their assets, collateral and deposits of trading or clearing
members.
(Source: Adopted from Reporter, BS. ‘Sebi Sets Timeline For Commodity Exchanges’.
Business-standard.com.)
M
questions
1. Which guidelines have been enforced by SEBI for

commodities exchanges to achieve a net worth of ` 100
N
crore by 5th May, 2017?

(Hint: Exchanges would need to submit an exhaustive
plan detailing how they will achieve the target of ` 100
crore net worth, refrain from profit distribution to their
shareholders till the time they reach their target).
2. Which regulations would the national commodity
exchanges would have to follow in order to address issues
related to shareholding limits?
(Hint: Commodity exchanges would have to keep their
regulator departments separate along with forming an
oversight committee for “product design” which would
be overseen by a Public Interest Director).

Case study 7
n o t e s
RBI STEADIES INTEREST RATES TO KEEP RATE OF

INFLATION IN CHECK
This case study discusses RBI’s holding the interest rates steady to
keep the inflation rate of the Indian economy in check. It is with
respect to Chapter 7 of the book.
The Reserve Bank of India (RBI) will continue to maintain its in-
terest rate of 6.75 per cent in order to suppress inflation while
India’s economic growth rose to 7.3 per cent in September, 2015
according to a Reuters poll of economists.
Reuters poll had a group of 45 economists who were surveyed and

they expected the forecasted growth for the gross domestic prod-
uct (GDP) to be between 6.9 and 7.6 per cent in the September
S
quarter of 2015.
India has posted a GDP growth of 7.0 per cent during the quar-
ter ending in June, 2015. Though, the economy is improving, it is
IM
unlikely that the government would be able to meet its target of 8
per cent GDP growth in the fiscal year ending March, 2016.
RBI had lowered its growth forecast for the current fiscal year in
October, 2015 to 7.4 per cent which is still good enough to place
India as one of the fastest growing economies of the world.
M
RBI is focusing upon inflation and has predicted that the consum-
er price inflation would jump to 5.8 per cent in January, 2016. This
is however, after inflation fell to 3.6 per cent at the beginning of
2015 but rose up to 5.0 per cent in October, 2015.
N
A group of economists expected RBI to reduce the repo rate to

6.5 per cent in the April–June quarter of 2016 after it succeeds in
trimming down the inflation rate. RBI has already reduced the
interest rate 4 times in 2015 and rate of inflation remains within
its target range of 2 to 6 per cent and expected to fall further by
January 2016.
The explanation given for slashing the repo rate by more than 50
basis points in September, 2015 was given by RBI’s governor Ra-
ghuram Rajan, indicating that the repo rate was slashed to coun-
teract the decrease in global economic growth.
Since the RBI is unlikely to ease its stance on the inflation rate,
the government would have to take measures for accelerating
the growth of the economy. The government has also vowed to
strengthen foreign investment and pass more economic reforms.

Case study 7: RBI STEADIES INTEREST RATES TO KEEP RATE OF INFLATION IN CHECK 281
Case study 7
n o t e s
“The RBI has done what it can do over the last few months, it is
fiscal policy which needs to come into picture now,” said Prashant
Sawant, senior economist at Verisk Maplecroft.
RBI would take precautions to control the inflation rate due to a

possible increase in US interest rates. Even though it is unlikely
that India would suffer to the extent that other emerging markets
would when the Federal Reserve would finally raise its interest
rates for the first time in the past decade.
“The RBI will keep a watch on the recent inflationary path and
the likely impact of geo-political tension in Europe on crude pric-
es,” said Shakti Satapathy, assistant vice president at AK Capital
Services.
(Source: Adopted from Reuters India,. ‘RBI To Hold Rates Steady, Growth Seen Rising
S
To 7.3 Pct In Sept Quarter - Reuters Poll’.)
questions
IM
1. Why was the repo rate cut by 50 basis points in September
2015 by RBI?
(Hint: to counteract the decrease in global growth.)
2. Why would RBI take precautions in the coming future?
(Hint: the Federal Reserve is likely to increase the interest
M
rate of US.)
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Case study 8
n o t e s
EVOLUTION OF agricultural nbfcs IN INDIA
This Case Study discusses the expansion of agricultural warehous-

ing organisations as agricultural non-banking financial companies
in India. It is with respect to Chapter 8 of the book.
Agricultural Non-Banking Financial Companies (NBFCs) are

springing up all over India to provide financial support and ser-
vices to farmers and businesses related to farming.
Several agricultural warehousing organisations have begun their

own NBFCs such as Sohan Lal Commodity Management Private
Limited, Star Agriwarehousing and Collateral Management Lim-
ited, and Shree Shubham Logistics Limited. There are a few oth-
er organisations that are in the process of exploring this option
S
such as National Bulk Handling Corporation and National Collat-
eral Management Services Limited.
Agricultural NBFCs’ aim of providing the farming sector with fi-

IM
nancing would be beneficial for their core warehousing business.
We have already started an agri-NBFC—StarAgriFinance—fo-

cused on farmers and agriculture related entrepreneurs, said Am-
ith Agarwal, Director at Star Agriwarehousing, which is a firm
engaging in agri-business solutions. In April 2014, Temasek Hold-
M
ings and IDFC Private Equity bankrolled a sum of ` 400 crores

into the company, part of which will be invested in the NBFC.
Raylight Leasing and Finance Limited was acquired by StarA-

gri Finance. StarAgri Finance is owned by Star Agriwarehousing.
N
Raylight Leasing and Finance is an NBFC registered with the Re-

serve Bank of India. StarAgri Finance is going to provide finan-
cial backing in lieu of agricultural assets like land and crops. It
also provides loans for purchase of agricultural equipment, tools
and machinery.
We have a portfolio of ` 100 crore which we wanted to make ` 2,000

crore in next three to four years. We have invested ` 150 crore as
capital for this business, Agarwal said.
Agarwal is of the opinion that entering into the NBFC business

would prove to be beneficial for Star Agriwarehousing as the or-
ganisation plans on substantially increasing its warehousing ca-
pacity from the current 16 lakh tonnes to 50 lakh tonnes in the
next 3-4 years.
We know the ground level reality. We understand that access to af-

fordable finance to enhance farm productivity and agriculture in-

Case study 8: EVOLUTION OF agricultural nbfcs IN INDIA 283
Case study 8
n o t e s
frastructure can change the financial future of a farmer household,

Agarwal said.
Sohan Lal Commodity Management is also planning to follow in

the footsteps of StarAgri Finance, which is being backed by Nex-
us Venture Partners and ICICI Bank.
Sohan Lal set up Kissandhan, its agri-NBFC, in March 2014. It is

now offering financing solutions to small agro processing units,
farmers and traders that engage in sale and purchase of agricul-
tural products.
The CEO of Sohan Lal Commodity Management, Sandeep

Sabharwal, has confessed that entering the agri-finance market
was a logical decision for them.
S
The idea was to provide a one-stop solution to the end user with
a diversified portfolio of services ranging from warehouse man-
agement, agriculture financing, collateral management to procure-
IM
ment. It helps the farmer and all stakeholders of the agriculture val-
ue chain to store the harvest safely and also get the finance against
his collateral, Sabharwal said.
Sohan Lal has provided loans within the range of ` 42 lakhs to

` 5 crores at an average interest rate of 14-15 per cent. Through
Kissandhan, it had provided loans to the tune of ` 130 crores till
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March 2015, having begun the organisation in July 2014 only.
Vibha Batra, Senior Vice-President of Icra Limited, which is an

Indian credit rating agency, says that providing loans to small
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farmers is a field where banks do remain active in order to fulfil

their social objectives.
Specialized entities like these could create niches for themselves

in other parts of agricultural lending, provided they manage their
credit cost well. As of now, some rice mills and sugar companies
already lend to farmers. With companies choosing the NBFC route,
more and more such activities will come under regulatory purview
and there can be better monitoring of these activities, Batra said.
(Source: Adopted from: Sanjai, P. (2015). The emergence of agricultural NBFCs in India.
http://www.livemint.com/.)
questions
1. Why does Star Agriwarehousing believe that entering the

agri-finance market would be beneficial for the company?
(Hint: The organisation plans on substantially increasing
its warehousing capacity from the current 16 lakh tonnes
to 50 lakh tonnes in the next 3-4 years.)

Case study 8
n o t e s
2. What is the idea behind Sohan Lal Commodity

Management entering the agri-finance market and why is
the decision logical?
(Hint: to provide a one-stop solution to the end user
with a diversified portfolio of services ranging from
warehouse management, agriculture financing, collateral
management to procurement.)
S
IM
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N

Case study 9
n o t e s
development of msme sector by sidbi
This Case Study discusses the steps taken by SIDBI to promote and
develop the MSME sector of India. It is with respect to Chapter 9 of
the book.
The Small Industries Development Bank of India (SIDBI) has

established a ‘Make in India’ fund worth an estimated ` 1000
crores for Micro, Small and Medium Enterprises (MSMEs). The
objective is to make our MSMEs world class manufacturing hub.
Under the fund, concessional finance will be provided to the identi-
fied MSME sectors, the bank added.
Kshatrapati Shivaji, an IAS and the CMD of SIDBI, has recently

spoken about the bank having operated in the MSME sector for
S
25 years now and how it has tended to several credit and devel-
opmental shortcomings in the MSME eco-system. In last 25 years,
SIDBI has provided financial assistance of ` 3.90 lakh crore which
IM
benefitted 346 lakh people in the MSME sector, he said.
SIDBI has granted microcredit to the tune of ` 9374 crores through

Micro Finance Institutions (MFIs). It has pledged an amount of
` 162 crore equity financial backing to 56 MFIs in order to rein-
force their capital base to be able to provide higher credit to the
microfinance sector. The microfinance support provided by SID-
M
BI has proved beneficial for more than 332 lakh underprivileged

people with a majority of them being women. It has helped to re-
alise a better quality of life with improvement in their health and
education conditions, as well as better social security.
N
SIDBI encourages developmental support in various fields such

as capacity building of Regional Rural Banks (RRBs) and promo-
tion of youth entrepreneurship in the country. It also provides
advisory services free of cost through various MSME centres in
order to offer additional credit for areas such as rural industrial-
isation, micro units, skill development, etc. These developmental
support of SIDBI helped in setting up of more than 1 lakh units and
skill development of more than 2 lakh people in the MSME sector,
Shivaji said.
SIDBI is endorsing energy efficiency in the MSME sector. It has

even entered into an agreement with the World Bank for ‘Par-
tial Risk Sharing Facility for energy efficiency (PRSF) projects’.
These projects have an estimated budget of $US 43 million, in-
cluding a guarantee fund of $US 37 million plus technical assis-
tance amounting to $US 6 million. The aim of this project is to
help the Indian government in the transformation of the Energy
Efficiency (EE) market of the country. This would be achieved by

Case study 9
n o t e s
boosting EE investments through the usage of Energy Service

Performance Contracting (ESPC) by Energy Service Companies
(ESCOs).
(Source: Adopted from: The Times of India,. (2015). SIDBI sets up ` 1000 crore ‘Make in
India’ fund for MSMEs - The Times of India. Retrieved 28 November 2015.)
questions
1. What is the objective behind setting up the ‘Make in India’

fund by SIDBI?
(Hint: to make India’s MSMEs a world class manufacturing
hub.)
2. What steps have been taken by SIDBI to promote EE in
the MSME sector of India?
S
(Hint: entered into an agreement with the World Bank for
‘Partial Risk Sharing Facility for energy efficiency (PRSF)
projects.)
IM
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N

Case study 10
n o t e s
SEBI ADVISES TO LIMIT RISK EXPOSURE OF

MUTUAL FUNDS
This case study discusses the reduction of exposure to mutual funds

and the steps being taken by SEBI to achieve it. It is with respect to
Chapter 10 of the book.
The Securities and Exchange Board of India (SEBI) is expected

to announce a sectoral cap and an exposure limit for single com-
panies, which would invest in corporate bonds by fixed income
mutual funds. Currently, the level of investment for single com-
panies is up to 15 per cent in mutual funds. These mutual funds
would help in easing unnecessary credit risks and avert the risk
of loss of monies of investors in case the bonds become illiquid.
S
“We are working on investment exposure norms for mutual funds.
There could be some sort of sectoral cap or single-company in-
vestment limit (in terms of bonds). The new norms will be an-
nounced soon,” U. K. Sinha, chairman, SEBI, said.
IM
This would help in prevention of crises similar to the one which
occurred in the two fixed income mutual funds operated by J. P.
Morgan Asset Management (India) Pvt. Ltd.
In relation to the crisis in J. P. Morgan, which suffered a rating

M
downgrade in the bonds issued by it and a subsequent decline in

the net assets’ value, Sinha opined that the mutual fund industry
management of the debt schemes is not done in a careful manner.
Moreover, credit rating norms need to be addressed in particu-
lar areas. “Mutual funds did not exercise adequate caution while
N
investing,” Sinha said. He also proposed that the rating of bonds

held by a company cannot be suspended in an abrupt manner
by credit rating agencies without providing relevant intimation.
Sinha insisted for more transparency and better disclosures with
respect to the ratings.
“One day, the credit rating agency maintains a high investment

grade for a given paper, and suddenly the rating is downgraded.
Is it because the company didn’t pay the credit rating agency or
is it something more serious? Such processes need to be more
streamlined and rating agencies must enable investors to take in-
formed investment decisions,” Sinha said.
In October 2015, SEBI asked asset management companies

(AMCs) to refrain for being dependent on credit rating agencies
entirely for assessment of their portfolio’s corporate bond invest-
ments.
SEBI and Association of Mutual Funds of India had requested mu-

tual funds to evolve internal credit appraisal systems at a meeting

Case study 10
n o t e s
held among their officials in order to address the dependence on

rating agencies.
The rating agencies have come under criticism for harsh and
abrupt decreases of corporate debt which had a severe effect on
the fixed income portfolio of mutual funds. For example, J. P. Mor-
gan AMC suffered a redemption crisis due to the downgrade of
Amtek Auto Ltd. bonds.
Due to these incidents, SEBI has cautioned AMCs to refrain from

undertaking unnecessary credit risks by making investments in
organisations which are burdened by loans and are at the risk of
suffering potential downgrades in their credit ratings.
Securities of net worth ` 4000 crore were degraded in value which
S
were controlled by AMCs in July, 2015. By August end, this num-
ber rose up to ` 13000 crore according to a data report revealed by
SEBI in October, 2015.
IM
SEBI had questioned AMCs to clarify their reasons for investing
in corporate bonds since SEBI wanted to avert another redemp-
tion crisis like the crisis encountered by J. P. Morgan AMC. Two
schemes of the AMCs suffered losses of ` 193 crore due to expo-
sure meted out to bonds held by Amtek Auto. Amtek Auto’s bonds
were downgraded by credit rating agencies due to the company’s
M
worsening financial situation.

(Source: Adopted from Laskar, Anirudh. ‘Sebi To Introduce Investment Cap For Debt
Mfs’. http://www.livemint.com/.)
questions
N
1. Why did SEBI ask asset management companies to

refrain from being completely dependent on credit rating
agencies for assessment of their portfolio’s corporate
bond investments?
(Hint: as credit rating agencies were suspending
bonds abruptly without providing relevant information
regarding their rationale for doing so.)
2. Why have the credit rating agencies come under criticism?
(Hint: for harsh and abrupt decreases of corporate debt
which had a severe effect on the fixed income portfolio of
mutual funds.)

Case study 11
n o t e s
World bank’s Strategy to counteract climate

change in africa
This Case Study discusses a strategy to be implemented in Africa

by the World Bank to alleviate poverty by taking proactive mea-
sures against climate change. It is with respect to Chapter 11 of
the book.
The World Bank has prepared a strategy costing US$16bn to aid
Africa in adaptation to climate change and thus avert the scenario
where millions of people occupying the continent would face the
prospect of poverty.
The bank has begun implementing new measures such as accel-
erating clean energy, urban protection and efficient farming as
part of the abovementioned strategy to augment the availability
S
and production of renewable energy and food production. It has
also started the process of planting several thousand trees in Afri-
ca. These measures would help in improving the living conditions
IM
for people in the cities, as well as leading to reduction in conflict,
poverty and migration of people.
Jim Yong Kim who is serving as the president of World Bank has
said that Africa despite emitting just 3 per cent of the total green-
house gas emissions in the world would be the most affected if
there is the slightest rise in global temperatures across the world.
M
The bank has estimated that Africa would need to spend in the
vicinity of US$5-10bn, rising to US$20-50bn by 2050 if global tem-
peratures are to increase by 2C and to US$100bn if global tem-
peratures are to increase by 4C.
N
Sub-Saharan Africa is highly vulnerable to climate shocks, and

our research shows that could have far-ranging impact on every-
thing from child stunting and malaria to food price increases and
droughts, said Kim.
The bank has enumerated in its report that even if global tempera-
tures would not go beyond 2C, sub-Saharan Africa would suffer
from extensive increases in the instances of poverty and malnutri-
tion. However, if the temperatures are to increase by 3-4C, which
might happen if no action is undertaken, around 70-80 per cent
of Africa’s land would suffer from heat waves, and a large part of
southern and central Africa would be at a severe risk of drought.
African cities would be affected but disproportionately. The prob-
lem will affect a growing number of people, as the urban population
of Africa is estimated to rise from its current level of 472 million to
659 million by 2025 and 1 billion by 2040. The poor will be especially
hard hit, said the bank.
Dakar experiences recurrent flooding; the 2009 floods affected al-
most 360,000 people and caused $100m in damages and losses. Re-

Case study 11
n o t e s
current floods in Bangui, the capital of Central African Republic,

cause on average $7m in damages and losses a year. By 2025, about
66 new cities will be added to the 81 cities currently in the medi-
um-city range. This group of cities needs support to enhance their
capacity to manage climate-related risks.The World Bank has rec-
ommended that US$500mn be used to decrease deforestation and
enhance wildlife conservation and protection in 14 countries. The
bank is also targeting restoration of 100mn hectares of deforested
areas by the year 2030. Most of the money would be raised from
carbon funds and other earmarked initiatives discussed in Paris
at a convention where this project was presented.
The bank has further proposed that a further amount of US$2.5bn
should be spent on improving irrigation, massive flood protection
projects and dams in Cameroon, Benin, Nigeria, Guinea, Burkina
Faso, Ivory Coast, Chad and Mali. It would be sufficient to gener-
S
ate electricity for around 3 million people.
Moreover, around US$ 3.6bn would be invested in projects such
IM
as hydropower, flood control and irrigation in the countries be-
longing to the Zambesi basin such as Zimbabwe, Angola, Mozam-
bique, Zambia, Botswana, Tanzania, Malawi and Namibia.
Furthermore, an amount of US$ 2bn has been allocated for im-
proving transport and building protective measures against natu-
ral disasters for 20 unspecified countries.
M
There are plans on investing US$8bn by 2024 in Africa. This mon-

ey would be used for building solar power stations and augment-
ing the growth of mini-grids and harnessing of wind power. In
present times, more than 600 million people and around 10 mil-
N
lion small and medium enterprises are disconnected from the

electricity grid in sub-Saharan Africa.
The World Bank has decided that it would focus on investing in
the development of renewable energy on an urgent basis in Africa
with plans for the construction of dams in Cameroon and West
Africa already in place.
Hydropower currently provides 24% of sub-Saharan Africa’s pow-
er needs, and there is potential to increase this share to 40% over
the coming years. Some 50GW of hydropower could be developed
immediately, at costs of $0.01–$0.08/kWh. These prices make hydro-
power the lowest cost, largest scale renewable energy resource cur-
rently available to the region – with potential for transformative,
growth-inducing developmental impacts, says the report.
The bank also has plans to boost food production. More efficient
livestock systems would increase protein availability while reduc-
ing emissions per kilogramme of meat or dairy produced. Conser-
vation agriculture techniques would protect soils from wind and
water erosion. Weather information and early warning systems

Case study 11: World bank’s Strategy to counteract climate change in africa 291
Case study 11
n o t e s
would enable farmers to take better decisions, reducing risk and

protecting yields in uncertain climate and weather conditions.The
World Bank report has professed that poverty is intimately relat-
ed to climate change as most of the population living in sub-Saha-
ran African either is dependent upon rains for agricultural needs
or lives in drought-affected regions.
Climate variability is already exacting a heavy toll on development;
future change may have catastrophic impacts, as drought, floods,
and storm surges could push millions of people into poverty and pre-
vent millions of others from emerging from it, it says.
The bank is hopeful that it would raise US$5.7bn of the proposed
US$16.1bn from the International Development Association
(IDA), which raises funds for some of the poorest countries of the
world.
S
A further US$2.2bn is expected to be generated from climate fi-
nance institutions such as Global Environment Facility, Climate
Investment Funds and the Green Climate Fund. Around US$3.5bn
IM
is expected to come from private sources and a further US$2bn
from bilateral and multilateral sources. A projected US$0.7bn is
going to be raised from domestic sources, while a further US$2bn
is yet to be sourced.
The World Bank’s vice-president in Africa, Makhtar Diop, has
said that the plan proposed by the bank has paved a clear path for
M
addressing the continent’s pressing climate needs and accelerat-

ing the sourcing of requisite finance.
While adapting to climate change and mobilising the necessary re-
sources remain an enormous challenge, the plan represents a criti-
N
cal opportunity to support a priority set of climate-resilient initia-

tives in Africa, said Diop.
(Source: Adopted from: Vidal, John. ‘World Bank Calls For $16Bn To Help Africa Weath-
er The Effects Of Climate Change’. The Guardian.)
questions
1. What is the strategy to combat climate change in Africa

hoping to achieve?
(Hint: alleviate poverty, increase food production,
augment electricity generation, build dams, develop
renewable energy, etc.)
2. From which sources does the World Bank hope to raise
finances for this strategy?
(Hint: IDA; climate finance institutions; private, domestic,
bilateral and multilateral sources.)

Case study 12
n o t e s
Stock Market Efficiency and Financial Crisis

– An Indian Perspective
This Case Study discusses the testing of weak form of efficiency in

the Indian stock market during, before, and after the 2002 dotcom
bubble and 2007 sub-prime crisis. It is with respect to chapter 12 of
the book.
Financial economists have always debated on the validity of the

postulates of Efficient Market Hypothesis (EMH). According to
EMH, the market is efficient and at any moment, the market
prices of stocks assimilate all relevant information present in the
market. Therefore, the market price of stocks always reflects their
intrinsic value. This is why in an efficient market, an investor can
never buy an undervalued stock or sell an overvalued stock.
S
Stock market efficiency has a significant impact on the overall
economic growth of a country. Therefore, the concept of EMH is
very relevant for the development of the stock market and the
IM
overall economy. If the stock market is efficient, fundamental as
well as technical analysis becomes a futile exercise for an investor
as these techniques no longer enable an investor to earn an ex-
traordinary return above the stock market return.
OBJECTIVES
M
Kinjal Jethwani and Sarla Achuthan conducted a study to find

out the efficiency of the Indian stock market. The objectives of the
study were to:
N
1. investigate whether the Indian stock market is weak-form

efficient or not.
2. empirically test whether the Indian stock market follows
random walk or not.
3. examine whether the ‘time period of crisis’ alters the
conclusion of efficiency of the stock market.
LITERATURE REVIEW
In his PhD dissertation, Bachelier (1900) first proposed the the-

oretical foundation of EMH in the form of Random Walk Theo-
ry (RWT) by proposing that fluctuations in commodity prices
are random in nature. Researchers, such as Working (1934) and
Cowles and Jones (1937) also concluded that US stock prices and
other economic data also show random fluctuations.
Studies on weak form efficiency of the Indian stock market have

shown mixed results. A recent study conducted by Joshi (2012)

Case study 12: Stock Market Efficiency and Financial Crisis – An Indian Perspective 293
Case study 12
n o t e s
concluded that the Indian stock market is efficient in the short

run, but inefficient in the long run. Another study conducted by
Khan, Ikram and Mehtab (2011) concluded that the Indian stock
market is inefficient.
DATA AND METHODOLOGY
Researchers collected CNX Nifty closing price of the period start-

ing from 1st January 1996 to December 2012 from the official web-
site of NSE. The return of the time series was calculated by using
the following formula:
Rt = (lnPt-lnPt-1)×100
Where,
S
R is the return in the period t.
P is the daily share price of the NSE Nifty 50 for the period t.
IM
ln is a natural logarithm.
t-1 is the previous day.
The entire time is divided under the following periods:

1. 1996-2012 (Overall period)
M
2. 1996-2000 (Before dotcom bubble)

3. 2000-2002 (Dotcom bubble)
4. 2002-2007 (Before credit crisis)
5. 2007-2009 (Credit crisis)
N
6. 2009-2012 (After credit crisis)
This division was done to test market efficiency at different time

periods, i.e., before, after and during the crisis.
Next, statistical tools like descriptive statistics, Kolmogrov Smirn-

ov test, runs test, autocorrelation test and variance ratio test were
used for analysing the data.
The research had the following two null hypotheses:

The Indian stock market is weak form efficient market
The Indian stock market follows random walk
RESULT
The following is the overall results of the tests performed:

Case study 12
n o t e s
Overall Results of all the tests performed

Period Descriptive K S Test Runs Test Autocorrelation Variance
Statistical. Ratio
1996-2012 Not Random Not Random Not Random Not Random Not Random
2007-2009 Not Random Random Random Not Random Not Random
2009-2012 Not Random Not Random Random Not Random Not Random
Conclusion
The study concluded that the Indian stock market is not weak-
form efficient in all periods, and the trend shows that the market
S
has been behaving efficiently from the year 2012.
questions
IM
1. What is the practical application of the conclusion of the
study that the Indian stock market has been behaving
efficiently since 2012 for an investor?
(Hint: The market price of the stocks reflects their
intrinsic value. Fundamental and technical analysis are
of no help to an investor if he wants to outperform the
M
market.)
2. From the investor’s point of view, what does an ‘inefficient
market’ signify?
N
(Hint: An inefficient market gives rise to arbitrage

opportunities as a result of undervalued and overvalued
stocks.)


S
IM
M
N

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Financial Institutions and Markets

Financial Institutions and Markets

TOC Reviewer Content Reviewer

Chief Academic Officer

Author: Sanjive Saxena

Reviewed By: Ms. Manisha Mishra

NMIMS Global Access - School for Continuing Education

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Financial System: An Overview 1

Regulation in Indian Financial Market – Regulators and

Institutions in the Financial Market—

8 Non-banking Financial Institutions (Nbfis) 147

9 Development Financial Institutions 163

10 Mutual Funds, Insurance and Venture 181

11 International Financial Institutions 205

12 Efficient Market and Market Anomalies 225

13 Risk Management in Financial Institutions 243

14 Case Studies 265

NMIMS Global Access - School for Continuing Education

NMIMS Global Access - School for Continuing Education

Non-banking Financial Institutions (NBFIs): NBFI– An Introduction, Types of NBFIs, Importance of

Development Financial Institutions: History and Evolution of Development Financial Institution in

NMIMS Global Access - School for Continuing Education

FINANCIAL SYSTEM: AN OVERVIEW

1.4 International Financial System

Self Assessment Questions

NMIMS Global Access - School for Continuing Education

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

SEBI was established in 1988 as a regulator for the Indian secu-

SEBI performs a number of functions so that the financial system

The prime objective of SEBI is to protect the interests of inves-

 Regulate the functioning of the stock exchange

 Prevent fraudulent practices by implementing various rules

NMIMS Global Access - School for Continuing Education

After studying this chapter, you will be able to:

The financial system of a country is divided into various segments such

financial services. The efficiency of each segment adds to the efficien-

liberalised approach towards the financial framework of an economy.

The most prominent factor of ensuring the efficiency of the finan-

NMIMS Global Access - School for Continuing Education

1.2 INTRODUCTION TO FINANCIAL SYSTEM

The prime motive behind the functioning of a financial system is to

surplus funds to sectors having the shortage of funds. Thus, it can be

 A financial system creates a link between borrowers and lenders

NMIMS Global Access - School for Continuing Education

The financial system creates a platform where the various types of

system to regulate the functioning of the financial framework of

self assessment Questions

1. A financial system smoothens trade-related activities by

NMIMS Global Access - School for Continuing Education

INDIAN FINANCIAL SYSTEM AND ITS

1.3.1 STRUCTURE OF INDIAN FINANCIAL SYSTEM AND ITS

The Indian financial system is considered to be a complex system as

Financial Financial Financial Financial

Institutions Markets Instruments Services

Figure 1.1: Structure of the Financial System of India

A financial institution refers to an intermediary that mobilises sav-

NMIMS Global Access - School for Continuing Education

These bodies are the Ministry of Finance of India, Company Law

issuers and microloan organisations. The major NBFIs in India

Investors can invest their money in the financial market by purchas-

Major participants in the financial market include corporations, fi-

NMIMS Global Access - School for Continuing Education

Based on Based on Based on

Regulate the functioning of the stock exchange

Prevent fraudulent practices by implementing various rules

A financial system creates a link between borrowers and lenders

1.3.1 STRUCTURE OF INDIAN FINANCIAL SYSTEM AND ITS

The concept of FII was introduced to increase foreign equity in-

Initially, banks were required to keep a major portion of deposit as

Credit data sharing between banks for guarding against defaulters.

Introduction of measures to reduce the quantum of non-perform-

Participation of foreign players was enhanced by allowing FDI lim-