Financial Institutions and Markets (DSC) MC 303 - Compressed

M.COM.
III SEMESTER COURSE- MC 303
Financial Institutions
& Markets
Lesson 1-20
Dr. Suresh Sharma

Prof. Vijay Kaushal
International Centre for Distance Education and Open Learning

Himachal Pradesh University, Gyan Path
Summer Hill, Shimla - 171005
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CONTENTS
SR. NO. TOPICS PAGE NO.
Contents
Syllabus
Chapter-1. Indian financial system 5
Chapter-2. Indian financial system 15
Chapter-3. Money markets 24
Chapter-4. Capital market 30
Chapter-5. Money market instruments 40
Chapter-6. Government securities market 48
Chapter-7. Industrial securities market 55
Chapter-8. National depository securities in india 67
Chapter-9. Role of sebi and nsdl 75
Chapter-10. Commercial banking 87
Chapter-11. Merchant banking 100
Chapter-12. Regulation for merchant banking 114
Chapter-13. Reserve banking of india: central banking 123
Chapter-14. International and multinational banking 131
Chapter-15. Non- banking institutions 139
Chapter-16. Mutual fund in india – an overview 149
Chapter-17. Latest mutual fund schemes in india – an overview 160
Chapter-18. Universal banking 171
Chapter-19. Financial regulations and reforms- securities market 179
Chapter-20. Financial regulations and reforms- capital market 193
‘assignments’ 194
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MC303: FINANCIAL INSTITUTIONS AND MARKETS (DSC)
Max Marks 80
Internal Assessment 20
Note: There will be Ten (10) questions in all spreading into Five Units consisting of two questions from
each unit. The candidate will require to attempt one question from each unit. Each question will carry
Sixteen (16) marks
Course Objective: The purpose of this course is to equip students with an understanding of the financial
system, its constituents, the principles on which it operates, inter linkages, regulatory concerns, and
implications for society &policy formulation.
Course Contents:
Unit I
Introductory: Nature and role of financial system – Financial System and financial markets. An economic
analysis of financial system in India. Indian financial system – A critical analysis. Financial Markets: Money
and capital markets. Money market Instruments: Call money, treasury bills, certificates of deposits,
commercial bills, trade bills, etc. Capital market: Government securities market, Industrial security market,
Role of SEBI – and overview; Recent developments National Depository Securities Ltd. (NDSL), Market-
Makers.
Unit II
Money Market Institutions: Central bank: Functions and its role in money creation, Commercial banks;
Present structure.
Unit III
Introduction to International and Multinational banking. Non- Banking Institutions: Concept, role of
financial institutions, sources of funds, Functions and types of non-banking financial institutions.
Unit IV
Mutual Funds: The evaluation of mutual funds, regulation of mutual funds (with special reference to SEBI
guidelines), Performance evaluation, Design and marketing of mutual funds scheme; Latest mutual fund
schemes in India – An overview. Evaluating of mutual funds. Merchant Banking: Concept, function,
growth, government policy regarding Merchant banking business and future of merchant banking in India.
Unit V
Changing Role of Financial Institutions: Role of banking, financial sector reforms, financial and
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promotional role of financial institutions, universal banking; concept and consequences.
References:
Auerbach, Robert D, Money, Banking and Financial Markets; Macmillan Publishing Co; New York and
Collier MacMillan Publisher; London.
Avadhani, V.A., Investment and Securities Market in India; Himalaya Publishing House; Bombay…Khan,
M.Y., Indian Financial System –Theory and Practice; Vikas Publishing House; New Delhi.
Mishkin, Frederics, S., The Economics of Money Banking and Financial Markets; Harper CollinsPublisher;
New York.
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Lesson-1
Indian Financial markets
STRUCTURE
1.0 Learning Objectives
1.1 Introduction
1.2 Paradigm Shift in Financial Markets
1.3 Financial Markets
1.4 Corporate Securities Market
1.5 Problem Areas in the Financial System
1.6 Financial Markets: Emerging Trends
1.7 Rational of Financial Market Reforms
1.8 Indian Financial System: An Economic Analysis
1.9 self Assessment Exercise
1.10 Summary
1.11 Glossary
1.12 Answers to Self Check Exercise
1.13 Terminal Questions
1.14 Answers to Terminal Questions
1.15 Suggested Readings
1.0 LEARNING OBJECTIVES
After studying this chapter you should be able to:
1. Understand the financial systems and its functions.
2. Explain the perfect capital market.
3. Know the different markets to be found in the financial system.
1.1 INTRODUCTION
The rapid economic growth and globalization of financial markets is perhaps one of the most significant
developments at the international level. The past two decades have witnessed a process of
accelerating changes in the global financial markets. Driven by an interacting process of liberalization
and innovation, controls and regulations have been removed, new financial products have emerged
and old boundaries between financial intermediaries have blurred. Financial innovations have brought
many advantages. A large number of financial assets and liabilities are not available to end-users. The
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costs of financial intermediation have fallen. Risk management tools have become increasingly
sophisticated. Global economics have found new ways to mobilize domestic and international savings.
In comparison with newly industrializing countries and ASEAN countries, India’s economic growth may
not measure up to the potential. Nonetheless, the liberalization policies have definitely helped the
country in recording better performance. However, the significant policy pronouncement that has been
made since the middle of 1991 had certainly improved the growth and performance of the economy
during the last few years.
With the objective of bringing about a highly competitive system and promoting efficiency in the real
sectors of the Indian economy, recently economic reforms in the areas of trade, industry, and the
exchange rate system have been undertaken to correct economic imbalances and bring about
structural adjustments. The liberalization and supportive policies of the Government have gained
momentum on the last few years with major plan of diversification, expansion and modernization of the
industrial sector in the country. This has led to an increased demand for funds and encouraged
authorities to find out alternative source of finance for industry. Since the conventional budgetary
support cannot be of any positive help to the public section, and at the same time the private help of the
public sector, and at the same time the private corporate sector which used to depend heavily on banks
and financial institutions in the past, now collects funds from the capital markets.
The Indian financial markets play a crucial role in economic development through the saving-
investment process, also known as capital formation. A vibrant and competitive financial market is a
necessary concomitant to gain the benefits of liberalization policies and to sustain the ongoing reforms.
Many financial reforms were undertaken to improve the efficiency and stability of the financial system.
The process of liberalization initiated by the Government has not been new but prior piecemeal efforts
were not stable and widespread. The structural reforms initiated during the period 1991-95 years have
had a 'positive impact on the investment climate of the country. The new economic policies aimed to
liberalization and globalizations are all embracing consistent and appear to be irreversible. The country
has pursued conservative, inward looking policies for almost four decades. The positive effects of these
policies may be there, but they are outweighed by their negative impact of inefficiency, corruption,
delays and the non-competitive nature of the industrial/economic environment. May mightily socialists
economics have crumbled under their own weight and India could very well imagine what is in store for
it, if it did not change its course.
In its bid to open up the country’s economy, the Government of the India has geared up the financial
sector to meet the Global challenges. As such, Indian financial markets are undergoing a process of
rapid change, which has transformed the entire complexion of the financial system. The Government of
India during the last several years announced a number of measures to make the Indian financial
markets more potent and. capable of raining vast resources from the .domestic market and abroad.
1.2 PARADIGM SHIFT IN FINANCIAL MARKETS
Financial markets play a vital role in mobilization and collection of savings in the economy that provides
useful inputs for formulation, implementation of policies and thus facilitate liquidity management, which
is consistent with the macro-economic policy objectives. In Indian context, Government of India,
Reserve Bank of India, Securities and Exchange Board of India are the major regulators of the financial
market, which play crucial role both pro-actively and recovery in the development of financial market.
Financial sector reforms viz., localization, liberalization and deregulation along with technological
advancement has integrated international markets which has facilitated the scope for uninterrupted
mobility of funds in various financial markets of the world.
Financial services are in a process of acquiring new meanings and dimensions. In this context, the law
of survival of the fittest would apply and thus only those who respond to the changes in the environment
and suitably modify their Structure, organization, procedures and process can think of growth and
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survival. As it is well known that Indian financial system was tailored keeping in view the requirements
of the mixed economy. But the domestic as Well as global contexts have dramatically changed during
nineties. Therefore, it would be relevant to have a look at the status and future of financial sector and
thus accordingly the changing role of market regulator. The challenges before various intermediaries of
financial sector and also the regulators arise because something has happened which tells us that
things cannot go as they used to go in the past.
1.3 FINANCIAL MARKETS

A real transaction that involves exchanges of money for real goods or services, whereas a financial
transaction involves creation or transfer of a financial asset. Financial transactions includes issue of
equity stock by a company purchased of bonds in the secondary market, deposit of money in a bank
account, transfer of funds from a current account to a saving account. The financial transactions are
very pervasive throughout the economic system.
Hence financial markets, which exist where ever financial transactions occur, are equally pervasive.
There are two broad segments, of the financial market, viz. the money market and the capital market.
The money market deals with short-term debt, whereas the capital market deals with long-term debt
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and stock (equity and preference). Further, each of these markets has a primary segment and a
secondary segment. New financial assets are issued in the primary market, whereas outstanding
financial assets are traded in the secondary segment.
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1.4 CORPORATE SECURITIES MARKET
The capital market is the market of financial assets that have long or indefinite maturity. The Figure 2
depicts the components of India Corporate Securities Market. When a company wishes to raise capital
by issuing securities or other entity intends to raise funds through units, debt instruments, bonds, etc., it
goes to the primary market which is the segment of the capital market where issuers exchange financial
securities for long-term funds. The primary market facilities the formation of capital.
There are three ways in which a company may raise capital in the primary viz., market-public issue,
right issue, and private placement. Public issue, which involves sale of securities to members of the
public, is the most important mode of raising long-term funds. Rights issue is the method of raising
further capital from existing shareholder by offering additional securities to them on a pre-emptive
basis. Private placement is a way of selling securities privately to a small group of investors.
The secondary market of India, where outstanding securities are traded, consists of the stock
exchanges which are self-regulatory bothes under the overall regulatory purview of the
government/SEBI. Recently, SEBI has proposed the trading in futures and options (capital market
derivatives): Accordingly, the definition of securities under SCRA will have to be amended.
The government has accorded powers to the Securities and Exchange Board of India (SEBI), as an
autonomous body, to oversee the functioning of the securities market and the operations of
intermediaries like mutual funds and merchant bankers, underwriter’s portfolio managers, debenture
trustee, hankers to an issue, sub brokers. FIIs (Foreign Institutional Investors), plantation companies
schemes including rating agencies and also to prohibit insider trading.
1.5 PROBLEM AREAS IN THE FINANCIAL SYSTEM
One of the basic problem with the financial system is that “it continues to the fragmented by artificial
barriers hindering smooth flow of resources making it inefficient (although the present economy has
taken the initiatives in the trisection of taking away these barriers and to make financial
markets/systems smooth and progressing) and expensive. Although, the financial sector reforms seeks
to address the problem of a fragmented system yet there is a scone for further improvement in the
system.
Hence to conclude Financial Markets. Services and institution in India are taking shape for. turbulent
times and various intermediaries, market participants and institutions are gearing themselves to meet
the challenges of change.
1.6 FINANCIAL MARKETS: EMERGING TRENDS
The rapid growth and globalization of financial markets is perhaps one of the most significant
developments in the world economy. This development has far reaching consequences, not only for
financial markets per se but the growth and direction of world business. No other development has
contributed so much to |the growth of inter-dependence among the nations. Total volume of funds
made available through these markets for exceed the flows of the un sponsored international financial
institutions.
In its bid to open up the country’s money, the Government of India has geared up the financial sector to
meet the challenges, which economy is likely to face. As such Indian financial market is undergoing a
process of rapid change which as transformed the entire complexion of financial system. The
Government of India during last few years have announced a number of measures to make the Indian
financial markets more potent and capable of raising vast resources from the domestic market and
abroad. This chapter discusses some of these aspects emerging from structural changes in financial
markets.
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Financial deregulation and innovations have changed the whole structure and functioning of financial
markets of many industrialized countries since the beginning of 1970s.
This trend also influenced the growth of financial systems of several countries in the Asia Pacific region
during 1980s and 1990s. The developments relating to globalization of financial markets, market
oriented financial structure, evolution of regional trading blocks like EEC. Asia-Pacific, North America,
etc. growth of investment banking, narrowing of functional differentiation between banking etc. are in
general the results of the above changes.
In comparison with Newly Industrializing Countries and ASIAN countries, out-economic growth may not
measure up to the potential nonetheless the liberalization policies have definitely helped the country in
recording better performance in the 1980s. However the significant policy pronouncements since the
middle of 1991 onwards certainly improved the growth of economy during the first subsequent years of
reform process.
1.7 RATIONALE OF FINANCIAL MARKET REFORMS
With the objective of bringing about a highly competitive system and promoting efficiency in the real
sectors of the Indian economy, recent economic reforms in the areas of trade, industry and exchange
rate system have been undertaken to coned the macro-economic imbalances and to bring about the
structural adjustments. The liberalization and supportive policies of the Government have gained
momentum in the last few years with major plans of diversification, expansion and modernization of
industrial sector in the country. This has led to an increased demand for funds and encouraged
authorities to find out alternative sources of finance for the industry. Since the conventional budgetary
support cannot he of any positive help to the public sector and the private corporate sector which used
to depend heavily on banks and financial institutions in the past, now collects funds from the capital
markets.
The Indian financial markets play a crucial role in economic development through, saving investment
process, also known as capital formation. A vibrant and competitive financial market is necessary
concomitant of trade and industrial policy liberalization to sustain the ongoing reform in the structural
aspects of the real economy. Many financial sector reforms were undertaken to improve the efficiency
and stability of the financial system and internal and external development which made it increasingly
difficult to maintain a rightly regulated financial system.
The process of liberalization initiated by the Government has not been new but prior piecemeal efforts
were not stable and widespread. The structural reforms initiated during since 1991 have had a positive
impact on the investment climate of the country. The new economic policies aimed at liberalization and
globalizations are all embracing, consistent and appear to be irreversible. The country has pursued
conservative, inward looking policies for almost four decades. The positive effect of these policies may
be many but they are out weighed by their negative impact of inefficiency, corruption, delays and non
competitive nature of industrial / economic environment. Many mighty socialist economies have
crumbled under their dead weight and India could very well imagine what is in store for it, if it does not
change the course. The whole nation is in a mood for change at the beginning of the new' century and
liberalization process is getting a fair trial in spite of scams and corruption charges.
Capita] market which is concerned with the supply of long-term funds in response to gradual
liberalization of economic and industrial policies since the beginning of eighties resulted in a virtual
capital market revolution. In its bid to open up the country’s economy, the Government of India has
geared up the financial sector to meet the challenges, which economy is likely to face. As such Indian
financial markets are undergoing a process of rapid change which has transformed the entire
complexion of financial system. The Government of India during last few years have announced a
number of measures to make the Indian financial markets more potent and capable of raising vast
resources from the domestic market and abroad.
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The purpose of this chapter is to examine the developments in the Indian financial markets, as a resu lt
of liberalized policy of the government The objective is to review the policy changes initiated to tap the
international resources for the development of the economy.
1.8 INDIAN FINANCIAL SYSTEM: AN ECONOMIC ANALYSIS
The role of money and finance in economic activities is a much discussed topic among economists.
The issue has been looked at differently in various branches of Economics. Is it possible to influence
the level of economic activities, that is the level of national income, employment, and so on, through
variations in the supply and volume of money and credit? How far can economic fluctuations or
business cycles be controlled by manipulating the period of production on the one hand and the
monetary factors on the other? How far is development a matter of financing capital formation?
Although money and finance by themselves cannot bring about economic development, it is now
agreed that they do play a significant role in bringing, about economic development. Given the real
resources and suitable attitudes, a well-developed financial system can contribute materially to the
acceleration of economic development.
Thus, the role of financial system is to accelerate the rate of economic development, and thereby
improve the general standard of living, and increase the social welfare. This is achieved through the
mobilization and increase of savings and investment, i.e. by stimulating the accumulation of capital and
by allocating capital efficiently for socially desirable and productive purposes. This, in turn, is achieved
by financial markets by performing a number of important and useful proximate functions or by
providing a number of services such as (i) enabling economic units to exercise their time preference,
(ii) separation, distribution, diversification, and reduction of risk, (iii) efficient operation of payment
mechanism, (iv) transmutation or transformation of financial claims so as to suit preferences of the
savers and borrowers, (v) enhancing liquidity of financial claims through securities trading, and
(vi) portfolio management. Let us briefly describe the process through which the financial system
contributes to economic development.
Economic development is to a very great extent dependent on the rate of investment or capital
formation which, in turn, depends on whether finance is made available in time, and the quantity of it,
and the terms on which it is made available. In any economy, in a given period of time, there are some
people whose current expenditures are less than their current incomes, while there are others whose
current expenditures exceed ‘their current incomes. In current terminology, the former are called the
ultimate savers or surplus-spending- units, and the latter are called the ultimate investors or the deficit-
spending-units.
Modern economies are characterized (a) by the ever-expanding nature of business organizations such
as joint-stock companies or corporations; (b) by the ever-increasing scale of production; (c) by the
separation of savers and investors; and (d) by the differences in the attitudes of savers (cautious,
conservative, arid usually averse to taking risks) and investors (dynamic and risk-takers). In these
conditions of what Samuelson calls the dichotomy of saving and investment, it is necessary to connect
the savers with the investors. Otherwise, savings would be wasted (hoarded) for want of investment
opportunities, and investment plans will have to be abandoned for want of savings. The function of a
financial system is to establish a bridge between the savers and the investors and thereby help the
mobilization of savings and thus enable the fructification of investment ideas into realities. Figure.3
reflects such a role of the financial system in economic development.
A financial system also directly helps to increase the volume and rate of savings by supplying
diversified portfolio of financial instruments, offering investment inducements and choices which are in
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keeping with the array of savers’ preferences. It becomes possible for the deficit-spending units to
undertake more investment expenditures because the financial system enabled them to command
more capital. As Schumpeter has said, without the transfer of purchasing power to him, an
entrepreneur cannot become the entrepreneur.
A financial system not only encourages investment, it also efficiently allocates resources in different
investment channels. It helps to sort out and rank investment projects by sponsoring, encouraging, and
selective supporting of business units or borrowers through project appraisal, feasibility stuthes,
monitoring, and generally keeping a watch over the execution and management of projects.
Fig.3 Relationship between financial system and economic development
The contribution of a financial system to the development process goes beyond merely increasing prior
saving based investment.
It plays a positive and catalytic role by providing finance or credit through creation of credit in
anticipation of savings. This, to a certain extent, ensures the independence of investment from saving
in a given period of time. According to Schumpeter, Keynes, and Kalecky, the investment financed
through created credit generates the appropriate level of income which, in turn leads to an amount of
savings which are equal to the investment already undertaken. The First Five Year Plan in India echoed
this view when it stated that the judicious credit creation in production and availability of genuine
savings has also a part to play in the process of economic development. It is however, to be noted that
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this role assumes that investment out of created credit is not faulty and that it results in prompt income
generation. If this assumption is not fulfilled, the initial credit creation results in sustained inflation rather
than sustained growth.
Another contribution of a well-developed financial system is to facilitate the normal production-process
and exchange of goods, and to enlarge markets over space and time. In other words, financial system
enhances the efficiency of the function of medium of exchange and thereby helps in economic
development.
The relationship between economic development and financial development is symbiotic or mutually
reinforcing. While financial markets accelerate development, they, in turn, grow with economic
development. In the words of Schumpeter, “the money market is always... the head quarters of the
capitalist system, from which orders go out to its individual divisions, and that which is debated and
decided there is always in essence the settlement of plans for further development. All kinds of credit
requirements come to this market; all kinds of economic project are first brought into relation with each
other and contend for their realization in it; all kinds of purchasing power flows to it to be sold. This
gives rise to a number of arbitrage operations and intermediate manoeuvres which may easily veil the
fundamental thing Thus, the main function of the money or capital market is trading in credit for the
purpose of financial development. Development creates and nourishes this market. In the course of
development, it becomes the market for sources of income themselves.
1.9 SELF CHECK EXERCISE:-
1. Define ‘Financial Market’.
2. What is ‘Financial System’?
3. What is ‘Security Market’?
4. What is ‘Financial Structure’?
1.10 SUMMARY
Indian financial markets are sub-divided broadly into money markets (that deal in short-term funds) and
capital markets (that deal in long-term funds). Structurally, money market comprises both organised
and unorganised sectors. Unorganised sector is normally made up of indigenous money lenders and
bankers who do not follow formal lines of business. Their businesses are informal and thus
independent of the Reserve Bank of India or banks for any fund support. This sector is shrinking but,
during the period of economic reforms launched after 1991, the activities of these institutions have
become a matter of serious concern and anxiety. The organised component of money market consists
of the RBI, commercial banks and cooperative banks. The RBI is the head of the financial institutions
as well as the monetary authority of the country. In the diagram, we have not shown anything about the
RBI.
1.11 GLOSSARY
Bank: Bank is a financial institution where customers can save or borrow money. Banks also invest
money to build up their reserve of money. Banks may give loans to customers under an agreement to
pay the money back to the bank at a later time, with interest.
Finance: Finance is a broad term that describes activities associated with banking, leverage or debt,
credit, capital markets, money, and investments. Finance also encompasses the oversight, creation,
and study of money, banking, credit, investments, assets, and liabilities that make up financial systems.
Financial Institution: Financial Institution is a company engaged in the business of dealing with
financial and monetary transactions such as deposits, loans, investments, and currency exchange.
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Financial System: Financial system is a system that allows the exchange of funds between
lenders, investors, and borrowers. Financial systems allow funds to be allocated, invested, or
moved between economic sectors. They enable individuals and companies to share the associated
risks.
Monetary System: Monetary system is something related to money or currency. The system
wherein people pay with dollar bills and other paper money is an example of the monetary system.
1.12 ANSWERS TO SELF CHECK EXERCISE
1. Refer to Section 1.2
1.13 TERMINAL QUESTIONS
1. What do you understand by financial system?
2. Discuss the functions of the financial system?
3. Discuss the functions of financial market?
4. Discuss the different markets to be found in the financial system?
1.14 ANSWERS TO TERMINAL QUESTIONS
1. Refer to Section 1.1, 1.2 & 1.3
3. Refer to Section 1.6 & 1.7
1.15 SUGGESTED READINGS
1. Pathak Bharati (2018). Indian Financial System. Pearson Education; Fifth edition.
2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall of
India,
3. Meir Kohn (2013). Financial Institutions and Markets. Oxford University Press
4. Rajesh Kothari (2012). Financial Services in India: Concept and Application, Sage
publications, New Delhi.
5. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain Book
Agency, Mumbai.
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CHAPTER 2
INDIAN FINANCIAL SYSTEM
STRUCTURE
2.1 Introduction
2.2 functions of the financial system
2.3 important functions of the financial system
2.4 problem areas in the financial system
2.5 nature of financial system
2.6 financial markets
2.8 Summary
2.9 Glossary
 Indian Financial System
 Functions of the Financial System
 Problem Areas in the Financial System
 Nature of financial system
2.1 INTRODUCTION
The financial system consists of a variety of institutions, markets and instruments. It provides
the principal means by which savings arc transformed into investments. Given its role in the
allocation of resources, the efficient functioning of the financial system is of critical importance to
a modem economy.
The Indian financial system is a complex and multifaceted network of institutions, markets, and
regulators that plays a crucial role in the country's economic development. It encompasses a
wide range of financial institutions, including commercial banks, cooperative banks, non-banking
financial companies (NBFCs), insurance companies, and mutual funds, among others. These
institutions collectively provide various financial services, such as savings and lending,
insurance coverage, investment opportunities, and risk management tools to individuals and
businesses.
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The Indian financial markets are divided into two primary segments: the money market and the
capital market. The money market deals with short-term instruments and transactions, such as
treasury bills and commercial paper, while the capital market focuses on long-term investments,
including stocks, bonds, and other securities. These markets provide a platform for individuals
and businesses to raise capital and invest their savings, driving economic growth.
Regulation and oversight of the Indian financial system are carried out by several key regulatory
bodies, including the Reserve Bank of India (RBI), the Securities and Exchange Board of India
(SEBI), the Insurance Regulatory and Development Authority of India (IRDAI), and the Pension
Fund Regulatory and Development Authority (PFRDA). These agencies work together to
maintain financial stability, protect investors, and ensure the integrity of the financial system.
In recent years, the Indian financial system has witnessed significant reforms and modernization
efforts, including the adoption of digital payment systems and the promotion of financial
inclusion through initiatives like Jan Dhan Yojana. These measures have made financial
services more accessible to a broader segment of the population and have contributed to the
country's economic progress. However, challenges such as non-performing assets (NPAs) in
the banking sector and ensuring equitable access to financial services in rural areas continue to
be areas of focus for policymakers and regulators. Overall, the Indian financial system remains
a critical pillar of the nation's economic infrastructure, supporting growth and development in
diverse sectors of the economy.
2.2 FUNCTIONS OF THE FINANCIAL SYSTEM
In modem economy, the financial system performs the following functions.
a) It provides a payment system for the exchange of goods and services.
b) It enables the pooling of funds for undertaking large scale enterprises.
c) It provides a mechanism for spatial and temporal transfer of resources.
d) It provides a way for managing uncertainty and controlling risk.
e) It generates information that helps in coordinating decentralized decision-making.
f) It helps in dealing with the problems of informational asymmetry.
A well-developed financial system offers a variety of instruments that enable economic agents to
pool price and exchange risk. It provides opportunities for risk pooling and risk sharing for both
household and business firms. As Robert Merton says:
“It facilitates efficient life-cycle risk bearing by households, and it allows for the separation of the
providers of working capital for real investments (i.e., personnel, plant and equipment) from the
providers of risk capital who bear the financial risk of those investments.”
Mainly, financial instruments, financial institutions, and financial markets constitute the financial
system. Financial instruments range from the common (coins, currency notes, demand deposits,
corporate debentures, gilt-edged securities, equity shares, units, agro-bonds) to the more exotic
(future-and options). Financial instruments may be viewed as financial assets and financial
liabilities.
Financial assets represent claims against the future income and wealth of others. Financial
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liabilities, the counterparts of financial assets, represent promise to pay some portion of
prospective income and wealth to others. Financial assets and liabilities emanate from the basic
process of financing. They distribute the returns and risks of economic activities to a variety of
participants.
The important financial assets and liabilities, claims and promises, in India are as follow:-
a) Money
b) Demand Deposit
c) Short-term Debt.
d) Intermediate-term Debt
e) Long term Dept
f) Equity Stock
g) Futures and options
h) Financial derivatives
i) Bonds
2.3 FOLLOWINGS ARE THE IMPORTANT FUNCTIONS OF INDI FUNCTIONS OF THE

FINANCIAL SYSTEM
1. Intermediation: It acts as an intermediary between savers and borrowers, channeling
funds from surplus units to deficit units.
2. Resource Allocation: It allocates financial resources to various sectors of the economy,

directing capital to its most productive uses.
3. Payment System: It provides a payment infrastructure for businesses and individuals to

settle transactions efficiently, including electronic funds transfer, checks, and credit cards.
4. Risk Management: Financial institutions offer a range of products like insurance and
derivatives to help individuals and businesses manage financial risks.
5. Price Determination: Financial markets help in determining the prices of financial assets,
which, in turn, affect real economic decisions.
6. Liquidity Provision: Financial institutions offer liquidity to depositors and investors,

allowing them to access their funds when needed.
7. Capital Formation: It facilitates capital formation by encouraging savings and

investments, thereby promoting economic growth.
8. Maturity Transformation: Banks convert short-term deposits into long-term loans,

bridging the maturity gap between savers and borrowers.
9. Information Aggregation: Financial markets gather and disseminate information about

economic conditions, which aids in decision-making.
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10. Currency Creation: Central banks have the authority to create and regulate the country's
currency supply, controlling inflation and economic stability.
11. Monetary Policy Transmission: The financial system acts as a conduit for monetary
policy, transmitting changes in interest rates and credit availability throughout the
economy.
12. Capital Market Development: It provides a platform for businesses to raise capital
through the issuance of stocks and bonds.
13. Facilitation of Trade: Exporters and importers use financial instruments like letters of
credit and trade finance services to facilitate international trade.
14. Wealth Management: It offers investment vehicles, such as mutual funds and wealth
management services, to help individuals grow and manage their wealth.
15. Corporate Finance: Financial institutions provide advisory and financing services to
corporations for mergers, acquisitions, and other strategic transactions.
16. Social Welfare: It supports government programs like social security and public pensions,
ensuring the financial well-being of citizens.
17. Asset Management: The financial system offers asset management services to optimize
investment portfolios and achieve financial goals.
18. Credit Creation: Banks create credit by lending out more money than they hold in
deposits, fostering economic growth and business expansion.
19. Regulatory Oversight: Regulatory authorities monitor and supervise financial institutions
to maintain market integrity and protect consumers.
20. Financial Inclusion: Efforts are made to promote financial inclusion by providing access
to banking and financial services to underserved and marginalized populations, reducing
poverty and inequality.
2.4 PROBLEM AREAS IN THE FINANCIAL SYSTEM
The financial system is complex and dynamic, and it can face various problem areas and
challenges that have the potential to disrupt financial stability and economic growth. Here are
some of the common problem areas in the financial system:
1. Systemic Risk: This is the risk that the entire financial system could collapse due to the
failure of one or more major financial institutions. It can result from interconnectedness
among institutions, excessive leverage, or a common external shock.
18
2. Banking Sector Vulnerabilities: Banks are susceptible to issues like high non-performing
loans (NPLs), insufficient capital adequacy, and poor risk management practices, which
can weaken their stability and ability to lend.
3. Shadow Banking: Shadow banking refers to non-bank financial intermediaries that

provide bank-like services. It can pose risks due to less stringent regulation and the
potential for runs on money market funds or other shadow banking entities.
4. Market Volatility: Excessive market volatility, especially in asset prices like stocks, bonds,
and real estate, can lead to market bubbles and abrupt corrections that affect investor
confidence.
5. Liquidity Risk: Liquidity risk arises when institutions are unable to meet their short-term
financial obligations. It can lead to financial distress and, in extreme cases, bankruptcy.
6. Credit Risk: Credit risk is the risk that borrowers will default on their obligations. High
levels of credit risk can result from poor underwriting standards and economic downturns.
7. Interest Rate Risk: Financial institutions are exposed to interest rate risk, where changes
in interest rates can affect the value of their assets and liabilities. Sudden interest rate
hikes can lead to losses.
8. Cybersecurity Threats: The financial system is vulnerable to cyberattacks, which can

disrupt operations, compromise customer data, and even lead to financial theft or fraud.
9. Regulatory Compliance: Navigating a complex web of financial regulations can be

challenging for institutions, and non-compliance can result in legal and reputational risks.
10. Global Economic Factors: The financial system can be affected by global economic
factors like trade tensions, currency fluctuations, and international financial crises.
11. Behavioral Biases: Investors' behavioral biases, such as herding behavior and
overconfidence, can lead to irrational market behavior and bubbles.
12. Financial Innovation: While financial innovation can bring benefits, it can also introduce
complex and opaque financial products and strategies that are poorly understood, leading
to unexpected risks.
13. Consumer Protection: Issues related to consumer protection, such as predatory lending
and mis-selling of financial products, can harm individuals and erode trust in the financial
system.
14. Climate and Environmental Risks: Climate change and environmental factors can pose
long-term risks to the financial system, affecting the value of assets and investments in
industries vulnerable to climate-related events.
19
15. Geopolitical Events: Political instability, trade disputes, and geopolitical conflicts can
create uncertainty in financial markets and impact global economic stability.
16. Income Inequality: Rising income inequality can lead to social and political unrest, which
can have indirect consequences on financial stability and policy.
2.5 NATURE OF FINANCIAL SYSTEM

A financial system is a complex, well-integrated set of sub-systems of financial institutions,
markets, instruments, and services which facilitate the transfer and allocation of funds, efficiently
and effectively.
There are four constituents of a financial system, viz.
(i) financial institutions,
(ii) financial markets,
(iii) financial instruments, and (iv) financial services.
Financial Institutions
Financial institutions are business organisations that act as mobilisers and depositors of savings
and as purveyors of credit or finance. They also provide various financial services to the
community. Financial institutions have been variously classified. Two important classifications
are as follows:
a) Banking institutions and Non-banking institutions
b) Intermediaries and non-intermediaries.
Banking institutions and Non-banking institutions
The banking institutions have quite a few things in common with the non-banking ones, but their
distinguishing character lien in the fact that unlike other institutions,
(i) they participate in the economy’s payments mechanism, i.e., they participate in the
economy’s payments mechanism, i.e., they provide transactions services,
(ii) their deposit liabilities constitute a major part of the national money supply, and
(iii) they can, as a whole, create deposits or credit which is money. Distinction between the two
has been highlighted by Sayers by characterising the former as “creators” of credit, and the
latter as were “purveyors” of credit.
b) Intermediaries and Non-intermediaries
Intermediaries intermediate between savers and investors; they lend money as well as mobilise
savings; their liabilities are towards the ultimate savers, while their assets are from the investors
or borrowers. Non-intermediary institutions do the loan business but their resources are not
directly obtained from the savers. All banking institutions are intermediaries, many non-banking
institutions also act as intermediaries and when they do so they are known as non-banking
financial inter-mediaries.
20
Financial market are a mechanism enabling participants to deal in financial claims. The market
also provide a facility in which their demands and requirements interact to set a price for such
claims. The participants on the demand and supply sides of these markets are financial
institutions, agents, brokers, dealers, borrowers, lenders, savers, and others who are inter-
linked by the laws, contracts, covenants and communications networks. Financial markets have
been variously classified.
Two important classifications are:
a) Primary market and secondary market; and
b) Money market and capital market.
a) Primary market and Secondary market The primary markets deal in the new financial claims
or new securities, and, therefore, they are also known as ‘new issue markets’. Secondary
markets deal in securities already issued or existing or outstanding. Primary markets mobilise
savings and they supply fresh or additional capital to business units. Secondary markets do not
contribute directly to the supply of additional capital, they do so indirectly by rendering securities
issued on the primary markets liquid.
b) Money market and Capital market Money market is a market for short-term securities with a
maturity of one year or less capital market is a market for long-term securities, that is, securities
having a maturity period of one year or more. Keeping in view different purposes, financial
markets have also been classified into
the following categories:
(i) organised and unorganised;
(ii) formal and informal;
(iii) official and parallels; and
(iv) domestic and foreign.
Financial Instruments
A financial instrument is a claim against a person or an institution for the payment at a future
data a sum of money and/or a periodic payment in the form of interest or dividend. The term
‘and/or’ implies that either of the payments will be sufficient but both of them may be promised.
Primary securities and Secondary securities Financial securities may be primary or secondary
securities. Primary securities are also termed as direct securities as they are directly issued by
the ultimate borrowers of funds to the ultimate user. Financial institution differ in terms of
marketability liquidity reversibility, type of options, return, risk and transaction costs.
Financial Services
Financial intermediaries provide key financial services such as merchant banking, leasing, hire
purchase, credit -rating, etc. Financial services rendered by the financial intermediaries bridge
the gap between the back of knowledge on the part of investors and increasing sophistication of
financial instruments and markets.

1. Define Financial Instruments
21
2. What is Financial Services
3. Discuss Financial Markets
4. Define Financial derivatives
2.8 Summary
The financial system consists of a variety of institutions, markets and instruments. It provides
the principal means by which savings arc transformed into investments. Given its role in the
allocation of resources, the efficient functioning of the financial system is of critical importance to
a modem economy. The Indian financial system is a complex and multifaceted network of
institutions, markets, and regulators that plays a crucial role in the country's economic
development. It encompasses a wide range of financial institutions, including commercial banks,
cooperative banks, non-banking financial companies (NBFCs), insurance companies, and
mutual funds, among others. These institutions collectively provide various financial services,
such as savings and lending, insurance coverage, investment opportunities, and risk
management tools to individuals and businesses.
2.9 Glossary
1. What is the financial system? And also state functions of the financial system
2. What are the important functions of the financial system
3. Discuss in detail about the problem areas in the financial system
4. Define financial market and nature of financial system

1. Refer to Section 2.1 and 2.2
4. Refer to Section 2.5 and 2.6
1 Pathak Bharati (2018). Indian Financial System. Pearson Education; Fifth edition.
22
2 Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall of
India,
3 Meir Kohn (2013). Financial Institutions and Markets. Oxford University Press
4 Rajesh Kothari (2012). Financial Services in India: Concept and Application, Sage
5 Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain Book
Agency, Mumbai.
23
Chapter-3
Money Market
STRUCTURE
3.1 Introduction
3.3 Money Market
3.4 Characteristics of the Money Market
3.5 Need for a Money market
3.6 Goals of the Money market investor
3.7 Self Check Exercise
3.8 Summary
3.9 Glossary
1. Explain the classification of the financial markets.
2. Describe the functions of the money market.
3.1 INTRODUCTION
Each and every business unit must operate within the financial environment. The financial system
consists of a number of organizations, institutions and market. They secure the needs of the
consumers, firms and governments. If a firm invests the idle funds temporarily in marketable
securities, then it has to approach the financial market. Most of the firms use the financial markets to
finance their investments in assets Financial markets can be defined as “All Institutions and procedures
for bringing buyers and sellers of the financial instruments together”. They provide better facilities for
buying and selling of all the financial claims and services. All the participants trade in the financial
products in the markets either directly or through the brokers. Financial institutions, agents, brokers,
dealers, borrowers, lenders and savers participate both on demand and supply sides of the financial
markets. The demand for capital will be influenced by the business expectations regarding the future
state of the economy. The demand for goods is highly influenced by the prices, government policies,
profitability, availability of internal funds, cost of funds and technology changes. On the other hand, the
supply of funds depends on its level of savings by the household sector, business sector and
government sector in a given economy. The savings of the participants in the market are determined by
a number of factors. The factors will depend on the level of current and expected income, distribution of
24
income in the economy, degree of certainty in income, wealth, inflation provision for old age, family
members, rate of interest, availability of savings media with required investment characteristics. The
development banks and financial institutions can also influence the supply of funds. The government
will determine the volume of supply of funds, allocation of funds, cost of funds and other factors.
3.2 FINANCIAL MARKETS
The financial markets are characterized by many imperfections, restrictive practices, existence of
transaction costs, lack of information, limited number of operators, direct and indirect intervention by the
authorities and soon.
The financial markets may be categorized as the primary and secondary markets. The Primary market
is also known as the Direct Market. The Secondary market is also known as the indirect market Further
the Direct market is called as the “New Issue Market”. The NIM deals with the new securities offered by
the newly established concerns or the existing enterprises. On the other hand the Secondary market
deals with securities that are already issued by the Companies. The primary market creates the capital
formation in the country. It channelises the savings in a productive way. The secondary markets do not
contribute directly to the supply of the additional capital. But it will provide liquidity to the primary
market. Therefore the NIM and secondary markets have impact on each other.
The financial markets are also classified as:
(a) Organized and Unorganized.
(b) Formal and Informal.
(c) Official and Parallel.
(d) Domestic and Foreign.
The financial transactions which arise in a systematic manner in an organized system are called as
“Organized Markets”. The financial transactions which take place outside the well-established
exchange constitute the “Unorganised Markets”. The Unorganized markets refer to the markets in rural
areas. The “Informal markets” constitute the financial transactions which arise between the individuals
and small families.
The financial markets are further classified as:
A. Money market, and
B. Capital market.
There is no difference between these two markets. Both of them perform the same functions in the
transferring of the financial assets. They provide a mechanism to sell the financial assets.
3.3 MONEY MARKET
The Money market is a market for the short-term funds. It provides funds for less than a period of one
year. It is dominated by the Central Bank. The RBI is the watch-dog of the monetary system. It provides
a channel for the exchange of the financial assets for money. The money market is of very great help in
the financing industry and commerce for their working capital requirements. The money market
includes money, capital and bill markets. Markets consists of both money and capital markets. In the
money market, the fund is being sold and purchased at a certain price. It is like the commodity market.
It refers to lending and borrowing activities of banking, financial institutions and individuals.
The Money market is defined by A. Crowther as “the money market is the collective name given to
various firms and institutions that deal with various grades of near money.” It deals with the trade bills,
promissory notes, and treasury bills for a short period. The RBI defined the money market as
“themoney market is a market for short-term financial assets that are close substitutes for money,
facilitates the exchange of money for the new financial claims in the primary market and also for the
financial claims, already issued in the secondary market.”
25
The Central Bank Act as a promotional and development banker in the money market. The money
market can be organized as the organized sector and unorganized sector. The unorganized sector
consists of indigenous bankers and village moneylenders. The organized sector consists of the RBI,
SBI, Mutual Funds, Companies, Cooperative Societies and Financial Institutions. Geographically, the
money market may be located or associated with a particular place like Indian Money Market, New
York Money Market, Bombay Money Market etc. In the Bombay Money Market, the short-term loanable
fund is available for the whole India. The London Money Market, on the other hand is a market of
international importance. It is known as the International Money Market. It attracts the short-term funds
from all over the world for redistribution among the borrowers. The demand for the short period comes
primarily from the Government, Business concerns and Private individuals. The Government has
become probably the biggest borrower; everywhere money is being required to meet the current
deficits. Individual and Commercial concerns borrow funds for working capital needs. Sometimes they
borrow to enable to carry additional inventories. The other important private borrowers include the stock
exchange brokers, dealers in the government and other security merchants, manufactures, fanners.
Banks themselves may require additional funds and may borrow from the Central Bank or from each
other. The supply of loanable funds in the money market comes mostly from the Central Bank of the
country, the Commercial Banks and other finance companies. The Central Bank is the source of credit
to the Commercial Banks while the latter constitute the most important source of the short-term credit to
the individual houses, business houses and the brokers.
3.4 CHARACTERISTICS OF THE MONEY MARKET
The following are the characteristics of the money market:
1. It involves in the arrangement of the short-term funds.
2. It is a tool for the preparation of the monetary policy and fiscal management.
3. It deals with the high liquid instruments.
4. The players in this market are the RBI, Commercial Banks and Companies.
5. It is subjected to the RBI regulations.
6. It tells about the trends in the liquidity and interest rates.
7. It provides funds at low transaction cost.
8. It suits the requirements of the borrowers for the short-term funds.
9. It encourages the open market operations.
Different sub-markets of a developed money market help in the proper functioning of the Central Bank.
The money market and the short-term rates of interest serve as a good barometer for monetary and
banking conditions in the country. Thus they provide a valuable guide in determining the Central
Banking Policy, the developed money market being a highly integrated structure enables the Central
Bank to deal with the most sensitive sub-markets also.
The main borrowers of the short-term funds in the money market are:
1. Commercial Banks.
2. Central Government
3. State Government.
4. Corporate Sector.
5. Local Bothes.
The money market is unable to meet the long-term requirements of the industries. It consists of Central
Banks, Commercial Banks, Cooperative Banks, Savings Banks, Discount Houses, Acceptance Houses,
bill market, bullion market etc. The existence of a well-developed money market ensures that the
26
market instruments can be converted into money without incurring much loss.
3.5 NEED FOR A MONEY MARKET
1. It is a coordinator between borrowers and lenders of the short-term funds.
2. It provides the transmission of funds from surplus concerns to the shortage funds concerns.
3. It is a device of the Government to balance its cash inflows and outflows.
4. It is a weapon of the business firms to meet their short-term funds.
5. Money Market creates the minimum rate of return on the idle fund lying at the disposal of the
Corporate and Banking Sectors.
6. It is tool to the finance managers in more utilization of the funds to enhance the share-holder’s
wealth.
The following chart shows the structure of the Indian Money Market:
27
3.6 GOALS OF THE MONEY MARKET INVESTOR
1. The main objective of the investors in the money market is about the safety and liquidity of the
principal amount. They also think about some gains along with their amount.
2. The Money market is a parking place of an idle fund.
3. The Investor wisely escapes from the long-term market risks.
4. Money market instruments generally offer more protection against the political risk and inflation
risk.
5. In money market, the investor never faces default risk.
On overall evaluation of the money market, we can find that it is entirely dominated by the RBI. All the
policy matters of the sector will be finalized by the India’s Central Bank. The SEBI and the other
statutory organizations have been playing an important role in the smooth functioning of the Money
Market. It is a powerful weapon in the hands of the Central Government. It is handled skillfully by the
Ministry of Finance. Crores of rupees are available in the market at the disposal of various large
organizations within few hours. Therefore the development of the Money Market can boost the wealth
of a nation. It also encourages the capital market.
3.7 SELF CHECK EXERCISE
1. What is ‘Money Market’?
2. Define ‘Capital Market’?
3. Define ‘Financial Market’?
4. What is ‘New Issue Market’?
3.8 SUMMARY
Money market basically refers to a section of the financial market where financial instruments with high
liquidity and short-term maturities are traded. The Money market has become a component of the
financial market for buying and selling of securities of short-term maturities, of one year or less, such as
treasury bills and commercial papers. Over-the-counter trading is done in the money market and it is a
wholesale process. It is used by the participants as a way of borrowing and lending for the short term.
Money market consists of negotiable instruments such as treasury bills, commercial papers and
certificates of deposit. It is used by many participants, including companies, to raise funds by selling
commercial papers in the market. Money market is considered a safe place to invest due to the high
liquidity of securities. The money market is an unregulated and informal market and not structured like
the capital markets, where things are organised in a formal way. Money market gives lesser return to
investors who invest in it but provides a variety of products.
3.9 GLOSSARY
Bill Market: Is a market where short-term papers or bills are traded. These bills include bills of
exchange and treasury bills.
Call/Notice Money Market: Is a market where the day-to-day surplus funds, mostly of banks are
traded.
Commercial Bill: It is an instrument used in the Indian money market to finance the movement and
storage of agricultural and industrial goods in domestic and foreign trade.
Commercial Paper: It enable highly rated corporate borrowers to diversify their sources of short-term
borrowing and also to provide an additional instrument to investors.
28
Derivative Promissory Notes: Under this instrument, banks were permitted to issue derivative usance
promissory note for a period not exceeding 90 days under the strength of underlying bills.
Discount Houses: It performs the function of discounting/rediscounting the commercial bills and T-
Bills.
Money Market: Is a market for short-term funds and covers money and financial assets that are close
substitutes for money.
Repo: It refers to a transaction in which a participant acquires fund immediately by selling securities
and simultaneously agreeing for repurchase of the same or similar securities after specified period of
time at a given price.
1. Describe the characteristics of a money market.
2. What is the need for a money market?
3. Explain the growth and components of the capital market.
2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice
Hall of India,
4. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage
5. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain
Book Agency, Mumbai.
---///---
29
Chapter-4
Capital Market
STRUCTURE
4.1 Introduction
4.2 Capital Market
4.3 Nature and Constituents
4.4 Growth of Capital Market
4.5 Components of the Capital Market
4.7 Summary
4.8 Glossary
 Components of the capital market
 Growth of the capital market
 capital markets functions
 nature and constituents
4.1 INTRODUCTION
Capital Market is the market for long-term funds. It deals long-term and medium term funds.
Capital market consists of shares, stocks, debentures and bonds. Securities dealt in capital
market are long- term securities. The funds which flows into the capital market comes from the
savers. It provides a market mechanism for those who have savings and to those who need
funds for productive investments. It diverts resources from wasteful and unproductive channels
to productive investments. Since 1951, the Indian Capital Market has been broadening slowly.
There is a steady improvement in the volume of savings and investment. Many types of
encouragement and tax relief exists in the country to promote savings. Many steps have been
taken to protect the interests of the investors. The growth of capital market indicates the growth
of Joint Stock Companies and corporate enterprises. In 1951, there were 28,500 companies with
a paid up capital of nearly Rs. 7.5 crores and as on 31 -3- 1998, there were more than 2,00,000
companies with a paid up capital of nearly Rs. 1,37,959 crores. The growth of investment has
been quite phenomenal in recent years in accordance with the accelerated tempo of
development.
30
Capital Market can be defined as “the market for relatively long-term financial instruments.”
According to Arun K. Datta the capital market may be defined as “the capital market is a
complex of institutions investment and practices with established links between the demand for
and supply of different types of capital gains.”
Further F. Livingston defined the capital market as “In a developing economy, it is the business
of the capital market to facilitate the main stream of command over capital to the point of the
highest yield. By doing so, it enables, control over resources to pass into the hands of those
who can employ them must effectively thereby increasing production capacity and spelling the
national dividend.”
Capital market consists of gilt edged market and fire industrial securities market. The gilt edged
market refers to the market for government and semi-government securities backed by the RBI.
The securities traded in this market are stable in value and are much sought after by the banker
and other institutions. The Industrial securities market refers to the market for equities and
debentures of old and new companies. The industrial securities market is further divided by the
new issue market and further capital issue market. The new issue market refers to the raising of
capital by the new companies in the form of shares and debentures. While further old issue
capital deals with securities already issued by the existing companies. The two markets are
equally important. But the NIM is much more important forthe capital formation in the country.
However, the functioning of NIM will be facilitated only when there are facilities for the transfer of
the existing securities. Considerable deregulation of financial markets whose taken place in
India favouring the unbridled growth of financial services companies. The reforms have been
increased competitiveness within the financial sector by means of, interest rates, allowing new
financial institutions and instruments. As a consequence, the scope and activities of the banks,
and non-banking finance companies have expanded rapidly due to the liberalization drive, more
particularly since 1991, the non-banking finance companies have been competing and
complementing the services of the Commercial Banks. It has been observed that the growth of
non-banking finance companies are more pronounced than banking companies.
1.4.2 NATURE AND CONSTITUENTS
The capital market is a segment of the financial market where individuals and institutions buy
and sell long-term financial assets, such as stocks, bonds, and other securities. It plays a vital
role in the allocation of capital and the long-term financing of businesses and governments.
Here are some key characteristics and features that define the nature of the capital market:
1. Long-Term Investments: Capital markets are focused on long-term investments, where
assets are typically held for several years or even decades. This distinguishes them from
the short-term nature of the money market.
2. Securities Trading: Capital markets facilitate the trading of various financial securities,
including stocks (equity securities) and bonds (debt securities).
3. Primary and Secondary Markets: Capital markets consist of primary and secondary
markets. The primary market is where new securities are issued and sold for the first time,
often through initial public offerings (IPOs). The secondary market involves the trading of
existing securities among investors.
4. Ownership and Debt Financing: Businesses can raise capital in the capital market
through equity (ownership) by issuing stocks or through debt financing by issuing bonds.
Investors in the capital market can choose to invest in either.
31
5. Risk and Return: Capital market investments carry varying degrees of risk and return
potential. Stocks tend to have higher potential returns but also higher risk, while bonds
offer more predictable income but lower potential returns.
6. Price Determination: Prices of securities in the capital market are determined by supply
and demand forces, investor sentiment, company performance, and economic conditions.
7. Market Intermediaries: Various intermediaries, such as stock exchanges, brokerage
firms, investment banks, and asset management companies, play essential roles in
facilitating trading and providing services to investors and issuers.
8. Regulation: Capital markets are subject to extensive regulatory oversight to ensure
fairness, transparency, and investor protection. Regulatory authorities like the Securities
and Exchange Commission (SEC) in the United States oversee capital market activities.
9. Information Disclosure: Issuers are required to provide comprehensive and timely
information about their financial health, operations, and performance to investors. This
transparency helps investors make informed decisions.
10. Diversification: Capital markets enable investors to diversify their portfolios by investing in
a wide range of securities, industries, and geographic regions, reducing investment risk.
11. Price Volatility: Prices of securities in the capital market can be subject to significant
fluctuations, influenced by a variety of factors, including economic indicators, geopolitical
events, and company news.
12. Economic Development: Well-functioning capital markets are crucial for economic
development as they provide businesses with access to long-term financing for expansion
and innovation.
13. Investor Participation: Capital markets are open to a broad range of investors, including
individual investors, institutional investors (e.g., mutual funds, pension funds), and foreign
investors.
14. Market Efficiency: Capital markets aim for efficiency, where prices reflect all available
information, making it challenging for investors to consistently outperform the market.
15. Globalization: Capital markets are increasingly global, with investors and issuers
participating in markets around the world, leading to greater interconnectedness and
opportunities for diversification.
4.3 Capital Markets Functions

2. The capital markets serve several important functions that contribute to the efficient allocation
of capital and facilitate economic growth. Here are the key functions of capital markets:
3.
1. Capital Formation
Capital markets provide a platform for companies, governments, and other entities to raise long-
term capital by issuing stocks, bonds, and other securities. This enables them to finance
investments, expand operations, fund projects, and support economic development.
32
2. Investment Opportunities
Capital markets offer a wide range of investment opportunities to individuals and institutions.
Investors can participate in the capital market by purchasing securities and earning returns
through dividends, interest payments, and capital appreciation.
3. Liquidity Provision
Capital markets provide liquidity, allowing investors to buy and sell securities easily. The
secondary market facilitates the transfer of securities, enabling investors to convert their
investments into cash when needed.
4. Price Discovery
Capital markets help in determining the fair prices of securities through the interaction of buyers
and sellers. The forces of supply and demand in the market determine the prices, reflecting the
perceived value and market sentiment.
5. Risk Management
Capital markets provide instruments such as derivatives that enable investors to manage risks
associated with price fluctuations, interest rate changes, and other market uncertainties.
Hedging and risk transfer mechanisms offered by capital markets help in mitigating risk
exposure.
6. Efficient Allocation of Capital

Capital markets play a crucial role in allocating capital to its most productive uses. Investors
direct funds towards companies and projects with strong growth prospects, contributing to
economic efficiency and resource allocation.
7. Wealth Creation and Distribution

Capital markets allow individuals and institutions to participate in wealth creation. Through
investments in securities, investors have the opportunity to earn returns and accumulate wealth,
which can contribute to wealth distribution and economic inclusiveness.
8. Corporate Governance and Transparency

Capital markets promote corporate governance practices by requiring listed companies to
adhere to disclosure and reporting standards. This enhances transparency, accountability, and
investor confidence in the financial system.
4.
5.4.4 GROWTH OF THE CAPITAL MARKET
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The Indian financial system is both developed and integrated today. Integration has been
through a participatory approach in granting loans as well as in saving schemes. The expansion
in size and number of institutions has led to a considerable degree of diversification and
increase in the types of financial instruments in the financial sector which are wholly owned by
the government
The development banks in the Indian financial system have witnessed vast changes in the
planning periods. Now the development banks constitute the backbone of the Indian capital
market. The relevant of the development banks in the industrial financial system is not merely
qualitative, but they have overwhelming qualitative dimensions in terms of their promotional and
innovational functions. The growth of the capital market is determined by the following factor:
• Economic development.
• Rapid industrialization.
• Level of savings and investment of the household sector.
• Technological advances.
• Corporate performance.
• Regulatory framework.
• Participation of foreign institutional investors in the capital market.
• Development of financial services.
• Liquidity factors.
• Political stability.
• Globalization.
• Financial innovation.
• Economic and financial sector reforms.
• International developments.
• Agency costs.
• Emergence of financial intermediaries.Specialization among investment managers.
• Incentives.
• Speed in acquiring, processing and acting upon information.
• NRIs investment
6.4.5 COMPONENTS OF THE CAPITAL MARKET
In a capital market, banks and financial institutions are the important components. They act as
catalysts in the economic development of any country. These institutions mobilize financial
savings from household, corporate and other sector of the economy and channelise them into
productive investments. They act as a Reservoir of resources and form the backbone of the
economic and financial system. The banking industry has undergone a sea change during the
last three decades. After the modernization of banks, they not only lend for the social and
economic causes but also participated in the development programmes of the central
government and state government. The main components of the capital market in India are:
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 New-Issue Market (NIM)
 Secondary Market (Stock market)
INSTRUMENTS OF CAPITAL MARKET
Savings of the investors are generally raised through a range of complex financial products
generally called capital market instruments such as shares, Debentures, bonds or any other
marketable securities of a like nature issued by any company etc. Following are the various types
of capital market instruments available in the Indian Capital Market:
Shares
The ownership capital of a company is divided into a number of indivisible units of a fixed amount.
These units are known as shares As per Section 43 of the Companies A 2013, the share capital
of a company limited by shares shall be of two kinds, namely Equity share capital and Preference
share capital.
Equity Shares
 The purpose of equity instruments issued by corporations is to raise funds for the firms.
 It is equity ownership that allows the holders of this stock to enjoy voting rights on
corporate matters.
 However, in case the company suffers heavy losses and ends up bankrupt, the holders of
the common stock are the last ones to get their money back after creditors, bondholders,
and holders of preferred stock.
Preference shares
 Preference shares are also a type of shares issued by a company that provides a
predetermined dividend to the holder unlike dividend to equity share holder where
shareholder gets dividend as per the profit earned.
 Although dividend on the preferred stock are larger but they do not get voting power on the
company matters.
 In case of liquidation of company, preference shareholders get to redeem their shares

before the holders of the common stock.
Debt instruments
A debt instrument is used by either companies or governments to generate funds for capital-
intensive projects that can be obtained either through the primary or secondary market. The
relationship in this form of instrument ownership is that of a borrower – creditor and thus, does not
necessarily imply ownership in the business of the borrower. The contract is for a specific
duration and interest is paid at specified periods. Types of Debt Instruments are of different types
like Bonds, Debentures and Government Securities (G - Secs) etc. Debentures A debenture is a
long-term debt instrument used by governments and large companies to obtain funds. It is a
certificate of agreement of loans which is given under the company's stamp and carries an
undertaking that the debenture holder will get a fixed return (fixed on the basis of interest rates)
and the principal amount whenever the debenture matures. In contrast to equity capital, which is
a variable income security, the debentures are fixed income (i.e. in respect of interest) security
with no voting rights. Debentures are generally freely transferrable by the debenture
holder. Bonds Bonds are debt instrument, that are issued by companies and government. Major
35
issuers of bonds are governments (Treasury bonds in US, gilts in the UK, Bunds in Germany) and
firms, which issue corporate bonds. Some corporate bonds are secured against assets of the
company that issued them, whereas other bonds are unsecured. By purchasing a bond, an
investor lends money for a fixed period of time at a predetermined interest rate. During this period
of time, investor receive a regular payment of interest semi-annually or annually. Issuing a bond
increase the debt burden of the bond issuer because contractual interest payments must be paid
to the borrowers. Bonds can be of following types:
 Government Bonds
 Municipal Bonds
 Institutions Bonds
 Corporate Bonds
The yield on bonds are expressed commonly in two forms:

1. Interest yield (or running yield) - The return on a bond taking account only of the coupon
payments.
2. Yield to maturity (or redemption yield)- The return on a bond taking account of the
coupon cash flows and the capital gain or loss at redemption.
Debt markets include:

1. Primary markets for bonds, i.e. the markets in which newly issued instruments are
bought,
2. Secondary markets , in which existing or second hand instruments are traded.
Green Bond
 The capital for green bond is raised to fund ‘green’ projects like renewable energy,
emission reductions etc.
 First Green Bond was issued by World Bank in 2007.
 The first ever green bond was issued by multilateral institutions (European Investment
Bank and World Bank) in 2007.
 The first green bond in India was issued by Yes Bank in
 In 2015, EXIM bank launched India’s first dollar denominated green bond of $500 million.
 Indian Renewable Energy Development Agency Ltd has issued bonds to finance
renewable energy without the tag of green bonds.
 India has become the seventh largest green bond market in the world.
 In January 2016, SEBI also released first Green Bond guidelines relating to listings,
norms for raising money etc.
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 According to SEBI, a bond shall be considered green bond if the funds raised through it will
be used for renewable and sustainable energy including wind, solar, bio-energy, other
sources of energy which use clean technology.
 Banks have also been permitted to issue green masala bonds.
 Rural Electrification Corporation’s first green bond has opened up for trading at the
London Stock Exchange.
 It is a Climate Bonds Initiative certified green bond.
 The proceeds of the bond shall be used to fund environment friendly projects in India such
as solar, wind
 and biomass assets, as well as sustainable water and waste management projects.
 Through listing at the LSE, the PSU hopes to reach out to a new investor base.
Blue Bonds
 The upcoming year will witness the first ‘blue bond’ issuance in India.
 As per Smart cities initiative, municipal bond market will be refueled for water supply
projects (a category of Blue Blonds) in cities like Pune and Hyderabad.
 It is a type of green bond which specifically invests in climate resilient water management
and water infrastructure.
Masala Bonds
 Masala bonds are rupee-denominated bonds issued by Indian entities in the overseas
market to raise funds.
 As of now, it is being traded only at the London Stock exchange.
 Masala bonds have been named so by the International Finance Corporation (IFC), an
investment arm of the World Bank which issued these bonds to raise money for
infrastructure projects in India.
 They protect investors from exchange rate fluctuations as opposed to external commercial
borrowing (ECB) that have to be raised and repaid in dollar.
4.6 Government Securities

Government securities, popularly known as G-Secs, are issued by Reserve Bank of India (RBI)
on behalf of the central or state governments to finance fiscal deficit. These securities are
absolutely risk-free and guaranteed by the government. Derivative instruments A derivative
instrument is whose value is derived from the value of one or more underlying assets which can
be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Forwards, Futures,
Options and Swaps are four most common examples of derivative instruments. The purpose of
these securities is to give producers and manufacturers the possibility to hedge risks. By using
37
derivatives both parties agree on a sale at a specified price at a later date. Derivatives market can
be divided into two as follows:
1. Exchange-traded derivatives
2. Over-the-counter derivatives.
Forwards and futures These are financial contracts that obligate the contracts’ buyers to
purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are
essentially the same in their nature. However, forwards are more flexible contracts because the
parties can customize the underlying commodity as well as the quantity of the commodity and the
date of the transaction. On the other hand, futures are standardized contracts that are traded on
the exchanges. Every futures contract has the following features:
 Buyer
 Seller
 Price
 Expiry
Options
 Options contracts are instruments that give the holder of the instrument the right to buy or
sell the underlying asset at a predetermined price.
 An option can be a 'call' option or a 'put' option.
 A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is
called 'strike price'.
 Similarly, a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the
buyer.
 Here the buyer of the contract has the right to sell and the seller has the obligation to
buy.
 So, in any options contract, the right to exercise the option is vested with the buyer of the
contract. The seller of the contract has only the obligation and no right.
 As the seller of the contract bears the obligation, he is paid a price called
as 'premium'. Therefore, the price that is paid for buying an option contract is called
as premium.
 The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the
asset in the spot market is less than the strike price of the call.
4.7 Summary
38
see chapter 3
4.8 Glossary
see chapter 3
see chapter 3
see chapter 3
see chapter 3
India,
4. Rajesh Kothari (2012). Financial Services in India: Concept and Application, Sage
Agency, Mumbai.
39
Lesson-5
Money Market Instruments
STRUCTURE
5.1 Introduction
5.2 Features of Money Market
5.3 Money Market Instruments
5.4 Call Money Market
5.5 Term Money Market
5.6 Treasury Bills
5.7 Certificates of Deposits (CDs)
5.8 Commercial Paper
5.10 Summary
5.11 Glossary
After studying this lesson you should know:
1. The features of the money market.
2. The various money market instruments.
5.1 INTRODUCTION
Money market is a very important segment of the Indian financial system. It is the market for dealing in
monetary assets of short-term nature. Short-term funds up to one year and for financial assets that are
close substitutes for money are dealt in the money market. Money .market instruments have the
characteristics of liquidity (quick conversion into money), minimum transaction cost and no loss in
value. Excess funds are deployed in the money market which in turn are availed of to meet temporary
shortages of cash and other obligations. Money market provides access to providers (financial and
other institutions and individuals) and users (comprising institutions and government and individuals) of
short-term funds to fulfill their borrowings and investment requirements at an efficient market clearing
price. The rates struck between borrowers and lenders represent an array of money market rates. The
inter-bank overnight money rate is referred to as the call rate. There are also a number of other rates
such as yields on treasury bills of varied maturities, commercial paper rate and rates offered on
certificates of deposit Money market performs the crucial role of providing an equilibrating mechanism
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to even out short-term liquidity and in the process, facilitating the conduct of monetary policy. Short-
term surpluses and deficits are evened out. The money market is the major mechanism through which
the Reserve Bank influences liquidity and the general level of interest rates. The Bank’s interventions to
influence liquidity serve as a signaling-device for other segments of the financial system.
The Indian money market was segmented and highly regulated and lacked depth till the late eighties. It
was characterized by a limited number of participants, regulation of entry and limited availability of
instruments. The instruments were limited to call (overnight) and short notice (up to 14 days) money,
inter-bank deposits and loans and commercial bills. Interest rates on market instruments were
regulated. Sustained efforts for developing and deepening the money market were made only after the
initiation of financial sector reforms in early nineties.
5.2 FEATURES OF MONEY MARKET
The money market is a wholesale market. The volumes are very large and generally transactions are
settled on a daily basis. Trading in the money market is conducted over the telephone, followed by
written confirmation from both the borrowers and lenders.
There are a large number of participants in the money market: commercial banks, mutual funds,
investment institutions, financial institutions and finally the Reserve Bank of India. The bank’s
operations ensure that the liquidity and short-term interest rates are maintained at levels consistent with
the objective of maintaining price and exchange rate stability. The central bank occupies a strategic
position in the money market. The money market can obtain funds from the central bank either by
borrowing or through sale of securities. The bank influences liquidity and interest rates by open market
operations, REPO transactions changes in Bank Rate, Cash Reserve Requirements and by regulating
access to its accommodation. A well-developed money market contributes to an effective
implementation of the monetary policy.
5.3 MONEY MARKET INSTRUMENTS
The money market instruments comprise of call money (which is overnight and short notice up to
14 days), term money (1,3 and 6 months), certificates of deposits (CD), participation certificates,
commercial paper (CP), money market mutual funds, commercial bills, treasury bills and inter-corporate
funds and Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS). Of these instruments, call
money and short notice money market and treasury bills form the most important segment of the Indian
money market. The major players in this market are banks, financial institutions and primary dealers.
5.4 CALL MONEY MARKET
The call/notice money market was predominantly an inter-bank market until 1987, except for UTI and
LIC which were allowed to operate as lenders since 1971. Call rates were freed from the ceiling rate in
May, 1991 enabling price discovery. The Discount and Finance House of India was set up on 1988, in
order to provide reasonable access to users of short-term money by promoting secondary market in
money market instruments; and Securities Trading Corporation of India (STCI) was set up in 1994 to
provide an active secondary market in government securities and public sector bonds. ‘Inter-bank
liabilities were freed from reserve requirements in April, 1997 to generate a smooth yield curve and
reduce volatility in call rates. The Bank has widened the market in 1996-97 by increasing the number of
participants. Apart from banks who traditionally formed the core, the bank permitted Primary Dealers to
participate in the call/notice money market as both borrowers and lenders. Eleven mutual funds set up
in the private sector and approved by the SEBI were also allowed to participate as lenders. The other
participants were the QIC, IDBI, NABARD, DFHI (1988) and STCI (1994) and corporate. Entities that
could provide evidence of surplus funds have been permitted to route their landings through PDs. The
minimum size of each transaction is Rs. 3 crore and the lender has to give an undertaking that no
outstanding loans exist from the banking sector and money market mutual funds.
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The market practice is that borrowers/ lenders inform the DFHI about the funds required by them or
available with them at the negotiated interest rate. After DFHI and the lender/borrower confirm the
transaction, these indications are converted into firm commitments. In case of borrowing by DFHI, a
call-deposit-receipt is issued to the lender against a cheque drawn on the Reserve Bank of India,
representing the amount lent. When DFHI lends, it issues the RBI cheque representing the amount lent
to the borrower against the call- deposit-receipt. The minimum size of operation per transaction is Rs.
10 crore.
The transaction is reversed the next day when the lender surrenders the deposit-receipt duly
discharged, against which the DFHl issues the RBI a cheque representing the principal amount
together with interest thereof. In the case of borrowing, a cheque drawn on the RBI in favour of the
DFHI is issued by the borrower representing the interest and principal, in receipt of which the DFHI
surrenders the deposit-receipt duly discharged. Lenders who wish to renew, inform the DFHI early in
the day or the next day or after the expiry, of the fixed deposit. In case DFHI needs funds, it can confiim
the extension of the transaction on the, deposit-receipt by recording the date of renewal and the rate of
interest. Renewals are allowed up to 14 days after which the transaction has to be reversed. Funds lent
on notice or term basis are reversed on the due dates. Cooperative banks also participate.
Measures were initiated in April, 1999 to enable non-bank participants to deploy their short-term
resources to develop and widen the repos market with proper regulatory safeguards such as delivery
versus payment and uniform accounting. Non-bank participants were also allowed to access short-term
money market through repos on par with banks and PDs to facilitate their cash management. The move
is expected to facilitate nonbank participants to move out of the call money market. A pure inter-bank
call/notice/term money market is likely to emerge where there would be no restriction on the maximum
period for which repos can be undertaken. During 1999-2000, the daily peak call rates averaged 9.51%,
whereas the daily low rates averaged 8.39%. The average daily call rates were 9.09%. The introduction
of Liquidity Adjustment Facility (LAF) on 5.6.2000 in which rate of interest and amount are varied to
respond to day-to-day liquidity conditions in the system is likely to impart a greater degree of stability to
the short-term money market rates and facilitate the emergence of a short-term rupee yield curve. The
refinance rate (export credit and credit to PDs) would also influence the call rates.
Various reform measures since May, 2001 have rendered the call money market into a pure inter-bank
market closing access of other participants, PDs, mutual funds. Corporate through primary dealers,
financial institutions and non-bank finance companies. To moderate short-term liquidity, Liquidity
Adjustment Facility was introduced in June, 2000. It has emerged as an effective instrument to provide
a corridor for the overnight call rate movement. This has resulted in stability and orderly market
conditions through clear signaling.
A few banks tended to be overly exposed to the call/notice money market imparting high volatility to call
loans. They carried out banking operations and long-term asset creation with the help of call money
market. The CBSR recommended that there must be clearly defined prudent limits beyond which banks
should not be allowed to rely on call money market and that access to this market should essentially be
for meeting unforeseen mismatches and not as regular means of financing banks lending operation.
After asset-liability management system was put in place, the mismatches in cash flows in the 1—28
days bucket were kept under check. Participants operate now within limits on both lending and
borrowing operations. The call money market is now an inter-bank market with ALM discipline for
participants and prudential limits for borrowing and lending.
In 2003-04, volatility in the call money market declined along with turnover (Rs. 9,809 crore in February,
2004 and Rs. 23,998 crore in October, 2003). The call money rates were in the range of 4.33%-1.91%.
A part of the activity migrated to the repo market (outside LAF) and Collateralized Borrowing and
Lending Obligation (CBLO) segment on account of cheaper availability of funds vis-a-vis call money
market.
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5.5 TERM MONEY MARKET
The term money market in India has been dormant. The factors that have inhibited the development of
term money market are statutory preemptions on inter-bank liabilities, regulated interest rate structure,
high degree volatility in the call money rates, availability of sector specific refinance, cash credit system
of financing, absence of Asset Liability management practices among banks and inadequate
development of money market instruments. RBI has gradually removed most of the constraints in the
past decade. Recent money market reforms encompassing development of the repo market,
introduction of exposure limits for banks in the call money market have infused vibrancy in the various
segments. The average daily turnover in the term money market rose by 52% to Rs. 519 crore in 2003-
04 from Rs. 341 crore in 2002-03. The volume of transactions has picked up in response to policy
measures to develop the market segments.
5.6 TREASURY BILLS
Treasury Bills of the Central Government have been issued since the inception of the bank. They offer
short-term investment opportunity financial institutions, banks under the normal borrowing programme
of the central government and market stabilization scheme (MSS). They were issued for 91 days. The
sales were occasionally suspended. Treasury Bills are claims, against the government. They are
negotiable securities and since they can be rediscounted with the Bank, they are highly liquid. Their
other features are absence of default risk, easy availability, assured .yield, low transaction cost,
eligibility for inclusion in the securities for SLR purposes and negligible capital depreciation. There are
14-day, 91-day, 182-day and 364-day treasury bills in vogue in 2005-06. They are not issued in scrip
form. The purchases and sales are affected through the Subsidiary General Ledger Account.
14-day intermediate Treasury Bills: They are issued for deployment of short-term cash surpluses by
state government. The outstanding amount was Rs. 7,253 crore in 2005-06.
91-day Treasury Bills: There are two types of 91-day Treasury Bills, ordinary and ad-hoc. Ordinary
Treasury Bills are issued to the public and the RBI for enabling the Central Government to meet the
temporary requirement for funds.
Treasury Bills were sold on tap, since 1965, throughout the week to commercial banks and the public at
a fixed rate. Under tap sale, bills can be purchased on any day of the week and the actual rate of
discount is not subject to fluctuations as a result of weekly auctions.
Treasury Bills are repaid at par on maturity. The difference between the amount paid by the tenderer at
the time of purchase (which is less than the face value) and the amount received on maturity
represents the interest on the Treasury Bills and is known as the discount.
In the 1992-93 auctions, a scheme was introduced for the issue of 91-day Treasury Bills with a
predetermined amount but with Reserve Bank participation. The notified amount of each auction is Rs.
100 crore. The cut-off yields were significantly higher than the fixed discount rate of 4.6 per cent per
anoum on such bills sold on tap. The notified amount for weekly auction of 91-day treasury bills was
raised to Rs. 500 crore during 2003-04.
182-Day Treasury Bills: These bills were reintroduced from the year 1999-2000 to enable the
development of a market for government securities. They are not rediscountable with RBI. They are
offered for sale on an auction basis. After discontinuing them they were reintroduced with notified
amount of Rs, 500 crore for fortnightly auction in 2005-06. 364-Day Treasury Bills Anew instrument in
the form of 364 days Treasury Bills was introduced at the end of April, 1992. They are a part of market
loans. The auction of these bills on a fortnightly basis has since then become a regular feature. On
account of its relative attractiveness and since it constituted a safe avenue for investors, the auction of
43
these bills evoked good response. These bills offer short-term investment opportunity to financial
institutions like banks and other parties. These bills are not rediscountable with the Reserve Bank of
India. They are offered periodically for sale on an auction basis by the Reserve Bank of India in
Bombay. The notified amount was Rs. 1,000 crore per auction since 2002- 03. The outstanding amount
is placed at Rs. 12,996 crore.
Primary Dealers: Primary dealer system was introduced in 1996 with the objective of strengthening the
securities market infrastructure and improvement in the secondary market trading, liquidity and turnover
in government securities and also for encouraging voluntary holding amongst a wider investor base.
The obligations of PDs include
• participating in the primary market in a substantial and consistent manner;
• serving as a market maker in the secondary market by providing two way quotes; and
• providing market related information to the public debt manager.
There are 18 PDs and their bidding commitment for auctions other than those under MSS for 2004-05
for dated securities was fixed at Rs. 1,20,300 crore (96.5%) of the issue amount to be raised.
5.7 CERTIFICATES OF DEPOSITS (CDS)
CDs in eurodollar market: CDs are similar to the traditional term deposits but are negotiable and can
be traded in the secondary market. It is often a bearer security and there is a single payment, principal
and an interest, at the end of the maturity period. The bulk of the deposits have a very short duration of
1, 3 or 6 months. For long-term CDs, there is a fixed coupon or a floating rate coupon. For CDs with
floating rate coupons, the life of CD is subdivided into sub-periods of usually 6 months. Interest is fixed
at the beginning of each period and is based on LIBOR or US Treasury Bill rate or prime rate.
In India Certificates of Deposits are being issued since 1989, by banks, either directly to the investors
or through the dealers. CDs are documents of title to time deposits with banks. They are interest
bearing, maturity dated obligations of banks and are technically a part of bank deposits. They represent
bank deposit accounts which are transferable. CDs are marketable or negotiable short-term
instruments in bearer form and are known as Negotiable Certificates of Deposit. They represent
securitized and tradeable term deposits. CDs are a high cost liability and are issued only when deposit
growth is sluggish but credit demand is high. The minimum issue of CDs to a single investor is.Rs.10
lakh (April 15, 1994) and additional amount in multiples of Rs. 5 lakh each. CDs are in bearer form and
can be traded in the secondary market. Since they are not homogeneous in terms-of issuer, maturity,
interest rate and other features, secondary market has not developed.
There has been a spurt in the growth of CDs on account of issue of guidelines by RBI on investment by
banks in non-SLR debt securities, reduction in stamp duty on CDs effective March 1, 2004 and greater
opportunity for secondary market trading’.
CDs are issued at face value for periods varying between 2 weeks to 5 years. They are commonly
issued for 90 days. Banks tailor the maturity to suit corporate customers. The outstanding amount of
CDs varied in the range of Rs. 1,485, Rs. 4,656 crore in 2003-04 in the range of 5% in 2003-04. Total
CDs outstanding constituted 5.1% of the aggregate deposits of issuing banks.
5.8 COMMERCIAL PAPER
Commercial paper was introduced in January, 1990, to enable highly-rated corporate borrowers to
diversify their sources of short-term borrowings and also to provide an additional instrument to the
investor.’ The guidelines issued by the RBI regulating the issue of commercial paper applies to all non-
banking financial arid non-financial companies. PDs have also been permitted to issue CPs to access
short-term funds.
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Issue of commercial paper Commercial paper can be issued by a company whose, (i) tangible net
worth (paid up capital plus free reserve) is not less than Rs. 5 crore; (ii) fund-based working capital
limits are not less than Rs. 4 crore; (iii) shares are listed on a stock exchange; (iv) specified credit rating
of P2 is obtained from Credit Rating Information Services of India Ltd. (CRISILJ-and A2 in the case of
Investment Information and Credit Rating Agency of India Limited (ICRA);
(v) borrower account is classified under health code No. 1; and
(vi) current ratio is 1.33 :1.
Usance Commercial paper should be issued for a minimum period of 7-days and a maximum of one
year. No grace period is allowed for payment and if the maturity date falls on a holiday it should be paid
on the previous working day. Every issue of commercial paper is treated as a fresh issue.
Denomination Commercial paper is issued in the denomination of Rs. 5 lakh. But the minimum lot or
investment is Rs. 25 lakh (face value) per investor. The secondary market transactions can be Rs. 5
lakh or multiplies thereof. Total amount proposed to be issued should be taised within two weeks from
the date on which the proposal is taken on record by the bank. The paper may be issued in a single day
or in parts on different dates in which case each paper should have the same maturity date.
Ceiling The aggregate amount that can be raised by commercial paper by corporate is 100% of the
working capital credit limit (November, 1996).
Mode of issue and discount rate Commercial paper should be in the form of usance promissory note
negotiable by endorsement and delivery. It can be issued at such discount to face value as may be
decided by the issuing company. Issue expenses Issue expense consisting of dealer’s fees, rating
agency fee and other relevant expenses should be borne by the company.
Investors Commercial paper may be issued to any person, banks, companies and other registered (in
India) corporate bothes and unincorporated bothes. Issue to NRIs can only be on a non-repatriable
basis and is non- transferable. The paper issued to the NRI should state that it is non-repatriable and
non-endorsable.
Procedure for issue Commercial paper is issued only through the bankers who have sanctioned
working capital limits to the company. It is counted as a part of working capital. Unlike public deposits,
commercial paper really cannot augment working capital resources. There is no increase in the overall
short-term borrowing facilities.
Every company proposing to issue commercial paper should submit the proposal in the form prescribed
by the RBI to the bank which provides working capital along with credit rating of the company. The bank
scrutinizes the application and on being satisfied that the eligibility criteria are met and conditions
stipulated are complied with, takes the proposal on record. The issue has to be privately placed within
two weeks by the company or through the good offices of a merchant banker. The initial investor pays
the discounted value of the paper to the account of the issuing company with the bank in writing. The
company has to advise the RBI through the bank, of the amount of commercial paper issued within
3 days.
Commercial paper proved popular as a money market instrument during periods of down swing of
credit growth when corporate are able to access the CP market at rates lower than the PLRs of banks.
The share of manufacturing companies in the amount of CPs declined over time to 31% in 2004-05; the
share of leasing/ finance companies increased to 56%; and FIS, 13%. Manufacturing companies
enjoyed larger internal accruals and introduction of sub PLR lending banks saving on stamp duty, costs
of demat and fees for issuing and paying agents. The outstanding amount of CPs was Rs. 9,131 crore
as on March 31, 2004. The weighted average discount rate was 5.11% at the end of March, 2004.
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Commercial bill market Trade bills are drawn by the seller (drawer) on the buyer (drawee) for the
value of goods delivered to him. Commercial banks as a part of the working capital limits grant a
component for discounting such bills. Normally, 20 per cent margin, is kept and the trade bill when
presented by the constituent proceeds to his account. These bills can be for 30 days, 60 days or 90
days depending on the credit extended in the industry to which the constituent belongs. Interest is
charged for the time it takes to collect the bill.
Bill discounting is a part of money market and the bill as an instrument provides short-term liquidity to
banks in need of funds by getting them discounted by financial institutions such as Banks, LIC, UTI,
GIC, ICICI, IRBI and ECGC. Although the cost of bill rediscounting is lower than the cost of inter-bank
deposits and loans of 60/90 days, the trade bill has hot become popular. Bills rediscounted by
commercial banks with FIs amounted to Rs. 735 crore at the end of February, 2000. The proportion of
bills Rs. 37,066 crore to total bank credit of (bills plus cash credit), Rs. 2,40,144 crore on March
31,1999 was 15.3 per cent. There is hardly any secondary market.
1. What is ‘Call Money Market’?
2. Define ‘Term Money Market’?
3. What are ‘Teasing Bills’?
4. What are “Certificate of Deposits”?
5.10 SUMMARY
The Capital market is referred to as a place where saving and investments are done between capital
suppliers and those who are in need of capital. It is, therefore, a place where various entities, trade
different financial instruments. The primary market is a new issue market; it solely deals with the issues
of new securities. A place where trading of securities is done for the first time. The main objective is
capital formation for government, institutions, companies, etc. also known as Initial Public Offer (IPO).
The secondary market is a place where trading takes place for existing securities. It is known as a stock
exchange or stock market. Here the securities are bought and sold by the investors. The main point of
difference between the primary and the secondary market is that in the primary market only new
securities were issued, whereas in the secondary market the trading is for already existing securities.
There is no fresh issue in the secondary market. The securities are traded in a highly regularised and
legalized market within strict rules and regulations. This ensures that the investors can trade without the
fear of being cheated. In the last decade or so due to the advancement of technology, the secondary
capital market in India has seen a great boom.
5.11 GLOSSARY
Capital: Capital is a large sum of money which you use to start a business, or which you invest in order
to make more money. Capital is the part of an amount of money borrowed or invested which does not
include interest.
Capital Market: Capital Market deals in financial instruments and commodities that are long-term
securities. The funds will be used for productive purposes and create wealth in the economy in the long
term.
Initial public offering (IPO): IPO or stock market launch is a type of public offering. Through this
process, a private company transforms into a public company. Initial public offerings are used by
companies to raise money for expansion and to become publicly traded enterprises.
Stock Exchange: Stock Exchange share market or bourse is a place where people meet to buy and
sell shares of company stock. Some stock exchanges are real places (like the New York Stock
Exchange), others are virtual places (like the NASDAQ).
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Stock Market: Stock Market is a place where shares of pubic listed companies are traded. The primary
market is where companies float shares to the general public in an initial public offering (IPO) to raise
capital.
Stock Market Works: Stock market works like an auction where investors who buy and sell shares of
stocks. These are a small piece of ownership of a public corporation.
1. Define money market and specify the instruments.
2. Who can issue commercial paper?
3. Discuss the different types of Treasury Bills.
India.
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Lesson-6
Government Securities Market
STRUCTURE
6.1 Introduction
6.2 Nature of Government Securities Market
6.3 Salient Features
6.5 Summary
6.6 Glossary
By the end of this chapter, you should be able to know:
1. The composition of the stock market in India.
2. The significance of the market in government securities.
3. The nature of the government securities market.
6.1 INTRODUCTION
This chapter and the next are devoted to describing and analyzing working of stock market. The stock
market is composed of the new issue market which is a primary market for raising fresh capital, and the
stock exchange which forms the secondary market for securities. Each of these markets deals in two
important groups of securities: (a) Government and semi government securities, and (b) industrial
securities. Although the stock market is associated in the minds of most people with a market for
industrial securities, in fact these’ constitute a relatively small part of the stock market. Fresh funds
mobilized through the issue of government and semi government securities and the private corporate
securities accounted for 93 to 97 per cent and 3 to 7 per cent, respectively, of the total amount of fresh
funds mobilized through the issue of all securities on the stock market during 1971-72 to 1977-78. The
share of government securities in the total capital raised varied between 94.1 and 79.44 per cent during
1986-87 to 1988-89.
Thus the market in government securities happens to be an overwhelmingly significant part of the stock
market in India. In the UK also, as in India, the market in government securities is much larger than that
in industrial securities. In the USA, however, it is the other way round. In this chapter we will discuss
various aspects of the working of the market in government securities in India.
6.2 NATURE OF GOVERNMENT SECURITIES MARKET
(i) The supply of government securities stems from the issue of government’s marketable debt. These
securities are issued by the Central government, State governments, and semi-government authorities
48
which include local government authorities like city corporations and municipalities, autonomous
institutions like port trusts, improvement trusts, state electricity boards, metropolitan authorities, public
sector corporations, and other government agencies such as IDBI, IFCI, SFCs, SIDCs, NABARD,
LDBs, housing boards, and the like. The Central Government issues bonds, treasury bills, and special
rupee securities in payment of India’s subscriptions to IMF, IBRD, ADB, IDA, and so on. The special
rupee securities are treated as a part of internal floating debt of the government. They are non-
negotiable and non-interest bearing claims. The market for treasury bills has already been discussed.
The State governments and semi-government agencies issue bonds or debentures. Certain
government agencies like IDBI are established to implement Government’s various lending operations
and they issue bonds to finance their activities. Originally, most of them were financed by the Treasury,
but there has been a trend towards their self-financing through the issuing of debentures. This segment
of the government securities market is, therefore, an expanding one.
(ii) Government securities are a unique and important financial instrument in the financial markets of
any country. Unlike other instruments (except TBs), it is also held by the central bank of the country,
and the working of two of the major techniques of monetary control of the central bank—open market
operations and statutory liquidity ratio—are closely connected with the dynamics of the market for this
instrument. Again, unlike other instruments, its issues are helpful in implementing the fiscal policy of the
Government. Financial institutions like commercial banks are required to maintain their secondary
reserve requirements in the form of these securities. It is also easier to obtain loans against the
collateral of these securities. Commercial banks in India can obtain accommodation from the RBI
against the collateral of these securities. As the RBI can issue currency notes against the backing,
apart from gold and foreign exchange, of the Central Government bonds, they constitute the ultimate
source of liquidity in the economy. As government security is a claim on the Government, it is an
absolutely secure financial instrument which guarantees the certainty of both income and capital. It is,
therefore, called a “gilt-edged” security or stock. It is true that many alternative instruments like
industrial debentures, and stocks of local “authorities are also quite secure, but the Central Government
securities are the safest of all such claims.
(iii) These securities are normally issued in the denomination of Rs. 100 or Rs. 1000. The face value
which used to be 100 till the middle of the 1980s was raised to 1000 in the recent past. The rate of
interest on these securities is relatively lower because of their being liquid and safe. In addition, it has
been deliberately maintained at a low level by the government in order to minimize the cost of servicing
public debt. Yet, the market for these securities has expanded every year because of the regulations,
statutory or otherwise, under which financial institutions are required to invest a certain proportion of
their investible funds in these, securities. At the rates of interest that can be earned on these securities,
any other borrower but government or government-backed organizations would have been unable to
raise funds on any significant scale, let alone on an increasing scale.
(iv) The interest on government securities is payable half yearly. Interest in respect of Central and
State government securities, along with income in the form of interest or dividends on other approved
investments, is exempt from income-tax subject to a limit The value of investments in these securities
and other investments specified in the Wealth Tax Act 1957 is exempt from wealth tax up to a limit. As
individuals do not normally invest in these securities, saving in tax liability does not seem to be an
important motivation behind investment in them. Unlike in the USA, interest on the securities of loca l
authorities is not exempt from tax in India.
(v) Although it is true that government securities are liquid and safe, securities of different authorities
differ in respect of the extent to which they possess these attributes. The marketability of securities of
State governments, and semi-governments is relatively restricted; therefore, they are less liquid than
Central government securities. There is no active market, particularly in semi-government securities.
There is no need for the underwriting or guaranteeing the sale of Central and State government
securities. The fact that the RBI is always ready to buy the unsubscribed (by public) part of any loan
49
issued amounts to underwriting of these issues. Around the 1950s, issues of State government
securities used to be underwritten, but, thereafter, such a need has not arisen. The securities of semi-
government agencies, however, may need to be underwritten. They are also guaranteed by the Central
or State government for repayment of principal and the payment of interest.
(vi) There are three forms of Central and State government securities: (a) inscribed stock or stock
certificate (SC); (b) promissory note (PN); (c) bearer bond. While these days, bearer bonds are not
usually issued in India, stock certificates are not very popular with investors. Consequently, most
government securities currently are in the form of promissory notes. Promissory notes of any loan can
be converted into stock certificates of any other loan or vice versa. In order to popularize the holding of
stock certificates, governments specially advertise the following advantages to distinguish them from
promissory notes: (a) they are safer than PN as the name of the holder is registered in the books of the
Public Debt Office (PDO); (b) the stock certificate relating to the application tendered at any branch of
the SBI or its subsidiary is sent to the applicant directly by the registered post by the PDO; (c) the. half-
yearly interest is remitted to the holder directly by an interest warrant drawn at par on any Treasury or
SBI as stipulated by the holder or is remitted by M.O. if so desired; (d) the holder, can sell it by signing
the transfer form on the reverse of the certificate. On the other hand, interest on PN is payable only on
the presentation of the note at the office at which it is enfaced. The major reason why SC is not popular
in spite of these advantages is its lack of quick transferability and negotiability. It is not transferable by
endorsement; the procedure for effecting its transfer is much more complex. In the case of PN, the title
is transferable by endorsement and delivery and it is a negotiable financial instrument. This suggests
that investors-who need to borrow often against the collateral of government securities prefer, PN to
SC. In a relative sense, if SCs are often bought by investors like L1C, PF, etc., PNs are in demand by
banks.
(vii) Government securities are issued through the PDO of the RBI. The method of selling them differs
from that of selling TBs. Instead of selling them through auction, the issues are notified a few days
before they become open for subscription and they are kept open for subscription for 2—3 days, but,
they may be closed for subscription earlier if the subscriptions approximate the amount of issue. The
budgeted amount of issues in a given year is raised in a number of tranches in that year. This is
obviously to avoid flooding the market with securities at a given time. However, as the issues are
mostly bought by institutional investors, there can be a small number of large issues. After the
announcement of new issue, the RBI suspends the sale of existing loans till the Closure of
subscriptions to new loans. The Government reserves the right to retain subscriptions up to a specified
percentage, say 10 per cent in excess of notified amounts. Applications for loans are received at the
offices of the RBI and at the branches of the SBI. In the case of issues of State government securities,
over-subscription to loans of one government is transferable to the other government whose loan is still
open for subscription, at the option of the subscriber. Due to the seasonal character of the money
market, issues are mostly concentrated dining the slack seasons.
Because of the size of debt and the continuous need for raising fresh capital, the effective issue and
redemption on single dates as happens in the case of industrial securities has become impossible. The
old method of issue of blocks of securities and their redemption on single maturity dates continues in
form, but, when the issue of bonds is announced, a part is taken over by the RBI which sells the
amount gradually through the stock exchanges in the ensuing period. Similarly, “grooming” and
“switching” implies that the RBI buys the bonds gradually through the stock exchange until usually only
a small proportion remains to be paid off on the formal maturity date. Thus, in practice, the process of
issue and redemption have become continuous. This also means that securities are available on “tap”,
and the securities thus obtained may be called “tap stocks”,
(viii) The role of brokers and dealers in the process of marketing of government securities in India is
much more limited than in other countries. The RBI does have, it’s approved brokers and the major part
of the turnover in the market takes place through these brokers. But the scope for participation in the
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market by other brokers is limited. A recent step taken by the RBI has also reduced the volume of
business available to official brokers. With effect from June 1978, the RBI has discontinued the practice
of charging differential interest rates for the purchase and sale of the Central government securities to
enable banks to approach it directly instead of through brokers. As regards the dealers, it may be
stated that the agency of dealer-banks is more active than that of individual dealers. There are some
half-a-dozen active firms of security dealers in Bombay, but their number elsewhere is limited. They are
in daily contact with the RBI as well as banks, LJC, and other institutional investors. They also keep in
touch with each other and as a result of their activities gilt-edged securities enjoyed the benefit of
extremely fine quotations. These dealers act mainly as jobbers. The gilt-edged market is an “over-the-
counter” market and each sale and purchase has to be separately negotiated. Orders received locally
by members of the stock exchange are passed on to the security brokers and dealers who then try
various sources, among which are banks. The brokers and dealers explore the possibilities of business
among themselves and with their upcountry correspondents, but such business is limited and the
market is confined mainly to institutional investors.
The scope for individual dealer activity in the Government securities market in India is limited perhaps
because the volume of floating stock is limited. Most of the investors who purchase government
securities usually hold them till maturity. Commercial banks can buy as much as they want, but they
cannot sell securities beyond a limit due to the SLR requirements. All such factors have restricted the
growth of the secondary market which, in turn, has restricted the scope for dealer activity. Commercial
banks deal in securities as they supply securities to the market. They also take up state loans and
corporation bonds when they are first floated, and sell them gradually when the market can absorb
them. The RBI acts as the biggest dealer through its OMOs. In other countries, the central bank
confines its dealings mainly to treasury bills as a part of OMOs; this has created a need for the services
of dealers in government securities in those countries. In India, on the other hand, continuous
participation by the RBI in the government securities market has resulted in the lack of growth of the
institution of dealers. Further, dealers need funds for their operations. Usually such funds are obtained
from the commercial banks in other countries. But the high cost of borrowing funds from banks
compared with the low yield on government securities has also inhibited the growth of dealers in this
market. With the tremendous growth of Government stocks however, there is a Scope for the growth of
dealers in the government securities market.
(ix) In any given year, both the Central and State governments need to raise funds through public
borrowings. The normal practice has been to sell their securities separately; but in 1954-55 and 1963-
64 only consolidated loans were issued. The method of issuing consolidated loans has, it was found,
certain important disadvantages. First, it is difficult to decide the share of various State is in a
consolidated loan. Second, the centralized method does not offer space for trapping local rsources.
The issue of securities may be undertaken for refunding, i.e, conversion or refinancing of maturing
securities; advance refunding of securities that have not yet matured (in India this is known as reissue
of loans) and cash financing. Refunding itself can be carried out either by selling new securities for
cash settlements and using the proceeds to retire old issues, or by offering holders of the maturing
securities the right to exchange (convert) old securities for new issues. The objectives of conversion
and reissue of loans is to lengthen the maturity structure of Government debt, and to reduce the volume
of cash repayment of loans. It may be relevant here to mention two other operations usually ca rried out
by the RBI in the government securities market to achieve the objectives just mentioned and to facilitate
the new issues of securities. They are “grooming” of the market and “switches” in the market. While
“grooming” may be defined as “acquiring securities nearing maturity to facilitate redemption and making
available on tap a variety of loans to broaden the gilt-edged market”, switches are “purchases of one
security against the sale of another security as distinct from outright purchase or sale of security.”
These operations are part of the OMOs of the Central Bank and might be said to differ technically from
“refunding” and “reissue” in that they are undertaken in the secondary market, while the latter are
undertaken in the primary market for government securities.
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(x) The RBI occupies a pivotal position in this market it is continuously in the market selling
Government securities and buying them mostly in switch operations and rarely for cash. It purchases
these securities out of the surplus funds of IDBI, EXIM Bank, and NABARD under special
arrangements. Switch operations are useful to banks and financial institutions to improve their yields on
their investments in Government securities. Sometimes, there are triangular switch transactions in
which one investor’s sale or purchase is matched by the purchase or sale transactions of another
investor, the RBI being the middle party. The RBI fixes annual quota, based on the size of the bank, for
switch transactions for each bank from time to time with a view to prevent banks from exclusive sales of
low-yielding securities to the RBI. It maintains separate lists of securities for purchase and sale
transactions. Different scrip’s are included in the two lists having regard to the stock of securities and
dates of their maturities. One of file unique features of trading in this market is the “voucher trading” or
“voucher benefit”. The banks and financial institutions whose earnings are taxed purchase the
securities around the interest due date and unload them in the market after availing themselves of the
voucher for the full year. This practice has activated trading in these securities, particularly around
interest due date. But this active trading is not a genuine trading. Therefore, Chakravarty Committee
has ‘asked the RBI to fix quotas for switch transactions, and to, suspend trading in a particular scrip for
one month before interest due date.
6.3 SALIENT FEATURES
Certain salient features of the market in government securities that emerge from the foregoing
discussion may be summarized below:
(1) In “terms of size, it is much bigger than the industrial securities market. Due to the growing
requirement of funds by the government for developmental and non-developmental needs, this market
has been rapidly expanding. This is similar to the situation obtaining in the UK, but not in the USA,
where the market for industrial securities is bigger than the market in government securities. This is so
because of the difference in the share of the public sector in investment in physical and financial
assets.
(2) The ownership pattern of government securities also differs from that of industrial securities.
Although indirect ownership has increased with regard to both, the participation by individuals is much
greater in the industrial securities market. On the other hand, government securities play a special role
in the asset management of many financial institutions. As far as individual ownership is concerned, the
situation in India is largely similar to that in the UK, but it differs somewhat from the USA where
government securities are owned by individuals to a greater extent.
(3) The average maturity of government debt at first decreased till 1965, then it increased substantially.
Thus, since the early 1970s, the risk of monetization of government securities and the threat from that
side to monetary policy have diminished.
(4) Unlike in the UK and the USA, the secondary market in government securities in India is narrow
and less active. Only commercial banks participate in this market on any significant scale. In the UK
and USA, the secondary market in government securities is quite active and sophisticated, because of
which the holders of government securities, particularly large ones, can earn dealing profits by a policy
of switching from one stock to another as temporary price differences appear. The institution, of dealers
is well-established in those countries and institutional developments like securities repurchase
agreements between dealers and corporations have emerged in a country like America. In India, there
is no worthwhile connection between the call money market and the government securities market.
(5) Interest rates in the government securities market are not aligned well with rates in other financial
markets, although the gap between rates in these markets has been significantly narrowed during the
1980s. In the UK, movements in the yield on-government bonds affect the entire structure of interest
rates.
(6) The intervention of authorities in the government securities market in India has been mainly for
supporting the market and for minimizing the cost of servicing public debt. The growing national debt
52
has also made it necessary for governments in the UK and the USA to intervene in this market mainly
for the same purpose.
1. What is ‘Stock Market’?
2. Define ‘Government Securities’?
6.5 SUMMARY
Government securities are the instruments issued by central government, state governments, semi-
government bothes, public sector corporations and financial institutions such as IDBI, IFCI, State
Financial Corporation’s (SFCs) etc. in the form of marketable debt. Government securities form an
important part of the stock market in India. Today, funds mobilised through the issue of government
securities account for more than 80% of the total amount of funds mobilised on the stock exchanges of
India through the issue of all securities including government and corporate). Funds mobilised are tired
to meet the short-term and long-term needs of the government. Central government securities are
considered to be the safest amongst all type of securities as regard to the payment of interest and
repayment of principal amount. They are free of default-risk or credit risk. They are considered to be
more liquid assets and ensure certainty of capital value not only at maturity but also before maturity.
Since the date of maturity as mentioned in the securities, these are also known as dated government
securities.
6.6 GLOSSARY
Government securities: government securities are the instruments issued by Central Government
State governments and is government bothes public sector corporations and Financial Institutions such
as IDBI IFSC state financial corporations etc.
Primary dealers (PD): primary dealers are introduced by Reserve Bank of India for strengthen the
infrastructure in the GSM so as to make it more vibrant liquid and broad-based.
Satellite dealers (SD): Reserve Bank of India introduced the concept of satellite dealers in order to
provide supporting infrastructure in the Government Security market. Satellite dealers help in trading
and distribution of government securities.
1. Refer to 6.1
2. Refer to 6.2
1. Describe the working of stock market.
2. Discuss the nature of government securities.
3. Explain the salient features of the market in government securities.
6.9 ANSWERS TO TERMINAL QUESTIONS:
1. Refere to Section 6.1 & 6.2
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Hall of India,
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54
Lesson-7
Industrial Securities Market
STRUCTURE
7.1 Introduction
7.2 Organization of the stock market
7.3 Industrial Securities
7.4 Ordinary Shares
7.5 Preference Shares
7.6 Debentures or Bonds
7.7 Salient Feature of Industrial Securities
7.9 Summary
7.10 Glossary
After studying this lesson you should be able to:
1. Know the significance of the industrial securities.
2. Explain the Organization of the stock market
3. Describe the different types of industrial securities premising in India.
7.1 INTRODUCTION
Having discussed the market in government securities in the previous chapter, we will now take up the
market in industrial securities.
7.2 ORGANIZATION OF THE STOCK MARKET
At the end of June 1989, there were eighteen recognized stock exchanges in India. Four of these—in
Bombay, Delhi, Calcutta, and Ahmadabad— accounted for about 90 per cent of the overall business,
and Bombay alone accounts for about 70 per cent of the total trading business on all the stock
exchanges put together. It accounts for 40 per cent of the total listed issues, 67 per cent of paid-up
capital, and 76 per cent of market value of issues listed in India. The stock exchange at Bombay is
distinguished not only by its size, but it is also the oldest market and has been recognized permanently,
while the recognition for other markets is renewed every five years. Stock markets are organized either
as voluntary, non-profit-making associations (Bombay, Ahmadabad, Indore), or public limited
companies (Calcutta, Delhi, Bangalore) or company limited by guarantee (Madras, Hyderabad). Thus,
55
unlike in the UK, there are in India separate, independent exchanges with diversity of organizational
structures, and there is neither the National Exchange nor provincial exchanges in our country. In the
UK there has been a move to create a unitary organization of stock exchanges. In 1965, 22 separate
provincial stock exchanges were merged into three regional stock exchanges, and in 1973 these, in
turn, were combined to form the National Stock Exchange under the title of the Stock Exchange which
has trading, floors in many former provincial centre. In view of the large size of the country, to adopt
such a policy for India is not advisable.
The size of the industrial securities market in India is relatively much smaller than that in other
industrialized countries. This is so because of the industrial structure, investment habits, and the level
of education of investors in India. During the planning period, the role of public sector companies has
much increased in the business activity of the country; today, in terms of paid-up capital, government
companies are much more important than companies in the private sector. The shares of government
joint stock companies are not yet quoted on stock markets, although there is .a move to offer a part of
capital (say, 25 per cent) of selected government companies for subscription to the public. Industrial
securities are not a major source of funds even for private sector industrial units. Nor are they a very
popular mode of savings for individuals. Savings in the form of industrial securities were hardly one per
cent of total financial assets of the household sector till the end of 1960s. Subsequently, this share was
about 3 per cent till 1984-85, and 4 to 6 per cent thereafter. In short, the volume of industrial securities
in relation to government securities, their role in financing the private sector, and their significance as a
savings medium, indicate that the industrial securities market can hardly be regarded as a barometer of
economic activity in India.
Movements in equity prices do not reflect the state of Indian economy. The market in equities in India is
dominated by speculators; it thrives on scarcities and inflation. The interest of stock market centres
around the performance of a few industrial units whose shares are valued by speculators. Hardly 30 to
40 scrips (2 per cent of listed stock) in the cleared as well as non-cleared list account for the bulk of
activity on the Bombay Stock Exchange. In 1981, 17 leading scrips accounted for over 90 per cent of
business in cleared securities. In 1988, 25 scrips accounted for 75 per cent of overall trading business.
We will not discuss here the details of membership rules, listing regulations, and trading rules
concerning stock market. Only a few important points may be noted here. Such securities only are
traded on the stock market as are “listed”. They (listed stock) are also known as quoted securities. With
effect from 13 February 1989, any company can list, duelist and realist its securities by paying a
stipulated fee, provided its equity capital is at least Rs. 3 crores and at least Rs. 1.8 crores, i.e. 60 per
cent of this capital, is offered for public A subscription. Earlier, minimum equity capital limit was Rs. 1
crore. Of this amount, a maximum of 11 per cent may be reserved for the Government, their
development agencies, and financial institutions. The principal objective behind the listing-requirement
is to ensure proper supervision and control of dealings in securities, and to protect the interests of
share-holders and the general investing public. Another objective is to avoid the concentration of
economic power, to give promoters an opportunity to invest sufficiently in the company for their own
benefit, and to require promoters to have a reasonable stake in the company.
Listed securities are classified as “cleared” or “specified” or “Group A” securities and “non-cleared” or
“unspecified” or “Group B” or “cash” securities. Cleared securities on a given exchange are those that
are included in the cleared list by the governing body of that exchange after the securities have
satisfied the following conditions: they are folly paid-up equity shares; they must not be shares of
banking companies; they must have been admitted to dealings for at least three years on the given
exchange; they must not appear on the cleared list of any other stock exchange; the companies whose
shares they are should be of public importance; the subscribed capital of these companies must be at
least Rs. 25 lakhs: their aggregate value at the ruling market price should be at least Rs. 1 crore; and at
least 49 per cent of the capital of the companies must be held by the public. At present, there are about
120 shares in the specified group in Bombay, Delhi, Calcutta and Ahmadabad exchanges; out of these
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scrips, 70 are listed on the Bombay Stock Exchange alone. As far as Bombay is concerned, the
average monthly turnover of “A Group” securities was Rs. 600 crores whereas for “Group B” it was Rs.
120 crores in 1987.
As the conditions laid down for inclusion in the cleared list are difficult to meet, cleared securities are
few in number and form only a small proportion of the total corporate securities. But because of their
characteristics, they are more actively traded in, and in terms of the number of shares traded, business
in them accounts for a major portion of the total business on the stock exchanges in India.
Transactions on stock exchanges are carried out on either cash basis or carry over basis, i.e. through
“clearing”. Exchanges at Bombay, Calcutta, Madras and Ahmedabad have their own clearing houses.
The business in Group A securities is settled through clearing houses in addition to other methods of
settlement. The stock exchange year is divided into periods called “accounts”. An account normally
runs into a fortnight, but sometimes it may be for longer durations of 3 to 4 weeks. All transactions
made during one account are to be settled by payment for purchases and by delivery of share
certificates in the case of sales on notified days of the clearing programme of a given stock exchange.
Transactions in non-specified securities have to be settled compulsorily by delivery; carryover is
permitted only in respect of Group A securities. At the end of a settlement period, the investor in
specified shares has three options: (a) he can terminate his contract of sale or purchase by a cross
contract, i.e. by squaring up transaction; (b) he can complete the contract by delivery or payment as the
case may be; and (c) he can carry over the contract to the next settlement. For example, if the investor
who has purchased shares has no money to pay for his purchases, he can arrange with his broker to
carry forward his business to the next settlement account. His broker would then find out someone who
would receive the shares on behalf of the said investor and pay for them on the due date, i.e. on pay-in-
day. The financier who advances the required funds will charge interest on the money loaned by him,
and this is known as “contango” or “badla” for the fortnight till the next pay-in-day. Sometimes the seller
may also have to pay the charge to the buyer when the shares are oversold and the buyers are in a
demanding position; this is known as “backwardation charge” or “undha badla”. The “badla” system
plays a crucial role in the carry forward transactions. The badla charges have the-approval of the stock
exchange authorities who may even fix badla charges under exceptional circumstances. Usually,
special sessions are held by the stock market at the end of each settlement period to determine the
badla charges of individual shares in the specified list in actual biddings.
The types of transactions on cash basis according to arrangement for delivery (delivery-wise) are:
(a) spot delivery, the delivery and payment are made on the same day as the day of contract or on the
next day; (b) hand deliver, the delivery and payment are made when stipulated or within 14 days
whichever is shorter; (c) special delivery, the delivery and payments are made beyond 14 days if
permitted by the stock exchange authority.
The marketing of old or new securities on the stock markets can be done only through members of the
stock exchanges. These members are either individuals or partnership firms. There are more individual
members than partnership firms. In the UK the authorities have allowed the entry of joint-stock
companies as brokers or dealers, for they can mobilize large amounts of funds. In India also, in order to
rid stock exchanges of the stranglehold of a few and powerful groups of brokers, and with a view to
broadening the base of the management of stock exchanges, moves have been initiated to allow
banks, mutual funds, and other financial institutions to become members of the stock exchanges. It is
also expected that individuals, partnerships, and family concerns of brokers would organize themselve s
into corporate bothes. The stock exchange members act in One or more capacity as: (a) commission
broker, (b), floor broker, (c) Tarvaniwala, (d) jobber or dealer, (e) odd lot dealer, (f) budliwala or
financier, and (g) arbitrageur. With regard to new issues, brokers do all that which is performed by
specialized issuing houses in the UK-’The practice of some commercial batiks managing issues
through their merchant banking divisions is also known to the market. The brokers advise promoters on
the composition of capital structure and the form in which the new issue is to be made; they draft
57
prospectus and application forms; they explore the possibilities of securing loans from financial
institutions; they arrange for underwriting, sub-underwriting, and placing of new issues; they organize
the preliminary distribution of securities; and they procure direct subscription from investors. The
commission rates of brokers are fixed by the stock exchanges. The official brokerage for both types of
issues is fixed at 1.5 per cent. It is found that some brokers offer commission as high as 4 to 5 per cent
to their sub-brokers to sell weak issues as attractive ones. This has detrimental effect on the interests
of investors.
A part of the transactions on the stock exchanges is riot covered by any of the four methods of setting
transactions mentioned earlier. This part is known as forward trading. In its wider sense, forward trading
includes not only dealings in forward markets, but also all orders given in advance and all long-term
contracts. Similarly, forward trading is done not only in shares but also in commodities, foreign
exchange, and so on. It refers to entering into contracts today (i.e. in advance) to buy or sell (i.e.
demand and supply) certain goods at some particular date in the future, the date being beyond a
certain minimum period of time fixed for settling spot transactions. In a market economy, forward
trading is a device to coordinate the price expectations and plans to buy arid sell by different
individuals. It is the uncertainty about the future and the desire to keep one’s hands free to meet that
uncertainty and profit from it which gives rise to forward trading. Forward markets are usually made of
hedgers, i.e. those who enter into forward Contracts in order to reduce the risk arising out of uncertainty
in regard to their desire to buy or sell in a future period, and speculators, i.e. those who seek a profit out
of a discrepancy between the future price and the spot price they expect to rule on the corresponding
date. As opposed to the hedger, the speculator puts himself in a more risky position as a result of his
forward trading. The forward market in shares is dominated by speculators rather than by hedgers.
Forward trading is said to be indispensable for ensuring price continuity, liquidity, free negotiability of
capital, and fair evaluation of securities. If this is so, a ban on forward trading should adversely affect
the activity connected with new issues. But in India, this has not actually happened.
Transactions on forward markets are determined by the relationship between the current spot price,
currently fixed future price, and the expected spot price at a particular date in the future. There is said
to be a Backwardation” if the future price is below the current spot price, a “contango” in the reverse
case. If the spot price is expected to be about the same at some future date as it is today, the future
price for delivery at that date would be below the spot price now ruling. On the other hand, contango
can arise only when spot prices are expected to rise sharply in the future; this usually means that
current spot prices are abnormally low.
With regard to the organization of the stock market, it is necessary to remember that the entire working
of the new issue market in India is governed by the Controller of Capital Issues (CCI) who exercises his
powers in terms of the Capital Issues (Control) Act, 1947. The timing of the new issues by private
sector companies, the composition of securities to be issued, interest (dividend) rates which can be
offered on debentures and preference shares, .the timings and frequency of bonus issues, the price of
right issues, the amount of prior allotment to promoters, floatation costs, premium to be charged on
securities are all subject to the regulation of the CGI. Over time, the CCI has liberalized the rules and
regulations. Effective from 1966, Private Ltd. Cos. and Government Companies not making public
issues, and banking and insurance companies have been exempted from the prior consent of the CCI.
Even in the case of non-financial non-government companies, so long as they conform to certain
prescribed norms pertaining to debt-equity ratio, public participation, and premium size, they now
merely need to inform the authorities of their intention to raise capital for which a no objection certificate
is issued by the CCI.
The extent of growth of listed stock can be gauged from Table 5.1. The number of companies whose
securities are listed on any one of the stock exchanges is very small, but in terms of paid-up capital,
listed companies constitute a major portion of the non-government corporate sector. It can also be
observed that in terms of various indicators, the growth of listed stock has occurred at a faster rate
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during the period after 1961. In fact, the proportion of listed paid-up capital to the total paid-up capital in
the private sector declined during 1946-61, picked up again and exceeded its original level
subsequently.
Table
Growth of Listed Stock in India, 1946-88
Item/Year 1946 1961 1977 1988
1. Number of listed companies 1125 1203 1996 5841
2. 1 as percentage of non-government companies 7 5 5 4
3. 1 as percentage of non-government public 11 18 26 32
limited companies
4. No. of stock issues of listed companies 1506 2111 3462 7694
5. No. of share units issued by listed companies 1565 4264 18910 ---
(lakhs)
6. Paid-up capital of listed companies (Rs. Crores) 270 675 2538 21465
7. 6 as percentage of paid-up capital of non- 65 53 75 ---

government companies
8. 6 as percentage of paid-up capital of non- 88 71 90 ---
government public limited companies
9. Market value of 6 (Rs. Crores) 971 1216 3276 51379
10. 9 as percentage of 6 359.63 180.15 129.08 239.36
Source: Bombay Stock Exchange, Stock Exchange Directory.

Another way to gauge the growth of stock market activity is to know the volume of turnover on stock
exchanges. Table 5.2.presents the annual turnover on all stock exchanges in India and on Bombay
stock exchange. It shows that the turnover has tripled during the decade
Table 5.2 Annual Turnover on Stock Exchanges in India, 1979-88 (Rs. Crores)
Year All-India Bombay
1979 3159 2211
1960 3095 2166
1981 8279 5795
1962 6794 4756
1983 3430 2401
1954 6364 4455
1955 8763 6134
1986 19423 13596
1987 12486 8740
1988 8695 6087
SOURCE: Bombay Stock Exchange.
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1979-88; that the volume of turnover is subject to fluctuations; that the peak in turnover was reached in
1986; and that Bombay stock exchange accounts for about 70 per cent of total turnover in India.
7.3 INDUSTRIAL SECURITIES
Business concerns raise capital through three major types of security. They are: (a) ordinary shares or
variable dividend securities or common stock, (b) preference shares, and (c) debentures or bonds.
Ordinary shares and preference shares are also known as “equities.” Unlike bank deposits and units,
these securities are the major primary securities in the financial markets of any country. They differ in
their investment characteristics and as such satisfy different preferences of various investors and enjoy
differing degrees of popularity. It is necessary to note the major characteristics and the variants of these
security types as they prevail in India.
7.4 ORDINARY SHARES
Ordinary shares are ownership securities which have certain advantages in favour of the issuing
companies and investors depending on their attitude to risk-taking. Investment in this financial
instrument is permanent but not illiquid. Due to the existence of a fairly active secondary market in
shares, investors can turn their share holdings into cash fairly quickly. Because of the high risk which
he bears, the investor can participate in the earnings and wealth of the company without limit. In a
period of inflation since the value of holdings increases, ordinary shares are expected to be a hedge
against inflation. From the point of view of the company, it is advantageous because dividend payments
on ordinary shares are not mandatory and there is no need to refinance the capital raised through the
issue of ordinary shares. As in other countries, this instrument is quite .popular with individual investors.
The face value of ordinary shares in India varies from Rs. 1 to Rs. 1000 but the most common and
popular denomination of shares is Rs. 100.
A special type of ordinary, share, called “deferred share”, was in vogue in India till the 1960s. The
existence of this novel financial instrument was a result of the managing agency system peculiar to
India. Managing agency firms issued shares with a low denomination, but, with disproportionate rights
in respect of voting, dividend, and distribution of assets on winding-up of the company. Invariably these
deferred shares were allotted to the managing agents and their associates. The practice of issuing
“deferred shares” has now been discontinued.
7.5 PREFERENCE SHARES
A preference share is a complex financial instrument with a number of modifications to its general
characteristics. Strictly speaking, it is an ownership security like an ordinary share, but carries a fixed
rate of return (dividend) like a debenture. The holders of preference shares are entitled to income after
the claims of creditors of the company have been met, but before ordinary shareholders receive any
income. Because of these modifications, one comes across the following types of preference shares in
the market; (a) cumulative and non-cumulative, (b) convertible and non-convertible, (c) redeemable and
non-redeemable, (d) participating and non-participating. On cumulative preference shares, if dividend is
skipped in any period/periods, it has to be paid subsequently. Convertible preference shares can be
converted into ordinary shares on terms and conditions fixed at the time of issue of such shares. A
redeemable preference share matures in a fixed period of time and for all practical purposes it is
regarded as a debt security like a debenture. Participating preference shareholders can earn a higher
dividend than the fixed one if the company makes good profits.
Most preference shares in India are fixed rate dividend shares with cumulative rights. Both redeemable
and non-redeemable shares are in vogue in India, but many redeemable shares are so, only at the
discretion of the companies. Over a period of time, there has been a trend towards increasing the
proportion of redeemable shares to total preference shares. The maturity period of redeemable shares
is usually between 12 to 15 years. The practice of issuing preference shares with participation and
conversion rights is not common. A study of 189 issues of preference shares during 1966-70 by the RBI
60
indicated that only two of them were convertible into equity. Preference shareholders have voting rights
only on those issues which vitally affect the rights attached to their shares or when dividend has not
been paid for a long period of time. The rate of dividend on these shares is subject to a ceiling fixed by
the Controller of Capital Issues. The denomination of preference shares is known to vary between Rs. 1
and Rs. 1000, but the most common and popular one has been Rs. 100.
In theory, a preference share offers a perfect certainty of income and, as such, is less risky. But “In fact
our analysis of relative frequencies of dividend skipping on preference and equity shares indicates that
the degree of risk attached to preference shares was only a shade less than that attached to equity
shares.” Apart from this uncertainty of return, the marketability and liquidity of preference shares are
low in practice because the market for them is narrow and less active. The importance of preference
share as a medium of investment for individuals has declined and now they are mostly held by
institutional investors. Their relative importance as a method of financing for companies has also
declined. However, in the case of new companies, they still play a relatively greater role than in the
case of older companies.
7.6 DEBENTURES OR BONDS
Unlike the two securities that have been considered, debenture or bond is a creditor-ship security with a
fixed rate of return, fixed maturity period, perfect income certainty, and low capital uncertainty. In the
USA, while bonds are secured by tangible physical assets of the company, debentures are secured
only by the general credit-worthiness of the company. No such distinction prevails in the UK and India
where industrial debenture might be secured or unsecured. There are different kinds of debentures:
(a) registered, (b) bearer, (c) redeemable, (d) perpetual, (e) convertible, (f) right, (g) nonconvertible, and
(h) partially convertible. Almost all the debentures which are listed on Indian stock exchanges are
mortgage registered debentures. Their face value varies from Rs. 5 to Rs. 5000, but, the most common
denomination is Rs. 100. The maturity period is up to 12 years, and the coupon rate is subject to the
ceding fixed by the Controller of Capital Issues (CCI). The CCl use to fix two rates, one for debentures
up to 7-year maturity and the other for debentures with 7 to 12 year maturity. Of late, the most common
maturity period of debentures in India has been 7 years and the ceiling rate is being fixed for these
debentures only.
An important development which has occurred in the field of bond financing during the 1970s is the
emergence of the practice of issuing convertible debentures and rights debentures. Convertible
debenture is one that can be converted at the option of the holder into ordinary shares of the same
company under specified terms and conditions. In the UK and USA, convertible debentures form a
significant portion of the total amount of debt securities. In India, although the issues of convertible
debentures were not unknown till 1970, there were very few of them. It is only after 1970 that a greater
possibility for issuing convertible debentures has been noticed. The nature of this security can be
understood with the help of a case of convertible debentures issued by Reliance Textiles in the second
half of 1.979. These debentures were issued for cash at par for public subscription in units of Rs. 500
each. An amount of Rs. 250 per debenture was payable on application and the’ balance of Rs. 250 on
allotment. Interest at the rate of 11 per cent per annum was payable on the debentures at equal half -
yearly installments. They were, if not converted, redeemable at par in five equal annual installments on
the expiry of the 8th, 9th, 10th, 11th and 12th year from ; the date of allotment. The debenture -holders
were entitled to convert 20 per cent of the face value of each debenture into four equity shares of Rs.
10 each credited as fully paid-up at a premium of Rs. 15 per share. The option for conversion was to be
exercised during the two months from 1 October to 30 November 1980 by giving notice to the company
to that effect. The total value of debentures to be thus issued was Rs. 7 crores. The practice of issuing
convertible debentures has increased in India during the 1970s and 1980s,
Another innovation introduced on the stock market a few years back was the issue of right debentures.
This was thought of as a solution to the problem of restrictions on acceptance of deposits by companies
61
from the public and from, their shareholders. The following characteristics bring out the nature of this
new financial instrument: (a) right debentures can be issued by public limited companies to raise
finance for long-term working capital requirements; (b) they are not issued to the public, but are issued
on a right basis to the existing shareholders of the issuing j company in a certain ratio to the ordinary
shares held by them. These j rights are transferable and renounceable. The issues of right debentures,
however, do not supplant the issues of conventional debentures to the public; (c) their maturity period is
up to 12 years; (d) their face value is Rs. 100; (e) they are listed on the stock exchanges; they are
secured mortgage debentures, (f) the amount of capital a company can raise through the issue of these
debentures cannot exceed 20 per cent of its current assets, loans advanced minus the long-term fund
available for financing working capital, or 20 per cent of the company’s paid-up share capital, including
preference capital and free reserves, whichever is lower subject to a maximum of Rs. 2.50 crores;
(g) the debt/equity ratio, including proposed debenture issue, should not exceed 1:1; (h) they can be
issued only by a listed company and only if its equity shares were quoted at or above the par value
during the six months prior to the date of the application for the issue of debentures; (t) debentures can
be actually allotted only after a minimum subscription of 75 per cent of the amount of debentures issued
has been secured; (/) although these debentures are mostly non-convertible, there have been cases of
companies who have combined “convertibility” and “right” features in issuing their debentures. Rights
debentures have been subscribed mainly by financial institutions and charitable and other trusts where
these debentures have been declared as “public securities” by the respective State governments. They
have not been able to attract genuine small investors. Of late, even financial institutions have
developed a reluctance to subscribe to these debentures because of their low interest rates and lack of
liquidity. The lack of liquidity is due to the absence of any good secondary market for debentures.
Financial institutions would like the ceiling rate of interest on these debentures to be raised. Most of
these debentures are quoted at a discount. The amount of capital issued through these debentures has
been quite small.
Whatever the actual trends on the new issue market, it is not desirable to rely significantly on right
debentures as a source of funds. The issue of right debentures, the conversion of a part of loans from
financial institutions into equity, and the practice of encouraging share-holders by offering higher
interest rates to keep deposits with their own companies have tended to make nonsense of the
debt/equity ratio officially prescribed for the corporate sector. They have tended to lower the security
available to the holders of creditor-ship securities. It is a sound principle of capital structure that an
increase in debt capital is required to be backed by an increase in equity capital. The norms with regard
to debt/equity ratio are prescribed in order to accord protection to the creditors. Now, when the same
investor is induced to provide both borrowed capital and equity capital in the same company, he is
required as the owner of the company to protect his own capital as a creditor. In other words, in such a
situation, although the balance between equity and debt capital may be maintained, there is no real
protection available to the creditors.
So far we have described the principal types of industrial securities/Let us now see what important
innovations have occurred in India during the 1980s in respect of these securities.
The instrument of ordinary debenture or Non-convertible Debenture (NCD) has now been made
extremely flexible as a result of the guidelines issued by the Government. Pursuant to the
recommendations made in 1981 by the N.N. Pai Working Group to develop primary and secondary
markets in debentures, the Government of India revised the guidelines about issuing -debentures, as a
result of which NCDs have become quite attractive, both to the investors and the issuing companies, in
respect of return, maturity, liquidity, tax status, and so on. The face value of NCDs is mostly Rs. 100
and their maturity period 7 years. There was a ceiling rate of interest on them of 15 per cent between
1982 to 1986 which was reduced to 14 per cent in 1987-88. These debentures have a buy-back facility
after a lock-in period of one year. They are in most cases redeemed at 105 per cent of the face value.
They are fully secured; interest is paid quarterly or six-monthly; and the interest income from them up to
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Rs. 2500 is not taxed at source. The companies are allowed to retain 50 per cent of oversubscribed
amount, to convert NCDs into equity shares, and to issue them not only for meeting expansion,
diversification, and long-term working capital needs but also to meet almost every conceivable need for
funds. The companies are mostly ready to review interest rate on these debentures upwards, in case of
an upward movement in interest rates in the economy. It means that these debentures are variable or
floating rate debentures. .
A few companies have issued linked NCDs”, i.e. they have issued ordinary share with NCDs; in this
case the applicant has to apply both for shares and NCDs in the specified proportion. When such linked
issues of NCDs are made, the interest rate offered on NCDs is lower than the i usual interest rate on
them.
There have been cases of issuing “zero bonds” i.e. zero interest convertible bonds. One company
recently issued such bonds at par on right basis to employees arid shareholders in the ratio of one
debenture for 100 equity shares held. The debentures would be fully convertible into equity shares at
the end of 3 years from allotment at a premium to be decided by CCI which will not be more than Rs.
30 per share. The face value of the debenture is Rs. 1000.
The Government approved in January 1989 a new instrument, namely, Partly Convertible Debenture
(PCD). It has a shorter maturity period of 5 years and the issuing company provides buy-back facility
relating to the residual non-convertible portion at the option of the investors.
In addition to the private corporate sector debentures and Government bonds, the market has become
familiar since 1985 with the Public Sector Bonds (PSBs). According to the guidelines issued by the
Government in September 1985, the existing and new public sector undertakings or Government
corporate bothes can issue these bonds which have a face value of Rs. 500 or Rs. 1000. Normally,
these bonds will not be redeemable before the expiry of 7 years; their maximum maturity is 10 years.
The interest rate on these bonds is fixed by the Union Finance Ministry; the maximum interest rate on
them at present is either 13 per cent or 9 per cent per annum; the interest can be cumulative or non-
cumulative. There is no deduction of tax at source on interest income, while 9 per cent .10-year bonds
are completely tax-free without limit, 13 per cent 7 to 10 year bonds are entitled to deduction under
SOL of Income Tax Act. Both categories of bonds are exempt from wealth-tax without limit. These
bonds are transferable by endorsement and delivery and they also enjoy buyback facility. The SBI buys
and sells these bonds at a small price difference across the counter. These bonds are guaranteed by
the Government; they are traded on stock exchanges; the holders up to Rs. 40000 enjoy the buy-back
facility provided they hold these bonds for at least 3 years. The “railway bonds” issued in the early part
of 1991 by the Indian Railway Finance Corporation are the latest example of public sector bonds.”
The public financial institutions have been issuing “capital gains bonds or debentures.” NHB, IDBI, and
HUDCO are some of the examples of institutions issuing these bonds. They carry the interest rate of 9
per cent per annum; they are available throughout the year at a number of outlets. They are meant for
investment of capital gains’ for the purpose of exemption from capital gains tax to the extent of 100 per
cent. Interest on them is payable in advance or on a six monthly basis. Capital gains from the sale of
long-term assets such as land, buildings, shares, securities, jewellery can be invested in these bonds.
There is no deduction of tax at source on interest earned. Interest income is exempted under SOL of
Income Tax Act, and bonds enjoy wealth tax benefits. The maturity period of bonds is 3 years. There is
an option to receive an advance payment of interest for the period of full 3 years on a discounted basis;
in the case of NHB, this can be done at the rate of Rs. 240 per Rs. 1000 invested and payable 3
months from the date of investment.
The bond market has also witnessed the issue of “NRI Bonds”. These are US dollar denominated bank
instruments in the form of promissory notes offered by the SBI to NRIs. They serve the purpose of
remitting to India dollar denominated funds of the NRIs. The first series of these bonds was issued in
1988 which had collected $92 million from NRIs in more than 70 countries. The second series of these
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bonds, which is more attractive, has been issued in December 1990. No interest is payable if the bonds
are encased before the expiry of one year. These bonds carry an interest rate of 11 per cent per annum
(11.5 per cent in the case of first series). The interest is payable on a cumulative or non-cumulative
basis; while in the case of the former, the interest is compounded half-y early in. US dollars and paid
along with the principal amount on maturity, in the case of the latter, the interest is paid non-repatriable
in Indian rupees. The maturity period of bonds of both the series has been 7 years. The bonds are
easily transferable among NRIs by endorsement and delivery. The first series bonds could be encased
after a minimum lock-in period of three years; there is no such lock-in period in the case of second
series bonds. While the first series bonds could be gifted to lineal descendants, the second series
bonds can be gifted to any Indian resident. The interest on bonds is free from income tax, wealth tax,
and gift tax, but these tax concessions are not available in the case of premature encashment. The
denominations of bonds are, $500, $ 1000, $5000, and $10000, and .the minimum investment is $500.
It is feared that these bonds might be used to convert black money into white money.
In the equities market, the Government introduced Cumulative Convertible Preference Shares (CCPs)
in August 1985. According to the Government guidelines, Indian public limited companies can issue
CCPs for the purposes of setting up new projects, expanding and diversifying existing projects, and
raising funds for normal capital expenditure and working capital needs. CCPs are fully convertible into
equity shares between the 3rd and 5th years of their issue and are deemed equity for purposes of debt-
equity ratio. The rate of dividend, payable on the CCPs is fixed at 10 per cent per year. The guideline
regarding the ratio of 1: 3 as between other preference shares and equity shares is not applicable to
the CCPs, the amount of issue of CCPs can be to the extent of equity shares offered by the company to
the public. The CCPs are compulsorily converted into equity at the end of five years and no CCP is
redeemable at any stage.
7.7 SALIENT FEATURES OF INDUSTRIAL SECURITIES
Certain features of the market in industrial securities may be summarized below:
(a) Industrial securities market comprises the new issue (Primary) market and stock exchange
(Secondary market).
(b) There are 18 stock exchanges in India at present; the Bombay Stock Market among them accounts
for about 70 percent of the total trading business of all stock exchanges put together.
(c) The small volume of industrial securities in relation to Government securities, their minor role in
financing the private sector, and their marginal significance as a saving medium indicate that industrial
securities market in not really a barometer of economic activity in India.
(d) Only the “listed” securities can be traded on stock exchanges and the marketing of old as well as
new securities can be done only through the members of stock exchanges.
(e) The entire working of the new issue market in India is controlled by controller of capital issue.
(f) During 1946 to 1988, the number of listed companies on stock markets has increased from 1125 to
5841 and their paid up capital has gone up from about Rs. 270 crores to about Rs. 21465 crores.
(g) The annual turnover on all stock exchanges has tripled from Rs. 3159 crores in 1979 to Rs. 8695
crores in 1988.
(h) Business concerns reuse capital through three major types of security Ordinary shares, preference
shares, and debentures. The subtypes of these securities are: cumulative, non-cumulative, convertible,
non-convertible, participating, non-participating, redeemable, non-redeemable, cumulative convertible
preference shares; convertible, non-convertible, partially convertible, rights, linked non-convertible,
zero, public sector units, capital gains, and NRI-bonds or debentures.
64
1. What is ‘Stock Market’?
2. What are ‘Industrial Securities’?
7.9 SUMMARY
Stock, market represents the secondary market where existing securities (shares and debentures) are
traded, Stock exchange provides an organised mechanism for purchase and sale of existing securities.
By now, we have 24 approved stock exchange in our country.
The investors want liquidity for their investments. The securities which they hold should easily be sold
when they need cash. Similarly there are others who want to invest in new securities. There should be
a place where the securities may be purchased and sold. Stock exchanges provide such a place where
securities of different companies can be purchased and sold. Stock exchange is a body of persons,
whether incorporated or not, formed with, view to helping, regulating and controlling the business of
buying and seam of securities.
7.10 GLOSSARY
Stock Exchange: stock exchanges are market places where securities that have been listed on May
be bought and sold for either investment of speculation.
Listing of securities: listing of security means permission to court shares and debentures officially on
the trading floor of the stock exchange.
Jobbers: Job Bazar security merchants dealing in shares and debentures as independent operators.
They buy and sell securities on their own behalf and try to earn through price changes.
1. Refers to 7.1
2. Refers to 7.3
1. Describe the organization of the stock market.
2. Discuss the followings:
(a) Ordinary shares
(b) Preference Shares
(c) Debentures
3. Explain the salient features of industrial securities.
1. Refers to Section 7.1 & 7.2
2. (a) Refers to 7.1
(b) Refers to 7.2
(c) Refers to 7.3
3. Refers to 7.4
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Hall of India,
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66
Lesson-8
NATIONAL DEPOSITORY SECURITIES IN INDIA
STRUCTURE
8.1 The Depository System
8.2 Benefits of A Depository System
8.3 The Depository Process
8.4 The National Securities Depository Limited
8.6 Summary
8.7 Glossary
After studying this chapter you should be to:
1. Describe the benefits of depository system
2. Explain the depository system in India
3. Discuss the national securities depository limited
8.1 THE DEPOSITORY SYSTEM
Technology has changed the face of the Indian stock markets in the post-liberalization era. Competition
amongst the stock exchanges, increase in the number of players, and changes in the trading system
have led to a tremendous increase in the volume of activity. The traditional settlement and clearing
system have proved to be inadequate due to operational inefficiencies. Hence, there has emerged a
need to replace this traditional system with a new system called the ‘depository system'.
Depository, in very simple terms, means a place where something is deposited for safekeeping. A
depository is an organization which holds securities of a shareholder in an electronic form and
facilitates the transfer of ownership of securities on the settlement dates. According to Section 2(e) of
the Depositories Act, 1996, ‘Depository means a company formed and registered under the Companies
Act, 1956 and which has been granted a certificate of registration under Section 12(1 A) of the
Securities and Exchange Board of India Act, 1992.'
The depository system revolves around the concept of paperless or scripless trading because the
shares in a depository are held in the form of electronic accounts, that is, in dematerialized form. Th is
system is similar to the opening of an account in a bank wherein a bank will hold money on behalf of
the investor and the investor has to open an account with the bank to utilize its services. Cash deposits
and withdrawals are made in a bank, in lieu of which a receipt and bank passbook are given, while in
67
depositories, scrips are debited and credited and an account statement is issued to the investor from
time to time. An investor in a bank deals directly with the bank while an investor deals through a
depository participant in a depository. A depository also acts as a securities bank, where dematerialized
physical securities are held in custody.
An effective and fully developed depository system is essential for maintaining and enhancing market
efficiency, which is one of the core characteristics of a mature capital market.
Need for Setting-up a Depository in India
 This need was realized in the 1990s due to various reasons as outlined below:
 Large-scale irregularities in the securities scam of 1992 exposed the limitations of the prevailing
settlement system.
 A lot of time was consumed in the process of allotment and transfer of shares, impeding the
healthy growth of the capital market.
 With the opening up of the Indian economy, there was a widespread equity cult which resulted
in an increased volume of transactions.
 Mounting fiscal deficit made the government realize that foreign investment was essential for
the growth of the economy and that was being stricted due to non-availability of depositories.
 There were various problems associated with dealing ii physical shares, such as
 problems of theft, fake and/or forged transfers,
 share transfer delays particularly due to signature mismatches; and
 paper work involved in buying, selling, and transfer leading to costs of handling, storage,
transportation, and other back office costs.
To overcome these problems, the Government of India, in 1996, enacted the Depositories Act, 1996 to
start depository services in India.
Depository can be in two forms—dematerialized or immobilized. In dematerialization, paper certificates
are totally eliminated after verification by the custodians. In immobilization, initial paper certificates are
preserved in safe vaults by custodians and further movement of papers are frozen.
The depository system provides a wide range of services.
 Primary market services by acting as a link between the issuers and the prospective
shareholders.
 Secondary market services, by acting as a link between the investors and the clearing house of
the exchange to facilitate the settlement of security transactions through book-keeping entries.
 Ancillary services, by providing services such as collecting dividends and interests, reporting
corporate information, and crediting bonus, rights, shares.
These services lead to a reduction in both time and cost which ultimately benefits the investors, issuers,
intermediaries, and the nation as a whole.
Difference Between a Demat Share and a Physical Share
A demat share is held by the depository on behalf of the investor whereas a physical share is held by
the investor himself. The holding and handling of a demat share is done electronically, whereas a
physical share is in the form of a paper. The demat share can be converted into a physical share on
request. This is referred to as the rematerialization of the share. The interface between the depository
and the investor is provided by a market intermediary called the depository participant (DP) with whom
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an investor has to open an account and give all instructions. The demat share does not have a folio
number, distinctive number, or certificate number like a physical share. Demant shares are fungible,
that is, all the holdings of a particular security will be identical and interchangeable. Though there is no
stamp duty on the transfer of demat shares from one account to another, the depository participant
charges a transaction fee and levies asset holding charges.
There is, however, no difference between demat shares and physical shares as far as the beneficial
interests of ownership of securities are concerned. The owner is entitled to exactly the same benefits of
ownership of a security no matter in what form it is maintained.
8.2 Benefits of a Depository System
A depository system enables immediate allotment, transfer, and registration of securities, thereby
increasing the liquidity of stocks. It eliminates all problems related with the holding of shares in physical
form, thereby increasing investor confidence. An investor saves in terms of costs like stamp duty,
postage, and brokerage charges (Table 18.1). Pledging of shares and portfolio shuffling become
convenient for an investor. This system enables trading of even a single share, thereby eliminating the
problem of odd-lot shares. Shares get credited into the demat holder's account in a couple of days,
unlike the physical mode where it took an average of a month to transfer the shares.
Further, loans against the pledged demat shares come at interest rates that are lower by 0.25 per cent
to 1.5 per cent in comparison to pledged physical shares. The limit of loan against dematerialized
security as collateral is double (at `20 lakh) of that against collateralized physical security (`10 lakh).
The Reserve Bank of India has also reduced the minimum margin to 25 per cent for loans against
dematerialized securities as against 50 per cent for loan against physical securities. Many brokerage
firms have brought down their brokerage to the extent of 0.5 per cent as the risk associated with bad
delivery has reduced.
This system has facilitated the introduction of the rolling settlement system which, in turn, has led to
shorter settlement cycles and a decrease in settlement risks and frauds. Lastly, this system helps in
integrating the domestic capital market with international capital markets.
Depository System in India
The move on to a depository system in India was initiated by the Stock Holding Corporation of India
Limited (SHCIL) in July 1992 when it prepared a concept paper on ‘National Clearance and Depository
System’ in collaboration with Price Waterhouse under a programme sponsored by the US Agency for
International Development. Thereafter, the government of India constituted a technical group under the
chairmanship of R. Chandrasekaran, Managing Director, SHCIL, which submitted its report in 1993.
Subsequently, the Securities and Exchange Board of India (SEBI) constituted a seven-member squad
to discuss the various structural and operational parameters of the depository system. The Government
of India promulgated the Depositories Ordinance in September 1995, thus paving the way for setting up
of depositories in the country.
Some features of the Depositories Ordinance are as follows:
 The depository is a registered owner of the share while the shareholder is the beneficial owner
retaining all the economic and voting rights arising out of share ownership.
 Shares in the depository will be fungible.
 Transfers pertaining to sale and purchase will be effected automatically.
 Any loss or damage caused to the participant will be indemnified by the depository.
 If trades are routed through depository, there is no need to pay stamp duty.
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The Depositories Act was passed by the Parliament in August 1996. It lays down the legislative frame-
work for facilitating dematerialization and book entry transfer of securities in a depository. The act pro-
vides that a depository is required to be a company under the Companies Act, 1956 and depository
participants (DPs) need to be registered with the SEBI. The investors have the option to hold se curities
in physical or dematerialized form or to rematerialize securities previously held in dematerialized form.
The SEBI issued a consultative paper No. X on the draft regulations for depositories and participants in
October 1995 for wide consultation and notified the regulations in May 1996. The SEBI has allowed
multiple depositories to ensure competition and transparency.
The Depositories Related Laws (Amendment) Ordinance, 1997, issued in January of that year enabled
units of mutual funds and UTI, securities of statutory corporations and public corporations to be dealt
through depositories. The Dhanuka Panel in its draft Depository Act (Amendment) Bill, 1998
recommended empowering the SEBI to make trading in demat shares mandatory. The SEBI laid down
an elaborate time schedule envisaging that beginning January 4, 1999, till March 26, 2001, 3,145 listed
scrips or 40 per cent of the total listed securities would be traded compulsorily in the demat form.
Besides equity, new debt issues will also be in demat form. The minimum networth stipulated by the
SEBI for a depository is `100 crore.
It is mandatory for all listed companies to have their securities admitted for dematerialization with both
the depositories, viz, NSDL and CDSL. Securities include shares, debentures, bonds, commercial
paper, certificate of deposits, pass through certificates, government securities and mutual fund units.
SEBI (Depositories and Participants) (Amendment) Regulations 2008 were notified on March 17, 2008,
which provided for the shareholding such as
1. sponsor should at all times hold at least 51 per cent shares in the depository;
2. no person, either singly or together with persons acting in concert, can hold more than 5 per
cent of the equity share capital in the depository;
3. the combined holding of all persons resident outside India in the equity share capital of the
depository will not exceed, at m\ time. 40 per cent of its total equity share capital, subject further
to the following:
a. the combined holdings of such persons acquired through the foreign direct investment route’ are
not more than 26 per cent of the total equity share capital, at any time;
b. the combined holdings of foreign institutional investors are not more than 23 per cent of the total
equal) share capital, at any time;
c. no foreign institutional investor acquires shares of the depository otherwise than through the
secondary market.
8.3 The Depository Process
There are four parties in a demat transaction: the customer, the depository participant (DP), the deposi-
tory and the share registrar and transfer agent (R&T).
Opening an Account An investor who wants to avail of the services will have to open an account with
the depository through a DP. who could either be a custodian, a bank, a broker, cr individual with a
minimum net worth of `1 crore. The investor has to enter into an agreement with the DP after
which he is issued a client account number or client ID number. PAN Card is now mandatory to
operate a demat account. The holder of a demat account is called 'beneficial owner’ (BO). He can open
more than one account with the same or multiple DPs.
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Dematerialization To convert his physical holdings of securities into the dematerialized form, the
investor: make an application to the DP in a dematerialization request form (DRF). Within seven days,
the DP forwards the form, along with the security certificates, to me issuer or its registrar and transfer
agent after electronically registering the request with the depository.
The depository electronically forwards the demat request lo the respective issuer or its registrar and
transfer agent, who verifies the validity of the security certificates as well as the fact that the DRF has
been made by a person recorded as a member in its register of members.
After verification, the issuer or its registrar and transfer agent authorises an electronic credit for the
security in favour of the client. Thereafter, the depository causes the credit entries to be made in the
account of the client.
Rematerialization To withdraw his security balance with the depository, the investor makes an
application to the depository through its DP. He requests for the withdrawal of balance in his account in
a rematerialization request form (RRF). On receipt of the RRF, the participant checks whether sufficient
free relevant security balance is available in the client’s account. If there is, the participant accepts the
RRF and blocks the balance of the client to the extent of the rematerialization quantity and
electronically forwards the request to the depository.
On receipt of the request, the depository blocks the balance of the participant to the extent of the
rematerialization quantity in the depository system. The depository electronically forwards the accepted
rematerialization application to the issuer or its registrar agent, which is done on a daily-basis.
The registrar and transfer agent confirm electronically to the depository that the RRF has been
accepted. Thereafter, the issuer or registrar and transfer agent despatches the share certificates arising
out of the rematerialization request within 30 days.
Distributing Dividend A company (issuer or its registrar and transfer agent shall make known the
depositor) of the Corporate actions such as dates for book closures, redemption or maturity of security,
conversion of warrant’s, and call money from time to time. The depository will then electronically
provide a list of the holdings of the clients-as on the cut-off date. The company can then distribute
dividend, interest, and other monetary benefits directly to the client on the basis of the list. If the
benefits are in the form of securities, the company or its registrar and transfer agent may distribute
these, provided the newly created security is an eligible security and the client has consented to receive
the benefits through depositor).
Closing an Account A client wanting to close an account shall make an application in the format
specified to that elfect to the participant. The client may close his account if no balances are
outstanding to his credit in the account. If any balance exists, the account may be dosed in the
fallowing manner: (i) By rematerialization of all its existing balances in his account and/or (ii) By
transferring his security balances to his other account held either with the same participant or with a
different participant.
The participant shall ensure that all pending transactions have been adjusted before dosing such an
account. After ensuring that there are no balances in the client’s account, the participant shall execute
the request for closure of the client’s account.
Trading/Settlement of Demat Securities
The procedure for buying and selling dematerialized securities is similar to the one for physical
securities. In case of purchase of securities, the broker will receive his securities in his account on the
payout day and give instruction to its DP to debit his account and credit investors account. Investor can
either give receipt instruction or standing instruction to OP for receiving credit by filling appropriate
form. In case of sale of securities, the investor will give delivery instruction to DP to debit his account
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and credit the broker's account. Such instruction should reach the DP’s office at least 24 hours before
the pay-in.
8.4 THE NATIONAL SECURITIES DEPOSITORY LIMITED
The Indian capital market took a major step in its rapid modernization when the National Securities
Depository Limited (NSDL) was set up as the first depository in India. The NSDL, promoted by the
Industrial Development Bank of India, the Unit Trust of India (UTI), the National Stock Exchange of
India Limited (NSE), and the State Bank of India (SBI) was registered on June 7, 1996, with the SEBI
and commenced operations in November 1996. The NSDL is a public limited company formed under
the Companies Act. 1956 with a paid-up capital of `105 crore.
The NSDL interacts with investors and clearing members through market intermediaries called
depository participants (DPs). The NSDL performs a wide range of securities-related functions through
the DPs. These services are as follows:
1. Core services
a. Maintenance of individual investors ‘beneficial holdings in an electronic form,
b. Trade settlement.
2. Special services
a. Automatic delivery of securities to the clearing corporation.
b. Dematerialization and rematerialization of securities.
c. Account transfer for settlement of trades in electronic shares.
d. Allotments in the electronic form in case of initial public offerings.
e. Distribution of non-cash corporate actions (bonus rights, etc).
f. Facility for freezing/locking of investor accounts.
g. Facility for pledge and hypothecation of securities.
h. Demat of National Savings Certificates (NSC) Kisan Vikas Patra (KVP).
i. Internet based services such as SPEED-e and IDeAS.
Business Partners of the NSDL
An important link between the NSDL and an investor is a DP. A DP could be a public financial
institution, a bank, a custodian, or a stock broker. Corporate entities are not allowed to become DPs nor
can they set up depositories. A DP acts as an agent of the NSDL and functions like a securities bank'
as an investor has to open an account with the DP. The SHCIL was the first depository participant
registered with the SEBI. The number of DPs operational as on March end 2010 stood at 287 as
against 24 in the end of March 1997 including ail custodians providing services to local and foreign
institutions.
At present, the competition among DPs has increased and, in a bid to attract and retain customers,
DPs are exploring new avenues including latest technology for increasing their efficiency. For instance,
many DPs have launched interactive voice response (IVR) units. They have also slashed their service
charges and many of them are rendering free-market and off-market buy services to them corporate
clients.
Besides DPs, other business partners of the NSDL include issuing companies/their share transfer
agents, clearing corporations/houses, and clearing members. The NSDL facilitates the settlement of
trades carried out in the book entry segment of stock exchanges. The actual settlement function is
performed by the clearing corporation/houses of the stock exchanges. The NSDL has its by-laws
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regarding the powers and functions of board of directors, executive committee, rules of business,
participants, nomination of persons of eminence, safeguards for clients, participants, and accounts by
book entry. Trading in dematerialized securities commenced on December 26, 1996, in the NSE.
The NSDL has achieved paperless trading in perhaps the shortest time in the world—a little over three
years. Today 99.9 per cent of all equity is traded in demat form. The NSDL has more than 1.58 crore
(Box 18.1) investor accounts and 268 DPs. making it the second largest depository in the world.
The NSDLs computer system handles around eight to nine million messages (to debit and credit indi-
vidual investor accounts) per day on an online basis, it links three types of data bases—a central NSDL
one those of 281 DPs as well as those of 8.338 companies. Moreover, it has the ability to monitor
everything that is happening in the computers of its DPs.
The NSDL has undertaken a pilot project to dematerialize securities like National Savings Certificates
and Kisan Vikas Patra at select post offices. In addition, it also manages a countrywide tax information
network for the ministry of finance. It has also been appointed as central Record keeping agency for the
New Pension System of the Government of India.
The NSDL has created three pioneering systems: SPEED-e, STeADY and IDeAS. SPEED-e allows
users to execute delivery instructions using the Internet. STeADY (Securities Trading—Information
Easy Access and Delivery) was launched by the NSDL or November 30, 2002 and it constitutes an
internet-based infrastructure few facilitating straight-through processing. It is a means of transmitting
digitally signed trade information with encryption across market participants electronically, through the
Internet. This facility enables brokers to deliver contract notes to custodians and or fund managers
electronically. ‘IDeAS’ (Internet-based Denial Account Statement) enables its account-holders including
clearing members to view their account balances and transactions of the last five days. These systems
reflect the continual process or sophistication of depository services being undertaken by the NSDL.
1. Define Depositary System.
2. Define “National Securities Depositary System”.
8.6 SUMMARY
One of the biggest problem faced by the Indian capital market has been the manual and paper based
settlement system. Under this system, the clearing and settlement of transactions take place only with
the use of paper work. The system of physical delivery of scrips poses many problems for the
purchaser as well as the seller in the form of delayed settlements, long settlement periods, high level of
failed trade, high cost of transactions, bad deliveries etc. In many cases transfer process takes much
longer time than two months as stipulated in section 113 of the Companies Act, 1956 or section 22 A of
the Securities Contracts (Regulations) Act, 1956. Moreover, a large number of transactions end up as
bad deliveries due to faulty compliance of paper work, mismatch of signatures on transfer deeds with
specimen record of the issuer or other procedural reasons. Besides, theft, forgery, mutilation of
certificates and other irregularities have also become rampant.
8.7 GLOSSARY
Depository participant: DP is an agent of the depository. If an investor wants to avail the services
offered by the depository, the investor has to open an account with DP.
Beneficial owner: beneficial owner means a person whose name is recorded as such with the
depository. Beneficial owner is the real owner of the securities who has lost his securities with the
depository in the form of book entry.
Depository: a depository is a form where in the securities of an investor are held in electronic form in
the same way as Bank holds money.
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National securities depository Limited (NSDL): NSDL was the first depository organisation promoted
by IDBI UTI and National Stock Exchange. NSDL was set up to provide electronic depository facilities
for securities being traded in capital market.
Rematerialisation of shares : rematerialisation is the process of conversion of electronic holding of
securities into physical certificate form. For rematerialisation of scripts the investor has to fill up a Re
mat request form and submit it to the Depository Participant.
1. Refers to 8.1
2. Refers to 8.4
1. What do you understand by depositary system in India?
2. Discuss the benefits of depositary system.
3. Explain the national depositary securities limited.
2. Refers to Section 8.2
Hall of India,
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Chapter-9
Role of SEBI and NSDL
STRUCTURE
9.1 Introduction
9.2 Functions Of Sebi
9.3 Power Of The Sebi
9.4 National Depository Securities Ltd. (Ndsl)
9.5 Functioning To Nsdl
9.6 Services Of Nsdl
9.7 Market Makers
9.8 Advantages And Disadvantages Of Market Maker
9.10 Summary
9.11 Glossary
9.12 Answers To Self Check Exercise
9.14 Answers To Terminal Questions

After studying this chapter you should be to:
 National Depository Securities Ltd. (NDSL)
 Market makers
 SEBI
9.1 Introduction
SEBI is the Indian stock market watchdog. The full form of SEBI is the Securities and Exchange
Board of India which regulates, monitors, and oversees the function of the stock market. SEBI is a
financial regulatory body that reports to the Ministry of Finance. It was established in 1988 as a
non-statutory organization, but in 1992 the SEBI Act granted it statutory powers that empower it
to regulate the securities market, protect investors' interests, and promote market development.
The Indian capital market is regulated primarily by this regulatory body. Regulatory, monitoring,
and management functions are performed by it for the Indian securities market. Incorporating
rules and regulations is intended to safeguard investors' interests and foster a safe investment
environment. As part of its work, it also develops investment-related guidelines for improving the
investment situation in India.
In 1980, there was tremendous growth in the capital market due to the increasing participation of
the public. The expanding investor population resulted in many malpractices by companies,
brokers, merchant bankers, etc.
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The Preamble of the SEBI Act provides for the establishment of a Board to protect the interests of
investors in securities and to promote the development of and to regulate the securities market.
9.2 FUNCTIONS OF SEBI BOARD:

1. Regulation and Oversight: SEBI formulates and enforces rules and regulations
governing the securities market in India. This includes overseeing stock exchanges,
intermediaries such as brokers and mutual funds, and listed companies.
2. Investor Protection: SEBI works to safeguard the interests of investors by ensuring fair
and transparent dealings in the securities market. It takes measures to prevent fraudulent
and unfair trade practices.
3. Promotion of Fair Practices: SEBI promotes fair and ethical practices in the securities
market. It enforces insider trading regulations, disclosure norms, and corporate
governance standards to maintain market integrity.
4. Regulation of Market Intermediaries: SEBI regulates various intermediaries in the

securities market, including stockbrokers, portfolio managers, merchant bankers, and
credit rating agencies. It issues licenses, sets eligibility criteria, and monitors their
activities.
5. Market Surveillance: SEBI conducts market surveillance to detect and prevent market
manipulation, fraud, and insider trading. It uses advanced technology and data analytics
for this purpose.
6. Registration of Securities: SEBI regulates the issuance and trading of securities in India.
It reviews and approves public issues, ensuring that companies adhere to disclosure and
listing requirements.
7. Regulation of Mutual Funds: SEBI regulates and oversees the functioning of mutual
funds in India. It approves fund offerings, ensures compliance with regulations, and
protects the interests of unit holders.
8. Takeover Regulations: SEBI enforces takeover regulations to ensure that the acquisition
of listed companies is conducted fairly and transparently. It aims to prevent hostile
takeovers that may harm minority shareholders.
9. Education and Awareness: SEBI educates investors and promotes financial literacy. It
conducts investor awareness programs and provides educational resources to help
investors make informed decisions.
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10. Policy Formulation: SEBI plays a significant role in formulating policies related to the
securities market. It regularly reviews and updates regulations to keep pace with evolving
market dynamics.
11. Market Development: SEBI works to develop and strengthen the Indian securities market
by introducing new financial products, encouraging innovation, and attracting both
domestic and foreign investments.
12. Dispute Resolution: SEBI provides a platform for resolving disputes between market
participants, investors, and listed companies. It has established mechanisms like the
Securities Appellate Tribunal (SAT) to handle appeals and grievances.
13. International Cooperation: SEBI collaborates with international regulatory bodies and
organizations to enhance its regulatory framework and align its practices with global
standards.
9.3 POWER OF THE SEBI

SEBI exercises powers under Section 11 and 11B of SEBI Act, 1992 and other regulations.
1. Regulatory Framework: SEBI has the authority to create, amend, and enforce regulations
related to various aspects of the securities market. This includes rules governing stock
exchanges, listed companies, intermediaries, and securities issuance.
2. Monitoring and Surveillance: SEBI has robust monitoring and surveillance capabilities to
detect market manipulation, insider trading, and other fraudulent activities. It uses
technology and data analytics to identify irregularities and take appropriate action.
3. Registration and Licensing: SEBI grants licenses and registrations to various entities
operating in the securities market, such as stockbrokers, mutual funds, merchant bankers,
and credit rating agencies. These registrations come with certain obligations and
compliance requirements.
4. Inspection and Investigation: SEBI can conduct inspections and investigations into the
activities of market participants, including listed companies, to ensure compliance with
regulations. It has the power to request documents, records, and information as part of
these investigations.
5. Imposition of Penalties: SEBI can impose fines and penalties on individuals and entities
found guilty of violating securities laws and regulations. These penalties can be substantial
and are meant to deter misconduct.
6. Adjudication: SEBI has its own adjudicating authority that adjudicates on matters related
to securities law violations. It can pass orders for penalties and other punitive actions.
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7. Market Operations: SEBI can intervene in the market to maintain its integrity and stability.
This includes measures such as placing trading restrictions, modifying trading rules, or
temporarily closing the market in extreme situations.
8. Setting Listing and Disclosure Standards: SEBI sets listing requirements and disclosure
norms for companies that are publicly listed. It mandates regular reporting of financial
information and material events to ensure transparency.
9. Takeover Regulations: SEBI formulates and enforces takeover regulations to ensure fair
treatment of shareholders during corporate takeovers and mergers.
10. Investor Education and Awareness: SEBI conducts investor education programs and
requires market participants to contribute to investor protection by disseminating
information about risks and rewards associated with various investments.
11. Policy Advocacy: SEBI plays a role in advocating for policy changes and reforms in the
securities market. It provides recommendations to the government and other regulatory
bodies to improve market conditions and promote growth.
12. Cooperation with Other Regulators: SEBI collaborates with other regulators and
international organizations to align its regulatory framework with global standards and best
practices.
SEBI’s market surveillance essentially focuses on:

i) Policy formulation for introduction of surveillance systems at the stock exchanges to bring
integrity, safety and stability in the Indian securities markets;
ii) Overseeing the surveillance activities of the stock exchanges including the monitoring of
market movements by them;
iii) Inspection of the surveillance cells of the sock exchanges;
iv) Preparation of reports and studies on market movements, which SEBI circulates periodically to
the Government of India and to securities markets regulators from other countries;
The primary responsibility of market surveillance has been entrusted to the stock exchanges.
However, SEBI keeps a proactive oversight on market monitoring and in exceptional
circumstances it analyses the same.
Assessment:
SEBI, no doubt, acts as a powerful regulator in the securities markets. But, nevertheless, some
serious shortcomings in its functioning and operations have been point out. Among these, the
more important are as follows:
One, on reading the rules, regulations, guidelines, directions and norms issued by the SEBI, one
doubts whether one is living in the ‘liberalised’ or ‘prudential’ regulation as opposed to ‘statistic
control’ environment at all. It is difficult to believe that ‘selfregulation’ and ‘regulation by exception’
is really the cornerstones of the SEBI’s regulatory philosophy. The number of rules, etc:
prescribed by SEBI has become too large; it has been adding to, and changing them too often
and in a back and forth fashion. This has created a veritable maze of a plethora of regulations.
This has led to a very high level of uncertainty and confusion.
Two, there is a widespread perception in the financial markets that SEBI is not really desirous
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about reforming the system and protecting the individual and small investors. It has quite often
failed to penalise the people responsible for causing abnormal price fluctuations on the stock
market. There has been a lack of will, dithering and hesitancy on the part of SEBI to strike against
the wrong doers. Even certain well-publicised market manipulations have gone unpunished.
Three, the regulatory ineffectiveness of the SEBI in certain cases has been due to its
concentration on symptoms rather than the root causes. The SEBI failure appears to be partly
deliberate also. There is a feeling among market watchers that, as in many other countries, the
SEBI as a regulatory has been rather soft and unduly favourable to the securities industry; it has
been more corporate friendly than investor friendly.
Four, it is imperative that SEBI should become more effective, efficient, socially accountable, and
small-investor friendly. It has often complained of having insufficient authority. The SEBI ought to
be made a truly autonomous regulatory authority which it is not at present.
9.4 National Depository Securities Ltd. (NDSL)
In April 1996 the Governing Board of SEBI approved the draft of SEBI (Depositories and
Participants) Regulations 1996. The Securities and Exchange Board of India notified these
regulations on May 16, 1996. The government of India in 1996 introduced in Lok Sabha the
Depository Bill to usher in scrip less trading and avoid “bad delivery, theft and forgery in share
transfer and settlement” . National Securities Depositories Ltd. (NSDL) promoted by Industrial
Development Bank of India, Unit Trust of India and National Stock Exchange emerged as the first
depository to be registered in India. There was a great debate on central-versusmultiple
depository system. Ultimately multiple depository system became a choice. Considering the sheer
size of the network that would have to be established, a single organisation may not be able to
handle it. To have competition, multiple depository is a must. Subsequently, another depository
emerged on Indian scene i.e. Central Depository Services Limited (CDSL). It received a certificate
of commencement of business from SEBI on February 8, 1999. CDSL was set up with the
objective of providing convenient, dependable and secure depository services at affordable cost
to all market participants. All leading stock exchanges like the National Stock Exchange, Calcutta
Stock Exchange, Delhi Stock Exchange, The Stock Exchange, Ahmedabad, etc have established
connectivity with CDSL. 29th November, 1996 was a red letter day for Indian capital market as in
rnore than 100 year history of stock exchanges in India, for the first time National Stock Exchange
witnessed trade in dematerialised scrips of an Indian Company i.e. ‘Reliance Industries’. The very
first lot of transaction was, as expected, at premium in comparison to prevailing price for physical
delivery due to inherent qualities of quick settlement. clean deliveries and exemptions from stamp
duty. To make the system operational on large scale, Government of India promulgated an
ordinance to amend the Depository Act to enable the shares of statutory bodies such as IDBI.
SBI, UTI and other public sector banks and the units of mutual funds to transact through
depositories. The changes in last few years in mechanism of capital market has made market
more efficient. About 99% of settlements are through depositories. Besides overcoming the
problems of bad deliveries, paper deliveries etc. this system has cut down the time taken in
settlement. Indian market now has attained T+3 settlement effectively and efficiently through
NSDL and CDSL.
National Security Depository Limited (NSDL) functions similar to a bank account system for
securities such as bonds and shares, which are represented by tangible or intangible certificates.
It was created to help with the quick transfer of securities. It saves a lot of time now since all
transfers are done electronically. The NSDL maintains Demat accounts, which are electronic
79
accounts where financial securities are maintained.
Several market participants, including banks, investors, and brokers can open accounts with
NSDL. However, do note that if you want to open an account with NSDL, you can’t approach it
directly. You have to do so through a Depository participant (DP). A DP is an intermediary
between you and NSDL.
9.5 FUNCTIONING TO NSDL
NSDL Demat accounts are fairly easy to open. These are the steps:
 Choose your preferred Depository Participant
 Account opening form is to be filled and submit all KYC documents including identity proof,
Address Proof, Pan Card, Aadhaar Card and Bank account details
 After all the documents have been received by the Depository Participant, a verification
process begins.
 Once all your documents are successfully verified, the depository participant will open the
NSDL Demat account on behalf of the customer.
 After the account gets opened the Depository Participant will provide you DP ID, Client ID,
master client report, tariff sheet, and a copy of the rights and obligations of the beneficial
owner and depository participant.
 In addition NSDL Demat account login credentials from the depository participant will also
be provided.
9.6 SERVICES OF NSDL

NSDL provides three services which includes
1. Basic Services
2. NSDL (Consolidated Account Statement)
3. Value Added Services
1. Basic Services
Under the provisions of the Depositories Act, NSDL provides various services to investors and
other participants in the capital market like, clearing members, stock exchanges, banks and
issuers of securities. These include basic facilities like account maintenance,
dematerialization, rematerialisation, settlement of trades through market transfers, off market
transfers & inter-depository transfers, distribution of non-cash corporate actions and
nomination/ transmission.
The depository system, which links the issuers, depository participants (DPs), NSDL and
Clearing Corporation/ Clearing house of stock exchanges, facilitates holding of securities in
dematerialized form and effects transfers by means of account transfers. This system which
facilitates scrip less trading offers various direct and indirect services to the market
participants.
Some of the services are as under
 Account Maintenance
 Dematerialization
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 Rematerialisation
 Market Transfers
 Off Market Transfer
 Margin Pledge
 Transmission/Nomination
 Corporate Action
2. NSDL CAS (Consolidated Account Statement)

NSDL CAS is a single statement which includes all investment made by single holders or joint
holders in the security market. This facility helps the investors to electronically access their
financial assets as a part of single account. The NSDL consolidated account statement
includes details of various instruments such as investment in equity shares, debentures,
government securities held in Demat form, Mutual funds, Treasury bills etc.
3. Value Added Services
Depository is a facility for holding securities electronically in which securities transactions are
processed by book entry. In addition to the core services of electronic custody and trade
settlement services, NSDL provides special services like
 Pledge or Hypothecation of securities
 Automatic Delivery out Instructions
 Dividend Distribution
 Lending and borrowing
 Public Issue
 SMS Alert
9.7 MARKET MAKERS
Market maker refers to a firm or an individual that engages in two-sided markets of a given
security. It means that it provides bids and asks in tandem with the market size of each
security. A market maker seeks to profit off of the difference in the bid-ask spread and
provides liquidity to financial markets.
Market Maker – Example
Consider a situation where a market maker in stock alpha can provide a quote for $5-$5.50,
100×200. It means that they want to buy 100 shares for the price of $5 while simultaneously
offering to sell 200 shares of the same security for the price of $5.50. The offer to buy is
known as the bid, while the latter offer to sell is the ask.
Other participants in the market have the option of lifting the offer from the market maker at
their ask price, i.e., $5.50. It means that they can buy from the market maker at the given
price. They can also hit the bid or sell to them for their bid price, which is $5.
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The difference of $0.50 in the ask and bid prices of stock alpha seems like a small spread.
However, small spreads, as such, can add up to large profits on a daily basis, owing to large
volumes of trade.
Entities Act as Market Makers

Market makers are entities or individuals that play a crucial role in maintaining liquidity and
facilitating trading in financial markets. They are typically responsible for quoting bid and ask
prices for securities and are willing to buy or sell these securities at those prices. Market makers
help ensure that there is a continuous flow of trading activity, even when there may be limited
interest in a particular security. Here are some of the common entities that act as market makers:
1. Broker-Dealers: Many brokerage firms also act as market makers. They maintain an
inventory of securities and are willing to buy from or sell to clients at quoted prices. These
broker-dealers earn a profit from the spread between the bid and ask prices.
2. Specialist Firms: In some stock exchanges, specialists are responsible for maintaining
orderly markets for specific securities. They match buy and sell orders, and they may also
step in as market makers when there is a lack of trading interest.
3. Designated Market Makers (DMMs): Some stock exchanges, like the New York Stock
Exchange (NYSE), have DMMs who oversee specific stocks and ensure smooth trading.
They provide liquidity by stepping in as buyers or sellers when needed.
4. Electronic Market Makers: With the rise of electronic trading, algorithmic trading firms
and high-frequency trading (HFT) firms have become important market makers. These
entities use automated trading strategies to provide liquidity in various markets.
5. Options Market Makers: In options markets, market makers are essential. They
continuously quote bid and ask prices for options contracts, providing traders with the
ability to buy or sell options at any time.
6. Market Making Firms: Some specialized firms focus exclusively on market making. They
may have expertise in specific asset classes or markets and dedicate their resources to
providing liquidity.
7. Banks and Financial Institutions: Large banks and financial institutions often act as
market makers in the foreign exchange (Forex) market. They facilitate currency trading by
quoting exchange rates and offering to buy or sell currencies.
8. Exchanges: Exchanges themselves can act as market makers by creating liquidity in

certain products or asset classes, especially in the early stages of a new product's
introduction.
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9. Government Entities: In some cases, government entities or central banks may act as
market makers to stabilize markets during times of crisis or to manage the exchange rate
of their currency.
9.8 ADVANTAGES AND DISADVANTAGES OF MARKET MAKER

Market makers play a crucial role in financial markets by providing liquidity and facilitating trading.
However, like any market participant, they have both advantages and disadvantages associated
with their activities.
Advantages of Market Makers:
1. Liquidity Provision: Market makers enhance market liquidity by continuously quoting bid
and ask prices, ensuring that there are buyers and sellers available for most securities or
instruments. This liquidity benefits all market participants.
2. Price Stability: Market makers help maintain stable and orderly markets by narrowing bid-
ask spreads, reducing price volatility, and preventing abrupt price movements due to large
trades.
3. Efficiency: They contribute to the efficiency of financial markets by reducing trading costs,
such as bid-ask spreads, for traders and investors. This makes it easier and more cost-
effective to buy and sell securities.
4. Reduced Execution Risk: Market makers offer guaranteed execution of trades at quoted
prices, reducing the risk of trades not being filled, especially in illiquid or volatile markets.
5. Market Depth: They increase market depth by standing ready to buy or sell a significant
volume of securities, even when there is limited trading interest. This attracts more
participants to the market.
6. Arbitrage Opportunities: Market makers can identify and exploit arbitrage opportunities,
ensuring that prices across different markets or exchanges are closely aligned.
Disadvantages of Market Makers:

1. Conflict of Interest: Market makers have an inherent conflict of interest because they
profit from the spread between bid and ask prices. This can lead to concerns that they may
not always act in the best interests of investors.
2. Market Manipulation: In rare cases, market makers with substantial market power may
engage in manipulative trading practices that can distort prices or harm other market
participants.
3. Lack of Competition: In markets dominated by a few powerful market makers, there may
be limited competition, which can result in wider spreads and less favorable trading
conditions for investors.
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4. Information Asymmetry: Market makers often have access to more information than
individual traders, potentially allowing them to exploit informational advantages.
5. Market Concentration: In some markets, a small number of market makers may control a
significant portion of trading activity, leading to concerns about market concentration and
potential abuse of market power.
6. Risk of Loss: Market makers assume significant financial risks. During periods of extreme
market volatility or unforeseen events, they can incur substantial losses if they are unable
to hedge their positions effectively.
7. Regulatory Scrutiny: Market makers are subject to strict regulatory oversight to prevent
market manipulation and protect investors. Compliance with these regulations can be
resource-intensive and costly.

1. Write a short note on the SEBI
2. What is National Depository Securities Ltd. (NDSL)
3. Write a short note on the MARKET MAKERS
4. What are the four services of the SERVICES OF NSDL
9.10 Summary
SEBI is the Indian stock market watchdog. The full form of SEBI is the Securities and Exchange
Board of India which regulates, monitors, and oversees the function of the stock market. SEBI is
a financial regulatory body that reports to the Ministry of Finance. It was established in 1988 as
a non-statutory organization, but in 1992 the SEBI Act granted it statutory powers that empower
it to regulate the securities market, protect investors' interests, and promote market
development. The Indian capital market is regulated primarily by this regulatory body.
Regulatory, monitoring, and management functions are performed by it for the Indian securities
market. Incorporating rules and regulations is intended to safeguard investors' interests and
foster a safe investment environment. As part of its work, it also develops investment-related
guidelines for improving the investment situation in India.
Market maker refers to a firm or an individual that engages in two-sided markets of a given
security. It means that it provides bids and asks in tandem with the market size of each security.
A market maker seeks to profit off of the difference in the bid-ask spread and
provides liquidity to financial markets.National Securities Depositories Ltd. (NSDL) promoted by
Industrial Development Bank of India, Unit Trust of India and National Stock Exchange emerged
as the first depository to be registered in India. There was a great debate on central-
versusmultiple depository system. Ultimately multiple depository system became a choice.
Considering the sheer size of the network that would have to be established, a single
organisation may not be able to handle it.
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9.11 Glossary
1. SEBI: SEBI is the Indian stock market watchdog. The full form of SEBI is the Securities and
Exchange Board of India which regulates, monitors, and oversees the function of the stock
market. SEBI is a financial regulatory body that reports to the Ministry of Finance. It was
established in 1988 as a non-statutory organization
2. National Depository Securities Ltd. (NDSL): National Securities Depositories Ltd. (NSDL)
promoted by Industrial Development Bank of India, Unit Trust of India and National Stock
Exchange emerged as the first depository to be registered in India. There was a great debate
on central-versusmultiple depository system. Ultimately multiple depository system became a
choice. Considering the sheer size of the network that would have to be established, a single
organisation may not be able to handle it.
3. MARKET MAKERS: Market maker refers to a firm or an individual that engages in two-sided
markets of a given security. It means that it provides bids and asks in tandem with the market
size of each security. A market maker seeks to profit off of the difference in the bid-ask spread
and provides liquidity to financial markets.


1. Define the sebi and what are the functions of sebi ,also discuss the power of the sebi?
2. What is national depository securities ltd. (ndsl) also write down the functioning to nsdl?
3. What are the various services of nsdl?
4. What is market makers and advantages and disadvantages of market maker?

1. Refers to Section 9.1 and 9.2 ,9.3
2. Refers to Section 9.4 and 9.5
4. Refers to Section 9.7 and 9.8
Hall of India,
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86
Lesson-10
Commercial Banking
STRUCTURE
10.1 Introduction
10.2 Theoretical Basis of Banking Operations
10.3 Present Structure of Banking
10.4 Role of Foreign Banks
10.5 Advantages and Disadvantages of Foreign Banks
10.6 Road Map for Foreign Banks in India
10.8 Summary
10.9 Glossary
After studying this lesson you should be able to
1. Describe the evolution of commercial banking
2. Explain the present structure of banking
3. Discuss the role of foreign banks in India
10.1 INTRODUCTION
Commercial banks are the oldest, biggest, and fastest growing financial intermediaries in India. They
are also the most important depositories of public saving and the most important disbursers of finance.
Commercial banking in India is a unique system, the like of which exists nowhere in the world. The truth
of this statement becomes clear as one stuthes the philosophy and approaches that have contributed to
the evolution of the banking policy, programmes and operations in India. This however is too big a
subject to be discussed here in detail. We will therefore confine ourselves to presenting an outline of
this philosophy and approaches.
The banking system in India works under the constraints that go with social control and public
ownership. The public ownership of banks has been achieved in three stages: 1955, July 1969, and
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April 1980. Not only the public sector banks but also the private sector and foreign banks are required
to meet targets in respect of sectoral deployment of credit, regional distribution of branches, and
regional credit-deposit ratios. The operations of banks have been determined by Lead Bank Scheme,
Differential Rate of Interest Scheme, Credit Authorization Scheme, inventory norms and lending
systems prescribed by the authorities, the formulation of the credit plans, and Service Area Approach.
The focus of this chapter is on discussing the actual working of banks and not on the philosophy and
approaches behind that working.
10.2 THEORETICAL BASIS OF BANKING OPERATIONS
Commercial banks ordinarily are simple business or commercial concerns which provide various types
of financial services to customers in return for payments in one form or another, such as interest,
discounts, fees, commission, and so on. Their objective is to make profits. However, what distinguishes
them from other business concerns (financial as well as manufacturing) is the degree to which they
have to balance the principle of profit maximization with certain other principles. In India specially,
banks are required to modify their performance in profit-making if that clashes with their obligations in
such areas as social welfare, social justice, and promotion of regional balance in development. In any
case, compared to other business concerns, banks in general have to pay much more attention to
balancing profitability with liquidity. It is true that all business concerns face liquidity constraint in
various areas of their decision making and, therefore, they have to devote considerable attention to
liquidity management. But with banks, the need for maintenance of liquidity is much greater because of
the nature of their liabilities. Banks deal in other people’s money, a substantial part of which is
repayable on demand. That is why for banks, unlike other business concerns, liquidity management is
as important as profitability management.
This is ‘reflected in the management and control of reserves of commercial banks. They are expected
to hold voluntarily a part of their deposits in the form of ready cash which is known as cash reserves;
and the ratio of cash reserves to deposits is known as the (cash) reserve ratio. As banks are likely to be
tempted not to hold adequate amounts of reserves if they are left to guide themselves on this point, and
since the temptation may have extremely destabilizing effect on the economy in general, the central
bank in every country is empowered to prescribe the reserve ratio that all banks must maintain. The
central bank also undertakes, as the lender of last resort, to supply reserves to banks in times of
genuine difficulties. It should be clear that the function of the legal reserve requirements is two fold to
make deposits safe and liquid, and to enable the central Bank to control the amount of checking
deposits or bank money which the banks can create. Since the reserve banks are required to maintain
a fraction of their deposit liabilities, the modem banking system is also known as the “fractional reserve
banking”.
Another distinguishing feature of banks is that while they can create as well as transfer money (funds),
other financial institutions can only transfer funds. In other words, unlike other financial institutions,
banks are not merely financial intermediaries. This aspect of bank operations has been variously
expressed. Banks are said to create deposits or credit or money, or it is said that every loan given by
banks creates a deposit. This has given rise to the important concept of deposit multiplier or credit
multiplier or money multiplier. The import of this is that banks add to the money supply in the economy,
and since money supply is an important determinant of prices, nominal national income, and other
macro-economic variables, banks become responsible in a major way for changes in economic activity.
Further, as indicated in chapter one, since banks can create credit, they can encourage investment for
some time without prior increase in saving.
Let us briefly discuss the basis and process of the creation of money by banks. In modem economies,
almost all exchanges are effected with money. Money is said to be a medium of exchange, a store of
value, an unit of account. There is much controversy as to what, in practice in a given year, is the
measure of supply of money in any economy. We do not need to go into that controversy here. Suffice
88
it to say that everyone agrees that currency and demand deposits with banks are definitely to be
included in any measure of money supply. Thus, apart from the currency issued by the Government
and central bank, the demand or current or checkable deposits with banks are accepted by the public
as money. Therefore, since the loan operations of banks lead to the creation of checkable deposits,
they add to the supply of money in the economy. To recapitulate, ,the money creating power of banks
stems from the facts that modem banking is a fractional reserve banking, and that certain liabilities of
banks are accepted (used) by the public as money.
The process of money creation works as follows: Assume that the legally required reserve ratio is 10
per cent and that banks are maintaining just that ratio. Assume further that a bank in the economy
receives a brand new input of Rs. 1000 of reserves either as a deposit or as proceeds of a sale of
Government bond to the central bank or as some other form. There is thus a creation of Rs. 1000 of
bank money, but there is yet no multiple expansion of money. If banks were required to keep 100 per
cent cash reserve balances, no bank would be in a position to create any extra money out of a new
deposit of Rs. 1000 with it.
But since a bank is required to hold only 10 per cent of its deposits as cash reserves, it now has
Rs. 900 as excess reserves which it can utilize to invest or to give loan. Assume that the bank gives a
loan of Rs. 900, and the borrower who takes the loan in cash or cheque deposits it either with the same
bank or with some other bank. Either way, there has been a creation of money and the total amount of
bank money created at this stage is Rs. 1000+900 = Rs. 1900. This process of creation can continue till
no bank anywhere in the system has reserves in excess of the required 10 per cent reserve, and the
total money supply created in the economy is Rs. 10,000. The ratio of new deposits to the original
increase in reserves is called the money multiplier or credit multiplier or deposit multiplier. This
multiplier will be equal to the reciprocal of the required reserve ratio.
The process of the creation of bank money does not work in practice to the full capacity or the full
potential as has been described. Banks may have a reserve ratio which is higher than the required
reserve ratio. There may also be leakages in the form of cash holding when the banks make Joans.
The process moves rather slowly and with jerks, and not as promptly and smoothly as implied. Subject
to such qualifications, there is no doubt that modem banks can create money in the process of their
working.”
With this theoretical background one should be in a position to understand the actual working of
commercial banks in India.
10.3 PRESENT STRUCTURE OF BANKING
Tables 7.1 to 7.4 and Figures 7.1 and 7.2 present the growth and structure of Indian banking system
with varying details and for different spans of time. Together they should enable the reader to assess all
the possible dimensions of the structure and growth of banks in India. For lack of space, only the salient
features of these aspects have been touched upon.
Table 7.1. Growth of Commercial Banks in India During Post-Nationalization Period
Variables 1969 1989

1. Total Deposits (Rs. Crores) 4667 145684
2. Deposits/National Income (%) 15.5 49

3. Number of Deposit Accounts (Million) 18 247
4. Deposits per office (Rs. lakhs) 57 252
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5. Rural Deposits/Total Deposits 3 15
6. Total Credit (Rs. Crores) 3602 90185
7. Number of Credit Accounts (Million) 1.1 25.6
8. Credit per office (Rs. lakhs) 44 156
9. Credit to Priority Sectors (Rs. crores) 504 36238
10. Priority sector credit/Total Credit (%) 14 40
11. Number of total branches (offices) 8187 57611
12. Number of Rural offices 1443 32873

13. Rural Offices/Total offices 18 57
14. Population served per office 65000 12000
SOURCE: RBI Bulletin, March 1990. pp. 198-99, and October 1990. p.766.
Table 7.2 Annual Average Rates of Growth of Commercial Banks in India 1951-1986 (Percentages)
Period Number of offices Deposits Credit

1951-61 2.7 12.98 11.45
1961-69 9.96 19.33 22.92
1969-78 23.16 49.90 44.64
1978-86 5.9 37.92 33.06
1951-86 25.30 367.47 314,81

SURCE: Based on Table 7.3.
In September 1990,296 scheduled banks had 59388 offices, Rs, 1,87,469 crores of deposits, and
Rs. 1,12,212 crores of credit. The corresponding figs, for 1951 were 93 banks, 2847 offices, Rs. 856
crores of deposits, and Rs. 459 crores of credit. In other words, compared to 1951, the banking
business in 1990 was 22 times in terms of offices, 219 times in terms of deposits, and 244 times in
terms of credit. Fig. 7.1.which is drawn with the ratio scale, and Table 7.3 (column 5) reflect this
phenomenal growth of Indian banking during a period of 40 years. According to the latest available
information, as on 22 March, 1991, the aggregate bank deposits and bank credit were Rs. 1,91,189
crores and Rs. 1,16,184 crores, respectively.
Table.7.-1.concentrates on the growth of banking only during the post-nationalization period but with
many core indicators. The growth of banking has been far more rapid after the nationalization than
before it. Further the overall growth in business has been accompanied by a significant increase in the
share of rural and priority sectors in the toted business. While the bank deposits to national income
ratio has increased from just 15 per cent in 1969 to as high as 50 per cent in 1989, the population
90
served per office has drastically- declined from 65000 to 12000 during the same period. However,
within the post-nationalization period, the annual rate of growth appears to have slowed down in the
1980s compared to the 1970s. Table 7.2 shows the extent and time pattern of this growth.
Table7.3. Structure and Growth of Commercial Banks in India. 1951 to 1986
Category of Indian Foreign Total Non Schedule Total Regional Rural

Banks Schedule Schedule Schedule Banks Banks
(3+4)
Variables Banks Banks Banks
(1) (2) (3) (4) (5) (6)
1. Number of Reporting Banks
1951 — — 92 474 566 —
(16.25)82 (83.74)210 (100)
1961 67 15 82 210 292 —
(22.94) (5.13) (28.08) (71.91) (100)
1969 58 13 71 14 85 —
(68.23) . (15.2,9) (83.5) (16.47) (100)
1978 61 12 73 4 77 48
(79.22) (15.58) (94,80) (5.19) (100)
1986 58 21 79 3 82 194
(70.73) (25.6) (96.34) (3.65) (100)
2. Number of Offices in India

1951 — — 2647 1504 4151 +-
(63.76) (36.23) (100)
1961 4319 71 4390 622 5012 —
(86.17) (1.41) (87.58) (12.41) (100)
1969 8696 131 8826 181 9007 —
(96.54) (1.44) (97.94) (2.09) (100)
1978 27596 129 27725 ' 57 27782 1722
(99.33) (0.46) (99.79) (0.20) (100)
1986 40725 136 40861 42 40903 12846
(99.56) (0.33) (99.89) (0.1) (100)
3. Total Deposits
(Rs. crores)
1951, — — — '— 909 —
1961 1792 257 2749 40 2089 —
(85.78) (12.30) (98.08) (1.91) (100) i'
1969 4808 487 5295 24 5319 —
(90.39) (9.15) (99.54) (0.45) (100)
1978 28084 1112 291% 10 29206 75
91
(96.15) (3,80) (99.96) (0.04) (100)
1986 114066 3725 117791 29 117820 1786
(96.81) (3.16) (99.97) (0.03) (100) '" -
4. Total Bank Credit
(Rs. crores)
1951 — — 681 46 727 —
(92.66) (7.33) (100)
1961 1090 230 1321 25 1345 '—
(81.15) (17.10) (98.21) (1.85) (100)
1969 3396 403 3799 12 3811 —
(89.11) (10.57) (99.8) (0.31) (100)
1978 18322 7% 19118 6 19124 91
(95.80) (4-16) (99.96) (0.04) (100)
1986 67013 2681 6%94 19 69713 1792
(96.13) (3.84) (99.97) (0.03) (100)
N.B.: (i) Figures in brackets are percentages to the totals.

(ii) Regional Rural Banks are also scheduled banks. They have been shown separately because
of their special position: Figures in columns 1,3,5 are exclusive of figures in column 6.
SOURCE: RBI, Statistical Tables Relating to Banks in India, various Issues
Years
· Deposits Rs. Crores ı Credit
* Inv. in Secu. • No of Offices
Fig. 7.1. The growth of scheduled banks in India (Source: RBI, RCF, various issues)
Note: The figures in brackets are % to total scheduled banks.
Source: RBI Statistical Tables Relating to Banks in India, various issued.
Figure 7.2.portrays the types of banks which constitute the Indian banking system and Tables 7.3 and
show the relative shares of these different types of banks in the total banking business in terms offour
indicators, namely the number of reporting banks and bank offices, and the volume of deposits and
credit
92
93
Among the scheduled banks, ‘the Indian scheduled banks’, excluding Regional Rural Banks (RRBs),
belonging to both the public mid private sectors have increased their share in the total banking
business during 1951 -90, and now they account for more than 95 per cent of this business.
On the other hand, over the years the number of foreign (scheduled) banks has increased, but their
share in the total business has-declined. They now account for 3 to 4 per cent of the total bank deposits
(credit) compared to 10 to 17 per cent till 1969.
The share in the total banking business of the scheduled banks in the public sector including RRBs has
increased, while that of the private sector banks has declined. This share of the public sector banks is
now more than 90 per cent, and that of the private sector banks is between 4 to, 5 per cent. At present
there are about 100 private sector banks, most of which have just one or two branches. Of these, only
24 banks are large enough and 3 of them account for about 70 per cent of the total business of private
sector banks.
Among the public sector banks, the State Bank of India (SBI) alone accounted for about 14 per cent of
the total number of bank offices, 21 per cent of the total bank deposits, and 24 per cent of the total bank
credit in 1986. If the subsidiaries of the SBI were included, the corresponding figures for the SBI group
were 20 per cent, 27 per cent, and 30 per cent, respectively it that year. As on 14 December, 1990
also, the SBI and the SBI group had shares in banking business very much similar to those that have
been discussed. The twenty nationalized banks other than the SBI and its subsidiaries now account for
50 to 60 per cent of the total banking business.
A beginning to set up the RRBs was made in the latter half of 1975 in accordance with the
recommendations of the Banking Commission. It was intended that the RRBs would operate
exclusively in rural areas and would provide credit and other facilities to small and marginal farmers,
agricultural labourers, artisans, and small entrepreneurs. They now carry all types of banking business
generally within one to five districts. The RRBs can be set up provided any public sector bank sponsors
them. The ownership' capital of these banks is held by the Central Government (50 per cent),
concerned State Government (15 per cent), and the sponsor bank (35 per cent). They are, in effect,
owned by the Government, and there is little local participation in the ownership and administration of
94
these banks also. Further, they have a large number of branches. In March 1990,196 RRBs were
operating in 369 districts with 14079 offices, Rs. 3119 crores of deposits, and Rs. 2919 crores of credit
The RRBs make an important part of the banking structure, in terms of the number of banks and
offices, but not in terms of deposits and credit. They accounted for 71 per cent of the number of banks,
24 per cent of the total number of bank offices, about 1.5 per cent of total deposits, and about 2.5 per
cent of total bank credit in 1986. There has been little change in this position since then.
The banking systems in India is thus characterized by excessive concentration of business in a small
number of scheduled public sector banks. The banking in India, as in the UK, is entirely of the type
called branch banking. If we exclude RRBs, just twenty-one banks (with seven subsidiaries) are now
operating a vast network of about 45000 branches over a vast geographical area: This concentration of
banking business has been brought about through the policy of mergers and consolidation of banks,
and their Government ownership. The number of major operating banks has been reduced from 566 in
1951 to about 75 exclusive of RRBs 'and to 270 inclusive of them in 1990. The phenomenon of branch
banking has aggravated the problem of organizational and operational inefficiency in the banking
sector. There is a need to decide on the optimum size of a bank in Indian conditions. Some of the
banks in India appear to have become too big to function efficiently. The branch banking has
accentuated another problem, namely, the drain of resources from the rural to urban areas so much so
that the authorities had to set different targets of credit/deposit ratio for different geographical areas.
In view of the vastness of the country coupled with regional disparities in the structure and level of
economic development, and in order to avoid the drain of resources from the rural areas, it would
perhaps have been a wiser policy if the small local banks were strengthened through suitable policy
measures instead of liquidating them or merging them with other banks. The policy of promoting and
nurturing unit banking system would perhaps have yielded better results. The working of many private
sector banks today support this viewpoint These banks are found to be compact in size which has
facilitated cutting of red tape, promoting good rapport between the staff and management, motivating
staff, and giving better service to the customers and community.
10.4 ROLE OF FOREIGN BANKS
It is now widely believed that for financial institutions to operate efficiently there is a need to maintain
competitive conditions. The empirical and theoretical literature in banking also suggests that a
competitive banking system is more efficient. It has therefore, been the endeavour of the Government
and the Reserve Bank to enhance competition through entry of new private sector banks, increased
presence of foreign banks and provision of operational flexibility to public sector banks. To diversify
ownership, public sector banks were allowed to raise funds from the capital markets, subject to the
Government shareholding being retained at 51 percent. Various other restrictions hindering the
competitive process have also been, by and large, phased out.
In recognition of the emergence of foreign banks as key vehicles in the international integration of the
financial systems, a liberalized policy towards foreign banks’ entry has become a high priority in
policymakers agenda in various countries in recent years. Liberalization of financial services by
allowing foreign financial institutions to participate in the domestic market improves competition,
thereby facilitating better and cheaper financial intermediation. Apart from increasing competition and
efficiency through infusion of technology and skill management, some of the other benefits of foreign
banks’ entry are said to include introduction of superior risk management practices and stronger capital
base, which is also less sensitive to host Country’s business cycle.
India also liberalized the entry of foreign banks in the post-reform period. In the roadmap by the
Reserve Bank released in February 2005, the opening up of the domestic banking sector to foreign
banks was envisioned in two phases. The first phase envisaged that foreign banks wishing to establish
presence in India for the first time could either choose to operate through branch presence or set up a
100 per cent wholly owned subsidiary (WOS) following the one-mode presence criterion. In the second
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phase (April 2009 onwards), the policy on foreign banks is to be taken up for a review. At that stage,
various issues associated with the increased presence of foreign banks such as impact on the domestic
banks, supervisory and regulatory challenges in view of their sophisticated operations and their
involvement in complex and sophisticated products, financial inclusion, credit to agriculture and SMEs,
and public policy on credit delivery, cost and allocation would need to be weighed. The issues relating
to co-ordination between home and host countries regulators would also pose a challenge.
10.5 ADVANTAGES AND DISADVANTAGES OF FOREIGN BANKS
The following are the commonly highlighted benefits of foreign bank entry. First, it heightens
competition and promotes efficiency leading to decline in costs or increase in productivity. When a
foreign bank enters through green field investment and sets up a de novo institution, the increase in the
number of banks in the host country directly enhances competition. Entry through merger and
acquisition, which infuses more skilled management and upgrade governance through introducing more
advanced systems and risk management, may force other banks in the host country to improve their
efficiency in order to protect their market shares. Second, entry of foreign banks improves credit
allocation, as in making credit decisions, they apply formal credit standards and risk-adjusted pricing
and are not influenced by other considerations.
Third, foreign banks help in the development of local financial markets since they have both the
incentives and the expertise to develop certain segments of local market, such as funding, derivatives
and securities markets. Foreign banks that lack a branch network to guarantee deposit financing of
their activities are more likely to turn to the inter-bank market. Foreign banks can also contribute by
bringing professional expertise to the local foreign currency markets. They often try to create markets or
gain market share through product innovation, especially by offering a variety of new financial services
to corporate clients, including structured products.
Fourth, the overall soundness of domestic financial system is enhanced by introducing the risk
management practices of the foreign parent banks. Based on tighter credit review policies and
practices, they adopt more aggressive measures to address asset quality deterioration and limit the
build-up of non-performing assets in the financial system.
Fifth, foreign banks may exert a stabilizing influence in times of financial distress, as stronger
capitalization and the possibility of an injection of additional funds by the parent, if needed, reduces the
probability of failure. For the same, foreign banks are less sensitive to both home and host country
business cycles, and consequently, lending to local residents in the local market is likely to be more
stable in times of stress than either cross- border lending or the lending of indigenous banks in the
markets. Further, when the foreign banks continue to operate in a crisis, the probability of the system
as a whole remaining functional increases.
Sixth, there could be long-term benefits from lower cost structures in the banking system. Foreign
banks, in general, are found to operate with lower administrative costs as has been found in Latin
America and most of other developing countries. However, in some countries such as India, operating
cost of foreign banks was found to be higher than that of domestic banks.
Seventh, foreign ownership usually involves the transfer of human capital at both the managerial and
the operational level. Complementary to this is the transfer of soft infrastructure such as back office
routines or credit control systems. Such transfers have gained importance to reap economies of scale
through standardization of processes.
There could also be several costs associated with the entry of foreign banks.
First, entry of foreign banks could also lead to concentration and loss of competition. In many countries,
foreign banks entered the system mainly by acquiring existing domestic banks, while in some countries
domestic banks consolidation and concentration occurred in response to foreign competition.
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Second, though foreign banks entry may lower interest margins and potentially foster the process of
financial intermediation, the impact would depend on the form it takes and may not benefit all
borrowers. The benefits would depend on whether the lower spread is the result of a more aggressive
pricing strategy across the board or the banks choosing to lend only to the most transparent segments
where there is more competition or at least greater market contestability.
Third, the growing presence of foreign banks can increase the complexity of the tasks facing
supervisory authorities and thus lead to regulatory conflicts. This could be a particular concern in
countries where foreign commercial banks expand their operations rapidly in the area of lion-bank
financial services such as insurance, portfolio management, and investment banking. Given the
complex structure of many internationally active banks, Integral issues within foreign banks are
increasingly being shown to be of potential systemic significance. Fourth, foreign banks expose the
country to some downside risks/ challenges attached with their entry. More strikingly, domestic banks in
emerging markets generally incur costs since they have to compete with large international banks with
better reputation, particularly in developing world.
Fifth, there is a general concern that as foreign banks have historically followed home-country
customers or specialized in servicing corporate customers, their entry would lead to neglect of rural
customers and small and medium sized firms. Another concern is that with foreign banks using the
inter-bank market for much of their funding, local banks could divert their funds from domestic loans to
the inter-bank market, thereby channeling fund to large corporate at the expense of small companies.
Sixth, it is also argued that the presence of foreign banks may not necessarily yield a more stable
source of credit to domestic borrowers because foreign banks can, at times, shift funds abruptly from
one market to another for risk management purposes. Literature also suggests that foreign banks will
be more likely to shift their funds to more attractive markets during a crisis if their parent banks are
weak.
10.6 ROAD MAP FOR FOREIGN BANKS IN INDIA
With a view to delineate the direction and pace of reform process in this area and to operationally the
extant guidelines of March 4, 2004 in a phased manner, the RBI, on February 28,2005, released the
road map for presence of foreign banks in India. The roadmap was divided into two phases.
Phase I: March 2005 to March 2009: During the first phase, foreign banks were permitted to establish
presence by way of setting up a wholly owned banking subsidiary (WOS) or conversion of the existing
branches into a WOS. The guidelines covered, inter alia, the eligibility criteria of the applicant foreign
banks such as ownership pattern, financial soundness, supervisory rating and the international ranking.
The WOS was required to have a minimum capital requirement of Rs. 300 crore and maintain a capital
adequacy ratio of 10 percent or as was prescribed from time to time on a continuous basis, from the
commencement of its operations. The WOS was treated on par with the existing branches of foreign
banks for branch expansion with .flexibility to go beyond the existing WTO commitments of 12 branches
in a year and preference for branch expansion in under-banked areas. During this phase, permission
for acquisition of share holding in Indian private sector banks by eligible foreign banks was limited to
banks identified by the RBI for restructuring. The RBI—if it was satisfied that such investment by the
foreign bank concerned was in the long-term interest of all the stakeholders in the invested bank—
permitted such acquisition. Where such acquisition was by a foreign bank having presence in India, a
maximum period of 6 months was given for conforming to the one form of presence concept.
Phase II: April 2009 onward: Phase II commenced in April 2009 after a review of the experience
gained and after due consultation with all the stakeholders in the banking sector. The review examined
issues concerning extension of national ‘treatment to WOS, dilution of stake and permitting
mergers/acquisitions of any private sector banks in India by a foreign bank in Phase II.
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The parent foreign bank will continue to hold 100 percent equity in the Indian subsidiary for a minimum
prescribed period of operation. The composition of the-Board of directors should, inter alia, meet the
following requirements: (a) not less than 50 percent of the directors should be Indian nationals resident
in India and (b) not less than 50 percent of the directors should be non-executive directors.
1. What is ‘Bank’?
2. What are ‘Commercial Banks’?
3. Define ‘Ferries’ Banks’?
10.8 SUMMARY
The importance of Commercial banks and their contribution are discussed. An attempt is made is to
provide the effect of RBI banking regulations, demand supply theory of money, interest and profitability
of banks are explained. The risk management practices observed by banks are discussed. The
management of primary and secondary reserves, loan policy formulation and issues involved are
discussed. There is also discussion on the financial institutions, which offer a variety of specialized to
traditional services to the business and act as mediators and agents of transfer of funds to create
wealth to the society at some charge for the service, which would be their source of revenue. They
have the obligation of creating a qualitative Financial System and should cooperate with the regulatory
bothes engaged with various measures to discipline the economic system.
10.9 GLOSSARY
Credit or loan: Credit or loan refers to sum of money along with interest payable. Finance: Finance is
monetary resources comprising debt and ownership funds of the state, company or person.
Financial Institutions: Financial Institutions are business organizations that act as mobilizes and
depositories of savings and as purveyors of credit or finance. They also provide various financial
services to the society.
Financial System: Financial System is concerned about money, credit and finance.
Money: Money refers to the current medium of exchange or means of payment.
1. Refers to 10.1
2. Refers to 10.2
3. Refers to 10.4
1. What is commercial Banking?
2. Discuss the growth and structure of Banking.
3. Describe the role of foreign Banks.
1. Refers to 10.1 & 10.2
2. Refers to 10.3
3. Refers to 10.4 & 10.5
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India.
3. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage publications,
New Delhi.
Agency, Mumbai.
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Lesson-11
Merchant Banking
STRUCTURE
11.1 Introduction
11.2 Origin of the Merchant Bankers
11.3 types of merchant banking
11.4 functions of merchant banking
11.5 Objectives of the Merchant Banking Company
11.6 advantages of merchant banking
11.7 Obligations and Responsibilities
11.8 Code of Conduct
11.9 Merchant Banking in India
11.10 Services Rendered by the Merchant Banks
11.12 Summary
11.13 Glossary
After studying this chapter you should be able to
1. Describe merchant bank and its activities
2. State the general obligations and responsibilities of a merchant banker
11.1 INTRODUCTION
Funds are tapped from the capital market to finance various mega industrial projects. In
attracting the public savings, the Merchant bankers play a vital role as specialized agencies. The
primary business of a merchant banker is the resource raising function. The primary market hold the
key of rapid capital formation, growth in industrial production, and exports. There has to be
accountability to the end use of the funds raised from the market. The trends in the primary market in
India suggest that merchant bankers have been playing a very significant role in the corporate sector’s
drive for mobilizing the funds from the public. If the number of issues and amount increases the number
of the merchant brokers also increase. Therefore, the field becomes a highly competitive market where
it requires a special skill in handling the situation. The financial assets that are sold to the public should
represent the genuine claims on future cash flows and viable assets. The Merchant banks have a social
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responsibility in building the industrial structure in India.
Merchant banking is an essential part of financial sector when a developing economy widens its
industrial base. Originally, the merchant banking business was established in Italy and France in the
metheval period. A merchant banker in those days was a trader-cum-entrepreneur who added banking
business with trading. In the U.K., merchant bankers came into existence by the end of the 18th
century. In the U.S.A., a kind of merchant banking activity emerged through investment bankers in the
early twentieth century.
In the Indian context, the Ministry of Finance defined merchant banker as “any person who is engaged
in the business of issue management either by making arrangements regarding selling, buying or
subscribing to securities as manager, consultant advisor or rendering corporate advisory service in
relation to such issue management.” There is a thin distinction between merchant banking and
investment banking. The former is purely fee-based. The later is both fees as well as fund-based.
11.2 ORIGIN OF THE MERCHANT BANKERS
In the 19th century, a British merchant used to send an agent out to little known parts of the world. The
agent took with the manufactured goods that were produced in the home country to sell and at the
same time he would buy the products of that country and ship them home. For this trade, money had to
be remitted from one country to another, the bill of exchange which was the instrument in usage
throughout the Europe since a long time came to be used more and more. The bill of exchange of
London became the means of financing the trade practically in the whole world. The well-established
merchant agreed to do for commission; and gradually the practice of accepting the bills to finance the
hade of others took the shape of accepting the bills to finance their own trade. These firms in London
are styled as the Merchant Banks. The oldest merchant bankers in London were the Barring Brothers. It
was very prominent in Europe in the 19th century. The Industrial revolution made England into a
powerful trading nation. Rich merchant houses which made their fortunes in the colonial trade had
diversified into Banking. They themselves involved in the acceptance of the Commercial bills pertaining
to domestic as well as international trade.
They became as “Acceptance Houses, Discount Houses and Issue Houses”. The Merchant banker was
primarily a merchant than a banker. The merchant banker was entrusted with the funds by his
customers.
11.3 TYPES OF MERCHANT BANKING
Merchant banks may be classified in the following three categories :
1) Full-Service Global Merchant Banks :

This category of merchant banks are characterized by their world-wide presence and offering a
complete range of services. They are generally large financial entities, the services of which are availed
by big companies, generally global giants.
Some examples of the full-service global merchant banks are Jefferies, Goldman Sachs, JP Morgan.
Chase & Co., Kotak Investment Banking, etc.
2) Regional Investment Banks :

Regional investment banks, also referred to as 'speciality investment banks', basically cater to the
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needs of the clients from a particular region. They possess a specialized acquaintance of the market of
that geographical area, and as such are in a position to offer the services according to the demands of
their clients.
Some examples of this category of merchant banks are SBI Capital Markets, Nomura Holdings, CLSA,
Maple Capital Advisors, ABN Amro, BNP Paribas, Piper Jaffray, Commerz Bank, Duff & Phelps, etc.
3) Boutique Investment Firms :

Investment banks of small size, operational at a local level covering a limited geographical area are
termed as Boutique Firms. They offer services in respect of specific industries or products, in which
they have an expertise. Their proficiency in the area of advisory services, like merger and acquisition
makes them much in demand for specific deals. The services offered by them are more in the nature of
personalized ones, and at times they try to serve as a partner of their clients instead of being
impersonal advisors.
11.4 FUNCTIONS OF MERCHANT BANKING
Role of merchant banking / The important activities undertaken by merchant banks and various
services provided by them are as follows :
1) Underwriter :
Underwriters may be defined as a group of financial institutions/entities, which give an assurance not
only for getting an issue fully subscribed, but also to absorb the balance securities, in case of failure of
the issue to get fully subscribed by the public. Underwriters are duly paid for the services rendered by
them in the form of commission as agreed upon between the security issuer and the underwriter, which
are subject to various terms and conditions stipulated under the Companies Act. Underwriting services
are provided by the commercial banks, term lending institutions, investment companies, brokers, etc.
In the overall development of the primary market, the role played by underwriters is very crucial,
although underwriting per-se is not. mandatory for an issuer. Before coming out with the issue, the
issuer appoints underwriter/s, with due discussion with the merchant banker/lead manager. The details
with regard to underwriters are mentioned in the prospectus issued by the company.
2) Banker :
Bankers are yet another constituent of the primary market, who perform an important role in the market
function and its development. 'Bankers to an issue are the bankers, who are responsible for the
acceptance of application money, from the prospective investors, for the issue of securities. They also
take the responsibility for the refund of application money to those applicants, whom no security could
be allotted.
3) Broker :
Brokers are individuals/entities who are primarily engaged in the business of obtaining subscriptions to
an issue by approaching the prospective investors and convincing them suitably. Appointment of
brokers by an issuing company is not mandatory under the existing law. They are at liberty to appoint
as many brokers as they deem fit, or not appoint any broker, if they decide to do so. Brokers to an
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issue are required to give their willingness by way of a consent letter, copy/copies of which need to be
filed, along with the prospectus, to the Registrar of Companies (RoC). The broker/s. appointed by the
issuer/manager of the issue. manages the preliminary distribution of securities in a coordinated
manner. They attempt to secure as much direct subscription as possible from a wide range of potential
investors. The maximum brokerage payable in respect of all the public issues of industrial securities is
@1.5%. irrespective of the fact whether the issue is underwritten or not. The maximum brokerage
payable in respect of the listed companies, on private placement basis is @0.5%. As far as the
promoters' quota is concerned (including the amount taken up by the directors, their friends and
employees, and in respect of rights issue taken by/renounced by the existing shareholders), no
brokerage is allowed to be paid. Similarly, no brokerage is permitted to be paid i in respect of the
following cases :
 If the applications are made by the institutions/banks as their part of underwriting obligations.
 If, as a result of under-subscription of the issue, amounts are devolved on the underwriters.
4) Registrar :
The registrar to an issue is essentially an intermediary in the primary market, who undertakes the
following activities :
 Collection of applications along with the application money from the investors.
 Maintenance of a proper record of the applications/monies received from the investors.
 Maintenance of a proper record of monies paid to the seller of the securities.
 Advising the issuers in taking decision with regard to the basis of allotment of securities in
consultation with the stock exchanges.
 Finalization of the allotment of securities and issuance of allotment letters.
 Other processes associated with the issue of capital, e.g. refund order certificates and other
related documents.
5) Debenture Trustee :
They are the trustees specifically appointed and entrusted with the responsibility of keeping a
watch on and protecting the interests of debenture holders. Their appointment is made by the
issuer of the debenture before the actual issue. Debenture trustees are required to get
themselves registered as such with the SEBI, before they get any assignment as debenture
trustees.
6) Portfolio Manager :
The term 'portfolio' refers to the total securities held by an individual/entity. Portfolio managers, as
the nomenclature suggests, are the managers of portfolios of their clients, by the virtue of a
contract entered into between them and their clients. Their activities are governed by the terms
and conditions of the said contract, Portfolio managers are generally authorized by their clients to
manage, in a judicious manner, the securities/funds held by them under their portfolio.
11.5 OBJECTIVES OF THE MERCHANT BANKING COMPANY

The Merchant Bankers render their specialized assistance in achieving the main objectives. They are
presented below:
1. To carry on the business of the merchant banking, assist in the capital formation, manage advice,
underwrite, provide stand by assistance, securities and all kinds of investments issued, to be issued or
guaranteed by any company corporation, society, firm, trust, person, government, municipality, civic of
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body, public authority established in India.
2. The main objective of the merchant banker is to create a secondary market for bills and discount
or rediscount bills and acts as an acceptance house.
3. Merchant bankers involve in assistance and promotion of economic endeavour, identification of
projects, promoters, preparation of project reports, project feasibility stuthes, market research, pre-
investment stuthes and investigation of industries at micro and macro level.
4. They also provide services to the finance housing schemes for the Construction of houses and
buying of land.
5. They render the services like foreign exchange dealer, money exchanges, authorized dealer and
to buy and sell foreign exchange in all lawful ways in compliance with the relevant laws in India.
6. They also involve in acquiring and holding one or more membership in stock exchange/National
Stock Exchange, trade associations, commodity exchange, clearing houses, or associations in India or
any part of the world.
7. They help to promote or procure in corporation formation or setting up to concerns and
undertakings as a company, body corporate, partnership or any other association or person for
engaging in any other association or persons in any industrial, commercial or business activities.
8. Their objective is to perform financial services including factoring and syndication of both the
loans i.e. short-term and long-term with financial institutions, bank and others to manage mutual funds
and to provide financial software programme.
9. The objective of the merchant banking is to carry on the business of financing the industrial
enterprises.
10. They invest in buying and selling of transfers, hypothecate, and deal with the disposal of shares,
stocks, debentures, securities and properties of any other company.
11.6 ADVANTAGES OF MERCHANT BANKING
The importance of merchant banking are as follows :
1) Utilize the Financial Surplus :
Merchant bankers facilitate directing the surplus funds available with the general public towards the
merchant avenues for their meaningful utilization.
2) Synchronized the Activities :
A number of mediators are involved in the process of 'share issue', e.g. the registrar, bankers,
advertising agency, underwriters, brokers, etc. Merchant bankers act as a coordinating agency ensuring
their cohesive activities in a synchronized manner.
3) Compliance with Rules and Regulations :
They play an important role in ensuring that various rules and regulations pertaining to the securities.
market are adhered to by the corporate participants of the market.
4) Identification of Investment Prospects :

They identify and exploit various investment prospects available at domestic and global level.
5) Analysis of Risk :
Merchant bankers undertake the analysis of inbuilt risks at macro and micro economic levels, which are
associated with specific countries/industries/companies and real estate assets. This is achieved by them
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through the process of extensive due diligence.
6) Execution of Activities :
Organizing the complicated investment proposals and implementation thereof, which involve activities
like detailed financial analysis, deal negotiation, transaction execution, etc.
7) Supporting Management and Partners :
Supporting the management and partners of a company in building their value and developing their core
businesses or portfolios. This may be accomplished, inter-alia, through :
 The representation on the companies Boards.
 Management oversight.
 Assessing a suitable time and manner in which to reap the benefits of an investment.
Disadvantages of Merchant Banking
The advantages notwithstanding, there are following shortcomings of merchant banking. List of the
Disadvantages / Problems of merchant banking are as follows :
1. The services offered by Merchant banks can be meant for the large corporate clients or smaller
business entities with exceptionally rich financial background, held by individuals.
2. The cases undertaken by the merchant bankers are likely to meet with partial success or in some
cases total disaster.
3. The nature of services offered by merchant bankers is fraught with risks.
11.7 OBLIGATIONS AND RESPONSIBILITIES

Merchant bankers has the following obligations and responsibilities:
Obligations of Merchant Bankers
1. Merchant Banker not to Associate with any Business other than that of the Securities Market:
No merchant banker, other than a bank or a public financial institution, who has been granted a
certificate of registration under these regulations, shall [after June 30th, 1998] carry on any business
other than that in the securities market.
Not-withstanding anything contained above, a merchant banker who prior to the date of notification of the
Securities and Exchange Board of India (Merchant Bankers) Amendment Regulations, 1997, has
entered into a contract in respect of a business other than that of the securities market, may, if he so
desires, discharge his obligations under such contract.
Maintenance of Book of Accounts, Records, etc.:
Every merchant banker shall keep and maintain the following books of accounts, records and
documents, namely:
(a) A copy of balance sheet as at the end of each accounting period;
(b) A copy of profit and loss account for that period:
(c)A copy of the auditor’s report on the accounts for that period; and
(d) a statement of financial position.
Every merchant banker shall intimate to the Board the place where the books of accounts, records and
documents are maintained.
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Without prejudice to sub-regulation (I), every merchant banker shall, after the end of each accounting
period furnish to the Board copies of the balance sheet, profit and loss account and such other
documents for any other preceding five accounting years when required by the Board.
3. Submission of Half-yearly Results:
Every merchant banker shall furnish to the Board half-yearly unaudited financial results when required by
the Board with a view to monitor the capital adequacy of the merchant banker.
4. Maintenance of Books of Accounts, Records and other Documents:
The merchant banker shall preserve the books of accounts and other records and documents for a
minimum period of five years.
5. Report on Steps taken on Auditor’s Report:
Every merchant banker shall within two months from the date of the auditors’ report take steps to rectify
the deficiencies, made out in the auditor’s report.
6. Appointment of Lead Merchant Bankers:
All issues should be managed by atleast one merchant banker functioning as the lead merchant banker
Provided that, in an issue of offer of rights to the existing members with or without the right of
renunciation the amount of the issue of the body corporate does not exceed rupees fifty lakhs, the
appointment of a lead merchant banker shall not be essential.
Every lead merchant banker shall before taking up the assignment relating to an issue, enter into an
agreement with such body corporate setting out their mutual rights, liabilities and obligations relating to
such issue and in particular to disclosures, allotment and refund.
7. Restriction on Appointment of Lead Managers:
The number of lead merchant bankers may not, exceed in case of any issue of;
8. Responsibilities of Lead Managers:
(1) No lead manager shall agree to manage or be associated with any issue unless his responsibilities
relating to the issue mainly, those of disclosures, allotment and refund are clearly, defined, allocated and
determined and a statement specifying such responsibilities is furnished to the Board atleast one month
before the opening of the issue for subscription:
Provided that, where there are more than one lead merchant banker to the issue the responsibilities of
each of such lead merchant banker shall clearly be demarcated and a statement specifying such
responsibilities shall be furnished to the Board atleast one month before the Opening of the issue for
Subscription.
No lead merchant banker shall, agree to manage the issue made by anybody corporate, if such body
corporate is an associate of the lead merchant banker.
9. Lead Merchant Banker not to Associate with a Merchant Banker without Registration:
A lead merchant banker shall not be associated with any issue if a merchant banker who is not holding a
certificate is associated with the issue.
10. Underwriting Obligations:
In respect of every issue to be managed, the lead merchant banker holding a certificate under Category I
shall accept a minimum underwriting obligation of five per cent of the total underwriting commitment or
rupees twenty-five lacs, whichever is less:
Provided that, if the lead merchant banker is unable to accept the minimum underwriting obligation, that
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lead merchant banker shall make arrangement for having the issue underwritten to that extent by a
merchant banker associated with the issue and shall keep the Board informed of such arrangement.
11. Submission of Due Diligence Certificate:
The lead merchant banker, who is responsible for verification of the contents of a prospectus or the letter
of offer in respect of an issue and the reasonableness of the views expressed therein, shall submit to the
Board atleast two weeks prior to the opening of the issue for subscription, a due diligence certificate in
Form C.
12. Documents to be Furnished to the Board:
(1) The lead manager responsible for the issue shall furnish to the Board, the following
documents, namely:
(i) Particulars of the issue;
(ii) Draft prospectus or where there is an offer to the existing shareholders, the draft letter of offer;
(iii) Any other literature intended to be circulated to the investors, including the shareholders; and
(iv) Such other documents relating to prospectus or letter of offer, as the case may be.
13. Continuance of Association of Lead Manager with an Issue:
The documents referred to in sub-regulation (1) shall be furnished atleast two weeks prior to date of filing
of the draft prospectus or the letter of offer, as the case may be, with the Registrar of Companies or with
the Regional Stock Exchanges, or with both.
The lead manager shall ensure that the modifications and suggestions, if any, made by the Board on the
draft prospectus or the letter of offer, as the case may be, with respect to information to be given to the
investors are incorporated therein.
The lead manager undertaking the responsibility for refunds or allotment of securities in respect of any
issue shall continue to be associated with the issue till the subscribers have received the share or
debenture certificates of refund or excess application money.
Provided that where a person other than the lead manager is entrusted with the refund or allotment of
securities in respect of any issue, the lead manager shall continue to be responsible for ensuring that
such other person discharges the requisite responsibilities in accordance with the provisions of the
Companies Act and the listing agreement entered into by the body corporate with the stock exchange.
14. Acquisition of Shares Prohibited:
No merchant banker or any of its directors, partner or manager or principal officer shall either on their
respective accounts or through their associates or relatives enter into any transaction in securities of
bodies corporate on the basis of unpublished price sensitive information obtained by them during the
course of any professional assignment either from the clients or otherwise.
15. Information to the Board:
Every merchant banker shall submit to the Board complete particulars of any transaction for acquisition
of securities of anybody corporate whose issue is being managed by that merchant banker within fifteen
days from the date of entering into such transaction.
16. Disclosures to the Board:
A merchant banker shall disclose to the Board as and when required, the following information,
namely:
(i) His responsibilities with regard to the management of the issue;
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1. Merchant banker should maintain proper books of accounts, records and submit half
yearly/annual financial statements to the SEBI within the stipulated period of time.
2. No Merchant banker should associate with another merchant banker who does not register with
the SEBI.
3. Merchant bankers should not enter into any transactions on the basis of unpublished information
available to them in course of their professional assignment.
4. Every Merchant banker must submit himself to the inspection by the SEBI when required for and
submit all the records.
5. Every Merchant banker must disclose information to the SEBI when it requires any information
from him
6. All Merchant bankers must abide by the code of conduct prescribed for them.
7. Every Merchant banker who acts as the lead manager must enter into an agreement with the
issuer settling out mutual rights, liabilities, obligations relating to such issues with particular references
to disclosers, allotment, refund etc.
11.8 CODE OF CONDUCT
According to the 13 Regulation of the SEBI Regulations 1992 (Merchant bankers), every merchant
banker should comply with the following code of conduct. They are:
The SEBI regulations have outlined the following code of conduct for the merchant bankers operation in
India;
• A merchant banker shall make all efforts to protect the interests of investors.
• A Merchant Banker shall maintain high standards of integrity, dignity and fairness in the conduct of its
business.
• A Merchant Banker shall fulfill its obligations in a prompt, ethical, and professional manner.
• A Merchant Banker shall at all times exercise due diligence, ensure proper care and exercise
independent professional judgment.
• A Merchant Banker shall Endeavour to ensure that enquiries from the investors are adequately dealt
with, grievances of investors are redressed in a timely and appropriate manner, where a complaint is not
remedied promptly, the investor is advised of any further steps which may be available to the investor
under the regulatory system.
• A Merchant Banker shall ensure that adequate disclosures are made to the investors in a timely
manner in accordance with the applicable regulations and guidelines so as to enable them to make a
balanced and informed decision.
• A Merchant Banker shall endeavor to ensure that the investors are provided with true and adequate
information without making any misleading or exaggerated claims or any misrepresentation and are
made aware of the attendant risks before taking any investment decision.
• A Merchant Banker shall endeavor to ensure that copies of the prospectus, offer document, letter of
offer or any other related literature is made available to the investors at the time of issue of the offer.
A Merchant Banker shall not discriminate amongst its clients, save and except on ethical and commercial
considerations.
A Merchant Banker shall not make any statement, either oral or written, which would misrepresent the
services that the Merchant Banker is capable of performing for any client or has rendered to any client.
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• A Merchant Banker shall avoid conflict of interest and make adequate disclosure of its interest. • A
Merchant Banker shall put in place a mechanism to resolve any conflict of interest situation that may
arise in the conduct of its business or where any conflict of interest arises, shall take reasonable steps to
resolve the same in an equitable manner.
• Merchant Banker shall make appropriate disclosure to the client of its possible source or potential areas
of conflict of duties and interest while acting as Merchant Banker which would impair its ability to render
fair, objective and unbiased services.
• A Merchant Banker shall always endeavor to render the best possible advice to the clients having
regard to their needs.
• A Merchant Banker shall not divulge to anybody either oral or in writing, directly or indirectly, any
confidential information about its clients which has come to its knowledge, without taking prior permission
of its client, except where such disclosures are required to be made in compliance with any law for the
time being in force.
• A Merchant Banker shall ensure that any change in registration status/any penal action taken by the
Board or any material change in the Merchant Banker‗s financial status, which may adversely affect the
interests of clients/investors is promptly informed to the clients and any business remaining outstanding
is transferred to another registered intermediary in accordance with any instructions of the affected
clients.
• A Merchant Banker shall not indulge in any unfair competition, such as weaning away the clients on
assurance of higher premium or advantageous offer price or which is likely to harm the interests of other
Merchant Bankers or investors or is likely to place such other Merchant Bankers in a disadvantageous
position while competing for or executing any assignment.
• A Merchant Banker shall maintain arms length relationship between its merchant banking activity and
any other activity.
• A Merchant Banker shall have internal control procedures and financial and operational capabilities
which can be reasonably expected to protect its operations, its clients, investors and other registered
entities from financial loss arising from theft, fraud, and other dishonest acts, professional misconduct or
omissions.
• A Merchant Banker shall not make untrue statement or suppress any material fact in any documents,
reports or information furnished to the Board.
• A Merchant Bankers shall maintain an appropriate level of knowledge and competence and abide by
the provisions of the Act, regulations made there under, circulars and guidance, which may be applicable
and relevant to the activities carried on by it. The merchant banker shall also comply with the award of
the Ombudsman passed under Securities and Exchange Board of India (Ombudsman) Regulations,
2003.
• A Merchant Banker shall ensure that the Board is promptly informed about any action, legal
proceedings etc., initiated against it in respect of material breach or non-compliance by it, of any law,
rules, regulations, directions of the Board or of any other regulatory body.
• A Merchant Banker or any of its employers shall not render, directly or indirectly, any investment advice
about any security in any publicly accessible media, whether real-time , unless a disclosure of his
interest including a long or short position, in the said security has been made, while rendering such
advice. In the event of an employee of the Merchant Banker rendering such advice, the merchant banker
shall ensure that such employee shall also disclose the interests, if any, of himself, his dependent family
members including their long or short position in the said security, while rendering such advice.
• A Merchant Banker shall demarcate the responsibilities of the various intermediaries appointed by it
clearly so as to avoid any conflict or confusion in their job description.
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• A Merchant Banker shall provide adequate freedom and powers to its compliance officer for the
effective discharge of the compliance officer‗s duties.
• A Merchant Banker shall develop its own internal code of conduct for governing its internal operations
and laying down its standards of appropriate conduct for its employees and officers in carrying out their
duties. Such a code may extend to the maintenance of professional excellence and standards, integrity,
confidentiality, objectivity, avoidance or resolution of conflict of interests, disclosure of shareholdings and
interests etc.
• A Merchant Banker shall ensure that good corporate policies and corporate governance are in place.
• A Merchant Banker shall ensure that any person it employs or appoints to conduct business is fit and
proper and otherwise qualified to act in the capacity so employed or appointed
• A Merchant Banker shall ensure that it has adequate resources to supervise diligently and does
supervise diligently persons employed if appointed by it in the conduct of its business, in respect of
dealings in securities market.
• A Merchant Banker shall be responsible for the acts or omissions of its employees and agents in
respect of the conduct of its business.
• A Merchant Banker shall ensure that the senior management, particularly decision makers have access
to all relevant information about the business on a timely basis.
• A Merchant Banker shall not be a party to or instrumental for creation of false market; price rigging or
manipulation; or passing of unpublished price sensitive information in respect of securities which are
listed and proposed to be listed in any stock exchange to any person or intermediary in the securities
market.
11.9 MERCHANT BANKING IN INDIA

The history of merchant banking in India is a tale of evolution from modest beginnings to a robust
and integral part of the country's financial system.
Pre-Independence Era: Merchant banking in India has its roots in the pre-independence era
when traditional merchant communities and business houses engaged in various financial
activities. These activities were primarily centered around trade financing and credit provision to
businesses. Merchants and trading communities acted as intermediaries between investors and
businesses seeking capital.
Early Development (1960s-1970s): The organized merchant banking activities in India began to
take shape in the 1960s and 1970s when financial institutions like ICICI (Industrial Credit and
Investment Corporation of India) and IDBI (Industrial Development Bank of India) initiated efforts
to provide financial support and advisory services to the industrial sector.
 ICICI: ICICI established a specialized division called the Industrial Finance Corporation
(IFC) in the 1950s to provide financial and advisory services. In 1969, IFC was merged
with ICICI to form a comprehensive development financial institution.
 IDBI: IDBI was set up in 1964 to provide long-term finance and development assistance to
various industrial projects.
Liberalization and Growth (1990s Onward): The landscape of merchant banking in India
underwent a significant transformation with economic liberalization in the early 1990s. Key
developments during this period included:
 Private Merchant Banks: The 1990s saw the emergence of private merchant banks and
financial institutions that expanded the scope and sophistication of merchant banking
services. Prominent names like Kotak Mahindra Capital, DSP Merrill Lynch, and JM
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Financial became prominent players.
 SEBI Regulation: The establishment of the Securities and Exchange Board of India
(SEBI) in 1992 brought a comprehensive regulatory framework for the capital markets,
including merchant banking activities. SEBI introduced the SEBI (Merchant Bankers)
Regulations, 1992, which set the guidelines and code of conduct for merchant bankers.
 Globalization: India's integration into the global economy led to increased foreign
investments and cross-border mergers and acquisitions, further boosting the demand for
merchant banking services.
11.10 SERVICES RENDERED BY THE MERCHANT BANKS

Merchant banks have been rendering diverse services and functions as organizing and extending
finance for the investments in projects, raising of EURO dollar loans, equipment leasing, mergers and
acquisitions, valuation of assets, investment management, and promotion of investment trusts. All
these services are not offered by all the merchant bankers. But different merchant bankers are
specialized in different services. The Merchant bank is a multi-service oriented agency. Merchant
banking is a creative activity. In India, the merchant banks have been engaging in the following
activities:
(a) Corporate Finance Services (management of public issues, credit syndication).
(b) Advisory Services (project counseling, financing, capital restructuring).
(c) Services to the NRls. (evaluation of investment portfolio, promotion of industries).
(d) Leasing (equipment, machinery etc,)
Merchant banks, also known as investment banks or corporate banks, provide a range of financial
services to businesses and individuals. Their primary focus is on assisting companies with various
financial needs, including capital raising, financial advisory, and strategic planning. Services typically
rendered by merchant banks:
1.Corporate Finance Advisory: Merchant banks offer expert advice on various financial matters to
corporate clients. This includes mergers and acquisitions (M&A) advisory, capital restructuring, and
financial planning. They help businesses make informed decisions about their financial strategies
and optimize their capital structure.
2.Capital Raising: One of the core functions of merchant banks is to help companies raise capital.
This can be done through various means, including initial public offerings (IPOs), private
placements, debt issuances, and mezzanine financing. Merchant banks have the expertise to
structure these transactions effectively to meet their clients' financial goals.
3.Underwriting Services: Merchant banks often act as underwriters for securities offerings. They
purchase securities from the issuer and then sell them to investors. This underwriting process
helps companies raise capital with the assurance that the offering will be successfully completed.
4.Private Equity and Venture Capital: Many merchant banks have private equity and venture capital
arms that invest in companies directly or facilitate investments from other investors. They provide
equity capital to startups and growth-stage companies in exchange for ownership stakes.
5.Debt Syndication: Merchant banks assist businesses in arranging and syndicating debt financing.
They help in structuring and marketing loan or bond offerings to a group of lenders or investors.
This is particularly important for large-scale infrastructure and corporate projects.
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6.Risk Management: Merchant banks offer risk management solutions to help companies hedge
against various financial risks, including currency exchange rate fluctuations, interest rate
fluctuations, and commodity price volatility. This is crucial for companies with international
operations or exposure to volatile markets.
7.Asset Management: Some merchant banks provide asset management services, where they
manage portfolios of securities on behalf of institutional and individual clients. This may include
investment advisory, portfolio management, and wealth management services.
8.Research and Market Analysis: Merchant banks often conduct in-depth research and analysis on
financial markets, industries, and specific companies. This research is valuable to their clients for
making investment and strategic decisions.
9.Advisory Services: Merchant banks offer strategic advisory services, helping clients develop
business strategies, assess potential investment opportunities, and navigate complex financial
transactions.
10. Trade Finance: They provide trade finance solutions to facilitate international trade. This includes
services such as letters of credit, export financing, and trade risk mitigation.
11. Treasury and Cash Management: Merchant banks assist companies in optimizing their cash
management processes. They offer solutions for efficient fund utilization, liquidity management,
and cash flow forecasting.
12. Trust Services: Some merchant banks offer trust and fiduciary services, including estate planning,
trust administration, and wealth transfer solutions for high-net-worth individuals and families.

1. Define “Merchant Banking”.
2. What is “Code of Conduct”?
11.12 SUMMARY
The origin of merchant banking can be traced back to 13th century when a few family owned and
managed firms engaged in sale and purchase of commodities were also found to be engaged in
banking activity. These firms not only acted as bankers to the kings of European States, financed
coastal trade but also borne exchange risk. In order to earn profits, they invested their funds where
they expected higher returns despite high degree of risk involved. They charged very high rates of
interest for financing highly risky projects. In turn, they suffered heavy losses and had to close down.
Some of them restarted the same activity after gaining financial strength. Thus merchant Banking
survived and continued during the 13th century.
Later, merchant bankers were known as “commission agents” who handled the coastal trade on
commission basis and provided finance to the owners or supplier of goods. They made investments in
goods manufactured by sellers and made huge profits. They also financed continental wars. The sole
objective of these merchant bankers was profit maximisation by making investments in risky projects.
11.13 GLOSSARY
Merchant banking: merchant banking has been so widely used that sometime it is lied to banks who
are not merchants sometimes two merchants who are not banks and sometimes to those
intermediaries who are neither merchants nor Bank.
Investment banking: investment banking channelization savings of individuals into the investments in
the securities issued by business Enterprises.
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Corporate counselling: this service is usually provided free of charge to a corporate unit.
Corporate counselling: this service is usually provided free of charge to a corporate unit merchant
bankers Randers advised to corporate enterprise from time to time in order to improve performance
and build better image among investors.
Portfolio management: portfolio management is bus service provided by merchant banker not only
two companies issuing the securities but also to the investors.
Stock Exchange: Stock exchanges are market places where securities that have been listed on May
be bought and sold for either investment of speculation.
1. Refers to 11.1
2. Refers to 11.8
1. Discuss the objectives of the merchant banking.
2. Describe the concept and functions of the merchant banking in India.
3. Discuss the type of merchant banking services and code of conduct in India.
3. Refers to Sections 11.3 & 11.8
India,
4. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage publications, New
Delhi.
5. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain Book Agency,
Mumbai.
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Lesson-12
Regulation for Merchant Banking
STRUCTURE
12.1 Introduction
12.2 Guidelines of the SEBI
12.3 Guidelines of the ministry of finance
12.4 Companies Act. 1956
12.5 Securities contract (Regulation) Act. 1956
12.6 Listing Guidelines of Stock exchange
12.8 Summary
12.9 Glossary
 Explain the regulations for merchant banking
 Listing Guidelines of Stock exchange
 Guidelines of the ministry of finance
12.1 Introduction
The origin of merchant banking can be traced back to 13th century when a few family owned
and managed firms engaged in sale and purchase of commodities were also found to be
engaged in banking activity. These firms not only acted as bankers to the kings of European
States, financed coastal trade but also borne exchange risk. In order to earn profits, they
invested their funds where they expected higher returns despite high degree of risk involved.
They charged very high rates of interest for financing highly risky projects. In turn, they suffered
heavy losses and had to close down. Some of them restarted the same activity after gaining
financial strength. Thus merchant Banking survived and continued during the 13th century
REGULATIONS FOR MERCHANT BANKING
Merchant banking activities are regulated in India by:
(a) Guidelines of the SEBI.
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(b) Guidelines of the Ministry of Finance.
(c) Companies Act, 1956.
(d) Securities Contract (Regulation) Act, 1956.
(e) Listing guidelines of the Stock Exchange.
12.2 GUIDELINES OF THE SEBI

After the abolition of the CCI, its place was occupied by a legal organ called ‘Securities and Exchange
Board of India’. The issue of capital and the pricing of issues by the companies has become free from
prior approval. The SEBI has issued guidelines for the issue of capital by the companies. The
guidelines broadly cover the requirement of the first issue by a new company or the first issue of a new
company set up by the existing company. The SEBI is the most powerful organization to control and
lead the primary and secondary markets. According to the SEBI guidelines, if any company approaches
the public, by the issue of share capital through the public issues, must be kept open for three working
days mid it should be mentioned in the prospectus. In the case of right issue, the subscription time
should not be kept more than 60 days. The gap between the rights and public issues should not exceed
30 days. The issued capital must he fully paid up within 12 months of the date of issue. The minimum
amount of subscription by the investors in the public issue either at par or premium has been fixed at
Rs. 5000. The amount of the issue should not exceed the amount specified in the prospectus.
Over subscription amount retention by the company is not permitted under any circumstances.
The SEBI has announced the new guidelines for the disclosures by the companies leading to the
investor protection. They are presented below:-
(a) If any company’s other income exceeds 10 per cent of the total income the details should be
disclosed.
(b) The company should disclose any adverse situation that affects the operations of the company and
that occurs within one year prior to the date of filling the offer document with the registrar of the
companies of the stock exchange.
(c) The company should disclose the information regarding the utilization of the plant for the last 3
years.
(d) The promoters of the company must maintain their holding at least at 20 per cent of the expanded
capital.
(e) The minimum application money payable should not be less than 25 per cent of the issue price.
(f) The company should disclose the time taken for the disposal of various types of investor’s
grievances.
(g) The company can make firm allotments in the public issues as follows:
1. Indian Mutual Funds (20%).
2. FIIs (24%).
3. Regular employees of the company (10%).
4. Financial Institutions (20%).
(h) The company should disclose the safety net scheme or buy back arrangements of the shares
proposed in the public issue. This scheme is applicable to a limited number of 500 shares per allotted
and the offer should be valid for a period of at least 6 months from the date of dispatch of the securities.
(i) According to the guidelines, in case of the public issues at least 30 mandatory collection centres
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should be established.
(j) According to the SEBI guidelines, regarding the rights issue, the company should give
advertisements at least in 2 newspapers about the dispatch of letters of offer. No preferential allotment
may be made along with any rights issue.
(k) The company should disclose about the fee agreed between the lead managers and the company
in the memorandum of understanding.
The guidelines will apply to all the issues to be made after the promulgation of the ordinance by which
the Capital Issues Act has been repealed. Further the SEBI issued guidelines for the “disclosure and
investor protection” as presented below (issued by the SEBI vide GL/IP No. 1/SEBI/PMD 92-93, dated
11-6-92).
(a) First Issue of the New Companies.
(b) First Issue of the existing private/closely held companies.
(c) Public Issue by the Existing Listed Companies.
(d) Underwriting.
(e) Issue of PCD/FCD/NCD.
(f) New Financial testaments.
(g) Reservation in Issues.
(h) Deployment of Issue Proceeds.
(i) Employee Stock Option Scheme.
(j) Promoter’s Contribution and lock-in period.
(k) Bonus issues’.
(l) Guidelines for the protection of the interest of the debenture holders,
(m) General.
(a) First Issue of New Companies
According to the guidelines, a new company is defined as: “one which has not completed 12 months of
commercial operations and its audited operative results are not available, where it is set up by the
entrepreneurs without a track record.” They will be permitted to issue the capital to the public only at
par. If a new company is being set up by the existing companies with a 5 years track record of
consistent profitability. It will be free to price its issue provided the participation of the promoting
companies would investors uniformly provided that the prospectus or offer documents would contain
the justification for the issue price.
A draft prospectus that contains the disclosures will be vetted by the SEBI, before a public issue is
made. No private placement of the promoter’s share should be made by the solicitation of the share
contribution from unrelated investors through any kind of market intermediaries. The shares of the
above companies can be listed on either the O.T.C. or any other stock exchange.
(b) First Issue by the Existing Private/Closely held Companies
According to the guidelines, the first issue by the existing private companies with 3 years track record of
consistent profitability should be permitted to freely price the issue and list their securities on the stock
exchanges. The pricing would be determined by the issuer and the lead managers to the issue and
would be on justification for the issue price.
(c) Public Issue by the Existing Limited Companies
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The SEBI permitted these companies to raise the fresh capital by freely pricing their further issues; The
Issue price will be determined by the issuer in consultation with the lead managers. The draft
prospectus will be vetted by the SEBI to ensure the adequacy of disclosures. The prospectus should
contain the net asset value of the company and a justification for the price of the issue. It should also
disclose high and low of the shares for the last 2 years.
(d) Underwriting
According to the SEBI guidelines underwriting is mandatory for the full issue and a minimum
requirement of 90 per cent subscription is also mandatory for each issue of capital to the public. The
number of underwriters would be decided by the issuing company. If the company does not receive 90
per cent of the issued amount from the public subscription plus accepted development from the
underwriters, within 120 days from the date of opening of the issue, then the company should refund
the amount of subscription. The lead managers must satisfy themselves about the net worth of the
underwriters and the outstanding commitments should disclose the same to the SEBI. The underwriting
agreements may be filed with the stock exchanges.
(e) Issue of FCD/PCD/NCD
The SEBI issued guidelines on the convertible and non-convertible debentures are as follows:
In case of the issue of fully convertible debentures, the debentures may be converted after 36 months
and the conversion is made optional with the put and call option. The crediting should be made if the
conversion period is after 18 months. In the prospectus, the premium time of conversion stages should
be indicated. The interest rate for the debentures will be freely determined by the issuing company.
In case of the issue of debentures with the maturity of 18 months or less are exempted from the
requirement of appointment of the Debenture Trustee. The trust deed should be executed within 6
months of the closure of the issues. The debenture holders are free in case of conversion, if it takes
place at or after 18 months from the date of allotment, but before 36 months. The rating is compulsory
in case of NCD/PCD if maturity period exceeds 18 months. The prospectus should inform all the
information regarding premium amount, conversion period, rate of interest and all other particulars. The
SEBI may prescribe additional disclosure requirement from time to time after the due notice.
(f) New Financial Instruments
The Issue of Capital should made adequate disclosures regarding the terms and conditions,
redemption, security conversion, and any other relevant features of the instruments such as deep
discount bonds, debentures with warrants, secured premium notes etc. Therefore, the investor can be
made reasonable determination of the risks, returns, safety and liquidity of the instalments. This
disclosures should be vetted by the SEBI in this regard.
(g) Reservation in Issues
The reservation can be made by the company with the consent of the SEBI in the following manner.
In case of the issue of capital by the new companies, reservations to the employees, promoting
companies, associate companies, working directors on a suitable percentage is permitted to the share-
holders of the group companies. In case of the existing companies, it can be offered on a preferential
basis. The shareholders of the promoters companies should also be eligible for the preferential
allotment. Reservations to the NRIs should be made according to the schemes prescribed by the RBI
from time to time.
(h) Deployment of the Issue Proceeds
After closing the issue, the company should report to the SEBI regarding the collection of money. If the
application money and the allotment amount together exceed Rs. 250 crores, the company would
voluntarily disclose and make arrangements for the use of the proceedings of the issue as per. the
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disclosure to be monitored by one of the financial institutions. In issue of the above size and beyond,
the amount to be called upon the application allotment and on various calls should not exceed 35 per
cent of the total quantum of issue.
(i) Employee Stock Option Scheme
The employee stock option is a voluntary scheme to motivate the employees to have a higher
participation in the company. A suitable percentage of reservation can be made by the issue company
for its employees. However the reservation amount should not exceed 5 per cent of the issue. Equal
distribution of shares among the employees will contribute to the smooth working of the scheme. The
company may like to have the non-transferability of shares at its discretion in the new issues. The
allotted shares to employees cannot be transferable for a period of 3 years.
(j) Promoter’s Contribution
The promoter has the choice to contribute the share capital which is offered to the public. The
promoters, directors, his friends, his relatives and associates can contribute up to 25 per cent of the
total issue of the equity capital and up to Rs. 100 crores and 20 per cent for issuing the above 100
crores. In case of the fully convertible, 1/3rd of the issue amount should be contributed by the
prompters, directors, friends and associates in the form of equity before the issue is made. In case of
the PCDs, 1/3rd of the convertible portion should be brought in as the contribution of promoter before
the issue is made. The minimum subscription by each of his friends/relatives and associates, should
not be less than Rs. 1.00 lakh. The promoter must bring his full subscription to the issue in advance
before the public issue. The promoter’s contribution should not be diluted for a lock in period of 5 years
from the date of commencement of the production or date of allotment.
Further, all the firm allotments, preferential allotments to collaborators, share-holders of the promoters
companies whether corporate or individual should not be transferable for 3 years from the date of
commencement of production or date of allotment. The share certificates issued to the promoter and
his associates should carry the inspection “not transferable” for a period of 3-5 years as may be
applicable from the date of commencement of production or date of allotment.
(k) Bonus Issue
The SEBI issued guidelines in case of the bonus issue. The company should ensure the following while
issuing the bonus shares:
1. The bonus issue is made out of free reserves or share premium collected in cash.
2. The reserves created by the revaluation of the fixed asset should not be capitalized.
3. The investment allowance reserve is considered as free reserve for the calculation of the residual
reserves.
4. All contingent liabilities would be taken into account in the calculation of the residual reserves.
5. The residual reserves after the proposed capitalization should be at least 40 per cent of the
increased paid capital.
6. The declaration of the bonus issue in lieu of the dividend is not made.
7. The bonus issue should be made only after the full payment of the share capital.
8. There should be a provision in the articles of association for capitalizing the reserves.
9. The company should get a resolution passed in its general body meeting for the bonus issue.
10. Before the bonus issue, the company should not default in the payment of interest and the dues to
employees.
11. The Company should implement the bonus issue within 6 months after the approval of the board
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(l) Protection of the Debenture Holders
The SEBI issued guidelines to protect the interest of the debenture holders in two aspects. They are:
1. Servicing of the Debentures
As per the SEB1 guidelines, a debenture redemption reserve should be created by all the companies
raising debentures on the following basis:
(a) The company may redeem the debentures in greater number of instalments.
(ii) The company may distribute dividends out of general resources in certain years.
(iii) A moratorium up to the date of the commercial production can be provided for the creation of the
DRR (Debenture Redemption Reserve).
(iv) The Company should create the DRR equivalent to 50 per cent of the amount of the debenture
issue before the redemption commences.
(v) Drawal from the DRR impermissible only after 10 per cent of the debenture liabilities has been
actually redeemed by the companies.
(vi) The DRR may be created either in equal instalments or higher amounts if profit permits.
(vii) In case of the PCDs, the DRR should be created.
(viii) In case of the convertible issues by the new companies, the creation of the DRR should earn
profits from the year for the remaining life of debentures.
2. Protection of the Debenture Holders Interest
(i) The debentures are issued by the companies for the purpose of avoiding the shares acquisition in
other countries.
(ii) The debenture-holders have the right to appoint a nominee director on the board.
(iii) The lead bank of the company will monitor the debentures raised for working the capital funds.
(iv) Institutional debenture holders should obtain a certificate from the Company’s auditor.
(m) General
1. The subscription list should be kept open for at least 3 days to the public issues and up to 60 days to
rights issue.
2. The quantum of the issue should not exceed the amount specified in the prospectus.
3. No retention of over-subscription is permitted under any circumstances.
4. After closing the issue, the company should submit a compliance report from the Chartered
Accountant and forward it to the SEBI by the lead managers to the issue within 45 days.
5. The SEBI will have the full rights to prescribe further guidelines to bring transparency in the primary
market.
6. Any violation of the guidelines by the issuers/intermediaries will be punishable through the
prosecution by the SEBI under the Act.
7. The provisions of the Companies Act, 1956 and other applicable laws should be compiled in
connection with issue of shares and debentures.
8. The SEBI should have the right to issue necessary clarifications to these guidelines to remove any
difficulty in its implementation.
9. According to the RBI guidelines, the stock invest would now be restricted to the individual investors
and the Mutual funds only. (RBI, Press release. Dated 6-9-94).
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The Merchant bankers, irrespective of the form in which they are organized are governed by the
Merchant Bank rules issued by the SEBI and the Ministry of Finance.
12.3 GUIDELINES OF THE MINISTRY OF FINANCE
The Ministry of Finance, Department of Economic Affairs has issued guidelines in April 1990. According
to the guidelines, any person or body proposing to engage in the business of merchant banking would
need authorization from SEBI. The guidelines indicated the following activities to be performed by the
merchant bankers:
(a) Issue management
(b) Corporate advisory services
(c) Underwriting
(d) Portfolio management
(e) Managers to the issue
(f) Consultants to the issue
(g) Advisers to the issue.
The guidelines also provided relating to authorization criteria, terms of authorization etc. The authorized
merchant bankers are required to observe the guidelines, follow the code of conduct and work as per
the requirements of SEBI: The certificate of registration has been made to be valid for the period of 3
years from the date of issue of the certificate. If merchant bankers were already carrying on activities as
registrars, share transfer agents, bankers to the issue, debenture trustees. They were required
separate application to be submitted for each of such activity. The government issued orders to the
Registrar of Companies for verification of prospectus, whether the prospectus has been drafted by the
authorized merchant bankers or not: Hence the merchant bankers in India should follow the guidelines
issued by the SEBI.
12.4 COMPANIES ACT, 1956
Companies raising funds from the market shall fulfil the regulatory compliances as per the rules and
regulations. The merchant banker should select the suitable form of organization like sole
proprietorship or partnership firm or Hindu Undivided family or a corporate enterprise. The corporate
form of enterprise is preferred by professionals who have the managerial expertise and skills. The scale
of operations, borrowing facilities, better resources position are the best advantages of the corporate
sector. Hence such enterprise may be incorporated under the Companies Act, 1956. A company can
be a private limited, public limited or a government company. It can appropriately render category
merchant banking services. A detailed project report should be prepared before establishing the
company. For forming a public company at least 07 persons and for forming a private company at least
02 persons are required as promoters. Sec. 12 of the Companies Act deals with the registration
formalities of the form of company. The members should subscribe their names to the memorandum of
association and comply with the Companies Act. The promoters should take a approval from the
Registrar of Companies. The Memorandum of association, Articles of association and prospectus
should submit to the ROC to get the approval. A certificate of incorporation will be issued by the
Registrar, after fulfilment of all legal formalities. The Registrar will issue a commencement of business
certificate for public companies. A private company is prohibited from inviting public to subscribe to its
share capital.
12.5 SECURITIES CONTRACT (REGULATION) ACT, 1956
Merchant bankers play a vital role in the capital market. They work as sponsors of the capital issues.
They render valuable services to the issuing company. They involve in determining the composition of
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the capital structure of the issuing company. They involve in public issues right from drafting of
prospectus and application forms, compliance with legal formalities, appointment of registrars,
underwriters, bankers to issue, listing of securities, selection of brokers, publicity and advertising agents
and printers. Hence the merchant banker is a guiding force behind the company for making success of
a public issue. He has to work under many regulations of the various Acts. The Securities Contract Act
provides the broad framework of the functioning of stock exchanges in India. The objectives of the A ct
is to prevent malpractice insecurities transactions by regulating the business. Hence the merchant
banker should fulfill all the conditions of the Securities Contract Act. 1956.
12.6 LISTING GUIDELINES OF THE STOCK EXCHANGE
The Sees. 21-22A of Security Contract Regulation Act deal with the process of listing a share with
recognized stock exchange. Listing means, an admission of a scrip to trade on stock exchange
officially. Sec. 73 of the Companies Act reveals that listing of security is compulsory, if a company
makes public issue. The legal serviced to issuing company.
(a) The prospectus shall contain only the facts.
(b) The prospectus should be advertised in tire media 10 days before the issue.
(c) Publicity material should be fifed with stock exchange.
(d) The company should abide by the advertisement code.
(e) The prospectus shall indicate about the mode of payment.
(f) The merchant bankers should take all precautions in printing of forms.
(g) The application must provide space for “PAN”.
(h) The MB shall make arrangements for the acceptance of forms through the bankers.
(i) The MB shall also made arrangements for sending allotment letters.
(j) The MB shall send the share certificates within 2 months or 10 weeks of closing of issue.
(k) The MB shall produce a certificate from the auditor regarding allotment of shares.
(l) The merchant bankers shall inform to the stock exchange about the date of completion, posting of
refund orders, allotment letters, certificate of shares.
3. Define regulations for “Merchant Banking”.
4. What is “underwriting”?
12.8 SUMMARY
The origin of merchant banking can be traced back to 13th century when a few family owned and
managed firms engaged in sale and purchase of commodities were also found to be engaged in
banking activity. These firms not only acted as bankers to the kings of European States, financed
coastal trade but also borne exchange risk. In order to earn profits, they invested their funds where they
expected higher returns despite high degree of risk involved. They charged very high rates of interest
for financing highly risky projects. In turn, they suffered heavy losses and had to close down. Some of
them restarted the same activity after gaining financial strength. Thus merchant Banking survived and
continued during the 13th century.
Later, merchant bankers were known as “commission agents” who handled the coastal trade on
commission basis and provided finance to the owners or supplier of goods. They made investments in
goods manufactured by sellers and made huge profits. They also financed continental wars. The sole
objective of these merchant bankers was profit maximisation by making investments in risky projects.
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12.9 GLOSSARY
Merchant banking: merchant banking has been so widely used that sometime it is lied to banks who
are not merchants sometimes two merchants who are not banks and sometimes to those
intermediaries who are neither merchants nor Bank.
Investment banking: investment banking channelization savings of individuals into the investments in
the securities issued by business Enterprises.
Corporate counselling: this service is usually provided free of charge to a corporate unit.
Corporate counselling: this service is usually provided free of charge to a corporate unit merchant
bankers Randers advised to corporate enterprise from time to time in order to improve performance
and build better image among investors.
Portfolio management: portfolio management is bus service provided by merchant banker not only
two companies issuing the securities but also to the investors.
Stock Exchange: Stock exchanges are market places where securities that have been listed on
May be bought and sold for either investment of speculation.
1. Refers to 12.1
2. Refers to 12.2
1. Discuss the Listing Guidelines of Stock exchange.
2. Describe the guidelines of sebi for the merchant banking in India.
3. Discuss the government policy and regulations for merchant banking in India.
3. Refers to Sections 12.1
Hall of India,
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Lesson- 13
Reserve Bank of India: Central Banking
STRUCTURE
13.1 Introduction
13.2 Central Banking
13.3 Organization and Management
13.4 The Role and Functions
13.5 Note Issuing Authority
13.6 Government Banker
13.7 Banker’s Bank
13.8 Supervising Authority
13.9 Exchange Control Authority
13.10 Promoter of the Financial System
13.11 Regulator of Money and Credit
13.12 Self Assessment Exercise
13.13 Summary
13.14 Glossary
13.15 Answers to Self Assessment Exercise
1. Explain the pattern of Central Banking
2. Analysis the monetary policy of the Reserve Bank of India.
3. Describe the functions of a Central Bank.
13.1 INTRODUCTION
A study of financial institutions in India should appropriately begin with a brief discussion of the
functions, role, working, and policy of the Reserve Bank of India (RBI or Bank). The RBI, as the central
bank of the country, is the nerve centre of the Indian monetary system. As the apex institution, the RBI
has been guiding, monitoring, regulating, controlling, and promoting the destiny of the IFS since its
inception. The purpose of this chapter is to help the reader to understand the functioning of the RBI by
highlighting the major aspects of its working.
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13.2 CENTRAL BANKING
The pattern of central banking in India was based on the Bank of England. England had a highly
developed banking system in which the functioning of the central bank as a banker’s bank and their
regulation of money supply set the pattern. The central bank’s function as ‘a lender of last resort was on
the condition that the banks maintain stable cash ratios as prescribed from time to time. The effective
functioning of the British model depends on an active securities market where open market operations
can be conducted at the discount rate. The effectiveness of open market operations however depends
on the member banks’ dependence on the central bank and the influence it wields on interest rates.
Later models, especially those in developing countries showed that central banks play an advisory role
and render technical services in the field of foreign exchange, foster the growth of a sound financial
system and act as a banker to government.
13.3 ORGANIZATION AND MANAGEMENT
The RBI is quite young compared with such central banks as the Bank of England, Riksbank of
Sweden, and the Federal Reserve Board of the USA. However, it is perhaps the oldest among the
central banks in the developing countries. It started functioning from 1 April 1935 in terms of the
Reserve Bank of India Act, 1934.1twasaprivate shareholders’ institution till January 1949. After which it
became a state-owned institution undo* the Reserve Bank (Transfer to Public Ownership) of India Act,
1948. This Act empowers the Central Government, in consultation with the Governor of the Bank, to
issue such directions to it as they might consider necessary in the public interest Further, the Governor
and all the Deputy Governors of the Bank are appointed by the Central Government
The Bank is managed by the Central Board of Directors, four Local Boards of Directors, and the
Committee of the Central Board of Directors. The functions of the Local Boards are to advise the
Central Board on such matters as are referred to them; they are also required to perform such duties as
are delegated to them. The final control of the Bank vests in the Central Board which comprises the
Governor, four Deputy Governors, and fifteen Directors nominated by the Central Government. The
Committee of the Central Board consists of the Governor, the Deputy Governors, and such other
Directors as may be present at a given meeting.
The internal organizational set-up of the Bank has been modified and expanded from time to time in
order to cope with the increasing volume and range of the Bank’s activities. The underlying principle of
the internal organization is the functional specialization with adequate coordination. In order to perform
its various functions, the Bank has been divided and sub-divided into a large number of Departments.
Apart from the Banking and Issue Departments, there are at present twenty Departments and three
training establishments at the Central Office of the Bank.
13.4 THE ROLE AND FUNCTIONS
The RBI functions within the framework of mixed economic planning. The legal, economic, and
institutional factors in India have rendered the issue of the independence of the central bank almost
irrelevant. With regard to framing various policies, it is necessary to maintain close and continuous
collaboration between the Government and the RBI. In the event of a difference of opinion or conflict,
the Government view or position can always be expected to prevail. Given this environment or setting,
the Bank performs a number of functions which are discussed in the following sections.
13.5 NOTE ISSUING AUTHORITY
The RBI has, since its inception, the sole right or Authority or monopoly of issuing currency notes other
than one rupee notes and coins, and coins of smaller denominations. The issue of currency notes is
one of its basic functions. Although one rupee coins and notes, and coins of smaller denominations are
issued by the Government of India, they are put into circulation only through the RBI. The currency
notes issued by the Bank are legal tender everywhere in India without any limit. At present, the Bank
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issues notes in the following denominations: Rs. 2,5,10,20,50,100, and 500. The responsibility of the
Bank is not only to put currency into, or withdraw it from, the circulation but also to exchange notes and
coins of one denomination into those of other denominations as demanded by the public. All affairs of
the Bank relating to note issue are conducted through its Issue Department In order to discharge its
currency functions, the Bank maintains (at present) 14 local offices and the currency chests in which
the stock of new and reissuable notes, and rupee coins are stored. The total number of currency chests
at the end of March 1990 was 3791. Of these, 17 chests were with the RBI, 2745 with the SBI and
associate banks, 622 with nationalized banks, 402 with treasuries, and 5 with Jammu and Kashmir
Bank.
As stated elsewhere, the currency even today forms the major part of the money supply in India. The
currency as percentage of money supply (Mt = currency + demand deposits with banks) was 69.2% in
1950-51,71.1% in 1960-61,51.0% in 1975-76, and 59,0% in 1988-89. The composition of currency in
1987 was: small coins=Rs. 440 crores; rupee coins=Rs. 423 crores; rupee notes=Rs. 300 crores; and
Bank notes=Rs. 28,743 crores. The volume of note issue (including one rupee notes) has increased
from Rs. 1114 crores in 1952 to Rs. 29043 crores in 1987.
The Bank can issue notes against the security of gold coins and gold bullion, foreign securities, rupee
coins, Government of India securities, and such bills of exchange and promissory notes as are eligible
for purchase by’ the Bank. The RBI notes have a cent per cent backing or cover in these approved
assets. Earlier, i.e. till 1956, not less than 40 per cent of these assets was to consist of gold coin and
bullion and sterling/ foreign securities. In other words, (he proportional reserve system of note issue
existed in India till 1956. Thereafter, this system was abandoned and a minimum value of gold coin and
bullion and foreign securities as a part of total approved assets came to be adopted as a cover for the
note issue.
13.6 GOVERNMENT BANKER
The RBI is the banker to the Central and State Governments. It provides to the Governments all
banking services such as acceptance of deposits, withdrawal of funds by cheques, receipts and
collection of payments on behalf of the Government, transfer of funds, making payments on
Government behalf, and management of the public debt.
The Bank receives Government deposits flee of interest, and it is not entitled to any remuneration for
the conduct of the ordinary banking business of the Government. The deficit or surplus in the Central
Government account with the RBI is managed by the creation and cancellation of Treasury bills (known
as ad hoc treasury bills).
As a banker to the Government, the Bank can make “ways and means advances” (i.e. temporary
advances made in order to bridge the temporary gap between receipts and payments) to both the
Central and State Governments. The maximum maturity period of these advances is three months.
However, in practice, the gap between receipts and payments in respect of the Central Government is
met by the issue of ad hoc treasury bills, while the one in respect of the State Governments is met by
the ways and means advances.
The ways and means advances to the State Governments are subject to some limits. These advances
are of the following types: (a) Normal or clean advances i.e. advances without any collateral security;
(b) Secured advances, i.e. those which are secured against the pledge of Central Government
securities; and (c) Special advances, i.e. those granted by the Bank at its discretion. The interest rate
charged by the Bank on these advances did not, till May 1976, exceed the Bank rate. Thereafter, the
Bank has been operating a graduated scale of interest based on the duration of the advance. ‘
Apart from the ways and means advances, the State Governments have made heavy use of the
overdrafts from the RBI. An overdraft refers to drawls of credit by the State Governments from the RBI
in excess of the credit (ways and means advances) limits granted by the RBI. In other words, overdrafts
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are unauthorized ways and means advances drawn by the State Governments on the RBI. At present,
overdrafts up to arid inclusive of the seventh day are charged at the Bank rate and from .the eighth day
onwards at 3 per cent above the Bank rate. The management of the States’ overdrafts has gradually
become one of the major responsibilities of the RBI on account of the persistence of large proportions
of those overdrafts.
The issue, management, and administration of the public (Central and State Governments) debt are
among the major functions of the RBI as the banker to the Government. The Bank charges a
commission from the Governments for rendering this service.
13.7 BANKERS’ BANK
The RBI, like all central banks, can be called a banker’s Bank because it has a very special relationship
with commercial and co-operative banks, and the major part of its business is with these banks. The
Bank controls the volume of reserves of commercial banks and thereby determines the deposits/credit
creating ability of the banks. The banks hold a part or all of their reserves with the RBI. Similarly, in
times of their needs, the banks borrow funds from the RBI. It is, therefore, called the bank of last resort
or the lender of last resort. On the whole, the RBI is the ultimate source of money and credit in India.
13.8 SUPERVISING AUTHORITY
The RBI has vast powers to supervise and control commercial and cooperative banks with a view to
developing an adequate and a sound banking system in the country. It has, in this field, the following
powers: (a) to issue licenses for the establishment of new banks; (b) to issue licenses for the setting up
of the bank branches; (c) to prescribe minimum requirements regarding paid-up capital and reserves,
transfer to reserve fund, and maintenance of cash reserves and other liquid assets; (d) to inspect the
working of banks in India as well as abroad in respect of their organizational set-up, branch expansion,
mobilization of deposits, investments, and credit portfolio management, credit appraisal, region-wise
performance, profit planning, manpower planning and training, and so on; (e) to conduct ad hoc
investigations from time to time into complaints, irregularities, and frauds in respect of banks; (f) to
control methods of operations of banks so that they do not fritter away funds in improper investments
and injudicious advances, (g) to control appointment, reappointment, termination of appointment of the
Chairman and chief executive officers of the private sector banks; and (h) to approve or force
amalgamations.
13.9 EXCHANGE CONTROL AUTHORITY
One of the essential functions of the RBI is to maintain the stability of the external value of the rupee. It
pursues this objective through its domestic policies and the regulation of the foreign exchange market.
As far as the external sector is concerned, the task of the RBI has the following dimensions: (a) to
administer the foreign Exchange Control (b) to choose the exchange rate system and fix or manage the
exchange rate between the rupee and other currencies; (c) to manage exchange reserves; and (d) to
interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing Union, and other
countries, and with international financial institutions such as the IMF, World Bank and Asian
Development Bank.
The RBI administers the Exchange Control in terms of the Foreign Exchange Regulation Act (FERA),
1947 which has been replaced by a more comprehensive Foreign Exchange Regulation Act, 1973. The
objective of exchange control is primarily to regulate the demand for foreign exchange within the limits
set by the available supply. This is sought to be achieved by conserving foreign exchange, by using it in
accordance with the plan priorities, and by controlling flows of foreign capital. In India, during most of
the years since 19S7, foreign exchange earnings have been far less than the demand for foreign
exchange, with the result that the latter had to be rationed in order to maintain exchange stability. This
is done through Exchange control which is imposed both on receipts and payments of foreign exchange
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on trade, invisible and capital accounts. The problem of foreign exchange shortage has been so
persistent and acute that the scope of exchange control in India has steadily widened and the
regulations have become progressively more elaborate over the years. The Bank administers the
control through authorized foreign exchange dealers.
FERA lays down that the exchange rates used for the conduct of foreign exchange business must be
those which are fixed by the RBI. The arrangements or the system under which exchange rate is fixed
by the RBI has undergone many changes over the years. Till about 1971 as a member of the IMF, India
had an exchange rate system of “managed flexibility.” This arrangement changed during 1970s as a
result of international monetary crisis in 1971. Since 1975, the exchange rate of the rupee has been
fixed in terms of the “basket of currencies”. The different exchange rate systems in India will be
discussed in detail in chapter 21 on foreign exchange market.
The RBI is the custodian of the country’s foreign exchange reserves, and it is vested with the
responsibility of managing the investment and utilization of the reserves in the most advantageous
manner. The RBI achieves this through buying and selling of foreign exchange from and to scheduled
banks which are the authorized dealers in the Indian foreign exchange market The Bank also manages
the investment of reserves in gold accounts abroad and the shares and securities issued by foreign
governments and international banks or financial institutions.
13.10 PROMOTER OF THE FINANCIAL SYSTEM
Apart from performing the functions already mentioned, the RBI has distinguished itself by rendering
“developmental” or “promotional” services which have strengthened the country’s banking and financial
structure. This has helped in the mobilization of savings and directing credit flows to desired channels,
thereby helping to achieve the objective of economic development with social justice. It has played a
major role in deepening and widening the financial system. As a part of its promotional role, the Bank
has been pre-empting credit for certain sectors at concessional rates.
In the money market, the RBI has continuously worked for the integration of its unorganized and
organized sectors by trying to bring indigenous bankers into the mainstream of the banking business. In
order to improve the quality of finance provided by the money market, it introduced two Bill Market
Schemes, one in 1952, and the other in 1970. With a view to increasing the strength and viability of the
banking system, it carried out a programme of amalgamations and mergers of weak banks with the
strong ones. When the Social Control of banks was introduced in 1968, it was the responsibility of the
RBI to administer the country for achieving the desired objectives. After the nationalization of banks, the
RBI’s responsibility to develop banking system on the desired lines has increased. It has been acting as
a leader in sponsoring and implementing the Lead Bank scheme. With the help of a statutory provision
for licensing the branch expansion of banks, the RBI has been trying to bring about an appropriate
geographical distribution of bank branches. In order to ensure the security of deposits with banks, the
RBI took the initiative in 1962 in creating the Deposits Insurance Corporation.
The RBI has rendered yeoman’s service in directing an increased flow of credit to the agricultural
sector. It has been entrusted with the task of providing agricultural credit in terms of the Reserve Bank
of India Act, 1934. The importance with which the RBI takes this function is reflected in the fact that
since 1955, it has appointed a separate Deputy Governor in charge of rural credit It has undertaken
systematic stuthes of the problem of rural credit and has generated basic data and information in this
area. This was first done in 1954 by conducting an All-India Rural Credit Survey. And that was followed
by the stuthes of the All-India Rural Credit Review Committee in 1968, the Committee to Review
Arrangements for Institutional Credit for Agriculture and Rural Development in 1978, and the
Agricultural Credit Review Committee in 1986.
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As a part of its efforts to increase the supply of agricultural credit, the Bank has been striving to
strengthen the cooperative banking structure through provision of finance, supervision, and inspection.
It provides the co-operative banks (through the State Co-operative Banks) short term finance at a
concessional rate for seasonal agricultural operations and marketing of crops. It subscribes to the
debentures of Land Development Banks. It operates the National Agricultural Credit (Long-Team
Operations) Fund, and foe National Agricultural Credit (Stabilization) Fund, through which it provides
long-term and medium-term finance to cooperative institutions. It established the Agricultural Refinance
Cooperation (now known as NABARD) in July, 1963 for providing medium-term and long-term finance,
for agriculture. It also helped in establishing an Agricultural Finance Corporation.
The role of the Bank in diversifying the institutional structure for providing industrial finance has been
equally commendable. All the Special Development Institutions at the Central and State levels and
many other financial institutions were either created by the Bank on its own or it advised and rendered
help in setting up these institutions. The UTI, for example, was originally an associate institution of the
RBI. A number of institutions providing financial and other services such as guarantees, technical
consultancy, and so on have come into being on account of the efforts of the RBI.
Through these institutions, the RBI has been providing short-term and long-term funds to the
agricultural and rural sectors, to small scale industries, to medium and large industries, and to the
export sector. It has helped to develop guarantee services in respect of loans to agriculture, small
industry, exports, and sick units. It also co-ordinates the efforts of banks, financial institutions, and
Government agencies to rehabilitate sick units.
The Bank has evolved and put through practice the consortium, cooperative, and participatory
approach to lending among banks, and other financial institutions, and among other financial
institutions. By developing the culture of inter-institutional participation, of expertise pooling, and of
geographical presence, it has helped to upgrade credit delivery and service capability of the financial
system. By issuing appropriate guidelines in 1977 regarding the transfer of loan accounts by the
borrowers, it has evolved mutually acceptable system of lending, so that the banking business should
grow in a healthy manner and without cutthroat competition.
13.11 REGULATOR OF MONEY AND CREDIT
The function of formulating and conducting monetary policy is of paramount importance for any central
bank. Monetary policy refers to the use of techniques of monetary control at the disposal of the central
bank for achieving certain objectives.
13.12 SELF ASSESSMENT EXERCISE
1. Define ‘Central Bank’.
2. What is Note Issuing Authority?
3. What is ‘Bankers Bank’?
4. “Exchange Control Authority”?
13.13 SUMMARY
The Reserve Bank of India (RBI) is India’s central bank, also known as the banker’s bank. The
RBI controls monetary and other banking policies of the Indian government. The Reserve Bank of
India (RBI) was established on April 1, 1935, in accordance with The Reserve Bank of India Act,
1934. The Reserve Bank is permanently situated in Mumbai since 1937. The Reserve Bank is
fully owned and operated by the Government of India, he primary objectives of RBI are to
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supervise and undertake initiatives for the financial sector consisting of commercial banks,
financial institutions and non-banking financial companies (NBFCs). The Preamble to the
Reserve Bank of India Act, 1934 (the Act), under which it was constituted, specifies its objective
as “to regulate the issue of Bank notes and the keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of the country
to its advantage”. While rising global integration has its advantages in terms of expanding the
scope and scale of growth of the Indian economy, it also exposes India to global shocks. Hence,
maintaining financial stability became an important mandate for the Reserve Bank.
13.14 GLOSSARY
Cash Reserve Ratio: Cash reserve ratio is the amount of funds that banks have to maintain with the
Reserve Bank of India (RBI) at all times. If the central bank decides to increase the CRR, the amount
available with the banks for disbursal comes down. The RBI uses the CRR to drain out excessive
money from the system.
Reserve Bank of India: RBI is the central bank of India, which was established on April 1935, under
the Reserve Bank of India Act. The Reserve Bank of India uses monetary policy to create financial
stability in India, and it is charged with regulating the country’s currency and credit systems.
Repo Rate: Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case
of India) lends money to commercial banks in the event of any shortfall of funds.
Reverse Repo Rate: Reverse Repo rate is the rate at which the Reserve Bank of India borrows funds
from the commercial banks in the country. In other words, it is the rate at which commercial banks in
India park their excess money with Reserve Bank of India usually for a short-term. Current Reverse
Repo Rate as of February 2020 is 4.90%.
SLR: SLR is used by bankers and indicates the minimum percentage of deposits that the bank has to
maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and
some other approved liability (deposits). It regulates the credit growth in India.
13.15 ANSWERS TO SELF ASSESSMENT EXERCISE
1. What do you understand by central Banking?
2. Discuss the functions of a central bank.
3. What is the monetary policy of Reserve Bank of India?
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India.
New Delhi.
Agency, Mumbai.
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Chapter-14
INTERNATIONAL AND MULTINATIONAL BANKING
STRUCTURE
14.1Introduction
14.2 definitions
14.3 brief history of international banking
14.4 international sources of finance
14.5 international banking – features
14.6 Types of Services Offered
14.7 Types of International banking
14.8 Reasons for International Banking
14.10 Summary
14.11 Glossary
3. Explain the regulations for merchant banking
14.1 Introduction
International banking has been one of the major growth industries of the 1970s, 1980s and
1990s. It seems at times as if the entire industry is rushing on fast-forward into till future. The
changes in the world of international banking over the last few years have been nothing if not
swift and sweeping. New financial centers have sprung up during the period and any bank which
has any pretensions or ambitions for growth can no longer afford to operate just within its home
country.
14.2 DEFINITIONS
Aliber defines "international banking" as a sub-set of commercial banking transactions and
activity having a cross-border and/or cross currency element, I11 other words,' international
banking comprises a range of transactions that CUI be distinguished from purely domestic
operations by (a) he currency of denomination of the transaction, (b) the residence of the bank
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customer and (c) the location of the booking office. A deposit or loan transacted in local
currency between a bank in its home country and a resident of that same country may be
termed pure domestic banking. Anything else, in one form or another, is international banking.
The range of possible variations of international (or cross-border) banking is obviously
considerable. Cohen illustrates one approach to finding suitable labels for all these possible
variations in table 1.1 While transactions in subset "A" represent pure domestic banking, those
in subset "B" broadly correspond to what traditionally have been described as foreign banking
operations - deposits from abroad or loans to customers abroad booked in local currency by a
bank in his home country. Historically until the development of what is today commonly called
the Euro- currency market that was the predominant from of An Overview international banking.
14.3 BRIEF HISTORY OF INTERNATIONAL BANKING

At the Bretton Woods Conference in 1944 it was decided to establish a new monetary order that
would expand international trade, promote international capital flows and contribute to monetary
stability. The IMF and the World Bank were borne out of this Conference of the end of World War
II.
The World Bank was established to help the restoration of economies disrupted by War by
facilitating the investment of capital for productive purposes and to promote the long-range
balanced growth of international trade. On the other hand, the IMF is primarily a supervisory
institution for coordinating the efforts of member countries to achieve greater cooperation in the
formulation of economic policies. It helps to promote exchange stability and orderly exchange
relations among its member countries. It is in this context that the present chapter reviews the
purpose and working of some of the international financial institutions and the contributions made
by them in promoting conomic and social progress in developing countries by helping raise
standards of living and productivity to the point of which development becomes self- sustaining
14.4 INTERNATIONAL SOURCES OF FINANCE
One major source of financing is international non-profit agencies. There are several regional
development banks such as the Asian Development Bank, the African Development Bank and
Fund and the Caribbean Development Bank.
The primary purpose of these agencies is to finance productive development projects or to
promote economic development in a particular region. The Inter- American Development Bank,
for example, has the principal purpose of accelerating the economic development of its Latin
American member countries. In general, both public and private entities are eligible to borrow
money from such agencies as long as private funds are not available at reasonable rates and
terms.
Although the interest rate can vary from agency to agency, these loan rates are very attractive
and very much in demand. Of all the international financial organisations, the most familiar is the
World Bank, formally known as the International Bank for Reconstruction and Development
(IBRD). The World Bank has two affiliates that are legally and financially distinct entities, the
International Development Association (IDA) and the International Finance Corporation (IFC).
Exhibit 1 provides a comparison among IBRD, IDA and IFC in terms of their objectives, member
countries, lending terms, lending qualifications as well as other details. All three organisations
have the same central goals: to promote economic and social progress in poor or developing
countries by helping raise standards of living and productivityto the point at which development
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becomes self-sustaining.
Toward this common objective, the World Bank, IDA and IFC have three interrelated functions
and these are to lend funds, to provide advice and to serve as a catalyst in order to stimulate
investments by others. In the process, financial resources are channelled from developed
countries to the developing world with the hope that developing countries, through this
assistance, will progress to a level that will permit them, in turn, to contribute to the development
process of other less fortunate countries. Japan is a prime example of a country that has come
full circle. From being a borrower, Japan is now a major lender to these three organisations.
South Korea is moving in a direction similar to that of Japan nearly a quarter of a century ago.
THE WORLD BANK The World Bank group is a multinational financial institution established at
the end of World War II (1944) to help provide long-term capital for the reconstruction and
development of member countries. The group is important to multinational corporations because
it provides much of the planning and financing for economic development projects involving
billions of dollars for which private businesses can act as contractors and suppliers of goods and
engineering related services.
Purpose for the setting up of the Bank are:
1. To assist in the reconstruction and development of territories of members by facilitating the
investment of capital for productive purposes, including the restoration of economies
destroyed or disrupted by war, the reconversion of productive facilities to peacetime needs
and encouragement of the development or productive facilities and resources in less
developed countries.
2. To promote private foreign investment by means of guarantees or participation in loans and
other investments made by private investors; and when private capital is not available on
reasonable terms, to supplement private investment by providing, on suitable conditions,
finance for productive purposes out of its own capital, funds raised by it and its other
resources.
3. To promote the long-range balanced growth of international trade and the maintenance of
equilibrium in balance of payments by encouraging international investment for the
development of the productive resources of members, thereby assisting in raising productivity,
the standard of living and condition of labour in their territories.
4. To arrange the loans made or guaranteed by it in relation to international loans through other
channels so that the more useful and urgent projects, large and small alike, can be dealt with
first.To conduct its operations with due regard to the effect of
5. International investment on business conditions in the territories of members and, in the
immediate post-war years, to assist in bringing about a smooth transition from a wartime to a
peacetime economy.
6. The World Bank is the International Bank for Reconstruction and Development (IBRD) and the
International Development Association (IDA). The IBRD has two affiliates, the International
Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). The
Bank, the IFC and the MIGA are sometimes referred to as the “World Bank Group”.
14.5 INTERNATIONAL BANKING – FEATURES: –

1. Expansion: International Banking assists traders to expand their business and trade
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activities beyond the boundaries of a nation. Economic growth and conducive climate for
carrying out the business activities in new nations are the factors because of which many
enterprises are looking beyond the borders of their own nations for their business growth.
Competitive advantages in respect of price, demand and supply factors, future growth
opportunities, cost of production and operating costs, etc., are some of the other important
factors for expansion of international trade and finance. In view of this, the presence of
banks across the nations have led to the growth of international banking.
2. Legal and Regulatory framework: Flexible legal and regulatory framework encourages
traders and investors to enter into the international markets. Quick approval to set up
business, less complicated compliance requirements and stable political situations help
many new players to enter into a number of nations to expand their activities Also, due to
lesser tax rates or no taxes to be payable, certain tax havens play important roles as off
shore banking centers which encourages many international banking units to open their
branches in such off shore centers.
3. Cost of Capital: The operating efficiency of an enterprise depends upon the average cost
of capital. Many companies enter into new emerging markets to take advantages of the
lower cost of capital in such markets. Banks as a financial intermediary play an important
role as source of funds. Banks through their professional skills take advantage of the
arbitrage opportunity in different international markets and increase their profits.
4. Current account and Capital account transactions: Banks play crucial role in export and
import trade. By providing different types of financial and non financial support, banks help
enterprises, corporate customers and individuals doing business in different countries, by
extending trade finance and investment opportunities. Banks also facilitate movement of
funds (inward and outward remittances) through their network and correspondent banking
arrangements.
5. Risks: Different risks paved ways for diversification, thereby global investors look for
alternative destinations to invest their savings with twin objectives of safety of funds and
better returns. In view of their presence in different time zones, international banks also
face various risks.
Benefits
1. Flexibility International banking facility provides flexibility to multinational companies to deal
in multiple currencies. The major currencies that multinational companies or individuals
can deal with include the euro, dollar, pounds, sterling, and rupee. The companies having
headquarters in other countries can manage their bank accounts and avail of financial
services in other countries through international banking without any hassle.
2. Accessibility International banking provides accessibility and ease of doing business to
companies from different countries. An individual or MNC can use their money anywhere
around the world. This gives them the freedom to transact and use their money to meet
any requirement of funds in any part of the world. International banking allows the business
to make international bill payments. The currency conversion facility allows the companies
to pay and receive money easily. Also, benefits like overdraft facilities, loans, deposits, etc.
are available every time for overseas transactions.
3. Accounts Maintenance A multinational company can maintain the records of global
accounts in a fair manner with the help of international banking. All the transactions of the
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company are recorded in the books of banks across the globe. By compiling the data and
figures, the accounts of the company can be maintained.
4. Globalization and growing economies around the world have led to the development of
international banking facilities. The world is now a marketplace and each business wants
to exploit it. Geographical boundaries are no more a concern. With access to technology,
banking facilities have grown vastly. One prime example of it is international banking. In
the years to come, such banks would see higher growth and higher profitability. Big
business houses are expanding themselves at a rapid pace.
5. To maintain the growth, these businesses will need the financial services of international
banking. Therefore, the demand for its facilities will increase.
14.6 Types of Services Offered

1. To arrange trade finance An international bank arranges the finance for the traders who
want o deal with the foreign country.
2. To arrange foreign exchange The core services provided by the international bank are to
arrange a foreign exchange for the import-export purpose.
3. To hedge the funds The international bank hedge the funds by buying the securities at the
lower price level and sell it when the price level rising.
4. Offer investment banking services It also offers an investment banking services by signing
underwriting of shares, financial decisions for investment.
5. A correspondent bank relationship Established when two banks maintain a correspondent
bank account with one another. The correspondent banking system provides a means for a
bank’s MNC clients to conduct business worldwide through his local bank or its contacts.
6. A representative office- A small service facility staffed by parent bank personnel that is
designed to assist MNC clients of the parent bank in its dealings with the bank’s
correspondents. It is a way for the parent bank to provide its MNC clients with a level of
service greater than that provided through merely a correspondent relationship.
7. A foreign branch bank- Operates as a local bank, but legally it is a part of the parent bank.
As such, a branch bank is subject to the banking regulations of its home country and the
country in which it operates. The primary reason a parent bank would establish a foreign
branch is that it can provide a much fuller range of services for its MNC customers through
a branch office than it can through a representative office. A subsidiary bank- is a locally
incorporated bank that is either wholly-owned or owned in major part by a foreign
subsidiary. An affiliate bank is one that is only partially owned but not controlled by its
foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the
country in which they are incorporated.
14.7 Types of International banking

1) Correspondent banks Correspondent banks involve the relationship between different
banks which are in different countries. This type of bank is generally used by the
multinational companies for their international banking. This type of banks is in small size
and provides service to those clients who are out of their country.
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2) Edge act banks Edge act banks are based on the constitutional amendment of 1919.
They will operate business internationally under the amendment.
3) Off-shore banking centre It is a type of banking sector which allows foreign accounts.
Offshore banking is free from the banking regulation of that particular country. It provides
all types of products and services.
4) Subsidiaries Subsidiaries are the banks which incorporate in one country which is either
partially or completely owned by a parent bank in another country. The affiliates are
somewhat different from the subsidiaries like it is not owned by a parent bank and it works
independently.
5) Foreign branch bank Foreign banks are the banks which are legally tied up with the
parent bank but operate in a foreign nation. A foreign bank follows the rules and
regulations of both the countries i.e. home country and a host country. Examples of
international banking City group
 HSBC Holdings
 Bank of America
 JP Morgan Chase
 Royal Bank of Scotland Group.
14.8 Reasons for International Banking

1. Low marginal costs – Managerial and marketing knowledge developed at home can be
used abroad with low marginal costs.
2. Knowledge advantage – The foreign bank subsidiary can draw on the parent bank’s
knowledge of personal contacts and credit investigations for use in that foreign market.
3. Home nation information services – Local firms in a foreign market may be able to obtain
more complete information on trade and financial markets in the multinational bank’s home
nation than is obtainable from foreign domestic banks.
4. Prestige Very large multinational banks have high perceived prestige, which can be
attractive to new clients
5. Regulatory advantage – Multinational banks are often not subject to the same regulations
as domestic Banks Wholesale defensive strategy – Banks follow their multinational
customers abroad to avoid losing their business at home and abroad.
6. Retail defensive strategy – Multinational banks also compete for retail services such as
travellers checks and the tourist and foreign business market.
7. Transactions costs – Multinational banks may be able to circumvent government currency
controls.
8. Growth – Foreign markets may offer opportunities for growth not found domestically.
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1. Define the international banking
2. Discuss World bank
3. What is Cost of capital
14.10 Summary
International banking has been one of the major growth industries of the 1970s, 1980s and
1990s. It seems at times as if the entire industry is rushing on fast-forward into till future. The
changes in the world of international banking over the last few years have been nothing if not
swift and sweeping. New financial centers have sprung up during the period and any bank
which has any pretensions or ambitions for growth can no longer afford to operate just within its
home country.
14.11 Glossary
1. Cost of Capital: The operating efficiency of an enterprise depends upon the average cost
of capital. Many companies enter into new emerging markets to take advantages of the
lower cost of capital in such markets. Banks as a financial intermediary play an important
role as source of funds. Banks through their professional skills take advantage of the
arbitrage opportunity in different international markets and increase their profits.
2. international banking" as a sub-set of commercial banking transactions and activity
having a cross-border and/or cross currency element, I11 other words,' international
banking comprises a range of transactions that CUI be distinguished from purely domestic
operations by (a) he currency of denomination of the transaction, (b) the residence of the
bank customer and (c) the location of the booking office
1. International banking and international sources of finance
2. What are the international banking features
3. What are the types of services offered and the types of international banking
4. What are the reasons for international banking
India.
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New Delhi.
4. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain BookAgen
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Chapter-15
Non- Banking Institutions
STRUCTURE
15.1 Introduction
15.2 types of nbfcs and the services they offer
15.3 role of nbfis
15.4 sources of funds for nbfi:
15.5 function of non banking financial institutions
15.6 types of non-bank financial intermediaries
15.8 Summary
15.9 Glossary

 Types of nbfcs and the services they offer
 Role of nbfis
 Sources of funds for nbfi:
 Function of non banking financial institutions
15.1 Introduction
An institution which collects funds from people in different forms & places them in financial assets,
such as deposits, bonds etc. It also lends loans and advances to needy people and institutions.
NBFIs are registered under company act and must be approved by RBI as Non- Banking
Financial Institution. Examples: IDBI, IFCI,ICICI, LIC,GIC,SFC etc.
15.2 TYPES OF NBFCS AND THE SERVICES THEY OFFER-

 Asset Financing
 Infrastructure Financing
 Microfinance
 Housing finance
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“Overview of Non-Banking Financial Companies (NBFCs) and their Services”
The specialization in certain sectors allows NBFCs to effectively serve the needs of specific
communities, especially those traditionally underserved by more traditional financial institutions.
Non-Banking Financial Companies (NBFCs) play a critical role in the Indian financial system by
catering to the credit needs of various sectors of the economy. NBFCs offer a wide range of
financial products and services, which can be categorized into several types based on their
services.
Asset Financing: NBFCs specializing in asset financing provide loans for purchasing assets
such as machinery, vehicles, and equipment. These loans are typically secured against the asset
being financed.
Infrastructure Financing: Infrastructure financing NBFCs provide loans for developing
infrastructure projects such as roads, ports, airports, and power plants. These loans are generally
long-term and involve a high degree of risk.
Microfinance: Microfinance NBFCs offer small loans to low-income individuals and small
businesses typically not served by traditional banks. These loans are often used for income-
generating activities such as starting a small business or purchasing inventory.
Housing Finance: Housing finance NBFCs provide loans for purchasing, constructing, or
renovating residential properties. These loans are typically secured against the property being
financed.
Commercial Finance: NBFCs provide working capital loans to businesses for various purposes,
such as inventory financing, trade finance, and invoice discounting.
Personal Finance: Personal finance NBFCs offer personal loans, credit cards, and other
financial products to individuals. These loans are typically unsecured and can be used for various
purposes, such as home renovations, weddings, or medical expenses.
In addition to the above categories, NBFCs may specialize in specific sectors such as agriculture,
education, and healthcare. For example, an agriculture finance NBFC may offer farmers loans to
purchase seeds, fertilizers, and equipment. In contrast, an education finance NBFC may provide
loans for students pursuing higher education.
 NBFC Registration
 NBFC Loan
 NBFC DSA Registration
 Bank or NBFC
15.3 ROLE OF NBFIs

Non-Bank Financial Institutions (NBFI) play a crucial role in the financial system by providing a
wide range of financial services and products.
1. Lending: NBFI provides loans to individuals and businesses, often filling gaps in the credit
market not served by traditional banks.
2. Asset Management: They manage investment portfolios, such as mutual funds, pension
funds, and hedge funds, to help clients grow their wealth.
3. Risk Diversification: NBFI allows investors to diversify their investments across various
asset classes, reducing risk.
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4. Financial Intermediation: They bridge the gap between borrowers and investors,
facilitating the flow of funds in the economy.
5. Wealth Management: NBFI offers customized financial planning and investment advisory
services to high-net-worth individuals and institutions.
6. Insurance: Many NBFI provide insurance products, such as life insurance, health
insurance, and property and casualty insurance.
7. Payment Services: They offer payment processing services, including credit card
processing and electronic fund transfers.
8. Leasing and Hire Purchase: NBFI provide leasing and hire purchase options for
individuals and businesses to acquire assets like vehicles and equipment.
9. Factoring: NBFI offer factoring services, allowing businesses to sell their accounts
receivable to obtain immediate cash.
10. Venture Capital and Private Equity: They invest in startups and established companies,
fostering entrepreneurship and innovation.
11. Real Estate Financing: NBFI finance real estate projects, including residential and
commercial properties.
12. Foreign Exchange Services: Some NBFI facilitate currency exchange and provide
foreign exchange risk management services.
13. Consumer Finance: They provide loans and credit facilities to consumers for various
purposes, such as buying durable goods or funding education.
14. Trade Finance: NBFI support international trade by providing trade finance solutions like
letters of credit and export financing.
15. Regulatory Arbitrage: In some cases, NBFI exploit regulatory arbitrage opportunities to
offer financial services with fewer regulatory constraints than traditional banks.
16. Role of Non-Banking Financial Companies (NBFCs) in Financial Inclusion

The role of NBFCs in the economy is significant, as they cater to the unbanked and
underbanked population of the country. NBFCs provide financial services to individuals,
small and medium-sized enterprises, and other businesses not served by traditional banks.
They are crucial in financial inclusion, a key component of sustainable economic growth.
The role of NBFCs in the economy is significant, as they cater to the unbanked and
underbanked population of the country. NBFCs provide financial services to individuals,
small and medium-sized enterprises, and other businesses not served by traditional banks.
They are crucial in financial inclusion, a key component of sustainable economic growth.
17. Contribution of NBFCs to Economic Development through Long-Term Capital for
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Infrastructure and MSME Sector: NBFCs also contribute to the development of the
economy by providing long-term capital to the infrastructure sector. They fund projects
such as roads, airports, ports, and power plants, which are critical for economic
development. NBFCs also play a vital role in the growth of the micro, small, and medium-
sized enterprises (MSME) sector by providing them with access to capital. However, the
scope of NBFCs comes with its challenges. One of the main challenges faced by NBFCs is
access to funding. Unlike banks, NBFCs cannot access cheap funding from the central
bank. They have to rely on market borrowings, which can be expensive and volatile. This
can pose a significant risk to their liquidity and solvency.
15.4 SOURCES OF FUNDS

Non-Bank Financial Institutions (NBFI) source funds from various channels to carry out their
operations. Below are some common sources of funds for NBFI, along with their advantages
and disadvantages:
Sources of Funds for NBFI:
1. Deposits: Some NBFI accept deposits from the public, functioning similarly to banks.
These deposits can be in the form of fixed deposits, recurring deposits, or savings
deposits.
 Advantages:
 Diversifies funding sources.
 Provides a stable source of low-cost funds.
 Disadvantages:
 May be subject to stricter regulations than other funding sources.
 May face challenges in attracting deposits due to lower brand recognition

compared to traditional banks.
2. Borrowings: NBFI can raise funds by borrowing from various sources, including banks,
other financial institutions, and capital markets. These borrowings can be in the form of
loans, bonds, or commercial paper.
 Advantages:
 Offers flexibility in terms of borrowing amounts and durations.
 Allows NBFI to tap into a wider pool of funds.
 Disadvantages:
 Interest payments and repayment obligations can strain the NBFI's financials.
 Market conditions can impact the cost and availability of funds through
borrowings.
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3. Equity Capital: NBFI can raise funds by issuing equity shares or ownership stakes to
investors. This can include private equity investments or going public through an initial
public offering (IPO).
 Advantages:
 Provides permanent capital without the obligation of repayment.
 Can attract long-term investors with a vested interest in the NBFI's success.
 Disadvantages:
 Dilution of ownership and control as more shares are issued.
 IPOs can be costly and time-consuming.
4. Retained Earnings: NBFI can reinvest their profits back into the business, using retained
earnings as a source of internal funding.
 Advantages:
 No cost of external financing.
 Demonstrates financial stability and profitability.
 Disadvantages:
 Limits dividend payouts to shareholders.
 May not be sufficient to meet the funding needs for expansion or growth.
5. Insurance Premiums: If an NBFI also operates an insurance subsidiary, it can generate

funds from the premiums paid by policyholders.
6. Securitization: NBFI can securitize their assets, such as mortgages or auto loans, by
selling them to a special purpose vehicle (SPV) and issuing securities backed by these
assets. This allows them to free up capital for further lending.
7. Subordinated Debt: Some NBFI issue subordinated debt instruments, which are lower in
priority compared to other debts in case of liquidation. These can attract investors seeking
higher yields.
8. Trade Credit: NBFI may obtain funds from suppliers and other businesses through trade
credit arrangements. This can be particularly relevant in the case of businesses that
extend credit to their customers.
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9. Government Support: In some cases, governments may provide financial support or
guarantees to NBFI, especially during times of financial crisis or economic downturns.
10. Grants and Donations: Non-profit NBFI may receive funds from grants and donations
from philanthropic organizations, government agencies, or individuals.
11. Asset Sales: NBFI can sell off non-core assets or underperforming assets to generate
funds.
12. Securities Repurchase Agreements (Repo): NBFI may engage in repo agreements,
where they sell securities with an agreement to repurchase them at a later date. This
serves as a short-term source of funds.
Advantages of Various Sources of Funds:

 Diversification: Using multiple sources of funds diversifies the NBFI's funding base,
reducing dependency on a single channel.
 Flexibility: Different sources offer flexibility in terms of borrowing terms, repayment

schedules, and funding amounts, allowing the NBFI to tailor its financing to its specific
needs.
 Cost Optimization: NBFI can choose the most cost-effective sources of funds based on
prevailing market conditions, interest rates, and their own financial situation.
Disadvantages of Various Sources of Funds:

 Costs and Obligations: Borrowings and equity capital often come with interest payments
or dividend obligations, which can impact profitability.
 Regulatory Constraints: Some sources of funds, like accepting deposits, may subject the
NBFI to more stringent regulatory requirements.
 Market Dependency: Access to certain funding sources, such as capital markets, can be
influenced by external factors like economic conditions and investor sentiment.
 Risk Exposure: Depending too heavily on one source of funding can expose the NBFI to
specific risks associated with that source.
15.5 FUNCTION OF NON BANKING FINANCIAL INSTITUTIONS

Non-Banking Financial Institutions (NBFI) perform various functions in the financial sector,
often complementing the services offered by traditional banks. Their functions include:
1. Intermediation: NBFI act as intermediaries between savers and borrowers by channeling
funds from those with surplus funds to those in need of financing. This helps allocate
resources efficiently in the economy.
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2. Lending: NBFI provide loans and credit facilities to individuals, businesses, and other
entities. They often specialize in specific types of lending, such as consumer finance,
microfinance, or real estate financing.
3. Asset Management: They manage investment portfolios on behalf of clients, including

mutual funds, pension funds, and private wealth management services. Their goal is to
maximize returns while managing risk.
4. Investment Banking: Some NBFI offer investment banking services, including

underwriting, mergers and acquisitions (M&A) advisory, and capital market activities like
initial public offerings (IPOs).
5. Insurance: Many NBFI operate insurance subsidiaries and offer various insurance
products, such as life insurance, health insurance, property and casualty insurance, and
more.
6. Wealth Management: NBFI provide customized financial planning and investment

advisory services to high-net-worth individuals and institutions, helping them achieve their
financial goals.
7. Payment Services: They offer payment processing services, including credit card
processing, electronic fund transfers, and payment gateways for e-commerce businesses.
8. Leasing and Hire Purchase: NBFI facilitate leasing and hire purchase arrangements,
allowing individuals and businesses to acquire assets like vehicles and equipment without
making an upfront purchase.
9. Factoring: They provide factoring services, enabling businesses to sell their accounts
receivable at a discount in exchange for immediate cash, improving cash flow.
10. Venture Capital and Private Equity: NBFI invest in startups and established companies,
providing equity financing to foster entrepreneurship, innovation, and business growth.
11. Real Estate Financing: NBFI finance real estate projects, including residential and
commercial properties, through mortgage lending and real estate investment trusts
(REITs).
12. Foreign Exchange Services: Some NBFI offer foreign exchange services, including
currency exchange and risk management products to help clients navigate international
transactions.
13. Trade Finance: NBFI support international trade by providing trade finance solutions such
as letters of credit, export financing, and trade credit insurance.
14. Regulatory Arbitrage: In some cases, NBFI exploit regulatory arbitrage opportunities to
offer financial services with fewer regulatory constraints than traditional banks.
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15. Financial Inclusion: NBFI often play a vital role in reaching underserved and unbanked
populations, promoting financial inclusion through microfinance, mobile banking, and other
innovative solutions.
16. Risk Management: They offer various risk management products and services, such as
derivatives and hedging instruments, to help clients mitigate financial risks.
17. Secondary Market Activities: Some NBFI participate in secondary market trading of
financial instruments, including stocks, bonds, and other securities.
15.6 TYPES OF NON-BANK FINANCIAL INTERMEDIARIES

On the basis of the functions they perform, these non-bank financial institutions are classified
broadly into the following three categories :
I) Investment Trusts : These institutions are also known as investment banks. They mobilise the
savings of scattered masses and channelize them to productive uses. They invest their excess
money in various securities in addition to the provision of long-term loans. They also undertake
merchant banking activities including underwriting of securities. This type of institutions include
the Life Insurance Corporation of India. (LIC), General Insurance Corporation of India (GICI) and
the Unit Trust of India (UTI).
2) Development Banks : These institutions are also known as special Financial Institutions. They
provide long-term financial assistance tc industrial undertaking in various forms. Since they also
undertake many promotional functions, they are known as development banks. These institutions
include Industrial Finance Corporation of India (IFCI). Industrial Credit and Investment
Corporation of India (ICICI) and Industrial Development Bank of India (IDBI) at national level while
the State Financial Corporations (SFCs) and State Industrial Development Corpo~ations (SIDCs)
exist at the State level.
3) Other Institutions : Generally some institutions do not provide financial assistance. They mainly
undertake promotional activities and provide various services to entrepreneurs. These institutions
include National Small Industries Development Corporation (NSIC), State Small Industries
Development Corporations (SSIDCs) and Technical Consultancy Organisations (TCOs).
1. What is equity capital
2. Define deposits
3. What is NBFIs
15.8 Summary
An institution which collects funds from people in different forms & places them in financial assets,
such as deposits, bonds etc. It also lends loans and advances to needy people and institutions.
NBFIs are registered under company act and must be approved by RBI as Non- Banking
Financial Institution. Examples: IDBI, IFCI,ICICI, LIC,GIC,SFC etc. The specialization in certain
sectors allows NBFCs to effectively serve the needs of specific communities, especially those
traditionally underserved by more traditional financial institutions.
Non-Banking Financial Companies (NBFCs) play a critical role in the Indian financial system by
catering to the credit needs of various sectors of the economy. NBFCs offer a wide range of
146
financial products and services, which can be categorized into several types based on their
services. NBFCs specializing in asset financing provide loans for purchasing assets such as
machinery, vehicles, and equipment. These loans are typically secured against the asset being
financed. Infrastructure financing NBFCs provide loans for developing infrastructure projects such
as roads, ports, airports, and power plants. These loans are generally long-term and involve a
high degree of risk. Microfinance NBFCs offer small loans to low-income individuals and small
businesses typically not served by traditional banks. These loans are often used for income-
generating activities such as starting a small business or purchasing inventory
15.9 Glossary
1. Housing Finance: Housing finance NBFCs provide loans for purchasing, constructing,
or renovating residential properties. These loans are typically secured against the
property being financed.
2. Commercial Finance: NBFCs provide working capital loans to businesses for various
purposes, such as inventory financing, trade finance, and invoice discounting.
3. Personal Finance: Personal finance NBFCs offer personal loans, credit cards, and other
financial products to individuals. These loans are typically unsecured and can be used for
various purposes, such as home renovations, weddings, or medical expenses.
4. Deposits: Some NBFI accept deposits from the public, functioning similarly to banks.
These deposits can be in the form of fixed deposits, recurring deposits, or savings
deposits.
5. Equity Capital: NBFI can raise funds by issuing equity shares or ownership stakes to
investors. This can include private equity investments or going public through an initial
public offering (IPO).

1. What are the types of nbfcs and the services they offer
2. Discuss the role of nbfis and sources of funds for nbfi:
3. What are the function of non banking financial institutions
4. Write a detailed note on the types of non-bank financial intermediaries

147
India.
New Delhi.
148
Lesson-16
Mutual Fund in India- An Overview
STRUCTURE
16.1 Introduction
16.2 Mutual Funds in India
16.3 Resource Mobilization by Mutual Funds
16.4 Objectives of Mutual Funds
16.5 Benefits of Mutual Funds
16.6 Types of Mutual Funds
16.7 Closed-end Funds
16.8 Open-end funds
16.9 Types of Schemes
16.10 Offshore funds
16.11 GETFs
16.12 Recommendations of the Study Group
16.13 SEBIs Directives for Mutual Funds
16.14 Private Mutual Funds
16.15 Problems of Mutual Funds
16.17 Summary
16.18 Glossary
After studying the lesson you should be able to
1. Understand the objectives of Mutual Funds.
2. Analyze the different types of mutual funds.
3. State the guidelines that regulate mutual funds.
16.1 INTRODUCTION
Mutual funds are financial intermediaries which collect the savings of investors and invest them in a
large and well diversified portfolio of securities such as money market instruments, corporate and
Government bonds and equity shares of joint stock companies. A mutual fund is a pool of commingle
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funds invested by different investors, who have no contact with each other. Mutual funds are conceived
as institutions for providing small investors with avenues of investment in the capital market. Since
small investors generally do not have adequate time, knowledge, experience and resources for directly
accessing the capital market, they have to rely cm an intermediary which undertakes informed
investment decisions and provides the consequential benefits of professional expertise. The raison
d’etre of mutual funds is their ability to bring down the transaction costs. The advantages for the
investors are reduction in risk, expert professional management, diversified portfolios, liquidity of
investment and tax benefits. By pooling their assets through mutual funds, investors achieve
economies of scale. The interests of the investors are protected by the SEBI which acts as a watchdog.
Mutual funds are governed by the SEBI (Mutual Funds) Regulations, 1993.
16.2 MUTUAL FUNDS IN INDIA
The first mutual fund to be set up was the Unit Trust of India in 1964 under an Act of Parliament. During
the years 1987-1992, seven new mutual funds were established in the public sector. In 1993, the
government changed its policy to allow fee entry of private corporate and foreign institutional investors
into the mutual fund segment. By fee end of March, 2005 there were 29 mutual funds, 8 in fee public
sector and 21 in fee private sector.
The UTI dominated the mutual fund sector until 1994-95, accounting for 76.5 per cent of the total
mobilization. But there were large purchases by UTI in 1995-96 and 1996-97 which resulted in reverse
flow of funds. Meanwhile, fee number of mutual funds especially in fee private sector have grown along
wife fee number of schemes matching fee preferences of investors. The year 1999-2000 was a
watershed year in which mutual funds emerged as an important investment conduit for investors at
large. Net resource mobilization by all mutual funds amounted to Rs. 21,972 crore. Growth was led
mainly by private sector mutual funds which witnessed an inflow of fee order of Rs. 17,171.0 crore.
Fiscal incentives provided in fee Union Budget 1999-2000 exempted all income received by fee
investors from UTI and other mutual funds from income tax. All open-ended equity oriented schemes
along wife fee US 64 scheme were exempted from dividend tax for three years. Buoyant stock markets
were also a contributory factor.
The outstanding net assets of all domestic schemes of mutual funds, stood at Rs. 1,49,601 crore at fee
end of March, 2005. The share of UTI in outstanding assets was 13.9%, public sector mutual funds
7.6% and private sector mutual funds 78.5%.
16.3 RESOURCE MOBILIZATION BY MUTUAL FUNDS
(a) Mutual funds mobilized large resources in the eighties and in the first four years of nineties
registering an annualized growth of more than forty per cent. The growth was aided mainly by the
buoyant secondary market, setting up of new mutual funds in the second half of the eighties and tailor-
made schemes introduced by them and UTI. Another contributory factor was the assured rate of return
offered by some mutual funds. In 1995-96 and 1996-97 the subdued stock market conditions, along
with a perceived lack, of transparency in the functioning of mutual funds, delayed refunds, poor
accountability and lack of efficient service led to the poor performance of many mutual fund schemes
resulting in low or, even in negative returns, thereby eroding the investors confidence. Consequently,
the resource mobilization of mutual funds (other than UTI) during 199A96 and 1996-97 was poor. With
respect to foe UTI, there were large reverse flows, in view of substantial repurchases. The mutual funds
had to get their act together by revamping their operations, be responsive to the investors’ needs and
infuse greater expertise and efficiency in their operations, in order to earn the investor’s confidence.
(b) After subdued performance in 1997-98 and 1998-99 a sharp turnaround was witnessed in 1999-
2000 when resource mobilization reached a peak of Rs. 21,972 crore mainly led by private sector funds
which mobilized Rs. 17,171 crore through offer of more than 44 new schemes to match investor
preferences.
The overall mobilization was aided by the tax benefits announced in the Union Budget for 1999-2000
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particularly those relating to equity oriented Schemes. The bullish trends in the secondary market
combined with attractive returns ort units of mutual funds had a favourable influence on the investors.
16.4 OBJECTIVES OF MUTUAL FUNDS
Mutual funds have specific investment Objectives, which are stated in their prospectus. The main
objectives are growth, growth-income, balanced income, and industry specific funds. Growth funds
strive for large capital gains, while growth-income funds seek both dividend income and capital gains
from the common stock. The balanced fund generally holds at of diversified common stocks, preferred
stocks and bonds with the hope of realizing capital gains, dividend and interest, income while at the
same time, conserving the principal. Income funds concentrate heavily on high interest and high,
dividend yielding securities. The industry specific mutual funds obviously specialize in selected
industries such as chemicals, petroleum or power stocks. In general, growth funds seems to have the
highest risk balanced funds, the lowest risk and income growth finds, intermediate risk.
16.5 BENEFITS OF MUTUAL FUNDS
Tax shelter is the most important advantage, the mutual funds industry enjoys in India. A mutual fund,
set up by a public sector bank or a financial institution or one that is authorized by the SEBI is
exemputed from tax, under Section 10 (23D) of IT act, provided it distributes 90 percent of its profits.
(c) The Union Budget for 1999-2000 granted tax exemption for a period of three years for US 64
scheme and for all open-ended equity oriented schemes of UTI and other mutual funds with more than
50 per cent investment in equity. It also announced the exemption from income tax of all income from
UTI and other mutual funds received in the hands of investors. The Budget for2000-01 however, raised
the tax rate on income distributed by debt-oriented mutual funds and UTI from 10% to 20%.
As compared to direct investment, mutual funds offer firstly, reduced risk and diversified investment.
Mutual funds help small investor’s ill reducing risk by diversification, economies of scale in transaction
cost and professional portfolio management Secondly, mutual funds offer revolving type of investments.
Automatic reinvestment of dividends and capital gains provide tax relief to the members. Thirdly,
selection and timing of investment are undertaken by mutual funds. The fund as an organization,
supplies expertise in stock selection and timing purchase and sale of securities to investors on the
invested funds to generate higher returns to them. Finally, mutual funds assure liquidity and investment
care. The units of mutual funds could be converted to cash without any loss of time, relieving investors
from various rules and regulations, which they have to comply with indirect investments.
16.6 TYPES OF MUTUAL FUNDS
Two major fund categories of mutual funds are closed-end funds and the open-end funds. Open-end
funds are commonly referred to as the mutual funds. Mutual funds can be further classified into equity
funds, growth funds, income funds, real estate funds, offshore funds, leveraged funds and hedge funds.
Such schemes are listed on the stock exchanges for dealings in the secondary market.
16.7 CLOSED-END FUNDS
Closed-end mutual funds have the following characteristics. Firstly, closed-end fund Investment
Company cannot sell share units after its initial offering. Its growth in terms of the number of shares is
limited. The shares are issued like the new issues of any other company, listed and quoted on a stock
exchange.
Secondly, the shares of the closed-end hinds are not redeemable at their NAV as in the case of open-
end funds. On the other hand, these shares are traded in the secondary market on a stock change, at
market prices that may be above or below their Net Asset Value (NAV). Thirdly, the objectives of the
closed-end funds may differ from that of the open-end funds. Fourthly, closed-end funds are canalized
into the secondary market, for the acquisition of corporate securities. Finally, the prices of closed-end
mutual funds’ shares are determined by demand and supply and not by NAV as in the case of open-
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end mutual fund shares. The minimum amount of the fund is Rs. 20 crore or 60% of targeted amount.
Redemption is after a specified period (4 to 7 years). Morgan Stanley’s scheme is for 15 years.-Other
examples are UTIs master share, SBls Magnum and Canbank’s can double. In all there were 129
close-ended schemes at the end of March 2006.
16.8 OPEN END FUNDS
The open-end mutual funds are characterized by the continual selling and redeeming of shares. In
other words, mutual funds do not have a fixed capitalization. It sells its shares to the investing public,
whenever it can, at their Net Asset Value per share (NAV) and stands ready to repurchase the same,
directly from the investing public, at the net asset value per share. Minimum amount of the fund is Rs.
50 crore or 60% of targeted amount. Examples are UTIs Unit 64, Kothari/ Pioneer, Prima and LIC
schemes. There were 463 open-ended schemes at end March 2006.
16.9 TYPES OF SCHEMES
Mutual funds offer growth, income, tax planning and miscellaneous schemes. The growth schemes are
usually closed-ended and listed on ‘the stock ‘exchange. Benefits of capital appreciation and dividend
exist. Examples are UTI’s Master share 86, Master gain 92 and SBIMF’s Magnum. Income schemes
can be closed-ended of open-ended. Monthly income schemes are closed-ended. Regular dividends
are paid since investment is primarily in debt instruments. Generally income schemes are not listed but
Unit 64 is listed on OTCEI and NSE. Examples are UTIs’ Unit 64, SBIMFs’ Magnum, Bank of India MF
s’ rising monthly scheme. Equity linked savings schemes called tax planning schemes are closed-
ended. Investment up to Rs. 10,000 provides 20% tax rebate under section 99 of IT Act. They are
growth oriented and provide capital appreciation. The schemes are not listed on stock exchange and
before 3 years are not transferable. Redemption after 10 years on NAV with 20% deduction at source.
Examples are Canbank’s Cahpep and SBIMFs tax gain. Finally, miscellaneous schemes have specific
purpose and, are generally open-ended. Investment matures on the fulfillment of the purpose, like
Children’s Gift Growth ‘plan and Senior Citizen’s plan. Specific purpose scheme units cannot be listed
or pledged. Tax concessions admissible as specified in the scheme. Examples are Canbank’s Canpep
and SBIMFs Tax Gain.
To avoid any distortion in the unit holding pattern and its impact, minimum number of 20 investors in a
scheme has been prescribed. No single investor should hold more than 25% of the corpus of any
scheme/ plan.
During 2005-06,592 schemes were in operation of which 463 schemes (78.2%) were open-ended
schemes. In terms of investment objectives income (debt oriented) schemes were 251(18.9%), growth
(equity oriented) schemes 231 (39.0%) and balanced (equity and debt) schemes 36 (6.0%).
16.10 OFFSHORE FUNDS
There were total of 12 offshore funds end-March, 2003. Of the 12 offshore funds, eight belong to the
public sector and remaining four to the private sector. The net assets of public sector mutual funds
were Rs. 552.55 crore (66.7% of total) arid private sector Rs. 276.89 crore (33.3%).
The funds (Rs. 796.55 crore) are mainly deployed in equity related instruments (96%) and debt/ money
market instruments (3.97%).
16.11 GETFs
SEBI notified on January 12,2006 the introduction of Gold Exchange Traded Funds. Any household can
buy and sell gold units for Rs 100. The assets of the scheme have to be kept in the custody of a bank
which is registered as a custodian With SEBI. The wholesale intermediary sells/buys gold units to
mutual funds. The funds of any such scheme should be invested only in gold or gold related
instruments except to the extent necessary to meet the liquidity requirements for honouring
redemptions or repurchases. Gold Exchange traded funds have only gold as the sole underlying asset.
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These spot instruments are freely transferable among the participants through stock exchange. Unit
holders have no right on the underlying asset but are entitled to the accrued benefit on the scheme by
way of dividend and market arbitrage. GETF units can be used as collateral for loans.
16.12 RECOMMENDATIONS OFTHE STUDY GROUP
In 1991, a 10-member study group headed by Dr. S.A. Dave. Chairman of the Unit Trust of India, was
formed by the Government of India to study the functioning of mutual funds, with a view to permit
mutual funds in the private joint sectors. The major recommendations’ of the study group are:
(i) Minimum amount to be raised in the closed end scheme should be Rs. 20 crore and that of the
open-end scheme is Rs. 50 crore.
(ii) The private mutual funds should-enjoy tax benefits similar to the UTT.
(iii) No minimum return should be guaranteed.
(iv) Distribution of at least 80 per cent earnings.
(v) A limit of Rs. 200 crore should be set for borrowing over two years.
16.13 SEBI’S DIRECTIVES FOR MUTUAL FUNDS
The Government brought mutual funds in foe security market under the regulatory framework of the
Securities and Exchange Board of India (SEW) in foe year 199J3. SEBI issued guideline^ in the year
1991 and a comprehensive set of regulations relating to the organization and management of mutual
funds in 1993.
SEBI’s Major Regulatory Provisions
1. Mutual funds shall be authorized for business by the SEBI.
2. Mutual funds shall be sponsored by the registered companies with sound track, general reputation
and fairness in all their business transactions.
3. Mutual funds shall be established in the form of trusts under Indians Trusts Act. The sponsoring
institution will be free to work out the details regarding the Constitutions of the Trust.
4. The Trust shall be authorized to float one or several different schemes under which units shall be
issued to the investors.
5. Mutual funds shall be operated by separately established Asset Management Companies (AMC)
to be approved by the SEBI.
6. AMC cannot act as the Trustee of Unit Trusts.
7. AMC cannot undertake any other business activity than management of mutual funds and such
other activities as financial services constantly, exchange of research and analysis on commercial basis
as long as these are not in conflict with the management activity itself.
8. The mutual funds shall use the services of a custodian registered with the SEBI.
9. The custodian shall be totally de-linked from the AMC.
10. Each authorized mutual funds shall be allowed to float different schemes as long as the AMC
concerned meets the required capital adequacy criteria.
11. Each scheme floated by a mutual fund shall have prior registration with SEBI.
12. Mutual funds can start and operate both closed-end and open-end schemes.
13. For each closed-end scheme, the mutual fund shall be required to raise at least Rs.20 crore and
for each open-end scheme at least Rs.50 crore.
14. Mutual funds cannot keep closed-end schemes open for subscription for more than 45 days. For
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open-end schemes, the first 45 days of the subscription period should be considered for determining
the target figure or minimum size.
15. Mutual funds shall provide continuous liquidity. Closed-end scheme shall have to be listed on
exchanges.
For open-end schemes, mutual funds shall sell and repurchase, units at predetermined prices based
on net asset value.
16. Mutual funds are allowed to invest only in transferable securities either in the money market or in
the capital market, including any privately-placed debentures or securitized debt. Privately placed
debentures, securitized debt and other unquoted debt instruments holdings shall not exceed 10% in
case of growth funds, and 40% in case of income funds.
17. Mutual funds shall not be allowed to provide term loan s for any purpose.
18. No individual scheme of the mutual fund shall invest more than 5 per cent of its corpus in any-one
company’s shares.
19. No mutual fund under all its schemes shall own more than 5 per cent of any company’s paid-up
capital carrying voting rights.
20. No mutual fund under all its schemes taken together shall invest more than 10 per cent of its
funds in the shares or debentures or other securities of a single company.
21. No mutual fund under all its schemes taken together shall invest more than 15 percent of its funds
in the shares or debentures of any specific industry.
22. No scheme shall invest in or lend to another scheme under the same AMC.
23. The AMC may charge the mutual fund with investment management and advisory services which
should have been disclosed fully in the prospectus subject to the following ceiling:
a) 1.25% of the weekly average net assets outstanding in the current year for the scheme concerned
as long as the net assets do not exceed Rs. 100 wore, and
b) 1% of the excess amount over Rs. 100 crore, where net assets so calculated exceed Rs. 100
crore, and
c) All mutual funds must distribute a minimum of 90 per cent of their profits in any given year.
The SEBI has recently allowed the Mutual funds to invest 100% of funds raised in Money Market up to
6 months and thereafter 30% of funds for 6 months to one year and only 25% in Money Market and
again 100% of funds in Money market, 6 months prior to repayment to investors.
24. Every scheme should have at least 20 investors and no single investor should hold more than 25
per cent of the fund’s assets.
25. Every mutual fund will have to furnish to SEBI at least the following periodic reports, in addition to
any other SEBI may ask for:
(a) Copies of the duly audited annual statement of account including the balance sheet and the profit
and loss account for the funds and for each scheme, once a year.
(b) Six-monthly un-audited accounts as above.
(c) A statement of movements in net assets for each of the schemes of the funds, every quarter.
(d) A portfolio statement, including changes from the previous periods, for each scheme, every
quarter.
26. All mutual funds are required to adopt a written code of ethics designed to deal with the potential
conflicts of interest that may arise from transition; by the affiliated persons or companies.
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27. Every mutual fund shall have to copy with a common advertising code laid down by the SEBI. The
fund is expected to submit to the SEBI the texts of tire marketing literature and advertisements issued
to the investors.
Mutual funds shall have to disclose in their marketing and publicity brochures for each scheme, the
investment objectives, the method and periodicity of valuation of investment, the exact method and
periodicity of sales and purchases and other details considered by to SEBI to be essential for investors.
28. SEBI can, after due investigation, impose penalties on mutual funds for violating the guidelines as
may be necessary. However, for cases of penalties of suspension or deauthorisation of mutual fund
entities, prior concurrence of the RBI and the government is necessary.
The regulatory framework for mutual funds smacks of ineffective panning, clarity of thought and suffers
from several shortcomings. There does not seem to be any justification for separate regulatory
framework to govern the operations of the mutual funds the UTI Act with comprehensive guidelines
already in existence. It would have been more logical to broaden the scope of the UTI Act to make it
applicable to all the mutual funds. Some of the guidelines issued by the RBI and SEBI are
contradictory. For instance, while the EBI prohibits bank sponsored mutual funds from investing in
finance companies, SEBI has actually made reservations for mutual funds in public issues of finance
companies. The existing rules and regulations are quite comprehensive to ensure greater ‘transparency
about the operations of mutual funds. However, there is some scope of effectively curbing the
malpractices, particularly in the field of distribution of mutual fund products by regulating the activities of
intermediaries. Further, some of the rules and regulations, viz., restrictions on investment, requirements
of underlying securities in the derivative market, individual investor’s communication and recording of
all secondary transactions have been identified as very stringent. These have had an adverse impact,
to some extent, on the performance of mutual funds.
SEBI rules regarding late trading and rapid trading are either ineffective or nonexistent Although SEBI
has introduced a specific regulation against late trading since March, 2004, it has failed to check late
trading. As a result, there is rampant late trading by mutual funds to the detriment of common investors.
What is most disturbing to note is that there are still no regulations to deter rapid trading in mutual
funds, even though the regulator is aware of how it can harm long-term investors. While late trading is
nothing short of cooking the books, rapid trading is not a crime but need to be discouraged.
16.14 PRIVATE MUTUAL FUNDS
Another key development in the financial sector was the opening up of mutual funds to private sector in
early 1992. Though quite a few industrial groups and financial majors evinced a keen interest in the
setting up of mutual funds, it took nearly two years for the first private mutual fund to be launched. The
first private sector mutual fund was launched by the Madras based H.C. Kothari group which, in
collaboration with the Pioneer group of the US offered two schemes in 1994. This was followed by
several mutual funds having foreign tie-ups with renowned asset management companies— 20th
century has collaboration with Kemper Financial Services, the Tata with Kleinwort Bonson and ICICI
with J.P. Morgan.
The competition becomes intense when investors switch over from one fund to another, based on their
decisions on the performance of the funds. And that should begin sooner than later, with as many as 29
mutual funds in the field. The trend world over especially in the USA, U.K. and Japan is for investors to
switch over from secondary markets to mutual funds. For the companies also, the retail route is quite
an expensive method of raising funds. The trends in private funding of equity and bought out deals in
our country, clearly indicate that individual households, in their own interest (since they lack stock
picking drills and manage their own portfolios) should leave the job to professionals such as mutual
funds.
SPONSOR WITH TRACK RECORD
A mutual fund in a private sector has to be sponsored by a limited company having a track record. The
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mutual fund has to be established as trust under the Indian Trust Act, 1882. The sponsoring company
should have at least a 40 per cent stake in the paid up capital of the asset management company.
Mutual funds are required to avail off the services of a custodian who has secured the necessary
authorization from the SEBI.
ASSET MANAGEMENT COMPANY (AMC)
A mutual fund is managed by an Asset Management Company that is appointed by the sponsor
company or by the trustees. The asset management company has to, be registered under the
Companies Act and has to be approved by the SEBI. The AMD manages the affairs of the mutual funds
and its schemes. AMCs are registered by the Registrar of Companies only after a draft memorandum
and the articles of association are cleared by the SEBI.
16.15 PROBLEMS OF MUTUAL FUNDS

India has a high household savings ratio. Indians, like most people anywhere, are conservative in their
habits, and it would take many years to change this behaviour, particularly when it comes to the use of
their savings. As in most countries, investment in physical assets (mainly housing and gold) accounts
for the most important percentage of household assets. Owning a home is usually a first priority once a
family has any disposable income at all.
COMPETITION WITH GOVERNMENT SCHEMES:
Mutual funds compete against a host of high yielding government-backed savings schemes such as
Public Provident Fund (PPF), National Savings Scheme (NSS), RBI Bonds, and so on, as well as
against life insurance products and, in the future, against the new pension schemes for the unorganized
sector. [1] The political and social reasons for keeping yields higher than the market for small savers,
particularly retired savers, is understandable. The market is distorted by such a policy. Government
should have the strategic aim of discontinuing over time or at least reducing the availability of the
unrealistically high yielding avenues for small savings. The objective of widening and deepening
ownership of mutual funds is unlikely to be met until this happens.
Fixed income and balanced mutual funds have offered a reasonably competitive rate of return but they
are not guaranteed, a key attraction to Indian investors. The net result is that mutual funds fail to attract
much money from retail investors, who prefer to invest in a no-risk, high return product, i.e. government
saving schemes or provident funds or keep their money safely in the bank.
Government -sponsored instruments crowd out mutual funds since for the majority of Indians buying
mutual funds, before they have their full complement of government-backed savings instruments, would
be both wrong and foolish.
In most countries government guaranteed financial instruments offer returns that are likely to be
significantly lower than private sector investments available from mutual funds or insurance companies.
This is the penalty that investors are prepared to pay for little or no risk. However, Indian retail investors
are not being asked to sacrifice any substantial amount of return in exchange for a government
guarantee. Conversely, returns on government assured investments are often better than that available
elsewhere. While conventional government bonds do give lower returns than equivalent private sector
corporate bonds, the retail government assured products give higher returns for almost no risk. It is
thus hardly surprising that an investor of modest means would choose to invest in, for instance, national
savings certificates, since he can thus obtain a better return for a much lower risk. Any investor would
be well advised to invest the maximum permitted in the various government assured schemes before
considering other forms of investment.
The reasons why the government is prepared to pay above market rates of interest on certain financial
products is understandable. At a time when interest rates have fallen substantially from their previous
levels, savers who had counted on the interest on their savings to provide an income, particularly in
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retirement, are being subsidized. Given that pension arrangements, particularly in the unorganized
sector, are not widespread, such an approach is reasonable and indeed most small savers are acting
rationally when they choose the low risk option. However, this approach conflicts with a desire to widen
and deepen participation in capital markets through mutual funds or other non-governmental savings
products by the less well-off sectors of the population.
COMPETITION FROM INSURANCE:
The take up life assurance is growing rapidly and may be pre-empting some of the market that mutual
funds could aim at. Life assurance is an easier product to sell, since in the mind of the investor the
payment of a premium is often linked to a specific outcome, a lump sum payment on death or a
guaranteed minimum sum on maturity. It also pays higher commissions to sales agents (typically the
amount of the first 5 to 6 months premium). Thus a sales agent will usually prefer to sell a life policy
since it will reward him better.
VOLATILITY OF MUTUAL FUND PERFORMANCE: There is a perception that mutual funds have
somehow let down their investors and given them poor returns. In July 2001 where UTI slashed down
the dividend rates for the year 2000-01 and suspended sales and repurchases of US-64 for a period of
6 months from July 2001 to December 2001, it created a crisis of confidence among the investors with
long-term effects.
TAX SYSTEMENCOURAGES SHORT-TERM OBJECTIVES:
Mutual funds are regarded in most countries as a diversified, professionally managed and well
regulated vehicle for mobilizing household savings and are often accorded tax privileges specifically in
pursuit of a government policy goal to encourage long-term savings, notably for retirement. [2] It is
unusual for such tax privileges to impel mutual-funds towards short-term goals, which is what seems to
be the case in India True, Indian unit trusts are diversified, professionally managed and well-regulated,
but they are certainly not serving long-term objectives.
The Mutual Fund Industry in India is quite sophisticated and successful. It is dominated by good and
reputable institutions, both Indian and International. Nevertheless improvements are always possible
and desirable in order to enhance file ability of the mutual fund industry to mobilized savings on a wider
scale and to contribute to the further development of capital market.
Although reforms in the financial sector since 1991 have been successful in creating a competitive
environment, the growth of mutual fund has solved down, partially due to the problems faced by UTI.
1. Define ‘Mutual Fund’
2. Define ‘Offshore Funds’.
3. What is ‘Asset Management Company’?
4. Define ‘GETF”.
16.17 SUMMARY
A mutual fund is a trust that pools the savings of a number of investors who share a common financial
goal. The money, thus, collected is then invested in capital market instruments such as shares,
debentures and other securities. The income earned through these investments and the capital
appreciation realised are shared by its unit holders in proportion to the number of units owned by them.
Thus, a mutual fund is the most suitable investment for the common man as it offers an opportunity to
invest in a diversified, professionally managed basket of securities at a relatively low cost. Mutual funds
have proved to be an attractive investment for many investors, the world over, since they provide them
a mixture of liquidity, return and safety in accordance with their performance. Further, the investor
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obtains these benefits without having to directly a diversified portfolio, which is handled by specialists.
The interests of various investors are generally protected through mutual funds. As individual investors,
they may not hold much clout in companies whose shares they hold, but by being part of institutional
investors like mutual funds, their bargaining power is enhanced.
16.18 GLOSSARY
Mutual Fund: A mutual fund is a kind of investment that uses money from investors to invest in stocks,
bonds or other types of investment.
Close-ended Funds: These funds are fixed in size as regards the corpus of the fund and the number
of shares.
Growth-oriented Funds: These funds do not offer fixed, regular returns but provide substantial capital
appreciation in the long run. The pattern of investment in general is oriented towards shares of high
growth companies.
Income-oriented Funds: These funds offer a return much higher than the bank deposits but with less
capital appreciation.
NAV: NAV is the market value of the fund’s assets divided by the number of outstanding shares/units of
the fund.
Open-ended Funds: In open-ended funds, there is no limit to the size of the funds. Investors can
invest as and when they like. The purchase price is determined on the basis of Net Asset Value (NAV).
Specialised Funds or Industry Funds: These funds are invested in a particular industry like cement,
steel, jute, power or textile, etc.
Tax Relief Funds: These funds are raised for providing tax relief to those investors whose income
comes under taxable limits.
ULIPs: ULIPs are a category of goal-based financial solutions that combine the safety of insurance
protection with wealth creation opportunities.
1. Discuss the benefits and objectives of mutual funds in India.
2. State the different types of mutual funds prevailing in India?
3. Discuss the SEBI’s regulatory provisions for Mutual Funds.
1. Refers to Section 16.3, 16.4 & 16.5
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1. Cohen, Jerome, B.: Zinbarg, Edward D., and Zeikel, Arthur (2006). Investment Analysis and
Portfolio Management. Homewood.
2. Cottle, C.C., and Whitman, W.T. (1953). Investment Timing: the formula plan approach. New
York, McGraw Hill.
3. Curley, Anthony J. and Bear, Robert M. (2003). Investment Analysis and Management. NY,
Harper & Row.
4. D. Ambrosio, Charles A. (1970). Guide to Successful Investing. Englewood Cliffs, NJ Prentice-
Hall.
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Chapter-17
Latest mutual fund schemes in India – An overview
STRUCTURE
17.1 Introduction
17.2 Evaluation Of Performance Of Mutual Funds

17.3 Process Of Evaluation Of Performance Of Mutual Funds
17.4 Latest Mutual Fund Schemes
17.6 Summary
17.7 Glossary

3. Explain the regulations for merchant banking
17.1 Introduction
Mutual Fund is an important segment of the financial system. Mutual Fund is a nonfund based
special type of institution which acts as an investment conduit. It is essentially a mechanism of
pooling together the savings of a large number of investors for collective investments with an
avowed objective of attractive yields and appreciation in their value. A Mutual Fund is a Financial
Service Organisation that receives money from shareholders, invests it, earns returns on it,
attempts to make it grow and agrees to pay the shareholder cash on demand for the current value
of his investment. A Mutual fund offers investors a proportionate claim on portfolio of assets that
fluctuates in value with the value of the assets that make up the intermediaries portfolio. It is
rather difficult to give a comprehensive concept of a mutual fund. What is a mutual fund is better
understood by the functions it performs and role it plays. It is a non-depository financial
intermediary. Mutual funds are mobiliser of savings, particularly from the small and household
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sectors, for investments in stock and money markets. Mutual funds mobilise funds by selling their
own shares also known as units. When an investor owns a unit in mutual funds he owns a
proportional share of the securities portfolio held by a mutual fund. In other words, share of a
mutual fund actually represents a part share in many securities that
17.2 EVALUATION OF PERFORMANCE OF MUTUAL FUNDS

The performance of a portfolio is measured by combining the risk and return levels into a single value.
The differential return earned by a portfolio may be due to the difference in the exposure risk from that
of, say the stock market index. There are three major methods of assessing a risk adjusted
performance. Firstly the return per unit of risk, secondly, differential return, and thirdly, the components
of investment performance.
RETURN PER UNIT OF RISK
‘The first measure determines the performance of a fund in terms of the return per unit of risk. The
absolute level of return achieved is related to the level of risk exposure to develop a relative risk
adjusted measure for ranking the fund performance. Funds that provide the highest return per unit of
risk would be judged as having performed well while those providing the lowest return per unit of risk
would be judged as poor performers (see Fig. 10.1.).
The return per unit of risk is measured by Sharpe’s investment performance index and Treynor’s
portfolio perform knee index.
Sharpe’s Index Sharpe’s investment performance index is a risk adjusted rate of return measure that
is calculated by dividing the assets risk premiums E(r) — R, by their standard deviations of returns. This
index is used to rank the investment performance of different assets, Sharpe’s index considers both the
average rates of return and the risk. It assigns the highest scores to the assets that have the best risk
adjusted rate of return. Sharpe’s reward to visibility of return is simply, the ratio of the reward defined as
the realized portfolio return (rs) in excess of foe risk-free rate (rf) to the variability of return, measured
by the standard deviation of return (op).
rf
Sharpe’s ratio rp = rp  
p
where, (rp) is the realized portfolio return or the assets’ average rate of return,
(rf) is the risk-free rate, and  p is the assets’ SD of return.
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In terms of the capital market theory, this portfolio performance measure uses the, total risk to compare
portfolios with the Capital Market Line (CML) [see Fig. 10.1]. A higher Sharpe’s ratio value than the
market portfolio would lie above the CML and would indicate superior risk adjusted performance.
Fig. 10.1: Differential Return for Funds A, M & Z

Treynor’s Index
An index of portfolio performance that is based on systematic risk, as measured by the portfolio’s beta
coefficients rather than on total risk as done by Sharpe’s measure was put forward by Jack Treynor. It
is used to rank the investment performance of different assets. It is a risk adjusted rate of return
measure that is calculated by dividing the assets’ risk premium E(r) – R, by their beta coefficients. The
index of systematic risk is a Characteristic of the Regression Line (CRL) and the beta coefficient. As
with the individual assets, the beta coefficient from a portfolio’s characteristic line is an index of the
portfolio’s systematic or undiversified risk. The systematic risk remains after the unsystematic variability
of retains of the individual assets average turns out to be zero. In view of this Treynor suggested
measuring a portfolio’s return, relative to its systematic risk rather than to its total risk, as is done in the
Sharpe’s measure:
A larger TR value indicates a higher slope and a better; portfolio for all the investors. Comparing a
portfolio’s TR value to a similar measure for the market portfolio, indicates whether the portfolio would
plot above the Security Market line (SML) [see Fig. 10.1]. Deviation from the characteristic line
measures the relative volatility of the portfolio’s returns, in relation to the returns for the aggregate
market or the portfolios beta coefficient. the SML.m
RM =Returns from the market portfolio.

m = Systematic risk of the market. In this expression, b equals 1.0 and the markets’ beta
indicates the slope of the SML. Therefore; a portfolio with a higher TR value than foe market portfolio
would lie above foe SML. This would indicate a superior risk adjusted performance. Comparison of
Sharpe’s and Treynor’s Measures are similar in a way, since they both divide the risk premium by a
numerical risk measure. However, foe Sharpe’s portfolio performance measure uses foe standard
deviation of returns as the measure of risk, whereas Treynor’s performance measure employs beta
coefficient as a denominator. Sharpe’s measure tanks the assets dominance m the CML’s risk return
space while foe Treynor’s measure ranks the dominance in foe CAPM’s risk return space. Both
measures assume that money can be freely borrowed and lent at R This assumption is required to
generate linear investment opportunities that emerge from Rand allow funds in different risk classes to
be compared and ranked. The standard deviation as a. measure of the total risk is appropriate when
evaluating foe ride return relationship for well diversified portfolios. On the other hand; foe beta
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coefficient is foe relevant measure of risk when evaluating less than fully diversified portfolios or
individual stocks. In spite of the risk measures they employ the Sharpe’s and Treynor’s portfolio
performance measures yield very similar ranking of portfolios in most cases.
Table. 9.2. illustrates the calculation of return per unit of ride under the two methods using two
hypothetical funds A and Z along with the market fond M, as a benchmark for comparison. The market
fund provided 0.26 return per unit of standard deviation and exceeded the Sharpe’s ratio of 0.25 return
provided for Z, but was below the Sharpe’s ratio of 0.3 for fond A According to the reward to volatility
ratio, the market, fund provided a return per unit of beta of 4, which again exceeds the Treynor’s ratio of
3.7 for fund Z, but way below foe Treynor’s ratio of 4.4 derived for fond A (Fig. 9.1)
The ranking of funds was identical under either measures and A was the best, Z the worst while the
markets fund M, an intermediate performer.
DIFFERENTIAL RETURN (ALPHA)
A second category of risk adjusted performance measure is the Jenson’s measure. This measure was
developed by Michael Jenson and is sometimes referred to as the differential return. This measure
involves the calculation of returns that should be expected for the fund, given the realized risk of the
fund and compare that with the returns realized over the period. It is assumed that the investor has a
passive or naive alternative of merely buying the market portfolio and adjusting for the appropriate level
of risk, by borrowing or lending at a risk-free rate. Given the assumption, the most commonly used
method of determining the return for a level of risk is by way of the alpha formulation:
 
N r p  rf   p  m   f 
  rp= rp-N rp 
To evaluate the performance of the fund A we insert the appropriate variables in the formula:
 
N r p  3  0.67(7  3)  5.68%
  6  5.68  0.32%
Fund A would have been expected to have earned 5.68% over the period. The fund actually earned
6.00% and thus provided a differential return of risk adjusted to 0.32% (Fig. vt). Jenson also provided a
way of determining whether the differential return could have occurred by change, or whether it was
significantly different from zero in statistical sense. It is possible to establish this, since Jenson’s
measure is ordinarily derived by running a regression of the monthly or quarterly returns of the fund,
being evaluated against the return of a market index, over the relevant performance period. The
regression equation is:
The form of the regression equation is similar to that of the previous equation, except that an intercept
term alpha and an error term (e) have been added. The error term enables in assessing how well the
regression equation fits the date, a low error indicating a well-defined relationship and a high error
indicating a poorly defined relationship. The intercept measures the performance of the fund with either
a negative value that indicates a below average performance, or a positive value for above a verage
performance.
 
rp  rf   p   p rm  rf  e
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X The form of the regression equation is similar to that of the previous equation, except that an
intercept terms alpha and an error term (e) have been added. The error term enables in assessing how
well the regression equation fits the data, a low error indicating a well-defined relationship and a high
error indicating a poorly defined relationship. The intercept measures the performance of the fund with
either a negative value that indicates a below average performance, or a positive value for above
average performance.
Table 10.1 Calculation of Return Per Unit of Risk Ratios
Fund Return Rp R-Rr S.D SR B TR
A 6 3 3 10 0.30 0.67 4.4
M 7 3 4 15 0.26 1.00 4.0
Z 8 3 5 20 0.25 1.33 3.7
17.3 PROCESS OF EVALUATION OF PERFORMANCE OF MUTUAL FUNDS

Evaluating the performance of mutual funds is essential for investors to make informed decisions
about their investments. There are several key steps and metrics to consider when evaluating the
performance of mutual funds:
1. Define Your Investment Goals and Risk Tolerance: Before evaluating any mutual fund,
it's crucial to determine your investment objectives, such as long-term growth, income
generation, or capital preservation. Additionally, assess your risk tolerance to determine
the appropriate asset allocation.
2. Choose Appropriate Benchmarks: Select a relevant benchmark or index against which

to compare the fund's performance. For example, if you're evaluating a U.S. large-cap
equity fund, you might use the S&P 500 index as the benchmark.
3. Gather Historical Performance Data: Obtain historical performance data for the mutual
fund you are evaluating. This information is typically available on the fund's website, in its
prospectus, or from financial news sources.
4. Analyze Returns: Evaluate the fund's historical returns over different time periods, such
as one year, three years, five years, and since inception. Compare these returns to the
chosen benchmark. Pay attention to both total returns and annualized returns.
5. Risk Assessment: Consider the fund's risk-adjusted performance. One common metric
for assessing risk-adjusted returns is the Sharpe ratio, which measures the excess return
per unit of risk (volatility).
6. Expense Ratios: Examine the fund's expense ratio, which represents the annual cost of
managing the fund as a percentage of assets under management (AUM). Lower expense
ratios are generally preferred, as they can have a significant impact on long-term returns.
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7. Portfolio Composition: Review the fund's portfolio holdings to understand its asset
allocation, sector exposure, and individual security holdings. Ensure that the fund's
investment strategy aligns with your goals and risk tolerance.
8. Manager Tenure and Expertise: Assess the experience and track record of the fund
manager or management team. Consistency in management can be a positive indicator.
9. Historical Volatility: Analyze the fund's historical volatility to gauge how much it fluctuates
in value. Lower volatility may be more suitable for risk-averse investors.
10. Distribution History: If you're interested in income-generating funds, such as bond funds
or dividend-focused equity funds, examine the fund's distribution history, including dividend
yields and consistency.
11. Tax Efficiency: Consider the tax implications of the fund's investments. Some mutual
funds are more tax-efficient than others due to their investment strategies.
12. Fund Expenses: Besides the expense ratio, evaluate any other costs associated with the
fund, such as front-end or back-end loads, transaction fees, and redemption fees.
13. Peer Comparison: Compare the fund's performance and characteristics to similar funds in
the same asset class or category. This can provide additional context for evaluation.
14. Consistency: Assess the fund's consistency in meeting its investment objectives.
Consistency can be a valuable indicator of a fund's reliability.
15. Recent News and Events: Stay informed about recent news or events related to the fund,
such as changes in management or significant shifts in strategy.
16. Consult with Financial Advisors: If needed, seek guidance from financial advisors or
professionals who can provide expert opinions and insights on mutual fund performance.
17.4 Latest MUTUAL FUND SCHEMES
MUTUAL FUND SCHEME CLASSIFICATION

Mutual funds come in many varieties, designed to meet different investor goals. Mutual funds can
be broadly classified based on –
1. Organisation Structure – Open ended, Close ended, Interval
2. Management of Portfolio – Actively or Passively
3. Investment Objective – Growth, Income, Liquidity
4. Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi Asset
5. Thematic / solution oriented – Tax saving, Retirement benefit, Child welfare, Arbitrage
6. Exchange Traded Funds

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7. Overseas funds
8. Fund of funds
SCHEME CLASSIFICATION BY ORGANIZATION STRUCTURE

• Open-ended schemes are perpetual, and open for subscription and repurchase on a
continuous basis on all business days at the current NAV.
• Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial
offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed to
provide exit route before maturity and can be sold/traded on the stock exchanges.
• Interval schemes allow purchase and redemption during specified transaction periods
(intervals). The transaction period has to be for a minimum of 2 days and there should be at least
a 15-day gap between two transaction periods. The units of interval schemes are also
mandatorily listed on the stock exchanges.
SCHEME CLASSIFICATION BY PORTFOLIO MANAGEMENT

Active Funds
In an Active Fund, the Fund Manager is ‘Active’ in deciding whether to Buy, Hold, or Sell the
underlying securities and in stock selection. Active funds adopt different strategies and styles to
create and manage the portfolio.
 The investment strategy and style are described upfront in the Scheme Information
document (offer document)
 Active funds expect to generate better returns (alpha) than the benchmark index.
 The risk and return in the fund will depend upon the strategy adopted.
 Active funds implement strategies to ‘select’ the stocks for the portfolio.
Passive Funds
Passive Funds hold a portfolio that replicates a stated Index or Benchmark e.g. –
 Index Funds
 Exchange Traded Funds (ETFs)
In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell
decision is driven by the Benchmark Index and the fund manager / dealer merely needs to
replicate the same with minimal tracking error.
ACTIVE V/S PASSIVE FUNDS
Active Fund –
 Rely on professional fund managers who manage investments.
 Aim to outperform Benchmark Index
 Suited for investors who wish to take advantage of fund managers' alpha generation
potential.
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Passive Funds –
 Investment holdings mirror and closely track a benchmark index, e.g., Index Funds or
Exchange Traded Funds (ETFs)
 Suited for investors who want to allocate exactly as per market index.
 Lower Expense ratio hence lower costs to investors and better liquidity
CLASSIFICATION BY INVESTMENT OBJECTIVES

Mutual funds offer products that cater to the different investment objectives of the investors such
as –
a. Capital Appreciation (Growth)
b. Capital Preservation
c. Regular Income
d. Liquidity
e. Tax-Saving
Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor the
investment to the investors’ needs.
GROWTH FUNDS
 Growth Funds are schemes that are designed to provide capital appreciation.
 Primarily invest in growth oriented assets, such as equity
 Investment in growth-oriented funds require a medium to long-term investment horizon.
 Historically, Equity as an asset class has outperformed most other kind of investments held
over the long term. However, returns from Growth funds tend to be volatile over the short-
term since the prices of the underlying equity shares may change.
 Hence investors must be able to take volatility in the returns in the short-term.
INCOME FUNDS
 The objective of Income Funds is to provide regular and steady income to investors.
 Income funds invest in fixed income securities such as Corporate Bonds, Debentures and
Government securities.
 The fund’s return is from the interest income earned on these investments as well as
capital gains from any change in the value of the securities.
 The fund will distribute the income provided the portfolio generates the required returns.
There is no guarantee of income.
 The returns will depend upon the tenor and credit quality of the securities held.
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LIQUID / OVERNIGHT /MONEY MARKET MUTUAL FUNDS
 Liquid Schemes, Overnight Funds and Money market mutual fund are investment options
for investors seeking liquidity and principal protection, with commensurate returns.
– The funds invest in money market instruments* with maturities not exceeding 91 days.
– The return from the funds will depend upon the short-term interest rate prevalent in the
market.
 These are ideal for investors who wish to park their surplus funds for short periods.
– Investors who use these funds for longer holding periods may be sacrificing better
returns possible from products suitable for a longer holding period.
* Money Market Instruments includes commercial papers, commercial bills, treasury bills,
Government securities having an unexpired maturity up to one year, call or notice money,
certificate of deposit, usance bills, and any other like instruments as specified by the
Reserve Bank of India from time to time.
CLASSIFICATION BY INVESTMENT PORTFOLIO

 Mutual fund products can be classified based on their underlying portfolio composition
– The first level of categorization will be on the basis of the asset class the fund invests in,
such as equity / debt / money market instruments or gold.
– The second level of categorization is on the basis of strategies and styles used to create
the portfolio, such as, Income fund, Dynamic Bond Fund, Infrastructure fund, Large-
cap/Mid-cap/Small-cap Equity fund, Value fund, etc.
– The portfolio composition flows out of the investment objectives of the scheme.
1. What is Treynor’s Index

2. What is differential return (alpha)
3. What are growth funds
4. What are active funds
17.6 Summary
Mutual Fund is an important segment of the financial system. Mutual Fund is a nonfund based
special type of institution which acts as an investment conduit. It is essentially a mechanism of
pooling together the savings of a large number of investors for collective investments with an
avowed objective of attractive yields and appreciation in their value. A Mutual Fund is a Financial
Service Organisation that receives money from shareholders, invests it, earns returns on it,
attempts to make it grow and agrees to pay the shareholder cash on demand for the current value
of his investment. A Mutual fund offers investors a proportionate claim on portfolio of assets that
fluctuates in value with the value of the assets that make up the intermediaries portfolio. It is
rather difficult to give a comprehensive concept of a mutual fund. What is a mutual fund is better
understood by the functions it performs and role it plays. It is a non-depository financial
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intermediary. Mutual funds are mobiliser of savings, particularly from the small and household
sectors, for investments in stock and money markets.
17.8 Glossary
1. Income funds: Income funds invest in fixed income securities such as Corporate Bonds,
Debentures and Government securities.The fund’s return is from the interest income earned on
these investments as well as capital gains from any change in the value of the securities.
2. GROWTH FUNDS: Growth Funds are schemes that are designed to provide capital
appreciation. Primarily invest in growth oriented assets, such as equity.Investment in growth-
oriented funds require a medium to long-term investment horizon.
3. Open-ended schemes are perpetual, and open for subscription and repurchase on a
continuous basis on all business days at the current NAV.
4. Close-ended schemes have a fixed maturity date. The units are issued at the time of the
initial offer and redeemed only on maturity. The units of close-ended schemes are
mandatorily listed to provide exit route before maturity and can be sold/traded on the stock
exchanges.
5. Interval schemes allow purchase and redemption during specified transaction periods
(intervals). The transaction period has to be for a minimum of 2 days and there should be
at least a 15-day gap between two transaction periods. The units of interval schemes are
also mandatorily listed on the stock exchanges.

1. What are various method for the evaluation of performance of mutual funds
2. What is the process of valuation of performance of mutual funds
3. What are the various latest mutual fund schemes

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India.
New Delhi.
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Chapter- 18
UNIVERSAL BANKING
STRUCTURE
18.1 Introduction
18.2 History Of Universal Banking
18.3 Evolution Of Universal Banking In India
18.4 Need For Universal Banking
18.5 Types Of Universal Banking Services
18.6 Advantages Of Universal Banking
18.7 Consequences Of Universal Banking
18.9 Summary
18.10 Glossary
After studying the chapter you should be able to:
 History Of Universal Banking
 Types Of Universal Banking Services
 Consequences Of Universal Banking
18.1 INTRODUCITON
Universal banking is a system in which banks provide a wide variety of comprehensive financial
services, including those tailored to retail, commercial, and investment services. Universal
banking is common in some European countries, including Switzerland.
Universal banking became more common in the United States starting in 1999 when the Gramm-
Leach-Bliley Act (GLBA) repealed the restrictions preventing commercial banks from offering
investment banking services. Proponents of universal banking argue that it helps banks better
diversify risk. Detractors think dividing up banking operations is a less risky strategy.
Universal banks may offer credit, loans, deposits, asset management, investment advisory,
payment processing, securities transactions, underwriting, and financial analysis. While a
universal banking system allows banks to offer a multitude of services, it does not require them to
do so. Banks in a universal system may still choose to specialize in a subset of banking services.
Universal banking combines the services of a commercial bank and an investment bank,
providing all services from within one entity. The services can include deposit accounts, a variety
of investment services, and may even provide insurance services. Deposit accounts within a
universal bank may include savings and checking.
18.2 HISTORY OF UNIVERSAL BANKING
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A universal bank is a type of bank which participates in many kinds of banking activities and is
both a commercial bank and an investment bank as well as providing other financial
services such as insurance. These are also called full-service financial firms, although there can
also be full-service investment banks which provide wealth and asset management, trading,
underwriting, researching as well as financial advisory.
The concept is most relevant in the United Kingdom and the United States, where historically
there was a distinction drawn between pure investment banks and commercial banks. In the US,
this was a result of the Glass–Steagall Act of 1933. In both countries, however, the regulatory
barrier to the combination of investment banks and commercial banks has largely been removed,
and a number of universal banks have emerged in both jurisdictions. However, at least until
the global financial crisis of 2008, there remained a number of large, pure investment banks.
In other countries, the concept is less relevant as there is no regulatory distinction between
investment banks and commercial banks. Thus, banks of a very large size tend to operate as
universal banks, while smaller firms specialised as commercial banks or as investment banks.
This is especially true of countries with a European Continental banking tradition. Notable
examples of such universal banks include Bank of America, Citigroup, JPMorgan Chase,
and Wells Fargo of the United States
Following the 1907 financial crisis, the U.S. Monetary Commission wanted to understand the
major financial systems of the world. A treatise by Jacob, the director of a Berlin bank, argued
that the German universal banking system possessed beneficial characteristics that allowed it to
efficiently provide inexpensive capital to industry and promote growth. Alexander
Gerschenkron also advanced the hypothesis that universal banking was critical to Germany's
industrialization. More recently, Emory University economist Caroline Fohlin has questioned the
validity of the Gerschenkron hypothesis.
18.3 EVOLUTION OF UNIVERSAL BANKING IN INDIA

Universal Banking In India
The issue of universal banking resurfaced in Year 2000, when ICICI gave a presentation to RBI to
discuss the time frame and possible options for transforming itself into an universal bank.
Reserve Bank of India also spelt out to Parliamentary Standing Committee on Finance, its
proposed policy for universal banking, including a case-by-case approach towards allowing
domestic financial institutions to become universal banks.
Now RBI has asked FIs, which are interested to convert itself into a universal bank, to submit their
plans for transition to a universal bank for consideration and further discussions. FIs need to
formulate a road map for the transition path and strategy for smooth conversion into an universal
bank over a specified time frame. The plan should specifically provide for full compliance with
prudential norms as applicable to banks over the proposed period.
The Narsimham Committee II suggested that DFIs should convert ultimately into either
commercial banks or non-bank finance companies. The Khan Working Group held the view that
DFIs should be allowed to become banks at the earliest. The RBI released a ‘Discussion Paper’
(DP) in January 1999 for wider public debate. The feedback indicated that while the universal
banking is desirable from the point of view of efficiency of resource use, there is need for caution
in moving towards such a system. Major areas requiring attention are the status of financial sector
reforms, the state of preparedness of the concerned institutions, the evolution of the regulatory
regime and above all a viable transition path for institutions which are desirous of moving in the
direction of universal banking.
18.4 NEED FOR UNIVERSAL BANKING

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Universal banking can be viewed as a model that meets the evolving needs of modern financial
markets and customers. Here are some of the key reasons why universal banking has gained
importance:
1. Customer Convenience: Universal banks offer a wide range of financial services under
one roof, making it convenient for customers to manage their various financial needs
without the need to deal with multiple institutions.
2. Diversification: Universal banks can diversify their income streams by engaging in various
financial activities, reducing their reliance on a single source of revenue. This
diversification can enhance financial stability.
3. Risk Management: By offering a broad spectrum of financial services, universal banks
can spread risk across different business lines, which can help them weather economic
downturns and financial market fluctuations more effectively.
4. Cross-Selling Opportunities: Universal banks can cross-sell different financial products
to their customer base. For example, a customer who has a savings account with the bank
may also be offered investment and insurance products, increasing revenue for the
institution.
5. Economies of Scale: Universal banks can achieve cost efficiencies by centralizing certain
operations and sharing resources among various business units. This can lead to cost
savings that may be passed on to customers.
6. Capital Allocation: They can allocate capital more efficiently to the most profitable
business units, optimizing their overall financial performance.
7. Innovation: The diverse range of services offered by universal banks can foster innovation
as they leverage expertise from different areas of finance to develop new and innovative
financial products and services.
8. Access to Capital Markets: Universal banks can help businesses and individuals access
capital markets for fundraising, which can be especially beneficial for smaller companies
looking to expand or raise capital.
9. Wealth Management: High-net-worth individuals can benefit from comprehensive wealth
management services, including asset management, estate planning, and tax optimization,
all of which can be offered by universal banks.
10. Global Expansion: Universal banks are often well-equipped to expand their services
across different regions and countries, providing access to financial services to a broader
customer base.
11. Financial Inclusion: Universal banks can play a role in promoting financial inclusion by
offering a range of services to diverse segments of the population, including underserved
and unbanked communities.
12. Research and Analysis: They can leverage their vast resources to conduct in-depth
research and analysis, benefiting both customers and investors.
13. Financial Stability: The diversification of revenue and risk can contribute to the overall
stability of the bank, reducing the likelihood of financial crises.
14. Funding Options: Universal banks have access to a variety of funding options, including
customer deposits, capital market financing, and interbank lending, allowing them to
manage liquidity effectively.
15. Adaptation to Changing Markets: Universal banks can adapt to changing market
conditions and customer preferences more effectively by adjusting their service offerings
as needed.
18.5 TYPES OF UNIVERSAL BANKING SERVICES

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Universal banking services encompass a wide range of financial products and offerings to cater to
diverse customer needs. Here are some of the key types of services typically provided by
universal banks:
1. Retail Banking Services:
 Savings Accounts: Providing customers a safe place to store their money while
earning interest.
 Checking Accounts: Offering convenient transactional accounts for everyday
financial needs.
 Personal Loans: Providing funds to individuals for various purposes, such as home
renovation, education, or medical expenses.
 Mortgages: Offering home loans for purchasing or refinancing residential
properties.
 Auto Loans: Providing financing for the purchase of vehicles.
 Credit Cards: Issuing credit cards with various benefits and reward programs.
 Certificates of Deposit (CDs): Offering fixed-term, interest-bearing deposits.
 Consumer Insurance: Providing various types of insurance, including life, health,
and property insurance.
 Wealth Management Services: Assisting clients in managing and growing their
wealth through investment advisory, financial planning, and estate planning.
2. Corporate and Commercial Banking Services:
 Business Loans: Extending credit to businesses for expansion, working capital,
and other purposes.
 Commercial Real Estate Financing: Providing financing for commercial property
purchases and development.
 Trade Finance: Offering services to facilitate international trade, such as letters of
credit and export financing.
 Treasury and Cash Management: Assisting businesses in optimizing their cash
flow and managing financial operations.
 Corporate Insurance: Providing insurance solutions tailored to the needs of
businesses.
 Merchant Services: Offering payment processing solutions for businesses,
including point-of-sale systems.
 Supply Chain Finance: Providing financing solutions to optimize supply chain
operations.
3. Investment Banking Services:
 Mergers and Acquisitions (M&A): Advising clients on buying or selling
businesses.
 Capital Markets: Assisting companies in raising capital through initial public
offerings (IPOs) and secondary offerings.
 Underwriting: Taking on the financial risk of securities issuances.
 Equity Research: Conducting analysis and providing recommendations on publicly
traded companies.
 Asset Management: Managing investment portfolios for institutional and individual
clients.
 Private Equity: Investing in private companies or taking significant stakes in
existing ones.
 Hedge Fund Services: Offering specialized investment strategies for accredited
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investors.
4. Insurance Services:
 Life Insurance: Providing coverage for individuals and families in case of death or
disability.
 Property and Casualty Insurance: Offering coverage for damage to property and
liability for accidents.
 Health Insurance: Providing coverage for medical expenses and healthcare
services.
 Reinsurance: Insuring insurance companies against catastrophic losses.
 Specialized Insurance: Offering niche insurance products tailored to specific
industries or risks.
5. Asset Management and Wealth Services:
 Asset Management: Managing various investment assets, including stocks, bonds,
real estate, and alternative investments, on behalf of clients.
 Wealth Planning: Assisting high-net-worth individuals and families in creating
comprehensive wealth management strategies.
 Estate Planning: Providing services to manage and transfer assets to heirs and
beneficiaries.
 Trust and Fiduciary Services: Acting as trustees or fiduciaries for clients' assets.
6. Global and International Banking Services:
 Foreign Exchange Services: Facilitating currency exchange for international
transactions.
 Cross-Border Banking: Offering banking services across multiple countries.
 Trade Finance: Providing services to support international trade, including export
financing and currency hedging.
7. Technology and Digital Banking Services:
 Online Banking: Providing customers with convenient digital access to their
accounts and financial services.
 Mobile Banking: Offering mobile apps for banking and financial management.
 Fintech Integration: Collaborating with financial technology companies to offer
innovative services such as digital wallets and peer-to-peer payments.
18.6 ADVANTAGES OF UNIVERSAL BANKING
Universal banking, also known as full-service banking or financial conglomerate, refers to a

banking model in which a single financial institution offers a wide range of financial services
beyond traditional banking functions. Here are 15 advantages of universal banking:
1. Diversification of Revenue Streams: Universal banks can generate income from various
financial activities, reducing their reliance on a single source of revenue.
2. Risk Management: The diversification of services allows universal banks to spread risk
across different business lines, making them more resilient in economic downturns.
3. Economies of Scale: Universal banks can achieve cost efficiencies by centralizing
operations and sharing resources among various business units.
4. Enhanced Customer Convenience: Customers can access a wide array of financial
services under one roof, simplifying their financial management.
5. Cross-Selling Opportunities: Universal banks can cross-sell different financial products to
their customers, increasing revenue and customer loyalty.
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6. One-Stop Shopping: Customers can meet various financial needs, including savings,
loans, investments, insurance, and more without the need to switch between different
institutions.
7. Capital Allocation: Universal banks can efficiently allocate capital to the most profitable
8. Product Development: These banks can develop innovative financial products and
services by leveraging expertise from different areas of finance.
9. Risk Hedging: Universal banks can use their various business units to hedge risks
effectively, reducing exposure to market fluctuations.
10. Geographic Expansion: They can expand their services across different regions and
countries, catering to a broader customer base.
11. Enhanced Competitive Position: Universal banks can compete more effectively by offering
a comprehensive suite of financial services.
12. Research and Analysis: These banks can leverage their vast resources to conduct in-
depth research and analysis, benefiting both customers and investors.
13. Access to Capital Markets: Universal banks can assist clients in accessing capital markets
for fundraising, such as through initial public offerings (IPOs) or debt issuance.
14. Wealth Management: They can provide high-net-worth individuals with a range of wealth
management services, including asset management, estate planning, and tax optimization.
15. Financial Stability: The diversification of revenue and risk can contribute to the overall
stability of the bank, reducing the likelihood of financial crises.
18.7 CONSEQUENCES OF UNIVERSAL BANKING
Universal banking, which involves financial institutions offering a wide range of financial services
beyond traditional banking functions, can have both positive and negative consequences. Here
are some of the potential consequences of universal banking:
Positive Consequences:
1. Diversification of Revenue Streams: Universal banks can generate income from various
financial activities, reducing their reliance on a single source of revenue.
2. Risk Management: The diversification of services allows universal banks to spread risk
across different business lines, making them more resilient in economic downturns.
3. Economies of Scale: Universal banks can achieve cost efficiencies by centralizing
operations and sharing resources among various business units.
4. Enhanced Customer Convenience: Customers can access a wide array of financial
services under one roof, simplifying their financial management.
5. Cross-Selling Opportunities: Universal banks can cross-sell different financial products
to their customers, increasing revenue and customer loyalty.
6. One-Stop Shopping: Customers can meet various financial needs, including savings,
loans, investments, insurance, and more without the need to switch between different
institutions.
7. Capital Allocation: Universal banks can efficiently allocate capital to the most profitable
8. Product Development: These banks can develop innovative financial products and
services by leveraging expertise from different areas of finance.
9. Risk Hedging: Universal banks can use their various business units to hedge risks
effectively, reducing exposure to market fluctuations.
10. Geographic Expansion: They can expand their services across different regions and
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countries, catering to a broader customer base.
Negative Consequences:
1. Conflict of Interest: Universal banks often face conflicts of interest, as they may prioritize
selling their own financial products over those that are more suitable for customers.
2. Systemic Risk: Large universal banks can become "too big to fail," meaning their failure
could have severe repercussions for the entire financial system.
3. Regulatory Complexity: Regulating universal banks can be challenging due to the
diverse range of services they offer. Ensuring fair and transparent practices across all
business lines requires robust regulatory oversight.
4. Risk Concentration: While universal banks diversify their services, they can sometimes
concentrate risk in certain areas, such as investment banking or proprietary trading, which
can lead to significant losses during financial crises.
5. Reduced Competition: As large universal banks become more dominant, competition in
the financial sector may diminish, leading to higher fees and less innovation.
6. Loss of Focus: The wide range of services offered by universal banks may lead to a loss
of focus on core banking functions, potentially affecting the quality of traditional banking
services like deposit accounts and lending.
7. Regulatory Capture: Universal banks may exert significant influence over regulators and
policymakers, potentially leading to lax regulatory enforcement.
8. Complex Financial Products: Universal banks may create complex financial products
that are difficult for customers to understand, leading to potential mis-selling and financial
losses.
9. Market Distortions: The sheer size and interconnectedness of universal banks can distort
financial markets, influencing prices and investment decisions.
10. Difficulty in Resolving Failures: If a universal bank faces financial distress, the resolution
process can be complicated and costly due to the interconnectedness of its various
operations.

1. Need for universal banking
2. What is Retail Banking Services
3. What is Online Banking
4. What is Mobile Banking
18.9 SUMMARY
18.10 GLOSSARY

1. Define universal banking and history of universal banking
2. What is need for universal banking and advantages of universal banking
3. What are the consequences of universal banking

177

2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services.
Prentice Hall of India,
Agency, Mumbai.
178
Chapter-19
Financial Regulations and Reforms- Securities
Market
STRUCTURE
19.1 Regulation of the Securities Market
19.2 Need the financial reforms
19.3 Major reforms after 1991
19.5 Summary
19.6 Glossary
1. Explain the regulation of the capital market.
2. Describe the need for financial reforms.
3. Discuss the major reforms after 1991.
19.1 REGULATION OF THE SECURITIES MARKET

The SEBI has powers to register and regulate all market intermediaries. The SEBI has powers penalize
them in case of violations of the previsions of the act, rules and regulations made there under.
It can conduct enquiries, audits, and inspection of all market intermediaries and adjudicate offences
under the SEBI Act, 1992.
The SEBI registers and regulates the intermediaries in the primary market. Some of the major inter-
mediaries it regulates are merchant bankers, underwriters, bankers to an issue, registrars to an issue
and share transfer agents and debenture trustees. The SEBI registers and regulates various.
intermediaries in the secondary market such as brokers, subbrokers, stock exchanges, foreign
institutional investors (FTIs) custodians, depositories, mutual funds, and venture capital funds.
19.2 NEED FOR FINANCIAL REFORMS
The need for financial reforms had arisen because the financial institutions and markets were in a bad
shape. The banking sector suffered from lack of competition, low capital base, low productivity and high
intermediation costs. The role of technology was minimal and the quality of service did not receive
adequate attention. Proper risk management system was not followed and prudential norms were
weak. All these resulted in poor assets quality. Development financial institutions operated in a over-
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protected environment with most of the funding coming from assured sources. There was little
competition in insurance and mutual funds industries. Financial markets were characterised by control
over pricing of financial assets, barriers to entry and high transactions costs. The banks were running
either at a loss or on very low profits and consequently were unable to provide adequately for loan
defaults and build their capital. There had been organisational inadequacies the weakening of
management and control functions, the growth of restrictive practices, the erosion of work culture and
flaws in credit management. The strain on the performance of the banks had emanated party from the
imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and directed credit
programmes for the priority sector-all at below market or concessional or subsidised interest rates. This
apart from affecting bank profitability adversely, had resulted in the low or repressed or depressed
interest rates on deposits and in higher interest rates on loans to the larger borrowers from business
and industry. The phenomenon of cross-subsidisation had got built into the system where concessional
rates provided to some sectors were compensated by higher rates charged to non-concessional
borrowers.
Further, the functioning of the financial system and the credit delivery as well as recovery process had
decode profoinocised which damaged the quality of lending and the culture of repaying loans. The
widespread or across the board write 0ffs of the loans had seriously jeopardised the viability of banks.
As the closure of sick industrial units was discouraged by the government, banks had to continue to
finance non-viable sick units. This further compromised their own viability. The legal system was not of
much help in recovering loans. There was a lack of transparency in preparing statements of accounts
by banks.
In order words, the reforms had become imperative on account of the facts that despite its impressive
quantitative growth and achievements, the financial health, integrity, autonomy, flexibility and vibrancy
in the financial sector had deteriorated over the past many years. The allocation of resources had
become severely distorted the portfolio quality had deteriorated and productivity, efficiency and
profitability had been eroded in the system. Customer service was poor, work technology remained
outdated and transaction costs were high. The capital base of the system remained low, the accounting
and disclosure practices were faulty, and the administrative expenses had greatly soared. The system
suffered also from a lack of delegation of authority, inadequate internal controls and poor
housekeeping.
It was felt by many that all this was the consequence of policy-induced rigidities of excessive degree of
centralised administrative direction of investments, credit allocations and internal management of banks
and financial institutions massive branch expansion, overstaffing and union pressures and excessive
political intervention interference and pressures.
For a long time an alarming increase of sickness in the Indian financial system had required urgent
remedial measures or reforms which were ultimately introduced in 1991.
The key words describing reforms have beers liberalisation, deregulation, marketisation, privatisation,
and globalisation, all of which convey reforms objectives in a succinct manner. The basic proxies
underlying the reforms has been that the state ownership and regulation have harmed the financial
system, particularly the banks and the investors, and that such regulation is no longer relevant and
adequate. To use the well-known academic terminology, the objective of financial reforms has been to
correct and eliminate financial repression; and so transform a financially repressed system into a free
system. At the same time, it has been held that the deregulation does not imply total absence of
regulation; instead, it assumes sophisticated form of prudential, supervisory structure which would
“protect the financial system without unnecessarily restraining it”. The reforms are said to be directed
towards “stringent prudential regulation” in a “deregulated environment”.
Financial sector reforms are said to be grounded in the belief that the competitive efficiency in the real
sectors of the economy cannot be realized so it’s full extent unless the locative efficiency of the private
sector was improved. The main thrust of financial sector reforms was on the creation of efficient and
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stable financial institutions and markets, the removal if structural bottlenecks, introduction of new player
and instruments, introduction of free pricing of financial assets, relaxation of quantitative restrictions,
improvement in trading, clearing, and settlement practices, promotion of institutional infrastructure,
refinement of market micro-structure, creation of liquidity, depth, and the efficient price discovery
process, and ensuring technological up gradation.
The approach or strategy of reforms has been such that they are being effected by adapting the old
institutions in the new tasks and ethos. A careful attempt has been made at crisis-avoidance and at
creating an environment' which promotes greater efficiency in the delivery of financial services. The
financial sector reforms have been operating in conjunction with a larger set of goals relating to eco-
nomic stability and growth. The reforms have been introduced at a gradual pace combined with
effective and appropriate regulation and intervention policy. Efforts have also been made to fulfil (meet)
the “commandments” (prerequisites) of financial sector reforms, namely, carrying out a macro-
economic stabilisation programme, introducing supportive fiscal and external sector policies, and
implementing wide-ranging reforms in oilier sectors simultaneously.
19.3 MAJOR REFORMS AFTER 1991
The reforms have had a broad sweep encompassing operational matters, banking, primary and
secondary stock markets, government securities market, external sector policies, and the system as a
whole. Some people have classified them into three areas: issues relating to creating a resilient
banking system; development of institutions such as private sector banks and mutual funds; and
monetary policy instruments such as interest rates, reserve ratios, and refinancing facilities. In other
words, reforms relate to the issues of ownership and control, competition, and policy and regulation
stance.
While presenting a list of reforms, it needs u» be pointed out that sometimes a distinction between
normal policy changes which are specific to tune and economic conditions, and reforms proper is not
maintained: the former are included in the latter, which makes the list of reforms unduly and
unmanageably long. To reforms means to make (improve) or become better by the removal of faults or
errors or abuses. It is primarily in this sense that the major reforms are listed below in terms of certain
categories.
(i) Systemic Policy Reforms
 Most of the interest rates in the economy deregulated; a beginning made to move towards
market rates on government securities; the system of administered interest rates largely
dismantled; and the structure of interest, rates greatly simplified.
 The pre-emption of banks’ resources through SLR in favour of the government was brought
down and the rate of return on SLR securities is maintained by and large at market rates. The
SLR on incremental net domestic and time liabilities (NDTL) of banks reduced from 38.5 per
cent in 1991-92 to 25 per cent now.
 The incremental CRR of 10 per cent removed, and the average CRR reduced from !5 per cent
in 1991-92 to !0 per cent in 1995-96. The CRR of FCNR (B) and NRNR deposit accounts
removed. The CRR on NRE deposits outstanding as on 27.10.1995 reduced from 14 per cent to
10 per cent and the CRR on an increase in NRE deposits removed.
 Capital adequacy norms for banks, financial institutions, and virtually all market intermediaries
introduced. The Basie Committee framework for capital adequacy adopted.
 A Board of Financial Supervision (BPS) with an advisory council and an independent
department of supervision established in RBI. It would supervise, apart from banks, all-India
financial institutions and non-banking financial companies from April-July 1995-A new
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Supervisory Reporting System, introduced in February 1995, will focus attention on critical
areas such as capital adequacy, assets quality, management, earnings, and liquidity.
 Recovery of Debts Due to Banks and Financial Institutions Act, 1993 passed to set up Special
Recovery Tribunals to facilitate quicker recovery of loan arrears.
 In order to moderate or minimise the automatic monetisation of the budget deficit, the
agreement to impose a ceiling on the issue of ad hoc Treasury' Bills (TBs) and to phase them
out in due course signed by the Government of India (GOI) and RBI in September 1994. Sub-
sequently, the system of ad hoc treasury bills abolished and replaced by the system of ways
and means advances effective April 1, 1997.
 The private sector allowed to set up banks, mutual funds, money market mutual funds,
insurance companies, etc., public sector banks permitted diversified ownership by law subject to
51 per cent holding of government/RBI. SBI, IFCI and IRBI converted into public limited
companies. The Industrial Development Bank of India Act, 1964 amended to allow IDBI to raise
capital up to 49 per cent of its paid-up capital from the public and to induct private participation
in its Board of Directors. The policy of permitting foreign banks to open branches liberalised.
 Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital Issues
abolished.
 Securities and Exchange Board of India (SEBI) made a statutory body in February 1992 and
armed with necessary authority and powers for regulation and reform of the capital market.
 Convertibility clause is no longer obligatory in the case of assistance sanctioned by term lending
institutions.
 Floating interest rate on financial assistance (linked to interest rate on 364-day TBs) introduced
by all-India development banks.
 The Reserve Bank of India (Amendment) Act 1997 passed requiring all non-bank financial
companies (NBFCs) with net-owned funds of Rs. 25 lakh and more to register with the RBL
 Over the Counter Exchange of India (OTCEI) and the National Stock Exchange (NSE) with
nationwide stock trading and electronic display, clearing and settlement facilities established
and made operational.
 Twin objectives of “maintaining price stability” and “ensuring availability of adequate credit to
productive sectors of the economy to support growth” continue to govern the stance of monetary
policy, though the relative emphasis on these objectives has varied depending on the
importance of maintaining an appropriate balance.
 Reflecting the increasing development or financial market and greater liberalisation, use of
broad money as an intermediate target has been de-emphasised and a multiple indicator
approach has been adopted.
 Emphasis has been put on development of multiple instruments to transmit liquidity and interest
rate signals in the short-term m a flexible and bi-directional manner.
 Interlink age between various segments of the financial market including money, government
security and force markets instruments has increased.
 There has been a move from direct instruments (such as, administered interest rates, reserve
requirements, selective credit control) to indirect instruments (such as, open market operations,
purchase and repurchase of government securities) for the conduct of monetary policy.
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 Liquidity adjustment facility (LAF) has been introduced, which operates through repo and
reverse repo auctions, effectively provide a corridor for short-term interest rate. LAF has
emerged as the tool for both liquidity management and also as a signalling devise for interest
rate in the overnight market.
 Use of open market operations are used to deal with overall market liquidity situation especially
those emanating from capital flows.
 There has been introduction of Market Stabilisation Scheme (MSS) as an additional instrument
to deal with enduring capital inflows without affecting short-term liquidity management role of
LAF.
 Automatic monetisation has been discontinued through an agreement between the government
and the Reserve Bank.
 Introduction of delivery versus payment system and deepening of inter-bank repo market.
 Primary dealers are introduced in the government securities market to play the role of market
maker. Securities Contracts Regulation Act (SCRA), has been amended to create the regulatory
framework.
 Government securities market has been deepened by making the interest rates on such
securities market related.
 Auction of government securities has been introduced.
 A risk-free credible yield curve has been developed in the government securities market as a
benchmark for related markets.
 A pure inter-bank call money market has been developed.
 Non-bank participants are allowed to participate in other money market instruments.
 Automated screen-based trading in government securities has been introduced through
negotiated dealing system (NDS).
 Setting up of risk-free payments and system in government securities through Clearing
Corporation of India Limited (CCIL).
 There has been Phased introduction of real time gross settlement (RTGS) system.
 Forex market has been deepened and autonomy of authorised dealers has increased.
 Technical advisory committee on monetary policy with outside experts has been set up to
review macroeconomic and monetary developments and advise the Reserve Bank on the
Stance of Monetary Policy.
 A separate financial market department within the RBI has been created.
(ii) Banking Reforms
 Interest rates on deposits and advances of ail co-operative banks including urban co-operative
banks deregulated. Similarly interest rates on commercial bank loans above Rs. 2 lakh, and or,
domestic term deposits above two years, and Non Resident (External) Rupee Accounts [NRNR]
deposits decontrolled. The number of administered interest rates on commercial bank advances
reduced from more than 20 in 1989-90 to 2 in 1994-95. Banks allowed to set their own interest
rate on post-shipment export credit in rupees for over 90 days.
 The State Bank of India and other nationalised banks enabled to access the capital market for
debt and equity.
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 Prudential norms for income recognition, classification of assets and provisioning for bad debts
for commercial banks, including regional rural banks and financial institutions introduced. They
are required to adopt uniform and sound accounting practices in respect of these matters, and
the valuation of investments. Banks are required to mark to market the securities held by them.
 The Performance Obligations and Commitments (PQ & C) obtained by RBI from each bank;
they provide tor essential quantifiable performance parameters which lay emphasis on
increased but low-cost deposits, quality lending, generation of more income and profits,
compliance with priority ; sectors and export lending requirements, improvement in the quality of
investments, reduction in expenditure, and stepping up of staff productivity. The PO & C are
meant to ensure a high level of portfolio qualify so that problems such as heavy losses, low
profits, erosion of equity do not recur. The non-fulfilment of PO & C entail penalty in the form of
higher CRR/SLR, stoppage of RBI refinance facility, stoppage of further capital contribution by
the government, etc.
 Banks required to make their balance sheets fully transparent and make full disclosures in
keeping with International Accounts Standards Committee.
 Banks given greater freedom to open, shift, and swap branches as also to open extension
counters.
 The perceived constraints on banks such as prior credit authorisation, inventory and receivables
norms, obligatory' consortium lending and curbs in respect of project finance relaxed.
 The budgetary support extended for recapitalisation of weak public sector banks.
 Banking Ombudsman Scheme 1995 introduced to appoint 15 ombudsmen (by RBI) to look into
 Publand resolve customers' grievances in a quick and inexpensive manner. Most of the
recommendations of Goiporia Committee in connection with improving customer service by
banks implemented.
 Banks set free to fix their own foreign exchange open position limit subject to RBI approval.
 Loan system introduced for delivery of bank credit. Banks required to bifurcate the maximum
permissible bank finance into loan component (short-term working capital loan) and cash credit
component, and the policy of progressively increasing the share of the former introduced.
 Operational autonomy has been granted to public sector banks.
 Public ownership in public sector banks are reduced by allowing them to raise capital from
equity market up to 49 per cent of paid-up capital.
 Transparent norms have been issued for entry of Indian private sector, foreign and joint-venture
banks and insurance companies, permission for foreign investment in the financial sector in the
form of foreign direct investment (FDI) as well as portfolio investment, permission to banks to
diversify product portfolio and business activities.
 Roadmap has been developed for presence of foreign banks and guidelines an issued for
mergers and amalgamation of private sector banks and banks and NBFCs.
 Guidelines on ownership and governance in private sector banks are developed.
 Sharp reduction in pre-emption through reserve requirement, market determined pricing for gov-
184
ernment securities, disbanding of administered interest rates with a few exceptions and
enhanced transparency and disclosure norms to facilitate market discipline.
 Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short
term liquidity management, facilitation of improved payments and settlement mechanism.
 Significant advancement in dematerialisation and markets for securitised assets are being
developed.
 Introduction and phased implementation of international best practices and norms on risk-
weighted capital adequacy requirement, accounting, income recognition, provisioning and
exposure.
 Measures to strengthen risk management through recognition of different components of risk,
assignment of risk-weights to various asset classes, norms on connected lending, risk
concentration, application of marked-to-market principle for investment portfolio and limits on
deployment of hind in sensitive activities.
 ‘Know Your Customer’ and ‘Anti Money Laundering’ guidelines, roadmap Sat Basel II introduc-
tion of capital charge for market risk higher graded provisioning for NPAs, guidelines for owner-
ship and governance, securitisation and debt restructuring mechanisms norms etc.
 Setting up of lok adalats (people’s courts), debt recovery tribunals, asset recommuction
companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for
quicker recovery/restructuring.
 Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of
Securities Interest (SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor
rights.
 Setting up of Credit Information Bureau of India Limited (CIBIL) for information sharing on
defaulters as also other borrowers.
 Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for
facilitating payments and settlement system relating to fixed income securities and money
market instruments.
 Establishment of the board for financial supervision as the apex supervisory authority for
commercial banks, financial institutions and non-banking financial companies.
 Introduction of CAMELS supervisory rating system, move towards risk-based supervision, con-
solidated supervision of financial conglomerates, strengthening of offsite surveillance through
control returns.
 Recasting of the role of statutory auditors, increased internal control through strengthening of
internal audit.
 Strengthening corporate governance, enhanced due diligence on important shareholders, fit and
proper tests for directors.
 Setting up of INFINET as the communication backbone for the financial sector, introduction of
negotiated dealing system (NDS) foe screen-based trading in government securities and real
time gross settlement (RTGS) system.
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(iii) Primary and Secondary Stock Market Reforms
 A norm of five shareholders for every Rs. 1 lakh of fresh issues of capital and to shareholders
for every Rs 1 lakh of offer for sale prescribed as an initial and continuing listing requirement.
 The payment of any direct or indirect discounts or commissions to persons receiving firm
allotment prohibited.
 Debt issues not accompanied by an equity component permitted to be sold entirely by the book-
building process.
 Housing finance companies considered to be registered for issue purposes, provided they are
eligible for refinance from the National Housing Bank
 Issuers allowed to list debt securities on stock exchanges without their equity being listed.
 Mutual funds permitted to underwrite public issues.
 The stock exchanges required to disclose, carry forward position scrip-wise and broker-wise at
the beginning of airy forward session.
 A ceiling of Rs 10 crore imposed on stock market members doing business of financing carry
forward transactions.
 Depositories Act, 1996 passed to provide a legal framework for the establishment of
depositories to record ownership details in book entry form, and to facilitate dematerialisation of
securities. The Depositories Related Laws (Amendment), 1997 issued through an Ordinance
will now allow banks, mutual funds and IDBI to dematerialise their scrips.
 Stock lending scheme without attracting capital gains introduced. Under this scheme, short
sellers can borrow securities through an intermediary before making such sales.
 Stock exchanges asked to modify listing agreements in order to provide for the payment of
interest by companies to investors from the 30th day of the closure of public issue
 All stock exchanges required to institute the buy-in or auction process
 Stock exchanges asked to collect 100 per cent daily margin ; cr. the notional loss of a broker for
every scrip, to restrict gross traded value to 33.33 times the broker’s base minimum capital, and
to impose quarterly margins on the basis of concentration ratios.
 The stock exchanges are being modernised; many of them have introduced electronic trading
system; the Bombay Stock Exchange has started its on-line trading system, BOLT.
 The Bombay Stock Exchange and other exchanges with screen-based trading system allowed
to expand their trading terminals to locations where no stock exchange exists, and to others
subject to an understanding with the local stock exchange.
 Both short and long sales are required to be disclosed to the exchange at the end of each day,
and they are to be regulated through the imposition of margins.
 There are many other stock market reforms which have been introduced during the past five to
six years. The important ones among them are listed in Chapter 7.
 SEBI framed guidelines relating to disclosure of grading of the Initial public offer (IPO) by issuer
companies who may want to opt for grading of their IPOs by the rating agencies. If the issuer
186
companies opt for grading, then they are required to disclose the grades, including the
unaccepted ones, in the prospectus.
 SEBI issued directions for the issuing companies, relating to qualified institutions’ placement, to
pave the path for a fast and cost-effective way of raising resources from Indian securities
market.
 In order to further strengthen Know- Your Client (KYC) norms in the cash market and to
generate a reliable audit trail, PAN was made mandatory for all transactions in the cash market
with effect from January 01. 2007.
 PAN was made mandatory for all demat accounts, opened after April 01, 2006, pertaining to all
categories including minors, trusts, foreign corporate bothes, banks, corporates. FIIs, and NRIs
For demat accounts that existed prior to April 01, 2006, time for furnishing and verification of
PAN card details was extended upto December 31. 2006.
 Procedure for re-introduction of derivatives contracts and modified position limits were reviewed
by the Secondary Market Advisory Committee (SMAC). Further, based on a decision taken by
SEB1 board, Derivatives Market Review Committee was set up to carry out a comprehensive
review of developments and to suggest future directions for derivatives market in India.
 The investment limit for Fills to government securities (including treasury bills) was raised from ,
USD 2 billion to USD 2.6 billion by RBI. Tire list of eligible investment categories of Fills was
enlarged to allow more participation in Indian securities market
 SEBI Board approved the draft guidelines for real estate mutual funds (REMFs). REMF means
a scheme of a mutual fund which has investment, objectives to invest directly or indirectly in real
estate property and shall be governed by the provisions and guidelines under SEBI (Mutual
Funds) Regulations.
(iv) Government Securities Market Reforms
 A 364-day treasury bill (TB) replaced the 182-day TB in 1992-93, and it is being sold by
fortnightly auction since April 1992.
 Auction of 91-day TB commenced from January 1993.
 Maturity period for new issues of Central government securities shortened from 20 to 10 years
and that for state government securities from 15 to 16 years.
 Funding of Auction TBs into fixed coupon dated securities at the option of holders introduced
since April 19, 1993.
 Six new instruments introduced: (a) zero coupon bonds on 18.1.94, (b) tap stock on 29.7.94,
(c) partly-paid government stock on 15.11.94, (d) an instrument combining the features of tap
and partly-paid stocks on 11-9-95, (e) floating rate bonds on 29.9.95, and (f) capital indexed
bonds in 1997.
 State governments and provident funds allowed to participate in 9i-day TB auctions on a non-
competitive basis from August 1994.
 A scheme for auction of government securities from RBI’s own portfolio as a part of its open
market operations announced to March 1995.
187
 The institution of primary dealers to government securities market established and guidelines for
them issued in March 1995.
 A system of Delivery vs. Payment (DVP) in Subsidiary General Ledger (SGL) transactions intro-
duced in Bombay in July 1995.
 Reverse repo facility with RBI to government dated securities extended to Discount and Finance
House of India (DFHI) and Securities Trading Corporation of India (STCI).
 Administered interest rates on government securities were replaced by an auction system far
price discovery.
 Automatic monetisation of fiscal deficit through toe issue of ad hoc treasury bills was phased
out.
 Primary dealers (PD) were introduced as market makers in the government securities market.
 For ensuring transparency in the trading of government securities, delivery versus payment
(DvP) settlement system was introduced.
 Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment.
 Subsequently, the liquidity adjustment facility (LAF) was introduced. LAF operates through repo
and reverse repo auctions and provide a corridor for short-term interest rate. LAF has emerged
as the tool for both liquidity management and also signalling device for interest rates in the
overnight market. The Second LAF (SLAF) was introduced in November 2005.
 Market stabilisation scheme (MSS) has been introduced, which has expanded the instruments
available to the Reserve Bank for managing the enduring surplus liquidity in the system.
 Effective April 1, 2006, RBI has withdrawn from participating in primary market auctions of
government paper.
 Banks have been permitted to undertake primary dealer business while primary dealers are
being allowed to diversify their business.
 Short sales in government securities is being permitted in a calibrated manner while guidelines
for "when issued’ market have been issued recently.
 91-day treasury bill was introduced for managing liquidity and benchmarking. Zero coupon
bonds, floating rate Bonds, capital indexed bonds were issued and exchange traded interest
rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced.
 Outright sale of Central Government dated security that are not owned have been permitted.
subject to the same being covered by outright purchase from the secondary market within the
same trading day subject to certain conditions.
 Repo status has been granted to State Government securities in order to improve secondary
market liquidity.
 Foreign Institutional Investors (Fills) were allowed to invest in government securities subject to
certain limits.
 Introduction of automated screen-based trading in government securities through negotiated
dealing system (NDS).
188
 Setting up of risk-free payments and settlement system in government securities through
Clearing Corporation of India Limited (CCIL).
 Phased introduction of real lime gross settlement system (RTGS).
 Introduction of trading in government securities on stock exchanges for promoting, retailing in
such securities, permitting non-banks to participate in repo market.
 Recent measures include introduction of NDS-OM and T+1 settlement norms.
(v) External Financial Market Reforms
 Flexible exchange rate system introduced and exchange controls largely dismantled.
 Foreign Institutional Investors (Fils) allowed access to Indian capital market on registration with
SEBI. Fils permitted to invest up to 10 per cent in equity of any company, to invest in unlisted
companies, to set up pure (100 per cent) debt funds, and to invest in government securities.
Foreign endowment funds, university funds, foundations and charitable trusts/societies are
allowed to register as Fils.
 Indian companies permitted to access international capital markets through various instruments
including euro-equity issues.
 The Union Budget 1997-98 proposed the replacement of Foreign Exchange Regulation Act
(FERAV 1972 by a Foreign Exchange Management Act (FEMA) to facilitate easy capital flows.
 Rupee made convertible on current account and a considerable progress made in introducing
capital account convertibility.
 The rate of long-term capital gains tax on portfolio investments by NRIs reduced from 20 per
cent to 10 per cent and brought on par with the rate for Fils.
 NRIs, OCBs Fils permitted to invest up to 24 per cent in equities of Indian companies engaged
in all activities except those of agriculture and plantation.
 In case of medium and long-term external commercial borrowings (ECBs), on lending or the
proceeds of development finance institutions to different borrowers at different immaturities
permuted. All corporates, institutions, railways, telecommunications permitted to utilise the
foreign currency proceeds upto US $3 million for incurring roper expenditure with a minimum
simple maturity of 3 years. Telecommunications and oil exploration; and development
(excluding refining companies permitted to raise ECBs at a minimum of 5 years average
maturity instead of 7 years even for borrowings exceeding US $15 million equivalent Exporters
permitted to raise ECB for wasting project-related rupee expenditure upto the equivalent of US
$15 million, or the average; annual exports of the previous three years, whichever is fewer. All
infrastructure and greenfield projects permitted to avail of ECBs to the extent of 35 precent of
project cost (50 per cent for telecommunication sector).
 Companies permitted to retain euro-issue proceeds as foreign currency deposits with banks and
public financial institutions in India. Further, companies permitted to remit funds into India in
anticipation of the use of funds for general corporate restructuring and working capital needs.
Euro issues are now treated as direct foreign investment in the issuing companies. Restrictions
on the number of issues to be floated by a company or group of companies in a given year
moved. Banks, financial institutions, NBFCs registered with the RBI made eligible for GDR
issue, without reference to the end-use.
189
 RBI made a single-window agency for receipt and disposal of proposals for overseas
investments by Indian companies.
 The Foreign Investment Promotion Board (EIPB) reconstituted and Foreign Investment
Promotion Council (FIPC) set up to promote foreign direct investment in India.
 Evolution of exchange rate regime from a single-currency change rate system to fixing the
value of rupee against a basket of currencies and further to market-determined floating
exchange rate regime.
 Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII
of the Articles of Agreement of the IMF. De Facto full capital account convertibility for non
residents and calibrated liberalisation of transactions undertaken for capital account purposes in
the case of residents
 Development of rupee-foreign currency swaps market.
 Introduction of additional hedging instruments, such as, foreign currency-rupee options.
 Authorised dealers permitted to use innovative products like cross-currency options; interest
rate swaps (IRS) and currency swaps, caps/coilars and forward rate agreements (FRAs) in the
international forex market.
 Authorised dealers permitted to initiate trading positions, borrow and invest in overseas; market
subject to certain specifications and ratification by respective Banks’ Boards. Banks are also
permitted to fix interest rates on non-resident deposits. subject to certain specifications, use
derivative products for asset-liability management and fix overnight open position limits and gap
limits in the foreign exchange market, subject to ratification by RBI.
 Permission to various participants in foe foreign exchange market, including exporters. Indians
investing abroad. Fils, to avail forward cover and enter into swap transactions without any limit
subject to genuine underlying exposure.
 Fils and NRIs permitted to trade in exchange-traded derivative contracts subject to certain
conditions.
 Foreign exchange earners permitted to maintain foreign currency accounts. Residents are
permitted to open such accounts within the general limit of US $ 25.000 per year.

1. What do you mean by ‘security Market’?
2. Define ‘SEBI’.
3. What is ‘Financial Reforms’?
19.5 SUMMARY
SEBI plays an important role in regulating all the players operating in the Indian capital markets. It
attempts to protect the interest of investors and aims at developing the capital markets by enforcing
various rules and regulations. SEBI is a statutory regulatory body established on the 12th of April, 1992.
190
It monitors and regulates the Indian capital and securities market while ensuring to protect the interests
of the investors formulating regulations and guidelines to be adhered to. The head office of SEBI is in
Bandra Kurla Complex, Mumbai. SEBI has a corporate framework comprising various departments
each managed by a department head. There are about 20+ departments under SEBI. Some of these
departments are corporation finance, economic and policy analysis, debt and hybrid securities,
enforcement, human resources, investment management, commodity derivatives market regulation,
legal affairs, and more.
19.6 GLOSSARY
include interest.
Debt security: Debt security refers to money borrowed that must be repaid that has a fixed amount, a
maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the
original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper.
Security: Security is any proof of ownership or debt that has been assigned a value and may be sold.
For the holder, a security represents an investment as an owner, creditor or rights to ownership on
which the person hopes to gain profit. Examples are stocks, bonds and options.
Securities Exchange Board of India (SEBI): Securities Exchange Board of India (SEBI) is a
regulatory authority, for the investment market in India. Its main objective is to protect the interests of
the investors in the new issue market and stock exchange and to regulate, develop and improve the
quality of the securities market in India.
Security Value: Security Value means the monetary value placed on security by a lender in
determining the extent to which it can make loans against such security.
1. What are the guidelines issued by securities exchange board of India with regard to the
security market?
2. Discuss the need for financial reforms in India.
3. Describe the major reforms in financial sector after 1991.
191
Hall of India,
192
Chapter-20
Financial Regulations and Reforms- Capital Market
STRUCTURE
20.1 Regulation of the Capital Market
20.2 The Securities and Exchange Board of India (SEBI)
20.3 Powers and Functions of the SEBI
20.4 Regulations and Guidelines Issued by the SEBI
20.6 Summary
20.7 Glossary
4. Explain the regulation of the capital market.
5. The Securities and Exchange Board of India (SEBI)
6. Powers and Functions of the SEBI
20.1 REGULATION OF THE CAPITAL MARKET
The securities market is regulated by various agencies such as the Department of Economics Affairs
(DEA), the Department of Company Affairs (DCA), the Reserve Bank of India (RBI), and the SEBI. The
activities of these agencies are coordinated by a high level committee on capital and financial markets.
The High Level Co-ordination Committee for Financial Markets (HLCCFM) discusses various policy
level issues which require inter-regulatory coordination between the regulators in the financial market,
viz., RBI, SEBI, Insurance Regulatory and Development Authority (IRDA), and Pension Fund
Regulatory and Development Authority (PFRDA). The Committee is chaired by the Governor, RBI,
Secretary-Ministry of Finance, Chairman—SEBI, Chairman—IRDA and Chairman—PFRDA are
members of the committee.
The capital market, i.e., the market for equity and debt securities is regulated by the Securities and
Exchange Board of India (SEBI). The SEBI has full autonomy and authority to regulate and develop the
capital market. The government has framed rules under the Securities Contracts (Regulation) Act
(SCRA). The SEBI Act and the Depositories Act. The SEBI has framed regulations under the SEBI Act
and the Depositories Act for registration and regulation of all market intermediaries, for prevention of
193
unfair trade practices, and insider trading. Under the acts, the Government and the SF.BI issue
notifications, guidelines, and circulars which need to be complied with by market participants. All the
rules and regulations are administered by the SEBI. The powers in respect of the contracts for sale and
purchase of government securities, money market securities and ready forward contracts in debt
securities are exercised concurrently by the RBI.
The four main legislations governing the capital market are as follows:
 The SEBI Act, 1992 which establishes the SEBI with four-fold objectives of protection of the
interests of investors in securities, development of the securities market, regulation of the
securities market and matters connected therewith and incidental thereto.
 The Companies Act, 1956 which deals with issue, allotment and transfer of securities,
disclosures to be made in public issues^ underwriting, rights and bonus issues and payment of
interest and dividends.
 The Securities Contracts (Regulation) Act, 1956 which provides for regulations of .securities
trading and the management of stock exchanges.
 The Depositories Act 1996 which provides for establishment of depositories tor electronic
maintenance and transfer of ownership of demat securities.
20.2 THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
With the announcement of the reforms package in 1991, the volume of business in both the primary
and secondary segments of the capital market increased. A multicrore securities scam rocked the
Indian financial system in 1992. The then existing regulatory framework was found .to be fragmented
and inadequate and hence a need for an autonomous, statutory, and integrated organization to ensure
the smooth functioning of capital market was felt. To fulfill this need, the Securities and Exchange
Board of India (SEBI), which was already in existence since April 1988, was conferred statutory powers
to regulate the capital market.
Objectives of SEBI
 Protect the interest of the investor in securities.
 Promote the development of securities market.
 Regulating the securities market
The SEBI got legal teeth through an ordnance issued on January 30, 1992. The ordinance conferred
wide-ranging powers on the SEBI, including the authority to prohibit ‘insider trading’ and ‘regulate sub-
stantial acquisition of shares’ and ‘take over of business’. With this, the Capital Issues (Control) Act was
repealed and the office of the Controller of Capital Issues (CCl) was abolished in 1992. The SEBI Was
set up with statutory powers on February 21, 1992. The objectives defined by the ordinance for the
board were: (i) investor protection; and (ii) promotion and development of the capita! market while
simultaneously regulating the functioning of the securities market. The function of market development
includes containing risk, broad basing, maintaining market integrity and promoting long-term
investment.
The ordinance was repealed by the SEBI Act on April 4, 1992. The Securities and Exchange Board of
India Act, 1992, provides for the establishment of the board to: protect the interest of the investors in
securities, promote the development of and regulate the securities market and matters connected
therewith or incidental to Certain powers under certain sections of the Securities Contracts (Regulation)
Act and the Companies Act were delegated to the SEBI. The regulatory powers of the SEBI were
increased through the Securities Laws (Amendment) Ordinance of January 1995, which was
subsequently replaced by an act or parliament. The SEBI works under the Ministry of Finance. It has
194
been given a status of an independent organization regulating each and every aspect of the securities
market backed by a statute and accountable to the parliament
Management of the SEBI Under the SEBI Act, 1992
Section 4 of the act lays down the constitution of the management of the SEBI. The board of members
of the SEBI shall consist of a chairman, two members from amongst the officials of the ministries of the
central government dealing with finance and law; one member from amongst the officials of the RBI
constituted under Section 3 of the RBI Act, 1934; two other members to be appointed by the central
government, who shall be professionals and, inter alia, have experience or special knowledge relating
to the securities market.
Figure 11.1 provides an overview of regulatory structure of financial institutions and markets.
REGULATORS
Reserve Bank Insurance Regulatory Securities and State SIDBI NABRD

of India and Development Exchange Board of Governments
Authority India
Urban Co-operative Rural

Banks Co-operative
Insurance Capital Market,
Banks
Companies: Capital market
Regional
Public Sector Intermediaries Mutual
Rural Banks
and Private Funds, Including UTI State Financial
Sector Life and II, Venture Capital Corporations State
Non-life Fits, Corporate Bond Industrial Development
Market, Comedies Corporate
Market
Commercial Urban State and All India Non-banking Government Foreign

Banks Co-operative District Financial Finance Securities Exchange
Banks Central Institutions: Companies Market and Market
Cooperative IFCI, IIBI, Cooperative Money
Banks Exix Bank Including Market
TFCI,SIDBI, Primary
NABARD. Dealers,
and. NHB MFIs
20.3 Powers and Functions of the SEBI

Section 11 (1) of the act casts upon the SEBI the duty to protect the interests of investors in securities
and to promote the development of and to regulate the securities market through appropriate
measures. These measures provide for the following:
 Regulating the business in stock exchanges and any other securities markets;
195
 Registering and regulating the working of stock brokers, sub—brokers, share transfer agents,
bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers,
underwriters portfolio managers, investment advisers and such other intermediaries who may
be associated with securities markets in any manner,
 Registering and regulating the working of the depositories, participants, custodians of securities,
foreign institutional investors, credit rating agencies and such other intermediaries as the Board
may, by notification, specify in this behalf;
 Registering and regulating the working of venture capital funds and collective investment
schemes, including mutual funds:
 Promoting and regulating self-regulatory organisations,
 Prohibiting fraudulent and unfair trade practices relating to securities markets;
 Promoting investors’ education and training of intermediaries of securities markets;
 Prohibiting insider trading in securities;
 Regulating substantial acquisition of shares and takeover of companies;
 Calling for information from, undertaking inspection, conducting inquiries and audits of the stock
exchanges, mutual funds, other persons .associated with the securities market, intermediaries
and self-regulatory organisations in the securities market;
 Calling for information and records from any person including any bank or any other
authority or board or corporation established or constituted by or under any central, or state act
which, in the. opinion of the Board, shall be relevant to any investigation or inquiry by the Board
in respect of any transaction-in securities; -
 Calling for information from, or furnishing information to, other authorities, whether in
India or outside India, having functions similar to those of the Board, in the matters relating to
the prevention or detection of violations in respect of securities laws, subject to the provisions of
other laws for the time being in force in this regard.
 Provided that the Board, for the purpose of furnishing any information to any authority outside
India, may enter into an arrangement or agreement or understanding with such authority with
the prior approval of the central government;
 Performing such functions and exercising such powers under the provisions of the
Securities Contracts ( Regulation) Act, 1956 (42 of 1956), as may be delegated to it by the
central government;
 Levying fees or other charges for carrying out the purposes of this section;
 Conducting research for the above purposes;
 Calling from or furnishing to any such agencies, as may be specified by the Board, such
information as may be considered necessary by it for the efficient discharge of its functions.
 Performing such other functions as may be prescribed.
The SEBI exercises powers under Sections 11 and 11B of the SEBI Act, 1992, and 17 other regula-
tions. The SEBI. with its powers, can carry out the following functions:
 Ask any intermediary or market participant tor information.
 Inspect books of depository participants, issuers or beneficiary owners.
196
 Suspend or cancel a certificate of registration granted to a depository participant or issuer.
 Request the RBI to inspect books of a banker to an issue. And suspend or cancel the
registration of the banker to an issue.
 Suspend or cancel certification issued to the custodian of securities.
 Suspend or cancel registration issued to foreign institutional investors.
 Investigate and inspect books of accounts and records of insiders.
 Investigate an acquirer, a seller, or merchant banker for violating takeover rules.
 Suspend or cancel the registration of a merchant banker.
 Investigate the affairs of mutual funds, their trustees and asset management companies.
 Investigate any person dealing in securities on complaint of contravention of trading regulation.
 Suspend or cancel the registration of errant portfolio managers;
 Cancel the certification of registrars and share transfer agents.
 Cancel the certification of brokers who fail to furnish information of transactions in securities or'
who furnish false information.
20.4 REGULATIONS AND GUIDELINES ISSUED BY THE SEBI
Regulations
 SEBI (Stock Brokers and Sub Brokers) Regulations, 1992.
 Guidance note to SEBI (Prohibition of Insider Trading) Regulations, 2015.
 SEBI (Merchant Bankers) Regulations, 1992.
 SEBI (Portfolio Managers) regulations, 1993.
 SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993.
 SEBI (Underwriters) Regulations, 1993.
 SEBI (Debenture Trustees) Regulations, 1993.
 SEBI (Bankers to an Issue) Regulations, 1994.
 SEBI (Foreign Portfolio Investors) Regulations, 2014.
 SEBI (Custodian of Securities) Regulations 1996.
 SEBI (Depositories and Participants) Regulations, 1996.
 SEBI (Mutual Foods) Regulations, 1996.
 SEBI (Substantial Acquisition-of Shares and Takeovers) Regulations, 1997.
 SEBI (Buyback of Securities) Regulations, 1998.
 SEBI (Credit Rating Agencies) Regulations, 1999.
 SEBI (Collective Investment Schemes) Regulations, 1999.
 SEBI (Foreign Venture Capital Investors) Regulations, 2000.
 SEBI (Procedure for Board Meeting) Regulations, 2001.
197
 SEBI (Issue of Sweat Equity) regulations. 2002.
With a view to making markets more competitive and compliant, the SEBI brought in the following new
regulations:
 SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market)
Regulations, 2003.
 SEBI (Ombudsman) Regulations, 2003.
 SEBI (Central Database for Market Participants) Regulations, 2003.
 SEBI (Self Regulatory Organizations) Regulations, 2004.
 SEBI (Issue and Listing of Debt Securities by Municipalities) Regulations, 2015.
 SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.
 SEBI (Procedure for Search and Seizure) Repeal Regulations, 2015.
 SEBI (Infrastructure Investment Trusts) Regulations, 2014.
 SEBI (Real Estate Investment Trusts) Regulations, 2014.
 SEBI (Research Analysts) Regulations, 2014.
 SEBI (Settlement of Administrative and Civil Proceedings) Regulations, 2014.
 SEBI (Share Based Employee Benefits) Regulations. 2014.
 SEBI (Investment Advisers) Regulations, 2013.
 SEBI (Issue And Listing Of Non-Convertible Redeemable Preference Shares) Regulations,
2013,
 SEBI (Alternative Investment Funds) Regulations, 2012.
 Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations,
2012.
 SEBI {KYC (Know Your Chent) Registration Agency} Regulations, 2011.
 SEBI (Delisting of Equity Shares) Regulations, 2009.
 SEBI (Investor Protection and Education Fund) Regulations, 2009.
 SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.
 *SEBI (Intermediaries) Regulations, 2008.
 SEBI (Issue and Listing of Debt Securities) Regulations, 2008.
 SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008.
 SEBI (Certification of Associated Persons in the Securities Markets) Regulations, 2007.
 SEBI (Regulator) Fee on Stock Exchanges) Regulations, 2006.
As a measure of regulatory productiveness, the existing regulations are frequently reviewed and
amendments notified. Regulations are superior to guidelines as the former have a stronger legal force.
Regulations are passed by the SEBI, tabled in the Parliament and are subject to explicit penalties and
remedial actions.
198
Guidelines
• Guidelines for opening of trading terminals abroad.
• Guidelines for Anti-money laundering measures.
• SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines 1999.
• Framework for recognition and supervision of stock exchanges/platforms of stock exchanges for
small and medium enterprises.
• SEBI (Aid for Legal Proceedings) Guidelines, 2009.
• SEBI (International Financial Services Centres) Guidelines, 2015.
The orders of the SEBI under the securities laws are appealable before a securities appellate tribunal.
(SAT) the body that hears appeals against the SEBI’s orders. The orders of the SAT are appealable
before the high court or the Supreme Court.
An order passed by the SEBI against market participants such as brokers, custodians, depositories, or
mutual funds can be challenged before the SAT. The market participants can move the high court or
the Supreme Court if they are not happy with the SAT order. The entire process can take years before
a case is finally resolved. There is a provision for out-of-court settlements in the SEBI guidelines. The
out-of-court settlement system attempts to resolve administrative, civil, and criminal disputes with the
consent of the involved parties and the SEBI. This system saves time, efforts and money of both the
involved parties and the regulator as they do not have to go through long range of legal proceedings.
Under SEBI guidelines,-the proposal to settle a dispute is first placed before a high-powered advisory
committee of the regulator. If the proposal gets the committee’s approval, the terms of settlement are
drafted and orders are passed by a panel of tub whole-time directors of the SEBI after the cause and
nature of violation is established. The panel normally imposes penalty on the offenders and can also
temporarily suspend a market participant. If a case is pending before the SAT, the committee files the
terms of settlement before the tribunal. It is mandatory for the accused to give an undertaking to the
regulator dial it will refrain from taking any legal action against it. If the accused violates any condition of
the settlement, the regulator can revive its legal action.
4. What do you mean by ‘Capital Market’?
5. Define ‘SEBI’.
6. What is ‘objectives of SEBI’?
20.6 SUMMARY
SEBI plays an important role in regulating all the players operating in the Indian capital markets. It
attempts to protect the interest of investors and aims at developing the capital markets by enforcing
various rules and regulations. SEBI is a statutory regulatory body established on the 12th of April, 1992.
199
It monitors and regulates the Indian capital and securities market while ensuring to protect the interests
of the investors formulating regulations and guidelines to be adhered to. The head office of SEBI is in
Bandra Kurla Complex, Mumbai. SEBI has a corporate framework comprising various departments
each managed by a department head. There are about 20+ departments under SEBI. Some of these
departments are corporation finance, economic and policy analysis, debt and hybrid securities,
enforcement, human resources, investment management, commodity derivatives market regulation,
legal affairs, and more.
20.7 GLOSSARY
include interest.
Debt security: Debt security refers to money borrowed that must be repaid that has a fixed amount, a
maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the
original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper.
Security: Security is any proof of ownership or debt that has been assigned a value and may be sold.
For the holder, a security represents an investment as an owner, creditor or rights to ownership on
which the person hopes to gain profit. Examples are stocks, bonds and options.
Securities Exchange Board of India (SEBI): Securities Exchange Board of India (SEBI) is a
regulatory authority, for the investment market in India. Its main objective is to protect the interests of
the investors in the new issue market and stock exchange and to regulate, develop and improve the
quality of the securities market in India.
Security Value: Security Value means the monetary value placed on security by a lender in
determining the extent to which it can make loans against such security.
1. What are the guidelines issued by securities exchange board of India with regard to the capital
market?
2. Discuss the Powers and Functions of the SEBI.
3. Describe the regulations and guidelines issued by the sebi?
200
Hall of India,
---///---
FINANCIAL INSTITUTION AND MARKET

Assignment:
Attempt 75% of the assignment
1. What do you understand by the financial system? Discuss its functions?
2. Explain the working of stock market in India.
3. What is commercial banking? Discuss the growth and structure of banking?
4. Discuss the SEBI's regulatory provisions for Mutual Funds.
201
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M.COM.

III SEMESTER COURSE- MC 303

Dr. Suresh Sharma

International Centre for Distance Education and Open Learning

Chapter-1. Indian financial system 5

Chapter-2. Indian financial system 15

Chapter-3. Money markets 24

Chapter-4. Capital market 30

Chapter-5. Money market instruments 40

Chapter-6. Government securities market 48

Chapter-7. Industrial securities market 55

Chapter-8. National depository securities in india 67

Chapter-9. Role of sebi and nsdl 75

Chapter-10. Commercial banking 87

Chapter-11. Merchant banking 100

Chapter-12. Regulation for merchant banking 114

Chapter-13. Reserve banking of india: central banking 123

Chapter-14. International and multinational banking 131

Chapter-15. Non- banking institutions 139

Chapter-16. Mutual fund in india – an overview 149

Chapter-17. Latest mutual fund schemes in india – an overview 160

Chapter-18. Universal banking 171

Chapter-19. Financial regulations and reforms- securities market 179

Chapter-20. Financial regulations and reforms- capital market 193

1.3 FINANCIAL MARKETS

Fig.3 Relationship between financial system and economic development

2.3 FOLLOWINGS ARE THE IMPORTANT FUNCTIONS OF INDI FUNCTIONS OF THE

2. Resource Allocation: It allocates financial resources to various sectors of the economy,

3. Payment System: It provides a payment infrastructure for businesses and individuals to

6. Liquidity Provision: Financial institutions offer liquidity to depositors and investors,

7. Capital Formation: It facilitates capital formation by encouraging savings and

8. Maturity Transformation: Banks convert short-term deposits into long-term loans,

9. Information Aggregation: Financial markets gather and disseminate information about

2.4 PROBLEM AREAS IN THE FINANCIAL SYSTEM

3. Shadow Banking: Shadow banking refers to non-bank financial intermediaries that

8. Cybersecurity Threats: The financial system is vulnerable to cyberattacks, which can

9. Regulatory Compliance: Navigating a complex web of financial regulations can be

2.5 NATURE OF FINANCIAL SYSTEM

2.7 self Assessment Exercise

2. What are the important functions of the financial system

3. Discuss in detail about the problem areas in the financial system

4. Define financial market and nature of financial system

2.12 Answers to Terminal Questions

4.3 Capital Markets Functions

6. Efficient Allocation of Capital

7. Wealth Creation and Distribution

8. Corporate Governance and Transparency

 In case of liquidation of company, preference shareholders get to redeem their shares

The yield on bonds are expressed commonly in two forms:

Debt markets include:

2. Secondary markets , in which existing or second hand instruments are traded.

 First Green Bond was issued by World Bank in 2007.

 The first green bond in India was issued by Yes Bank in

 Banks have also been permitted to issue green masala bonds.

 It is a Climate Bonds Initiative certified green bond.

 As of now, it is being traded only at the London Stock exchange.

4.6 Government Securities

 An option can be a 'call' option or a 'put' option.

7. 6 as percentage of paid-up capital of non- 65 53 75 ---

Source: Bombay Stock Exchange, Stock Exchange Directory.

9.0 LEARNING OBJECTIVES

9.2 FUNCTIONS OF SEBI BOARD:

4. Regulation of Market Intermediaries: SEBI regulates various intermediaries in the