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Financial System

The term Financial Environment refers to the financial sector or financial system of a country. It comprises various financial institutions, instruments, policies and services concerning the financial sector.

Meaning of Financial System  The financial system of a country means a set of financial arrangements by which the savings in the economy are mobilized for investment in productive assets.
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The financial system deals with all types of finance, agricultural, industrial, developmental and governmental finance. The suppliers and users of funds are a part of the financial system. Thus, the financial system is concerned with borrowing and lending of funds or the demand and supply of funds of all individuals, institutions, companies and the Government.

Constituents of the Financial System
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Financial Markets: Provide facilities for raising long term and short term funds. Financial Institutions: Serve as intermediaries between borrowers and lenders of funds. Financial Instruments: Are used to raise funds in the financial markets Financial Services: Services offered by various financial institutions.

Financial Markets:  Financial Markets refer to the market for borrowing and lending of funds. They provide facilities for buying and selling of financial claims.

Capital Market: A capital market may be defined as the market for borrowing and lending of long term funds. It is concerned with the raising of capital for the purpose of investment. Capital market is a market where securities issued by firms (ie shares, bonds and debentures) can be bought and sold freely.
The demand for capital comes from business firms, agriculture and Government while the supply of capital is provided by individual savers, corporate savings, specialized financial institutions.

Capital Markets (contd)
The capital market is classified into:  Primary Market: The primary market or the new issues market refers to the raising of new capital by the issue of new shares, debentures and bonds.

By prospectus: It is an invitation to the general public for subscribing to the capital. By offer for sale: This method is almost similar to the prospectus method except with a difference that shares are taken up by a third party in bulk. Later a statement like prospectus is issued for sale to the public. Thus the company has already received the money and any premium from the public goes to the third party. By private placing: Shares are sold to individuals or institutions directly by making a private appeal to them. By offering rights issue: Under a rights issue, the shareholders have the right to a certain number of shares in proportion to the shares held by them.

Secondary Market: The secondary market or the stock exchange is the market for old or already issued securities. It comprises of the stock market in which industrial securities are bought and sold. The capital market serves a very useful purpose by pooling the capital resources of the country and making them available to the enterprising investors. Well developed capital markets augment resources by attracting and lending funds on a global scale.

Money Markets

Money market refers to the market for lending and borrowing of short term funds. It is the market in which the short term surplus investible funds of banks and other financial institutions are demanded by borrowers. A well organized money market is the basis of an effective monetary policy. The money market consists of the Organised and Unorganised Sector. The rates of interest differ between the two markets. Organised Sector: Comprises the Reserve Bank of India, public and private sector banks, foreign banks, finance corporations, mutual funds etc. This consists of the submarket such as the commercial bill market and the interbank call money market. The RBI is the Apex organization in the Indian money market  The Unorganised Sector consist of indigenous bankers and money lenders who pursue the banking business on traditional lines and non banking financial companies such as chit funds, nidhis and finance companies. The unorganized sector is by and large outside the control of the Central Bank and is characterized by lack of uniformity and formality in their business dealings.

Functions of Money Market

By providing various kinds of credit instruments suitable and attractive for different sections, a money market augments the supply of funds Efficient working of a money market helps to minimize the stringencies in the money market due to the seasonal variations in the flow of and demand for funds. A money market by augmenting the supply of funds and making them readily available to the legitimate borrowers, helps in making funds available at cheaper rates. A well organized money market, through quick transfer of funds, helps to avoid regional imbalances in availability of funds and enhances the liquidity available. A money market by providing profitable investment opportunities for short term surplus funds, helps to enhance the profit of FIs

Constituents of the Indian Money Market

Call money Market: The call money market consists of overnight and money at short notice for period upto 14 days. It is meant to balance the short term needs of banks, most important of these being to meet the CRR requirements. This is the most sensitive part of the financial system and any change in flow of funds is clearly reflected in it. There is currently no ceiling on the call money rate. Treasury Bill market : This market deals in treasury bills and in India are short term liability of the Central Government. These bills are issued to meet deficits which a Government faces due to its excess of expenditure over revenue. Treasury bills are

promissory notes issued by the Central Government to raise short term funds to bridge short term mismatches between receipts and expenditures. The treasury bill market in India is
quite underdeveloped and RBI is the major holder of these bills as it is under an obligation to purchase all treasury bills being offered by the Government. RBI is also required to rediscount treasury bills that are presented to it by banks and others.

Constituents of the Indian Money Market

Repo Market: Repo market helps in collateralised short term borrowing and lending through sale / purchase operations in debt instruments. Under a repo transaction, securities are sold by their holder to an investor with an agreement to repurchase at a predetermined rate and date. Under reverse repo transaction, securities are purchased with a simultaneous commitment to resell at a predetermined interest and rate. Repos help to maintain liquidity conditions in the short term. Certificate of Deposit market: A certificate of deposit is a certificate issued by a bank to depositors of funds that remain on deposit at the bank for a specified time period between fifteen days to one year. They are similar to traditional term deposits but are negotiable and tradeable in the short term money market. CDs are issued at discount to face value and the discount rate is market determined. They are freely transferable by endorsement and delivery, however as banks pay a high interest rate on CDs, holders of CDs prefer to hold them till maturity.

Constituents of the Indian Money Market

Commercial Paper: Commercial paper is a short term instrument of raising funds by corporates and Institutional investors. It is essentially a sort of unsecured promissory note sold by the investor. The maturity of the instrument is flexible and borrowers and lenders adopt a maturity to a CP as per their needs. Highly rated corporates which can obtain funds at a cost lower than the cost of borrowing from banks are generally keen on issuing CPs. CP can be issued for maturities between a minimum of 15 days and a maximum up to one year from the date of issue. CP will be issued at a discount to face value as may be determined by the issuer
Money market mutual funds: Banks, public and private financial institutions can set up MMMFs and can issue untis to corporate enterprises and others. Resources mobilised by MMMFs can be invested in call money market, CDs, CPs, commercial bill etc.The MMFS have been brought under the purview of SEBI.

Money Market Reforms

RBI deregulated money market interest rates in 1989 to make interest rates flexible and lend transparency to transaction. Earlier the call money was subject to interest rate ceiling of 10%, rediscounting of commercial bills 12.54% etc. Over the past fifteen years four major money market instruments have been introduced – 182 days treasury bills, 364 days treasury bills, CDs and CPs. Introducing money market mutual funds in 1991 which provide an additional short term avenue to investors and bring money market instruments within the reach of individuals

Money Market Reforms (contd…)

Developing call money market: Earlier only UTI and LIC were allowed to operate as lenders in the call money market. As of now, broadly speaking banks are operating as lenders and borrowers while a number of non bank financial institutions and mutual funds are operating only as lenders. Setting the Discount and Finance House of India (DFHI): The DFHI was set up in 1988 and its major function is to bring into the fold of the Indian money market the financial system comprising of scheduled commercial banks, foreign and co-operative banks so that their short term surpluses and deficits are equilibrated at market related prices. Sector specific refinance facilities: Refinance is used by central banks to meet liquidity shortage in the system, to control monetary and credit conditions and direct credit to selective sectors. Currently there are two refinance schemes – export credit refinance and general refinance. With the emergence of the bank rate as the signaling rate of monetary policy stance, the RBIs policy has been to keep the refinance rate linked to the bank rate.

Foreign Exchange Market: In this market foreign currency is made available. It comprises of the RBI, authorized dealers in foreign currency, money changers, foreign banks, exporters and importers. The Indian forex market has grown in depth in the 1990s. Government Securities Market: Government requires considerable amount of funds to invest in economic and social projects. The market in which Government securities are purchased and sold is known as the Government securities market. Treasury bills are issued for raising short term funds while bonds are issued for long term funds. Market for Government and semi government securities is known as the Gilt edged market. Gilt edged market is relatively risk free and returns are guaranteed, RBI plays a dominant role and its position is that of a monopolist. Government securities are the most liquid debt instruments.

Financial Market

Capital Market

Money Market Organised Market Unorganised Market

Foreign Exchange Market

Government Securities Market

Primary Market Secondary Market


Treasury Bills Bonds

Authorised Dealers

Foreign Banks Importers and Exporters

Financial Instruments:
Primary or Direct Securities: These are financial claims
against real sector units. They are created by real sector units as ultimate borrowers for raising funds. Eg: Equities, bills of exchange, bonds etc.

Secondary or Indirect Securities: These are financial
claims issued by financial institutions for raising funds from the public. Eg: Currency, bank deposits, insurance policies, government securities etc. Bank drafts, cheques, dividend warrants, treasury bills, railway receipts, promissory notes, credit and debit cards, letters of credit, travelers cheques etc. are also examples of financial instruments. Some of these instruments are described below

Promissory Note: An instrument in writing containing an unconditional promise signed by the maker to pay a certain sum of money to the bearer of the instrument.

Bill of exchange: An instrument in writing containing an unconditional order signed by the maker, directing the certain person to pay certain some of money to the bearer of the instrument Commercial Paper Credit Card Cheque

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Financial Services:
Some of the prominent types of financial services are: Mutual Funds  A mutual fund is a fund established in the form of a trust by a sponsor to raise money by the trustees through the sale of units to the public under one or more schemes for investing in securities in accordance with the regulations.  A mutual fund raises funds from the investors by offering various types of unit schemes and invests the mobilized funds in eligible instruments and securities. In a mutual fund the legal relationship between the investor and the mutual fund is that of a trustee and beneficiary while in the case of a bank it is of a creditor and debtor.  Mutual Funds offer both open ended and close ended schemes. Mutual funds offer the follow. benefits:  Diversification of risks  Liquidity  Professional management  Convenience  Tax Benefits: Tax benefits are available under the Income Tax Act, Wealth Tax Act etc.

Financial Services:
Venture Capital Funds:  Venture capital funds provide commercial support to new ideas and for the introduction and adoption of new technologies.  Banks and financial institutions require a sizable equity contribution from the promoter of a project.  However technocrats and scientists who want to become entrepreneurs cannot afford to provide such capital. It is the venture capital funds which provide them the equity capital for such projects.  However one must bear in mind that there is a high degree of risk involved. In India, the VC funds are regulated under the SEBI Regulations, 1996. Merchant Banking:  A financial institution that specializes in providing various financial services such as accepting bills arising out of trade, underwriting new issues and providing advice on mergers, acquisitions etc. Law now requires that all public issues are managed by merchant bankers who function as Lead Managers. They help the company in carrying out functions relating to new issues such as determination of securities to be issued, drafting of prospectus, application forms, allotment letter, appointment of registrars etc.

Financial Services: Factoring:

Factoring is a continual financial arrangement under which a financial institution undertakes the credit and collection functions for its client, purchases his receivables as they arise, maintains the sales ledger, and attends to other functions such as accounts receivables. Factoring is of recent origin in India. Eg: Canbank Factors Ltd. Etc. A financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on agreement. Factoring company pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt

Leasing:  Leasing means an agreement between the leasing company (called lessor) and the user (called lessee), under which the former undertakes to buy the capital equipment for use by the latter. The lessor remains the owner of the asset during the specified period . The lessee has to pay the rentals to the lessor.

Financial Services:
Credit Rating:  Credit rating by a competent and authorized agency provides a bird’s view of the financial strength of the company and its securities  Such an agency makes a systematic analysis of the strengths and weaknesses of a company and its securities before assigning a rating to it.  This means a codified rating assigned to an issue of securities by an authorized credit rating agency.  Financial Institutions like IDBI, ICICI, UTI and commercial banks have established credit rating agencies.  Credit Rating and Information Services of India Ltd (CRISIL), Investment Information and Credit Rating Agency of India Ltd (ICRA) and Credit Analysis and Research Ltd. (CARE) are prominent credit rating agencies in India.

Financial Institutions
The financial institutions maybe classified as: Banking Institutions:  A bank is an institution which deals in money and credit. It accepts deposits from the public and lends to the borrowers. The Banking Regulation Act. 1949 defines banking as “the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise”.  Central Bank The Reserve Bank of India is the central bank of the country. It supervises and regulates the entire banking system.  Commercial Banks: They perform the usual banking functions of mobilizing deposits and providing credit.  Cooperative Banks: They are organized on the principles of cooperation to encourage thrift and savings amongst members. They are usually formed by low and middle income groups in urban and rural areas.  Agricultural Banks: They provide financial assistance to farmers. Generally, loans are provided against mortgage of agricultural land. Regional Rural Banks were set up to provide credit and deposit facilities to farmers, agricultural labor and small entrepreneurs in rural areas.  Merchant Banks: These banks manage and underwrite new issues of securities. They undertake credit syndication, advise companies on fund raising and other financial matters etc.  Indigenous Banks: In rural and semi urban areas, moneylenders carry on banking business in a traditional manner and usually charge a high interest rate.

Non Banking Institutions/ Non Banking Finance Companies:

The NBFC raise deposits from the public by offering attractive interest rates and other incentives and thereafter advance loans to small scale industries, traders and semi employed persons. NBFCs generally provide unsecured loans and thereby charge high interest rates. Besides giving loans, they run chit funds, purchase and discount hundies and undertake other financial activities like hirepurchase and leasing. NBFCs are financial intermediaries engaged primarily in the business of accepting public deposits and making loans and advances. They cannot accept demand deposits.

Non Banking Institutions/ Non Banking Finance Companies
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Relatively lower degree of regulation Simplified and speedy sanction and disbursement procedures. Orientation towards customers Attractive interest rates on deposits Flexibility and timeliness in meeting the credit needs of customers. Wide rage of financial services.

Risks are faced due to:  Bulk of their loans are unsecured and are given to risky enterprises.  The loans though given for short periods are often renewed.  The same firm may borrow from more than one finance company  The deposits made by the public with the NBFC are not protected by the Deposit Insurance Corporation.

Types of NBFC

Loan Companies: Lend money to companies and individuals. Eg: Housing finance companies Investment Companies: These companies mobilize savings and invest them in industrial securities. They provide the benefits of diversification of risk and a steady return to investors. Eg: UTI, LIC Leasing Companies: They provide loans to small firms and individuals who want to buy new machines and equipment. Chit Funds: Under this scheme the promoter collects subscriptions at specified time periods from enrolled members and the amount so collected if handed over to a member on rotation. Housing Finance Companies: HUDCO is a national level institution which gives loans to individuals and societies for building houses and flats

Objectives of Financial Institutions
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To promote and develop new industries so as to fill gaps in the industrial structure of the country. To meet the growing needs of industries for long term finance To help promotion of new enterprises by identifying and formulating new projects, training and developing entrepreneurs, streamlining the management of assisted industrial units. To provide merchant banking facilities. To mobilize public savings and accelerate the rate of capital formation To ensure balanced regional development To develop a strong and healthy capital market To assist in the modernization, expansion and diversification of existing industries. To encourage the growth of small scale industries and new and technical entrepreneurs. To optimize the use of scarce resources.

Industrial Finance Corporation of Indiawas established on July 1, 1948. It was jointly owned by the GOI, The IFCI
the RBI and the financial institutions. In 1993, IFCI was converted into a Public Limited Company to enable it reshape its business strategies with greater authority, tap the capital market for funds, expand its equity base and provide better customer services. Objective:  Making medium and long term credit available to industrial concerns.

Assisting industrial concerns which have planned schemes for manufacture of or modernization and expansion of a plant.
Provide project finance, merchant banking, equipment leasing etc. and promotional services. To give priority to development of backward areas, new entrepreneurs and technocrats, indigenous technology, ancillary industries etc. Provide financial assistance to public companies and cooperative sectors engaged in manufacturing, mining, shipping, hotel business etc.

Industrial Finance Corporation of India
Functions, Scope:
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Granting loans and advance to or subscribing to debentures of industrial concerns. Guaranteeing loans raised by industrial concerns from the capital market. Providing guarantees for deferred payments for import of capital foods manufactured in India. Guaranteeing with the approval of the GOI, loans raised from or credit arrangements made by industrial concerns with any bank or financial institution outside India. Underwriting the issue of shares and debentures by industrial concerns. Subscribing directly to the shares and debentures of industrial concerns. Providing financial assistance on concessional terms for setting up industrial projects in backward areas. Providing guidance in project planning and implementation through specialized agencies like Technical Consultancy Organisation. The financial assistance is available for setting up new projects and for the expansion, diversification and modernization of existing units.

Industrial Finance Corporation of India Before sanctioning assistance, IFCI evaluates the proposal in terms of:
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Importance of the industry in the national economy Feasibility and cost of the project Competence of the management Nature of the security offered Adequacy of supply of technical personnel and raw materials The country’s requirements of the product manufactured and its quantity.

IFCI has been criticized for the following reasons:

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Assistance sanctioned for new projects has been only about 20% of the total assistance Equity finance has been very little as compared to debt finance Adequate focus has not been laid on backward regions and small scale sector. Percentage share of infrastructure projects in the total loans outstanding is about 13% There has been a sharp fall in the assistance provided in foreign currency. Income of IFCI has fallen sharply Non performing assets of IFCI are very high of the total net assets. Its capital adequacy ratio has fallen to less than one percent.

Industrial Credit and Investment Corporation of India (ICICI Bank)
Was established in 1955 as a public limited company in the private sector. ICICI set up the ICICI Bank in 2002. The ICICI Ltd was later merged with its subsidiary the ICICI Bank ltd. ICICI Bank is now the second largest commercial bank in India and the largest bank in the private sector. It has assumed the role of a universal bank. Objectives:  Main aim was to promote industrial development in the private sector by providing financial, technical, administrative and other services  To assist in the promotion, expansion and modernization of industrial enterprises in the private sector  To encourage and promote the participation of private capital, both Indian and foreign  To stimulate the growth of private ownership of industrial investments and expansion of investment markets.

Industrial Credit and Investment Corporation of India (ICICI Bank)
Functions: ICICI provides assistance in the following ways  Granting medium and long term rupee loans to industrial concerns  Advancing loans in foreign countries towards the cost of imported capital equipment.  Providing guarantees to the loans raised by companies in the open market  Sponsoring and underwriting new issues of industrial securities.  Subscribing directly to shares and debentures of companies  Making funds available for reinvestment by revolving investments as rapidly as prudent  Providing technical and managerial know how to industries.  Encouraging the participation of private capital in industrial concerns  Assisting industrial concerns in obtaining technical and administrative services from internal and external sources ICICI has played a vital role in the development of industries in the private sector and in strengthening the capital market in the country. It has become the largest supplier of foreign currency to private sector industries. It has also played a leading role in the areas of venture capital. ICICI Bank Ltd. is listed on the New York Stock Exchange. It launched infinity the first internet banking service in India.

Industrial Development Bank of India

It started operations in 1964. IDBI represents an attempt to combine in a single institution the requirements of an expanding economy and need for a coordinated approach to industrial financing. In 1994 the Bank was permitted to issue equity shares in the capital market. Majority of its shares are still owned by the Government.

Objectives:  To co-ordinate, regulate and supervise the activities of all financial institutions providing long term finance to industry.  To enlarge the usefulness of these institutions by supplementing their resources and by widening the scope of their assistance  Provide direct finance to industry to bridge the gap between demand and supply of long term and medium term finance to industrial concerns in both the public and private sectors  Locate and fill up gaps in the industrial structure of the country  Adopt and enforce a system of priorities so as to diversify and speed up the process of industrial growth

Industrial Development Bank of India Functions:
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Subscribe to the shares and bonds of financial institutions Refinancing term loans and export credits extended by other financial institutions Granting loans and advances directly to industrial concerns Guaranteeing deferred payments due from and loans raised by industrial concerns Subscribing to and underwriting shares and debentures of industrial concerns Accepting, discounting and rediscounting commercial bills or promissory notes of industrial concerns Financing turnkey projects by Indians outside India Planning, promoting and developing industries to fill gaps in the industrial structure of the country. Providing technical and managerial assistance for promotion and expansion of industrial undertakings Coordinating and regulating the activities of other financial institutions.

On 30.12.2003, IDBI was converted into a banking company and IDBI Bank Ltd and IDBI were merged together.

Small Industries Development Bank of India (SIDBI)
Set up in 1990as a wholly owned subsidiary of IDBI. SIDBI took over the outstanding portfolio of IDBI related to the small scale sector worth Rs. 4000 crores. Objective:  It was envisaged as the principal financial institution for the promotion, financing and development of the industry in the small scale sector and to coordinate the functions of other institutions engaged in similar activities. Functions:  Refinancing loans and advances extended by primary lending institutions to small scale industrial units  Discounting and rediscounting bills in the small scale sector  Extending need capital /soft loan assistance under the National Equity Fund.  Granting direct assistance and refinance for financing exports of products manufactured in the small scale sector  Providing financial support to NSIC (National Small Industries Corporation) for providing leasing, and marketing support  Providing services like leasing, factoring to industrial concerns in the small scale sector.