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/ 279
(OMANIMAN YO FT
© Choice Based Credit System
TAXMANN"'S
Financial Markets
Institutions
&
Financial Services
Dr. Vinod Kumar
Department of Commerce
SGTB Khalsa College
University of Dethi
Atul Gupta
Department of Commerce
Hindu College
University of Dethi
Manmeet Kaur
Department of Commerce
SGTB Khalsa College
University of Delhi SYLLABUS
FINANCIAL MARKETS, INSTITUTIONS AND FINANCIAL
SERVICES.
Paper: BCM [5.4(C)] DSE Group
Duration: 3 hrs.
Objective: To provide the student a basic knowledge of financial markets and
institutions and to familiarize them with major financial services in India.
Unit I: An Introduction to Financial System and its Components
Financial markets and institutions. Financial intermediation, Flow of funds
matrix. Financial system and economic development. An overview of Indian
financial system.
Unit II: Financial Markets Money
Money market-functions, organization and instruments. Role of central
bank in money market; Indian meney market —Anoverview:
Capital Markets-functions, organization and instruments. Indian debt
market; Indian equity market-primary and secondary markets; Role of
stock exchanges in India.
Unit I: Financial Institutions
Depository and non-depository institutions, Commercial banking-
introduction, its role in project finance and working capital finance.
Development Financial Institutions (DFls)-An overview and role in Indian
economy. Life and non-life insurance companies in India; Mutual Funds-
Introduction and their role in capital market @evelopment. Non-banking
financial companies (NBFCs).
Unit IV: Overview of Financial Services Industry
Fund based and fee based financial services, Merchant’ banking-pre and
post issue management, underwriting, Regulatory ftamework relating to
merchant banking in India. Tie SYEEARUS.
UiCV: Leasing and hire purchase
Consumer hnane«
bonk puarantecs and lett
and Portfolio
and housing
Venture capital nance. Facto Ing services,
ler of credit: Credit 1
ating, Financial Counselling
Management Services | Contents
ABOUT THE AUTHORS
ACKNOWLEDGEMENT
SYLLABUS
1 CHAPTER 1
AN INTRODUCTION TO FINANCIAL SYSTEM
I CHAPTER 2
MONEY MARKETS
I CHAPTER 3
CAPITAL MARKETS INSTRUMENTS
1 CHAPTER 4
INDIAN DEBT MARKETS
[CHAPTER 5
PRIMARY MARKETS
I CHAPTERS
“SECONDARY MARKETS
I CHAPTER 7
_-SEBI AND INVESTOR PROTECTION
I CHAPTER 8
FINANCIAL INSTITUTIONS
1 CHAPTER 9
COMMERCIAL BANKING
ri
a
ral
108
ng 112 CONTENTS
1 CHAPTER 10
DEVELOPMENT FINANCIAL INSTITUTIONS
§ CHAPTER 11
LIFE AND NON-LIFE INSURANCE COMPANIES IN wou
fl CHAPTER 12
MUTUAL FUNDS “~~
I CHAPTER 13
NON-BANKING FINANCE COMPANIES. a
CHAPTER 14
OVERVIEW OF FINANCIAL SERVICES INDUSTRY
| CHAPTER 15
MERCHANT BANKING 4
T CHAPTER 16
LEASING AND HIRE PURCHASE
I CHAPTER 17
VENTURE CAPITAL AND FACTORING SERVICES »
I CHAPTER 18 —
CREDIT RATING
CHAPTER 19
CONSUMER AND HOUSING FINANCE
CHAPTER 20
LETTER OF CREDIT AND BANK GUARANTEE
I CHAPTER 21
FINANCIAL COUNSELLING AND PORTFOLIO MANAGEMENT
SERVICES
QUESTION PAPERS B.COM. (HONS.)
GLOSSARY
PAGE
135
140
156
168
17
180
212,/
aay
234/
240
2474
257
264 An.Introduction to
SYSIE
Introduction
The resources required for developing any economy are generated through
the process of savings. These savings remain unutilized or underutilized
if the financial system of the economy is under developed. The size of the
savings and its appropriate utilization for investment in industries can help
economic growth. However, this channelizing of savings from savers to
the industry requires the presence of vibrant, active and reliable financial
markets system that aids in mobilization and appropriate channelization.
The efficiency of the financial markets, decides the speed of the economic
growth of a country.
Financial markets are markets through which funds required bythe users
are supplied by the savers of funds. It helps in exchange of financial assets
between those who have the funds and those who require these funds.
Owners of funds would save more when they have incentive to save, which
depends upon variety of financial instruments available and the return on
the financial instruments. Savings can be easily multiplied if the savers or
investors invest in different instruments depending upon thereturn and the
corresponding risk. The efficiency in the creation of various instruments
1
‘TAXMANN® AN INTRODUCTION TO FINANCIAL SYSTEM
markets to meet the different re
vs of funds decides the size of fund
Financial markets also help in
mechanism throu
speculators.
With the developmentof the finane
by financial surplus units can be
In acon
the
quirements of savers as well
1s mobilized
Providing liquidity, price discovery and a
igh which the risk
can be transferred from hedgers to
markets the savings that are generated
allocated to preferred investment outkets,
plex modern. economy, the system of financial markets facifitates
transfer of resources from financial surplus units to financial deficit
units and thereby helps the funds’ appropriate usage for development of
an economy.
Development of an cconomy is therefore highly dependent upon a well
regulated and efficient financial system. An efficient, vibrant anddeveloped
financial system is essential for rapid economic growth. The institutional
structure, operational polici
market are largely influ
well as the government:
, financial intermediaries (bankers,
insurers, and mutual funds), informatio:
n providers, and regulators.
In order to reconcile the interests of user:
s of funds and providers of funds,
institutions called financial intermediaries provide valuable services, Finan-
cial intermediaries purchase the primary securities issued by the ultimate
users and, in turn, acquire funds for issuing their own securities, which are
tailored to the needs of ultimate savers, especially to relatively small savers.
This is called Indirect Finance. Banks, insurance companies and mutual
funds do this activity of conversion of direct securities into indirect securi-
ties. These institutions help to channelize savings to high priority industries
indirectly and in return make it safer for the savers to invest their money.
= TAXMANN®
|
|
| AN INTRODUCTION TO FINANCIAL SYSTEM 3
The innovative nature of financial markets allows the market participants
to convert their innovative ideas into products which meet the needs of
the markets.
Existing economic units need access to funds for expanding facilities,
for financing inventories, for maintaining adequate cash reserves, or for
emergencies. They shall approach financial intermediaries to meet their
requirement of funds.
Financial markets also serve the function of providing financial surplus
units like households the access to earning assets like shares, bonds or units
without requiring them to purchase real assets. If saving is increased by
income generating financial claims, the accumulation of the plants, equip-
ments, and materials that contribute to the growth, economies’ productive
capacity gets enhanced. This results into economic growth.
Indian Financial System
Till the early nineties, the planned economic development in India had
greatly influenced the course of financial development. In the post-1990s,
the financial system that emerged was in response to the imperatives of
a liberalized, globalised and deregulated economic era. This has helped
the Indian economy to mobilize more funds for appropriate investments.
The financial system of a country consists of financial institutions, instru-
ments, services and markets.
The evaluation of Indian Financial System can be divided into following
three phases:
TAXMANN® 4 AN INTRODUCTION TO FINANCIAL SYSTEM
The financial system up to 1951 (Phase 1)
The financial system from 1951 to mid-Eighties (Phase II)
+ The financial System from 1990 onwards (Phase III)
1. The financial system up to 1951 (Phase I)
Indian financial system (IFS) before 1951 was largely closed-circle charac-
ter of industrial entrepreneurship; wherein a semi-organized and narrow
industrial securities market was devoid of issuing institutions. There was
a virtual absence of participation by financial intermediaries for the long-
term financing of industry. Such a system was not responsive to opdor-
tunities for industrial investment. During this period the industrial sector
was neglected by the government. The growth of the period showed a
slow growth of economic development reflected in low per capita income,
savings, national income and purchasing capacity.
2. The financial system from 1951, mid-Eighties (Phase II)
Post-1951 period evolved in response to theimperatives of planned economic
development. Planning signified the distribution of credit and finance in
conformity with the planned priorities, which, in turn, implied Government
control over the financial system. The funds therefore, funneled towards
the pre-rreditated priority sectors by the government. During this period
the major characteristics of the financial system were:
(a) Public ownership of financial institutions
Public ownership of Financial Institutions was brought about partly
through nationalization of existing institutions [e.g. State Bank of
India (1956), LIC (1956), Commercial banks (1969) and GIC (1972)]
and partly through the creation of the public sector new institutions,
namely, special-purpose term-lending institutions (development
banks) and UTI. =
(b) Fortification of the institutional structure
The fortification of the institutional structure of the Indian Financial.
System was partly the result of modification in the structure and
policies of the existing Financial Institutions and also with the ad-
dition of new institutions. The banking policies and practices were
structured to be in tune with the planned policies and practices.
Banks were encouraged to reorient their operational policies towards
financing of industry, as against commerce and trade. They were also
encouraged to enter into new forms of industrial financing, namely,
underwriting and term-lending rather than lending for pure short
term loan.
TAXMANN® AN INTRODUCTION TO FINANCIAL SYSTEM 5
The banks also enlarged their functional coverage in terms of financ-
ing of small scale industries, exports and agriculture. To expand the
coverage and fill the credit gaps of the priority sector, a scheme of
social control was introduced. This was followed up by nationalisa-
tion of the banks to meet the needs of development of the economy
in conformity with national priorities and objectives.
(c) Protection to Investors
Along with the measures being taken to strengthen and diversify the
institutional structure of the Indian financial system, extensive legal
reforms were carried out during this period to provide protection
to investors so as to restore their confidence in industrial securities.
The main elements of the elaborate legislative code adopted by the
Government were: Companies Act; Capital Issues (Control) Act (CCA),
now repealed and replaced by the SEBI Act; Securities Contracts
(Regulation) Act (SCRA); MRTP Act (now replaced by Competition
Act) and; Foreign Exchange Regulation Act (FERA), now replaced
by Foreign Exchange Management Act (FEMA).
(d@) Participation of Financial Institutions (FIS) in Corporate Management
Asignificant feature of the Indian Financial System in this phase was
the participation by the Financial Institutions in the management
and control of companies to which finance was provided, in marked
contrast to the time-honoured tradition of not getting involved in
the control and management of assisted companies. This change in
approach of the Fls‘could be ascribed to three factors: Government
policy; structure of the industrial securities; and the deep involvement
of the Financial Institutions in the fortune of the companies through
lending operations for protecting their funding in these companies.
3. The Financial System from 1990 onwards (Phase III)
The post-nationalization period yielded significant changes in the operational
policies and practices of banks. This resulted in an acceleration of credit
availability to the priority sector and consequent declinein the share of large
industry in the total bank credit, due to regulations and cre@it rationing.
The backbone of the institutional structure of the Indian Financial System
during this phase was the variegated structure of development banks,
namely, IDBI, SIDBI, IFCI, ICICI, SFCs, S{DCs, SIICs and so on. They were
conceived as instruments of the State policy of directing capital into a
chosen area of industry, in conformity with the planned priorities, and of
generally securing the development of private industry along the desired
path, to facilitate effective public control of private enterprise. They were
also the agency through which specific socio-economic objectives of State
TAXMANN® 6 AN INTRODUCTION TO FINANCIAL SYSTEM
policy, such as encouragement to new entrepreneurs and small enterprises
and the development of backward regions to broad base the growth of
industry, were being realized.
The setting up of the LIC, as a result of an amalgamation of 245 life in-
surance companies into a single monolithic state-owned institution, was a
part of the deliberate and conscious attempt to mould the Indian Financial
System according to the requirements of planned development. It not only
transferred an important saving institution from private to public owner-
ship, but also brought about a massive concentration of long-term funds
in the hands of LIC, which emerged as the largest reservoir of long-term
savings in the country.
Similarly, the setting up of the UTI was the culmination of a long overdue
need of the Indian Financial System to encourage indirect holding of secu-
rities by the public by bolstering up the confidence of the investing public
in the securities markets.
An overview of Indian financial system
Indian financial sector has undergone significant changes in during the past
few decades with Private sector institutions growing rapidly in commercial
banking and asset management business. The deregulation of the financial
system and intensification of competition amongst financial intermediaries
have led to a decline in interest rates.
The regulators of the various segments of the market like The Securities and
Exchange Board of India and the Insurance Regulatory and Development
Authority (IRDA), PFRDA have become important institutions of the
financial sector of India.
Notwithstanding the dominance of the Public sector banks (PSBs), private
sector banks are gradually gaining strong foothold in the financial sector ‘of
India. The Government is also proposing to reduce its equity stake in PSBs
to 33 per cent. This can ultimately lead to privatization of PSBs.
As part of the liberalisation process, the RBI has been giving licenses to
new private sector banks. Restructuring of private sector banking has
started with a few banks merging in order to form stronger entities. Bank
of Rajasthan has been taken over by ICICI bank. Similarly Centurion Bank
of Punjab has been taken over by HDFC bank. The existing private sector
banks have far better managerial capability and financial strength com-
pared to public sector banks and therefore are expected to expand rapidly.
TAXMANN® AN INTRODUCTION TO FINANCIAL SYSTEM 7
/ | Development Finance Institutions (DF)
DFls such as IDBI and ICICI which were largely known as developmental
ntered other segments of financial services such as commercial
ing, asset management and insurance through separate ventures.
This move to universal banking has really caught up with a majority of the
banks now taking up short term as well as long term financing.
Several measures have been initiated and include new money market
instruments, strengthening of existing instruments and setting up of the
Discount and Finance House of India (DFHI).
The RBI conduets its sales of dated securities and treasury bills through
its open market operations (OMO) window. Primary dealers bid for these
securities and also trade in them. The DFHI is the principal agency for
developing a secondary market for money market instruments and
Government of India treasury bills. The RBI has introduced a liquidity
adjustment facility (LAF) in which liquidity is influenced through repo and
reverse repo auctions.
On account of the substantial issue of government debt, the gilt-edged
market occupies an important position in the financial set-up.
SEBI has now decided to concentrate on the development of a long-term
debt market which is crucial to the financing of infrastructure. The dema-
terialisation of debt instruments in order to encourage paperless trading
has helped in streamlining the debt markets.
The number of shareholders in India is estimated in millions. However,
only a very small number of an estimated two lakh persons actively trade
in stocks. There has been a dramatic improvement in the country’s stock
market tradinginfrastructure during the last few years. Indian equity market
has now become an attractive emerging market with tremendous potential.
DV Ihdian Mutual Funds Market
~ Notwithstanding the fact that retail investor's participation in the markets
for direct investments has reduced, their faith in the mutual funds has
improved remarkably during the past few years.
The mutual funds industry is now regulated under the SEBI (Mutual Funds)
Regulations, 1996 and amendments thereto. With the issuance of SEBI
guidelines, the industry had a framework for the establishment of many
more players, both Indian and foreign players.
The popularity of the mutual funds in recent years has been driven by the
growthin the securities markets and tax advantages granted for investment
in mutual fund units.
TAXMANN®
——— 0
8 AN INTRODUCTION TO FINANCIAL SYSTEM.
The growth of Mutual fund segment got a further filip with the entry of
foreign owned AMCs. They were instrumental with the introduction of new
products, setting new standards of customer service, improved disclosure
standards and experimenting with new types of distribution.
The Indian insurance industry is the latest to be thrown open to competi-
tion from the private sector including foreign players. As per rules, foreign
companies can only enter joint ventures with Indian companies, with par-
ticipation restricted to 49 per cent of equity.
The major improvements in the working of various financial markets have
been taken up gradually with a step-by-step approach, not a big bang one.
The entry of foreign players has assisted in the introduction of interna-
tional practices and systems. Technological developments have improved
customer service. Some gaps, however, still remain like an active corporate
debt market. On the whole, the cumulative effect of the developments since
1991 has been quite encouraging.
Foreign companies are already allowed to hold a majority stake in asset
management companies and NBFCs, up to 49 per cent in banks and a
maximum of 49 per cent in insurance companies.
Banking system
An indication of the strength of the reformed Indian financial system can
be seen from the way India was not affected by the Southeast Asian crisis
and subprime crisis.
Major changes in the banking system in recent years include the intro-
duction of Prudential norms for income recognition, asset classification,
provisioning for delinquent loans and capital adequacy. In order to reach
thestipulated capital adequacy norms, substantial capital has been provided
by the Government to PSBs.
The Government pre-emption of banks’ resources through statutory
liquidity ratio (SLR) and cash reserve ratio (CRR) was also brought down
in two stages.
Other prominent measures include:
Interest rates on deposit and lending sides almost entirely deregulated.
New private sector banks allowed to promote competition.
PSBs were encouraged to approach the public to raise resources.
Bank lending norms were liberalised and a loan system to ensure
better control over credit was introduced.
o co information bureau has been established to identify bad
TAXMANN® ’
AN INTRODUCTION TO FINANCIAL SYSTEM 9
| __ Derivative products such as forward rate agreements (FRAs) and interest
rate swaps (IRSs) and credit default swaps introduced,
by } indian Capital Market significant changes were introduced for better reg-
“ulation of the Thdian Capital Markets. Some of the prominent ones are the
Sapital Issues