y ig B.Com. (Hons.) Semester-V Based on CBCS Syllabus, Odisha MARKETS t Babs) Cer)T.R. Jain Former Principal S.A. Jain College Ambala City % Global Publications Pvt. Ltd.Printing History: Syllabus Govered: First Edition: 2018-19 UA NCSe UTM ton tits Reprint: 2019-20 Colleges of Odisha for LXeCeTn (aloha A etna Price: One Hundred Seventy Five Rupees ( 175/-) ISBN: 978-93-87958-07-4 ‘©Copyright Reserved by the Authors ‘aight reserved Nout hs book maybe reproduced stored ina retivalsyster, ‘ earunted any form or by any means, without waiten pemision fom the putin Published By VK Global Publications Pvt. Ltd. Regd. Office: 4323/3, Ansari Road, Darya Ganj, New Delhi-110002 Ph: 91-11-23250105, 23250106 Fax: 91-11-23250141 Corporate Office: 15/1, Main Mathura Road, Faridabad (NCR) Haryana-121003 Phone: 0129-7117719-48 lines, Fax: 0129-2250322 Email: [email protected] www.vkpublications.com : + Every effort has been made to avold errors or omissions inthis publications Printed At: Inapte of th, some ertors might Rave cept Any mute or of Adinath Printers dhcrepancy notedmaybebroughtto our note while ken care ot Inthe next edition. itisnotified that neither the publishers nor the author or seller wl be responsible for any damage o loss of action to anyone, of any kind, in any manne, theretrom, For binding mistakes. misprints of for missing pages, etc the publishers lability is imited to replacement within ‘one month of purchase by similaredition. Allexpensesinthisconnectionare tobeborneby the purchaser1. An Introduction to Financial System. .. 2. Financial Markets-I: Money Market 3. Financial Markets-II: Capital Market ... 4, Indian Debt Market 5. Indian Equity Market-I: Primary Market 6. Indian Equity Market-I: Secondary Market 7. Financial Institutions: An Overview 8. Commercial Banking. 9. Development Financial Institutions (DFls)... 10. Insurance Companies in India. 11, Mutual Funds ... 12. Non-Banking Financial Companies (NBFCs) ... 13. Financial Services: An Overview. 14, Merchant Banking 15. Leasing and Hire-Purchase 16. Factoring Services 17. Venture Capital Finance 18. Credit Rating 19. Consumer and Housing Finance—=ay os Maximum Marks: 199 Duration: 3 Hours Objective: To provide the student a basic knowledge of financial markets and institutions and to familiarize them with major financial services in India. UNIT-1 An Introduction to Financial System, its Components — financial markets and institutions, financial femmediation, Flow of funds matrix, financial system and economic development, an overview of Indian financial system, UNIT-2, Financial Markets: Money market-functions, organization and instruments. Role of central bank in ‘money market;Indian money market-An overview, Cepital Markets-functions, organization and. instruments. Indian debt market; Indian equity ‘market- primary and secondary markets;Role ofstockexchangesin india oduction, its role in project finance and working capital finan )-An overview and role in Indian economy, Life and non- life insurance companies in India; Mutual Funds-Introduction and their role in capital market development. Non-banking inancialcompanies(NBECS) Overview of Financial Services Industry: Merchant bankin “pre and post i t, underwriting Regubtoryamewerkrelatingtomerchant banking os Sh sur nego UNIT-5 coating and Hire-purchase: Consumer and housing finance; Venture capital; Factorin services, bank Credit rating; Counseling ' 8Financial Markets, Institutions and Services Semester-VChapter 1 AN INTRODUCTION TO FINANCIAL SYSTEM @ What is Financial System? Every country has a financial system of its own that serves as a backbone for its entire development. A financial system is a set of institutional arrangements through which financial surplus in the economy is mobilised from surplus units and transferred to deficit spenders. Financial system may be defined as a set of institutions, instruments and markets which foster savings and channels them to their most efficient use. The system consists of individuals (savers), intermediaries, markets and users of savings. \& Definitions Various authors have defined financial system as follows: w» According to H.R. Machiraju, “A financial system may be defined as a set of institutions, instruments and markets which foster savings and channels them to their most efficient use. The system consists of individuals (savers), intermediaries, markets and users of savings.” = According to L.M. Bhole, “The financial system or the financial sector of any country consists of specialised and non-specialised financial institutions, of organised and unorganised financial markets, of financial instruments and services which facilitate transfer of funds. Procedures and practices adopted in the markets and financial interrelationships are also parts of the system.” = According to P.N. Varshney and D.K. Mittal, “Financial systems facilitate expansion of financial markets over space and time and promote efficient allocation of financial resources for socially desirable and economically productive purposes.” = According to V.A. Avadhani, “Financial system refers to the activity relating to the provisions of the services in terms of money and facilitates activity in real system.” = According to Shashik Gupta, Nishi Aggarwal and Neeti Gupta, “Financial system comprises of a set of sub-systems of financial institutions, financial markets, financial instruments and services which help in the formation of capital. It provides a mechanism by which savings are transformed into investments.” Thus, after considering the above definitions, it may be said that financial system provides system for the financial markets, institutions and instruments. It provides a mechanism through which savings are transformed into investments. Thus, a financial system helps in the capital formation of a country. The capital formation depends greatly on the efficiency of the financial system of the country. © Functions/Roles of the Financial System A financial system performs the following functions/norms: 1. It promotes the process of capital formation by providing a mechanism for transformation of savings into investments.Financial Markets, Institutions and Servic 2. Itserves as a link between savers and investors. It mobilises the savings of the scattered saver into productive investments. hanism of payment for the exchange of services and good: 3. It provides an efficient mec! 4. Itensures that the transactions are effected safely and swiftly on an ongoing basis, 5. Itprovides alternate forms of deposits according to the preferences and liquidity position of the savers. 6. Itdistributes the risk through diversification and thus reduc: case of mutual funds. 7. Ithelps in lowering the cost of trans in lending and borrowing. e the risk of the savers, such as in the sactions and increase the returns through economies of scale It provides a mechanism for the transfer of resources beyond geographical boundaries. 9, Itprovides detailed information needed to the various players of the market such as individuals, intermediaries, businesshouses and government, etc. 10. It helps in managing such portfolios who: information. Components of Indian Financial System Three main components of Financial System are: (i) Financial Instruments (Assets) (ii) Financial Markets (iii) Financial Intermediaries or Insi ions. These components are shown in the given chart: se risk is less and return is more by providing better Components of Financial System VRS Financial Instruments Financial Markets ¥ esertel ¥ Financial Intermediaries Primary or Direct, Secondary or Indirect Organised [- Unorganised Vv Banking Institutions Non-Banking Financial Institutions‘An Introduction to Financial System inancial Instruments (Assets) One of the major components of Financial System is Financial Instruments Assets, Financial assets are claims on others. These are of two types: (i) Primary or Direct Securities: Direct or primary financial assets are those securities which represent financial claims against real sectors. For example, bills, bonds, shares, book debts, etc. are direct securities. These securities are created by the final debtors of real sector in order to finance those expenses which they cannot meet with their own resources. As such they have to arrange finance from others. (ii) Indirect or Secondary Securities: These securities refer to such financial claims against financial intermediaries that are created when the latter mobilise finances from the public. For instance, new currency i.e. notes and coins issued by the Reserve Bank of India; bank deposits, life insurance policies, units of UTI, IDBI bonds, ete. In the present time, the most significant financial assets of Indian Financial System are currency notes, coins, bank deposits (current, saving and term deposits), post office saving deposits, life insurance policies, contribution to provident fund, government and corporate sector bonds, bills, hundis, company-shares, units of UTI, deposits in companies, deposits in investment companies, merchant bank deposits, mutual funds, etc. National Saving Certificates, Infrastructure Bonds, Indira Vikas Patra, Krishi Vikas Patra, etc. are examples of financial assets. The different type of securities may be listed as below: © (1) Debentures ‘A debenture is a type of loan acknowledgment which is taken by the company from the public. Debentureholders are entitled to get interest at a specified rate on the face value of the debenture. A company can issue redeemable convertible debentures. The debentures can be secured or unsecured. It can be registered or bearer. © (2) Shares The capital of the company can be divided in several parts with a definite value. Each partis called a share. Holders of these shares are called shareholders. There are two types of shares which a company may issue, i.e., preference shares and equity shares. (i) Preference Shares: Preference shares are those shares on which shareholders enjoy namely two preferences over equity shareholders. These preferences are: (a) Payment of dividend out of profits; and (b) Repayment of capital in case of liquidation. These shareholders do not have any right to participate in the management of the company. Al preference shares are redeemable within 10 years. Preference shares are of different types, viz., cumulative or non-cumulative, convertible or non-convertible, participating or non-participating, etc. (ii) Equity Shares: Equity or ordinary shareholders are the real owners of the company. It tepresents risk capital. The shareholders can participate in the management of the company. These shareholders have residual claims on the income and assets of the company. The rate of dividend is determined by directors on the basis of annual profits. It may exceed the rate of preference dividend. Such shareholders may also go without idend if no profit is made byFinancial Markets, Institutions and Service: 6 the company. The terms on which shares are to be issued by the company are given in the e prospectus. SEBI has issued various guidelines to safeguard the interest of equity shareholders, preference shareholders and debentureholders. © (3) Innovative Instruments ments are the new instruments issued by companies and financial institutions in Innovative instru parts: recent years. For the purpose of study, these may be divided in two / A. Issued by Companies: A variety of instruments have been issued by companies. These are: (a) Participating Debentures: Participating debentures are eligible to participate in the excess profits of the company, after the payment of equity dividend. This is unsecured corporate debt security. : (b) Convertible Debentures with Options: These debentures have the option to exit either by the company or debentureholders from the terms of the issue. The coupon rate is specified at the time of issue. (c) Third Party Convertible Debentures: These are the debts with a warrant which entitle the holders to subscribe to the equity of another firm at a preferential price instead of market price. The interest rate offered is generally lower in this type of debt in comparison with the simple debentures due to conversion option. (d) Secured Zero Interest Partly Convertible Debentures with Detachable and Separately Tradeable Warrants: These debentures contain zero interest but are of secured nature. Such debentures have two parts: Part A and Part B. Part A is convertible into shares at a fixed rate on the date of allotment. Part B is non-convertible and is redeemable at par on the expiry of the specified period. It also contains a separately tradeable warrant which can be converted into equity shares. (e) Convertible Debentures Redeemable at Premium: These debentures are issued at par but with an option to investor to sell the debentures to the issuer at a premium later on, They are basically similar to convertible debentures but carry less risk. (f) Debt Equity Swaps: These are a type of convertible debentures, These provide offers to exchange debentures for equity. This type of instrument is quite risky for the investor because the anticipated capital appreciation may not materialise, (g) Zero-coupon Convertible Notes: These debentures have a right to be converted into shares. But on the date of conversion, they have to sacrifice accrued or unpaid interest. Zero-coupon convertible notes are quite sensitive to changes in the interest rates. holder sells it back to the company after the lock-in period. Hot 7 a wever, he will be entitled to get additional interest in instalments ifthe redemption is made after : : the expiry of the firm of SPN. ly and get equity shares allotted. This sion of detachable warrant into equity d by the company. The attached warrant assures the right to holder to appl right is available only if the SPN is fully paid. The conver: shares will have to be done within the time limit allowe‘An Introduction to Financial System 7 (i) Non-Convertible Debentures (NCD) with Detachable Equity Warrants: These debentureholders have an option to buy a specified number of equity shares at a fixed rate on the expiry of certain period. There is lock-in period for NCD, after which the debentureholder can exercise his option for equity shares. If such an option is not exercised within the stipulated period, the company will be at liberty to dispose off the unapplied portion of shares in the market. The warrants attached to NCDs can be converted into shares only if they are fully paid () Zero Interest Fully Convertible Debentures: These debentures get automatically and compulsorily converted into shares after the specified time period. These type of debentures generally contain no interest. No interest will be paid during lock-in period. Fully Convertible Debentures (FCDs) can be converted into shares if they are fully paid. If the company goes for rights issue meanwhile, it shall only do so after the FCD holders are offered securities. (k) Fully Convertible Debentures (FCDs) with Interest: These debentures do not yield any interest for a short period. After this period, the debentureholders get the option to apply for equities issued at premium without paying for the premium. Such option should be indicated in the application form itself. A specified rate of interest is payable on FCDs between the two conversion dates in lieu of which shares are issued (1) Warrants: A warrant is another type of convertible debenture which entitles the holders to purchase a specified number of shares at a specified rate before the specified period. These warrants may be issued with either debentures or equity shares. They are also called sweeteners. The number of shares entitled, the expiration date, along with the stated/exercise price, ete. are clearly specified in the warrants. The warrants have a secondary market. They are generally issued by new/growing firms and venture capital firms. They do not contain any floatation cost and when they are exercised, the firm receives additional funds at a price lower than the current market, yet, higher than those prevailing at the time of issue. A few Indian companies have issued warrants since 1998. B. Issued by Financial Institutions Financial institutions in India have also issued innovative securities. These are listed as below: (a) Floating Rate Bonds (FRBs): The interest rate on these bonds linked to some other rates, such as, bank rate, maximum interest on term deposits, prime lending rate, yield on treasury bills, ete. The floating rate is fixed in terms of margin above/below the benchmark rate. It ensures that neither the borrower nor the lender suffer from changes in interest rates. For example, the SBI's floating rate bond issue was linked to the maximum interest on term deposits which was 10 per cent at that time. The floor rate was 12 per cent in this case. (b) Zero-Coupon Bonds/Deep Discount Bonds: No interest is payable on these bonds. These bonds are sold to customers at a discounted rate. They have long maturity period, generally of 20-25 years. The return to the investor is the difference between acquisition value and the redemption value. The example of itis the deep discount bonds of Sardar Sarvor Nigam Ltd., which were issued at a price of % 3600 per bond and have the redemption value of & 1,11,000 after 21 years. (c) Easy Exit Bonds with a Floating Interest Rate: The rate of interest on these bonds is flexible. It means it is reset every six months. Small investors have been protected under this scheme with an option of exit up to a specified amount. But if a investor holds the bonds forFinancial Markets, institutions and Services more than 18 months from the date of allotment, he gets an additional interest. Call and put options are also available on these bonds. These bonds are targeted at the segment that is sensitive to inflation and wants an additional safety net in the form of exit. (d) Regular Income Bonds: These are issued for a specified period of time. The interest is generally payable half-yearly on these bonds. The interest is paid at a pre-determined rate. The bonds also carry option for investors and call option for issuer and an early bird incentive. For example, the IDBI Regular Income Bonds were 10 year bonds issued in 1996, bearing a coupon of 16 per cent, payable half-yearly. The additional interest of 0.5 per cent was also paid in this scheme. It brings annualised yield equivalent to 18.2 per cent. The price of each bond was % 5,000. Indian Finance Corporation of India (IFCI) has issued 5 year tenure bonds with a semi-annual yield of 16 per cent and an early bird incentive of 0.75 per cent. (e) Retirement Bonds: These bonds are issued for those who wish to get instalments of fixed amount after their retirement. The investor gets monthly fixed amount after the expiry of the wait period which is at the option of the investor. The investor can also choose the lurnp sum amount. Investor could also opt for a nil waiting period, in which he starts getting monthly income immediately, from next month only. These retirement bonds may also carry put and call options. For example, IDBI issued such type of bonds in 1996 with a maturity period of 10 years. (f) Step-up Liquidity Bonds: The maturity period of these bonds is generally 5 years. The put option is available every year. The interest steps up every year. For example, IFCI issued these bonds in 1997. The interest rate offered was 16 per cent, 16.25 per cent, 16.5 per cent, 16.75 per cent and 17 per cent at the end of every consecutive year. (g) Growth Bonds: These bonds generally have a rederption period of 10 years. However, some ‘companies provide put options at the end of 5 or 7 yea:s. For example, [FCI issued such types of bonds in 1996. The face value of each bond was 4 20,000 and the maturity value was 2 1,00,000 after 10 years. If xe put opt'on is exe:cised by the investor, he gets % 43,500 after 5 years and % 60,600 after 7 years. (h) Index Bonds: These boncs provide 20th the sect city of money invested and the potential of appreciation in return to the investor. «Ar index bor.d has two parts, a deep discount bond (Part A) and a detachable incey: warrent (Part B). Part A is deep discount bond whereas Part B gives return in proportion to the increese’cecrease ir the BSE SENSEX. The face value of the bond wil! appreciate thy number of times the SENSEX has appreciated. The investors’ returns will be rez ted as capital gains. For example, ICICI issued index bond in 1997 at a price of ® 6,000. Part was.a 12 year de2p discount bond of face value of ® 22,000 (initial investment % 4,000) end part B in the form of index warrant at % 2,000 which gives return in proportion to the increase/de -rease in BSE SENSEX after 12 years. (i) Capital Gain Bonds: These bunds e» issued with two options maturity — 3 years (option I) and 7 years (option Il). 20% rebate in income tax is allowed on the investment in these bonds. Investment through stock-invest wil, not qualify for the rebate. IDBI, ICICI are issuing such type of bonds. These bonds are beneficial for indivic'vals who are in high tax brackets. These bonds are also called tax-saving bonds. @) Encash Bonds: These bonds have a feat. e that interest is stepped up every year. These bonds can be redeemed ater 1 year and 8 months. The encashing facility is available only 10An Introduction to Financial System 9 A original bondholders. These bonds not only offer higher return but also widen the banking 7 mare investors. Improved yield maturity results in favourable secondary market price of @ Financial Markets Financial market is that market where financial transactions take place. Such markets are classified into two categories on the basis of short-term and long-term transaction. @ (i) Money Market Money market refers to that market wherein short-term monetary assets are bought and sold According to Reserve Bank of India, “Money market is the centre of dealings mainly of short term character in monetary assets.” Two main components of money market are: (a) Financial Institutions and (b) Financial Instruments. (a) Financial Institutions: Financial institutions of Indian money market are divided into organised and unorganised sectors, (1) Organised Sector: Organised sector of the Indian money market refers to that sector whose activities and sections are coordinated systematically by the monetary authority. It includes the following institutions. (i) Reserve Bank of India: Reserve Bank is the apex institution of Indian money market. It is the central bank of the country. (ii) Commercial Banks: Commercial banks are the strong constituents of organised sector. It includes the following types of banks: (i) Public Sector Banks (State Bank of India + its subsidiaries + Nationalised banks + Regional Rural Banks) and (ii) Private Sector Banks (scheduled banks + non-scheduled banks + Foreign Banks). (iii), Cooperative Banks: These are the constituents of cooperative credit institutions and comprise of three-tier structure. State Co-operative Bank is at the top of this structure. At distinct level there are Central cooperative banks and at local level there are rural primary cooperative societies and urban cooperative banks. (2) Unorganised Sector: Unorganised Sector refers to that sector whose activities are not co-ordinated in a systematic order by monetary authorities. It includes mostly (i) Indigenous Banks; (ii) Money-lenders; (iii) Funds; (iv) Chit Funds, etc. (b) Financial Instruments: The other component of Indian Money Market are financial instruments through which short term loans are provided. These include: Bills, Treasury Bills, Promissory Notes; Hundies, Certificates of Deposits, Commercial Papers, etc. @ Organisation of Indian Money Market Indian Money Market includes the following organisations: (1) Call Money Market: The call money market deals with loans of very short duration. It mainly deals in one day loan which is not renewed for the second day. Mostly banks participate in call-money market. It is therefore called Inter-banking Call Market (2) Bankers Acceptance Market: By acceptance market we mean the market for banker's acceptance which arise out of trade transactions, both domestic and foreign.10 Financial Markets, Institutions and Services is often secured against collateral security (3) Collateral Loan Market: In this market loan es, etc. Thus, the market for loans secured by Security may be inany form, viz., pledge, mortgags vollateral security is called the collateral loan market (4) Treasury Bill Market: The market that deals with treasury bills is called Treasury Bill Market, Treasury Bills are issued by the central government to secure short-term (91 days) loans. These tie are sold by the Reserve Bank on behalf of the government These are bought by the Reserve Bank, Commercial banks, non-banking financial intermediaries, LIC, UTI and GIC. Treasury bills are most liquid because Reserve Banks always willing to buy and discount them rket: It is the market that deals in bills. Commercial bills are those bills ge for goods bought or sold. By making use of given date, to the (5) Commercial Bill Mai which are issued by the firms or traders in exchans the promissory notes, the buyer promises to pay particular amount, on a seller. On the other hand, the seller issues commercial bill directly to the buyer ordcing the latter to pay a particular amount, on a given date, for the goods received by him.The buyer counter signs the bill by tvay of acceptance. Such bills are mostly of three months duration ¢ (ii) Capital Market Capital market is a centre which deals in mechanism by which debtors secure long-term securities. In the words of Prof. Dougal, * The capital equity.” Constituents of the capital market can be divided into two parts as shown in the following chart. Constituents of the Capital Market a el Lender's Sector ] Borrower's Sector long term funds. In other words, capital market is a loans and creditors invest their capital in long-term | market deals in long-term funds, both debt and Capital is supplied by the lender sector and is demanded by the borrower sector of the capital market. We will now see as to who makes a demand for capital © (A) Lender's Sector Constituents of this sector are those individuals and institutions who provide loans for long term. It has two parts. (I) Organised Sector Organised sector of the capital market comprises of the following institutions: (1) Stock Exchange: It deals in corporate securities like shares, debentures and bonds and ee or gilt-edged securities. It is the most important constituent of the capital market ies (i) Corporate security market and (ii) Gilt -edged security market. Corporate : ‘curity Market can further be classified into New Issue Market and Secondary Market : Secondary Market deals in old corporate securities like shares, debentures, etc (2) Non-l ) Now Banking Financial Intermediaries: Non-Banking Financial Intermediaries are lutions which do not accept demand deposits from the public as the banks do.An Introduction to Financial System (a) Development Bank and (b) Investment Institutions (a) Development Banks: These bank are as a matter of fact, special financial institutions that provide medium term an \d long term loans. Main development banks are: (i) Industrial Finance Corporation of India (IFCI). (i) Industrial Credit and Investment Corporation of India (ICICI) (ii) Industrial Development Bank of india (IDBI), (iv) Small Industries Development Bank of India (SIDBI) (v) Industrial Reconstruction Bank of India, (vi) State Finance Corporations (SFC) (vii) State Industrial Development Corporations (SIDCs) (b) Investment Institutions: These institutions help large and increasing number of investors to invest in shares and debentures of the companies by extending them various facilities. These include the following institutions: (i) Unit Trust of India (UTI), (ii) Life Insurance Corporation of India (LIC), (iii) General Insurance Corporation of India (GIC). Some ne investment institutions have also come into being. These are (i) Merchant Banking (ii) Mutual Funds, (iii) Lease companies and (iv) Venture Capital Financing: (II) Unorganised Sector It includes mostly indigenous bankers, money lenders, chit funds and similar other institutions like investment companies, finance companies, hire purchase companies, etc. Unorganised sector has very limited role to play in capital market. (B) Borrower's Sector It includes those borrowers who borrow medium term and long term capital. It comprises of the following: (1) Government Sector: In this sector are included (a) Central government and (b) State governments. On account of ever expanding developmental and non-developmental activities of the government, demand for capital funds on the part of the government has increased tremendously. Railways, road transport, power corporations, departmental enterprises of the government borrow funds from capital market. Central and state governments and local public bodies have floated loans by issuing long-term securities, bonds etc. Government securities are called Gilt-edged securities. (2) Corporate Sector: Both private and public corporate sectors make demand for long-term capital for diverse reasons. They mobilise long-term funds. They (i) issue shares, (ii) sell debentures, (iii) borrow from development banks and investment institutions and (iv) attract term deposits from general public and in this way collect long-term funds @ Financial Instruments Financial instruments of the capital market are classified into the following two categories: (1) Government or Gilt-edged securities, (2) Corporate securities. ®@ (1) Government or Gilt-edged Securities Central and state governments borrow funds from the people by issuing long-term bonds like National Saving Certificates, Gold Bonds, Railway Bonds, Special Bearer Bonds, etc. Investment in government securities is considered very safe and they enjoy tax rebates also.12 Financial Markets, Institutions and Services © (2) Financial Instruments of Corporate Sector Corporate sector are as under: silding fixed capital, Joint stock companies are authorised to issue shares, According to Companies Act, two kinds of shares can be issued by the companies (i) Ordinary shares and (ii) Preference shares. Shareholders get dividend only when companies nt of loss suffered by the company, the value of the share goes Main financial instruments of (i) Shares: For the purpose of bu or corporate earn profit. In the ever down (ii) Debentures: It is a sort of loan called debenture-holders. Pre-determined rate of interest is pai whether the corporation earns profit or suffers loss. (ili) Public Deposits: Companies also accept long-term deposits from the public. (iv) Loan from Institutions: Long-term loan from special financial institution like Finance Corporation of India is also an important financial instrument in the capital market document. Those who advance loans to the company are id to the debenture-holder, In short, Capital market structure consists of financial institutions, lenders and borrowers sector and financial instruments. @ Financial Intermediaries Another important component of Indian Financial Syste intermediaries is meant those institutions which collect saving from those who save and make available the same to the investors for their use. In other words, these are the institutions which act as middle-men between the lenders and the borrowers. Their main function is to collect savings or financial surpluses from the economic units and lend the same to those economic units whose expenditure exceeds income, that is, who are either investors or consumers. Such financial intermediaries or institutions are mainly classified sm is Financial Intermediaries. By financial into two categories: (I) Institutional or Organised (II) Non-institutional or Unorganised @ |. Institutional or Organised Those institutions which are controlled by the central bank of the country (RBI, in case of India) are called institutional or organised. These are mainly divided into two parts: (a) Banking Institutions and (b) Non-banking Financial Intermediaries. © (a) Banking Institutions Bank is an institution that accepts deposits from the public, mobilises their savings and keeps the same under its custody. These deposits are withdrawable by cheque. It lends money to those who need it and also performs diverse agency functions It also creates credit. In terms of Indian Banking Companies Act, “Banking company is one which transact the business of banking which means the acceptance 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.” In Banking Institutions are divided into two categories: (i) Commercial Bank and (ii) Co-operative Bank. These banks are under the control of Reserve Bank of India.‘An Introduction to Financial System @ Reserve Bank of India eee India is the central bank of our country. It was established in 1935 and in 1949 it eee te Hapa iby a Central Board of Directors Existing Board of Directors has 20 members. Chairman of the is called Governor. He is appointed b n "9 government of India. Head office of the Bankis situated at Mumbai. In terms of the preamble of Reserve Bank of India Act (1934), "the main functions of the bank are to regulate the issue of bank notes and keeping the reserves with the view to ing monetary stability in ee lity in India and generally to operate the currency and credit system of the country Main functions of the Reserve Bank are as under: @ (A) Central Banking Functions Reserve Bank performs the following central banking functions: (1) Issue of Paper-Currency: Reserve Bank of India has the monopoly to issue currency notes. Reserve Bank issues notes of the denomination of & 2,5,10, 20, 50, 100, 500 and 1000. (2) Regulation of Credit: Reserve Bank decides the credit policy of the country and also controls the volume of credit. It adopts various methods of credit control, namely (i) Change in Bank Rate: Bank rate is that rate of interest at which it advances loans to other banks. (ii) Open Market Operations i.e. buying and selling of government securities in the open market. (iii) Change in Cash Reserve Ratio: It means that all banks in the country must keep a minimum percentage of their deposits with the Reserve Bank. (iv) Change in Statutory Liquidity Ratio: It means that the banks must keep a certain percentage of their deposits in cash form compulsorily with themselves. (v) Regulation of Consumer Credit. (vi) Change in Marginal Requirements of Loans. It means the difference between the amount of loan given by the bank and value of the goods mortgaged. (vii) Rationing of Credit (3) Banker of Banks: When need be, banks borrow from the Reserve Bank. The latter supervises and guides them. (4) Banker of the Government. (5) Regulation of Foreign Exchange. e (B) General Banking Functions Reserve Bank also performs the following general banking functions as well: (i) To accept deposits Reserve Bank accepts deposits from the government as well as private individuals . How itdoes not pay any interest thereon. (ii) To Deal in Bills (iii) Lending of Money. Reserve Bank advances short term loans to the government and other banks. Reserve Bank is the central bank of India. In conformity with the policy of the government, it controls the entire banking system of the country and formulates as well as regulates monetary policy of the country. @ Commercial Banks Commercial banks are the institutions that accept deposits of the people and ordinarily advances short term loans, Commercial banks create credit also. In India, such banks alone are called commercial banks as are established in accordance with the provisions of India Companies Act 1913. Commercial Banks are of two categories:7 Financial Markets, Institutions and Services (a) Scheduled Banks: (i) Scheduled banks are those banks whose minimum paid up capital and reserve fund amount to five lakh Rupees. (ii) These banks have to submit detail of their activities to the Reserve Bank every week. (iii) These banks are listed in the second schedule of the Reserve Bank. (b) Non-Scheduled Banks: Paid-up capital of these banks is less than @ 5 lakh. These banks are not listed in the second schedule of the Reserve Bank, nor has the latter any effective control ‘over them. However, even these banks are required to submit weekly report of their activities of the Reserve Bank. @ Scheduled Banks in India Structure of scheduled banks in India is shown in the following chart: Scheduled Banks in India = 7 Commercial Banks Co-operative Banks Pubic Sector] [Foreign | [Regional Rural] [ Pavate rea eae Banks (25) | | Banks (32) | | Barks (@2) "| | Banks (21) Banks (52) Banks (32) State Bank of india | [Other Nationalised id Private New Private and its Associates Banks (19) Banks (14) Banks (7) @) @ (1) Public Sector Banks Public Sector banks are those banks which are owned, controlled and managed by the government. Public sector banks in India are divided into three categories: (i) State Bank of India and its subsidiary banks: State Bank of India is the first public sector bank of the country. It was established in 1955, In 1959, State Bank of India (Subsidiary) Act was passed. By virtue of the provisions of this Act, seven banks of the erstwhile princely states were made the subsidiary banks of State Bank of India. These seven subsidiary banks are: (i) State Bank of Hyderabad; (2) State Bank of Jaipur and Bikaner; (3) State Bank of Travencore, (4) State Bank of Mysore, (5) State Bank of Patiala, (6) State Bank of Indore and (7) State Bank of Saurashtra. State Bank of Saurashtra merged with SBI in 2008, After that State Bank of Indore was also merged with SBI in 2010. Thus, at present there are only five associates of SBI. (i) Nationalised Bank: In 1969, government of India nationalised 14 banks. Later in 1980 another lot of 6 banks was nationalised. Thus total number of nationalised banks was twenty: However their number came down to 19 when New Bank of India was merged in Punjab National Bank. By opening their branches liberally, nationalised banks have sought to make banking facilities available almost all across the country.‘An Introduction to Financial System 15 (iii) Regional Rural Banks: On the recommendation of the Banking Commission (1972), on October 2, 1975, five Regional Rural Banks were established. Their main function is to provide financial help to small and marginal farmers and rural workers in order to develop rural economy. Capital is provided to these banks by the Central government, state government and the founder banks. On March 31, 2010, as many as 82 Regional Rural Banks were functioning in the country, (2) Private Sector Banks Banks whose ownership vests in the private sector are called private sector banks. They fall under three categories: @ (i) Old Private Banks, (ii) New Private Banks, (iii) Foreign Banks Since 1991, subsequent to economic reforms. Reserve Bank has been giving acceptance to the establishment of new banks in the private sector. Even non-resident Indians (NRIs) and foreign companies can buy shares of private sector banks. New private banks provide high level of modern customer services. As a consequence, level of customer services has improved appreciably. At the end March 2010, out of 21 private banks, 14 are old private banks and 7 are new private banks. Foreign banks are those banks whose headquarter is situated in foreign countries. In the past, these banks used to confine their activities Mainly to foreign exchange and so were called Foreign Exchange and so were called Foreign Exchange Banks. Presently, they are called Foreign Banks. They now perform all sorts of banking functions. They are 32 in number. Co-operative Credit Institutions 7 Rural Co-operative Urban Co-operative Credit Institutions Bank t : L Short-term Long-term Structure. ‘Structure Primary District Central State Agriculture Co-operative Co-operative Credit Societies Bank Banks EHUB ELEY [State Co-operative Agriculture| Primary Co-operative and Rural Development Agriculture and Rural Banks Development Banks= Financial Markets, Institutions and Services @ Co-operative Banks Co-operative Banks constitute an important form of organised banking sector. It is a banking organisation wherein people join voluntarily on equal basis for the betterment of their economic interests In India, it was in 1904 that Agricultural Credit Societies were formed. Co-operative Banks are those banks Which are established in accordance with the provisions of State Co-operative Credit Societies Act Organisation of Co-operative institutions is evident from the following chart (i) State Cooperative Bank: Every state has a main co-operative bank that runs all the central It also lends money to them. At the end March 2010, 32 state cooperative banks in that state. cooperative banks are functioning in the country. (ii) District Central Cooperative Banks: These banks supervise primary co-operative societies of a district or any part of it. These banks also provide financial assistance to such societies. Number of these banks is approximately 372 as on 31 March 2010. (iii) Primary Agricultural Credit Societies: These societies operate in villages. In most of the states, more than ten persons join to from a co-operative credit society. These societies accept deposits from their members and provide them short-term and medium-term loans. Presently, till 31 March 2010 about 94,647 primary cooperative credit societies are functionary in the country. (iv) Primary Cooperative Agriculture and Rural Development Banks: These banks advance long-term loans on the security of immovable property that is mortgaged with them by the debtors. (v) State Co-operative Agriculture and Rural Development Banks: These banks advance loans to Primary Co-operative Agriculture and Rural Development Banks. Entire state comes iction. They are 20 in number at present. under their juris (vi) Urban Co-operative Banks: These banks operate in urban areas and accept deposits from the public and also advance loans to them. Presently these banks are supervised by the Reserve Bank of India. These are managed by the state governments. Their number is 1,674 at present. @ Non-Banking Financial Intermediaries Non-banking financial companies (NBFCs) have gathered considerable momentum in India Apart from commercial and government banks all other financial institutions are called non-banking financial intermediaries. These intermediaries mobilise savings of the public and advance loans to the investors. NBFCs must get themselves registered with the Reserve Bank of India. Main difference between such intermediaries and banks is that the former do mobilise savings of the public but do not accept their demand deposits. They do not issue cheques nor do they perform many other functions of the banks. According to Reserve Bank Act 1934 that was amended in 1994, main functions of the intermediaries are: toaccept deposits and advance loans like financial institutions, to invest in securities, hire purchase finance or equipment leasing, Main Non-banking Financial Intermediaries in India are as under: Development Banks: These banks belong to the category of special institutions that provide medium and long term finance to private entrepreneurs and in this way make significant contribution t© economic development. Their main functions is to promote investment and develop enterprise. They are engaged in the development of industry, agriculture, foreign trade, etc. They operate both at all India levelAn Introduction to Piyanclal Syste 7 as well as state level, Development Banks engaged at the national level for the development of industries are mainly as und (1) Industrial F ‘poration of India Limited, (2) Industrial Development Bank ‘of India, (3) Small Indus Development Bank of India (4) Industrial Investment Bank of india, (5) Industrial Credit and Investment Corporation of Ind nee At state level, State Finance Corporation and State Industrial Development Bank are in operation. National Agriculture and Rural Development Bank (NABARD) is meant to develop agricultural sector. Export-Import Bank is serving the interest of India’s foreign trade. Apart from these specialised banks, there are diverse financial institutions to meet specific needs, e.g., Life Insurance Corporation of India; General Insurance Corporation; Unit Trust of India; Investment Companies; Hire purchase Finance Companies; Equipment Leasing Company; Loan Company; Housing Finance Company; Residuary Non-Banking Company; Mutual Benefit Company; Nidhi Company; Merchant Banks; Chit Fund Company; Venture Capital Funds/Companies, etc. By virtue of Reserve Bank of India (Amendment) Act 1997, RBI has been authorised to supervise these companies and issue them guidelines to enable them to function properly. @ Il. Non-Institutional Or Unorganised Indigenous Bankers are included in the unorganised sector of Indian Banking System. It is called unorganised sector because Reserve Bank has no control over it. According to Banking Commission (1972), Indigenous bankers include those individuals and firm who accept deposit or depend on credit to run their business or deal in short-term credit instrument (hundi) in order to provide financial help for goods and services. This institution is known by different names in different parts of the country. In Gujarat itis called Saraf, in U.P Sahukar, in South Chattiors, in Assam itis called Kayas, in Tiruonthali district of a South it is Kalidaifurichy Brahamin, money-lender, etc., unorganised sector play a significant role in rural economy, In urban areas, indigenous bankers largely finance small industries and petty traders. It is the main source of finance to village artisans and farmers. According to one estimate, in urban areas almost 30% of credit needs of wholesale and retail trade, export trade banking activity, hotel and restaurant, etc., are met by unorganised sector. This sector acts both as a competitor as well as complementary to the banking sector. This sector is classified as under: (i) Unregulated NBFCs (ii) Indigenous Bankers (ili) Finance Brokers iv) Money Lenders (v) Other Lenders Main credit instrument of unorganised sector is hundie. It is an indigenous version of bill of exchange and is written in vernacular. This sector meets the credit needs of farmers, village artisans, small traders, small producers, etc., because, banking sector hesitates to accommodate them due to risk involved. Indigenous bankers have personal relations with their customers. Mode of advancing loan is simple. However, they do have some demerits, like manipulation of accounts, exorbitant rate of interest, loans for unproductive purpose, loans for speculation, fraudulent practices to deprive the farmer of his land, etc. All these demerits imply that unorganised sector should be wound up. But there are other people who are of the view that unorganised sector should not be ended but mended. This sector must modernise its functioningFinancial Markets, Institutions and Sery 18 @ Regulatory Authorities The following are the Regulatory Aut! financial institutions: (i) Reserve Bank of India (RBI): Banks, State Co-operative Ban! financial institutions and non-banking companies India is sole authority in respect of all transactions | market. (ii) Securities and Exchange Board of Indi capital market in India-both the primary an powers to regulate the Mutual Funds and Venture d Development Authority (IRDA): Established in 1990, IRDA authority for all insurance companies in orities in india, which regulate, supervise and control vario, Commercial banks - both Indian and Foreign, Regional Rural Fa fall within supervisory purview of RBI. In addition, the are also regulated by it. Reserve Bank of n the money market and foreign exchange a (SEBI): SEBI is the principal regulator in the d secondary segments. It is also conferred the Capital Funds in India. ii) Insurance Regulatory an with its headquarters at Hyderabad is the regulatory India including the Life Insurance Corporation of India @ Flow of Funds Matrix “The financial system is complex in structure and function through the world, it was created in purpose to facilitate the flow of funds from savers to investors. It includes many different types of institutions: Financial intermediaries (banks, insurance companies and mutual funds), Financial markets {stock and bond markets). Indirect Finance Funds Household pall Business firms Funds Financial eae Households For Direct Finance decd Financial system provides a transm borrower-spenders. Funds flow indirectly fr intermediaries (banks or other financial instituti : to ultimate borrowers (business firms, ae Foreigners iss nission mechanism between saver-lenders and ee lenders (households) through financial ie rectly through financial markets (stock exchange) | and other households) ™ Financial System and Economic Developm ent increase in the level of skilled TS es ir ill diverse workforces, innovation, leadersh i M , leadership, social environmen’An Introduction to Financial System is technological environment, economic environment and labour market environment are prime reasons for the development of Indian financial system. The Indian financial system play following roles in the economic development of India: 1. Transfer of Resources: Financial system facilitate the transfer of real economic resources from lenders to ultimate borrowers. It helps in matching the terms, fund requirements and expectations of different entities. It facilitates pooling of resources. Investors on one hand have small amounts of money to invest and the business on other hand need large amount of money. The financial system can pool in resources of many such investors in order to make it available to businesses or the Government in such cases. It also matches the returns expectations in terms of their timings, quantum and surety. 2. Development of Industries: The financial system through its institutions, assets, markets and services play a vital role in the industrial growth of developing nations like India. The financial system facilitates industries by providing medium and long-term capital, generally to the private sector, although public sector is not excluded. Its operations also include conducting ‘of market surveys, preparation of project report, provision of technical advice and management services. 3. Providing Rural Credit: Regional Rural Banks have been in existence for around three decades in the Indian financial scene. Inception of regional rural banks (RRBs) can be seen asa unique experiment as well as experience in improving the efficacy of rural credit delivery mechanism in India. With joint shareholding by Central Government, the concerned State Government and the sponsoring bank, an effort was made to integrate commercial banking within the broad policy thrust towards social banking keeping in view the local peculiarities. 4. Mopping up Savings: The financial system mops up small savings of masses at reasonable rates with several options. The common man has options to park her/his savings under the alternatives which are made available in the financial system 5. Balanced Development: The financial system focuses its efforts on less developed and backward regions of the country for its balanced economic development. It mobilizes resources of the country into profitable channels taking in view the goal of balanced development of the country. It provides several social sector schemes for the betterment of deprived class of the country, 6. Promoting International Trade: The financial system also fosters trade between countries as it provides various facilities through its innovative product and institutions to bring together local and foreign entrepreneurs. 7. Promoting Inclusive Growth: The financial system helps the Indian economy in its inclusive growth by creating economic opportunities along with ensuring equal access to them. Financial inclusion is the key driver for inclusive growth. @ An Overview of Indian Financial System © |. Period upto 1968 India has a long history of financial intermediation. The first bank in India to be set up on modern lines was in 1770 by an agency house. The earliest but short-lived attempt to establish a central bank was in 1773. India was also a forerunner in terms of development of financial markets. The Bombay Stock Exchange was functional as early as 1870. The first Life Insurance Company in the country, Oriental» Financial Markets, batmstions and Services Life Insurance Company, had been established as far back in 1818 and the first general (non-tte insurance company was set up in 1850. By independence, India had a fairly well developed commercial banking system in existence. In 1951, there were 566 private commercial banks in Incie wth 4 15) branches, mostly confined to larger towns and cities. Savings in the form of bank Geposits accounted for less that of 1 per cent of national income The Reserve Bank of India (RBI) was orginally established 1935. After independence. the Reserve Bank became a state-owned institution from January 1, 1949. It was onlly in this year that the Banking Regulation Act was enacted to provide a framework for regulation and supervision of commercial banking activity. However, despite the widespread development of banking system, the Indian financial system was characterised by lack of depth at the time of independence Organised credit institutions had a negligible presence in rural India After independence, the countrys’ immediate need was to mobilize savings in order to raise the investment rate. At the beginning of planning in 1951. the Indian economy operated at relatively low levels ‘of savings and investment. The First Plan observed that desirable rate of growth in output could be achieved only if investment could be stepped up substantially. The planning strategy was based on the concept of mixed economy where both public and private sectors had to play a role with regard to investment activity and in mobilization of resources. The experience during the planning period suggested that institution building and development of financial system was propelled by the vision of the country's planners after independence. The vision was to ensure that sectoral needs of credit to agriculture and industry were met in an organised manner. The RBI was vested with the major responsibility of developing the institutional infrastructure in the financial system. The commercial banking was expanded to take care of the general banking needs of accepting deposits and extending short-term working capital to industry. Further State Bank of India was given the responsibility to meet the credit needs of the co-operative sector. Development Finance Institutions like State Finance Corporations were also established by RBI to cater to long-term financing needs of industry at national level. The Unit Trust of India came into existence in 1964 to provide a channel for retail investors for participating in the capital market. Recognising the significance of export, an Export Risk Insurance Corporation was set up in July 1957 which was later converted into the Export Credit and Guarantee Corporation in January 1964. The Deposit Insurance Corporation was set up in 1962. In 1969, the average population per bank office declined from 132,700 (in 1950) to 64,000. But there was a distinct increase in the share of credit to industry from 34 per cent in 1951 to 67.5 percent 1968, agricultural sector got a little over 2 per cent to total bank credit. @ Il. Period from1969-1990 (The Pre-Economic Reform Years) Inithis period, the scheme of social control over banks that envisaged organisational and legislative ‘changes was initiated by the Government, with a view to bring about a wider diffusion of banking facilities and changes in the pattern of bank lending. In July 1969, 14 largest Commercial banks were with the purpose of rapid branch expansion, channeling of credit according to plan priorities and also to mop UP potential savings and meet the credit gaps in agriculture and small scale industries. In April 1980, six mow private sector banks were nationalised For providing agricultural credit Regional Rural Banks were set up in 1975. By the end of 1975 three separate institutional arrangements ~ Commercial banks, Co-operative banks, and RRBs ~ known as multi-agency approach for providing credit in the rural areas emerged. Establishment of National Bank for