CHAPTER 2 INDIAN FINANCIAL SYSTEM

To understand

•Financial System And Its Function

•Classification Of Financial Markets

•Money Market Instruments

•Capital Markets Instruments

•Government Securities Market

Objectives of the Session

FINANCIAL SYSTEM

It is an orderly mechanism and structure that is available in an economy to mobilize the monetary resources/capital from various surplus sectors of the economy and allocate and

distribute the same to various needy sectors. The term financial system is a set of inter-related activities/services working together to achieve some predetermined purpose or goal. It includes different markets, the institutions, instruments, services and mechanisms which influence the generation of savings, investment capital formation and growth.

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• Van Horne defined the financial system as the purpose of financial markets to allocate savings efficiently in an economy to ultimate users either for investment in real assets or for consumption.

• Christy has opined that the objective of the financial system is to "supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires.“

• According to Robinson, the primary function of the system is "to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth."

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Inter-relationship in the Financial System

Policy

Risk Payment

Liquidity

Savings

Financial System

FUNCTIONS OF FINANCIAL SYSTEM

CLASSIFICATION OF FINANCIAL MARKETS

• Financial Markets: Market in which financial assets are created or transferred.

• Financial Markets can be classified as:

1. Money Market: Deals with transactions related to short-term instruments with maturity period less than one year

2. Capital Market: Deals with transactions related to long-term instruments with maturity period greater than one year.

MONEY MARKET INSTRUMENTS

•Call money

•Commercial Papers

•Certificate of Deposits

CALL MONEY/NOTICE MONEY

• Call money : Money lent for 1 day

• Notice money: Money lent for 2-14 days.

• Purpose: - To help commercial banks by discounting commercial bills. - To help the banks in meeting the CRR requirement - To meet the sudden demands for funds

- To meet the temporary mismatches.

Can both lend and borrow: (e.g. Commercial banks, DFHI, STCI etc.)

Can only lend

(e.g. LIC, UTI, Mutual funds etc.)

•Participants:

CALL MONEY/NOTICE MONEY

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COMMERCIAL PAPERS– Short-term, unsecured promissory notes issued at a

discount to face value by well known companies with a high credit- rating.

– Commercial Paper (CP) is popular, among highly rated entities, as a tool for diversifying their sources of short term borrowings and for reducing the cost of such borrowings.

– It was introduced in India in 1990.– Corporates, primary dealers (PDs) and the All-India

Financial Institutions (FIs) are eligible to issue CP.– Maturity period: 15 days – 1 year. – Issued in multiples of Rs. 5 lakh ;the amount invested

by a single investor should not be less than Rs. 5 lakh. – They usually have a buy-back facility. – Negotiable by endorsement and delivery – Highly flexible instruments.

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CERTIFICATE OF DEPOSIT• This scheme was introduced in July 1989, to enable the

banking system to mobilise bulk deposits from the market, which they can have at competitive rates of interest.

• Issued by banks in the form of usance promissory notes.

The major features are: • Who can issue: Scheduled commercial banks (except

RRBs) and All India Financial Institutions within their `Umbrella limit’.

• CRR/SLR: Applicable on the issue price in case of banks • Investors: Individuals (other than minors),

corporations, companies, trusts, funds, associations etc

• Maturity Min: 7 days Max : 12 Months (in case of FIs minimum 1 year and maximum 3 years).

• Amount Min: Rs.1 lac, beyond which in multiple of Rs.1 lac

continued

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• Interest Rate: Market related. Fixed or floating

• Loan Against collateral of CD not permitted

• Pre-mature cancellation Not allowed

• Transfer Endorsement & delivery. Any time

• Nature Usance Promissory note. Can be issued in Dematerialisation form only only wef June 30, 2002

Other conditions

• If payment day is holiday, to be paid on next preceding business day

• Issued at a discount to face value

• Duplicate can be issued after giving a public notice & obtaining indemnity

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Money Market Mutual Funds•MMMFs were set up to make available the

benefits of investing in money markets to small investors.

•MMMFs invest primarily in money market instruments of very high quality and of very short maturities.

•MMMFs can be set up by commercial banks,RBI and public financial institutions either directly or through their existing mutual fund subsidiaries.

•MMMfs are regulated and governed by SEBI.

•Schemes offered can either be open- ended or close – ended.

CAPITAL MARKETS

•They deal with securities with maturity period > 1 year.

CAPITAL MARKETS

PRIMARY MARKETS

SECONDARY MARKETS

PRIMARY MARKETS

• Helps companies in raising funds through issue

of securities like shares and debentures. • Governed by SEBI (Securities and Exchange

Board of India).

• Methods of issuing securities in Primary Market: - Public Issue - Rights Issue - Bonus Issue - Private Placement - Bought-out Deals

SECONDARY MARKET

• Securities already issued in the primary market are traded in the secondary market.

• Provides liquidity to the securities held by the investors.

• Operates through stock exchanges that regulate the trading activities in this market.

STOCK EXCHANGES

• They are auction markets for securities. • Transaction at stock exchange occur by

placing an order.• Types of Orders:

– Limit Orders – Best Rate Order – Immediate or cancel order– Limited Discretionary Order– Stop Loss Order – Open Order

• Delivery of share certificate after execution of order may be spot, specified or hand delivery

GOVERNMENT SECURITIES MARKET

•Securities that are issued by the Central government, state governments and entities that are wholly owned by the government.

•Fully secured in nature.

Forms in which government securities can be held: - Stock Certificate

- Promissory Notes - Bearer Bonds

Examples of Government Securities:

-Treasury Bills -Public Sector

Bonds

GOVERNMENT SECURITIES MARKET

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TREASURY BILLS

• Short-term promissory notes issued by the government to meet their short-term obligations.

• They are useful in managing short-term liquidity. • At present, the Government of India issues three

types of treasury bills through auctions, namely, 91-day, 182-day and 364-day.

• There are no treasury bills issued by State Governments.

• The RBI acts as an agent for issuing T-Bills. • Subscribers: Banks, primary dealers, financial

institutions, insurance companies, provident funds, NBFCs, FIIs and state governments.

• Treasury bills are available for a minimum amount of Rs.25,000 and in multiples of Rs. 25,000.

• Treasury bills are issued at a discount and are redeemed at par.

Issued for a minimum amount of Rs. 25,000 and in multiples of 25,000 thereof.

Maturity Period: 91 days and 364 days

TREASURY BILLS

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PUBLIC SECTOR BONDS

•Bonds issued by public sector companies

•Secured in nature.

•Maturity Period: 5 to 7 years.

• Investors: Banks, Insurance Companies, Corporate, Provident Funds, Mutual Funds, Individuals.

• Interest income eligible for deduction under Section 80L of I.T. Act.

Summary

Financial System And Its FunctionClassification Of Financial MarketsMoney Market InstrumentsCapital Markets InstrumentsGovernment Securities Market

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Objectives of the Session:

To understand• INTERNATIONAL CAPITAL MARKETS

• FINANCIAL INSTITUTIONS

• BANKING SYSTEM

• INSURANCE

• NON-BANKING FINANCIAL COMPANIES

Section II: Indian Financial System

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INTERNATIONAL CAPITAL MARKETS

• INSTRUMENTS IN INTERNATIONAL MARKETS

Equity Instruments

-Global Depository Receipts

-American Depository Receipts

Debt Instruments

-Euro Bonds

-Foreign Bonds

-Euro Notes

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GLOBAL DEPOSITORY RECEIPTS & AMERICAN DEPOSITORY RECEIPTS

• A GDR or ADR means any instrument in the form of a Depository receipt or certificate, created by the Overseas Depository Bank (ODB) outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of issuing company.

• These are negotiable instruments denominated in US $ representing a non-US company’s publicly traded, local currency equity shares.

• The issue of such instruments involves the delivery of ordinary shares of an Indian company to a domestic custodian bank in India, which in turn instructs an overseas depository bank to issue GDR/ADR on a predetermined ratio.

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• The GDR/ADR can be sold outside India in their existing form.

• The underlying shares (arising after redemption of GDR/ADR) can also be sold in India.

• While ADRs are listed on the US stock exchanges, the GDRs are usually listed on a European stock exchange.

• A GDR/ADR may evidence one or more GDS/ADS.

• Each GDS/ADS represent underlying share of Issuing company.

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EURO BONDS• Eurobonds are bonds that are issued for sale outside the issuer’s home country.

• They can be issued in the currency of the foreign country, or another currency.

• Interest payments and principal are to be returned to the holder in the currency in which the bond was issued.

• In most cases, the interest is paid annually.

• The Eurobond marketis extremely liquid. While the majority of the trading is centralized around London’s trading hours.

• Eurobond trading takes place 24 hours a day worldwide.

• Eurobonds are named after the currency they are denominated in. For example, Euroyen and Eurodollar bonds are denominated in Japanese yen and American dollars respectively.

• A Eurobond is normally a bearer bond, payable to the bearer.

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FOREIGN BONDS• Bonds issued by foreign entities for raising medium to long-term

financing from domestic money centers in their domestic currencies.

• A bond issued in a particular country by a foreign borrower (or) a bond sold by a foreign borrower, denominated in the currency of country in which it is sold and is underwritten & syndicated by national underwriting syndicate in the lending country .

• Foreign bonds are floated in the domestic capital markets (and are in the domestic currency of those markets) by nonresident entities.

• These bonds are different from Euro bonds in the sense that they are governed by the regulations of the country in which they are issued whereas Euro bonds are not.

• The bonds are generally named on the basis of the capital markets in which they are floated.

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Types of Foreign Bonds

• Yankee Bonds: Yankee bond is a dollar denominated bond issued in U.S by a non-U.S. borrower in the U.S. market.

• Samurai bond: Samurai bonds are yen denominated bonds issued in Japan by a non-Japanese borrower.

• Bulldog bonds: Bulldog bonds are pound denominated bonds issued in U.K. domestic market by a non U.K. borrower.

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FOREX MARKETS

• Foreign Exchange Market: Deals with transactions in currencies other than one’s own currency.

• Exchange rate: The rate at which one currency can be converted into another currency

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Participants:

ExportersImportersCommercial BanksCentral BanksAuthorized Dealers and Money ChangersBrokers

FOREX MARKETS cntd…

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DERIVATIVES MARKET

• Financial derivative is a product derived from the market of an underlying asset.

Participants:

- Hedgers: Hedgers wish to eliminate or reduce the price risk to which they are already exposed

- Speculators: Speculators are those class of investors who willingly take price risks to profit from price changes in the underlying.

- Arbitrators : Arbitrageurs profit from price differential existing in two markets by simultaneously operating in two different markets.

Types of Derivatives:

- Futures

- Options

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FINANCIAL INSTITUTIONS

• Industrial Development Bank of India

• Industrial Finance Corporation of India

• Industrial Credit and Investment Corporation of India

• Industrial Investment Bank of India

• Export and Import Bank of India

• State Financial Corporations

• Investment Institutions

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ORGANIZATION OF BANKING SYSTEM

Commercial Banks

Scheduled Banks Non-Scheduled Banks

State Co-op Bank

Commercial Banks

Central Co-operative Banks and Primary Credit Societies

Reserve Bank of India

Indian Foreign

Public Sector Banks

Private Sector banks

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RESERVE BANK OF INDIA

• It is the central bank of India.

• Established to guide, monitor, regulate, promote and guide the Indian financial system.

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FUNCTIONS OF RBI

• Currency issuing authority• Acts as banker the central and state governments• Serves as banker’s bank• Foreign exchange control authority• Exercises monetary control through: -Bank Rate

-Reserve requirements: CLR and SLR -Open market operations• Undertakes developmental activities

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COMMERCIAL BANKS• Most important depositors and disbursers of finance. • They are expected to hold a part of the deposits in

the form of ready cash, known as cash reserves as prescribed by RBI.

SCHEDULED BANKS • Scheduled banks are those that are included in the

second schedule of Banking Regulation Act, 1949; the others are non-scheduled banks.

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Requirements that should be fulfilled to be a Scheduled bank:

A bank must have a paid-up capital and reserve of not less than Rs. 5 lakh,

It must ensure that its affairs are not conducted in a manner detrimental to the interests of its depositors.

SCHEDULED BANKS cntd…

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LIABILITIES AND ASSETS OF A BANK

LIABILITIES ASSETS

1. Demand deposits

a. Current deposits

b. Savings deposits

c. Call deposits

2. Time deposits

3. Other liabilities

(e.g. borrowings form RBI, refinance form IDBI, NABARD etc.)

1. Cash in hand

2. Balances with RBI

3. Assets with the banking system

4. Investments in Government and other approved securities

5. Bank Credit

a. Demand and Term loans

b. Cash Credit/Overdraft arrangement

c. Bill financing

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INSURANCE

From an individual’s point of view, insurance is an economic device whereby the individual can substitute a small definite cost (premium) for a large uncertain financial loss [the contingency insured against] that would have to be borne if insurance was not available.

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CLASSIFICATION OF INSURANCE BUSINESS

1.Life Insurance: A life policy covers risk of death due to natural causes as also due to accidents.

2.General Insurance: Insurance other than the life insurance fall under the category of general insurance.

a.Fire Insurance

b.Marine Insurance

c.Miscellaneous Insurance

Insurance Regulatory and Development Authority: Regulates, promotes and ensures orderly growth of the insurance business and reinsurance business.

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NON BANKING FINANCIAL COMPANIES

• Investment Trusts and Investment Companies

• Mutual Benefit Funds

• Merchant Banks

• Hire Purchase Finance Companies

• Lease Finance Companies

• Housing Finance Companies

• Non-Housing Bank

• Venture Capital Funding Companies

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Summary

FINANCIAL SYSTEM AND ITS FUNCTION

CLASSIFICATION OF FINANCIAL MARKETS

MONEY MARKET INSTRUMENTS

CAPITAL MARKETS INSTRUMENTS

GOVERNMENT SECURITIES MARKET

INTERNATIONAL CAPITAL MARKETS

FINANCIAL INSTITUTIONS

BANKING SYSTEM

INSURANCE

NON-BANKING FINANCIAL COMPANIES