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CHAPTER – III

INDIAN FINANCIAL SYSTEM AND PRIVATE FINANCIAL

INSTITUTIONS

3.1 INTRODUCTION

3.2 INDIAN FINANCIAL SYSTEM

3.3 FINANCIAL INSTITUTIONS IN INDIA

3.4 UNORGANIZED SECTOR OF INDIAN FINANCIAL SYSTEM

3.5 POSITION OF PRIVATE FINANCIAL INSTITUTIONS IN

INDIAN FINANCIAL SYSTEM

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3.1 INTRODUCTION:

A financial system plays a vital role in the economic growth of a country.

A country’s economy runs on the sound financial system that the country has. As

the area of the present research work ‘Private Financial Institutions’ i.e. NBFCs

and UIBs being the component of the financial system of the country, it is very

much important to discuss the existing financial system. An overview of the

country’s financial system will certainly help to perceive a better knowledge and

understanding of the present study.

3.2 INDIAN FINANCIAL SYSTEM:

A financial system is a complex, well-integrated set of sub-systems of

financial institutions, markets, instruments and services which facilitates the

transfer and allocation of funds, efficiently and effectively. It intermediates

between the flow of funds belonging to those who save a part of their income and

those who invest in productive assets. It mobilizes and usefully allocates scarce

resources of a country.

The financial systems of most developing countries are characterized by

coexistence and cooperation between the formal and informal financial sectors.

This coexistence of these two sectors is commonly referred to as ‘financial

dualism’.1 The formal financial sector is characterized by the presence of an

organized, institutional and regulated system which caters to the financial needs of

the modern spheres of economy; the informal financial sector is an unorganized,

non-institutional and non-regulated system dealing with the traditional and rural

spheres of the economy.

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The informal financial sector has emerged as a result of the intrinsic

dualism of economic and social structures in developing countries, and financial

repression which inhibits the certain deprived sections of society from accessing

funds. The informal system is characterized by flexibility of operations and

interface relationships between the creditor and the debtor. The advantages are:

low transaction costs, minimal default risk, and transparency of procedures. Due to

these advantages, a wide range and higher rates of interest prevail in the informal

sector.

Different designs of financial systems are found in different countries. The

structure of the economy, its pattern of evolution, and political, technical and

cultural differences affect the design of the financial system. Two prominent polar

designs can be identified among the variety that exists. At one extreme is the

bank-dominated system, such as in Germany, where a few large banks play a

dominant role and the stock market is not important. At the other extreme is the

market dominated financial system, as in the US, where financial markets play an

important role while the banking industry is much less concentrated.

“In bank-based financial systems, banks play a pivotal role in mobilizing

savings, allocating capital, overseeing the investment decisions of corporate

managers and providing risk-management facilities. In market-based financial

systems, the securities market share centre stage with banks in mobilizing the

society’s savings for firms, exerting corporate control and easing risk

management.”2 The other major industrial countries fall in between these two

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extremes. In India, banks have traditionally been the dominant entities of financial

intermediation. The nationalisation of banks, an administered interest rate regime

and the government policy of favouring banks led to the predominance of a bank-

based financial system.

3.2.1 Structure of Indian Financial System:

The Indian financial system can be broadly classified into the formal

(organized) financial system and the informal (unorganized) financial system. The

formal financial system comes under the purview of the Ministry of Finance

(MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board of

India (SEBI) and other regulatory bodies. The informal financial system consists

of:

• Individual moneylenders such as neighbours, relatives, landlords, traders

and storeowners.

• Groups of persons operating as ‘funds’ or ‘associations’. These groups

function under a system of their own rules and use names such as ‘fixed

funds’, ‘association’, and ‘saving club’.

• Partnership firms consisting of local brokers, pawnbrokers and non-bank

financial intermediaries such as finance, investment, and chit-fund

companies.

With the existence of both the sectors, i.e., formal and informal sectors, it can

be said that Indian Financial System has a dualistic character –in one hand, strong

and well established institutions, markets and instruments and on the other hand

components of unorganized sector. In India, the spread of banking in rural areas

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has helped in enlarging the scope of the formal financial system. The chart 2.1

shows the structure and components of the Indian Financial System.

3.2.2 Components of the Formal Financial System:

The formal financial system consists of four segments or components.

These are: financial institutions, financial markets, financial instruments, and

financial services.

3.2.2. (A) Financial Institutions:

These are intermediaries that mobilize savings and facilitate the allocation

of funds in an efficient manner. “Financial institutions can be classified as banking

and non-banking financial institutions. Banking institutions are creators and

purveyors of credit while non-banking financial institutions are purveyors of

credit. While the liabilities of banks are part of the money supply, this may not be

true of non-banking financial institutions. In India, non-banking financial

institutions, namely, the developmental financial institutions (DFIs), and non-

banking financial companies (NBFCs) as well as housing finance companies

(HFCs) are the major institutional purveyors of credit.”3

Financial Institutions can also be classified as term-finance institutions

such as the Industrial Development Bank of India (IDBI), the Industrial Credit and

Investment Corporation of India (ICICI), the Industrial Financial Corporation of

India (IFCI), the Small Industries Development Bank of India (SIDBI) and the

Industrial Investment Bank of India (IIBI).

Financial institutions can be specialized finance institutions like the Export

Import Bank of India (EXIM), the Tourism Finance Corporation of India (TFCI),

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ICICI Venture, the Infrastructure Development Finance Company (IDFC), and

sectoral financial institutions such as the National Bank for Agricultural and Rural

Development (NABARD) and the National Housing Bank (NHB).

Investment institutions in the business of mutual funds Unit Trust of India

(UTI), public sector and private sector mutual funds and insurance activity of Life

Insurance Corporation (LIC), General Insurance Corporation (GIC) and its

subsidiaries are classified as financial institutions.

There are state-level financial institutions such as the State Financial

Corporations (SFCs) and State Industrial Development Corporations (SIDCs)

which are owned and managed by the State governments.

3.2.2. (B) Financial Markets:

Financial market is a mechanism enabling participants to deal in financial

claims. The main organized financial markets in India are the money market and

the capital market. The first is a market for short-term securities while the second

is a market for long-term securities, i.e., securities having a maturity period of one

year or more.

Financial markets can also be classified as primary and secondary markets.

While the primary market deals with new issues, the secondary market is meant

for trading in outstanding or existing securities. There are two components of the

secondary market: over-the-counter (OTC) market and the exchange traded market

(Stock Exchanges). Recently, the derivatives market (exchange traded) has come

into existence.

3.2.2. (C) Financial Instruments:

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A financial instrument is a claim against a person or an institution for

payment, at a future date, of a sum of money and/or a periodic payment in the

form of interest or dividend. The term ‘and/or’ implies that either of the payments

will be sufficient but both of them may be promised. Financial instruments

represent paper wealth shares, debentures, like bonds and notes. Many financial

instruments are marketable as they are denominated in small amounts and traded

in organized markets. This distinct feature of financial instruments has enabled

people to hold a portfolio of different financial assets which, in turn, helps in

reducing risks. Different types of financial instruments can be designed to suit the

risk and return preferences of different classes of investors.

Financial securities are financial instruments that are negotiable and

tradable. Financial securities may be primary or secondary securities. Primary

securities are also termed as direct securities as they are directly issued by the

ultimate borrowers of funds to the ultimate savers. Examples of primary or direct

securities include equity shares and debentures. Secondary securities are also

referred to as indirect securities, as they are issued by the financial intermediaries

to the ultimate savers. Bank deposits, mutual fund units and insurance policies are

secondary securities.

Financial instruments differ in terms of marketability, liquidity,

reversibility, type of options, return, risk and transaction costs. Financial

instruments help financial markets and financial intermediaries to perform the

important role of channelizing funds from lenders to borrowers.

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3.2.2. (D) Financial Services:

These are those that help with borrowing and funding, lending and

investing, buying and selling securities, making and enabling payments and

settlements, and managing risk exposures in financial markets. The major

categories of financial services are funds intermediation, payments mechanism,

provision of liquidity, risk management and financial engineering.

Financial services are necessary for the management of risk in the

increasingly complex global economy. They enable risk transfer and protection

from risk. Risk transfer of services helps the financial market participants to move

unwanted risks to others who will accept it. The speculators who take on the risk

need a trading platform to transfer this risk to other speculators. In addition,

market participants need financial insurance to protect themselves from various

types of risks such as interest rate fluctuations and exchange rate risk.

Growing competition and advances in communication and technology have

forced firms to look for innovative ways for value creation. Financial engineering

presents opportunities for value creation. These services refer to the process of

designing, developing and implementing innovative solutions for unique needs in

funding, investing and risk management. Restructuring of assets and/or liabilities,

off-balance sheet items, development of synthetic securities, and repackaging of

financial claims are some examples of financial engineering.

The producers of these financial services are financial intermediaries, such

as banks, insurance companies, mutual funds and stock exchanges. Financial

intermediaries provide key financial services such as merchant banking, leasing,

hire purchase and credit rating. Financial services rendered by the financial

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intermediaries bridge the gap between lack of knowledge on the part of investors

and the increasing sophistication of financial instruments and markets. These

financial services are vital for creation of firms, industrial expansion and economic

growth.

3.3 FINANCIAL INSTITUTIONS IN INDIA:

Financial institutions operating in India can be broadly classified into two

categories – organized financial institutions and unorganized financial institutions.

Under organized (formal) financial institutions, they can be classified into (1)

Banking Institutions which comprises of (a) Scheduled Commercial Banks

including Public sector banks – nationalized banks and state bank groups, Private

sector banks, Foreign banks in India and Regional Rural banks, (b) Scheduled

Cooperative Banks – Scheduled State Cooperative Banks and Scheduled Urban

Cooperative Banks; (2) Non-Banking Financial Institutions comprising (a)

Developmental Finance Institutions which includes (i) All-India Financial

Institutions like IFCI, IDBI, IIBI, SIDBI, IDFC, NABARD, EXIM Bank, NBH,

etc. (ii) State-level Institutions like SFCs, SIDCs, etc. and (iii) Other Institutions

like ECGC, DICGC, etc. (ii) Non-Banking Finance Companies; (3) Mutual Funds

comprising Public sector and Private sector mutual funds; and (4) Insurance and

Housing Finance Companies. Under unorganized (informal) financial institutions,

various financial institutions like moneylenders, local bankers, traders, landlords,

pawn brokers, etc. are few selected common names.

3.3.1 Banking Institutions in India:

The banking sector is the lifeline of any modern economy. It is one of the

important financial pillars of the financial system, which plays a vital role in the

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success/failure of an economy. Banks are one of the oldest financial intermediaries

in the financial system. They play an important role in the mobilisation of deposits

and disbursement of credit to various sectors of the economy. The banking system

reflects the economic health of the country. The banking sector is dominant in

India as it accounts for more than half the assets of the financial sector.

3.3.1. (A) Scheduled Commercial Banks:

Scheduled commercial banks are those included in the second schedule of

the Reserve Bank of India Act, 1934. In terms of ownership and function,

commercial banks can be classified into four categories: public sector banks,

private sector banks, foreign banks in India and regional rural banks. As on

October 2006, there are 86 scheduled commercial banks – 27 public sector banks,

29 in the private sector and 30 foreign banks in India.

3.3.1. (A) (i) Public Sector Banks:

Public sector banks are banks in which the government has a major

holding. These can be classified into two groups: (i) the State Bank of India and its

associates and (ii) nationalized banks.

The State Bank of India was initially known as the Imperial Bank. The

Imperial Bank, which was formed by taking over the three Presidency banks – the

Bank of Bengal, the Bank of Bombay and the Bank of Madras in 1921, was

nationalized under the State Bank of India Act, 1955, which was passed on 8 May,

1955. The State Bank of India came into existence on 1 July, 1955. The main

objective of nationalisation was extending banking facilities on a large scale,

particularly in the rural and semi-urban areas. The State Bank of India holds the

dominant market position among all Indian banks. It is the world’s largest

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commercial bank in terms of branch network with a staggering more than 14,000

branches and 51 foreign branches.

The State Bank of India has seven subsidiaries: (i) the State Bank of

Bikaner and Jaipur, (ii) the State Bank of Hyderabad, (iii) the State Bank of

Indore, (iv) the State Bank of Mysore, (v) the State Bank of Patiala, (vi) the State

Bank of Saurashtra and (vii) the State Bank of Travancore.

3.3.1. (A) (ii) Nationalised Banks:

In 1969, fourteen big Indian joint stock banks in the private sector were

nationalized. Six more commercial banks in the private sector with deposits over

Rs. 200 crore were nationalized on 15 August, 1980. In all, 28 banks were

nationalized from 1955-1980. At present, there are 27 nationalised banks: the State

Bank of India and its seven associates and 19 nationalised banks (New India Bank

was merged with Punjab National Bank).

The major objectives of nationalisation were to widen the branch network

of banks particularly in the rural and semi-urban areas which, in turn, would help

in greater mobilisation of savings and flow of credit to neglected sectors such as

agriculture and small-scale industries. Public sector banks have an edge over

private sector banks in terms of size, geographical reach and access to low-cost

deposits. Huge size enables them to cater to the large credit needs of corporate.

The nationalized banks are a dominant segment in commercial banking.

The bulk of the banking business in the country is in the public sector. Public

sector banks have expanded their branch network and catered to the socio-

economic needs of a large mass of the population, especially the weaker section

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and in the rural areas. Public sector banks dominate with 75 per cent of deposits

and 71 per cent of advances in the industry.

3.3.1. (A) (iii) Private Sector Banks:

For over two decades, after the nationalisation of 14 larger banks in 1969,

no banks were allowed to be set up in the private sector. In the pre-reforms period,

there were only 24 banks in the private sector. The Narasimham Committee, in its

first report, recommended the freedom of entry into the financial system. The

banks which have been setup in the 1990s taking into consideration the guidelines

of the Narasimham Committee are referred to as new private sector banks.

Today, there are 27 private sector banks in the banking sector: 19 old

private sector banks and 8 new private sector banks. The public sector banks are

facing a stiff competition from the new private sector banks.

3.3.1. (A) (iv) Foreign Banks in India:

There were 29 foreign banks from 19 countries operating in India with 258

branches spread over 40 centres across 19 States/Union Territories as on

September 30, 2006. While four banks had 10 or more branches at end-March

2006, nine banks were operating with only one branch each. The Standard

Chartered Bank leads the pack with 81 branches in India.

Foreign banks have been operating in India since decades. A few foreign

banks have been operating in India for over a century. ANZ Grindlays has been in

India for more than hundred years, while Standard Chartered Bank has been

around since 1858. Many foreign banks from different countries set up their

branches in India during the 1990s – the liberalisation period. A total of 27 new

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foreign banks opened branches in India following the reforms of 1991, in addition

to the 18 which were already operating in India.

3.3.1. (A) (v) Regional Rural Banks:

A new category of scheduled banks came into existence in 1975 when 6

regional rural banks (RRBs) came into existence under the Regional Rural Banks

Ordinance, 1975. This ordinance was promulgated by the Government of India on

26 September, 1975. The ordinance was subsequently replaced by the Regional

Rural Banks Act, 1976.

The number of RRBs rose from six in 1975 to 196 in 2001. These 196

RRBs operate in 500 districts with a network of 14,313 branches excluding

satellite branches and extension counters. The branch network comprises six

metropolitan, 348 urban, 1,875 semi-urban and 12,084 rural branches. RRBs

branch network forms nearly 37 per cent of the total rural branch network of all

scheduled commercial banks. Uttar Pradesh has the highest number of RRBs, i.e.,

thirty six, Kerala two and the north-eastern states have only on RRB.

3.3.1. (B) Scheduled Cooperative Banks:

Cooperative banks came into existence with the enactment of the

Cooperative Credit Societies Act of 1904 which provided for the formulation of

cooperative credit societies. Subsequently, in 1912, new act was passed which

provided for the establishment of cooperative central banks. Cooperative credit

institutions play a pivotal role in the financial system of the economy in terms of

their reach, volume of operations and the purpose they serve.

The cooperative banking system supplements the efforts of the commercial

banks in mobilizing savings and meeting the credit needs of the local population.

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A cooperative bank is member promoted and has to be registered with the state-

based Registrar of Cooperative Societies. It functions with the rule of ‘one

member one vote’ and ‘no-profit, no loss bases.

The cooperative credit sector in India comprises rural cooperative credit

institutions and urban cooperative banks. The rural cooperative credit institutions

comprise of institutions such as state cooperative banks, district central

cooperative banks and primary agricultural credit societies, which specialize in

short-term credit, and institutions such as state cooperative agriculture and rural

development banks and primary cooperative agriculture and rural development

banks, which specialize in long-term credit.

Cooperative banks came under the purview of the Banking Regulation Act

only in 1966. UCBs are supervised by the RBI, while rural cooperative credit

societies are supervised by the NABARD. State registrars of cooperative societies

also regulate certain functions of both urban and rural cooperative banks/societies.

Multi-State UCBs are regulated by the union government as well and are

registered under the Multi-State Cooperative Societies Act. The RBI is the

regulatory and supervisory authority of UCBs for their banking operations while

managerial aspects come under the purview of the state governments under their

respective cooperative societies act. Only UCBs with Rs. 50 crore net owned

funds or above can extend their area of operation to the entire country.

3.3.2 Non-Banking Institutions:

Non-banking institutions can be broadly classified into Development

Financial Institutions which comprises (a) All-India Financial Institutions like

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IFCI, IDBI, IIBI, SIDBI, IDFC, NABARD, EXIM Bank, NHB, etc. (b) State-level

Institutions like SFCs, SIDCs, etc. and (c) Other Institutions like ECGC, DICGC,

etc. and Non-Banking Finance Companies.

3.3.2. (A) Development Financial Institutions:

Development Financial Institutions/banks are financial agencies that

provide medium and long-term financial assistance and act as catalytic agents in

promoting balanced development of the country. They are engaged in promotion

and development of industry, agriculture and other key sectors. They also provide

development services that can aid in the accelerated growth of an economy.

The first step towards building up a structure of development financial

institutions was taken in 1948 by establishing the Industrial Finance Corporation

of India Limited (IFCI). This institution was set up by an act of parliament with a

view to providing medium and long-term credit to units in the corporate sector and

industrial concerns.

The State Financial Corporations Act was passed in 1951 for setting up

State Financial Corporations (SFCs) in different states in order to cater to the

needs of small and medium enterprises spread in different states. By 1955-56, 12

SFCs were set up and by 1967-68; all the 18 SFCs now in operation came into

existence. SFCs extend financial assistance to small enterprises.

Even as the SFCs were being set up, a new corporation was established in

1955 at the all-India level known as the National Small Industries Corporation

(NSIC) to extend support to small industries. The NSIC is a fully government-

owned corporation and helps Small-Scale Industries (SSIs) through various

promotional activities.

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The above institutions had kept themselves away from the underwriting

and investment business as these were considered to be risky. To fill this gap, the

Industrial Credit and Investment Corporation of India Limited (ICICI) was set up

in January 1955 as a joint stock company with support from the Government of

India, the World Bank, the Commonwealth Development Finance Corporation and

other foreign institutions. It provides term loans and takes an active part in the

underwriting of and direct investments in the shares of industrial units.

In 1958, another institution, known as the Refinance Corporation for

Industry (RCI) was set up by the RBI, the Life Insurance Corporation of India

(LIC) and commercial banks with a view to providing refinance to commercial

banks and subsequently to SFCs against term loans granted by them to industrial

concerns in the private sector. When the Industrial Development Bank of India

(IDBI) was set up in 1964 as the central coordinating agency in the field of

industrial finance, the RCI was merged with it.

At the state level, another type of institution, namely, the State Industrial

Development Corporation (SIDC) was established in the 1960s to promote

medium and large scale industrial units in the respective states. SIDCs were made

eligible for IDBI refinance facilities in 1976.

State Small Industries Development Corporations (SSIDCs) were also

established to cater to the requirements of the industry at the state level. They help

in setting up and managing industrial estates, supplying raw materials, running

common service facilities and supplying machinery on hire-purchase basis.

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The Industrial Development Bank of India (IDBI) was set up in 1964 as an

apex institution to establish an appropriate working relationship among financial

institutions, coordinate their activities and build a pattern of inter-institutional

cooperation to effectively meet the changing needs of the industrial structure.

IDBI was set up as a wholly owned subsidiary of the RBI. In February 1976, the

IDBI was restructured and separated from the control of the RBI.

An important feature of industrial finance in the country is the participation

of major investment institutions in consortium with other all-India financial

institutions. The Unit Trust of India (UTI), established in 1964, the Life Insurance

Corporation of India (LIC), established in 1956 and the General Insurance

Corporation of India (GIC), established in 1973, work closely with other all-India

financial institutions to meet the financial requirements of the industrial sector.

Specialized institutions were also created to cater to the needs of the

rehabilitation of sick industrial units, export finance and agricultural and rural

development. In 1971, the Industrial Reconstruction Corporation of India Limited

(IRCI) was set up for the rehabilitation of sick units. In January 1982, the Export-

Import Bank of India (EXIM Bank) was set up. The export finance operations of

the IDBI were transferred to the EXIM Bank with effect from 1 March, 1982.

With a view to strengthening the institutional network catering to the credit needs

of the agricultural and rural sectors, the National Bank for Agriculture and Rural

Development (NABARD) was set up in July 1982.

The country is being served by 58 financial institutions at the national level

and 46 institutions at the state level. These financial institutions have a network of

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branches and are supported by technical consultancy organizations with IDBI

acting as the apex institution for cooperating their diverse financing and

promotional activities.

The national-level institutions, known as All India Financial Institutions

(AIFIs), comprise four All India Development Banks (AIDBs), also known as

term-lending institutions three refinance institutions, two investment institutions

and three specialized financial institutions. The term-lending institutions are

Industrial Finance Corporation of India Limited (IFCI), Industrial Investment

Bank of India Limited (IIBI), Export-Import Bank of India (EXIM Bank) and

Tourism Finance Corporation of India Limited (TFCI).

At the state level, there are 18 State Financial Corporations (SFCs) and 28

State Industrial Development Corporations (SIDCs).

The specialized financial institutions comprise Infrastructure Development

Finance Company Limited (IDFC), IFCI Venture Capital Funds Ltd. (IVCF) and

ICICI Venture Funds Management Company Limited (ICICI Venture).

The investment institutions are the Life Insurance Corporation of India

(LIC) and General Insurance Corporation of India (GIC).

The refinance institutions are National Bank for Agricultural and Rural

Development (NABARD), Small Industries Development Bank of India (SIDBI)

and National Housing Bank (NHB). These institutions extend refinance to banks

as well as non-banking financial intermediaries for lending to agriculture, small

scale industries and housing finance companies.

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3.3.2 (B) Non-Banking Finance Companies:

Non-banking financial companies (NBFCs) constitute an important

segment of the financial system in India. NBFCs are financial intermediaries

engaged primarily in the business of accepting deposits and delivering credit. They

play an important role in channelizing the scarce financial resources to capital

formation. NBFCs supplement the role of the banking sector in meeting the

increasing financial needs of the corporate sector, delivering credit to the

unorganized sector and to small local borrowers. NBFCs have a more flexible

structure than banks. As compared to banks, they can take quick decisions, assume

greater risks, tailor-make their services and charges according to the needs of the

clients. Their flexible structure helps in broadening the market by providing the

saver and investor a bundle of services on a competitive basis.

A non-banking financial company has been defined vide clause (b) of

Section 45-1 of Chapter IIIB of the Reserve Bank of India Act, 1934, as (i) a

financial institution, which is a company; (ii) a non-banking institution, which is a

company and which has as its principal business the receiving of deposits under

any scheme or arrangement or in any other manner or lending in any manner; (iii)

such other non-banking institutions or class of such institutions, as the bank may

with the previous approval of the central government and by notification in the

official gazette, specify.

NBFC has been defined under Clause (xi) of Paragraph 2(1) of Non-

Banking Financial Companies Acceptance of Public Deposits (Reserve Bank)

Directions, 1998, as: ‘non-banking financial company’ means only the non-

banking institution which is a loan company or an investment company or a hire

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purchase finance company or an equipment leasing company or a mutual benefit

finance company.

NBFCs provide a range of services such as hire purchase finance,

equipment lease finance, loans, and investments. Due to the rapid growth of

NBFCs and a wide variety of services provided by them, there has been a gradual

blurring of distinction between banks and NBFCs except that commercial banks

have the exclusive privilege in the issuance of cheques.

NBFCs have raised large amount of resources through deposits from

public, shareholders, directors, and other companies and borrowings by issue of

non-convertible debentures. In the year 1998, a new concept of public deposits

meaning deposits received from public, including shareholders in the case of

public limited companies and unsecured debentures/bonds other than those issued

to companies, banks, and financial institutions, was introduced for the purpose of

focused supervision of NBFCs accepting such deposits.

3.4 MUTUAL FUNDS:

A mutual fund is a financial intermediary that pools the savings of

investors for collective investment in a diversified portfolio of securities. A fund is

‘mutual’ as all of its returns, minus its expenses, are shared by the fund’s

investors.

The Securities and Exchange Board of India (Mutual Funds) Regulations,

1996 defines a mutual fund as ‘a fund established in the form of a trust to raise

money through the sale of units to the public or a section of the public under one

or more schemes for investing in securities, including money market instruments’.

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According to the above definitions, a mutual fund in India can raise

resources through sale of units to the public. It can be set up in the form of a trust

under the Indian Trust Act. The definition has been further extended by allowing

mutual funds to diversify their activities in the following areas.

1. Portfolio management services

2. Management of offshore funds

3. Providing advice to offshore funds

4. Management of pension or provident funds

5. Management of venture capital funds

6. Management of money market funds

7. Management of real estate funds

A mutual fund serves as a link between the investor and the securities market

by mobilizing savings from the investors and investing them in the securities

market to generate returns. Thus, a mutual fund is akin to portfolio management

services (PMS). Although, both are conceptually same, they are different from

each other. Portfolio management services are offered to high net worth

individuals; taking into account their risk profile, their investment are managed

separately. In the case of mutual funds, savings of small investors are pooled

under a scheme and the returns are distributed in the same proportion in which the

investments are made by the investors/unit-holders. Mutual funds in India are not

much different from portfolio managers for select corporate and high net worth

individuals whose collective share in MF investment is more than 80 per cent.

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Mutual fund is a collective savings scheme. Mutual funds play an important

role in mobilizing the savings of small investors and channelizing the same for

productive ventures in the Indian economy.

3.4.1 Growth of Mutual Funds in India:

The Indian mutual fund industry has evolved over distinct stages. The

growth of the mutual fund industry in India can be divided into four phases: Phase

I (1964-87), Phase II (1987-92), Phase III (1992-97), and Phase IV (beyond 1997).

Phase – I:

The mutual fund concept was introduced in India with the setting up of

UTI in 1963. The Unit Trust of India (UTI) was the first mutual fund set up under

the UTI Act, 1963, a special act of the parliament. It became operational in 1964

with a major objective of mobilizing savings through the sale of units and

investing them in corporate securities for maximizing yield and capital

appreciation. This phase commented with the launch of the Unit Scheme 1964

(US-64), the first open-ended and the most popular scheme. UTI’s investible

funds, at market value grew from Rs.49 crore in 1965 to Rs.219 crore in 1970-71

to Rs. 1,126 crore in 1980-81 and further to Rs.5,068 crore by June 1987. Its

investor base had also grown to about two million investors. It launched

innovative schemes during this phase. UTI maintained its monopoly and

experienced a consistent growth till 1987.

Phase – II:

The second phase witnessed the entry of mutual fund companies sponsored

by nationalized banks and insurance companies. In 1987, SBI Mutual Fund and

Canbank Mutual Fund were set up as trusts under the Indian Trust Act, 1882. In

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1988, UTI floated another offshore fund, namely, The India Growth Fund which

was listed on the New York Stock Exchange (NYSE). By 1990, the two

nationalized insurance giants, LIC and GIC, and nationalized banks, namely,

Indian Banks, Bank of India, and Punjab National Bank had started operations of

wholly-owned mutual fund subsidiaries. In October 1989, the first regulatory

guidelines were issued by the RBI, but they were applicable only to mutual funds

sponsored by banks. Subsequently, the Government of India issued comprehensive

guidelines in June 1990 covering all the mutual funds. With the entry of public

sector funds, there was a tremendous growth in the size of the mutual fund

industry with investible funds, at market value, increasing to Rs.53,462 crore and

the number of investors increasing to over 23 million. The buoyant equity markets

in 1991-92 and tax benefits under equity-linked savings schemes enhanced the

attractiveness of equity funds.

Phase – III:

The year 1993 marked a turning point in the history of mutual funds in

India. The Securities and Exchange Board of India (SEBI) issued the Mutual Fund

Regulations in January 1993. The SEBI notified regulations bringing all the

mutual funds except UTI under a common regulatory framework. Private domestic

and foreign players were allowed entry in the mutual fund industry. The Kothari

group of companies, in joint venture with Pioneer, a US fund company, set up the

first private mutual fund, the Kothari Pioneer Mutual Fund, in 1993. Several other

private sector mutual funds were set up during this phase. UTI launched a new

scheme, Master-gain, in May 1992, which was a phenomenal success with a

subscription of Rs. 4,700 crore and the number of investor accounts increased to

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50 million. The industry’s investible funds at market value increased to Rs.78, 655

crore and the number of investor accounts increased to 50 million. However, the

year 1995 was the beginning of the sluggish phase of the mutual fund industry.

During 1995 and 1996, unit holders saw erosion in the value of their investments

due to a decline in the NAVs of the equity funds. Moreover, the service quality of

mutual funds declined due to a rapid growth in the number of investor accounts,

and the inadequacy of service infrastructure. A lack of performance of the public

sector funds and miserable failure of foreign funds like Morgan Stanley eroded the

confidence of investors in fund managers. Investors’ perception about mutual

funds gradually turned negative. Mutual funds found it increasingly difficult to

raise money. The average annual sales declined from about Rs.13, 000 crore in

1991-94 to about Rs.9, 000 crore in 1995 and 1996.

Phase – IV:

During this phase, the flow of funds into the kitty of mutual funds sharply

increased. This significant growth was aided by a more positive sentiment in the

capital market, significant tax benefits, and improvement in the quality of investor

service. Investible funds, at market value, of the industry rose by June 2000 to

over Rs.1, 10,000 crore with UTI having a 68 per cent of the market share. During

1999-2000 sales mobilization reached a record level of Rs.73, 000 crore as against

Rs.31, 420 crore in the preceding year. This trend was, however, sharply reversed

in 2000-01. The UTI disclosed the NAV of US-64 - its flagship scheme as on 28

December 2000, just at Rs.5.81 as against the face value of Rs. 10 and the last sale

price of Rs. 14.50. The disclosure of NAV of the country’s largest mutual fund

scheme was the biggest shock of the year to the investors. The Pioneer ITI, JP

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Morgan and Newton Investment Management pulled out from the Indian Market.

The Bank of India MF liquidated all its schemes in 2002. The Indian mutual fund

industry stagnated at around Rs. 1, 00,000 crore assets during the years 2000-01

and 2001-02.

The Unit Trust of India lost out to other private sector players during this

period. While there was an increase in AUM by around 11 per cent during the year

2002, UTI, on the contrary, lost more than 11 per cent in AUM. The private sector

mutual funds have benefitted the most from the debacle of US-64 of UTI. The

AUM of this sector grew by around 60 per cent for the year ending March 2002.

There was a record growth in funds mobilized through a record number of new

schemes during the year 2004-2005. The assets under management during the year

2004-05 was Rs. 1,49,554 crore which subsequently increased to Rs. 1.65 lakh

crore on 30 June 2005 and Rs. 3,26,388 crore on 31 March, 2007.

3.4.2 Types of Mutual Fund Schemes:

The objectives of mutual funds are to provide continuous liquidity and

higher yields with high degree of safety to investors. Based on these objectives,

different types of mutual fund schemes have evolved.

Table No. 3.1:

Types of Mutual Fund Schemes

Functional Portfolio Geographical Other

* Open-ended

Schemes

* Close-ended

Schemes

* Interval

*Debt Schemes

� Money market

schemes

� Gilt schemes

� Income schemes

*Domestic

*Off shore

*Load Funds

*Index Funds

*ETFs

*P/E ratio Fund

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Schemes *Equity Schemes

� Equity linked

saving schemes

� Sectoral

schemes

� Diversified

schemes

� Growth schemes

*Balanced Schemes

*Fund of Funds

*Floating rate Funds

*Thematic Funds

* Gold Exchange

Traded Funds

* Capital Protection

Schemes

* Derivatives

Arbitrage Funds

* Fixed Maturity

Plans

* Real Estate Mutual

Funds

3.4.3 Unit Trust of India:

The Unit Trust of India (UTI) is India’s first mutual fund organisation. It is

the single largest mutual fund in India which came into existence with the

enactment of the UTI Act in 1964.

UTI was set up as a trust without ownership capital and with an

independent board of trustees. The board of trustees manages the affairs and

business of UTI. The board performs its functions, keeping in view the interest of

the unit holders under various schemes.

UTI has a wide distribution network of 54 branch offices, 266 chief

representatives and about 67,000 agents. These chief representatives supervise

agents. UTI manages 72 schemes and has an investor base of 20.02 million

investors. UTI has set up 183 collection centres to serve investors. It has 57

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franchisee offices which accept applications and distribute certificates to unit

holders.

UTI has set up associate companies in the fields of banking, securities

trading, investor servicing, investment advice and training, towards creating a

diversified financial conglomerate and meeting investors’ varying needs under a

common umbrella.

UTI Bank Limited: UTI Bank was the first private sector bank to be set up

in 1994. The bank has a network of 121 fully computerized branches spread across

the country. The bank offers a wide range of retail, corporate and forex services.

UTI Securities Exchange Limited: UTI Securities Exchange Limited was

the first institutionally sponsored corporate stock broking firm incorporated on 28

June, 1994, with a paid-up capital of Rs.300 million. It is wholly owned by UTI

and promoted to provide secondary market trading facilities, investment banking,

and other related services. It has acquired membership of the NSE, the BSE, the

OTCEI, and the Ahmedabad Stock Exchange (ASE).

UTI Investor Services Limited: UTI Investor Services Limited was the first

institutionally sponsored registrar and transfer agency set up in 1993. It helps UTI

in rendering prompt and efficient services to the investors.

UTI Institute of Capital Markets: UTI Institute of Capital Market was set

up in 1989 as a non-profit educational society to promote professional

development of capital market participants. It provides specialized professional

development programmes for the varied constituents of the capital market and is

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engaged in research and consultancy services. It also serves as a forum to discuss

ideas and issues relevant to the capital market.

UTI Investment Advisory Services Limited: UTI Investment Advisory

Services Limited, the first Indian Investment advisor registered with SEC, US, was

set up in 1988 to provide investment research and back office support to other

offshore funds of UTI.

UTI International Limited: UTI International Limited is a 100 per cent

subsidiary of UTI, registered in the island of Guernsey, Channel Islands. It was set

up with the objective of helping in the UTI offshore funds in marketing their

products and managing funds. UTI International Limited has an office in London,

which is responsible for developing new products, new business opportunities,

maintaining relations with foreign investors, and improving communication

between UTI and its clients and distributors abroad.

UTI has a branch office at Dubai, which caters to the needs of NRI

investors based in six Gulf countries, namely, UAE, Oman, Kuwait, Saudi Arabia,

Qatar and Bahrain. This branch office acts as a liaison office between NRI

investors in the Gulf and UTI offices in India.

UTI has helped in promoting/co-promoting many institutions for the

healthy development of financial sector. These institutions are Infrastructure

Leasing and Financial Services (ILFS), Credit Rating and Information Services

Limited (CRISIL), Stock Holding Corporation of India Limited (SHCIL),

Technology Development Corporation of India Limited (TDCIL), Over the

Counter Exchange of India Limited (OTCEI), National Securities Depository

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Limited (NSDL) and North-Eastern Development Finance Corporation Limited

(NEDFCL).

UTI offers a wide variety of schemes to investors. Apart from equity, debt

and balanced schemes, UTI offers schemes which meet specific needs like low

cost insurance cover, monthly income needs of retired persons and women,

income and liquidity needs of religious and charitable institutions and trusts,

building up of funds to meet cost of higher education and career plans for children,

future wealth and income needs of the girl child and women, building savings to

cover medical insurance at old age and wealth accumulation to meet income needs

after retirement.

The Unit Trust of India helps in industrial growth through sanctioning and

disbursing assistance under project and non-project finance. It also provides to the

corporate sector financial services, including underwriting to the corporate sector.

Regarding the performance of mutual fund industry, “Out of a total of 2.99

crore investor accounts in the mutual fund industry, 1.23 crore or 41 per cent of

the individual investors are in UTI mutual fund and other public sector mutual

funds. The UTI mutual fund has the largest number of small individual investors

who contribute 77.26 per cent to UTI’s total net assets. However, the private

sector mutual funds manage 80.47 per cent of the net assets where the public

sector mutual funds manage only 19.53 per cent of the total net assets. Corporates

and Institutions who form only 1.67 per cent of the total number of investor

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accounts are the largest contributors (49.94 per cent) to the total net assets in the

mutual fund industry.”4

The mutual fund industry has been remarkably resilient over the last

decade in spite of varying economic conditions, capital market scams and

increasing competition. At present, 755 schemes are offered but this number is a

miniscule fraction of the 13,000 odd schemes offered by the mutual funds in the

US. Moreover, in the US, there is more money in mutual funds than in bank

deposits. Mutual funds in India have tapped only one per cent of the urban

population and the rural penetration is negligible.

Due to liberalization, privatization and globalization policies of Indian

economy since 1991, many new and foreign mutual funds have entered in this

sector and they have successfully doing business with the introduction of various

new innovative products in the mutual fund market. In India, mutual funds have a

lot of potential to grow. Mutual fund companies have to create and market

innovative products and frame distinct marketing strategies. Product innovation

will be one of the key determinants to success.

3.5 INSURANCE COMPANIES:

Insurance may be described as a social device to reduce or eliminate risk of

loss to life and property. Insurance is a collective bearing of risk. Insurance is a

scheme of economic corporation by which members of the community share the

unavoidable risks. The risks which can be insured against include fire, the perils of

sea, death, accidents and burglary. Insurance can not prevent the occurrence of

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risk but it provides for the losses of risks. It is a scheme which covers large risks

by paying small amount of capital. Insurance is also a means of savings and

investment.

The insurance companies are distinct financial institutions (intermediaries)

in the financial system.

(i) Insurers collect insurance premiums by issuing insurance policies

which are debt instruments (claims) and invest these premiums in the

financial assets and markets to generate cash flows to play future

claims. Thus, insurers are liability-driven financial intermediaries.

(ii) Unlike other intermediaries, insurers have to hold risk capital or

solvency capital to ensure their obligations to the insured. Insurers

demonstrate their financial strength to the insured by holding risk

capital which provides a cushion against unexpected losses. Another

unique feature of the industry is the distinct principles such as

uberrimae fidei, indemnity, subrogation, causa proxima and insurable

interest of which underwriters (insurers) are more aware of than the

insured.

(iii) Also, insurance pricing differs from the pricing of other products. In

case of other products, the producer knows the cost of production and

the profit he wants to earn. Insurance is a different activity from most

other kinds of business activities. Insurers are in the business of risk. It

is very difficult to price risk. In case of insurance, the actual cost of risk

coverage can be known only at the expiry of the contract or when the

event occurs whereas the premium rate is determined at the beginning

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of the contact. The determination of premium rate involves a lot of

statistics, use of probability theories and study of demographic trends

and market trends.

(iv) Marketing of insurance products is a challenging task. Insurance is sold,

never bought. The seller (agent) should possess expert knowledge of

the insurance products, have the skill in making people listen carefully

and strive to establish a long-term relationship with the clients to get

repeat business. Only those who are open to new ideas, able to plan

their activity well and willing to face challenges can succeed in

marketing insurance products.

3.5.1 History of Insurance in India:

The early history of insurance in India can be traced back to the Vedas. The

Sanskrit term ‘Yogakshema’ (meaning well being), the name of Life Insurance

Corporation of India’s corporate headquarters, is found in the Rig Veda. Some

form of ‘community insurance’ was practiced by the Aryans around 1000 BC. The

joint family system prevalent in India was an important form of social

cooperation.

Life insurance in its modern form came to India from England in 1818. The

Oriental Life Insurance Company was the first insurance company to be set up in

India to help the widows of the European community. The insurance companies,

which came into existence between 1818 and 1869, treated Indian lives as

subnormal and charged an extra premium of 15 to 20 per cent. The first Indian

insurance company, the Bombay Mutual Life Assurance Society, came into

existence in 1870 to cover Indian lives at normal rates. Moreover, in 1870, the

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British Government enacted for the first time the Insurance Act, 1870. Other

companies, such as the Oriental Government Security Life Assurance Company,

the Bharat Insurance Company and the Empire of India Life Insurance Company

Limited, were set up between 1870 and 1900.

The Swadeshi movement of 1905-07, the non-corporation movement of

1919 and Civil Disobedience Movement of 1929 led to an increase in number of

insurance companies. In 1912, the first legislation regulating insurance, the Life

Insurance Companies Act, 1912, was promulgated. The growth of life insurance

was witnessed during the first two decades of the twentieth century not only in

terms of number of companies but also in terms of number of policies and sum

assured. ‘The Indian Insurance Year Book’ was published for the first time in

1914.

The Insurance Act, 1938, the first comprehensive legislation governing

both life and non-life branches of insurance, was enacted to provide strict state

control over the insurance business. By the mid-1950s, there were 154 Indian

insurers, 16 foreign insurers and 75 provident societies carrying on life insurance

business in India. The government, being felt the need to nationalize the insurance

business in India, set up the Life Insurance Corporation of India (LIC) in 1956 to

take over 245 life companies. The nationalization of life insurance was followed

by general insurance in 1972. The General Insurance Corporation of India and its

subsidiaries were set up in 1973. According to the recommendations of the

committee under the chairmanship of R.N. Malhotra, the insurance sector was

finally thrown open to the private sector in 2000. The Insurance Regulatory and

Development Authority (IRDA) was set up in 2000 as an autonomous insurance

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regulator. The government has entrusted the IRDA with the responsibility for

carrying out the reforms in this sector. The Insurance (Amendment) Act, 2002, has

allowed cooperative societies to carry on insurance business with a view to

enhancing coverage in rural areas. The Reserve Bank of India has given NBFCs

blanket permission to take up insurance agency business on a fee basis and

without risk participation, without the approval of the central bank. However, the

risks involved in insurance agency cannot be transferred to the business of the

NBFC and they need to obtain permission from the IRDA.

The Indian insurance industry is governed by the Insurance Act, 1978, the

General Insurance Business (Nationalization) Act, 1972, Life Insurance

Corporation Act, 1956 and Insurance Regulatory and Development Authority Act,

1999.

With deregulation, competition has increased in the insurance sector. The

entry of private sector players has brought about a paradigm shift in the definition

of the word insurance. The rate of annual growth of insurance business is an

average of 20 per cent for life and 15 per cent for non-life. Despite this growth

rate, India is under-insured when compared to other countries. India’s insurance

sector has a long way to catch up with the rest of the world. According to

Chartered Financial Analysts of India, India is the twenty-third largest insurance

market in the world. The current size of the Indian insurance market is USD 9.9

billion, while the global insurance market is around USD 2,422.4 billion.

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3.6 UNORGANIZED SECTOR OF INDIAN FINANCIAL SYSTEM:

The unorganized sector or the informal sector of the Indian Financial

system consists of:

1. Individual moneylenders such as neighbours, relatives, landlords, traders

and storeowners.

2. Groups of persons operating as ‘funds’ or ‘associations’. These groups

function under a system of their own rules and use names such as ‘fixed

fund’, ‘association’, and ‘saving club’.

3. Partnership firms consisting of local brokers, pawnbrokers and non-

banking financial intermediaries such as finance, investment and chit-fund

companies.

Some of these components of unorganized sector of Indian financial system

are being discussed here in a more elaborate way in order to find out their role in

the economic development of the society.

3.6.1 Moneylenders:

The definition of the term ‘Moneylender’ in legislation is generally all

inclusive and means a person who is in the business of lending money (loans),

whether as principal business or otherwise. However, nearly all legislations

expressly exclude certain categories of persons from the definition. The excluded

categories are either incorporated bodies or institutions in the business of banking,

insurance and dealing in securities, etc., which are otherwise regulated by formal

regulatory bodies in the country. There are certain other non-incorporated but

registered bodies such as registered cooperative societies, which are also excluded

from the definition of moneylenders. In addition to such individuals being

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expressly excluded, the laws abroad also exclude either a class of loans or loans

provided by a class of persons from being regarded as ‘loans’ for the purpose of

the money lending legislation thereby taking them out of the purview of those

laws.

Various Moneylenders’ Acts define a moneylender as a person whose main

or subsidiary occupation is the business of advancing and realizing loans. Banks

and Co-operative Societies are excluded from the purview of the Acts of many

states. Generally, the laws have been made applicable to individuals, firms,

association of individuals and companies. However, Nagaland and Andhra

Pradesh (as applicable to the Andhra Region Scheduled Areas) have excluded

companies from the purview of their respective enactments.

3.6.1.1 Registration of Moneylenders:

Moneylenders are being instructed to get themselves registered under

Moneylenders’ Acts of respective states which is under the control of Registrar of

Co-operative Societies of the states.

The advantages for registration of moneylenders as perceived by

moneylenders are (i) Registration would help them to carry on business lawfully

and have legal recourse against defaulters and (ii) Registration would enable them

to exhibit their names over office which would enhance their status in society and

also bring new customers and help in warding off undue harassment by police

authorities.

A number of moneylenders do not register themselves due to many

reasons. District Officials who are looking after the registration of moneylenders

felt that most of the moneylenders did not register because of (i) the ceiling on the

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interest rate on lending, (ii) the cumbersome process of registration, (iii) the high

registration and renewal fee, (iv) the fear of disclosure of unaccounted money and

audit, (v) the fear of penalties, and (vi) the need to submit statements/returns

compulsorily at periodic intervals, etc.

3.6.1.2 Continued Dependence on Moneylenders:

The rural India continued to depend on moneylenders for their credit needs

though the efforts have been made to open more bank branches in the ‘unbanked

areas’ in the country and RBI’s instruction of ‘priority sector lending’. “…..In this

period, the dependence on the money-lender fell from 70 per cent of rural credit to

about 46.5 per cent. While there are no data to prove this, the RBI has shown time

and again how qualitative measures help strengthen the quantitative aspects of

credit-related issues. While the reduced dependence on the moneylender was

good, it was not good enough because it implied that still nearly half of the credit

accessed by rural population even in 1991 was non-institutional. The reason for

this has much to do with the asset ownership patterns in Rural India.”5

The All India Debt and Investment Survey as on June 30, 2002 (NSS Fifty

Ninth Round released in December, 2005) had shown that the share of

moneylenders in the total dues of rural households had increased from 17.5 per

cent in 1991 to 29.6 per cent in 2002.

The reasons for continued dependence on moneylenders can be discussed

as follows:

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(i)Limited Outreach of Formal Credit Institutions: One of the important

reasons for continued dependence on moneylenders is that despite its penetration,

the formal credit delivery structure has not percolated down to the villages. The

villagers, especially the poor, have to necessarily depend on moneylenders for

their survival. It would seem from this that any attempts to stop money lending

will affect the poor people in the villages by cutting off all access to credit. The

main problem seems to be that the credit institutions that were created to replace

the moneylenders have become very formal with cumbersome procedures. Equally

importantly, the formal credit delivery channels also lack the personal bonds that

moneylenders enjoy with the borrowers.

(ii) Banks do not like to deal with marginal farmers: More than 50 per cent of

the farmers belong to this category, with cultivable areas of less than one hectare.

They did not get loans from the banks and were therefore, compelled to approach

moneylenders for their needs

(iii) Moneylenders’ ‘doorstep service’ and respect for borrowers’ privacy:

Moneylenders provide 24/7 service and maintain confidentiality. They even visit

households and give money and collect interest and also principal periodically,

maintaining one-to-one business relationships.

(iv)They lend for consumption purposes without hesitation: Apart from

agricultural operations, farmers are dependent on moneylenders for their

requirements like weddings, illnesses in the family, education of children, etc. As

consumption needs are not met by the formal sector, people approach

moneylenders, even at centers where branches of commercial and co-operative

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banks are present. The rate of indebtedness is more in Kerala particularly among

non-asset owning classes, because people tend to borrow more for consumption

(sometimes of the conspicuous variety) and not for farming activities alone.

(v)Inadequate and delayed credit by formal financial institutions: Under-

financing coupled with the delay in sanctioning of loans by banks often forced the

borrowers to approach moneylenders even though they charged much higher rates

of interest. . Owing to the high rate of interest charged, and the coercive methods

used by them, clearing debts to moneylenders is given higher priority by the

borrowers compared to bank loans. The result is that bank loans become overdue

and sometimes turn into Non- Performing Assets (NPAs).

3.6.1.3 Money Lending Legislation:

It has known to the policy makers of the country that though moneylenders

are the main credit suppliers in the rural India, they are also responsible for

exploiting these poor rural Indians due to their higher rate of interest. Many

farmers in the country lost their agricultural lands and houses as they kept on

mortgage their properties for the credit that they have taken from these

moneylenders. The information given in table 3.1 below reveals that out of every

Rs.1, 000 outstanding of farmer households in the country, Rs. 257 was sourced

from moneylenders, Rs 356 from the bank and only Rs 25 from the government.

Among the different states of the country the share of moneylenders in the

indebtedness of farmer households in Manipur is well above the national average,

with Andhra Pradesh at the top with Rs 534.

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Table 3.1

Per 1000 rupees distribution of outstanding loan taken by farmer households in

different States of North East India

States

Sources of Loan

Govt. Co-op.

society

Bank Money

lender

Trader Relatives

&

friends

Doctor,

lawyer

etc.

Others All

Arunachal

Pradesh

61 0 208 0 159 507 0 65 1000

Assam 70 27 278 155 120 247 5 99 1000

Manipur 15 0 167 329 40 401 0 49 1000

Meghalaya 60 0 0 128 3 809 0 0 1000

Mizoram 243 31 499 0 33 193 0 0 1000

Nagaland 75 77 536 3 153 155 0 0 1000

Sikkim 348 0 230 73 221 67 0 61 1000

Tripura 164 28 605 20 39 119 0 25 1000

All India 25 196 356 257 52 85 9 21 1000

Estimated

No. (00)

14769 114785 117100 125000 53902 77602 7181 14605 434242

Sample

Number

992 5844 6296 6919 3018 4528 345 872 23935

Source: Reserve Bank of India, Money lender’s Act.

The penetration of moneylenders is significant even in States that are

regarded as being adequately banked (Andhra Pradesh and Tamil Nadu). Within

the region Assam is next in the penetration of money lenders followed by

Meghalaya with Rs 155 and Rs 128 out of Rs 1,000 distribution to farmers’

households in the form of loan.

Considering the problems of the poor farmers in rural villages of the

country and increasing trend of suicides of the poor rural farmers the Apex

Financial Institution in the country felt the need to control the moneylenders in the

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country and to bring them into the organized sector of the financial system. The

Reserve Bank Governor announced in the Annual Policy Statement dated April

18, 2006 for the year 2006-07, that a Technical Group would be set up to review

the efficacy of the existing legislative framework that governs money lending. The

Group would also review the enforcement machinery in different States and make

recommendations for its improvement.

According to what was reported by the 11 Regional Offices of the RBI

there were 12,601 registered moneylenders as on March 1995. This number has

increased to 19,627 as on March 2006. Anecdotal evidence suggests that there is a

corresponding increase in unregistered moneylenders. The main reason behind the

increasing trend of money lenders are due to their mode of operations, viz.,

maintaining inter-personal relationship with the borrowers, their informal

approach, round-the-clock availability of finance, etc., have made them the most

important lenders in the villages. Their policy of 'any time, anywhere, any

amount', which is borrower-friendly, has strengthened their position in the

villages, thus reducing the role of banks. They offer a variety of products tailor-

made to the needs of the borrowers.

In India, with the instructions of the Reserve Bank of India, every state has

been encouraged to have their own Act for regulating the moneylenders in the

state. Many states do already have their own Acts in this concern. The

Constitution of India has conferred the power to legislate on matters relating to

money lending and moneylenders to the States. Most of them have enacted the

laws; many of these are comprehensive legislations providing detailed and

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stringent provisions for regulation and supervision of the money lending business.

These legislations contain provisions aimed at protecting the borrowers from

malpractices of the moneylenders.

Till date there is no provision / control of such UIBs within the framework

of RBI Act or Companies Act 1956 in the region except prohibiting such UIBs

accepting deposits from public. However, the Tamil Nadu Government has

already enacted a legislation “Tamil Nadu Protection of Interests of Depositors (in

financial Establishments) Act 1997 which contain penal provision for promoters of

financial establishment defaulting on repayment of deposits and interest payments,

and attachment of assets of defaulters to ensure payments to depositors was

passed. The enactment has been appreciated by the RBI which has advised other

states also to enact similar laws. Thus, there is an urgent need of the RBI to set up

a common guidelines as do’s and don’ts for these UIBs to check the

uncontrollable growth in one side and prevention of investors or depositors’

interest in the region in particular and country as general.

The name by which moneylenders are called may vary from country to

country but they can be found performing similar activities all over the world. It is

natural therefore that, with a view to having a level playing field, several

governments should have attempted to regulate the activity. In this Chapter we

analyse the main features of money lending legislation in the following countries.

The sample includes developed as well as the developing countries.

1. Hong Kong -Moneylenders’ Ordinance, 1997

2. Singapore -Moneylenders’ Act, 1959

3. Japan - Money Lending Business Control and Regulation Law, 1983

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4. United Kingdom-Consumer Credit Act, 1974

5. West Pakistan -The Punjab Moneylenders Ordinance, 1960

6. USA (S. Dakota) -Title 54 of the South Dakota State Laws (Debtor & Creditor)

7. South Africa -The National Credit Act, 2005

3.6.2 Rotating Savings and Credit Associations (ROSCAs):

Rotating Savings and Credit Associations (ROSCAs) are essentially a

group of individuals who come together and make regular cyclical contributions to

a common fund, which is then given as a lump sum to one member in each cycle.

For example, a group of 12 persons may contribute Rs.100 per month for 12

months. The Rs. 1,200 collected each month is given to one member. Thus, a

member will lend money to other members through his regular monthly

contributions. After having received the lump sum amount when it is his turn (i.e.

borrow from the group), he then pays back the amount in regular/further monthly

contributions. This explains the name rotating savings and credit associations for

such groups [Bouman, 1979:253]. Depending on the cycle in which a member

receives his/her lump sum, members alternate between being lenders and

borrowers. That is, there is a mutual give-and-take involved in ROSCAs. In the

state of Manipur, the ROSCA is known by its local name ‘Marup’. It is the most

popular form of savings in Manipur society. 90 per cent of the households save

money through this form. This form of savings and credits are found everywhere

in Manipur and most of the households are the members of either one or the other

Marup (ROSCA).

While the above description explains the principles behind a ROSCA, they

however vary considerably in their functioning and organisation. Typical

variations include:

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(i)Membership: Members participating in a ROSCA are selected by the organizer

based on the ethnic lines or geographical limitations. ROSCAs are organized for

members of the same ethic background, same place of origin, same native

language speaking persons, etc. It may also be organized on the basis of a street in

a settlement, or the settlement as a whole.

(ii)Contribution Amount: The amount to be contributed in each cycle is decided

based on the number of participating members, the total winning amount that each

member can get and other socio-economic factors. Contributions can also be in the

form of shares, thus allowing a member to have more than one share or

contribution in a particular cycle – increasing his chances of winning the lump

sum, but also increasing the regular contributions he has to make [Bouman,

1979:258].

(iii) Cycle Period: Cycle periods – frequency with which contributions has to be

made in each cycle. This can be daily, weekly, biweekly, monthly and half-yearly,

depending on the amount to be contributed. Usually, smaller amount, shorter the

cycle. But this may not true all the time.

(iv)Mode of Selecting Winner: The basis of deciding the winner is decided in any

one of the three ways: (a) By consensus, whereby common agreement between

members, the amount is usually given to a member who is in most need for

finance. (b) By lots, where a lottery determines who gets the lump sum in a

particular cycle. Members who have received the lump sum do not participate in

subsequent lotteries, but continue to make their contribution. In some cases it is

found that winners of each cycle are determined by doing lottery at the beginning

of the ROSCA. (c) By bidding, where the lump sum amount is bid for by the

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members during each cycle. Thus, the member who wins the bid will receive the

lump sum minus the bid amount; other members pay their contributions minus

their share of the bid amount. This type of ROSCA (Marup in local Language) is

known as ‘Tender’ in Manipur.

ROSCAs can be seen in almost every society around the world, and have in

existence for a considerable period of time. They are flexible and adapt themselves

easily to rural and urban peculiarities as well as existing community patterns of

grouping/organizing. This flexibility is one reason for their world wide popularity.

ROSCAs have lots of advantages. The basic advantage of the ROSCA is

that it offers an opportunity for members to save and at the same time keep such

savings fairly liquid and maximizing return. It facilitates the availability of a lump

sum of money, which allows for higher investment to be made earlier than

accumulation of savings. Most ROSCAs are organized along democratic lines,

where operating procedures and other details are decided / agreed upon by its

members. Risk of default is shared by all members and thereby there is pressure to

ensure that all members make their contributions on time. The ROSCA provides a

means for the utilization of surplus funds and savings of low-income households

an easy and local savings mechanism. As it employs a democratic (in most types)

to decide the organizational and operational aspects and thus encourages

community interaction-involvement of community in interaction and participation.

It respects existing community leadership patterns and decision-making process –

use of community patterns in designing savings and credit programmes.

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3.6.3 Pawn Brokers:

Pawn brokers, as the name suggests, lend money by using marketable

assets such as gold, jewellery, household articles, etc. as collateral or security.

Borrowers in need of money pawn an asset or article as security or pledge and

receive a loan which is lower in proportion to the value of the pawned article – this

is usually 40 to 50 per cent of the value of the item.

A pawn ticket is issued to the borrower as a transaction record. On payment

of the loan plus interest, the pawned article is returned to the borrower. The pawn

ticket usually records name and address of the pawn broker and the pawner or

borrower, loan amount and its terms and conditions, detailed description of the

pawned article, etc.

Pawn broking has been in vogue from ancient times with households

holding their assets primarily in gold and jewellery – assets that can be transported

easily in times of unrest and pawned in times of financial need. Thus, pawn

broking has its attractive points for the lender (the pawn broker) as well as the

borrower (the pledger or pawner). The pledger sells, as it were, his pawn for a

certain sum below the going (appraised) market value and retains the right to buy

it back within a specified time by returning the original sum plus interest. If he

does not, he will lose his property, but no further debt exists and hence no ever-

ending debt load.

As with money lenders, pawn brokers in India come under the preview of

the Pawn Brokers Act of 1962. It lays out the procedure for a pawn broker to

register and obtain a license to operate from the Registrar of Pawn Brokers and

fees to be paid for the license. It details out the rates of interest chargeable

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(ranging from 12 to 18 per cent, depending on the loan amount), repayment details

and grace periods. Compliance with this Act has also not been widespread, with

only about 35 to 40 per cent of the pawn brokers in any city actually registered

with the Office of the Registrar of Pawn Brokers.

There are certain advantages of pawn brokers. These advantages can be

listed out as (i) No spiraling debt cycle is created by loans from pawn brokers as a

defaulting loan is recovered by the pawn broker from the pawned item. (ii) Costs

of lending is covered by providing loans that are lower than the cost of the pawned

item. (iii) Collateralized/pawned item is usually a movable asset, as against

immovable/fixed assets such as land, houses, etc. (iv) Lengthy procedure for

establishing credit worthiness is avoided as it is established by the value of assets

pawned. From the point of view of borrowers, they have disadvantages while

taking loans from pawn brokers. They can be – (i) If for some reason, the

borrower is unable to repay the loan amount, he looses his right to redeem his

pawned article. This is a loss, since the amount he received as a loan is less than

the value of the article pawned. (ii) Pawn Brokers auction or sell off articles that

are not redeemed by the borrowers and usually make a profit from the sale –

which is not passed on to the article’s original owner/borrower.

3.6.4 Indigenous Bankers:

Indigenous bankers constitute the ancient banking system of India. These

are individuals doing banking business, along with trading and commission

business in many cases. Their activities are not organised. They follow rules of

their own. But, they are trusted people in their own locality. The people of the area

deposit their savings with them. They lend money to people who need it for

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purchasing fertilisers, seeds, agricultural equipments or even for social obligations.

Loans are given on the security of jewellery and other valuable assets. They have

been carrying on their age-old banking operations in different parts of the country

under different names.

In Chennai, these bankers are called Chettys ; in Northern India Sahukars,

Mahajans and Khatnes; in Mumbai, Shroffs and Marwaris; and in Bengal, Seths

and Banias. According to the Indian Central Banking Enquiry Committee, an

indigenous banker or bank is defined as an individual or private firm which

receives deposits, deals in hundies or engages itself in lending money.

The indigenous bankers can be divided into three categories:

(a) Those who deal only in banking business (e.g., Multani bankers);

(b) Those who combine banking business with trade (e.g., Marwaris and

Bengalies); and

(c) Those who deal mainly in trade and have limited banking business.

The indigenous banker is different from the moneylender. The

moneylender is not a banker; his business is only to lend money from his own

funds. The indigenous banker, on the other hand, lends and accepts funds from

public.

3.6.4.1 Importance & Functions of Indigenous Bankers:

The indigenous bankers occupy an important place in the Indian money

market and play a vital role in financing the internal trade. They are especially

popular in the areas, which lack joint stock banks or are not properly served by

these banks. Although with the growth of joint stock banking in the country, the

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activities of the indigenous bankers have declined considerably, still these bankers

have control over a good deal of financial business.

The popularity of indigenous bankers is mainly due to the following

reasons:

(a) They provide prompt and flexible credit,

(b) They give loans to the small productive units not fully catered by the

commercial banks,

(c) They have cordial relationship with the customers,

(d) They keep close contact with their customers and remain fully acquainted with

their problems and financial requirements;

(e) They are not merely bankers to their customers, but are also their friends and

advisers.

The main functions of the indigenous bankers are as follows:

1. Accepting Deposits:

The indigenous bankers accept deposits from the public. These deposits are

of two types:

(a) The deposits which are repayable on demand and

(b) The deposits which are repayable after a fixed period.

The indigenous bankers pay higher rate of interest than that paid by the

commercial banks.

2. Advancing Loans:

The indigenous bankers advance loans to their customers against all types

of securities such as land, crops, gold and silver, etc. They also give credit against

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personal security. They provide loans to small industrialists who cannot fulfil the

necessary loan conditions of commercial banks.

3. Business in Hundies:

The indigenous bankers deal in hundies. They write hundies, buy, and sell

hundies. They also discount hundies and, thereby, meet the financial needs of the

internal traders. They also transfer funds from one place to another through

discounting of hundies.

4. Non-Banking Functions:

Most of the indigenous bankers also carry on their non-banking business

along with the banking activities,

(a) They generally have their retail trading business,

(b) Sometimes, they act as agents to large commercial firms and earn income in

the form of commission,

(c) They also participate in speculative activities.

3.6.4.2 Defects of Indigenous Bankers:

The organisation and functioning of indigenous bankers suffer from the

following defects:

1. Mixing Banking and non-Banking Business:

The indigenous bankers generally combine banking and non-banking

business. This is against the principle of sound banking.

2. Un-organised Banking system:

The indigenous banking system is highly unorganized and segmented.

Different indigenous bankers operate separately and independently. They have no

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coordination with each other and have no link with other banking sectors. The

transfer of funds is not possible in such a system.

3. Insufficient Capital:

The indigenous bankers largely depend upon their own capital or that of

their family members or relatives. The financial resources of these bankers,

therefore, are insufficient to meet the demand of the borrowers.

4. Meagre Deposit Business:

The main business of the indigenous .bankers is to give loans and deal in

hundies. Their deposit business is very small. They do not mobilize saving of the

general public in large scale.

5. Higher Interest Rates:

The indigenous bankers charge much higher interest rates from their

borrowers than those charged by the commercial banks. High rates of interest

adversely affect the inducement to produce. According to Sir Daniel Hamilton, the

"secret of successful industry is to buy your finance cheap and to sell your produce

dear (costly). The Indian buys his finance dear and sells his produce cheap. His

creditor generally fixes the price for both."

6. Defective Lending:

The indigenous bankers generally do not follow the sound banking

principles while granting loans. They provide loans against insufficient securities

or even against personal securities. They also extend credit against immovable

properties. They also do not distinguish between short-term and long-term loans.

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7. Unproductive Loans:

The indigenous bankers do not pay attention to the purpose for which the

loan is used. They generally give money for unproductive and speculative

activities, for paying interest or for paying off old debts.

8. Secrecy of Accounts:

The indigenous bankers keep secrecy about their accounts and activities.

They neither get their accounts audited nor publish annual balance sheets. This

raises suspicion in the minds of the people.

9. Exploitation of Customers:

The indigenous bankers indulge in all types of malpractices and exploit

their customers in many ways:

(a) They make unauthorised deductions from the loans,

(b) They overstate the amount of loans in the document,

(c) They do not give receipt against payments received.

10. No Control of Reserve Bank:

The indigenous banking business is unregulated. The Reserve Bank of

India has not control over these bankers and cannot regulate their activities. In this

way, the indigenous bankers are a great hurdle in the way of creating an organised

money market in the country.

11. Discouragement to Bill Market:

The indigenous bankers also stand in the way of developing a proper bill

market in the country. They very often give cash loans and hundies play a small

role.

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3.7 POSITION OF PRIVATE FINANCIAL INSTITUTIONS IN INDIAN

FINANCIAL SYSTEM:

The presence of a large number of institutions both in organized sector as

well as in unorganized sector makes the Indian Financial and Banking System a

very complex system. The organized sector is under the direct control and

supervision of Reserve Bank of India, but the institutions under unorganized sector

are not amenable to the direct control and supervision of RBI. To bring them

under organized sector, there is a constant effort through the registration of these

money lenders, indigenous bankers and NBFCs under different Acts.

In the early stage of the establishment of the private financing agencies it

was very difficult to recognize and give a place in the Indian financial and

banking system due to its unique nature of activities covering various functions of

different types of institution like Chit Funds, Co-operative societies, money

lenders, hire-purchase finance companies and banking companies.

Since 2000-01 due to strict supervision and guidance of Reserve Bank and

the State Government, due to narrowing down of their coverage of activities, now

it is in a position to classify and recognize them. With a thorough study of the

Indian Financial and Banking system, it can be possible to give them a proper

place in the system.

Those Private Financing Institutions registered under Manipur State Co-

operative Societies Act, 1976 as thrift and credit co-operative societies Ltd. can be

considered as a part of three-tier system of co-operative banks in the country. It

can be said that they belong to the lowest strata of co-operative banking system i.e.

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primary co-operative credit societies which are at the village level to promote

thrift and savings of the farmers and to meet their credit needs of cultivation.

Those private financing institutions registered under Bombay Money

Lenders’ Act, 1946 can be easily identified as money lenders. At present, there are

18 Private Financing Institutions who got license under this Act since 2005. These

private financing institutions started feeling that it is a need for them to get

registered under this Act to run this business of credit lending. It is a great

revolution and the state Government and RBI should give more awareness,

motivation and a force to get registered those non-registered private financing

institutions. The illegal commission, charges and corruption of the officials

handling this activity of issuing license under the Act should be checked.

As per the Reserve Bank of India, these financial institutions come under

the category of Non-Banking Financial Companies (NBFCs) and Unincorporated

Bodies engaged in financial activities (UIBs), and have been compelled to get

registered as NBFC under Reserve Bank of India and as Moneylender under

state’s regulations.