MODULE 1 PDF - Indian Financial System Syllabus

Syllabus Modules at a Glance Sr. No. Modules No. of Lectures 1 Indian Financial System...

Syllabus Modules at a Glance Sr. No. Modules No. of Lectures 1 Indian Financial System 15 2 Financial Markets in India 15 3 Commodity Market 15 4 Derivatives Market 15 Total 60 Sr. No. Modules/Units 1 Indian Financial System Introduction, Meaning, Functions of financial system, Indian financial system from financial neutrality to financial activism and from financial volatility to financial stability, Role of Government in Financial development, Overview of phases of Indian financial system since independence (State Domination-1947-1990, Financial Sector reforms 1991 till Financial sector Legislative Reforms Commission 2013), Monitoring Framework for financial conglomerates. Structure of Indian Financial System – Banking and Non-banking Financial Institutions, Organized and Unorganized Financial Markets, Financial Assets/Instruments, Fund based and Fee based financial services. 2 Financial Markets in India  Indian Money Market – Meaning, Features, Functions, Importance, Defects, Participants, Components of Organized and Unorganized Markets and Reforms.  Indian Capital Market – Meaning, Features, Functions, Importance, Participants, Instruments, Reforms in Primary and Secondary Market.  Indian Stock Market – Meaning and Functions of Stock Exchange, NSE and BSE.  Equity Market – Primary Market, IPO, Book Building, Role of Merchant Bankers, ASBA, Green Shoe Option, Issue of Bonus Shares, Right Shares, Sweat Equity Shares, ESOP.  Indian Debt Market –Market Instruments, Listing, Primary and Secondary Segments. 3 Commodity Market Introduction to commodities market – Meaning, History and origin, Types of commodities traded, Structure of commodities market in India, Participants in commodities market, Trading in commodities in India (cash and derivative segment), Commodity exchanges in India and abroad and Reasons for investing in commodities. 4 Derivatives Market Introduction to Derivatives market - Meaning, History and origin, Elements of a derivative contract, Factors driving growth of derivatives market, Types of derivatives, Types of underlying assets, Participants in derivatives market, Advantages and disadvantages of trading in derivatives market, Current volumes of derivative trade in India, Difference between Forwards and Futures.  1 Introduction to Indian Financial System Objectives:  To familiarise students with the basics of Indian Financial System Structure:  Introduction to Indian Financial System  Financial System  Role/Functions of Financial System  Components/Constituents of Indian Financial system  Financial institutions  Financial Markets  Financial Instruments  Financial Services  Phases in Indian Financial system  Pre-reforms Phase  Financial Sector Reforms in India INTRODUCTION TO INDIAN FINANCIAL SYSTEM Economic growth and development of any country depends upon a well-knit financial system. Financial system comprises, a set of sub-systems of financial institutions financial markets, financial instruments and services which help in the formation of capital. Thus a financial system provides a mechanism by which savings are transformed into investments and it can be said that financial system play an significant role in economic growth of the country by mobilizing surplus funds and utilizing them effectively for productive purpose. The financial system is characterized by the presence of integrated, organized and regulated financial markets, and institutions that meet the short term and long term financial needs of both the household and corporate sector. Both financial markets and financial institutions play an important role in the financial system by rendering various financial services to the community. They operate in close combination with each other. 2 Financial Markets FINANCIAL SYSTEM Seekers of Suppliers of Flow of funds (Services) funds (mainly funds (mainly business firms households) and Flow of financial services government) Incomes, and financial claims The word "system", in the term "financial system", implies a set of complex and closely connected or interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the economy. The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial inter-mediation ROLE/ FUNCTIONS OF FINANCIAL SYSTEM A financial system performs the following functions: * It serves as a link between savers and investors. It helps in utilizing the mobilized savings of scattered savers in more efficient and effective manner. It channelises flow of saving into productive investment. It assists in the selection of the projects to be financed and also reviews the performance of such projects periodically.  It provides payment mechanism for exchange of goods and services.  It provides a mechanism for the transfer of resources across geographic boundaries.  It provides a mechanism for managing and controlling the risk involved in mobilizing savings and allocating credit.  It promotes the process of capital formation by bringing together the supply of saving and the demand for Investible funds.  It helps in lowering the cost of transaction and increase returns. Reduce cost motives people to save more.  It provides you detailed information to the operators/ players in the market such as individuals, business houses, Governments etc. COMPONENTS/CONSTITUENTS OF INDIAN FINANCIAL SYSTEM The following are the four main components of Indian Financial system 1. Financial institutions 2. Financial Markets 3. Financial Instruments/Assets/Securities 4. Financial Services. Introduction to Indian Financial System 3 FINANCIAL INSTITUTIONS Financial institutions are the intermediaries who facilitate smooth functioning of the financial system by making investors and borrowers meet. They mobilize savings of the surplus units and allocate them in productive activities promising a better rate of return. Financial institutions also provide services to entities seeking advices on various issues ranging from restructuring to diversification plans. They provide whole range of services to the entities who want to raise funds from the markets elsewhere. Financial institutions act as financial intermediaries because they act as middlemen between savers and borrowers. These financial institutions may be of Banking or Non- Banking institutions. FINANCIAL MARKETS Finance is a prerequisite for modern business and financial institutions play a vital role in economic system. It's through financial markets the financial system of an economy works. The main functions of financial markets are: 1. to facilitate creation and allocation of credit and liquidity; 2. to serve as intermediaries for mobilization of savings; 3. to assist process of balanced economic growth; 4. to provide financial convenience FINANCIAL INSTRUMENTS Another important constituent of financial system is financial instruments. They represent a claim against the future income and wealth of others. It will be a claim against a person or an institutions, for the payment of the some of the money at a specified future date. FINANCIAL SERVICES Efficiency of emerging financial system largely depends upon the quality and variety of financial services provided by financial intermediaries. The term financial services can be defined as "activities, benefits and satisfaction connected with sale of money, that offers to users and customers, financial related value". Meaning of Financial Services Financial services can also be called financial inter-mediation. Financial inter-mediation is a process by which funds are mobilised from a large number of savers and make them available to all those who are in need of it and particularly to corporate customers. There are various institutions which render financial services. Some of the institutions are banks, investment companies, accounting firms, financial institutions, merchant banks, leasing companies, venture capital companies, factoring companies, mutual funds etc. These institutions provide variety of services to corporate enterprises. Such services are called financial services. Thus, services rendered by financial service organisations to industrial enterprises and to ultimate consumer markets are called financial services. These are the services and facilities required for the smooth operation of the financial markets. In short, services provided by financial intermediaries are called financial services. 4 Financial Markets Functions of financial services 1. Facilitating transactions (exchange of goods and services) in the economy. 2. Mobilizing savings (for which the outlets would otherwise be much more limited). 3. Allocating capital funds (notably to finance productive investment). 4. Monitoring managers (so that the funds allocated will be spent as envisaged). 5. Transforming risk (reducing it through aggregation and enabling it to be carried by those more willing to bear it). Characteristics or Nature of Financial Services From the following characteristics of financial services, we can understand their nature: 1. Intangibility: Financial services are intangible. Therefore, they cannot be standardized or reproduced in the same form. The institutions supplying the financial services should have a better image and confidence of the customers. Otherwise, they may not succeed. They have to focus on quality and innovation of their services. Then only they can build credibility and gain the trust of the customers. 2. Inseparability: Both production and supply of financial services have to be performed simultaneously. Hence, there should be perfect understanding between the financial service institutions and its customers. 3. Perishability: Like other services, financial services also require a match between demand and supply. Services cannot be stored. They have to be supplied when customers need them. 4. Variability: In order to cater a variety of financial and related needs of different customers in different areas, financial service organisations have to offer a wide range of products and services. This means the financial services have to be tailor-made to the requirements of customers. The service institutions differentiate their services to develop their individual identity. 5. Dominance of human element: Financial services are dominated by human element. Thus, financial services are labour intensive. It requires competent and skilled personnel to market the quality financial products. 6. Information based: Financial service industry is an information based industry. It involves creation, dissemination and use of information. Information is an essential component in the production of financial services. Types of Financial Services Financial service institutions render a wide variety of services to meet the requirements of individual users. These services may be summarized as below: 1. Provision of funds: (a) Venture capital (b) Banking services (c) Asset financing (d) Trade financing Introduction to Indian Financial System 5 (e) Credit cards (f) Factoring and forfaiting 2. Managing Investible funds: (a) Portfolio management (b) Merchant banking (c) Mutual and pension funds 3. Risk financing: (a) Project preparatory services (b) Insurance (c) Export credit guarantee 4. Consultancy services: (a) Project preparatory services (b) Project report preparation (c) Project appraisal (d) Rehabilitation of projects (e) Business advisory services (f) Valuation of investments (g) Credit rating (h) Merger, acquisition and re-engineering 5. Market operations: (a) Stock market operations (b) Money market operations (c) Asset management (d) Registrar and share transfer agencies (e) Trusteeship (f) Retail market operation (g) Futures, options and derivatives 6. Research and development: (a) Equity and market research (b) Investor education (c) Training of personnel (d) Financial information services Scope of Financial Services The scope of financial services is very wide. This is because it covers a wide range of services. The financial services can be broadly classified into two: (a) fund based services and (b) non-fund services (or fee-based services) 6 Financial Markets Fund based Services The fund based or asset based services include the following: 1. Underwriting 2. Dealing in secondary market activities 3. Participating in money market instruments like CPs, CDs etc. 4. Equipment leasing or lease financing 5. Hire purchase 6. Venture capital 7. Bill discounting. 8. Insurance services 9. Factoring 10. Forfaiting 11. Housing finance 12. Mutual fund Non-fund based Services Today, customers are not satisfied with mere provision of finance. They expect more from financial service companies. Hence, the financial service companies or financial intermediaries provide services on the basis of non-fund activities also. Such services are also known as fee based services. These include the following: 1. Securitisation 2. Merchant banking 3. Credit rating 4. Loan syndication 5. Business opportunity related services 6. Project advisory services 7. Services to foreign companies and NRIs. 8. Portfolio management 9. Merger and acquisition 10. Capital restructuring 11. Debenture trusteeship 12. Custodian services 13. Stock broking The most important fund based and non-fund based services (or types of services) may be briefly discussed as below: A. Asset/Fund Based Services 1. Equipment leasing/Lease financing: A lease is an agreement under which a firm acquires a right to make use of a capital asset like machinery etc. on payment of an agreed fee called Introduction to Indian Financial System 7 lease rentals. The person (or the company) which acquires the right is known as lessee. He does not get the ownership of the asset. He acquires only the right to use the asset. The person (or the company) who gives the right is known as lessor. 2. Hire purchase and consumer credit: Hire purchase is an alternative to leasing. Hire purchase is a transaction where goods are purchased and sold on the condition that payment is made in installments. The buyer gets only possession of goods. He does not get ownership. He gets ownership only after the payment of the last installment. If the buyer fails to pay any installment, the seller can repossess the goods. Each installment includes interest also. 3. Bill discounting: Discounting of bill is an attractive fund based financial service provided by the finance companies. In the case of time bill (payable after a specified period), the holder need not wait till maturity or due date. If he is in need of money, he can discount the bill with his banker. After deducting a certain amount (discount), the banker credits the net amount in the customer’s account. Thus, the bank purchases the bill and credits the customer’s account with the amount of the bill less discount. On the due date, the drawee makes payment to the banker. If he fails to make payment, the banker will recover the amount from the customer who has discounted the bill. In short, discounting of bill means giving loans on the basis of the security of a bill of exchange. 4. Venture capital: Venture capital simply refers to capital which is available for financing the new business ventures. It involves lending finance to the growing companies. It is the investment in a highly risky project with the objective of earning a high rate of return. In short, venture capital means long term risk capital in the form of equity financ e. 5. Housing finance: Housing finance simply refers to providing finance for house building. It emerged as a fund based financial service in India with the establishment of National Housing Bank (NHB) by the RBI in 1988. It is an apex housing finance institution in the country. Till now, a number of specialised financial institutions/companies have entered in the filed of housing finance. Some of the institutions are HDFC, LIC Housing Finance, Citi Home, Ind Bank Housing etc. 6. Insurance services: Insurance is a contract between two parties. One party is the insured and the other party is the insurer. Insured is the person whose life or property is insured with the insurer. That is, the person whose risk is insured is called insured. Insurer is the insurance company to whom risk is transferred by the insured. That is, the person who insures the risk of insured is called insurer. Thus insurance is a contract between insurer and insured. It is a contract in which the insurance company undertakes to indemnify the insured on the happening of certain event for a payment of consideration. It is a contract between the insurer and insured under which the insurer undertakes to compensate the insured for the loss arising from the risk insured against. According to Mc Gill, “Insurance is a process in which uncertainties are made certain”. In the words of Jon Megi, “Insurance is a plan wherein persons collectively share the losses of risks”. Thus, insurance is a device by which a loss likely to be caused by uncertain event is spread over a large number of persons who are exposed to it and who voluntarily join themselves against such an event. The document which contains all the terms and conditions of insurance (i.e. the written contract) is called the ‘insurance policy’. The amount for which the insurance policy is taken is called ‘sum assured’. The consideration in return for which 8 Financial Markets the insurer agrees to make good the loss is known as ‘insurance premium’. This premium is to be paid regularly by the insured. It may be paid monthly, quarterly, half yearly or yearly. 7. Factoring: Factoring is an arrangement under which the factor purchases the account receivables (arising out of credit sale of goods/services) and makes immediate cash payment to the supplier or creditor. Thus, it is an arrangement in which the account receivables of a firm (client) are purchased by a financial institution or banker. Thus, the factor provides finance to the client (supplier) in respect of account receivables. The factor undertakes the responsibility of collecting the account receivables. The financial institution (factor) undertakes the risk. For this type of service as well as for the interest, the factor charges a fee for the intervening period. This fee or charge is called factorage. 8. Forfaiting: Forfaiting is a form of financing of receivables relating to international trade. It is a non-recourse purchase by a banker or any other financial institution of receivables arising from export of goods and services. The exporter surrenders his right to the forfaiter to receive future payment from the buyer to whom goods have been supplied. Forfaiting is a technique that helps the exporter sells his goods on credit and yet receives the cash well before the due date. In short, Forfaiting is a technique by which a forfaiter (financing agency) discounts an export bill and pay ready cash to the exporter. The exporter need not bother about collection of export bill. He can just concentrate on export trade 9. Mutual fund: Mutual funds are financial intermediaries which mobilise savings from the people and invest them in a mix of corporate and government securities. The mutual fund operators actively manage this portfolio of securities and earn income through dividend, interest and capital gains. The incomes are eventually passed on to mutual fund shareholders Non-Fund Based/Fee Based Financial Services 1. Merchant banking: Merchant banking is basically a service banking, concerned with providing non-fund based services of arranging funds rather than providing them. The merchant banker merely acts as an intermediary. Its main job is to transfer capital from those who own it to those who need it. Today, merchant banker acts as an institution which understands the requirements of the promoters on the one hand and financial institutions, banks, stock exchange and money markets on the other. SEBI (Merchant Bankers) Rule, 1992 has defined a merchant banker as, “any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, advisor, or rendering corporate advisory services in relation to such issue management”. 2. Credit rating: Credit rating means giving an expert opinion by a rating agency on the relative willingness and ability of the issuer of a debt instrument to meet the financial obligations in time and in full. It measures the relative risk of an issuer’s ability and willingness to repay both interest and principal over the period of the rated instrument. It is a judgement about a firm’s financial and business prospects. In short, credit rating means assessing the creditworthiness of a company by an independent organisation. 3. Stock broking: Now stock broking has emerged as a professional advisory service. Stock broker is a member of a recognized stock exchange. He buys, sells, or deals in shares/securities. It is compulsory for each stock broker to get himself/herself registered Introduction to Indian Financial System 9 with SEBI in order to act as a broker. As a member of a stock exchange, he will have to abide by its rules, regulations and by-laws. 4. Custodial services: In simple words, the services provided by a custodian are known as custodial services (custodian services). Custodian is an institution or a person who is handed over securities by the security owners for safe custody. Custodian is a caretaker of a public property or securities. Custodians are intermediaries between companies and clients (i.e. security holders) and institutions (financial institutions and mutual funds). There is an arrangement and agreement between custodian and real owners of securities or properties to act as custodians of those who hand over it. The duty of a custodian is to keep the securities or documents under safe custody. The work of custodian is very risky and costly in nature. For rendering these services, he gets a remuneration called custodial charges. Thus custodial service is the service of keeping the securities safe for and on behalf of somebody else for a remuneration called custodial charges. 5. Loan syndication: Loan syndication is an arrangement where a group of banks participate to provide funds for a single loan. In a loan syndication, a group of banks comprising 10 to 30 banks participate to provide funds wherein one of the banks is the lead manager. This lead bank is decided by the corporate enterprises, depending on confidence in the lead manager. A single bank cannot give a huge loan. Hence a number of banks join together and form a syndicate. This is known as loan syndication. Thus, loan syndication is very similar to consortium financing. 6. Securitisation (of debt): Loans given to customers are assets for the bank. They are called loan assets. Unlike investment assets, loan assets are not tradable and transferable. Thus loan assets are not liquid. The problem is how to make the loan of a bank liquid. This problem can be solved by transforming the loans into marketable securities. Now loans become liquid. They get the characteristic of marketability. This is done through the process of securitization. Securitization is a financial innovation. It is conversion of existing or future cash flows into marketable securities that can be sold to investors. It is the process by which financial assets such as loan receivables, credit card balances, hire purchase debtors, lease receivables, trade debtors etc. are transformed into securities. Thus, any asset with predictable cash flows can be securitised. Securitization is defined as a process of transformation of illiquid asset into security which may be traded later in the opening market. In short, securitization is the transformation of illiquid, non- marketable assets into securities which are liquid and marketable assets. It is a process of transformation of assets of a lending institution into negotiable instruments. Securitisation is different from factoring. Factoring involves transfer of debts without transforming debts into marketable securities. But securitisation always involves transformation of illiquid assets into liquid assets that can be sold to investors. Challenges faced by the financial service sector. Financial service sector has to face lot of challenges in its way to fulfill the ever growing financial demand of the economy. Some of the important challenges are listed below: 1. Lack of qualified personnel in the financial service sector. 2. Lack of investor awareness about the various financial services. 10 Financial Markets 3. Lack of transparency in the disclosure requirements and accounting practices relating to financial services. 4. Lack of specialisation in different financial services (specialisation only in one or two services). 5. Lack of adequate data to take financial service related decisions. 6. Lack of efficient risk management system in the financial service sector. The above challenges are likely to increase in number with the growing requirements of the customers. However, the financial system in India at present is in a process of rapid transformation, particularly after the introduction of new economic reforms. Components of Indian Financial System Financial Institutions Financial Markets Financial Instruments Financial Services Banking Non Banking Money Capital Term Type Fund Based Fee Based Institutions Institutions Market Market – Short term – Leasing – Call money market Commercial Cooperative – Medium term – Hire Purchase – Treasury bills Banks – Long term – Factoring Banks – Commercial Bills – Primary Market – Primary Securities – Merchant Banking Public Sector – Secondary Market – Secondary Securities – Credit Rating Private Sector – Derivative Market – Innovative Instruments – Mergers R R Bs Foreign Banks Organised Financial Unorganized Financial Institutions Institutions PHASES IN INDIAN FINANCIAL SYSTEM Pre-reforms Phase Until the early 1990s, the role of the financial system in India was primarily restricted to the function of channelling resources from the surplus to deficit sectors. Whereas the financial system performed this role reasonably well, its operations came to be marked by some serious deficiencies over the years. The banking sector suffered from lack of competition, low capital base, low Productivity and high inter-mediation cost. After the nationalization of large banks in 1969 and 1980, the Government-owned banks dominated the banking sector. The role of technology was minimal and the quality of service was not given adequate importance. Banks also did not follow proper risk management systems and the prudential standards were weak. All these resulted in poor asset quality and low profitability. Among non-banking financial intermediaries, development finance institutions (DFIs) operated in an over-protected environment with most of the funding coming from assured Introduction to Indian Financial System 11 sources at concessional terms. In the insurance sector, there was little competition. The mutual fund industry also suffered from lack of competition and was dominated for long by one institution, viz., the Unit Trust of India. Non-banking financial companies (NBFCs) grew rapidly, but there was no regulation of their asset side. Financial markets were characterized by control over pricing of financial assets, barriers to entry, high transaction costs and restrictions on movement of funds/participants between the market segments. This apart from inhibiting the development of the markets also affected their efficiency. FINANCIAL SECTOR REFORMS IN INDIA It was in this backdrop that wide-ranging financial sector reforms in India were introduced as an integral part of the economic reforms initiated in the early 1990s with a view to improving the macroeconomic performance of the economy. The reforms in the financial sector focused on creating efficient and stable financial institutions and markets. The approach to financial sector reforms in India was one of gradual and non-disruptive progress through a consultative process. The Reserve Bank has been consistently working towards setting an enabling regulatory framework with prompt and effective supervision, development of technological and institutional infrastructure, as well as changing the interface with the market participants through a consultative process. Persistent efforts have been made towards adoption of international benchmarks as appropriate to Indian conditions. While certain changes in the legal infrastructure are yet to be effected, the developments so far have brought the Indian financial system closer to global standards. The reform of the interest regime constitutes an integral part of the financial sector reform. With the onset of financial sector reforms, the interest rate regime has been largely deregulated with a view towards better price discovery and efficient resource allocation. Initially, steps were taken to develop the domestic money market and freeing of the money market rates. The interest rates offered on Government securities were progressively raised so that the Government borrowing could be carried out at market-related rates. In respect of banks, a major effort was undertaken to simplify the administered structure of interest rates. Banks now have sufficient flexibility to decide their deposit and lending rate structures and manage their assets and liabilities accordingly. At present, apart from savings account and NRE deposit on the deposit side and export credit and small loans on the lending side, all other interest rates are deregulated. Indian banking system operated for a long time with high reserve requirements both in the form of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit and a high degree of monetisation of fiscal deficit. The efforts in the recent period have been to lower both the CRR and SLR. The statutory minimum of 25 per cent for SLR has already been reached, and while the Reserve Bank continues to pursue its medium-term objective of reducing the CRR to the statutory minimum level of 3.0 per cent, the CRR of SCBs is currently placed at 5.0 per cent of NDTL. As part of the reforms programme, due attention has been given to diversification of ownership leading to greater market accountability and improved efficiency. Initially, there was infusion of capital by the Government in public sector banks, which was followed by expanding the capital base with equity participation by the private investors. This was followed by a reduction in the Government shareholding in public sector banks to 51 per cent. Consequently, the share of the public sector banks in the aggregate assets of the banking sector has come down from 90 per cent in 1991 to around 75 per cent in 2004. With a view to enhancing efficiency and productivity through competition, guidelines were laid down for establishment of new banks in the private sector and the foreign banks have been allowed more liberal entry. Since 1993, twelve new private sector banks have been set up. As a major step towards enhancing competition in the banking sector, foreign direct investment in the private sector banks is now allowed up to 74 per cent, subject to conformity with the guidelines issued from time to time.