Indian Financial System PDF

1 The Financial System: An Introduc...

1 The Financial System: An Introduction Chapter Objectives INTRODUCTION This chapter will enable you to develop an A financial system plays a vital role in the economic growth of a country. It intermediates understanding of the following: 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. 1 Meaning of a financial system A financial system is a complex, well-integrated set of sub-systems of financial insti- 2 Components of a financial system tutions, markets, instruments, and services which facilitates the transfer and allocation of funds, efficiently and effectively. 3 Functions of a financial system 4 Key elements of a well-functioning financial system Formal and Informal Financial Sectors 5 Bank-based and market-based The financial systems of most developing countries are characterized by coexistence and financial systems cooperation between the formal and informal financial sectors. This coexistence of these two sectors is commonly referred to as ‘financial dualism.’ The formal financial sector is char- 6 Nature and role of financial acterized by the presence of an organized, institutional, and regulated system which caters institutions and financial markets to the financial needs of the modern spheres of economy; the informal financial sector is an 7 Link between money markets and unorganized, non-institutional, and non-regulated system dealing with the traditional and capital markets rural spheres of the economy. 8 Link between primary markets and The informal financial sector has emerged as a result of the intrinsic dualism of economic secondary markets and social structures in developing countries, and financial repression which inhibits the certain deprived sections of society from accessing funds. The informal system is charac- 9 Functions and characteristics of terized by flexibility of operations and interface relationships between the creditor and the financial markets 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. An interpenetration is found between the formal and informal systems in terms of opera- tions, participants, and nature of activities which, in turn, have led to their coexistence. A high priority should be accorded to the development of an efficient formal financial system as it can offer lower intermediation costs and services to a wide base of savers and entrepreneurs. The Indian Financial System Informal Financial System The Indian financial system can also be broadly classified into the formal (organized) finan- cial system and the informal (unorganized) financial system. The formal financial system Advantages comes under the purview of the Ministry of Finance (MoF), the Reserve Bank of India Low transaction costs (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies. The Minimum default risk informal financial system consists of: Transparency of procedures Disadvantages Individual moneylenders such as neighbours, relatives, landlords, traders, and Wide range of interest rates ­storeowners. Higher rates of interest Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a Unregulated system of their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘­ saving club.’ Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies. 4 Part I Financial System In India, the spread of banking in rural areas has helped in enlarging the scope of the formal financial system. 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 (refer Figure 1.1). Financial Institutions Classification of These are intermediaries that mobilize savings and facilitate the allocation of funds in an efficient manner. Financial Institutions Financial institutions can be classified as banking and non-banking financial institutions. Banking Banking and institutions are creators and purveyors of credit while non-banking financial institutions are purveyors of non-banking credit. While the liabilities of banks are part of the money supply, this may not be true of non-banking Term finance financial institutions. In India, non-banking financial institutions, namely, the developmental financial Specialized institutions (DFIs), and non-banking financial companies (NBFCs) as well as housing finance companies Sectoral (HFCs) are the major institutional purveyors of credit. Investment Financial institutions can also be classified as term-finance institutions such as the Industrial Develop- State-level ment Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), the Indus- trial 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), ICICI Venture, the Infrastructure Develop- ment Finance Company (IDFC), and sectoral financial institutions such as the National Bank for Agricul- tural 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 Insur- ance 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. In the post-reforms era, the role and nature of activity of these financial institutions have undergone a tremendous change. Banks have now undertaken non-bank activities and financial institutions have taken up banking functions. Most of the financial institutions now resort to financial markets for raising funds. Financial Markets Types Financial markets are a mechanism enabling participants to deal in financial claims. The markets also Money market provide a facility in which their demands and requirements interact to set a price for such claims. Capital market 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 Segments having a maturity period of one year or more. Primary market Financial markets can also be classified as primary and secondary markets. While the primary market Secondary 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. The government securities market is an OTC market. In an OTC market, spot trades are negotiated and traded for immediate delivery and payment while in the exchange-traded market, trading takes place over a trading cycle in stock exchanges. Recently, the derivatives market (exchange traded) has come into existence. Financial Instruments 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 risk.  Indian Financial System Formal (Organized) Informal Financial System (Unorganized) Financial System Financial Financial Financial Regulators: Institutions Instruments Services MoF, SEBI RBI, IRDA (Intermediaries) Moneylenders Local Bankers Term: Type Traders MutualFunds Short Landlords Banking Non-banking Insurance Medium Pawn Brokers Institutions Institutions and Long Housing Public Private Finance Sector Sector Companies Primary Secondary Securities Securities Scheduled Scheduled Non-banking Development Depositories Commercial Cooperative Finance Finance Custodial Companies Institutions Equity, Time Deposits, Banks Banks Credit Rating Preference, MF Units Factoring Debt and Insurance Policies Forfaiting Various Merchant Banking Public Private Foreign Regional Combinations Leasing Sector Sector Banks in Rural Banks Hire Purchase Banks Banks India Guaranteeing All-India Financial State-level Other Portfolio Management 5 Institutions:IFCI, Institutions: Institutions: Underwriting IDBI, SIDBI, SFCs, SIDCs ECGC, IDFC, NABARD, DICGC EXIM Bank, NHB Financial Markets Capital Money Market Market Equity Debt Market Treasury Bills, Market Call Money Market, Notes Private Corporate Debt Commercial Bills, PSU Bond Market Commercial Papers, IDBI : Industrial Development Bank of India Government Securities Certificates of Deposit, Term Money IFC I : Industrial Finance Corporation of India Market SIDBI : Small Industries Development Bank of India Primary Market Secondary Derivatives Market IDFC : Infrastructure Development Finance Company Limited — Public Market — Exchange Traded NABARD : National Bank for Agriculture and Rural Development Issues Primary Secondary EXIM Bank : Export–Import Bank of India — Private NSE Futures and Options Segment Segment SFC : State Financial Corporation Placement BSE SIDC : State Industrial Development Corporation OTCEI Index Stock ISE ECGC : Export Credit Guarantee Corporation of India Domestic International Regional — OTC DICGS : Deposit Insurance and Credit Guarantee Corporation Stock Interest Primary Secondary OTC : Over the Counter Market Market Exchanges Rate Segment Segment NHB : National Housing Bank Derivatives Figure 1.1 Indian Financial System 6 Part I Financial System Types of Financial Different types of financial instruments can be designed to suit the risk and return preferences of Securities different classes of investors. Primary Savings and investments are linked through a wide variety of complex financial instruments known Secondary as ‘securities.’ Securities are defined in the Securities Contracts Regulation Act (SCRA), 1956 as includ- ing shares, scrips, stocks, bonds, debentures, debenture stocks or other marketable securities of a similar Distinct Features nature or of any incorporated company or body corporate, government securities, derivatives of securi- Marketable ties, units of collective investment scheme, security receipts, interest and rights in securities, or any other Tradeable instruments so declared by the central government. Tailor-made Financial securities are financial instruments that are negotiable and tradeable. 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 secu- rities, 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 inter- mediaries to perform the important role of channelizing funds from lenders to borrowers. Availabil- ity of different varieties of financial instruments helps financial intermediaries to improve their own risk management. Financial Services Need of Financial These are those that help with borrowing and funding, lending and investing, buying and selling securi- Services for ties, making and enabling payments and settlements, and managing risk exposures in financial markets. Borrowing and The major categories of financial services are funds intermediation, payments mechanism, provision of funding liquidity, risk management, and financial engineering. Lending and investing Funds intermediating services link the saver and borrower which, in turn, leads to capital forma- Buying and selling tion. New channels of financial intermediation have come into existence as a result of information securities technology. Payment services enable quick, safe, and convenient transfer of funds and settlement of Making and enabling transactions. Payments and Liquidity is essential for the smooth functioning of a financial system. Financial liquidity of financial settlements claims is enhanced through trading in securities. Liquidity is provided by brokers who act as dealers by Managing risk assisting sellers and buyers and also by market makers who provide buy and sell quotes. Financial services are necessary for the management of risk in the increasingly complex global econ- omy. They enable risk transfer and protection from risk. Risk can be defined as a chance of loss. Risk transfer of services help 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 specu- lators. 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 com- panies, 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 finan- cial 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. Before investors lend money, they need to be reassured that it is safe to exchange securities for funds. The financial regulator who regulates the conduct of the market and intermediaries to protect the investors’ interests provides this reassurance. The regulator regulates the conduct of issuers of securities and the intermediaries to protect the interests of investors in securities and increases their confidence in markets which, in turn, helps in the growth and development of the financial system. Regulation is necessary not only to develop a system, but a system once developed needs to be regulated. The RBI regulates the money market and the SEBI regulates the capital market. The securities market is regulated  Chapter 1 The Financial System: An Introduction 7 by the Department of Economic Affairs (DEA), the Department of Company Affairs (DCA), the RBI, and the SEBI. A high-level committee on capital and financial markets coordinates the activities of these agencies. Interaction Among Financial System Components The four financial system components discussed do not function in isolation. They are i­nterdependent Interaction Among the and interact continuously with each other. Their interaction leads to the development of a smoothly Components ­functioning financial system. Interdependent Financial institutions or intermediaries mobilize savings by issuing different types of financial Interactive instruments which are traded in the financial markets. To facilitate the credit-allocation process, these Close links ­institutions acquire specialization and render specialized financial services. Competing with each Financial intermediaries have close links with the financial markets in the economy. Financial institu- other tions acquire, hold, and trade financial securities which not only help in the credit-allocation process but also make the financial markets larger, more liquid, stable, and diversified. Financial intermediaries rely on financial markets to raise funds whenever the need arises. This increases the competition between financial markets and financial intermediaries for attracting investors and borrowers. The development of new sophisticated markets has led to the development of complex securities and portfolios. The evalu- ation of these complex securities, portfolios, and strategies requires financial expertise which financial intermediaries provide through financial services. Financial markets have also made an impact on the functioning of financial intermediaries such as banks and financial institutions. The latter are, today, radically changed entities as the bulk of the service fees and non-interest income that they derive is directly or indirectly linked to financial market-related activities. Moreover, liquid and broad markets make financial instruments a more attractive avenue for sav- ings, and financial services may encourage further savings if the net returns to investors are raised or increased. FUNCTIONS OF A FINANCIAL SYSTEM One of the important functions of a financial system is to link the savers and investors and, thereby, help Functions of a in mobilizing and allocating the savings efficiently and effectively. By acting as an efficient conduit for Financial System allocation of resources, it permits continuous upgradation of technologies for promoting growth on a Mobilize and allocate sustained basis. savings A financial system not only helps in selecting projects to be funded but also inspires the operators to Monitor corporate monitor the performance of the investment. Financial markets and institutions help to monitor corporate performance performance and exert corporate control through the threat of hostile takeovers for underperforming Provide payment and firms. settlement systems It provides a payment mechanism for the exchange of goods and services and transfers economic Optimum allocation resources through time and across geographic regions and industries. Payment and settlement systems of risk-bearing and play an important role to ensure that funds move safely, quickly, and in a timely manner. An efficient reduction payment and settlement system contributes to the operating and allocation efficiencies of the financial Disseminate price- system and thus, overall economic growth. Payment and settlement systems serve an important role in the related information economy as the main arteries of the financial sector. Banks provide this mechanism by offering a means Offer portfolio of payment facility based upon cheques, promissory notes, credit and debit cards. This payment mecha- adjustment facility nism is now increasingly through electronic means. The clearing and settlements mechanism of the stock Lower the cost of markets is done through depositories and clearing corporations. transactions One of the most important functions of a financial system is to achieve optimum allocation of risk Promote the process of financial deepening bearing. It limits, pools, and trades the risks involved in mobilizing savings and allocating credit. An and broadening efficient financial system aims at containing risk within acceptable limits. It reduces risk by laying down rules governing the operation of the system. Risk reduction is achieved by holding diversified port­folios and screening of borrowers. Market participants gain protection from unexpected losses by buying ­financial insurance services. Risk is traded in the financial markets through financial instruments such as derivatives. Derivatives are risk shifting devices, they shift risk from those who have it but may not want it to those who are willing to take it. A financial system also makes available price-related information which is a valuable assistance to those who need to take economic and financial decisions. Financial markets disseminate information for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment, 8 Part I Financial System or holding a particular asset. This information dissemination enables a quick valuation of financial assets. Moreover, by influencing the market price of a firm’s debt and equity instruments, this process of valua- tion guides the management as to whether their actions are consistent with the objective of shareholder wealth maximization. In addition, a financial system also minimises situations where the information is asymmetric and likely to affect motivations among operators when one party has the information and the other party does not. It also reduces the cost of gathering and analysing information to assist operators in taking decisions carefully. A financial system also offers portfolio adjustment facilities. These are provided by financial markets and financial intermediaries such as banks and mutual funds. Portfolio adjustment facilities include services of providing a quick, cheap and reliable way of buying and selling a wide variety of financial assets. A financial system helps in the creation of a financial structure that lowers the cost of transactions. This has a beneficial influence on the rate of return to savers. It also reduces the cost of borrowing. Thus, the system generates an impulse among the people to save more. A well-functioning financial system helps in promoting the process of financial deepening and broad- ening. Financial deepening refers to an increase of financial assets as a percentage of the Gross Domestic Product (GDP). Financial depth is an important measure of financial system development as it measures the size of the financial intermediary sector. Depth equals the liquid liabilities of the financial system (currency plus demand and interest-bearing liabilities of banks and non-bank financial intermediaries divided by the GDP). Financial broadening refers to building an increasing number and variety of par- ticipants and instruments. KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM Basic Elements of The basic elements of a well-functioning financial system are (i) a strong legal and regulatory envi- a Well-functioning ronment, (ii) stable money, (iii) sound public finances and public debt management, (iv) a central Financial System bank, (v) a sound banking system, (vi) an information system, and (vii) a well-functioning securities A strong legal market. and regulatory Since finance is based on contracts, strong legal and regulatory systems that produce and strictly environment enforce laws alone can protect the rights and interests of investors. Hence, a strong legal system is the Stable money most fundamental element of a sound financial system. Sound public finances Stable money is an important constituent as it serves as a medium of exchange, a store of value and public debt (a reserve of future purchasing power), and a standard of value (unit of account) for all the goods and management services we might wish to trade in. Large fluctuations and depreciation in the value of money lead to A central bank financial crises and impede the growth of the economy. Sound banking system Sound public finance includes setting and controlling public expenditure priorities and raising rev- Information system enues adequate to fund them efficiently. Historically, these financing needs of the governments world over Well-functioning led to the creation of financial systems. Developed countries have sound public finances and public debt securities market management practices, which result in the development of a good financial system. A central bank supervises and regulates the operations of the banking system. It acts as a banker to the banks, banker to the government, manager of public debt and foreign exchange, and lender of the last resort. The monetary policy of the central bank influences the pace of economic growth. An autonomous central bank paves the way for the development of a sound financial system. A good financial system must also have a variety of banks both with domestic and international opera- tions together with an ability to withstand adverse shocks without failing. Banks are the core financial intermediaries in all countries. They perform diverse key functions such as operating the clearing and payments system, and the foreign exchange market. The banking system is the main fulcrum for transmit- ting the monetary policy actions. Banks also undertake credit risk analysis, assessing the expected risk and return on the projects. The financial soundness of the banking system depends on how effectively banks perform these diverse functions. Another foundational element is information. All the participants in a financial system require infor- mation. A sound financial system can develop only when proper disclosure practices and networking of information systems are adopted. Securities markets facilitate the issue and trading of securities, both equity and debt. Efficient securi- ties markets promote economic growth by mobilizing and deploying funds into productive uses, lowering the cost of capital for firms, enhancing liquidity, and attracting foreign investment. An efficient securities market strengthens market discipline by exerting corporate control through the threat of hostile takeovers for underperforming firms.  Chapter 1 The Financial System: An Introduction 9 FINANCIAL SYSTEM DESIGNS A financial system is a vertical arrangement of a well-integrated chain of financial markets and institu- Financial System tions that provide financial intermediation. Different designs of financial systems are found in different Designs countries. The structure of the economy, its pattern of evolution, and political, technical, and cultural dif- Bank-based ferences affect the design (type) of financial system. Market-based 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 concen- trated. The other major industrial countries fall in between these two extremes (Figure 1.2). Demirguc Kunt and Levine (1999) have provided explanations of bank-based and market-based financial systems. 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 markets share centre stage with banks in mobilizing the society’s savings for firms, exerting corporate control, and easing risk management. Bank-based systems tend to be stronger in countries where governments have a direct hand in indus- trial development. In India, banks have traditionally been the dominant entities of financial intermedia- tion. The nationalization of banks, an administered interest rate regime, and the government policy of favouring banks led to the predominance of a bank-based financial system. Demirguc Kunt and Levine, using a database of 150 countries, have classified countries according to the structure and level of financial development (Table 1.1). Their comparison of financial systems across different income groups reveals several patterns. First, financial systems are, on an average, more developed in rich countries. There is a tendency for a finan- cial system to become more market-oriented as the country becomes richer. Second, countries with a common-law tradition, strong protection of shareholders’ rights, and low levels of corruption tend to be more market-based and have well-developed financial systems. Arnold and Walz (2000) have attempted to identify factors leading to the emergence of bank-based or market-based financial systems. When problems relating to information persist but banks are competent Table 1.1 Classification of Financial Structure and Level of Development of Select Economies Extent of Development Bank-based Market-based Developed Japan, Germany, France, Italy US, UK, Singapore, Malaysia, Korea Under-developed Argentina, Pakistan, Sri Lanka, Bangladesh Brazil, Mexico, the Philippines, Turkey Source: Demirguc Kunt, A. and R. Levine (1999), Bank-based and Market-based Financial System: Cross-Country Comparisons, World Bank Policy Research Working Paper No. 2143. US UK Japan France Germany Financial Markets Central Central Developed Fairly Important Unimportant Banks Competitive Concentrated Trade-offs Financial Financial Markets Intermediaries Competition Insurance Efficiency Stability Public Information Private Information but Free-riding but no Free-riding External Control Autonomy Source: Allen and Gale (2000), Comparing Financial Systems, MIT Press, Cambridge, Mass. Figure 1.2 Overview and Trade-offs of Financial Systems 10 Part I Financial System Market-based enough right from the beginning and, with the passage of time, learn through experience to become more Financial System productive, they come to dominate the financial system. Conversely, if banks are initially incompetent and Advantages fail to improve themselves by experience, the bank-based system gives way to the growth of a market- Provides attractive based financial system. terms to both Given these two types of financial systems, questions arise about the advantages and disadvantages investors and of a bank-based financial system vis-a-vis a market-based financial system. Some researchers sug- borrowers gest that markets are more effective at providing financial services while some tout the advantages of Facilitates intermediaries. diversification Proponents of the market-based view argue that efficiency is associated with the functioning of Allows risk-sharing competitive markets. Financial markets are attractive as they provide the best terms to both inves- Allows financing of tors and borrowers. Stock markets facilitate diversification and allow efficient risk-sharing. They new technologies provide incentives to gather information that is reflected in stock prices and these prices, in turn, Drawbacks provide ­signals for an efficient allocation of investment. An important area in which financial mar- Prone to instability kets ­perform differently from financial intermediaries is in situations where a diversity of opinion is Exposure to market important, such as the financing of new technologies or when an unusual decision has to be made. risk Hence, in emerging industries with significant financial and technological risks, a market-based Free-rider problem system may be preferable. The drawbacks of the market-based system are that it is more prone to instability, its investors are exposed to market risks, and that there is a free-rider problem. The last drawback arises when no indi- vidual is willing to contribute towards the cost of something but hopes that someone else will bear the cost. This problem arises whenever there is a public good and separation of ownership from control. For example, shareholders take little interest in the management of their companies, hoping someone else will monitor the executives. In a market-based system, the free-rider problem blunts the incentives to gather information. On the other hand, a bank-based system is perceived to be more stable, as the relationship with parties is relatively close. This leads to the formation of tailor-made contracts and financial products and efficient inter-temporal risk-sharing. Financial intermediaries can eliminate the risks that cannot be diversified at a given point of time but can be averaged over time through inter-temporal smoothing of asset returns. This requires that investors accept lower returns than what the market offers in some periods in order to get higher returns in other periods. This provides an insurance to investors who would otherwise be forced to liquidate assets at disadvantageous prices. Bank-based Financial The banking system avoids some of the information deficiencies associated with the securi- System ties markets. The free-rider problem is eliminated as private incentives to gather information are Advantages higher in the case of a bank-based system. Moreover, banks can perform screening and monitoring­ Close relationship functions on behalf of the investors; these functions, left to themselves, can be undertaken only at a with parties high cost. Provides tailor-made The greatest drawback of a bank-based system is that it retards innovation and growth as banks have contracts an inherent preference for low-risk, low-return projects. Moreover, powerful banks may collude with firm Efficient intertemporal managers against other investors, which, in some cases, could impede competition, effective corporate risk-sharing control, and entry of new firms. No free-rider problem The current trend is a preference for the market-based system. France and Japan have reformed their Drawbacks markets to make them more competitive. It is partly due to the growing volume of banking activity in Retards innovation the financial markets. The European Union is moving towards a single unified market to increase its and growth global competitiveness. In India also, the role of stock markets has gained prominence. The govern- Impedes competition ment has put in substantial efforts to reform the financial markets. The Indian equity market, now, is at par with some of the developed markets of the world. Moreover, the ratio of market capitalization to Box 1.1 Evolution of Financial Systems In the 1950s and 1960s, Gurley and Shaw (1955, 1960, 1967) and Goldsmith (1969) discussed the stages in the evolution of financial systems. According to them, there is a link between per capita income and the development of a financial system. At low levels of develop- ment, most investment is self-financed and financial intermediaries do not exist, as the costs of financial intermediation are high rela- tive to benefits. As countries develop and per capita income increases, bilateral borrowing and lending take place leading to the birth of financial intermediaries. The number of financial intermediaries grows with further increases in per capita income. Among the financial intermediaries, banks tend to become larger and prominent in financial investment. As countries expand economically, non-bank financial intermediaries and stock markets grow in size and tend to become more active and efficient relative to banks. There is a general tendency for financial systems to become more market-oriented as countries become richer.  Chapter 1 The Financial System: An Introduction 11 assets of scheduled commercial banks has risen sharply from 28.4 per cent in March 1991 to 79.3 per cent in March 2000. The relative share of banks in the aggregate financial assets of banks and financial institutions taken together, which stood at nearly three-fourths in the early 1980s, is now hovering around the two-thirds mark since the 1990s. This implies that there is considerable potential for growth in market financing. Allen and Gale (2000) have put forward two explanations for the universal popularity of financial markets: (i) government intervention is regarded as a negative factor and government failures are as important a problem as market failures, (ii) economic theory, pertaining to firms, stresses the effective- ness of markets in allocating resources. Empiral analysis in various researches do not emphatically suggest the superiority of one system over the other. Whatever be the type of financial system, both financial intermediaries and financial markets play a crucial role in the development of a sound financial system. Both systems can coexist as they encourage competition, reduce transaction costs, and improve resource allocation within the economy, leading to the development of a balanced financial system. NATURE AND ROLE OF FINANCIAL INSTITUTIONS (INTERMEDIARIES) AND FINANCIAL MARKETS Financial institutions (intermediaries) are business organizations serving as a link between savers and Financial Institutions investors and so help in the credit-allocation process. Good financial institutions are vital to the function- Provide Three ing of an economy. If finance were to be described as the circulatory system of the economy, financial Transformation institutions are its brain. They make decisions that tell scarce capital where to go and ensure that it is used Services most efficiently. It has been confirmed by research that countries with developed financial institutions Liability, asset, and grow faster and countries with weak ones are more likely to undergo financial crises. size transformation Lenders and borrowers differ in regard to terms of risk, return, and terms of maturity. Financial institu- Maturity tions assist in resolving this conflict between lenders and borrowers by offering claims against themselves transformation and, in turn, acquiring claims on the borrowers. The former claims are referred to as indirect (secondary) Risk transformation securities and the latter as direct (primary) securities. Financial institutions provide three transformation services: Liability, asset, and size transformation consisting of mobilization of funds, and their allocation by providing large loans on the basis of numerous small deposits. Maturity transformation by offering the savers tailor-made short-term claims or liquid deposits and so offering borrowers long-term loans matching the cash-flows generated by their investment. Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios. Through these services, financial institutions are able to tap savings that are unlikely to be acceptable otherwise. Moreover, by facilitating the availability of finance, financial institutions enable the consumer to spend in anticipation of income and the entrepreneur to acquire physical capital. The role of financial institutions has undergone a tremendous transformation in the 1990s. Besides providing direct loans, many financial institutions have diversified themselves into areas of financial ser- vices such as merchant banking, underwriting and issuing guarantees. Financial Markets Types Financial Markets Money Market—a Financial markets are an important component of the financial system. They are a mechanism for the market for short-term exchange trading of financial products under a policy framework. The participants in the financial mar- debt instruments kets are the borrowers (issuers of securities), lenders (buyers of securities), and financial intermediaries. Capital Market—a Financial markets comprise two distinct types of markets: market for long-term equity and debt the money market instruments the capital market Segments Primary—a market for Money Market A money market is a market for short-term debt instruments (maturity below one new issues year). It is a highly liquid market wherein securities are bought and sold in large denominations to reduce Secondary—a transaction costs. Call money market, certificates of deposit, commercial paper, and treasury bills are the market for trading major instruments/segments of the money market. outstanding issues 12 Part I Financial System The functions of a money market are to serve as an equilibrating force that redistributes cash balances in accordance with the liquidity needs of the participants; to form a basis for the management of liquidity and money in the economy by monetary authorities; and to provide reasonable access to the users of short-term money for meeting their requirements at realistic prices. As it facilitates the conduct of monetary policy, a money market constitutes a very important segment of the financial system. Capital Market A capital market is a market for long-term securities (equity and debt). The purpose of capital market is to mobilize long-term savings to finance long-term investments; provide risk capital in the form of equity or quasi-equity to entrepreneurs; encourage broader ownership of productive assets; provide liquidity with a mechanism enabling the investor to sell financial assets; lower the costs of transactions and information; and improve the efficiency of capital allocation through a competitive pricing mechanism. Money Market and Capital Market There is strong link between the money market and the capital market: Often, financial institutions actively involved in the capital market are also involved in the money market. Funds raised in the money market are used to provide liquidity for long-term investment and redemp- tion of funds raised in the capital market. In the development process of financial markets, the development of the money market typically precedes the development of the capital market. A capital market can be further classified into primary and secondary markets. The primary market is meant for new issues and the secondary market is one where outstanding issues are traded. In other words, the primary market creates long-term instruments for borrowings, whereas the secondary market provides liquidity through the marketability of these instruments. The secondary market is also known as the stock market. Link Between the Primary Capital Market and Secondary Capital Market Primary and the Secondary Capital Even though the secondary market is many times larger than the primary market, they are interdependent Market in many ways. A buoyant The primary market is a market for new issues, but the volume, pricing, and timing of new secondary market is issues are influenced by returns in the stock market. Returns in the stock market depend on indispensable for the macroeconomic factors. Favourable macroeconomic factors help firms earn higher returns, presence of a vibrant which, in turn, create favourable conditions for the secondary market. This in turn, influences primary capital the market price of the stock. Moreover, favourable macroeconomic factors necessitate raising market. fresh capital to finance new projects, expansion, and modernization of existing projects. A The secondary market provides a basis for buoyant secondary market, in turn, induces investors to buy new issues if they think that is a the determination of good decision. Hence, a buoyant secondary market is indispensable for the presence of a vibrant prices of new issues. primary capital market. Depth of the The secondary market provides a basis for the determination of prices at which new issues can be secondary market offered in the primary market. depends on the The depth of the secondary capital market depends upon the activities in the primary market because primary market. the bigger the entry of corporate entities, the larger the number of instruments available for trad- Bunching of new ing in the secondary market. The secondary market volume surge in 2007–08 was part driven by a issues affects prices in rampant primary market, as newly listed stocks tend to have a high turnover. the secondary market New issues of a large size and bunching of large issues may divert funds from the secondary market to the primary market, thereby affecting stock prices.  Chapter 1 The Financial System: An Introduction 13 Characteristics of Financial Markets Financial markets are characterized by a large volume of transactions and the speed with which financial resources move from one market to another. There are various segments of financial markets such as stock markets, bond markets—primary and secondary segments, where savers themselves decide when and where they should invest money. There is scope for instant arbitrage among various markets and types of instruments. Financial markets are highly volatile and susceptible to panic and distress selling as the behaviour of a limited group of operators can get generalized. Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors. Negative externalities are associated with financial markets. A failure in any one segment of these markets may affect other segments, including non-financial markets. Domestic financial markets are getting integrated with worldwide financial markets. The failure and vulnerability in a particular domestic market can have international ‘ramifications.’ Similarly, problems in external markets can affect the functioning of domestic markets. In view of the above characteristics, financial markets need to be closely monitored and supervised. Functions of Financial Markets The cost of acquiring information and making transactions creates incentives for the emergence of finan- cial markets and institutions. Different types and combinations of information and transaction costs moti- vate distinct financial contracts, instruments and institutions. Financial markets perform various functions such as enabling economic units to exercise their time preference; separation, distribution, diversification, and reduction of risk; efficient payment mechanism; providing information about companies. This spurs investors to make inquiries themselves and keep track of the companies’ activities with a view to trading in their stock efficiently; transmutation or transformation of financial claims to suit the preferences of both savers and ­borrowers; enhancing liquidity of financial claims through trading in securities; and providing portfolio management services. A variety of services are provided by financial markets as they can alter the rate of economic growth by altering the quality of these services. KEY TERMS Bank-based Financial System Financial Instruments Informal Financial System Capital Market Financial Markets Market-based Financial System Financial Broadening Financial Services Money Market Financial Deepening Formal Financial System ­Primary Market and Secondary Market Financial Institutions Free-rider SUMMARY 5. Financial markets are a mechanism enabling participants to deal in financial claims. The markets also provide a facility in which 1. A financial system is a complex, well-integrated set of sub-­systems of their demands and requirements interact to set a price for such financial institutions, markets, instruments, and services which facili- claims. tates the transfer and allocation of funds, efficiently and ­effectively. 6. The main organized financial markets in India are the money market 2. The financial systems of most developing countries are character- and the capital market. The first is a market for short-term securities ized by coexistence and co-operation between the formal and infor- while the second is a market for long-term securities, i.e., securities mal financial sectors. having a maturity period of one year or more. 3. Formal financial systems consist of four segments or components: 7. Financial markets are also classified as primary and secondary mar- financial institutions, financial markets, financial instruments, and kets. While the primary market deals in new issues, the secondary financial services. market is meant for trading in outstanding or existing securities. 4. Financial institutions are intermediaries that mobilize savings and 8. Financial services are those that help with borrowing and ­funding, facilitate the allocation of funds in an efficient manner. Financial lending and investing, buying and selling securities, making and institutions can be classified into banking and ­non-banking, term enabling payments and settlements, and managing risk exposures finance, specialized, sectoral, investment, and state-level. in financial markets. 14 Part I Financial System 9. The RBI regulates the money market and the SEBI regulates the 3. Arnold, L. and U. Walz (2000), ‘Financial Regimes, Capital Struc- capital market. ture and Growth,’ European Economic Review, Vol. 16, pp. 491–508. 10. The four sub-systems do not function in isolation. They are inter- 4. Bencivenga, Valerie R. and Bruea D. Smith (2003), Monetary dependent and interact continuously with each other. Their interac- ­Policy and Financial Market Evolution, The Federal Reserve Bank tion leads to the development of a smoothly functioning financial of St. Louis, July/August 2003, pp. 7–20. system. 5. Bhole, L. M. (1999), Financial Institutions and Markets, Structure, 11. The functions of a financial system include mobilizing and allo- Growth and Innovation, Tata McGraw-Hill, New Delhi. cating savings, monitoring corporate performance, providing 6. Demirguc Kunt, A. and R. Levine (1999), Bank-based and Market- payment and settlement systems, optimum allocation of risk- based Financial Systems: Cross Country Comparisons, World Bank bearing and reduction, disseminating price-related information, Policy Research Working Paper No. 2143. offering portfolio adjustment facility, lowering the cost of trans- 7. Demirguc Kunt, A. and V. Maksimovic (2000), Funding Growth in actions, and promoting the process of financial deepening and Bank-based and Market-based Financial System—Evidence from broadening. Firm Level Data, World Bank Policy Research Working Paper­ 12. The basic elements of a well-functioning financial system are (i) No. 2432. a strong legal and regulatory environment, (ii) stable money, (iii) 8. Germidis, Dimitri, Devis Kesiler and Rachel Meghir (1991), Finan- sound public finances and public debt management, (iv) central cial Systems and Development: What a Role for the Formal and bank, (v) a sound banking system (vi) an information system, and Informal Financial Sector, Development Centre Studies, OECD, (vii) a well-functioning securities market. Paris. 13. The two types of financial system designs are: bank-based and 9. International Financial Corporation (1999), Financial Institutions: market-based. Lessons of Experience, IFC, Washington, D.C. 14. At one extreme is the bank-dominated system, such as in 10. Jalan, Bimal (2000), ‘Finance and Development—Which Way ­Germany, where a few large banks play a dominant role and the Now,’ RBI Bulletin, June 2000, pp. 29–45. stock market is not that important. At the other extreme, is the 11. Low, Chee-Keong (2000), Financial Markets in Hong Kong, market-dominated financial system, as in the US, where financial Springer-Verlag Singapore Ltd. markets play an important role while the banking industry is much 12. Neave, Edwin (1998), Financial Systems: Principles and Organization, less concentrated. Routledge, London. 13. Reserve Bank of India, Report on Currency and Finance, 1999– 2000 and 2000–01. REVIEW QUESTIONS 14. Robinson, R. I. and D. Wrightsman (1981), Financial Markets, McGraw-Hill, London. 1. What is a financial system? Discuss the components of a formal 15. Rousseau, Peter L. and Richard Sylla (2001), ‘Financial System, financial system. Economic Growth and Globalization,’ NBER Working Paper 2. Discuss the types of financial markets and their inter-relationship. No. 8323, June 2001. 3. What are the characteristics and functions of financial markets? 16. Shaw, G. S. (1973), Financial Deepening in Economic Develop- 4. ‘A market-based financial system is preferable over a bank-based ment, Oxford University Press, New York. system.’ Comment critically. 17. Singh, Ajit (1997), ‘Financial Liberalization, Stock Markets and 5. ‘A financial system is a well-integrated system whose parts interact Economic Development.’ The Economic Journal, vol. 107 (May), with each other.’ Explain. pp. 771–82. 18. Singh, Ajit and B. A. Weisse, (1998), ‘Emerging Stock Markets, Portfolio Capital Flows and Long Term Economic Growth; Micro REFERENCES and Macro-Economic Perspective World Development,’ vol. 26, 1. Adams, Dale (1991), ‘Taking a Fresh Look at Informal Finance,’ in no. 4 (April), pp. 607–22. Phillips Callier (ed.), Financial Systems and Development in Africa, 19. Stigilitz, J. E. (1994), ‘The Role of State in Financial Markets,’ The World Bank, Washington, D.C. in M. Bruno and B. Pleskoviz (eds.), Proceedings of the World 2. Allen, Franklin and Douglas Gale (2000), Comparing Financial Bank Annual Bank Conference on Development Economics 1993, Systems, MIT Press, Cambridge, Mass. Washington, D.C., World Bank, pp. 19–52.  4 The Money Market Chapter Objectives Introduction This chapter will enable you to develop an The money market is a market for financial assets that are close substitutes for money. It is understanding of the following: a market for overnight to short-term funds and instruments having a maturity period of one or less than one year. It is not a physical location (like the stock market), but an activity that 1 Meaning of Money Market. is conducted over the telephone. The money market constitutes a very important segment of 2 Characteristics, functions, and the Indian financial system. benefits of the money market The characteristics of the money market are as follows: 3 Development of the money It is not a single market but a collection of markets for several instruments. market in India It is a wholesale market of short-term debt instruments. 4 Different money market Its principal feature is honour where the creditworthiness of the participants is ­important. instruments such as : The main players are: the Reserve Bank of India (RBI), the Discount and Finance Treasury bills : Types, importance, House of India (DFHI), mutual funds, insurance companies banks, corporate ­investors, participants, and size non-banking finance companies (NBFCs), state governments, provident funds, p­ rimary Commercial papers : Meaning, dealers, the Securities Trading Corporation of India (STCI), public sector undertakings participants, guidelines, and size (PSUs), and non-resident Indians. Commercial bills : Types, features, It is a need-based market wherein the demand and supply of money shape the market. and size Trunsactions in the money market can be both secured and unsecured, i.e., without Certificates of deposit : Features, collaterals. size, and comparison of CDs and CPs Call/Notice Money Market: ­Importance, participants, call rate, size, and steps to convert call Functions of the Money Market money market into pure inter-bank money market A money market is generally expected to perform three broad functions. Collateralized lending and Provide a balancing mechanism to even out the demand for and supply of short-term ­borrowing obligation funds. Provide a focal point for central bank intervention for influencing liquidity and general 5 Money market intermediaries such as Discount and Finance level of interest rates in the economy. House of India and Money Market Provide reasonable access to suppliers and users of short-term funds to fulfill their Mutual Funds ­borrowings and investment requirements at an efficient market clearing price. Plays a central role in the monetary policy transmission mechanism as through it the 6 Link between the money market operations of monetary policy are transmitted to financial markets and ultimately to and the monetary policy in India the real economy. 7 Tools for managing liquidity in the Besides the above functions, a well-functioning money market facilitates the develop- money market. ment of a market for longer-term securities. The interest rates for extremely short-term use 8 Money market derivatives of money serve as a benchmark for longer-term financial instruments. Money market rates reflect market expectations of how the policy rate could evolve in the future short-term. Benefits of an Efficient Money Market An efficient money market benefits a number of players. It provides a stable source of funds to banks in addition to deposits, allowing alternative financing structures and competition. 46 PART II Financial Markets Benefits of an Efficient It allows banks to manage risks arising from interest rate fluctuations and to manage the maturity struc- Money Market ture of their assets and liabilities. Provides a stable A developed inter-bank market provides the basis for growth and liquidity in the money market includ- source of funds to ing the secondary market for commercial paper and treasury bills. banks. An efficient money market encourages the development of non-bank intermediaries thus increasing Encourages the competition for funds. Savers get a wide array of savings instruments to choose from and invest their development of non- savings. bank entities. A liquid money market provides an effective source of long-term finance to borrowers. Large borrow- Facilitates ers can lower the cost of raising funds and manage short-term funding or surplus efficiently. government market A liquid and vibrant money market is necessary for the development of a capital market, foreign borrowing. exchange market, and market in derivative instruments. The money market supports the long-term debt Makes effective market by increasing the liquidity of securities. The existence of an efficient money market is a precondi- monetary policy tion for the development of a government securities market and a forward foreign exchange market. actions. Trading in forwards, swaps, and futures is also supported by a liquid money market as the certainty of Helps in pricing prompt cash settlement is essential for such transactions. The government can achieve better pricing on different floating its debt as it provides access to a wide range of buyers. It facilitates the government market borrowing interest products. programme. Monetary control through indirect methods (repos and open market operations) is more effective if the money market is liquid. In such a market, the market response to the central bank’s policy actions are both faster and less subject to distortion. The Indian Money Market The average turnover of the money market in India is over `1,00,000 crore daily. This is more than 3 per cent let out to the system. This implies that 2 per cent of the annual GDP of India gets traded in the money market in just one day. Even though the money market is many times larger than the capital market, it is not even a fraction of the daily trading in developed markets. Role of the Reserve Bank of India in the Money Market The Reserve Bank of India is the most important constituent of the money market. The market comes within the direct purview of the Reserve Bank regulations. The aims of the Reserve Bank’s operations in the money market are to ensure that liquidity and short-term interest rates are maintained at levels consistent with the monetary policy objectives of maintaining price stability; to ensure an adequate flow of credit to the productive sectors of the economy; and to bring about order in the foreign exchange market. The Reserve Bank influences liquidity and interest rates through a number of operating instruments— cash reserve requirement (CRR) of banks, conduct of open market operations (OMOs), repos, change in bank rates, and, at times, foreign exchange swap operations. Steps to Develop the Money Market in India The money market in India is divided into the formal (organized) and informal (unorganized) segments. One of the greatest achievements of the Indian financial system over the last 50 years has been the decline in the relative importance of the informal segment and increasing presence and influence of the formal segment upto the mid-1980s, money market was characterized by lack of depth, small number of instru- ments, and strict regulation on interest rates. The money market consisted of the inter-bank call market, treasury bills, commercial bills, and participation certificates. Several steps were taken in the 1980s and 1990s to reform and develop the money market. The reforms in the money market were initiated in the latter half of the 1980s. In the 1980s A committee to review the working of the monetary system under the chairmanship of Sukhamoy Chakravorty was set up in 1985. It underlined the need to develop money market instruments. As a follow up, the Reserve Bank set up a working group on the money market under the chairmanship of N. Vagul which submitted its report in 1987. This committee laid the blueprint for the institution of a money market. Based on its recommendations, the Reserve Bank initiated a number of measures.  Chapter 4 The Money Market 47 The Discount and Finance House of India (DFHI) was set up as a money market institution jointly by the Reserve Bank, public sector banks, and financial institutions in 1988 to impart liquidity to money market instruments and help the development of a secondary market in such instruments. Money market instruments such as the 182-day treasury bill, certificate of deposit, and inter-bank participation certificate were introduced in 1988–89. Commercial paper was introduced in January 1990. To enable price discovery, the interest rate ceiling on call money was freed in stages from ­October 1988. As a first step, operations of the DFHI in the call/notice money market were freed from the interest rate ceiling in 1988. Interest rate ceilings on inter-bank term money (10.5 per cent to 11.5 per cent), rediscounting of commercial bills (12.5 per cent), and inter-bank participation with- out risk (12.5 per cent) were withdrawn effective May 1989. All the money market interest rates are, by and large, determined by market forces. There has been a gradual shift from a regime of ­administered interest rates to market-based interest rates. In the 1990s The government set up a high-level committee in August 1991 under the chairmanship of M. Narasimham (the Narasimham Committee) to examine all aspects relating to structure, organization, functions, and procedures of the financial system. The committee made several recommendations for the development of the money market. The Reserve Bank accepted many of its recommendations. The Securities Trading Corporation of India was set up in June 1994 to provide an active secondary market in government dated securities and public sector bonds. Barriers to entry were gradually eased by: (a) setting up the primary dealer system in 1995 and satel- lite dealer system in 1999 to inject liquidity in the market; (b) relaxing issuance restrictions and sub- scription norms in respect of money market instruments; (c) allowing the determination of yields based on the demand and supply of such paper; (d) enabling market evaluation of associated risks; by withdrawing regulatory restriction such as bank guarantees in respect of commercial papers; and (e) increasing the number of participants by allowing the entry of foreign institutional investors (FIIs), non-bank financial institutions, and mutual funds. Several financial innovations in instruments and methods were introduced. Treasury bills of vary- ing maturities and RBI repos were introduced. Auctioned treasury bills were introduced leading to market-determined interest rates. The development of a market for short-term funds at market-determined rates has been fostered by a gradual switch from a cash-credit system to a loan-based system, shifting the onus of cash manage- ment from banks to borrowers. Ad hoc and on-tap 91-day treasury bills were discontinued in April, 1997. They were replaced by Ways and Means Advances (WMA) linked to the bank rate. The introduction of WMA led to the limiting of the almost automatic funding of the government. Indirect monetary control instruments such as the bank rate—reactivated in April 1997, strategy of combining auctions, private placements, and open market operations—in 1998–99, and the liquidity adjustment facility (LAF)—in June 2000 were introduced. The LAF helped to develop interest rate as an important instrument of monetary transmission. The minimum lock-in period for money market instruments was brought down to 7 days. The inter-bank liabilities were exempted from the cash reserve ratio and the statutory liquidity ratio (SLR) stipulations for facilitating the development of a term money market. New money market derivatives such as forward rate agreements (FRAs) and interest rate swaps (IRSs) were introduced in 1999. Money market instruments such as certificate of deposits and commercial paper are freely acces- sible to non-bank participants. The payment system infrastructure was strengthened with the introduction of the negotiated dealing system (NDS) in February 2002, setting-up of the Clearing Corporation of India Limited (CCIL) in April 2002 and the implementation of real time gross settlement (RTGS) system from April 2004. Collateral Borrowing and Lending Obligation (CBLO) was operationalized as a money market instrument through the CCIL on January 20, 2003. Transformation of Call Money Market into a pure inter-bank market by August, 2005. Widening of collateral base by making state government securities eligible for LAF operations since April, 2007. Operationalization of a screen-based negotiated system (NDS-CALL) for clearings in the call/ notice and term money markets in September, 2006. The reporting of all such transactions made compulsory through NDS-CALL in November, 2012. 48 PART II Financial Markets Reforms in the Money The repo in corporate banks allowed in March 2010. Market Operationalization of a reporting platform for secondary market transuctions in CPs and CPs in New instruments July 2010. New participants The development and profile of the money market has changed in the nineties. A basic objective of Changes in the money market reforms in the recent years has been to facilitate the introduction of new instruments and their operating procedures appropriate pricing. The Reserve Bank has endeavoured to develop market segments which exclusively deal of monetary policy in specific assets and liabilities as well as participants. Accordingly, the call/notice money market is now a Fine tuning of liquidity management pure inter-bank market. In order to ensure systemic stability, prudential limits on exposures to the call money operations market have been imposed. Standing liquidity support to banks from the Reserve Bank and facilities for Technological exceptional liquidity support have been rationalized. The various segments of the money market have inte- infrastructure grated with the introduction and successful implementation of the LAF. The NDS and CCIL have improved the functioning of money markets. They have facilitated a speedier conversion of notice/call money market into a pure inter-bank money market and enabled the growth of a buoyant repo market outside the LAF. Money Market Centres There are money market centres in India at Mumbai, Delhi, and Kolkata. Mumbai is the only active money market centre in India with money flowing in from all parts of the country getting transacted there. Money Market Instruments The instruments traded in the Indian money market are: 1. Treasury Bills (T-bills); 2. Cash Management Bills (CMBs); 3. Call/notice money market—Call (overnight) and short notice (up to 14 days); 4. Commercial Papers (CPs); 5. Certificates of Deposits (CDs); 6. Commercial Bills (CBs); 7. Collateralized Borrowing and Lending Obligation (CBLO). Call/notice money market and treasury bills form the most important segments of the Indian money mar- ket. Treasury bills, call money market, and certificates of deposit provide liquidity for government and banks while commercial paper and commercial bills provide liquidity for the commercial sector and intermediaries. Treasury Bills T-Bills are short-term Treasury bills are short-term instruments issued by the Reserve Bank on behalf of the government to tide instruments used over short-term liquidity shortfalls. This instrument is used by the government to raise short-term funds by the government to bridge seasonal or temporary gaps between its receipts (revenue and capital) and expenditure. They to raise short-term form the most important segment of the money market not only in India but all over the world as well. funds. T-bills are repaid at par on maturity. The difference between the amount paid by the tenderer at the time of purchase (which is less than the face value) and the amount received on maturity represents the interest amount on T-bills and is known as the discount. Tax deducted at source (TDS) is not applicable on T-bills. Features of T-Bills They are negotiable securities. They are highly liquid as they are of shorter tenure and there is a possibility of inter-bank repos in them. There is an absence of default risk. They have an assured yield, low transaction cost, and are eligible for inclusion in the securities for SLR purposes. They are not issued in scrip form. The purchases and sales are effected through the Subsidiary General Ledger (SGL) account. At present, there are 91-day, 182-day, and 364-day T-bills in vogue. The 91-day T-bills are auctioned by the RBI every Friday and the 364-day T-bills every alternate Wednesday, i.e., the Wednesday preceding the reporting Friday. Treasury bills are available for a minimum amount of `25,000 and in multiples thereof.  Chapter 4 The Money Market 49 Types of T-Bills There are three categories of T-bills. On-tap Bills On-tap bills, as the name suggests, could be bought from the Reserve Bank at any time at an interest yield of 4.66 per cent. They were discontinued from April 1, 1997, as they had lost much of their relevance. Ad hoc Bills Ad hoc bills were introduced in 1955. It was decided between the Reserve Bank and the Government of India that the government could maintain with the Reserve Bank a cash balance of not less than `50 crore on Fridays and `4 crore on other days, free of obligation to pay interest thereon, and whenever the balance fell below the minimum, the government account would be replenished by the creation of ad hoc bills in favour of the Reserve Bank. Ad hoc 91-day T-bills were created to replenish the government’s cash balances with the Reserve Bank. They were just an accounting measure in the Reserve Bank’s books and, in effect, resulted in automatic monetization of the government’s budget deficit. A monetized deficit is the increase in the net Reserve Bank credit to the central government which is the sum of the increase in the Reserve Bank’s holdings of: (a) the government of India’s dated securities; (b) 91-day treasury bills; and (c) rupee coins for changes in cash balances with the Reserve Bank. In the 1970s and 1980s, a large proportion of outstanding ad hocs were converted into long-term dated and undated securities of the Government of India. This conversion is referred to as ‘funding.’ Their expansion put a constraint on the Reserve Bank conduct of monetary policy and hence they were discontinued from April 1, 1997. The outstanding ad hoc T-bills and tap bills as on March 31, 1997 were funded on April 1, 1997 into special securities without any specified maturity at an interest rate of 4.6 per cent per annum. A system of Ways and Means Advances from April 1, 1997 was introduced to replace ad hoc bills and to accommodate temporary mismatches in the government of India receipts and payments. Auctioned T-Bills Auctioned T-bills, the most active money market instrument, were first introduced in April 1992. The Reserve Bank receives bids in an auction from various participants and issues the bills subject to some cut-off limits. Thus, the yield of this instrument is market determined. These bills are neither rated nor can they be rediscounted with the Reserve Bank. At present, the Reserve Bank issues T-bills of three maturities—91-days, 182-days, and 364-days. Importance of T-Bills The development of T-bills is at the heart of the growth of the money market. T-bills play a vital role in the cash management of the government. Being risk free, their yields at varied maturities serve as short-term benchmarks and help in pricing different floating rate products in the market. The T-bills market is the preferred central bank tool for market intervention to influence liquidity and short-term interest rates. The development of the T-bills market is a pre-condition for effective open market operations. Development of the T-Bills Market Ad hoc 91-day T-bills were introduced in the mid-1950s. These bills were introduced to replenish on an automatic basis, the central government’s cash balance with the Reserve Bank so that only the minimum required level was maintained. These bills opened up an era of uncontrolled monetization of the central government’s deficit. Before the 1960s, there was an active T-bills market owing to the weekly auctions of the 91-day T-bills. In the mid-1960s, the auction system for the issue of 91-day T-bills was replaced by on-tap bills. Till 1974, the tap bills rate changed with changes in the bank rate which sustained the interest of the par- ticipants