Financial Institutions and Services PDF

*  %    " %  + Edited by: Dr. Rupesh Roshan Singh FINANCIAL INSTITUTIONS AND SERVICES Edited By Dr. Rupesh Roshan Singh  Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-...

*  %    " %  + Edited by: Dr. Rupesh Roshan Singh FINANCIAL INSTITUTIONS AND SERVICES Edited By Dr. Rupesh Roshan Singh  Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for Lovely Professional University Phagwara  SYLLABUS Financial Institutions and Services Objectives: Management of Financial Institutions and Services course is intended not only for those interested in careers in Financial Service Firms, but also for those who wish to extend their institutional, industry specific knowledge. The teaching objective is to provide students with conceptual and pragmatic frameworks of issues confronting Managers of Financial Institutions. This course will emphasize management issues such as risk management and regulatory compliance, but will also touch upon some public policy concerns. S. No. Description 1. Financial system: Introduction, functions of financial system and its components 2. Financial markets: Introduction, Types-Capital market: Primary and secondary (introduction), money market: introduction, types of money market instruments-money at call, treasury bill, certificates of deposits, commercial papers. 3. Financial institutions: Definition, types, role in economic development, Commercial banks: emergence of private sector bank after liberalization, financial innovation in commercial banks 4. Financial Regulation: Reserve bank of India, its role and functions, SEBI-introductions and guidelines, Types of exchanges – National, Regional & Local 5. NABARD: Role and functions 6. NBFCs: Concept, guidelines, growth and prospects, IFCI, SFCs, IRBI, SIDC ,SIDBI– Introduction and operational policies 7. Mutual Funds: Introduction of UTI, types of mutual funds, significance, growth & performance of MFs in India, Basic operation of Private and public sector insurance (life and general) 8. Leasing: Meaning, types, financial, legal and tax aspects, Hire purchasing: Concept, legal framework and taxation, Factoring and forfaiting-meaning and mechanics, Bills rediscounting. 9. Management of Non Performing Assets by Banks: Introduction, Tools available to manage NPAs 10. Credit Rating: Introduction, Growth of credit rating agencies in India, Credit Rating Agencies in India  CONTENT Unit 1: Financial System 1 Manpreet Kaur, Lovely Professional University Unit 2: Financial Markets 16 Manpreet Kaur, Lovely Professional University Unit 3: Financial Institutions 26 Manpreet Kaur, Lovely Professional University Unit 4: Reserve Bank of India 43 Manpreet Kaur, Lovely Professional University Unit 5: Securities and Exchange Board of India 54 Rupesh Roshan Singh, Lovely Professional University Unit 6: NABARD 75 Rupesh Roshan Singh, Lovely Professional University Unit 7: Non-banking Financial Companies 83 Rupesh Roshan Singh, Lovely Professional University Unit 8: Insurance Sector 99 Rupesh Roshan Singh, Lovely Professional University Unit 9: Mutual Funds 130 Mahesh Kumar Sarva, Lovely Professional University Unit 10: Financial Services 145 Mahesh Kumar Sarva, Lovely Professional University Unit 11: Leasing 164 Mahesh Kumar Sarva, Lovely Professional University Unit 12: Hire Purchasing 178 Mahesh Kumar Sarva, Lovely Professional University Unit 13: Factoring and Forfeiting 193 Sukhpreet Kaur, Lovely Professional University Unit 14: Merchant Banking 202 Sukhpreet Kaur, Lovely Professional University Unit 15: Management of NPAs by Banks 212 Sukhpreet Kaur, Lovely Professional University Unit 16: Venture Capital 225 Sukhpreet Kaur, Lovely Professional University Unit 17: Credit Rating 237 Mahesh Kumar Sarva, Lovely Professional University Manpreet Kaur, Lovely Professional University Unit 1: Financial System Unit 1: Financial System Notes CONTENTS Objectives Introduction 1.1 Functions of Financial System 1.2 Components of Financial System 1.3 Summary 1.4 Keywords 1.5 Self Assessment 1.6 Review Questions 1.7 Further Readings Objectives After studying this unit, you will be able to: Explain the functions of financial system Describe the components of financial system Introduction The questions and challenges that the world faces in the current times are fundamentally different from those that it has wrestled with for decades after decades. Liberalization and globalization have breathed new life into the foreign exchange markets while simultaneously besetting them with new challenges. Commodity trading, particularly trade in commodity futures, have practically started from scratch to attain scale and attention. The banking industry has moved from an era of rigid controls and government interference to a more market-governed system. New private banks have made their presence felt in a very strong way and several foreign banks have ventured into territories other than their own. Financial market provides channels for allocation of savings of assets to savers as well as various forms in which the investors can raise funds. 1.1 Functions of Financial System The functions of a good financial system are manifold. They are as follows: 1. Regulation of currency: As a part of the financial system, central banks generally control the supply of a currency and interest rates, while currency traders control exchange rates. 2. Banking functions (a) to assemble capital and make it effective; (b) to receive deposits and make collections; (c) to check out and transfer funds; LOVELY PROFESSIONAL UNIVERSITY 1 Financial Institutions and Services Notes (d) to discount or lend; (e) to exercise fiduciary or trust powers; (f) to issue circulating notes. 3. Performance of agency services and custody of cash reserves: Different constituents of the financial system act as the agents for their clients. They buy and sell shares and bonds, receive and pay utility bills, premiums, dividends, rents and interest for their clients. 4. Management of national reserves of international currency: Various parts of financial system help the economy in particular and polity in general to manage international reserve. 5. Credit control: Financial system controls credit by serving the dual purpose of: (a) increasing sales revenue by extending credit to customers who are deemed a good credit risk, and (b) minimizing risk of loss from bad debts by restricting or denying credit to customers who are not a good credit risk. 6. Ensure stability of the economy: Financial system performs the function of administering national, fiscal, and monetary policy to ensure the stability of the economy. 7. Supply and deployment of funds for productive use: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. 8. Maintaining liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. 9. Price determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. 10. Information aggregation and coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers. 11. Risk sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments. 12. Improve efficiency: Financial markets reduce transaction costs and information costs. 13. Ensure long term growth to itself: Long-term growth of financial markets is ensured through: (a) Giving autonomy to Financial Institutions to become efficient under competition (b) Education of investors (c) Consolidation through mergers (d) Facilitating entry of new institutions to add depth the market (e) Minimizing regulatory measures and market segmentation. 2 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System Notes Caselet Outlook for Indian Financial Markets: Stocks up, Rates Down? I ndian markets, with their increasing levels of integration with the international markets, have not been an exception to the corrections taking place in global markets now. But, as a consequence of the fact that our level of integration with the global markets is still only "increasing" and there is yet some policy restriction with respect to seamless flow of capital between the local and international markets, there have been differing reactions in various segments of the financial markets in India. Equities have fallen quite sharply as the international exposure of the domestic stock markets is relatively much higher than that of the other key financial market segment, namely, debt. The debt markets, dominated by government debt and with very limited international participation, have been influenced only by prevailing liquidity conditions (and perceptions about the same) in the domestic banking system. Sovereign bond yields have moved up in the past couple of weeks, particularly in the last couple of days, as the Reserve Bank of India put in place some measures for broadly stabilising/restricting the liquidity level in the financial system. Therefore, while equity markets have moved in sympathy with stocks globally, the Indian bond market has seen yields rising while globally sovereign bond yields have fallen substantially. Source: www.thehindubusinessline.com 1.2 Components of Financial System Figure 1.1: Components of a Financial System Financial System Financial Assets/Instruments Financial Markets Financial Intermediaries Forex Market Capital Market Money Market Credit Market Primary Market Secondary Market Money Market Instruments Capital Market Instruments Hybrid Instruments LOVELY PROFESSIONAL UNIVERSITY 3 Financial Institutions and Services Notes The financial system consists of the Central Bank, as the apex financial institution, other regulatory authorities, financial institutions, markets, instruments, a payment and settlement system, a legal framework and regulations. The financial system carries out the vital financial intermediation function of borrowing from surplus units and lending to deficit units. The legal framework and regulators are needed to monitor and regulate the financial system. The payment and settlement system is the mechanism through which transactions in the financial system are cleared and settled. 1. Regulatory Authorities 2. Financial Institutions 3. Financial Markets 4. Financial Instruments 5. Payment and Settlement Infrastructure. Let us get introduced to them one by one. Regulatory Authorities The main component of any financial system is the regulatory system it has. In any economy, the financial system is regulated by the central banking authority of that country. In India, the central banking bank is named as the Reserve Bank of India. Reserve Bank of India (RBI) The regulation and supervision of banking institutions is mainly governed by the Companies Act, 1956, Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980, Bankers' Books Evidence Act, Banking Secrecy Act and Negotiable Instruments Act, 1881. The regulation and supervision of finance companies is done by the Banking Regulation Act, 1949 which governs the financial sector. Individual Institutions are regulated by Acts like: 1. State Bank of India Act, 1954 2. The Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003 3. The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act, 1993 4. National Bank for Agriculture and Rural Development Act 5. National Housing Bank Act 6. Deposit Insurance and Credit Guarantee Corporation Act. Securities and Exchange Board of India (SEBI) The Securities and Exchange Board of India was made a statutory body on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto. Insurance Regulatory and Development Authority (IRDA) Insurance Regulatory and Development Authority regulates and supervises the insurance industry-insurance companies and their agents and insurance brokers to protect the interests of 4 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System the policyholders, to regulate, promote and ensure orderly growth of the insurance industry Notes and for matters connected therewith or incidental thereto. Financial Institutions The financial system consists of many financial institutions. While most of them are regulated by the Reserve Bank, there are some which it manages just indirectly. Institutions regulated by the Reserve Bank of India The institutions regulated by the RBI are: 1. Nationalised Commercial Banks 2. Specialised Banks 3. Registered Finance Companies 4. Registered Finance Leasing Establishments 5. Micro-finance Institutions. Institutions not regulated by the Reserve Bank of India Certain financial institutions are not regulated by the Reserve Bank of India. These include securities firms, investment banks and mutual funds which come under the purview of the SEBI, Insurance Companies and Insurance Brokers which are regulated by the IRDA, etc. Financial Markets The Financial Market, which is the market for credit and capital, can be divided into the Money Market and the Capital Market. The Money Market is the market for short-term interest-bearing assets. Examples: 1. Treasury bills 2. Commercial paper 3. Certificates of deposits The major task of the Money Market is to facilitate the liquidity management in the economy. The Capital Market is the market for trading in medium-long-term assets. Examples: 1. Treasury bonds 2. Private debt securities (bonds and debentures) 3. Equities (shares) The main purpose of the Capital Market is to facilitate the raising of long-term funds. Did u know? The main issuers in the 1. Money Market are the Government, banks and private companies, while the main investors are banks, insurance companies and pension and provident funds. 2. Capital Market are the Government, banks and private companies, while the main investors are pension and provident funds and insurance companies. LOVELY PROFESSIONAL UNIVERSITY 5 Financial Institutions and Services Notes The Financial Market can also be classified according to instruments, such as the debt market and the equity market. The debt market is also known as the Fixed Income Securities Market and its segments are the Government Securities Market (Treasury bills and bonds) and the Private Debt Securities Market (commercial paper, private bonds and debentures). Another distinction can also be drawn between primary and secondary markets. The Primary Market is the market for new issues of shares and debt securities, while the Secondary Market is the market in which existing securities are traded. The Reserve Bank of India through its conduct of monetary policy influences the different segments of the Financial Market in varying degrees. The Reserve Bank's policy interest rates have the greatest impact on a segment of the Money Market called the inter-bank call money market and a segment of the Fixed Income Securities Market, i.e. the Government Securities Market. Financial Instruments The main financial instruments can be categorized as under: Deposits Deposits are sums of money placed with a financial institution, for credit to a customer's account. There are three types of deposits — demand deposits, savings deposits and fixed or time deposits. Demand deposits are mainly used for transaction purposes and for the safekeeping of funds. Funds can be withdrawn on demand. Demand deposits do not earn interest, but banks provide a number of services to demand deposit- holders like cheque facilities, standing orders, Automated Teller Machine (ATM) cards and debit cards to facilitate withdrawals and payments. Savings deposits earn interest, which may be calculated on a daily, weekly, monthly or annual basis. Funds may be withdrawn from savings accounts at any time. However, if the number of withdrawals exceeds four in any month, interest will not be paid for that particular month. Financial institutions issue passbooks or statements detailing transactions to savings deposit holders and also provide services such as ATM and debit cards. Fixed or time deposits are funds placed at financial institutions for a specified period or term. Fixed/time deposits earn a higher rate of interest than savings deposits. Fixed/time deposits can be for short, medium or long term. Funds can only be withdrawn before the maturity date with prior notice and a penalty may be imposed. A fixed/time deposit holder has a facility to borrow funds from the financial institution using the deposit as collateral. Loans A loan is a specified sum of money provided by a lender, usually a financial institution, to a borrower on condition that it is repaid, either in installments or all at once, on agreed dates and at an agreed rate of interest. In most cases, financial institutions require some form of security for loans. Treasury Bills and Bonds Treasury bills are government securities that have a maturity period of up to one year. Treasury bills are issued by the central monetary authority (the RBI), on behalf of the Government of India. Treasury bills are issued in maturities of 91 days, 182 days and 364 days. Treasury bills are zero coupon securities and are sold at a discount to face value, which is paid at maturity. The difference between the purchase price and the face value is the interest income to the owner. 6 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System Treasury bills are considered liquid assets as they can be easily sold in the secondary market and Notes converted to cash. Treasury bonds are medium and long-term government securities and are issued in maturities ranging from 2 years to 20 years. Treasury bills and bonds are guaranteed by the Government and are the safest of all investments, as they are default risk free. Treasury bills and bonds are tradable securities which are sold by auction to Primary Dealers, who in turn market the securities to the public. Notes The yields on Treasury bills and bonds are market determined and the market is both active and liquid. Repurchase Agreements Repurchase agreements (Repo) are arrangements involving transaction between two parties that agree to sell and repurchase the same security. Under repurchase agreement, the seller sells the specified securities to the buyer with an agreement to repurchase the same at a mutually decided future date and price. Such kind of transaction between parties approved by RBI and in securities (Treasury Bills, Central/State Govt. securities) as approved by RBI. Task Find out the differences between the sale price and the repurchase price from the financial system of India. Commercial Paper Commercial Papers (CPs) are short-term, non-collateralised (unsecured) debt securities issued by private sector companies to raise funds for their own use, by banks and other financial intermediaries. CPs are generally issued by creditworthy (high-rated) institutions in large denominations and have additional bank guarantees of payment. CPs are usually sold at a discount, although some are interest bearing. Corporate Bonds and Debentures Corporate bonds are medium or long-term securities of private sector companies which obligate the issuer to pay interest and redeem the principal at maturity. Corporate bonds that are not backed by a specific asset are called debentures. Debentures are medium or long term, interest-bearing bonds issued by private sector companies, banks and other financial institutions that are backed only by the general credit of the issuer. Debentures are usually issued by large, well-established institutions. The holders of debentures are considered creditors and are entitled to payment before shareholders in the event of the liquidation of the issuing company. 1. Convertible Debentures are debentures issued with an option to debenture holders to convert them into shares after a fixed period. A convertible debenture is a type of debenture or commercial loan that gives the choice to the lender to take stock or shares in the company, as an alternative to taking the repayment of a loan. It is any form of debenture which can be converted into some other kind of security like shares or Common Stocks. Convertible debentures are either partially or fully convertible. In case of partially convertible debentures, part of the instrument is redeemed and part of it is converted into LOVELY PROFESSIONAL UNIVERSITY 7 Financial Institutions and Services Notes shares and in case of fully convertible debentures, the full value of the debenture is converted into equity. Convertible debentures are generally issued to prevent sudden outflow of the capital at the time of maturity of the instrument, which may cause liquidity problems. The conversion ratio, which is the number of equity shares exchanged per unit of the convertible debenture is clearly stated when the instrument is issued. Usually, Convertible Debentures offer more safety to the investor compared to Common Shares or Preference Shares. They are suitable for investors who look for potential increases in asset value (appreciation) compared to that yielded by Bonds, and more earnings than Common Stocks provide. 2. Non-convertible Debentures are debentures issued without conversion option. The total amount of the debenture will be redeemed by the issuing company at the end of the specific period. Asset-backed Securities (Secured Debentures) Asset-backed Securities (ABS) are bonds collateralised (secured) by mortgages, loans, or other receivables. Typically, the issuing institution sells mortgages, loans, instalment credit, credit card or other receivables to a trust or a Special Purpose Vehicle (SPV) that in turn sells ABSs to the public. ABSs are interest- bearing instruments and are often enhanced through the use of guarantees or insurance. Warrants Warrants can be described as a derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Warrants are often confused with call options. But the main difference between the two is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months. Shares Shares are securities representing a portion of the ownership of a company that are a claim on the company's earnings and assets. Shareholders are paid dividends which are a percentage of the profits of the company. Shares in the company may be similar i.e. they may carry the same rights and liabilities and confer on their holders the same rights, liabilities and duties. There are two types of shares under Indian Company Law: 1. Equity shares: Equity shares are shares which do not enjoy any preferential right in the matter of payment of dividend or repayment of capital. The equity shareholder gets dividend only after the payment of dividends to the preference shares. There is no fixed rate of dividend for equity shareholders. The rate of dividend depends upon the surplus profits. In case of winding up of a company, the equity share capital is refunded only after refunding the preference share capital. Equity shareholders have the right to take part in the management of the company. However, equity shares also carry more risk. 8 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System 2. Preference shares: Preference shares are the shares which carry preferential rights over the Notes equity shares. These rights are: 1. receiving dividends at a fixed rate, 2. getting back the capital in case the company is wound-up. Investment in these shares are safe, and a preference shareholder also gets dividend regularly. Preference Shares may be of following types: (a) Cumulative or non-cumulative: A non-cumulative or simple preference share gives right to fixed percentage dividend of profit of each year. In case no dividend thereon is declared in any year because of absence of profit, the holders of preference shares get nothing nor can they claim unpaid dividend in the subsequent year or years in respect of that year. Cumulative preference shares however give the right to the preference shareholders to demand the unpaid dividend in any year during the subsequent year or years when the profits are available for distribution. In this case dividends which are not paid in any year are accumulated and are paid out when the profits are available. (b) Redeemable and non-redeemable: Redeemable Preference shares are preference shares which have to be repaid by the company after the term for which the preference shares have been issued. Irredeemable Preference shares are those preference shares that need not be repaid by the company except on winding up of the organisation. However, under the Indian Companies Act, a company cannot issue irredeemable preference shares. In fact, a company limited by shares cannot issue preference shares which are redeemable after more than 10 years from the date of issue. In other words the maximum tenure of preference shares is 10 years. If a company is unable to redeem any preference shares within the specified period, it may, with consent of the Company Law Board, issue further redeemable preference shares equal to redeem the old preference shares including dividend thereon. A company can issue the preference shares which from the very beginning are redeemable on a fixed date or after certain period of time not exceeding 10 years provided it comprises of following conditions: i. It must be authorised by the articles of association to make such an issue. ii. The shares will be only redeemable if they are fully paid up. iii. The shares may be redeemed out of profits of the company which otherwise would be available for dividends or out of proceeds of new issue of shares made for the purpose of redeem shares. iv. If there is premium payable on redemption it must have provided out of profits or out of shares premium account before the shares are redeemed. v. When shares are redeemed out of profits a sum equal to nominal amount of shares redeemed is to be transferred out of profits to the capital redemption reserve account. This amount should then be utilised for the purpose of redemption of redeemable preference shares. This reserve can be used to issue of fully paid bonus shares to the members of the company. (c) Participating preference share or non-participating preference shares: Participating preference shares are entitled to a preferential dividend at a fixed rate with the right to participate further in the profits either along with or after payment of certain rate of dividend on equity shares. A non-participating share is one which does not have any such right to participate in the profits of the company after the dividend and the capital have been paid to the preference shareholder. LOVELY PROFESSIONAL UNIVERSITY 9 Financial Institutions and Services Notes Financial Derivatives A financial derivative is a financial instrument that is linked to another specific financial instrument, indicator or commodity and through which specific financial risks (such as interest rate risk, foreign exchange risk, equity and commodity price risk) can in their own right, be traded in financial markets. The value of a financial derivative comes from the price of an underlying item such as an asset or index. Financial derivatives can be used for risk management, hedging (protecting) against financial losses on commercial transactions and financial instruments and arbitrage between markets and speculation. There are two distinct classes of financial derivatives — forwards and related instruments, and options. The most common forward instruments are forward contracts, futures contracts, Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRS). Financial derivatives are traded over-the-counter, in which case they are customised and can be purchased from financial institutions or are standardised products which are traded on organized exchanges. Payment and Settlement Infrastructure One of the most important functions of the financial system is to ensure safety and efficiency in payments and securities transactions. Financial infrastructure refers to the different systems that provide for the execution of both large-value and small-value payments. Payment and settlement systems enable the transfer of money in the accounts of financial institutions to settle financial obligations between individuals and institutions. Case Study Should Financial Systems be Rule-based? A fter evaluating the pitfalls and advantages of both the systems, there is a view emerging that the financial system should be more rules-based. The recent global meltdown has proved one thing: Neither a rules-based regulatory system nor a principles-based regulatory system is a guarantee against bank failure. However, after evaluating the pitfalls and advantages of both the systems, there is a view emerging that the financial system should be more rules-based; this is especially true in the UK. In contrast, two committees set up in India - the Percy Mistry Committee (2007) and the Raghuram Rajan Committee (2008) - to look into financial sector reforms have recommended that India's regulatory regime should move from rules-based to a principles- based one. Principles-based regulation (PBR) implies moving away, wherever possible, from dictating, through detailed prescriptive rules and supervisory actions, how firms should operate their businesses. Rules-based regulation, it is pointed out, is too rigid and prescriptive, and often the regulator and the regulated adopt adversarial and antagonistic postures. Some of the countries that follow principles-based regulatory systems are the UK, Australia, Canada and Ireland. Some of the leading countries whose regulatory regime is based on rules are the US, Spain and India. However, as noted in the Turner Review, banks in countries following either of the systems have failed. For example, banks have failed in the US and the UK. So in a way, neither of the regulatory systems has proven to be robust. One way to draw lessons from the crisis would be to examine what countries such as India, Spain and Canada did right to insulate their financial systems from succumbing to the global crisis. Contd... 10 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System Notes Spanish Method It would be worthwhile to examine the approaches of the various regulators to housing or mortgage finance. Spain, which follows a rules-based system, has a clearly spelt out mortgage risk policy for its credit institutions. Banco De Espana (BE) lays down that lending policy of credit institutions for mortgage should take into account the repaying capacity of the borrowers and should not just be based on the collateral. BE also emphasises on the importance of the loan to value (LTV) ratio. It cautions its credit institutions against being too permissive about LTV as this typically increases the expected losses in a mortgage loan portfolio. The conservatism that insulated Spanish banks from crisis also played its role in keeping the banking system healthy in Canada, which follows a principles-based system of regulation. For example, mortgages with less than a 20 per cent down-payment have to be insured, and most of the securitised mortgage market consists of Canada Mortgage Bonds, which carry a government guarantee. The Canadian central bank also did not allow creation of complex, synthetic securitised instruments involving Canadian mortgage assets. In India, the Reserve Bank of India (RBI) has strict rules regarding housing finance, specifying the risk weights to be attached to loans extended to borrowers. These risk weights vary according to the LTV ratios. The RBI also specifies the maximum sanctioned amount for LTV ratios as less than or equal to 75 per cent. UK's System In the UK, the Financial Services Authority (FSA) follows a principles-based regulation. However, in its proposed reforms for mortgage lending, it has categorically banned certain practices such as self-certified mortgages replacing it with those requiring verification of the income of the borrowers. It also now requires mortgage advisers to be personally accountable to the FSA. Having realised that non-interventionist principles-based system need not always lead to the desired regulatory outcome, there appears to be a distinct shift in the UK from a non- interventionist stance to a more intrusive one. The Federal Reserve has also notified a revision in its Regulation Z (which implements the Truth in Lending Act and Home Ownership and Equity Protection Act), prohibiting creditors from making higher-priced mortgage loans based on the "value of the consumer's collateral without regard to the consumer's repayment ability". Thus, in the case of the US and the UK, at least with respect to mortgage lending, the bias is in favour of a rules-based system. But is this desirable? One of the biggest criticisms levelled against the rules-based system is that it stifles innovation by being too interfering. In contrast, a principles-based regulation is more accommodative to innovation because it is pliant and flexible. But, as the recent meltdown has shown, while gains from financial innovation benefit a few, the losses affect a greater number through systemic instability. When it comes to a trade-off between profitability and financial stability, the choice is very clear. Financial stability creates conducive atmosphere for profitability and for carrying out banking. Therefore, a rules-based system clearly scores over a principles-based system. A developing country like India has its own compulsions which make a rules-based system better suited when it comes to meeting our development objectives. For example, with respect to financial inclusion, unless it is specifically laid down that banks must offer Contd... LOVELY PROFESSIONAL UNIVERSITY 11 Financial Institutions and Services Notes no-frills accounts to their customers with zero or minimum balance and also relax criteria for identification and account opening, the goal of financial inclusion may not be achieved. Also, there is nothing in the rules-based system that disallows innovation. If that were the case, Indian banks wouldn't have been allowed to offer several products that they now offer. The pace of innovation would be slow but if it ensures financial stability for the system, the trade-off would be well worth it. Question Discuss the importance of rules and regulation in financial system. Source: http://www.thehindubusinessline.in 1.3 Summary The financial system is the system that allows the transfer of money between savers and borrowers. It is a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions. India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors Government plays the role of regulator. RBI is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms. The commercial banking sector comprises of public sector banks, private banks and foreign banks. The public sector banks comprise the 'State Bank of India' and its seven associate banks and nineteen other banks owned by the government and account for almost three fourth of the banking sector. India has a two-tier structure of financial institutions with thirteen all India financial institutions and forty-six institutions at the state level. All India financial institutions comprise term-lending institutions, specialized institutions and investment institutions, including in insurance. State level institutions comprise of State Financial Institutions and State Industrial Development Corporations providing project finance, equipment leasing, corporate loans, short-term loans and bill discounting facilities to corporate. Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for retail assets and are regulated by RBI. RBI also regulates foreign exchange under the Foreign Exchange Management Act (FEMA). SEBI established under the Securities and Exchange Board of India Act, 1992 is the regulatory authority for capital markets in India. Insurance sector in India has been traditionally dominated by state owned Life Insurance Corporation and General Insurance Corporation and its four subsidiaries. Insurance Development and Regulatory Authority (IRDA) is the regulatory authority in the insurance sector under the Insurance Development and Regulatory Authority Act, 1999. 12 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System 1.4 Keywords Notes Capital Market: The capital market is the market for securities, where companies and governments can raise long-term funds. Deposit: An account at a banking institution that allows money to be deposited and withdrawn by the account holder. Loan: A type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower. Money Market: That segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. 1.5 Self Assessment Fill in the blanks: 1. RBI regulates foreign exchange under the........................ 2. A loan is a specified sum of money provided by a lender to a borrower on condition that it is................. 3. The main purpose of the capital market is to facilitate the raising of................ funds. 4. A................ is a financial instrument that is linked to another specific financial instrument. 5................. are securities representing a portion of the ownership of a company. 6. Corporate bonds that are not backed by a specific asset are called................. 7................. are funds placed at financial institutions for a specified period or term. 8. Financial system performs the function of administering national, fiscal, and monetary policy to ensure the..................... of the economy. 9. Financial markets provide the holders of..................... with a chance to resell or liquidate these assets. 10. Long-term growth of financial markets is ensured through giving.................. to financial institutions to become efficient under competition. 11. The........................ system is the mechanism through which transactions in the financial system are cleared and settled. 12. The debt market is also known as the........................ Market. 13...................... are mainly used for transaction purposes and for the safekeeping of funds. 14. Treasury bills are government securities that have a maturity period of up to...................... 15. Corporate bonds are medium or long-term securities of........................ sector companies. 1.6 Review Questions 1. What do you mean by financial system? 2. Is financial system synonymous to financial markets? If yes, elucidate upon the similarities. If no, discuss the difference. 3. Examine the various components of the Indian financial system. LOVELY PROFESSIONAL UNIVERSITY 13 Financial Institutions and Services Notes 4. Comparing it with others, what is the main difference that you see in the components of the financial system of developed countries and that of India? 5. What in your opinion is the main reason for having various regulatory authorities in a financial system? Is the central monetary authority (the representative of the government itself) unable to control the entire system? 6. Why does business need long-term finance? Explain in brief. 7. Give the advantages of equity shares to: (a) The Management and (b) The Shareholders 8. Differentiate between: (a) Equity shares and preference shares (b) Shares and debentures 9. Comment on the state of Indian financial system vis a vis its international counterparts. 10. Why might a company choose debt over equity financing? 11. What do you consider as the biggest advantage of financial derivatives? 12. Are asset based securities of any use to general public? If yes, elucidate upon the benefit/s. If no, to whom and how are they beneficial? Answers: Self Assessment 1. Foreign Exchange Management Act, 2. repaid 3. long-term 4. financial derivative 5. Shares 6. debentures 7. Time deposits 8. stability 9. financial assets 10. autonomy 11. payment and settlement 12. Fixed Income Securities 13. Demand deposits 14. one year 15. private 1.7 Further Readings Books Cooper Kersey and Donald R. Fraser, The Financial Market Place, Addison Wesley Publishing Company (Latest Edition). Khan M.Y, Indian Financial System, Tata McGraw Hill. Mandura Jeff, Financial Markets and Institutions, West Publishing Company, New York. Meir Kohn, Financial Institutions and Markets, McGraw Hill Publishing Company, New York. 14 LOVELY PROFESSIONAL UNIVERSITY  Unit 1: Financial System Notes Online links www.helplinelaw.com www.sebi.gov.in LOVELY PROFESSIONAL UNIVERSITY 15 Financial Institutions and Services Manpreet Kaur, Lovely Professional University Notes Unit 2: Financial Markets CONTENTS Objectives Introduction 2.1 Types of Financial Market 2.2 Capital Market 2.2.1 Primary Capital Market 2.2.2 Secondary Capital Market 2.3 Money Market 2.3.1 Types of Money Market 2.3.2 Money Market Instruments 2.4 Summary 2.5 Keywords 2.6 Self Assessment 2.7 Review Questions 2.8 Further Readings Objectives After studying this unit, you will be able to: State the types of financial market Define capital market Explain primary capital market and secondary capital market Define money market State the types of money market Define call money, treasury bills, certificates of deposits and commercial papers Introduction Financial Market is the interface between a large number of buyers and sellers of the financial products. The prices of the products are fixed by the market forces of demand and supply within the market itself. The financial market promotes the savings of the economy, providing an effective channel for transmitting the financial policies. Technically speaking, a financial market facilitates: 1. Raising of capital (in the capital markets); 2. Transfer of risk (in the derivatives markets); 3. International trade (in the currency markets). 16 LOVELY PROFESSIONAL UNIVERSITY  Unit 2: Financial Markets 2.1 Types of Financial Market Notes A Financial Market can be defined as the market in which financial assets are created or transferred. As against a real transaction that involves exchange of money for real goods or services, a financial transaction involves creation or transfer of a financial asset. Financial Assets or Financial Instruments represent a claim to the payment of a sum of money sometime in the future and/or periodic payment in the form of interest or dividend. 1. Money Market: The money market is a wholesale debt market for low-risk, highly-liquid, short-term instrument. Funds are available in this market for periods ranging from a single day up to a year. This market is dominated mostly by government, banks and financial institutions. 2. Capital Market: The capital market is designed to finance the long-term investments. The transactions taking place in this market will be for periods over a year. 3. Forex Market: The Forex market deals with the multicurrency requirements, which are met by the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of funds takes place in this market. This is one of the most developed and integrated market across the globe. 4. Credit Market: Credit market is a place where banks, FIs and NBFCs Purvey short, medium and long-term loans to corporate and individuals. Caselet Financial Literacy F inancial literacy should make us aware of the rewards and risks in the financial markets and help us make informed choices. It is a tool to improve the skill and confidence with which a common man improves and secures his financial condition. It is only a primary step and not a driving force behind financial inclusion. India is among the world's most efficient financial markets in terms of technology and regulation. It has one of the highest savings rate in the world yet only four per cent of it is invested in the financial markets. Unless the common man becomes a wiser investor, wealth creation will remain a distant dream. The Government can declare the next year as financial literacy year and focus on educating the average Indian family. Money sense, like civic sense, should me inculcated in people as early as possible. 2.2 Capital Market The capital market is the market for securities, where companies and governments can raise long-term funds. It is a market in which money is lent for periods longer than a year. The different types of financial instruments that are traded in the capital markets are equity instruments, credit market instruments, insurance instruments, foreign exchange instruments, hybrid instruments and derivative instruments. Capital Market consists of primary market and secondary market. In primary market newly issued bonds and stocks are exchanged and in secondary market buying and selling of already existing bonds and stocks take place. LOVELY PROFESSIONAL UNIVERSITY 17 Financial Institutions and Services Notes Notes Many people divide the Capital Market into Bond Market and Stock Market. 1. Bond Market provides financing by bond issuance and bond trading. 2. Stock Market provides financing by shares or stock issuance and by share trading. As a whole, Capital Market facilitates raising of capital through the trading of long-term financial assets. 2.2.1 Primary Capital Market The primary capital markets is also called the New Issue Market or NIM. The securities which are introduced in the market are sold for first time to the general public in this market. This market is also known as the long-term debt market as the fund raised from this market provides long-term capital. The act of selling new issues in the primary capital market follows a particular process. This process requires the involvement of a syndicate of the securities dealers. The dealers who are running the process get a certain amount for as commission. The price of the security offered in the primary capital market includes the dealer, commission also. Again, if the issue is a primary issue, the investors get the issue directly from the company and no intermediary is needed in the process. For the purpose, the investor needs to send the exact amount of money to the respective company and after receiving the money, the particular company provides the security certificates to the investors. The primary issues which are offered in the primary capital market provide the essential funds to the companies. These primary issues are used by the companies for the purpose of setting new businesses or to expanding the existing business. At the same time, the funds collected through the primary capital market, are also used for the modernization of the business. At the same time, the primary capital market is also involved in the process of creating capital for the respective economy. There are three ways of offering new issues in the primary capital market. These are: 1. Initial Public Offering (IPO): An IPO is the first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market. 2. Preferential Issue: A preferential issue can be defined as an issue of stock available only to designated buyers. These buyers are a select set of people, whether promoters, their relatives, or institutional investors. One could call it a wholesale equity market since the retail investors or shareholders are not invited to participate. 3. Rights Issue: The rights issue is a special form of shelf offering or shelf registration for existing Companies. With the issued rights, existing shareholders have the privilege to buy a specified number of new shares from the firm at a specified price within a specified time. 18 LOVELY PROFESSIONAL UNIVERSITY  Unit 2: Financial Markets Notes ! Caution A rights issue is in contrast to an initial public offering, where shares are issued to the general public through market exchanges. Case Study TOUAX Success of Rights Issue T OUAX is a French company and is currently Europe's no.1 in shipping containers and river barges, and no.2 in modular buildings and freight railcars. The Group provides operating leases to customers around the world, both on its own account and for third-party investors. On June 24, 2009, TOUAX announced that its capital increased by waiving preferential subscription rights but with priority for existing shareholders, launched on 18th June 2009 for a total of E17,851,519.76 (gross) through the issue of 936,596 new shares which were subscribed in the entirety. Following partial application of the extension clause, 952,747 shares were placed or 101.72% of the issue; total proceeds were E18,159,357.82. This rights issue has enabled the Group to strengthen its financial structure, to position itself with advantage for possible acquisitions of tangible stock, and to grasp opportunities thrown up by the crisis (purchase of shipping containers, modular buildings, river barges and railcars, for hiring out on mainly long-term leases). 370,062 new shares allotted under absolute entitlement were subscribed or 39.51% of the total number of new shares on issue. Another 555,685 shares were applied for subject to cutting back in the event of over- subscription, and orders for these were all filled. Another 27,000 shares had been applied for by the general public, and following partial application of the extension clause it proved possible to fill orders for all of these. As the result of the rights issue, TOUAX is well placed to respond to the boom in corporate outsourcing of non-core assets, and every day provides over 5,000 customers with quick and flexible leasing solutions. TOUAX is now listed on Euronext in Paris - NYSE Euronext Compartment C (ISIN Code FR0000033003), and features in the SBF 250 Index. Questions 1. After analyzing the case, do you think all the companies that can afford, should opt for rights issue to improve their financial status? 2. What do analyse as the 2 main advantages of the rights issue? 3. What do think can be the risks posed by rights issue? 2.2.2 Secondary Capital Market The secondary capital market deals with those securities that are already issued in an initial public offering in the primary market. Typically, the secondary markets are those where previously issued securities are purchased and sold. In the secondary capital market, the securities are generally sold by and transferred from one investor to another. Hence, the secondary capital market needs to be highly liquid in nature. A high transparency for the secondary market trading is also required. With the advancement of the technology, the trading concept in secondary market has changed substantially. In the earlier days, the investors needed to meet at fixed place in order to carry out the transactions. But now trading in secondary capital market has become much easier for the investors. LOVELY PROFESSIONAL UNIVERSITY 19 Financial Institutions and Services Notes The secondary bond markets play a market place for the bonds that are already issued in the primary market while the secondary stock market trades those stocks that are already issued by the issuers. The treasury bills secondary market handles the trading of treasury bills. The secondary market trading is vital for the capital market. A study in the secondary market trend can give some information on the investor's preference for liquidity. It means whether the investors want to invest their money for a short period of time or a longer period. It has been seen that the investors in the capital market do not prefer to put their money for the long term investments. But the secondary market investors, however, can compensate their investments with proper strategy. The secondary market value of a stock or a bond is different from their face value. This happens due to the fluctuating interest rates. The resale value of the bonds in the secondary market is based on the interest rates at that very time when the sale goes through. In a typical secondary market, when the interest rate falls, the bond value goes up while when the rate rises, the bond value goes down. 2.3 Money Market A money market can be defined as a market for short-term debt securities with a maturity of one year or less and often 30 days or less. Money market securities are generally very safe investments which return a relatively low interest rate that is most appropriate for temporary cash storage or short-term time horizons. The money market is better known as a place for large institutions and government to manage their short-term cash needs. However, individual investors have access to the market through a variety of different securities. 2.3.1 Types of Money Market Money market can be of two types namely organized money market and unorganized money market. Organised money market: It comprises of commercial banks, financial institutions and all short term asset trading institutions. Unorganised money market: Along with the organized money market, there exists a very strong unorganised money market, especially in countries that are developing but are still to be developed. In such countries, people and small companies prefer taking loans from relatives, usurers, sahukars, etc, instead of going and applying to organised institutions registered under the monetary authorities. 2.3.2 Money Market Instruments The money market can be defined as a market for short-term money and financial assets that are near substitutes for money. The term short-term means generally a period up to one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost. Some of the important money market instruments are briefly discussed below: 1. Call/Notice Money 2. Treasury Bills 3. Term Money 20 LOVELY PROFESSIONAL UNIVERSITY  Unit 2: Financial Markets 4. Certificate of Deposit Notes 5. Commercial Papers Let us understand the main instruments of money market by the discussion hereunder: 1. Call/Notice Money: Call money is the money borrowed or lent on demand for a very short period. When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on the next working day, (irrespective of the number of intervening holidays) is "Call Money". When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money". No collateral security is required to cover these transactions. 2. Treasury Bills: Treasury Bills are short term (up to one year) borrowing instruments of the union government. It is an IOU of the Government. It is a promise by the Government to pay a stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year). They are issued at a discount to the face value, and on maturity the face value is paid to the holder. The rate of discount and the corresponding issue price are determined at each auction. 3. Certificates of Deposits (CDs): Certificates of Deposit is a negotiable money market instrument and issued in dematerialized form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India, as amended from time to time. CDs can be issued by: (a) scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (b) select All India Financial Institutions that have been permitted by RBI to raise short- term resources within the umbrella limit fixed by RBI. Banks have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term money, term deposits, commercial papers and intercorporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 4. Commercial Papers (CPs): CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the debt obligation is transformed into an instrument. CP is thus an unsecured promissory note privately placed with investors at a discount rate to face value determined by market forces. CP is freely negotiable by endorsement and delivery. Guidelines for issue of CP were for long governed by various directives issued by the Reserve Bank of India, as amended from time to time. On July 2, 2007, a master circular (Ref.No. FMD.MSRG.No.14/02.02.009/2007-08) incorporating all the existing guidelines/instructions/directives on the subject was issued by the office of Chief General Manager of RBI, which states the following: (a) Who can Issue Commercial Paper: Corporates, Primary Dealers (PDs) and the All India Financial Institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by the Reserve Bank of India are eligible to issue CP. A corporate would be eligible to issue CP provided: (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than 4 crores; (b) company has been sanctioned working capital limit by bank/s or all-India financial institution/s; and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s/institution/s. LOVELY PROFESSIONAL UNIVERSITY 21 Financial Institutions and Services Notes (b) Rating Requirement: All eligible participants shall obtain the credit rating for issuance of Commercial Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating agencies as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review. (c) Maturity: CP can be issued for maturities between a minimum of 7 days and a maximum up to one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is valid. (d) Denominations: CP can be issued in denominations of 5 lakhs or multiples thereof. Amount invested by a single investor should not be less than 5 lakhs (face value). (e) Limits and the Amount of Issue of CP: CP can be issued as a "stand alone" product. The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency for the specified rating, whichever is lower. Banks and FIs will, however, have the flexibility to fix working capital limits duly taking into account the resource pattern of companies' financing including CPs. An FI can issue CP within the overall umbrella limit fixed by the RBI, i.e., issue of CP together with other instruments, viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP may be issued on a single date or in parts on different dates provided that in the lattercase, each CP shall have the same maturity date. Every issue of CP, including renewal, should be treated as a fresh issue. (f) Who can Act as Issuing and Paying Agent (IPA): Only a scheduled bank can act as an IPA for issuance of CP. (g) Investment in CP: CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI). (h) Mode of Issuance: CP can be issued either in the form of a promissory note (Schedule I) or in a dematerialised form through any of the depositories approved by and registered with SEBI. CP will be issued at a discount to face value as may be determined by the issuer. No issuer shall have the issue of CP underwritten or co-accepted. (i) Procedure for Issuance: Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investor's account with a depository. 22 LOVELY PROFESSIONAL UNIVERSITY  Unit 2: Financial Markets Investors shall be given a copy of IPA certificate to the effect that the issuer has a Notes valid agreement with the IPA and documents are in order. Task Do a research and list all the instruments of money market and capital market in India. 2.4 Summary Financial market can be explained as a mechanism that allows people to easily buy and sell (trade) financial securities, commodities (such as precious metals or agricultural goods) and other fungible items of value at low transaction costs. Financial market is used to match those who want capital to those who have it. Financial markets are essential for fund raising. Financial market is of two types, viz. Capital Market and Money Market. The market where investment funds like bonds, equities and mortgages are traded is known as the capital market. The primal role of the capital market is to channelise investments from investors who have surplus funds to the ones who are running a deficit. Money market is that segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short-term, from several days to just under a year. Money market instruments consist of Treasury Bills, Certificate of Deposits, Commercial Papers, etc. 2.5 Keywords Call Money Market: Market in which brokers and dealers borrow money to satisfy their credit needs, either to finance their own inventory of securities or to cover their customers' margin accounts. Financial Market: It is a mechanism that allows people to easily buy and sell (trade) financial securities, commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis. Initial Public Offer: Introduction of new stocks in the market. Underwriting: The process of offering new issues of existing stocks to the purchasers. 2.6 Self Assessment Fill in the blanks: 1................. is the money borrowed or lent on demand for a very short period. 2. Money market can be of two types namely.................. money market and................ money market. 3. The................ and the corresponding.............. are determined at each auction of the treasury bills. LOVELY PROFESSIONAL UNIVERSITY 23 Financial Institutions and Services Notes 4. The secondary market value of a stock or a bond is different from their............... 5. With the rights issue,.............. have the privilege to buy a specified number of new shares. 6. The................ markets play a market place for the bonds that are already issued in the primary market. 7. A financial market can be defined as the market in which financial.............. are created or transferred. 8. The financial market promotes the savings of the economy, providing an effective channel for transmitting the......................... 9. Financial Instruments represent a claim to the payment of a sum of money sometime in the......................... 10. The capital market is the market for securities, where companies and governments can raise..................... funds. 11. The issue is a....................., the investors get the issue directly from the company. 12. The rights issue is a special form of shelf registration for.................. companies. 13. The resale value of the bonds in the secondary market is based on the.................. at that very time when the sale goes through. 14. Banks have the freedom to issue..................... depending on their requirements. 15. CP is a note in evidence of the debt obligation of the................... 16. The market where investment funds like bonds, equities and mortgages are traded is known as the.................. market. 2.7 Review Questions 1. What do you mean by financial markets? 2. Analyse the discussion in the unit carefully and tell the difference between the capital and money market else than the former being a market for long-term assets and the latter being for short-term. 3. What are the instruments of money market that a middle class bread earner would generally prefer and why? 4. Do the capital markets exist only for big corporate houses? To which market will the transaction belong in which an individual goes to a commercial bank for a 20 year housing loan? 5. Discuss the advantages/disadvantageous that you/your acquaintance faced due to availing a loan from unorganized money market. 6. Find how can a company admit its Commercial Paper in NSDL and discuss the process. 7. Credit risk depends on both internal and external factors. Identify some such external as well as internal factors. 8. Which is the instrument that is issued for automatic monetization of debt? Analyse its importance. 9. Why would it be desirable to avoid an excessively conservative regulation of the risk sensitivity in a regulatory capital regime? 24 LOVELY PROFESSIONAL UNIVERSITY  Unit 2: Financial Markets 10. Discuss the role of any two parties involved in floating an issue. Notes 11. Make a comparative study of the investment objective of any five investment alternatives. 12. What care should an investor take while investing in securities? Answers: Self Assessment 1. Call money 2. organized, unorganized 3. rate of discount, issue price 4. face value 5. existing shareholders 6. secondary bond 7. assets 8. financial policies 9. future 10. long-term 11. primary issue 12. existing 13. interest rates 14. certificates of deposits 15. issuer 16. capital 2.8 Further Readings Books Auerbach Robert D., Finance Markets and Institutions, Macmillan Publishing Co. Inc., New York. Bhole M.K., Financial Markets and Institutions, Macmillan Publishing Co. Inc., New York. Cooper Kersey and Donald R. Fraser, The Financial Market Place, Addison Wesley Publishing Company (Latest Edition). Khan M.Y, Indian Financial System, Tata McGraw Hill. Mandura Jeff, Financial Markets and Institutions, West Publishing Company, New York. Meir Kohn, Financial Institutions and Markets, McGraw Hill Publishing Company, New York. Online links bulletin.rbi.org.in www.rbi.org.in LOVELY PROFESSIONAL UNIVERSITY 25 Financial Institutions and Services Manpreet Kaur, Lovely Professional University Notes Unit 3: Financial Institutions CONTENTS Objectives Introduction 3.1 Definition of Financial Institutions 3.2 Types of Financial Institutions 3.3 Role in Economic Development 3.4 Commercial Banks 3.5 Emergence of Private Sector Bank after Liberalization 3.6 Financial Innovation in Commercial Banks 3.7 Assets and Liabilities Management by Commercial Banks 3.8 Summary 3.9 Keywords 3.10 Self Assessment 3.11 Review Questions 3.12 Further Readings Objectives After studying this unit, you will be able to: Define financial institutions Explain types of financial institutions Discuss the role of financial institutions in economic development List the commercial banks Discuss emergence of private sector bank after liberalization Know the financial innovation in commercial banks Describe the assets and liabilities management by commercial banks Introduction Financial sector plays an indispensable role in the overall development of a country. The most important constituent of this sector is the financial institutions, which act as a conduit for the transfer of resources from net savers to net borrowers, that is, from those who spend less than their earnings to those who spend more than their earnings. The financial institutions have traditionally been the major source of long-term funds for the economy. These institutions provide a variety of financial products and services to fulfill the varied needs of the commercial sector. Besides, they provide assistance to new enterprises, small and medium firms as well as to the industries established in backward areas. 26 LOVELY PROFESSIONAL UNIVERSITY  Unit 3: Financial Institutions 3.1 Definition of Financial Institutions Notes A financial institution is an institution that provides financial services for its clients or members. Any institution that collects money and puts it into assets such as stocks, bonds, bank deposits, or loans is considered a financial institution. There are two types of financial institutions primarily, viz., 1. Depository institutions and 2. Non-depository institutions. Depository institutions pay you interest on your deposits and use the deposits to make loans. Examples: 1. Banks 2. Credit unions 3. Trust companies 4. Mortgage loan companies. Non-depository institutions, on the other hand undertake the function of selling financial products. In other words, those government or private that serve as an intermediary between savers and borrowers, but do not accept time deposits, are known as non-depository institutions. Such institutions fund their lending activities either by selling securities or insurance policies to the public. Their liabilities (depending on the liquidity of the liability) may fall under one or more money supply definitions, or may be classified as near money. Examples: 1. Insurance companies 2. Pension funds 3. Brokerage firms 4. Underwriting firms 5. Mutual fund companies 6. Investment trust Many financial institutions provide both depository and non-depository services. Probably the most important financial service provided by financial institutions is acting as financial intermediaries. Most financial institutions are highly regulated by government bodies. Finance companies typically enjoy high credit ratings and are hence able to borrow at the lowest market rates, enabling them to make loans at rates not much higher than banks. Even though their customers usually do not qualify for bank credit, these companies have experienced a low rate of default. Finance companies in general tend to be interest rate-sensitive-increases and decreases in market interest rates affect their profits directly. 3.2 Types of Financial Institutions Financial institutions can be of different types in accordance with the difference in the financial systems of different economies. In India, the financial system includes the following types of institutions, viz. 1. Financial Authorities LOVELY PROFESSIONAL UNIVERSITY 27 Financial Institutions and Services Notes 2. Commercial Banks 3. Regional Rural Banks 4. Non-banking Financial Companies 5. Co-operative Societies, etc. Let us take them in details now: 1. F