Finance Management Module 1 (SEM III 2024) PDF

Finance Management Module 1: Overview of Indian Financial System Machhindranath Patil V.E.S. Institute of Technology Mumbai July, 2024 Indian Financial System A system in an engineering sense is a set of different components put together to perform...

Finance Management Module 1: Overview of Indian Financial System Machhindranath Patil V.E.S. Institute of Technology Mumbai July, 2024 Indian Financial System A system in an engineering sense is a set of different components put together to perform the certain tasks. ▶ In a similar manner, one can understand the financial system, that comprises different components in the economy to perform certain financial activities. ▶ In the economy, there are two sectors. ▶ First one is surplus sector that comprises individual or business entities who want to invest their savings (surplus money). ▶ The second sector is deficit sector that comprises individual or business entities who seek the money or want to borrow money. ▶ Financial system is the link between these two sectors. Indian Financial System Machhindranath Patil 2 Features of Indian Financial Systems ▶ A financial system plays a significant role in the economic growth of a country by mobilizing the surplus funds and utilizing them effectively for productive purposes. ▶ The role of financial system in the economy of the country can be featured through following points. ▶ It encourages both savings and investment. ▶ It links savers, investors and borrower. ▶ It helps in capital formation. ▶ It helps in allocation of risk. ▶ It facilitates expansion of financial markets. Indian Financial System Machhindranath Patil 3 Components of Financial System A financial system is composition of Institutions, Markets, Laws and Regulations, Financial Services, Transactions etc. So broadly,a financial system consists of four major components 1. Financial Institutions 2. Financial Instruments 3. Financial Markets 4. Financial Services Indian Financial System Machhindranath Patil 4 1. Financial Institutions ▶ Financial institution is the intermediary that facilitates smooth functioning of the financial system by making investors and borrowers meet productive activities that promises a better rate of return. ▶ They mobilize savings of the surplus units and allocate them in productive activities promising a better rate of return. ▶ Also, they offer various services such as plan for restructuring of debt to diversification of investments to individuals or business entities and even to the government. ▶ Financial institutions can be classified into two categories: ▶ Organized sector ▶ Unorganized sector. ▶ They can also be classified as, A Banking Institutions. B Non-Banking Financial Institutions. Indian Financial System Machhindranath Patil 5 The Organized Versus Unorganized Sectors ▶ The organized sector consists of the RBI, commercial banks, financial intermediaries such as the Life Insurance Corp. of India, Credit and Investments Corporation of India, Unit Trust of India, Land Mortgage Banks, Cooperative Banks, Insurance Companies etc. and perform their activities under various regulators. ▶ The unorganized sector is largely made up of indigenous bankers, money lenders, traders, commission agents etc., some of whom combine money lending with trade and other activities. This sector is essentially unregulated. Indian Financial System Machhindranath Patil 6 Banking Institutions ▶ Indian banking industry is subject to the control of the Central Bank. ▶ The Reserve Bank of India (RBI) as the apex institution organizes, runs, supervises, regulates and develops the monetary system and the financial system of the country. ▶ The main legislation governing commercial banks in India is the Banking Regulation Act, 1949. ▶ Indian Banking Institutions are categorized into two sectors, 1. Organized Sector-Institutions that come directly or indirectly under the regulations of the RBI constitute the organized sector. 2. Unorganized Sector-Institutions that does not come under purview of the central banking regulations. They can come under organized sector or unorganized sectors Indian Financial System Machhindranath Patil 7 Banking Institutions The organized banking sector consists of ▶ Commercial banks ▶ Cooperative banks ▶ The regional rural banks ▶ Foreign banks Indian Financial System Machhindranath Patil 8 Commercial Banks ▶ The commercial banks may be scheduled banks or non-scheduled banks. ▶ RBI is the highest monetary authority in the country. ▶ It makes rules and regulations for the scheduled commercial banks in India. ▶ There are broadly divided into two types Scheduled and Non-scheduled banks ▶ Scheduled Banks - These are the banks that have been included in the Schedule-II of the RBI Act, 1934. The banks included in this category should fulfill two conditions, i. The paid up capital and collected fund of the bank should not be less than Rs. 5 lac. ii. Any activity of the bank will not adversely affect the interests of the depositors. ▶ Non-scheduled Banks –The banks that are not included in the list of the scheduled banks are called the Non- Scheduled Banks. Indian Financial System Machhindranath Patil 9 Co-operative banks ▶ An important segment of the organized sector of Indian banking is the co-operative banking. ▶ The segment is represented by a group of societies registered under the Acts of the states relating to co-operative societies. ▶ In fact, co-operative societies may be credit societies or non-credit societies. Note that, A credit co-operative society formed by the a group of people of the same class to fulfill economic requirements. Such society is jointly owned and controlled such people democratically. ▶ Different types of co-operative credit societies are operating in Indian economy. These institutions can be classified into two broad categories: (a) Rural credit societies which are primary agriculture. (b) Urban credit societies which are primarily non-agriculture. Indian Financial System Machhindranath Patil 10 Regional Rural Banks (RRB) ▶ Regional Rural Banks (RRB) were set by the state government and some commercial banks (sponsoring banks) with an objective of developing the rural economy. ▶ The regional rural banks were set up with a view to provide credit facilities to weaker sections. ▶ Regional rural banks provide banking services and credit to farmers and small entrepreneurs in the rural areas. There were – 06 RRBs in 1975, 107 RRBs in 1981, 196 RRBs in 2002. As on today, there are 43 major RRB’s in India as per official website of Dept. financial services of India. Indian Financial System Machhindranath Patil 11 Foreign Banks ▶ Foreign banks have been established in India since the British days. ▶ As name implies, these are banks of different countries performing banking operations in India. ▶ They have head office in their home country while they may have branches in other countries ▶ With the deregulation (Elimination of Government Authority) in 1993, large number of foreign banks are entering India. e.g Foreign Banks are: Citi Bank, Standrad Charted Bank, HSBC Bank etc. Indian Financial System Machhindranath Patil 12 Unorganized Banking Sector ▶ Indigenous Bankers: ▶ Indigenous Bankers are private firms or individual who operate as banks and as such both receive deposits and given loans. ▶ Like bankers, they are also financial intermediaries. ▶ They should be distinguished professional money lenders whose primary business is not banking and money lending. ▶ The indigenous banks are trading with the Hundies, Commercial Paper. ▶ Money lenders: ▶ Money lenders depend entirely on their own funds. ▶ Money Lenders may be rural or urban, professional or non-professional such as farmers, merchants, traders. ▶ Their operations are entirely unregulated and they charge very high rate of interest. Indian Financial System Machhindranath Patil 13 Non-Banking Financial Institutions ▶ NBFI don’t work under Banking Regulation Act, but they work under Companies Act. ▶ They are not part of credit and settlement systems unlike Banking Institutions (BI). ▶ They are not allowed to receive Demand Deposits (Deposits that can be withdrawn on demand) from public unlike BI. ▶ They can not create a credit unlike banks. ▶ They dont have to maintain specified cash reserve ratio and statutory liquidity ratio unlike banks. ▶ Foreign investments up to 100% is possible unlike BI (private only), where this can be only 74%. Indian Financial System Machhindranath Patil 14 2. Financial Instruments ▶ Financial instruments are documents/certificate (may be in electronic form) that represent financial claims on assets. ▶ They assures a claim of the repayment of a invested sum of money at the end of a specified period together with interest or dividend if applicable. Therefore, the are also called as financial securities. ▶ There are two categories of financial securities, ▶ Primary or Direct securities: These are securities directly issued by the ultimate borrower to the ultimate investor. For example, shares and debentures issued directly to the public. ▶ Secondary or Indirect securities: These are securities issued by some financial intermediaries to the ultimate savers (investor). For example, Unit Trust of India and mutual fund houses issue securities in the form of units to the public and the money pooled is invested in companies. Indian Financial System Machhindranath Patil 15 Based on the duration, instruments may be classified as, ▶ Short-term securities for period less than 1 year. e.g. Treasury Bills (T-Bills), Commercial Papers (CPs), Certificates of Deposit (CDs). ▶ Medium term securities for period of 1 year to 5 years. e.g. Government of India Securities (G-Secs) with shorter maturity, Corporate Bonds with medium-term maturity, State Development Loans (SDLs) with shorter maturity, etc. ▶ Long - term securities for period of 5 years or more. e.g. Government of India Securities (G-Secs) with longer maturity, Corporate Bonds with longer maturity, State Development Loans (SDLs) with longer maturity, Infrastructure Bonds etc. Indian Financial System Machhindranath Patil 16 3. Financial Markets ▶ Financial markets refer to the institutional arrangements for trading of financial assets and credit instruments of different types such as currency, cheques, bank deposits, bills, bonds etc. ▶ In other words, financial markets are marketplace where the trading of securities occurs. For example, stock market, bond market, forex market, derivatives market etc. ▶ Financial markets plays vital role in smooth operation of market based economies. Indian Financial System Machhindranath Patil 17 Functions of Financial markets Financial markets essentially performs following functions, ▶ To facilitate the creation and allocation of credit and liquidity. ▶ To provide intermediaries for the mobilization of savings. ▶ To assist in the process of balanced economic growth. ▶ To provide financial convenience. ▶ To cater to the various credit needs of businesses. ▶ To facilitate price discovery of financial assets. ▶ To enable risk transfer and management. Financial markets are boroadly classified into two types, ▶ Capital Market ▶ Money Marke Indian Financial System Machhindranath Patil 18 Capital Market The capital market is a market for financial assets that have a long or indefinite maturity. Generally, it deals with long-term securities, which have a maturity period of above one year. Capital market may be further divided into three categories, I Industrial securities market. II Government securities market III Long term loans market. Industrial securities market - As the name suggests, it is a market for industrial securities. ▶ In this market the industrial concerns raise their capital or debt by issuing appropriate instruments such as equity shares (or ordinary shares), preference shares, debentures or bonds. ▶ It can be further subdivided into two, ▶ Primary market or New issue market ▶ Secondary market or Stock exchange Indian Financial System Machhindranath Patil 19  Capital Market Indian Financial System Machhindranath Patil 20 I. Industrial securities market As the name suggests, it is a market for industrial securities. ▶ In this market the industrial concerns raise their capital or debt by issuing appropriate instruments such as equity shares (or ordinary shares), preference shares, debentures or bonds. ▶ It can be further subdivided into two, ▶ Primary market or New issue market ▶ Secondary market or Stock exchange Indian Financial System Machhindranath Patil 21 Primary Market This is the place where new securities are issued and sold directly by companies to investors. ▶ It deals with those securities which are issued to the public for the first time. ▶ In the primary market, borrowers exchange new financial securities for long-term investment of funds. Thus, the primary market facilitates capital formation. ▶ There are four main ways by which a company may raise capital in a primary market: ▶ Public Issue: This is a common method of raising capital where companies (both new and existing) sell securities to the public. ▶ Rights Issue: When an existing company wants to raise additional capital, securities are first offered to the existing shareholders on a pre-emptive basis. This is also known as a Rights Offer. ▶ Private Placement: This is a way of selling securities privately to a small group of investors. In India, it’s also known as Preferential Allotment when made to a select Indian Financial System Machhindranath Patil 22 group of persons. Secondary Market This is the market place where existing securities are traded among investors. ▶ In the secondary market, securities which have already been issued through the ’primary market’ are traded. ▶ Usually, securities are traded through stock exchanges. ▶ This market consists of all stock exchanges recognized by the Government of India. ▶ The stock exchanges in India are regulated under the Securities Contracts (Regulation) Act, 1956. ▶ The Securities and Exchange Board of India (SEBI) oversees and regulates the functioning of the stock exchanges. ▶ BSE (Bombay Stock Exchange) and NSE (National Stock Exchange) are the two principal stock exchanges of India. Indian Financial System Machhindranath Patil 23 ii. Government Security Market This is a market where government securities are traded. ▶ In India, primarily long-term government securities are traded in this market. (Short-term government securities, like Treasury Bills, are typically traded in the money market). ▶ Securities in this market are issued by various government entities: ▶ Central Government: Issues Government of India (G-Sec) bonds ▶ State Governments: Issues State Development Loans (SDLs) ▶ Semi-Government authorities: Such as City Corporations, Port Trusts, etc., which issue municipal bonds or other specific securities Indian Financial System Machhindranath Patil 24  ▶ The Reserve Bank of India (RBI) acts as the debt manager for the government and regulates this market. ▶ Government securities are considered low-risk investments due to sovereign backing. ▶ Mutual funds that primarily invest in government securities are called Gilt funds. Consequently, this market is often referred to as the Gilt-Edged securities market. ▶ The government securities market plays a crucial role in: ▶ Financing government deficits ▶ Implementing monetary policy through open market operations ▶ Establishing a benchmark yield curve for pricing other financial products Indian Financial System Machhindranath Patil 25 III. Long term Loan Market Development banks and commercial banks play a key role in this market by providing long-term loans to corporate customers. Long-term loans market may further be classified into, ▶ Term loans market ▶ Mortgages market ▶ Financial Guarantees market Indian Financial System Machhindranath Patil 26 Term loans market ▶ In India, many industrial financing institutions have been created by the Government both at the national and regional levels to supply medium and long-term loans to corporate customers. These development banks have played a significant role in industrial finance in India. Examples include: ▶ IDFC (Infrastructure Development Finance Company), now IDFC First Bank ▶ IFCI (Industrial Finance Corporation of India) ▶ ICICI (Industrial Credit and Investment Corporation of India), now ICICI Bank ▶ SIDBI (Small Industries Development Bank of India) Indian Financial System Machhindranath Patil 27 Mortgages market ▶ A mortgage loan is a loan secured against immovable property, typically real estate. ▶ In India, the mortgage market includes both residential and commercial mortgages. ▶ Types of mortgages in India include: ▶ Home loans (for residential properties) ▶ Loan against property (LAP) ▶ Commercial mortgage loans ▶ Key players in the Indian mortgage market include: ▶ Commercial banks (e.g., SBI, ICICI Bank, HDFC Bank) ▶ Housing finance companies (e.g., HDFC Ltd, LIC Housing Finance) ▶ Non-banking financial companies (NBFCs) ▶ The National Housing Bank (NHB) regulates housing finance companies. ▶ Equitable mortgages (where documents of title are deposited with the lender) are common in India due to their simplicity and lower costs. Machhindranath Patil Indian Financial System 28 Financial Guarantees market ▶ A financial guarantee is a promise by a guarantor to assume the debt obligation of a borrower if that borrower defaults. In India, this market includes: ▶ Bank guarantees: Issued by banks to guarantee payment or performance. ▶ Corporate guarantees: Issued by parent companies for their subsidiaries. ▶ Government guarantees: For public sector undertakings or specific projects. ▶ Export credit guarantees: Provided by the Export Credit Guarantee Corporation of India (ECGC). Indian Financial System Machhindranath Patil 29  ▶ Key players in this market include, ▶ Commercial banks ▶ Non-banking financial companies (NBFCs), ▶ Specialized institutions like Export Credit Guarantee Corporation of India (ECGC) ▶ Insurance companies offering surety bonds. ▶ The Reserve Bank of India (RBI) regulates bank guarantees, while IRDAI (Insurance Regulatory and Development Authority of India) oversees insurance companies offering guarantee products. ▶ Financial guarantees play a crucial role in facilitating trade, infrastructure projects, and corporate finance in India. Indian Financial System Machhindranath Patil 30  Money Market Indian Financial System Machhindranath Patil 31 Money Market ▶ Money market is a market that deals with short-term financial assets and securities, typically with maturities of one year or less. ▶ The money market in India may be subdivided into the following categories: I Call money market II Commercial bills market III Treasury bills market IV Short-term loan market V Certificate of Deposit (CD) market VI Commercial Paper (CP) market Indian Financial System Machhindranath Patil 32 I. Call Money Market The call money market is a market for very short-term loans, typically ranging from one day to fourteen days. ▶ These loans are generally repayable on demand by either the lender or the borrower, hence the term "call" money. ▶ The liquidity of investment in this market is very high due to its short-term nature. ▶ A key feature of this market is its volatility. It is very sensitive to changes in demand and supply of call loans. ▶ The interest rate in the call money market can vary significantly, even on an intraday basis, reflecting changes in liquidity conditions. ▶ In India, the call money market is primarily interbank, with banks, primary dealers, and select financial institutions as participants, and the RBI regulates this market. ▶ Major financial centers like Mumbai (formerly Bombay), Kolkata (formerly Calcutta), Chennai (formerly Madras), Delhi, and Ahmedabad continue to be important, but the market is no longer strictly location-bound. Indian Financial System Machhindranath Patil 33 Commercial bills market Bill Market is the market for short-term bills, typically of three months maturity or less. ▶ A bill is a promise to pay a specified amount by the borrower (drawer) to the creditor (drawee). ▶ In the context of the Indian money market, the bill market primarily deals with: ▶ Bills of exchange or commercial bills: Used to finance trade. These are drawn by sellers on buyers and are often discounted by banks. ▶ Finance bills or promissory notes: These are issued by financial institutions or large corporates. ▶ Commercial bills may be bought and sold in the discount market, which includes participants such as: ▶ Commercial Banks ▶ Non-Banking Financial Companies (NBFCs) ▶ Primary Dealers ▶ The Reserve Bank of India (RBI) has taken several measures to develop the bill market in India, including the introduction of the Trade Receivables Discounting System Indian Financial System Machhindranath Patil 34 Treasury Bills Market Treasury Bills market is a distinct category in the Indian money market due to the unique characteristics of these instruments and their crucial role in government finance and monetary policy. ▶ It is a market for Treasury Bills, which are short-term government securities with maturities of up to one year. ▶ A Treasury Bill is a zero-coupon instrument issued by the Government of India to meet its short-term borrowing requirements. ▶ Treasury Bills are highly liquid because their repayment is guaranteed by the Government of India. ▶ They are an important instrument for the Government’s short-term borrowing and play a significant role in managing temporary mismatches in cash flows. Indian Financial System Machhindranath Patil 35  ▶ In the current Indian context, there are three types of Treasury Bills based on their maturity period: ▶ 91-day Treasury Bills ▶ 182-day Treasury Bills ▶ 364-day Treasury Bills ▶ Treasury Bills are issued through auctions conducted by the Reserve Bank of India (RBI) on behalf of the Government of India. ▶ They are available for investment to individuals, firms, companies, corporate bodies, trusts, and institutions. ▶ Ad hoc Treasury Bills, which were earlier issued to the RBI, have been discontinued since April 1997 as part of financial sector reforms. Indian Financial System Machhindranath Patil 36 IV. Short term loan market Short-term loan market is a market where short-term loans are given to corporate customers for meeting their working capital requirements. ▶ Commercial banks play a significant role in this market. They provide short-term loans primarily in the form of: ▶ Cash credit ▶ Overdraft facilities ▶ Working capital loans ▶ Overdraft facilities are typically provided to businesses and individuals, allowing them to withdraw more than the account balance up to a pre-agreed limit. ▶ Cash credit is a type of short-term borrowing arrangement, commonly used by businesses, especially in manufacturing and trading sectors. ▶ While overdraft is generally a temporary accommodation provided in the current account itself, cash credit is usually sanctioned for a period of up to one year and is maintained in a separate account. Indian Financial System Machhindranath Patil 37  ▶ Working capital loans are another form of short-term financing, typically with a tenure of up to one year, designed to fund a company’s everyday operations. ▶ In recent years, there’s been growth in alternative lending channels: ▶ Non-Banking Financial Companies (NBFCs) have become significant players in this market. ▶ Fintech companies are increasingly offering innovative short-term lending products. ▶ The Reserve Bank of India (RBI) regulates this market to ensure prudent lending practices and financial stability. Indian Financial System Machhindranath Patil 38 V. Certificate of Deposit (CD) market The Certificate of Deposit (CD) market is a segment of the money market where large-denomination, short-term, interest-bearing time deposits are issued and traded. ▶ CDs are negotiable money market instruments issued in dematerialized form or as usance promissory notes. ▶ In India, CDs can be issued by: ▶ Scheduled commercial banks (excluding Regional Rural Banks and Local Area Banks) ▶ Selected All-India Financial Institutions (AIFIs) that have been permitted by RBI ▶ The minimum amount of a CD is Rs. 1 lakh, issued at a discount to face value. with maturity period ranges from 7 days to 1 year. Indian Financial System Machhindranath Patil 39  ▶ For AIFIs, the maturity period ranges from 1 year to 3 years. ▶ CDs are freely transferable after the lock-in period. Banks and FIs cannot buy their own CDs before maturity. ▶ The interest rate on CDs is determined by market forces and depends on the prevailing conditions in the money market. ▶ CDs are subject to reserve requirements like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). ▶ The RBI regulates the CD market and has prescribed guidelines for issuance of CDs. Indian Financial System Machhindranath Patil 40 Commercial Paper (CP) market The Commercial Paper (CP) market is a segment of the money market where short-term, unsecured promissory notes issued by highly rated corporations are traded. ▶ CPs are unsecured money market instruments issued in the form of promissory notes. ▶ In India, CPs can be issued by: ▶ Companies ▶ Primary Dealers (PDs) ▶ All-India Financial Institutions (AIFIs) ▶ Non-Banking Financial Companies (NBFCs) ▶ The minimum amount of a CP is Rs. 5 lakhs or multiples thereof, with the maturity ranges from 7 days to 1 year from the date of issue. ▶ CPs are issued at a discount to face value and are redeemed at par. Indian Financial System Machhindranath Patil 41  ▶ Only entities with a minimum credit rating of ’A3’ as per rating agency Credit Rating Information Services of India Limited (CRISIL) or equivalent rating by other agencies can issue CPs. ▶ CPs are usually bought by institutional investors like banks, mutual funds, and insurance companies. ▶ The interest rate on CPs is market-determined and generally lower than bank rates for short-term loans. ▶ CPs provide an additional source of short-term borrowing for companies and offer higher returns to investors compared to bank deposits. ▶ The RBI regulates the CP market and has issued guidelines for the issuance of CPs. ▶ CPs are traded in both primary and secondary markets, enhancing liquidity for investors. Indian Financial System Machhindranath Patil 42  D. Financial Services Indian Financial System Machhindranath Patil 43 Financial Services ▶ Efficiency of financial system is largely dependent on the quality and variety of financial services provided by financial intermediaries. ▶ Financial service industry mainly comprises banks, financial institutions and non-banking financial companies. ▶ The term financial services can be defined as activities” that is connected with the financial goods offered to the customers. ▶ According to the finance and Development Department of the International Mone- tary Fund (IMF), financial services are the processes by which consumers or businesses acquire financial goods. ▶ Professional Advisory, Wealth Management, Mutual Funds, Insurance, Stock Market, Treasury/Debt Instruments, Tax/Audit Consulting. Indian Financial System Machhindranath Patil 44  Thank You Indian Financial System Machhindranath Patil 45