Indian Financial System: Introduction and Components

Unit: I Introduction to Indian Financial System Unit: 1 Introduction to Financial System Meaning of Financial System The financial system plays a key role in mobilizing the savings, financing the requirement of the corporate, providing liquidity to the corporate sector and to the investors. Fina...

Unit: I Introduction to Indian Financial System Unit: 1 Introduction to Financial System Meaning of Financial System The financial system plays a key role in mobilizing the savings, financing the requirement of the corporate, providing liquidity to the corporate sector and to the investors. Financial system is an intermediary between those who save a part of their income and those who invest in productive ventures/ activities and assets. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. According to Sullivan, financial system is the system that allows the transfer of money between savers and investors and borrowers. "A set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions." The term “system” in “Financial System” indicates a group of complex and closely linked institutions, agents, procedures, markets, transactions, claims and liabilities within an economy. In Countries like India, there is a coexistence of both the formal and informal financial sectors. This coexistence of the two sectors is termed as financial dualism. Financial system has a close linkage with the economy of any country. In any economy there are two types of economic units: Surplus spending economic units and Deficit Spending economic units. Surplus spending economic units are those units whose consumption and investments are less than their income. They hold their savings in the form of cash balances and financial assets. Financial assets are the claims, securities or instruments through which transfer of savings is possible for investment. Example of financial assets are, equity instruments, debt instruments, deposits, units and insurance policies. It is an economic unit which has income that is greater than or equal to expenditures on consumption or real investment over the course of a period. A surplus spending unit will use its additional income to buy goods, invest, lend money to deficit spending units or pay off its own deficit for an earlier period. It refers to either an individual or a group that will provide funds to deficit spending units. It includes brokers and dealers and other entities which require a fee for their services through the financial markets; in this case the stock exchanges. The surplus spending units would be investors who will provide the funds to deficit spending units in order to obtain the ownership of securities. Surplus spending units are any person or entity, which earns more or brings in more than it spends. Deficit spending is the amount by which spending exceeds revenue over a particular period of time and requires money from surplus spending units. The Corporates require money for investment purpose for creating assets which they can get from surplus spending units. SSU = Surplus Spending Units DSU = Deficit Spending Unit SSU lend to financial institution who then lend to DSU. Here, financial system plays a very important link as it channelizes the savings into productive investments. SSU(surplus) : Households Business Firms FINANCIAL INTERMEDIARY: Banks DSU( Deficit):Government, Government and financial institutions corporates Foreign Investors Key Elements/Components of the Financial System Formal and Informal Financial System The Indian financial system can also be broadly classified into the formal (organised) financial system and the informal (unorganised) financial system. The formal financial system comes under the purview of the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies. The informal financial system consists of:  Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners.  Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a system of their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘saving club.’  Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies. COMPONENTS OF THE FORMAL FINANCIAL SYSTEM The formal financial system consists of four segments or components. These are: (a) Financial Institutions (b) Financial Markets (c) Financial Instruments (Assets or Securities) (d) Financial Services (a) Financial Institutions  Financial institutions are the intermediaries who facilitate smooth functioning of the financial system by creating a link between savers and borrowers. They mobilize savings of the surplus units and allocate them to the deficit units. Financial institutions also provide services to entities seeking advice on various issues ranging from restructuring to diversification of investments. These are intermediaries that mobilise savings and facilitate the allocation of funds in an efficient manner. Financial institutions can be classified as banking and non-banking financial institutions. Banking institutions are creators and purveyors of credit while non-banking financial institutions are purveyors of credit. While the liabilities of banks are part of the money supply, this may not be true of non-banking financial institutions. In India, non-banking financial institutions, namely, the developmental financial institutions (DFIs), and non-banking financial companies (NBFCs) as well as housing finance companies (HFCs) are the major institutional purveyors of credit.  Financial institutions can also be classified as term-finance institutions such as the Industrial Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), the Industrial Financial Corporation of India (IFCI), the Small Industries Development Bank of India (SIDBI), and the Industrial Investment Bank of India (IIBI). Financial institutions can be specialised finance institutions like the Export Import Bank of India (EXIM), the Tourism Finance Corporation of India (TFCI), ICICI Venture, the Infrastructure Development Finance Company (IDFC), and sectoral financial institutions such as the National Bank for Agricultural and Rural Development (NABARD) and the National Housing Bank (NHB). Investment institutions in the business of mutual funds Unit Trust of India (UTI), public sector and private sector mutual funds and insurance activity of Life Insurance Corporation (LIC), General Insurance Corporation (GIC) and its subsidiaries are classified as financial institutions. There are state-level financial institutions such as the State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs) which are owned and managed by the State governments (b) Financial Markets Financial system of any country works through the financial markets. The main functions of financial markets are to (1) facilitate creation and allocation of credit and liquidity, (2) To serve as intermediaries for mobilization of savings, (3) To assist process of balanced economic growth (4) To provide financial convenience. A financial market is the place where financial assets are created or transferred or a financial transaction takes place. It can be broadly categorized into money markets and capital markets.  Money market is a market for financial assets that are close substitutes for money. It is a market for overnight to short-term funds and instruments having a maturity period of one or less than one year. The instruments traded in the Indian money market are treasury bills (T-bills), call/notice money market - call (overnight) and short notice (up to 14 days), commercial papers (CPs), certificates of deposits (CDs), commercial bills (CBs), and collateralised borrowing and lending obligations (CBLOs). The history of the capital market in India dates back to the eighteenth century when East India Company securities were traded in the country. It has been a long journey for the Indian capital market. Now the capital market is organised, fairly integrated, mature, more global and modernised. The Indian equity market is one of the best in the world in terms of technology. Capital markets take care of those financial assets that have maturity period of more than a year. The capital market is a market for long-term funds— both equity and debt—and funds raised within and outside the country. The capital market is further classified as Primary markets and secondary markets. o Primary Market handles new issue of securities. The primary market refers to the long-term flow of funds from the surplus sector to the government and corporate sector and to banks and non-bank financial intermediaries. Primary issues of the corporate sector lead to capital formation. The primary market is a market for new issues. Funds are mobilised in the primary market through (a) prospectus, (b) rights issues, (c) preferential allotment, and (d) private placement. o Issues are offered to the public through prospectus and the public subscribes directly. IPO is an offering of either a fresh issue of securities or an offer for sale of existing securities or both by an unlisted company for the first time to the public. A seasoned public offering (SPO) is an offering of either a fresh issue of securities or an offer for sale to the public by an already listed company through an offer document. Rights issue is the issue of new shares in which existing shareholders are given pre-emptive rights to subscribe to the new issue on a pro-rata basis. A preferential issue is an issue of shares or of convertible securities by listed companies to a select group of persons under Section 81 of the  Companies Act, 1956 which is neither a rights issue nor a public issue. The direct sale of securities by a company to some select people or to institutional investors is called private placement. Private placement refers to the direct sale of newly-issued securities by the issuer to a small number of investors through merchant bankers. The public sector garnered huge resources from the private placement market. In terms of instruments, debt instruments, mainly bonds and debentures of different maturities, were preferred the most. Private placements are now regulated. Companies wanting to list their privately placed bonds have to make disclosures as per the Companies Act and the SEBI guidelines o Secondary Markets take care of securities that are presently available in the stock market. Unlike primary issues in the primary market which result in capital formation, the secondary market facilitates only liquidity and marketability of outstanding debt and equity instruments. Secondary market is a market in which existing securities are resold or traded. This market is also known as the stock market. In all, there are, at present, 22 stock exchanges in India—19 RSEs, the BSE, the NSE, the OTCEI, and the Inter-connected Stock Exchange of India (ISE). The stock market index is the most important indices of all as it measures overall market sentiment through a set of stocks that are representative of the market. The stock market index is a barometer of market behaviour. It reflects market direction and indicates day to day fluctuations in stock prices. There are two major indices in India: the BSE Sensex and the NSE Nifty. The BSE Sensitive Index of equity share prices was launched in 1986. It comprises 30 shares and its base year is 1978–79. o Derivatives Market: In India, commodity futures dates back to 1875. The government banned futures trading in many of the commodities in the 1960s and the 1970s. Forward trading was banned in the 1960s by the government despite the fact that India had a long tradition of forward markets. Derivatives were not referred to as options and futures but as ‘tezi-mandi. On March 1, 2000, the government lifted the three-decade-old prohibition on forward trading in securities by rescinding the 1969 notification. Derivatives trading formally commenced in June 2000 on the two major stock exchanges, the BSE and the NSE. The Securities Contracts (Regulation) Act, 1956, defines derivatives in the following manner. Derivatives include: (i) a security derived from a debt instrument, share, loan, risk instrument, or contract for  differences, or any other form of security. (ii) a contract which derives its value from the prices or index of prices of underlying securities. The different types of financial derivatives are forwards, futures, options, warrants, swaps, and swaptions. The different traders in derivatives market are hedger, speculators, and arbitrageurs. A forward contract is a customised contract between two parties where settlement takes place on a specific date in the future at a price agreed today. They are over-the-counter traded contracts. Futures are exchange-traded contracts, or agreements, to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the seller and buyer. o The Debt Market: The debt market is one of the most critical components in the financial system of any economy. The corporate debt market comes under the purview of the Securities Exchange and Board of India (SEBI). The debt market in most developed countries is many times bigger than the other financial markets, including the equity market. The US bond market is more than USD 35 trillion in size with a turnover exceeding 500 billion daily, representing the largest securities market in the world. The size of the world bonds market is close to USD 47 trillion which is nearly equivalent to the total GDP of all the countries in the world. The total size of the Indian debt market is currently estimated to be in the range of USD 150 billion to 200 billion. India’s debt market accounts for approximately 30 per cent of its GDP. The Indian bond market, measured by the estimated value of the bonds outstanding, is next only to the Japanese and Korean bond markets in Asia. The Indian debt market, in terms of volume, is larger than the equity market. In terms of the daily settled deals, the debt and the forex markets currently command a volume of Rs. 1,40,000 crore against a meagre Rs. 20,000 crore in the equity markets. The debt market comprises of the following: Private corporate debt market, Public sector undertaking bond market, Government securities market - the government securities market accounts for more than 90 per cent of the turnover in the debt market. It constitutes the principal segment of the debt market. (c ) Financial Instruments  A financial instrument is a claim against a person or an institution for payment, at a future date, of a sum of money and/or a periodic payment in the form of interest or dividend. The term ‘and/or’ implies that either of the payments will be sufficient but both of them may be promised. Financial instruments represent paper wealth shares, debentures, like bonds and notes. Many financial instruments are marketable as they are denominated in small amounts and traded in organised markets. This distinct feature of financial instruments has enabled people to hold a portfolio of different financial assets which, in turn, helps in reducing risk. Different types of financial instruments can be designed to suit the risk and return preferences of different classes of investors. Savings and investments are linked through a wide variety of complex fi nancial instruments known as ‘securities.’ Securities are defi ned in the Securities Contracts Regulation Act (SCRA), 1956 as including shares, scrips, stocks, bonds, debentures, debenture stocks or other marketable securities of a similar nature or of any incorporated company or body corporate, government securities, derivatives of securities, units of collective investment scheme, security receipts, interest and rights in securities, or any other instruments so declared by the central government. Financial securities are fi nancial instruments that are negotiable and tradeable. Financial securities may be primary or secondary securities. Primary securities are also termed as direct securities as they are directly issued by the ultimate borrowers of funds to the ultimate savers. Examples of primary or direct securities include equity shares and debentures. Secondary securities are also referred to as indirect securities, as they are issued by the fi nancial intermediaries to the ultimate savers. Bank deposits, mutual fund units, and insurance policies are secondary securities. Financial instruments differ in terms of marketability, liquidity, reversibility, type of options, return, risk, and transaction costs. Financial instruments help fi nancial markets and fi nancial intermediaries to perform the important role of channelising funds from lenders to borrowers. Availability of different varieties of fi nancial instruments helps fi nancial intermediaries to improve their own risk management Assets may be classified into two:  Non Marketable: These are the assets which cannot be transferred from one person to another. Examples of non-marketable assets are bank deposits, post office certificates and insurance schemes. Marketable: These are the assets which can be transferred or sold. Examples of marketable assets are shares, government securities, ties, debentures, and mutual fund units There is a wide range of securities in the markets since the needs of investors and credit seekers are different. FINANCIAL ASSETS NON MARKETABLE MARKETABLE POST OFFICE BANK INSURANCE GOVERNMENT MUTUAL SAVINGS SHARES DEBENTURES DEPOSITS SCHEMES SECURITIES FUND UNITS INSTRUMENTS EQUITY PREFERENCE IRR REDEEMABLE REDEEMABLE (d) Financial Services  Financial services offer the help to get the necessar necessary funds and also make sure that they are efficiently deployed.  The services offered are of borrowing, selling and purchasing of securities, lending and investing, making and allowing payments and settlements and taking care of risk exposures in financial markets.   These services mainly ranges from the leasing companies, mutual fund houses, merchant bankers, portfolio managers, and bill discounting and acceptance houses.  The financial services sector offers a number of professional services like credit rating, venture capital financing, mutual funds, merchant banking, depository services, book building, etc.  Financial services aims at facilitating the financial transactions between individuals and institutional investors  The financial services include all activities connected with the transformation of savings into investment. Financial services enables the payments and settlements, manages the risk exposure also.These services are offered by various intermediaries like banks, insurance companies and mutual funds. Functions of Financial System 1. Mobilization of savings: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments, etc. is an important role played by financial markets. In the absence of financial system, the savings would never be mobilised and channelized to productive investments from the unproductive ones. Borrowers (e.g. bond issuers) are connected with lenders (e.g. bond buyers) in financial markets. 2. Aids Investment: Van Horne defined the financial system as the purpose of financial markets to allocate savings efficiently in an economy to ultimate users either for investment in real assets (tangible or intangible) or for consumption. 3. For accelerating national growth: An important role played by financial system is that, it contributes to a nation's growth by ensuring continuous flow of surplus funds to deficit units. The primary function of the financial system is the mobilisation of savings, their distribution for industrial investment and stimulating capital formation to accelerate the process of economic growth. 4. Aids the growth of entrepreneurs: Financial markets allow entrepreneurs (and established firms) to access the funds required to invest in projects or companies. It links the savers and the investors. 5. Monitors the corporate performance: Apart from mobilising and channelizing of savings, an efficient financial system is responsible for monitoring the corporate performance. 6. Provides Payment mechanism: The Banks, depositories and clearing houses are responsible for the settlement of payment mechanism. Banks provide this through issue of cheques, promissory notes, and credit and debit cards. 7. Size and Maturity transformation: It is a process through which small savings are converted into big ones. In case of maturity transformation, the various alternative forms of deposits are being offered to savers according to their liquidity preferences. 8. Provision for liquidity: Providing liquidity means a mechanism for an investor to sale the securities whenever he wants. 9. Risk reduction: Mutual funds reduces the risk of the savers. Mutual funds pools the savings of small investors and channelizes them for investment, hence providing diversification benefits to the small investors and reducing their risk. 10. Aids in disseminating the price information: Financial system facilitates the price information to savers and business firms. In conclusion, financial system performs the essential economic function of transfer of surplus funds from lenders to those who are having shortage of funds. This system provides a flow of funds from those who have to those who do not have. Regulatory Framework The need for a regulatory framework has been universally felt to safeguard the interest of a large number of savers and also ensures proper functioning of the institutions. In India the two principal regulatory authorities are RBI and SEBI. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. RBI: Reserve Bank of India In India the two principal regulatory authorities are RBI and SEBI. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. Reserve bank of India is the apex institution which controls and monitors all the organizations in the organized sector. It controls the monetary policy of the country. RBI was established on 1st April 1935, 80 years ago in accordance with the provisions of the RBI Act, 1934. RBI was nationalized on 1st January 1949.The RBI plays an important role in the development strategy of the government of India. The bank is also entrusted with the responsibility of promoting financial inclusion policy. The basic functions of RBI are to regulate the issue of bank notes, maintaining reserves to secure monetary stability, to operate the currency and credit system in the best interests of the country. Functions of RBI Issue of Currency Notes: The Reserve Bank of India has the sole right to issue currency notes except one rupee notes which are issued by the Ministry of Finance. Currency notes issued by the Reserve Bank are declared unlimited legal tender throughout the country. Banker to the Government: Reserve Bank manages the banking needs of the government. It has to-maintain and operate the government’s deposit accounts. It collects receipts of funds and makes payments on behalf of the government. It represents the Government of India as the member of the IMF and the World Bank. Custodian of Reserves: The commercial banks hold deposits in the Reserve Bank and the latter has the custody of the cash reserves of the commercial banks. The Reserve Bank has the custody of the country’s reserves of international currency, and this enables the Reserve Bank to deal with crisis connected with adverse balance of payments position. Lender of Last Resort: The commercial banks approach the Reserve Bank in times of emergency to tide over financial difficulties, and the Reserve bank comes to their rescue though it might charge a higher rate of interest. Clearance and Accounts Settlement: Since commercial banks have their surplus cash reserves deposited in the Reserve Bank, it is easier to deal with each other and settle the claim of each on the other through book keeping entries in the books of the Reserve Bank. The clearing of accounts has now become an essential function of the Reserve Bank. Credit Controller: Since credit money forms the most important part of supply of money, and since the supply of money has important implications for economic stability, the importance of control of credit becomes obvious. Credit is controlled by the Reserve Bank in accordance with the economic priorities of the government. SEBI: Securities and Exchange Board of India Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a non-statutory body for regulating the securities market. It became an autonomous body in 1992 and more powers were given through an ordinance. Since then it regulates the market through its independent powers. The Securities and Exchange Board of India (SEBI) is the regulator for the securities market in India. It was established in the year 1988 and given statutory powers on 12 April 1992 through the SEBI Act, 1992. SEBI has to be responsive to the needs of three groups, which constitute the market: the issuers of securities the investors The market intermediaries. SEBI is consisting of eight members Chairman One member representing the Reserve Bank of India Two members from the officials of Central Government dealing with Ministry Of Finance Five members as a public representatives from different fields appointed by Central government Objectives of SEBI  To promote the development of the securities market  To protect the interests of investors in securities  To regulate the securities market  To ensure the growth of market and to take necessary and corrective steps to maintain the same  To regulate the securities markets Functions of SEBI The functions of SEBI can be divided into: Regulatory Functions & Development Oriented Functions 1. Issue Guidelines to companies: SEBI issues guidelines to the companies for disclosing information and to protect the interest of investors. The guidelines relates to issue of new shares, convertible debentures, issue by new companies. 2. Registration of brokers and sub brokers and other players in the market: In development and effective functioning of capital market broker plays an important role. Brokers help in completing the transaction smoothly. Brokers charge commission for their services. SEBI controls the brokers as brokers have to register themselves with SEBI. 3. Action for delay in Transfer and Refunds: SEBI has acted against many companies for delay in transfer of shares and refund of money to the applicant to whom the shares are not allotted. Registration of collective Investments Schemes and mutual funds: In capital market various financial intermediaries plays an important role. The various financial intermediaries need to be registered with the SEBI for carrying business. Regulation of stock exchanges and other self-regulatory organisations, merchant banks etc.: Stock exchange is the place where the already issued securities are traded. Prohibition of all fraudulent and unfair trade practices: SEBI prescribed various guidelines for investor protection and to curb unfair trade practices. All the participants in the market are required to adhere these guidelines. Controlling insider training and takeover bids: Insider trading means by trading by insider on the basis of unpublished information. The insider trading is virus in the efficient market which all together destroys efficient markets. SEBI makes guidelines for takeovers and mergers to ensure transparency in acquisition of shares. Development Oriented functions Investor Education and to create awareness amongst the investors Training to Intermediaries Promotion to fair practices and code of conduct for all SROs (Self-Regulatory Organisation) Conducting research programmes and publishing information useful to all market participants. IRDA: Insurance Regulatory Development Authority Insurance Regulatory and Development Authority of India, an agency of Government of India for insurance sector supervision and development. IRDA is an autonomous body set up under the IRDA Act, 1999 IRDA’s Mission is to protect the interests of policyholders and to regulate and develop the insurance industry. Frames regulations for insurance industry in terms of Section 114A of the Insurance Act 1938 From the year 2000 has registered new insurance companies in accordance with regulations Monitors insurance sector activities for healthy development of the industry and protection of policyholders’ interests  IRDA is established to protect the interest of policy holders, to regulate, promote and ensure orderly growth of the industry and to amend the INSURANCE ACT 1938, the LIC ACT 1956 and the GIC ACT 1972. The objectives of IRDA is  To protect the interest of policy holder:  To strengthen insurance industry  The aim of IRDA is to provide long term fund to government for the growth of economy.  IRDA also provides information regarding insurance.  Also responsible for establishing the grievance Redressal machinery Functions of IRDA:  Issuing certificate of registration: issuing to the applicant a certificate of registration, to renew, modify, withdraw, suspend, or cancel such registration.  Protection of the Interest of policy holders: To protect the interest of policy holders in the context of assigning of policy nomination by policy holders. settlement of insurance claims.  To provide practical training: Specifying required qualifications, code of conduct and to provide practical training to insurance intermediaries and agents are the functions of IRDA.  IRDA is responsible for specifying the code of conduct for surveyors and loss assessors.  IRDA will supervise the working of the Traffic Advisory Committee. MOF: Ministry of Finance The Ministry of Finance is an important ministry within the Government of India. It concerns itself with taxation, financial legislation, financial institutions, capital markets, centre and state finances, and the Union Budget. The ministry of finance in India governs the entire fiscal system of the Government of India. It centralizes around all the issues in India pertaining to economy and finance. It also includes the task of mobilization of resources in terms of execution of developmental programmes. It governs the expenditure department of government, which mainly deals with the transfer of resources across the states in India. The five departments headed by the ministry of finance in India include: a) economic affairs, b) expenditure, c) revenue d) Financial services and e) Investment and public Asset Management Functions/ role  Plays a role in creating regulators.  Prior to the reforms of the nineties, played the role of supervisor of rules and regulations.  Legislative work. Big picture policy questions that go beyond the agenda of any one regulator. Conflict of interest: owner of many finance companies