Indian Economy & Indian Fiancial System.pdf

INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM  INDIAN INSTITUTE OF BANKING & FINANCE (ISO 9001:2015 Certified) Kohinoor City, Commercial-II, Tower-1,2nd & 3rd Floor, Kirol Road,'Off-L,B,S. Marg, Kurla-W...

INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM  INDIAN INSTITUTE OF BANKING & FINANCE (ISO 9001:2015 Certified) Kohinoor City, Commercial-II, Tower-1,2nd & 3rd Floor, Kirol Road,'Off-L,B,S. Marg, Kurla-West, Mumbai-400070 Established on 30th April 1928 MISSION To develop professionally qualified and competent bankers and finance professionals primarily through a process of education, training, examination, consultancy/counselling and continuing professional development programmes. VISION To be the premier Institute for developing and nurturing competent professionals in banking and finance field. OBJECTIVES To facilitate study of theory and practice of banking and finance. To test and certify attainment of competence in the profession of banking and finance. To collect, analyse and provide information needed by the professionals in banking and finance. To promote continuous professional development. To promote and undertake research relating to Operations, Products, Instruments, Processes, etc., in banking and finance and to encourage innovation and creativity among finance professionals so that they could face competition and succeed. COMMITTED TO PROFESSIONAL EXCELLENCE Website: www.iibf.org.in INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM (For JAIIB/Diploma in Banking & Finance Examination) Indian Institute of Banking & Finance macmillan education © INDIAN INSTITUTE OF BANKING & FINANCE, MUMBAI, 2023 (This book has been published by Indian Institute of Banking A Finance. Permission of the Institute is essential for reproduction of any portion of this book. The views expressed herein are not necessarily the views of the Institute.) All rights reserved under the copyright act. No part of this publication may be reproduced, transcribed, transmitted, stored in a retrieval system or tianslated into any language or computer language, in any form or by any means, electronic, mechanical, magnetic, optical, chemical, manual, photocopy or otherwise without the prior permission of the copyright owner. Any person who does anj unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published, 2023 MACMILLAN EDUCATION INDIA PRIVATE LTD Bengaluru Delhi Chennai Kolkata Mumbai Ahmedabad Bhopal Chandigarh Coimbatore Guwahati Hyderabad Lucknow Madurai Nagpur Patna Pune Thiruvananthapuram Visakhapatnam Kochi Bhubaneshwar Noida Sahibabad Hubli ISBN: 978-93-5600-031-I Published by Macmillan Education India Private Limited (formerly Macmillan Publishers India Private Limited), 21, Patullos Road, Chennai 600002, India Printed at: Universal Offsets, Noida - 201301 INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM First Edition (2023) Modules A & B—Authored/Revised/Updated by Mr, Bibekananda Panda, AGM & Economist, SBl & Vetted by Dr. Sangeeta Pandit, FCA, HOD Finance, Sydenham B-School Modules C & D—Authored/Revised/Updated by Mr. Sugata K Darta, Retd CGM, BOI and Ex-Faculty IIBF & Vetted by Mr. K. S. Padmanabhan. Retd. CGM, NABARD "This book is mean! for educational and learning purposes. The author)?) of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any copyright or other intellectual property rights of any person in any manner whatsoever. In the event the authorfs) has/have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for any corrective action." FOREWORD Formal education will make you a living; self-education will make you afortune. -Jim Rohn The banking sector, currently, is experiencing a transformation catalysed by digitalization and information explosion with the customer as the focal point. Besides, competition from NBFCs, FinTechs, changing business models, growing importance of risk and compliance have contributed to this radical shift. Such an ever-evolving ecosystem requires strategic agility and constant upgradation of skill levels on the part of foe Banking & Finance professionals to chart a clear pathway for their professional development. The mission of the Indian Institute of Banking & Finance is to develop professionally qualified and competent bankers and finance executives primarily through a process ofeducation, training, examination, counseling and continuing professional development programs. In line with the Mission, the Institute has been offering a bouquet of courses and certifications for capacity building of foe banking personnel. The flagship courses/examinations offered by the Institute are the JAIIB, CAIIB and the Diploma in Banking & Finance (DB&F) which have gained wide recognition among banks and financial institutions. With banking witnessing tectonic shifts, there was an imperative need to revisit the existing syllabi for the flagship courses. The pivotal point for revising the syllabi was to ensure that, in addition to acquiring basic knowledge, the candidates develop concept-based skills for keeping pace with foe developments happening in the financial ecosystem and to ensure greater value addition to the flagship courses and to make them more practical and contemporary. This will culminate in creating a rich pool of knowledgeable and competent banking & finance professionals who are capable ofcontributing to foe sustainable growth of their organizations. Keeping in view the above objectives, the Institute had constituted a high-level Syllabi Revision Committee comprising of members from public sector banks, private sector banks, co-operative banks and academicians. On the basis of foe feedback received from various banks and changes suggested by the Committee, the syllabi of JAIIB & CAIIB have since been finalized. The revised JAIIB syllabi will now have four compulsory subjects as under: 1. Indian Economy & Indian Financial System 2. Principles & Practices of Banking 3. Accounting &. Financial Management for Bankers 4. Retail Banking & Wealth Management The new subject on Indian Economy & Indian Financial System will cover the basics of economics and financial system prevalent in India. This will familiarise the candidates with the evolving financial ecosystem of the country. Insofar as the book on Accounting & Financial Management is concerned, two new modules viz Financial Management and Taxation & Fundamentals of Costing have been introduced. With bankers having to cater to the requirements of varied industries, it is imperative that they have an underlying understanding of the relationships between cost accounting, financial accounting, management accounting and financial vi /VOFSD management. Some of the other topics that have been covered are Cost of Capital, Equipment Leasing, GST, Standard Costing, Marginal Costing, Budgetary Control system e... [87 Simplification of process will also greatly enhance the competitiveness of Indian exports. The situation demands for a drastic realignment of India’s trade strategy and considering the strategic retreat from globalisation and implementation of inward, rather than outward-looking economic policies as a threat which may pop up at a short notice. As COVID-19 has brought a new world order, it is very much imperative for India to explore significant reforms in trade policies including diversification of export products as well as destinations, increased domestic production, land and labour law reforms, speedy environmental clearances, and setting up alternative payment mechanisms, among others in its new FTP 2022-27. 8.5 FDIs. Fils AND RECENT TRENDS Foreign Direct Investment (FDI) Foreign direct investment (FDI) is an investment made in a country, by a foreign investor, often a company, to control the ownership of an entity. FDI is a key engine of economic growth, assisting in maintaining high growth rates, enhancing productivity, and generate employment. A favourable policy framework and a stable business environment promote FDI inflows. The Indian government has been implementing a series of changes intended at liberalising and simplifying FDI policy, in its attempt to optimise the ease of doing business in the nation, which would culminate in increased FDI inflows. Defence, construction, broadcasting, civil aviation, plantation, trade, private sector banking, satellite installation and operation, and credit information companies are among the sectors that have been liberalised. Net FDI has increased from $ 3.7 billion in 2004-05 to $ 36.6 billion by 2021-22. However, in 2021-22 the Net Foreign Direct Investment in India reached $ 36.6 billion, 16.7 per cent lower compared to year earlier. Routes of FDI in India FDI enters the domestic economy through two channels: the RBI’s automatic route and the government route. Automatic Route of RBI FDI is permitted through the automatic route without prior approval from the Government or the RBI in all activities/sectors specified in the Government of India’s consolidated FDI Policy, as amended from time to time. The Indian firm that receives FDI through the automatic route must follow the terms of the FDI policy, including reporting the FDI and issuing shares to the RBI. The investor must follow a two-stage reporting process. First, the Indian company is required to report to the foreign exchange department, regional office concerned of the RBI, under whose jurisdiction its Reg stered Office is located, within 30 days of receipt of share application money/amount of consideration from the non-resident investor; and second, upon issue of shares to non-resident investors, the company is required to submit required documentation with the foreign exchange department, regional office concerned of the RBI. Government Route Foreign investment in activities not covered by the automa lie route requires prior government permission. Proposals for foreign investment through the government route are reviewed by the relevant administrative ministry/department. Proposals involving a total foreign equity infusion of more than Rs. 5,000 crores require clearance from the Cabinet Committee on Economic Affairs. FDI from Pakistan is also placed under government route. 88 | IW-DiAN ECONOMY INDIAN FINANCIAL SYSTEM Sector wise FDI Flow routes and Limits to India ai Sector FDI Limit Entry Route Ho i Agriculture & Animal Husbandry 100% Automatic 2 Plantation Sector 100% Automatic 3 Mining 100% Automatic 4 Mining (Coal & Lignite) 100% Automatic 5 Petroleum & Natural Gas 100% Automatic 6 Defence Manufacturing 100% 74% through the Automatic Route for new defence industrial license and up to 100% by government Route in access to modem technology 7 Broadcasting 100% Automatic 8 Broadcasting Content Services 49% Government 9 Up-linking of Non- News & Current Affairs’ 100% Automatic TV Channels/ Down-linking of TV Channel * 10 Print Media 26% Government 11 Civil Aviation - Airports 100% Automatic 12 Civil Aviation - Air Transport Services 100% Automatic up to 49% Above 49% under Government route 100% Automatic for NRIs 13 Civil Aviation 100% Automatic 14 Construction Development: Townships, 100% Automatic Housing, Built-up Infrastructure 15 Industrial Parks (new & existing) 100% Automatic 16 Private Security Agencies 74% Automatic up to 49% Above 49% & up to 74% under Government route 17 Satellites- establishment and operation, 100% Government subject to the sectoral guidelines of Department of Space/ISRO 18 Telecom Services 100% Automatic 19 Cash & Carry Wholesale Trading 100% Automatic 20 E-commerce activities 100% Automatic 21 Single Brand retail trading 100% Automatic up to 49% Above 49% under Government route 22 Multi Brand Retail Trading 51% Government (Cantd.)  FOREIGN TRADE POLICY, FOREIGN INVESTMENTS 89 SI. Sector FDI Limit Entry Route NO 23 Duty Free Shops 100% Automatic 24 Railway Infrastructure 100% Automatic 25 Asset Reconstruction Companies 100% Automatic 26 Banking - Private Sector 74% Automatic up to 49% Above 49% & up to 74% under Government route 27 Banking- Public Sector 20% Government 28 Credit Information Companies (CIC) 100% Automatic 29 Infrastructure Company in the Securities 49% Automatic Market 30 Insurance 74% Automatic 31 Pension Sector 49% Automatic 32 Power Exchanges 49% Automatic 33 White Label ATM Operations 100% Automatic 34 Financial services activities regulated by 100% Automatic RBI, SEBI, IRDAor any other regulator 35 Pharmaceuticals (Green Field) 100% Automatic 36 Pharmaceuticals (Brown Field) 100% Automatic up to 74% Above 74% under Government route 37 Food products manufactured or produced 100% Government in India i Types of FDI There are three types of FDI * Greenfield FDI It is a sort of investment in which, a parent corporation establishes a subsidiary in the destination country. It builds operations from the scratch. McDonald’s, Hyundai India, Pepsi India are examples of greenfield FDIs. Brownfield FDI It is an investment in which a multinational corporation buys stock in an established firm in the host country. For example, Daiichi Sankyo of Japan acquired Ranbaxy India Joint Venture Based on an agreement, a foreign company and a local company join up to share investment, technology, profits, and so on (e.g. Hero Honda) 90 FDI Prohibited Sectors FDI in India is prohibited and not allowed to function in the following sectors: Lottery Business, which includes Govemment/private lottery, online lotteries, etc. Gambling, Betting as well as casinos, etc. Chit funds Nidhi company Trading in Transferable Development Rights (TDRs) Real Estate Business Construction of Farmhouses (Real estate business does not include development of townships, construction of residential/commercial premises, roads or bridges) Manufacturim of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes Activities/sectors not open to private sector investment, e.g., Atomic Energy and Railway operations (other than permitted activities) Foreign Institutional Investment ,FII) FII refers to short-term capital invested in stocks or hedge funds. It is generally volatile, and the possibility of capital flight is always there in the case of an economic slump, political turmoil, or herd behaviour of short-term capital outflow. Foreign institutional investors are companies, based outside India that offer investment proposals in India. The portfolio investment programme allows rdreign Institutional Investors, Non-Resident Indians, and Persons of Indian Origin to invest in India’s primary and secondary capital markets. Under this arrangement, FIIs/NRIs can acquire shares/debentures in Indian companies through Indian stock exchanges. They are registered as Fils with SEBI and play an essential part in a country’s capital market performance. FPIs/FIls (Foreign Portfolio Investors/Foreign Institutional Investors) have been a major driver of India’s financial markets, in the financial year 2021-22, net FPIs were negative $ 11.97 billion (FII outflows were $ 9.34 billion, and portfolio investment by India was $ 2.63 billion), compared to a net inflow of $ 36.14 billion in the previous year($ 14.03 billion). Because of its well-developed primary and secondary markets, India has attracted FIIs/FPIs. However, geopolitical instability, the Russia-Ukraine dispute, and COVID-related uncertainties have resulting in a capital flight during 20? I -22. Difference Between FDI and FII SI. Foreign Direct Investment Foreign Institutional Investment No. 1 It goes airectiy into machines, i.e., in the production It goes into hedge funds, short-term equities, and of goods and services securities, etc. 2 It has long-term perspective It has short-term perspective 3 it contributes into GDP of the country by way of The FII does not go into production activities but production of goods and services. in short-term equities and can be recalled by the investor at any time. However, the profit and bsses and the taxes imposed on such investments (e.g., capital gain tax) may add or subtract from a country's GDP (Contd.).* k' 1 : r r -1' i. » ' \ r. - p SI. Foreign Direct Investment Foreign Institutional Investment No 4 It is stable in nature and there is hardly any threat It is generally volatile in nature and threat of capital of capital flight flight is always there in the eventuality of economic slowdown or political instability or because of herd behaviour of short-term capital 5 It depends upon the macroeconomic profile of the It depends upon the arbitrage and hedging host nation and economic and political stability variations across different parts of the world. It also depends upon the capital liberalisation measures adopted by a nation to attract such capital 6 It is of different types line Greenfield investment, It is also called hot money and takes the torm ot Brownfield investment, and Joint ventures hedge kinds 8.6 ECONOMIC DEVELOPMENT VS ECONOMIC GROWTH Economic Development Economic development is defined as a sustained improvement in a society's material well-being. Apart from national income growth, it encompasses social, cultural, political, and economic developments that contribute to material progress. It includes changes in available resources, capital formation rates, population size and composition, technology, skills and efficiency, and organisational and institutional architecture. These reforms contribute to the larger goals of guaranteeing more equitable income distribution, more employment, and poverty reduction. In short, economic development is a long chain of interrelated changes in fundamental supply factors and demand structure that contribute to the increase in a country's net national product in the long term. Economic development is a wider concept than economic growth. Economic Growth Economic growth is defined as the process by which, an economy's actual national and per capita income grows over time. When compared to economic development, economic growth is a restricted term. It entails a rise in output in quantitative terms, but it also includes qualitative changes such as social attitudes and behaviours, in comparison with the quantitative growth in output or national income. Difference Between Economic Growth and Economic Development 1 SI. Economic Growth Economic Development NO 1 Economic Growth refers to the increment in Economic development refers to the reduction amount of goods and services produced in an and elimination of poverty, unemployment and economy inequality with the context of growing economy 2 Economic growth means an increase in real Economic development means an improvement national income/national output in the quality of life and living standards, e.g., measures of literacy, life-expectancy, and ’lealthcare (ConfcQ 92 rsi Economic Growth Economic Development No. 3 economic growth focuses on production of goods Economic development focuses on distribution and services of resources 4 Economic growth Is single dimensional in nature Economic development is multi-dimensional as it only focuses on income of the people in nature as it focuses on both income and improvement of living standards of the people 5 Economic Growth is the precursor and prerequisite Economic development comes after economic for economic development. It is the subset of growth, ft is a positive impact of economic growth economic development 6 Indicators of economic growth are; Indicators of economic development are GDP Human Development Index (HDI) GNl Human Poverty Index (HPI) Per capita income Gini Coefficient Gender Development Index (GDI) Balance of trade Physical Quality of Life Index (POLI) 7 economic growth only looks at the quantitative Economic development brings quantitative and aspect. It brings quantitative changes in the qualitative change in the economy economy 8 it refers to increase in production it refers to increase in productivity 9 Economic growtn is relatively narrow concept as It is a broader concept than economic development compared to economic development 10 Economic growth is more relevant metric for More relevant to measure progress and quality of assessing progress in developed countries life in developing countries 8.7 IMPORTANCE OF ECONOMIC DEVELOPMENT AS A DIMENSION, ETC. Economic development is defined as a persistent increase in the material well-being of society. Economic development refers to a larger set of ideas than economic growth, ft comprises social, cultural , political, and economic developments that contribute to material advancement, in addition to national income growth. Economic growth includes increases in income, savings, and investment, as well as progressive changes in the country's socioeconomic structure, including both institutional and technical developments. Economic development includes the human capital growth, elimination ofsocioeconomic inequalities, and structural changes that improve the public's quality of life. To assess economic development, qualitative indicators such as the HDI (Human Development Index), gender-related indexes, Human Poverty Index (HPI), infant mortality, literacy rate, etc., are used. LET US SUM UP t. Foreign trade policy refers to the economic policy that governs an economy's export-import activity. 2. Prior to 1991, the Indian economy was protected by high tariffs and taxes. Foreign investment was not permitted in India, in addition to significant quantitative restrictions.  FORPfUM TRADE POLICY FOREIGN INVESTMENTS, | 93 3. In line with the ‘Make in India’ initiative, the FTP 2015-20 provides a framework for promoting goods and services exports, as well as employment generation and value addition in the economy. 4. The FTP aimed to increase India’s merchandise and services expons from $465 billion in 2013-14 to $900 billion by 2019-20. 5. The FTP 2015-20 included two new schemes: the ‘Merchandise Exports from India Scheme (MEIS)' for exporting defined products to designated destinations, and the 'Services Exports from India Scheme (SEIS)’ for promoting exports of designated services 6. FDI is a key engine of economic growth, assisting in maintaining high growth rates, enhancing productivity, and generate employment. A favourable policy framework and a stable business environment promote FDI inflows. 7. FDI enters the domestic economy through two channels: the RBI’s automatic route and the government route. 8. FDI is permitted through the automatic route without prior approval from the Government or the RBI in all activities/sectors specified in the Government of India’s consolidated FDI Policy, as amended from time to time. 9. Foreign investment in activities not covered by the automatic route requires prior government permission. FDI from Pakistan is also placed under government route. 10. There are three types of FDI: Greenfield FDI, Brownfield FDI and Joint Venture 11. Foreign institutional investors are companies based outside India that offer investment proposals in India. 12. FII refers to short-term capital invested in stocks or hedge funds. It is generally volatile, and the possibility of capital flight is always there in the case of an economic slump, political tunnoil, or herd behaviour of short-term capital outflow. 13. Economic development is a wider concept than economic growth. 14. To assess economic development, qualitative indicators such as the HDI (Human Development Index), gender-related indexes, Human Poverty Index (HPI), infant mortality, literacy rate, etc., are used KEYWORDS Investment; growth; capital formation; green field; joint venture; strategy; foreign trade; doing business; FDI; FII; manufacturing; development; human capital; savings CHECK YOUR PROGRESS Tick the Correct Answer 1. The Foreign Trade Policy 2015-2020 targeted to increase India's merchandise and services exports to_______________ by 2019-20. (a) $900 billion (b) $700 billion (c) $600 billion (d) $500 billion 2. FDI from Pakistan is placed under________ »_____ (a) Automatic route (b) Government route  3. FDI limit in Private banking is______________. (a) 26% '(b) 49% (c) 74% (d) 100% 4. FDI in India is prohibited in which of the sectors'’ (a) Defence (b) Irrigation (c) Health (d) Lottery Business 5. Which is known as 'Hot Money’ (a) FII (b) FDI (c) FPI (d) None of the above ANSWERS TO CHECK YOUR PROGRESS 1. (a); 2. (b); 3.(c); 4. (d); 5. (a)  INTERNATIONAL ECONOMIC ORGANISATIONS (WORLD BANK, IMF, ETC.) STRUCTURE 9.0 Objectives 9.1 International Economic Organisations (World Bank, IMF, etc.) 9.2 IMF and World Bank 9.3 World Trade Organization (WTO) - India and WTO 9.4 Regional Economic Co-operations 9.5 Recent International Economic Issues Let Us Sum Up Keywords Check Your Progress Answers to Check Your Progress 96 ( IND'AN Mixed Economy (d) Laissez-faire economy 8. Laissez-faire economy is (a) The extreme case of a Market Economy (b) The extreme case of a Command Economy (c) The extreme case of a Mixed Economy (d) None of these 9. Market economy is also known as (a) Mixed Economy (b) Capitalistic Economy (c) Command Economy (d) Socialistic Economy 10. Which of the following is a Capitalistic Economy? (a) England (b) China (c) India (d) None of the above ANSWERS TO CHECK YOUR PROGRESS I. (c); 2. (d); 3. (c); 4. (b); 5. (d>; 6. (a); 7. (c); 8. (a); 9. (b); 10. (a)  UNIT 13 SUPPLY AND DEMAND STRUCTURE 13.0 Objectives 13.1 Introduction 13.2 The Demand Schedule & Diminishing Marginal Utility Concept 13.3 Forces behind the Demand Curve 13.4 Shifts in Demand & Exceptions to the Law of Demand 13.5 The Supply Schedule 13.6 Forces behind the Supply Curve 13.7 Shifts in Supply 13.8 Equilibrium of Supply and Demand 13.9 Effect of a Shift in Supply or Demand Curve 13.10 Interpreting Changes in Price and Quantity Let Us Sum Up Keywords Check Your Progress Answers to Check Your Progress 136 ? INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM 13.0 OBJECTIVES This chapter will be helpful in understanding: * Concepts of Demand and Supply * Demand Schedule, Demand Curve, Market Demand * Supply Schedule, Supply Curve * Equilibrium of Supply and Demand * Price Mechanism 13.1 INTRODUCTION Like weather, markets are dynamic, subject to periods of storm and calm, and constantly evolving. Vet, as with weather forecasting, a careful study of markets will reveal certain forces underlying the apparently random movements. To forecast prices and outputs in individual markets, you must first understand the concept of supply and demand. Economics has a pow< rui tool for explaining such changes in the economic environment. It is called the theory of supply and demand. This theory shows how consumer preferences determine consumer demand for commodities, while business costs determine the supply of commodities. The increase in the price of petrol occurred either because the demand for petrol had increased or because die supply of crude oil had decreased. The same is true for every market, from food to diamonds to land: changes in supply and demand drive changes in output and prices. If you understand how supply and demand works, you have gone a long way toward understanding a market economy. This Unit introduces the notionsofsupply and demand and shows how they operate in competitive markets for individual commodities. We begin with demand curves and then discuss supply curves. Using these basic tools, we will see how the market price is determined where these two curves intersect - where the forces of demand and supply are in balance. It is the movement of prices - the price mechanism - which brings supply and demand into balance or equilibrium. This Unit deals with some examples of how supply-and-demand analysis can be applied. 13.2 THE DEMAND SCHEDULE & DIMINISHING MARGINAL UTILITY CONCEPT Both common sense and careful scientific observation show that the amount of a commodity people buy depends on its price. The higher the price of an article, other things held constant, the fewer units consumers are willing to buy. The lower is its market price, the more units of it are bought. There exists a definite relationship between the market price of a good and the quantity demanded of that good, other things held constant. This relationship that exists between price and quantity bought is called the demand schedule, or the demand curve. Let us look at a simple example. Table 13.1 presen s a hypothetical demand schedule for apples. At each price, we can determine the quantity of apples that consumers purchase. For example, at Rs. 500 per box, consumers will buy 9 million boxes per year. At a lower price, more apples are bought. Thus, at a price of Rs. 400, the quantity bought is I0 million boxes. At yet a lower price (P) equal to Rs. 300, the quantity demanded (Q) is still greater, at 12 million, and so forth. We can observe that the quantity demanded increases with the fall in price as shown in Table 13.1.  SUPPLY AND OEMAND | 137 Table 13.1 The Demand Schedule for Apple ----------------------------------- 1 Quantity demanded Price (fis. per box) (millions of boxes per year) At each market price, consumers will want to buy a certain quantity of apples. As the price of apples falls, the quantity of apples demanded will rise. The Demand Curve Demand Curve Figure 13.1 Above is the graphical representation of the demand schedule, the demand curve. Ws show the demand curve which graphs the quantity of apples demanded on the horizontal X axis and the price of apples on the vertical V axis. Note that the quantity and the price are inversely related; that is, Q goes up when P goes down. The curve slopes downward, going from northwest to southeast. This important property is called the law ofdownward-sloping demand. It is based on common sense as well as economic theory and has been empirically tested and verified for practically all commodities - apples, petrol, computers, etc. Law ofdemand: When the price of a commodity is raised (and other things being constant), buyers tend to buy less of the commodity. Similarly, when the price is lowered, other things being constant, quantity demanded increases. Quantity demanded tends to fall as price rises for two reasons. First is the substitution effect^ 1 find an alternative cheaper good. The price of a particular good rises, I will substitute other similar goods for 138 | INDIAN ECONOM Y & INDIAN FINANCIAL SYSTEM it, example is the price of dal rises, I eat more vegetables. Second is the income effect, this comes into play, when a higher price reduces quantity demanded. As price goes up, 1 find myself somewhat poorer than I was before. If petrol prices double, I have in effect less real income, so 1 will naturally curb my consumption of petrol and other goods. Market Demand Our discussion of demand has so far referred to ‘the’ demand curve. But whose demand is it? Mine? Yours? Everybody’s? The fundamental building block for demand is individual preferences. However, in this chapter, we will focus on the market demand, which represents the sum total of all individual demands. The market demand is what is observable in the real world. The market demand curve is found by adding together the quantities demanded by all individuals at each price. Quantities ofApples (Millions of boxes per year) Figure 13.2 A Downward-Sloping Demand Curve relates Quantity Demanded to Price Does the market demand curve obey the law of downward - sloping demand? It certainly does. If prices drop, the lower prices attract new customers through the substitution effect and induce extra purchases by existing customers due to the income effect. Conversely, a rise in the price of a good, will cause us to buy less. Law of Diminishing Marginal Utility This is a very interesting phenomenon. The more we consume, the lesser satisfaction, each additional unit of consumption, will give us. For example, if we are extremely thirsty, the Ist glass of cool water will give us a lot of satisfaction, 2nd glass too is welcome but will give lesser satisfaction and satisfaction keeps decreasing with every additional unit of consumption.  139 13.3 FORCES BEHIND THE DEMAND CURVE What determines the market demand for apples or petrol or computers? A whole array of factors influences how much will be demanded at a given price: average levels of income, the size of the population, the prices and availability of related goods, individual and social tastes and special influences. The average income of consumers is a key determinant of demand. As people's income rises, individuals tend to buy more ofalmost everything, even ifprices do not change. Automobile purchases tend to rise sharply With higher levels of income. The size ofthe market-measured, say, by the population - clearly affects the market demand. The demand for apples in Mumbai Market is higher than the demand obtained in Bhubaneswar Market, as the population in Mumbai is larger than in the Bhubaneswar. The prices and availability of related goods influence the demand for a commodity. A particularly important connection exists among substitute goods - ones that tend to perform the same function, such as apples and oatmeal, pens and pencils, small cats and large cats, or oil and nar iral gas. Demand for goods “A” tends to be low, if the price of substitute product “B” is low. In addition io these objective elements, there is a set ofsubjective elements called tastes orpreferences. Tastes represent a variety ofcultural and historical influences. They may reflect genuine psychological or physiological needs (for liquids, love, or excitement). And they may include artificially contrived cravings (for cigarettes, drugs, or fancy s ports cars). The] may also contain a large element oftradition or religion (eating beef is popular in America but taboo in India, while curried jellyfish is a delicacy in Japan but woulo make many Americans gag). Finally, special influences will affect the demand for particular goods. The demand for umbrellas is high in rainy Mumbai but low in sunny Delhi; the demand for air conditioners will rise in hot weather. In addition, expectations about future economic conditions, particularly prices, may have an important impact on demand. Please note that each of the above factors, in addition to the price, affects the total demand (market demand) of a particular good in a specified market. While drawing a demand curve, we see the influence of only price on the total demand and assume that other factors are constant. If any of the above factors changes, the demand curve will not remain same and we will have to draw another curve to show relationship between demands and prices of that good. In other words, the demand curve will shift from its original position 13.4 SHIFTS IN DEMAND & EXCEPTIONS TO THE LAW OF DEMAND As economic life evolves, demand changes incessantly. Demand curves sit still only in textbooks. Why does the demand curve shift? Because demand is influenced by issues other than the change in the good’s price. Let us work through an example of how a change in a non-price variable shifts the demand curve. We know that the average income of Indians rose sharply during the economic boom of2006-08. Because there is a powerful income effect on the demand for automobiles, this means that the quantity ofautomobiles demanded at each price will rise. For example, if average income rose by 10 per cent, the quantity demanded (of a car) at a price of Rs. 2,00,000 might rise from I0 million to 12 million units. This would be a shift in the demand curve, because the increase in quantity demanded reflects factors other than the good’s own price. Similarly, changes in other factors, mentioned in para 2.3 above, result in change in demand. 140 INDIAN ECONOMY 4 INDIAN FINANCIAL SYSTEM Quality demanded of automobiles (Millions per year) Figure 13.3 Increase in Demand for automobiles The net effect of the changes in underlying influences is what we call a shift in demand. An increase in the demand for automobiles is illustrated in Fig. 13.3 as a rightward shift in the demand curve. Note that the shift means that more cars will be bought at every price. EXCEPTIONS TO THE LAW OF DEMAND There are certain exceptions to the Law of Demand. For example, even ifthe price ofwhiskey rises, demand will not fall. Exceptions to the law of demand generally apply to Giffen goods, Veblen commodities, and necessary items. Veblen Goods This is named after the economist Thorstein Veblen, who pioneered the principle of ‘conspicuous *. consumption Certain things, according to Veblen, become more valuable as their price rises. When a commodity is expensive, its worth and utility are thought to be greater, and hence demand for that commodity rises. This is due to perception that expensive means better quality and positioning of goods making them in restricted quantity, affordable by few. Example of high-priced cell phone model and designer bags are examples ofVeblen goods that are exceptions to the Law of Demand. These observations point to deviations to the law of demand. Giffen Goods This concept was introduced by Sir Robert Giffen. These are commodities that are inferior in compared to luxury items. However, a distinguishing feature of Giffen goods is that when their prices rise, so does their demand. For example, a household is consuming rice (10 kgs at Rs. I O-Rs. 100) and potatoes (10 kgs at Rs.20-Rs.200) and spending Rs.300 per month. If price of rice increases from Rs. 10 to Rs. 12, their consumption will not decrease, they will consume less potatoes (same 10 kgs of rice for Rs. 120 and 9  ' 141 kgs of potatoes for Rs. 180). Inferior /Giffen goods are an exception to the law of demand. The Giffen goods notion is shown by the Irish Potato Famine. The potato is an important part of the Irish cuisine. When the price of potatoes rose during the potato famine, people spent less on luxury items like meat and bought more potatoes to keep to their diet. As the price of potatoes rose, it was still affordable being a cheap good, so, demand did not fall, resulting in a complete reversal of the law of demand. Necessary Goods and Services Another exception to the law of demand is the purchase of necessities or basic items. Even if the price of necessities such as medicines or basic staples such as sugar or salt rises, people will continue to purchase them. The pricing of these items has no effect on the demand for them. Governments try to control the prices of basic necessities. Change In Income The demand for a product may alter, in response to changes in income. If a household's income rises, they may purchase more things regardless of price increases, raising demand for the product. Similarly, if their income has reduced, individuals may postpone purchasing a good even though its price has decreased. As a result, changes in a consumer’s income pattern may likewise be considered an exception to the law of demand. 13.5 THE SUPPLY SCHEDULE Let us now move from demand to supply. The supply side ofa market typically involves the terms on which businesses produce and sell their products. The supply of tomatoes tells us the quantity of tomatoes that will be sold at each tomato price. More precisely, the supply schedule relates the quantity supplied of a good to its market price, other things being constant. In considering supply, the other things that are held constant include input prices, technology, prices of related goods and government policies. The supply schedule (or supply curve) for a commodity shows the relationship between its market price and the amount of that commodity that producers are willing to produce and sell, other things being constant. The Supply Curve Table 2.2, shows a hypothetical supply schedule for apples, and plots the data from the table in the form of a supply curve. The data show that at an apples’ price of Rs. 100 per box, no apples will be produced at all. At such a low price, apple cultivators might want to devote their resources to producing other types of products like cereals and pulses that earn them more profit than apples. As the price of apples increases, more apples will be produced. At ever-higher apples prices, cereal makers will find it profitable to add more workers and to buy more automated apple-juice making machines and establish more apple factories. All these will increase the output of apples at the higher market prices. Table 13.2 Supply Schedule for Apple Quantity supplied Price (Rs. per box) (mHlions of boxes per year) ' -r' 1 fContd.) 142 | INDIAN ECONOMY & INDIAN FINANCIAL SYSTEM Quantity supplied Price (Rs. per box) (millions of boxes per year) Figure 13.4 shows the typical case of an upward-sloping supply curve for an individual commodity. Supply Curve: the above table showing increase in Supply as prices increase can be shown graphically as below: l» s a! SOO b/ 400 2 £ c/ 300 - +nJmw*n>er») tuTd Kfrirw W GN REGS Much would **> ©as*J on demand 19.4 PLAN EXPENDITURE Revenue Expenditure 1. Central Plan 2. Central Assistance for State & Union Territory Plans Capital Expenditure 1. Central Plan 2. Central Assistance for State & Union Territory Plans Plan Expenditure: Revenue Expenditure + Capital Expenditure Total Expenditure: Total Non-Plan Expenditure + Total Plan Expenditure 19.5 DEFICIT CONCEPTS * Revenue deficit is the excess of revenue expenditure over revenue receipts. Effective Revenue deficit is the Revenue deficit minus Grants in Aid for creation of capital assets * Fiscaldeficit is the excess of total expenditure including loans, net of recoveries overrevenuc receipts (including external grants) ar d non-debt receipts. In other words, Fiscal deficit = Total Expenditure - Total revenue (Excluding the borrowings) Primary deficit is the difference between the fiscal deficit and interest payments. The net RBI credit to the Central Government is the sum of increase in the Reserve Bank's holding of i) Treasury Bills, ii) Government of India dated securities iii) rupee coins and iv) Loans and Advances from the Reserve Bank to the Central Government since April I.I997, adjusted for changes in Center’s cash balances with the Reserve Bank.  225 LET US SUM UP 1. Net Tax Revenue: Gross tax revenue (-) NCCD transferred to the National Calamity Contingency Fund (-) *States Share. 2. Ibtal Revenue Receipts: Net Tax Revenue t- Total Non-Tax Revenue. 3. Total Receipts: Total Revenue Receipts + Capital Receipts + Draw-Down of Cash Balance. 4. Total Expenditure: Total Non-Plan Expenditure + Total Plan Expenditure. KEYWORDS Growth-oriented budget; Revenue Receipts; Capital Receipts; Total Receipts; Non-plan Expenditure; Plan Expenditure; Total Expenditure; Revenue Deficit; Fiscal Deficit; Primary Deficit. CHECK YOUR PROGRESS Tick the CorrectAnswer 1. Expand NCCD (a) National council on Crime and Delinquency (b) National council on Credit and Debentures (c) National council on Commercial and deregulation (d) None of the above 2. Pick odd one out (a) Customs (b) Service Tax (c) Interest Receipts (d) Income Tax 3. Pick odd one out (a) Securities issued against Small Savings (b) Recoveries of Loans & Advances (c) State Provident Funds (d) Other Receipts 4. Pick odd one out (a) Loans to Public Enterprises (b) Pensions (c) Subsidies (d) Police 226 I MIAN L"ONi. y r r FINANCIAL SYSTEM 5. Net fiscal deficit is the difference between (a) gross fiscal deficit and net interest payments (b) gross fiscal deficit and interest payments (c) gross fiscal deficit and net lending (d) None of the above ANSWERS TO CHECK YOUR PROGRESS l.(a);2.(c); 3. (b); 4. (a); 5.(c)  MODULE - C kSsSt INDIAN FINANCIAL ARCHITECTURE Unit 20. Indian Financial System - An Overview Unit 21. Indian Banking Structure Unit 22. Banking Laws - Reserve Bank of India Act 1934 & Banking Regulation Act 1949 Unit 23. Development Financial Institutions Unit 24. Micro Finance Institutions Unit 25. Non-Banking Financial Companies (NBFCs) Unit 26. Insurance Companies Unit 27. Indian Financial System - Regulators and Their Roles Unit 28. Reforms & Developments in the Banking Sector  INDIAN FINANCIAL SYSTEM AN OVERVIEW STRUCTURE 20.0 Objective 20.1 Introduction 20.2 Types of Financial Systems 203 Phases of Development of Financial System 20.4 Phase I - Pre-independence (prior to ’947) 20.5 Phase II - Post-independence (1947 to 1991) 20.6 Phase III - Liberalisation (1991 to 2010) 20.7 Phase IV - Post Global Financial Crisis (GFC| (2010 to present) 20.0 Present Status of the Banking Sector Let Us Sum Up Keywords Check Your Progress Answers to Check Your Progress 230 20.0 OBJECTIVE The objective of this unit is to provide an overview of the Indian Financial System and the developments which had taken place in the financial and banking systems, during different phases, as also the distinctive features of the development, in each of these phases, while giving an account of the status of the system presently obtained. 20.1 INTRODUCTION For the growth of any economy, capital formation is essential. Capital is the source of funds with which, an entrepreneur is able to take the risk of setting up and operating a business enterprise. The capital is, however, normally not available with the entrepreneurs and businesses, who need them. The capital is available, instead, with persons with wealth who have savings. These persons with wealth, howsoever little it may, needs to be able to make the wealth available with the entrepreneurs, who can invest the savings made available to them. Examples of wealth possessors are individuals, firms, corporates and government. These entities are also those who require finance for producing goods and services, in the role of entrepreneur and businesses. Wealth must, therefore, flow from pockets of sutplus to pockets of deficit. It is for that purpose the financial and banking systems are required. 20.2 TYPES OF FINANCIAL SYSTEMS In all economies, financial systems are of two basic types - the informal system and the formal system. 20.2.1 Informal Financial System The informal financial system has evolved as an extension of the social structure and is characterised by lack of regulations, low transaction cost, unstructured procedures, transparency and low default rates. Typical examples components of the informal financial system are: * Individual money lenders who could be traders, relatives, neighbours, etc. * Groups of persons who could be operating as associations and funds * Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies. Although informal and unregulated, this section of financial system has its own importance, especially in the earlier days and in rural and lesser developed geographies. 20.2.2 Formal Financial System The formal financial sector, on the other hand, is characterised by the presence of unorganised, institutional, and regulated system, which caters to the financial needs of the modem spheres ofeconomy. It forms the backbone of any economy and one of the most important systems in the growth of any nation. The components of the formal financial system are the financial institutions, financial instruments and financial markets. Financial Institutions, while on one hand, cater to the entities who possess wealth, on the other hand, they catei to those entrepreneurs and businesses who require the wealth in the form of capital, for their investments.  RfcANCl SYSTEM ". 231 Examples of financial institutions are: * Financial Regulators * Commercial and Cooperative Banks * Non-Banking Financial Companies (NBFCs) * Development Financial Institutions (DFIs) * Insurance companies * Insurance brokers * Mutual Funds * Pension Funds The financial institutions can further be divided into two types: * Banking Institutions or Depository Institutions - This includes banks and other credit unions which collect money from the public against interest provided on the deposits made and lend that money to the ones in need. * Non-Banking Institutions or Non-Depository Institutions - Insurance, mutual funds and brokerage companies fall under this category. They cannot ask for monetary deposits but sell financial products to their customers. Further, Financial Institutions can be classified into three categories: * Regulatory - Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc. * Intermediates - Commercial banks which provide loans and other financial assistance such as SBI, BOB, PNB, etc. * Non Intermediates - Institutions that provide financial aid to corporate customers. It includes NABARD, SIBDI, etc. Financial Instruments are in the nature of financial products and services. These include instruments on the asset as well as on the liability side of the financial institution's balance sheet. They can also be in the form of intangible value-added services, which can facilitate financial development. Financial instruments on the asset side of the balance sheet include loans and advances, investments, placements, derivatives, etc., whereas financial instruments on the liabilities side of the balance sheet include deposits, money accepted from customers for remittances, insurance policies and mutual funds units issued and contribution received for building up a corpus for payment of pension. While financial institutions and financial instruments provide the base for capture and transfer of wealth from savers to investors, the process cannot be complete, without the presence of financial markets. Typically, a market is a place, where two parties can gather together to facilitate the exchange of goods and services. The term 'market' as used by economists has a different meaning from ordinary usage. It does not mean literally the physical place in which commodities are sold or purchased (as in a village market), nor does it mean the stages that a commodity passes through between the producer and the consumer. Instead, it refers in an abstract way to the purchase and sale transactions of a commodity and the formation of its price. Used in this way, the term refers to the countless decisions made by producers of a commodity (the supply side of the market) and consumers of a commodity (the demand side of the market), which taken together determine the price of the commodity. A financial market is a market where buyers and sellers trade money, commodities, financial securities, foreign exchange and derivatives, at low transaction costs and at prices that are determined by forces of demand and supply. 232 The financial market has four major segments, viz., Money market. Foreign exchange (forex) market, Capital market and, Insurance market. Figure 20.1 shows the structure of the Financial System in India. r inanciai Svstcm Financial Financial Financial Intermediaries Instruments Markets asset Money — Regulators Products Market Liability Forex Banks Products h irket _ Capital Services - NBFCs Market insurance Insurance Market Cn^-^iies Mutual Funds Pension Funds Figure 20.1. Structure of Financial System in India 20.3 PHASES OF DEVELOPMENT OF FINANCIAL SYSTEM The Indian Financial System has come a long way from the times when finance was left, basically, in the hands of traders and merchants. History has recorded that the first commercial bank set up in India was Bank of Hindustan in the year 1770. Similarly, the first insurance company to be set up in India was National Insurance Company, in the year 1906, and the Company is still in existence. Development of the financial system in India can be segmented into die following phases: 1. Pre-independence (prior to 1947) 2. Post-independence () 947 to 1991) 3. Post-liberalisation (1991 to20l0) 4. Post-Global Financial Crisis (20IO to present)  233 20.4 PHASE I - PRE-INDEPENDENCE (PRIOR TO 1947) The reminisce of banking in India can be traced back to the 4th century BC, in the 'Kauulya Arthashastra’, which contains references to creditors and lenders. During the pre-independence phase, a large number of banks were present in India - which was around 600. Establishment of Bank of Hindustan in the year 1770, in Calcutta, marked the starting ut the formal Indian financial system. This bank, however, discontinued its services in 1832. There were various banks that evolved after the Hindustan Bank, such as General Bank of India (1786-1791) and Oudh Commercial Bank (1881-1958). However, these banks were also notable to continue for long. The earliest precursor of the present State Bank of India, namely, Bank of Calcutta was established in 1806. This was later renamed to Bank of Bengal in 1809.' The Bank of Madras and Bank of Bombay were established in 1843 and 1863, respectively. All these three banks merged in 1921, to form the Imperial Bank of India, which was subsequently converted into the country’s first Public Sector Bank, i.e., State Bank of India on 1st July 1955. A few banks set up in.he 19th century are exist even today, such as Punjab National Bank, which was formed in 1874. During this phase, the Bombay Stock Exchange (BSE) also established in 1875 and it was Asia’s first stock exchange. The BSE played a yeomen role in development of India’s capital markets, including the retail capital market, and has enabled the Indian corporate sector to grow. The pre-independence phase (during the 1920s) was marked by extreme turbulence in the financial market, which led to the closing down of a number of banks. This spurred the establishment of a banking regulator. The setting up of a central bank, namely Reserve Bank of India, was recommended by the Hilton Young Commission in 1935. The regulation of the foreign exchange market also originated during this phase, with implementation of the Defense of India Rules (DIR) on 3rd September, 1939, which coincided with the commencement of World War II. These draconian regulations were superseded by an equally tough legislation in 1947 (Foreign Exchange Regulations Act, FERA). The pre-independence phase was one in which majority of small-sized banks failed to function properly and were unable to gain people's confidence. People were more associated with money lenders and unregulated players, for meeting their savings and borrowing needs. 20.5 PHASE II - POST-INDEPENDENCE (1947 TO 199 i) This was the Second Phase of development of the Financial System in India. Post-Independence, India launched into a stage for social development and development of the country’s infrastructure and the organisation of the Indian financial system during this period evolved in response to the imperatives of planned economic development. Economic growth with social justice was enshrined in the Indian Constitution, under the Directive Principles of State Policy and the scheme of planned economic development was initiated in 195 L, with the launch of the First Five-Year Plan. This led to adoption of mixed economy, as the pattern of industrial development, in which a complementary role was conceived for the public and private sectors. This phase commenced with the nationalisation of Reserve Bank of India in 1948, followed by that of State Bank of India in 1955. In the succeeding year, on 1st September 1956,245 private insurance companies were nationalised to form the Life Insurance Corporation of India (LIC). 234 While the economy was coming under increasing degrees of socialism, bank finance was still out of reach of most of the population. Money Lenders had become too exploitative and poor people could not afford to take bank loans, due to lack of collaterals. The ban'-.s themselves were selectively catering to large industries and businesses, and the slowing growth of the agricultural sector, small-scale industries and exports showing its ill-effects. This was followed by two years of crippling droughts in 1965 and 1966 and the country hau to resort to heavy imports of food grains and financial aid from overseas. In an attempt to bring in tight social control over the banking sector, the Government nationalised the largest 14 private banks on 19th July 1969. Each of these banks had deposits over Rs 50 crores. The socialised banking sector was enlarged with the nationalisation of 6 more banks, each with deposits exceeding Rs 200 crores, on 16th April, 1980. Figure 20.2 shows the list of the banks which were nationalised in 1°69 and l°80. S.No 1969 1980 1. Allahabad Bank Andhra Bank 2. Bank of Baroda Corporation Bank 3. Bank of India Punjab & Sind Bank 4. Bank of Maharashtra Vijaya Bank 5. Canara Bank Oriental Bank of Commerce 6. Central Bank of India New Bank of India 7. Syndicate Bank 8. UCO Bank 9. United Bank of India 10. Union Bank 11. Punjab National Bank 12. Indian Overseas Bank 13. Indian Bank 14. Dena Bank Figure 20.2 List of banks nationalised in 1969 and 1980 In the meanwhile, another measure which was taken by the Government was the setting up of the General Insurance Corporation (GIC) in 1972, as a result of the nationalisation of 55 private general insurance companies and simu.tancous formation of four 4 public sector general insurance companies, namely, National Insurance Co. Ltd., Oriental Insurance Co. Ltd., The Oriental Insurance Co. Ltd. and The New India Assurance Co. Ltd. A major step taken during this phase was the setting up of Regional Rural Banks (RRBs) in 1975. These Banks were set up with the aim of serving the Rural Populace and to promote Financial Inclusion. This phase of development of the Financial System was also marked by establishment of Development Financial Institutions (DFIs) and the setting up of the Industrial Finance Corporation of India (IFCI) in 1948, marked the beginning of the era of development banking in India. The structure of development banking consisted of both all India as well as state-level institutions. U ider the State Financial Corporations Act, 1951, as counterpart of the IFCI at the state level, regional institutions, State Financial Corporations  - I FINANCIAL S -'S ‘ EW i’. O rr. 235 (SFCs), were organised to assist the small/medium enterprises. The establishment of the Industrial Credit and Investment Corporation of India (ICICI) Ltd, in 1955, represented a landmark in the diversification of development banking in India, as it was a pioneer in many respects like underwriting of issues of capital, channelisation of foreign currency loans from the World Bank to private industry, etc. One of the important roles of Reserve Bank of India has been the setting up of institutions that fostered economic development. These were institutions that had been hived off from different departments of RBI. Institutions that were so set up include the Industrial Development Bank of India (IDBI) in 1964, National Bank for Agriculture and Rural Development (NABARD) and Export Import Bank (EXIM), both set up in 1982, the National Housing Bank (NHB) set up in 1988 and the Small Industries Development Bank of India (SIDBI), which was set up in 1990. In the arena of Mutual Punds, a significant step was the setting up of the Unit Trust of India (UTI). Unit Trust of India (UTI) was established in 1963, by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978, UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. Whilst on one hand, a plethora of steps were being taken to develop the Indian economy and give it a socialist colour, the confidence of depositors was also required to be maintained - especially since there had been a number of bank failures, in the past. It was in I960 that the failure of Laxmi Bank and the subsequent failure of the Palai Central Bank which catalyzed the introduction of deposit insurance scheme in India. The Deposit Insurance Corporation (DIC) Bill received the assent of the President on December 7,1961 and the Deposit Insurance Corporation commenced functioning on January I, 1962, providing an insurance cover of Rs 1 lakh for every deposit customer. It was during this phase, in 1986, that BSE first Launched its equity index - the Sensex - which was built up ofthe top 100 shares, based on market capitalisation. The movement of the Sensex since its launch, till today, is itself a testimony of the crowth of the financial sector in the country and depicted in Fig. 20.3. Figure 20.3 Sensex chart since its inception in 1986 236 20.6 PHASE III - LIBERALISATION (1991 TO 2010) 20.6.1 What triggered liberalisation? 1991 was the year that India embarked upon liberalisation and opening of country’s economy to the world. There were three main economic reasons that led to this move. * In the scenario of planned economy, India predominantly looked inwards and this led to a slow rate of growth (approximately 3% pa) during the 1960s to 1980s. This was as against the rapid export- led growth witnessed in certain other parts of the world, especially the countries in South East Asia like South Korea, Thailand and the Philippines (! sian Tigers). * Since the 1960s, Indian exports were mainly to the Soviet Union (USSR) and Eastern bloc of countries. India even had a bilateral system of making payments, where the Indian Rupee could be used to settle import and export transactions and hard (foreign) currency was not required. After the dismantling of die USSR, these export markets went into disarray and India's exports plummeted. Exports markets in USA and Europe had not been tapped to any significant large extent by die Indian exporters. This led to a severe decline in India's exports. * A large component of India's imports was crude oil, as it is even today. With slowing exports and increasing demand for oil, the country's balance of payments was severely affected adversely. In August 1990, the first Gulf War broke out and the price of oil doubled from USD 15 per barrel to USD 33. This sharply jacked up India's import bill leading to a payment crisis in June 1991. To make matters worse, international credit rating agencies downgraded India twice, after February 1991, to junk status. The triple whammy of Actors jusl described pushed India to brink of bankruptcy with forex reserves covering only 3 weeks' imports, with forex reserves crashed to just under USD 1.1 billion. On 1st July 1991, India devalued the INR by 9%, followed by another 11% on 3rd July 1991. India was also forced to approach the World Bank and the IMF, for emergency loans and IMF approved a loan for USD 3.9 bn for which, the Indian Government had to pledge 67 tonnes of physical gold. The IMF loan came with stiff conditionalities, one of which was that die country had to liberalise its economy. One of the path-breaking financial sector reforms that were brought in was the direct result of the recommendations of the Narasimham Committee. There were two committees headed by Shri M Narasimham, former Governor of RBI and the recommendations of the two committees are enumerated here. 20.6.2 NarasimhamCommlttee-I (1991) The recommendations of the Narasimham Committee -1 were as follows: o Establishment of a 4-tier hierarchy for banking structure with 3 to 4 large banks (including SBI) at the top and, at the bottom, rural banks engaged in agricultural activities. o The supervisory functions over banks and financial institutions to be assigned to a quasi-autonomous body sponsored by RBI. o A phased reduction in Statutory Liquidity Ratio.  237 o Phased achievement of 8% Capital Adequacy Ratio. o Abolition of branch licensing policy. o Proper classification of assets and full disclosure of accounts of banks and financial institutions. o Deregulation of interest rates. o Setting up an Asset Reconstruction Fund to take over a portion of the stressed asset loan portfolio of banks. Based on the above-listed recommendations of the Narasimham Committee -I, the government implemented the following measures: 1. Lowering SLR and CRR: The high SLR and CRR reduced the profits of the banks. The SLR was reduced, in stages, from 38.5% in 1991 to 25% in 1997. This measure has resulted in increase in loanable funds with banking system for allocation to agriculture, industry, trade, etc. The CRR was brought down from 15 per cent in 1991 to 4.1 per cent in June, 2003. 2. Prudential Norms: Prudential norms were introduced by RBI, in order to impart professionalism in commercial banks. The purpose of introducing prudential norms included adequate disclosure of income, classification of assets and provision for bad debts, so as to ensure tnat the books of the banks reflect the accurate and correct financial position. 3. Capital Adequacy Norms: Capital Adequacy Ratio (CAR) is the ratio of minimum capital to risk- weighted assets. In April 1992, RBI fixed CAR at 8%, and by March 1996, all public sector banks had attained the ratio of 8%. 4. Deregulation of Interest Rates: The Narasimham Committee advocated that the interest rates should be allowed to be determined by the market forces. Since 1992, interest rates were freed, in stages, both for deposits as well as for advances. 5. Recovery of Debts: GOI passed the “Recovery of Debts due to Banksand Financial Institutions Act 1993" in order to facilitate and speed up the recovery of debts due to banks and financial institutions, and six Special Debt Recovery Tribunals were set up. 6. Competition from New Private Sector Banks: Banking was opened to the private sector and new private sector banks were licensed and started functioning. These new private sector banks are allowed to raise capital contribution from foreign institutional investors up to 20% and from NRIs up to 40%. Freeing of the banking space to private banks, led to increased competition. 7. Access to Capital Market: The Banking Companies (Acquisition and Transfer of Undertakings) Act was amended, in order to enable the banks raise capital through public issues. This was, subject to the provision that the holding oft entral Government would not fell below 51% of paid-up capital. 8. Freedom of Operation: Scheduled Commercial Banks are given freedom to open new branches and upgrade their extension counters, after attaining the required capital adequacy ratio and adhering to the prudential accounting norms. The banks are also permitted to close non-viable branches, in centres other than those in rural areas. 9. Local Area Banks (LABs): In 1966, RBI had issued guidelines for setting up Local Area Banks, and it gave its approval for setting up 7 LABs in the private sector. LABs were instrumental in mobilizing rural savings and in channelling them into investments, in the designated local areas. 10. Supervision of Commercial Banks: The RBI had set up a Board for Financial Supervision (BFS) with an Advisory Council to strengthen the supervision of banksand financial institutions. In 1993, RBI established a new department known as Department of Supervision, as an independent unit for supervision of commercial banks. 238 | UiD(A> £C C N'?M.- ; * i; i Z* 1 L> * *’J4f - SYSTEM 20.6.3 Narasimham Committee - It (1998) In 1998, the government appointed yet another committee under the chairmanship of Shri Narasimham. Better known as the Committee on Banking, it was mandated to review the progress in banking reforms and to recommend a path, for further strengthening the financial system in India. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc., and it submitted Its report to the government in April 1998, with the following recommendations. 1. Strengthening of Banks in India: The committee considered a stronger banking system, in the context of the Current Account Convertibility. It postulated that Indian banks must be capable of handling problems regarding domestic liquidity and exchange rate management in the light of the convertibility. Accordingly, it recommended the merger of strong banks which could have a ‘multiplier effect’ on the industry. 2. Narrow Banking: In those days, many public sector banks were facing problems of high non-performing assets (NPAs). Some of them had gross NPAs that were as high as 20% of their assets. Thus, for successful rehabilitation of these banks, it recommended the ‘Narrow Banking Concept’ whereby weak banks would be allowed to place their funds only in the short-term and risk-free assets. 3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking system, the committee recommended that the Government should raise the prescribed minimum capital adequacy norms to 9%. This would further improve their loss absorption capacity also. 4. Bank ownership: The committee opined that government control over the banks in the form of management and ownership and bank autonomy did not go hand in hand and thus, it recommended a review of the functioning of Boards of Banks so as to enable them to adopt professional corporate strategies. 5. Review of banking laws: The committee considered that there was an urgent need for reviewing and amending major laws governing the Banking Industry like RBI Act, Banking Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. These modifications would bring them in line with the obtaining needs of the banking sector in India. Apart from these major recommendations, the committee also recommended faster computerisation, technology up gradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc. 20.6.4 Other Steps taken for Liberalisation of the Financial Sector Some of the other steps taken for development of the financial sector in the liberalisation period (1991 to 2010) were: * Establishment of 3 credit rating agencies, namely, Credit Rating Information Services of India Ltd (CRISIL), Investment Information and Credit Rating Agency Ltd (ICRA) and Credit Analysis and Research Ltd (CARE). * Establishment of two stock exchanges, namely, the National Stock Exchange (NSE) Ltd. and the Over-The-Counter Stock Exchange of India (OTCEI) Ltd and introduction of screen-based trading  239 system in the capital market. NSE introduced screen-based trading at its inception in 1992, and this was followed by other stock exchanges. Screen-based trading made it possible to conduct on-line, electronic, anonymous and order-driven transactions from remotely situated trading terminals. The Depositories Act, 1996 was another landmark development in the history of India’s capital market. Thereafter, two depositories, namely, Central Depository Services Limited (CDSL) and National Securities Depository Limited (NSDL) were set up. The NSDL and CDSL have been successful in the dematerialisation of securities to the extent of 99% of the total market capitalisation. Another notable achievement in development ofthe capital market was the shortening ofthe settlement cycle and adoption of the rolling settlement method. Earlier on, the settlement cycle was as high as 14 days for spe rifled scrips and 30 days for others. The settlement risk was very high as many adverse situations could occur between the transaction and the settlement dates. Initially, the settlement cycle was reduced to a week. Thereafter, rolling settlement on a Tt5 basis was introduced in July 2001. The settlement cycle was further reduced to T+3 in April 2002 and to T+2 in April 2003. Foreign Institutional Investors (Fils) were permitted to invest in India in 1992, under the Portfolio Investment Scheme (PIS). They were allowed to participate in the Public Issues of debt and equities within the sectoral limits set for equities and the overall limit fixed for the debt instruments by the government. * In the post-1990 period, a notable development in the area of money market operations was the emergence of specialised institutions, namely, Primary Dealers (PDs), and Money Market Mutual Funds (MMMFs). These institutions serve as market makers and go to deepen the bond and government securities market in India. 20.6.5 Steps Towards Liberalisation in Other Sectors While the financial sector is one of the critical sectors in development of any nation, there has to be coordinated developments in other sectors, as well, in order for a nation to march ahead. Accordingly, in the case of India, sweeping reforms were also witnessed in the following areas: * Imports delicensed * Import duties reduced * Production licensing done away with License Raj abolished Trade policy reforms introduced * Fiscal reforms introduced * Exchange rate unpegged * Foreign exchange regulation relaxed (FEMA) FDI norms relaxed Disinvestment of Public Enterprises 20.7 PHASE IV- POST GLOBAL FINANCIAL CRISIS [GFC] (2010 TO PRESENT) There have been several crises that have faced economies, during the 20th and 21st centuries. Each of these crises has provided lessons to be leamt and has helped in formulating ways and means by which financial systems can become stronger and more robust. The Global Financial Crisis of 2007-08 (GFC) was one such crisis - probably the severest of them all, after the Great Depression of 1930. 240 The Global Financial Crisis originated in the United States mortgage market and, thereafter, extended to the rest of the world. The financial crisis forced the insolvency of many banks and financial institutions in the U.S. and the world. This led to collapse of a number of investing institutions spread across the globe, which had nothing to do with the US mortgage market, but had only invested their funds in the securities derived out of the sub-prime loans. In a nutshell, the whole financial system was frozen. The events that led to the Global Financial Crisis are depicted in Fig. 20.4, in the form of a flow chart. 1. Post 9/11 (attack on the World Trade Centres in New York), interest rates in USA crashed 2. Loans to consumers become cheap, leading to huge demands in mortgage loans 3. investment Banks securitise home loan portfolios so that the assets can be moved out of the balance sheets of the banks. 4. Interest rates on the securitised assets being higher, investors including foreign investors buy the securitised products 5. Banks flush with funds look for more borrowers and start financing sub-prime borrowers 6. Interest rates rise and sub-prime borrowers start to default. Banks foreclose homes and prices of homes crash 7. The cascading defaults lead to crash in price of the securitised products 8. Investors run up huge losses because of price crash. Some large investment banks foil 9. The crisis spreads across the world, due to contagion effect Figure 20.4 Flow of events leading to Global Financial Crisis (2007-2008) Although the rest of the world was reeling from the impact of the GFC, the impact on India was, fortunately, to a much lesser degree. This was mainly because India, to a large extent, was not as closely connected with the affected economies, as it could have been. Nevertheless, the RBI took a number of quick measures which helped in mitigating most of the risks that flowed out of the GFC. Some of the slew of measures taken by RBI, some in stages, were: The policy repo rate under the Liquidity Adjustment Facility (LAF) was reduced from 9.0% to 4.75%. The policy reverse repo rate under the LAF was reduced from 6.0% to 3.25%. Reduction of CRR from 9% to 5%. Reduction of SLR to 24%. Raising the interest rate ceiling on non-resident repatriable deposits to attract larger inflows. The ceiling rate on export credit in foreign currency was raised by 250 basis points to Libor+350 basis points, in order to conserve foreign exchange.  241 Increasing the ceiling rates on External Commercial Borrowings (ECBs) and foreign currency trade credit (buyers credit) - again for the purpose of conserving foreign exchange. Extending the time period for realisation of export proceeds from 6 months to 12 months. Banks were permitted to restructure stressed accounts, as a one-time measure, without classifying the restructured accounts as NPA, in all sectors apart from exposures to capital market and commercial real estate. Although the steps taken to protect the Indian financial sector from the ravages of the GFC, some of the measures like enabling one-time restructuring of accounts, without slippage in asset classification, led to many unviable accounts being given a fresh lease of life, which unfortunately turned out to be unsustainable. It led to a behaviour of “kicking the can down the road” - as was famously described by the former RBI Governor, Dr Raghuram Rajan. This action of putting stressed accounts on oxygen, led to accumulation of a spate of bad accounts, which in turn threatened to cripple the balance sheets of ba nks. A number of reform measures have been taken during the post-GFC phase, both for consolidating the financial sector and giving it extra teeth to deal with NPAs, as well as measures which promote moving the financial sector to undergo a paradiem change, by harnessing new cutting-edge technologies and associating with FinTech companies. This phase of development of the financial sector has been marked by the following: Strengthening the drive for financial inclusion by introduction of the Prime Minister's Jan Dhan Yojana (PMJDY) and leveraging of the JAM Trinity (Jan-Dhan, Aadhar and Mobile) Licencing of differentiated banks, namely, the Payments Banks and Small Finance Banks. These were theme direct result of the recommendations of the Nachiket Mor Committee on Comprehensive Financial Services for Small Businesses and Low-Income Households, set up by the RBI in September 2013. Setting up of the P J Nayak Committee (officially known as the ( ommittee to Review Governance of Boards of Banks in India), by the RBI in 2014, to review the governance of the board of banks in India. The Committee, which was chaired by P J Nayak, the former Chairman and CEO of Axis Bank Ltd, was mandated to examine the following: o To look into various problems related to bank boards - such as standards of specification, pol icy, legal, etc. and to suggest measures to be taken. o To examine the working of bank boards and issues of strategy, growth, governance and risk management in banks. o To review the RBI guidelines on Government ownership in banks. o To analyze the work, conflict of interest and independence in the bank boards and make suggestions towards the same. o To assess the fit and proper criteria for directors and their tenures. o To examine board compensation guidelines. Setting up of the EASE (Enhanced Access Service Excellence) agenda, for calibrating die performance of Public Sector Banks and fostering healthy competition and collaboration amongst these banks. Consolidation amongst PSU Banks, in order to reduce the number of such banks from 27 to 12. Operationalising the Insolvency and Bankruptcy Code (1BC), for speedy resolution ofstressed assets in order to preserve and protect economic wealth. Taking steps to set up National Bank for Financing Infrastructure and Development (NaBFID), as the apex Development Financial Institution. 242 Taking steps to set up the National Asset Reconstruction Co. Ltd (NARCL - or ‘Bad Bank’) to take over, initially, impaired assets to die extent of about Rs 2 lakh crores from commercial banks for recovery of the same. * Amending the Banking Regulations Act, so as to bring the Cooperative Banks, under the supervision and control of RBI. Increasing the deposit insurance cover, extended by Deposit Insurance Corporation from Rs 1 lakh to Rs 5 lakhs, per customer. Bringing in sweeping changes in the Payments and Settlements space, to make it amongst the best in the world, including introduction of the Unified Payment Interphase (UPI), making both NEFT and RTGS systems, round the clock (24 x 7), etc. * Increasing the FDI limit in the insurance sector, from 49% to 74%. * Taking steps for launching Initial Public Offering (IPO) for Life Insurance Corporation (LIC). 20.8 PRESENT STATUS OF THE BANKING SECTOR The total number of hanks in inaia, and their number, category-wise is depicted in Fig. 20.5. PUBLIC RBI PAYMENTS BANKS (6) CtXWLRAmi iwn Source RBI. Figure 20.5 Number of Banks in India (categorywise) As on 31st March 2021, scheduled commercial banks had a total of 158,416 functional branches spread over entire India. In addition to that, there were 213,575 ATMs, of which, 115,605 were on-site and 97,970 were off-site. LET US SUM UP In any economy, there are entities who are savers and there are entities who are the investors. The role of a financial system is to transfer the capital from the savers to the investors. Financial system consists of financial institutions, financial instruments and financial markets. Development of the financial system in India was in four phases, from pre-independence to the present post Global Financial Crisis phase.  243 KEYWORDS Commercial Banks; Cooperative Banks; NBFCs; Development financial institutions; Global Financial Crisis; Enhanced Access Service Excellence (EASE); Insolvency and Bankruptcy Code (IBC). check your progress L Which of the following is not part of the informal financial system? (a) Moneylender (b) Mutual fund (c) Relatives (d) Mahajan 2. Which of the following is not pan of the formal financial system? (a) Association (b) Banks (c) NBFCs (d) Insurance company ’ Which of the following is/arc part of the financial system? (a) Financial market (b) Financial instrument (c) Financial institution (d) All of the above 4. Which was the first bank to be established in India? (a) Bank of India (b) State Bank of India (c) Bank of Hindustan (d) Punjab National Bank 5. In which nhase of development of the financial system was focus laid on setting up of Development Financial Institutions? (a) Phase 1 (b) Phase II (c> Phase III (d) Phase IV ANSWERS TO CHECK YOUR PROGRESS 1: (b); 2: (a); 3: (d);4: (c); 5: (b) REFERENCES 1. Indian Financial System- Bharati V. Pathak 2- Indian Financial System -MY Khan  INDIAN BANKING STRUCTURE STRUCTURE 21.0 Objective 21.1 Introduction 21.2 What is Banking? 21.3 History of Banking in India 21.4 Important Legislations affecting Establishment of Banks 21.5 Types of Banks 21.6 Scheduled Banks 21.7 Non-Scheduled Banks 21.8 Public Sector Banks 21.9 Private Sector Banks 21.10 Foreign Banks 21.11 LocalArea Banks 21.12 Regional Rural Banks 21.13 Differentiated Banks 21.14 Cooperative Banks 21.15 Role of Fintech, Techfins and NeoBanks in Indian Economy 21.16 Payment Eco-System 21.17 Recent developments in the Banking Sector Let Us Sum Up Keywords Check Your Progress Answers to Check Your Progress 246 21.0 OBJECTIVE The objective of this Unit is to provide an overview to the readers with regard to the importance of banks in the financial system in India. As a key component of the financial system, banks allocate funds from savers to borrowers, in an efficient manner. They provide specialized financial services, which reduce the cost of obtaining information about both savings and borrowing opportunities. In this unit, we discuss more about the various types of banks and financial agencies operating in the system. 21.1 INTRODUCTION Banks perform various roles in die economy. First, they ameliorate the information problems between investors and borrowers, by monitoring the latter and ensuring a proper use of the depositors * funds. Second, they provide intertemporal smoothing of risk that cannot be diversified at a given point in time, as well as insurance to depositors against unexpected consumption shocks. Because of the maturity mismatch between their assets and liabilities, however, banks are subjected to the possibility of runs and systemic risk. Third, banks contribute to the growth of the economy. Fourth, they perform an important role in corporate governance. The relative importance of the different roles ofbanks varies substantially across countries and times but, banks are always critical to the financial system. 21.2 WHAT IS BANKING? Banking is classically defined in the Banking Regulations Act, 1949 (BR Act). As per Section 5(1) (b) of the BR Act, banking is ‘the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise.’ Section 5(l)(c), further defines a banking company as any company which transacts the business of banking in India. Section 6 of the BR Act defines, in detail, the types of activities that banks are authorised to carry out, although under modem day banking, banks have embraced many other types of activities, too. The traditional types of businesses that banks undertake are acceptance of deposits, exunding loans and advances and other miscellaneous services. Deposits from customers are of two basic types, viz., demand deposits and time (or, term) deposits. While the demand deposits, as the name suggests, are those deposits for which, the depositor can demand repayment any time, term deposits are those which are placed in banks for fixed periods of time and are repayable to the depositor, only on the maturity date. While there are several types of advances that banks extend to their customers, they can be classified into two broad segments, viz., fund-based facilities and non- fund-based facilities. Fund-based facilities include those repayable on demand like demand loans, overdrafts and cash credits, whereas term loans are those extended for procuring capital items /equipment like plant and machinery, etc. and which are contracted to be repaid only in periodical instalments, or at the end of the period of the loan. Non- fund-based facilities are those where the bank does not actually provide hard cash, but enhances the creditworthiness of their customers, by ‘lending their name? Examples of such facilities are Letters of Credit, Bank Guarantees, Bills Co-Acceptance Facilities, etc.  247 Besides the primary functions of mobilising deposits and giving advances, banks provide a range of miscellaneous services, including transfer of hinds, collection of bills, foreign exchange services, safe deposit lockers, safe custody of documents, executor and trustee services, gift cheques, merchant banking, etc. Another important aspect on banking in India is that, in terms of Section 7