Module 1 Financial System PDF

MODULE 1 FINANCIAL SYSTEM Financial system refers to a set of activities, which facilitate transfer of resources from savers to borrowers. It is an institutional framework existing in a country to enable financial transactions. It comprises of financial instituti...

MODULE 1 FINANCIAL SYSTEM Financial system refers to a set of activities, which facilitate transfer of resources from savers to borrowers. It is an institutional framework existing in a country to enable financial transactions. It comprises of financial institutions, financial markets, financial instruments and financial services. This system provides for regular, smooth efficient and cost effective linkage between depositors and investors. Unorganised financial markets are also part of the financial system. These are interdependent components. A financial system may be defined as a set of institutions, instruments and markets which foster savings and channelise them to their most efficient use. Features of Financial System A well developed financial system is characterised by the existence of an integrated, organized and well regulated financial markets, innovative financial instruments, services and dynamic institutions that meet the short term and long term financial needs of individuals, government and corporate segments. (i) Organised and unorganised financial markets are part of financial system. (ii) It regulates transactions between various economic units (i.e., Govt., Industry and Household) (iii) Financial system provides a linkage between depositors and investors. (iv)It promotes efficient allocation of financial resources. (v) It promotes economic development. (vi) It facilitates expansion of financial markets. (vii) It aids in financial deepening and broadening.  Financial deepening may be defined as the process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost.  Financial broadening means offering a wider range of financial goods and services with different maturities, risks and returns from a variety of financial intermediaries. COMPONENTS OF FINANCIAL SYSTEM The Indian financial system consists of financial markets, financial Instruments, financial institutions and financial services. 1  1. FINANCIAL MARKETS A financial market is an institutional arrangement that facilitates the exchange of financial assets, including deposits and loans, stocks and bonds, options and futures. The financial markets may be orgainsed or unorganised. An organised financial market is a recognised and formal market governed by rules and regulations and controlled by market regulators. Organised sector of financial market consists of two important markets viz., money market and capital market. Money market comprises of groups of connected sub-markets, which deal in money, and monetary assets of short-term nature such as call money, treasury bills, bills of exchange etc. Capital market consists of a number of institutions which borrow lend for long-term such as equity, debentures, bonds etc. Capital market further divided into Industrial securities market and Government securities market. Primary market and secondary markets are the two major segments of capital market. Primary market is the market where securities are issued for the first time. Securities issued in the primary market are traded in the secondary market i.e., stock exchanges. A well developed and well functioning financial market is necessary for economic growth of any country. Unorganised financial market is an informal arrangement for financial intermediation by individuals or firms characterized by exorbitant interest rates, exploitation, non-standardised procedures and are out of the purview of market regulators. 2 2. FINANCIAL INSTITUTIONS Financial institutions are organizations that mobilize savings and provide finance or credit to individuals and organizations. These institutions are necessary for free, fair and transparent market operations. Regulatory Institutions play a regulatory role in the market by controlling other financial institutions and ensuring fair and transparent market operations. They include Ministry of Finance (MoF), SEBI, RBI etc. Financial institutions are also called Financial Intermediaries because they act as middlemen between lenders and borrowers. Financial institutions can be classified into three: viz. i. Monetary or Banking Financial institutions, ii. Non-monetary or Non-banking institutions, iii. Specialized Financial institutions. Monetary institutions include central bank, commercial banks, RRBs, Co-operative banks etc. Non-monetary institutions comprise of NBFCs, Investment companies, leasing firms, VCFs etc. Specialised institutions include state level financial institutions (like SFCs, SIDCs) industrial development banks, industrial co-operatives etc. The various institutions can be listed as follows. A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, leasing, hire-purchase, insurance business, chit business. It does not include any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property. An NBFC cannot accept demand deposit or issue cheques to the customers. All NBFCs should register with RBI. Asset Finance Company (AFC), Investment Company, Loan Company etc. are the different classes of NBFCs. Small Finance Banks & Payment Banks RBI has granted in principle approval to start small finance and payment banks in India recently. Entities with a small finance bank license can provide basic banking service within limited area of operation. The objective is to financially include sections of the economy not being served by other banks, such as small business units, small and marginal farmers, micro and small industries and unorganised sector entities. Example, ESAF Small Finance Bank Payment banks can accept deposits (up to ₹ 1,00,000 per customer) but cannot undertake lending activities. They offer small savings accounts, payment/remittance services to migrant labour, low income households small businesses etc. These banks will be extensively operated on technology, to reduce operational costs. Examples, India Post Payments Bank, Paytm Payments Bank etc. 3  3. FINANCIAL INSTRUMENTS The term "Financial instrument' is used for a variety of written legal claims on money that are transferable from one person to another. Financial instruments are documentary evidence of claim against an individual/firm/ state for payment of principal and/or interest or dividend on a specified maturity date or on the spot. They are issued by financial intermediaries in financial markets for channelising funds from lenders to borrowers. Basically financial instruments/securities are of primary or secondary nature. Primary or direct instruments are directly issued by the ultimate borrowers (companies) in the market to the ultimate savers (investors). E.g., Equity Shares, Debentures etc. Secondary or indirect instruments are issued by financial intermediaries to the ultimate savers. E.g., Mutual Fund Units, Insurance Policies etc. Financial instruments are broadly classified into money market instruments like call money, certificate of deposits, treasury bills etc. and capital market instruments like equity shares, bonds, debentures, derivative instruments etc. The demand and supply of money by the participants in the financial markets are catered to through these instruments. Financial instruments differ in terms of rate of return, marketability, nature, risk, transaction cost etc. 4. FINANCIAL SERVICES Financial services are activities and benefits connected with sale of money or money's worth. They facilitate financial transactions of individual and institutional investors. Financial services cover a wide range of activities including insurance, banking and credit services such as merchantbanking, mutual funds, venture capital financing, leasing, stock broking, hire purchase, housing finance, portfolio management, credit rating, consumer finance, factoring, custodial services etc. The financial services offered in the financial market can be categorized into five viz. Funds Intermediation, Payments Mechanism, Provision of Liquidity, Risk Management and Financial Engineering. 4 Development of Indian Financial System  The Pre-Independence financial system was unorganized and weak. With limited number of financial intermediaries and absence of a mechanism to mobilize savings, the industrial sector had no access to the savings of the economy. Capital market was primitive and the unorganized sector played a major role in the provision of finance.  Development since independence: The Indian Financial System has The undergone a remarkable change since Independence. By the adoption of mixed economic system, govt. resorted to a planned financial system which essentially includes control over credit and finance. Government started to strengthen the institutional structure by establishing development financial institutions, term lending institutions and banks RBI was nationalized in 1949 to act as a regulator and supervisor of financial intermediaries and facilitate the development of the system. The governancal continues its nationalition policy to bring about banks and insurance companies unser its ambit and stregthen the institutional infrastructure of the financial system These developments resulted in the formation of a closed financial system controlled by the state. From the mid-1960 to the early 1990 Indian Governments, in effect, treted the financial system as an instrument of public finance. A comples web of regulations fixed the details of deposit and lending rates and loan amounts, channeling credit to the government and prionty sectors at below market rate. Thie hindered the growth of industry and other related sectors which are in need of finance. Entry and growth restrictions (MRTP Act. 1969), industrial licensing, restriction on foreign firms and capital (FERA, 1973) controlled issue pricing (Capital Issues (Control) Act, 1947), lack of financial innovations, lack of efficient financial markets, dominanance of public financial institutions, directed credit, and a host of other reasons resulted in reduced capital formation and economic growth  Development of Indian Financial System after 1991 Indian financial system has undergone a sea change with the economic reforms in 1991. The reforms included opening for international trade and investment, deregulation, initiation of privatization, lax reforms, and inflation-controlling measures. This initiated the LPG regime (Liberalisation, Privatisation & Globalisation) in India. The major developments during the post economic reforms are;  Abolishment of the Controller of Capital Issues (which decided the prices and number of shares that a firm could issue) in 1992. This was a break through reform in the Indian financial system.  Introduction of the SEBI Act, 1992 which gave SEBI the legal authority to register and regulate all security market intermediaries.  Gradual liberalization of interest rates, commencing in 1992.  Measures were introduced to liberalise credit allocation, improve regulation and supervision, liberalise capital account etc.  Starting of Over the Counter Exchange of India (Estd. in 1990) in 1992. It was set up to aid enterprising promoters in raising finance for new projects in a cost effective manner and to provide investors with transparent & efficient mode of trading. 5   Establishment of the National Stock Exchange (1994) with screen based trading system. This was a motivation for reforms of Indias other stock exchanges.  In 1992, Indian firms permitted to raise capital from international markets by issuing bonds and Global Depository Receipts.  Establishment of National Multi-Commodity Exchange (NMCE) the country's online, demutualised, multi-commodity exchange with nation-wide reach in 2002.  Liberalisation of the restrictions on foreign direct investment.  Allowed Foreign Institutional Investors to invest in securities and repatriate capital and earnings. Gradually they were allowe to invest in Government and corporate debt securities.  Encouraging foreign direct investment by increasing the maximum limit on share of foreign capital in joint ventures from 40 to 51 percent with 100 percent foreign equity permitted in priority sectors  Foreign Exchange Management Act 2000 was enacted by repealing FERA 1973.  Development of a share Depository in 1996, National Securities Depositories Ltd (NSDL)according to the provisions of Depositories act 1996.  Introduction of new variety of innovative financial instrumen including hybrid and customizable products (e.g., Credit Default Swap (CDS).  Development of sub-markets like Foreign exchange, derivativer commodity market etc.  Establishment of Credit rating agencies (CRISIL, ICRA, CARE etc.) jointly by development banks and all India financial institutions for facilitating informed investing and risk reduction.  Enactment of Fiscal Responsibility and Büdget Management Act 2003, for reducing fiscal deficit. This will reduce the macroeconomic volatility and increase the availability of finance to the private sector.  Developments in Banking Sector  Entry of new private and foreign banks and easing of restrictions of foreign banks.  Reduced Cash Reserve and Statutory Liquidity Requirements  Measures to improve credit quality and risk management.  Tightening of Prudential Norms and NPA (Non-Performing Assets) and Improved Banking Supervision  Implementation of BASEL II norms.  Diversification to various areas like merchant banking, underwriting, lease financing, venture capital financing, factoring, portfolio management, Mutual Funds etc.  Development of Pension and Insurance sector for increased finance for long term investment  Private insurance companies are allowed to enter. IRDA Act 1999 passed and Insurance Regulatory and Development Authority formed to regulate the insurance market.  Private players are allowed to operate pension funds. Constitution of Pension Fund Development and Regulatory Authority in 2003 to regulate and develop the Indian pension sector. 6  Entrance of Private sector mutual funds. This offers wide range of investment options to Indian investors and efficient mobilisation of public savings.  Adoption of Book Building mechanism for pricing of issues. This facilitates efficient pricing of new issues based on market demand, and effective channelization and utilisation of savings.  Non-banking financial corporations (NBFCs) were allowed to operate. They offer lease finance, housing finance, corporate counselling and other services.  Developments in financial services sector to improve the welfare and satisfaction of customers with financial innovation and engineering. Recent Developments in Indian Financial System Few major developments happened recently in our financial system are i. Foreign companies are allowed to raise capital by issuing Indian Depository Receipts. ii. Establishment of a 'Commission for legislative reforms' in financia sector in 2010 and the issue of licenses for establishment of new banks for corporates and existing NBFCs. Two new private banks were given licence in 2014 viz. IDFC Ltd. and Bandhan Financial Services Pvt Ltd iii. Govt. opened domestic equity market to qualified foreign investos Services (QFIs), Foreign individual investors can invest in public issues. The will increase overseas capital inflows. iv. The merger of the Forward market Commsmission with SEBI (in Sept 2015) increased the scope and functions of SEBI as a unified regulator for Securities and derivatives. This will help in strengthen the regulation of commodity forward markets and reduce wild speculation. v. Establishment of Micro Units Development & Refinance Agency Ltd (MUDRA) a new institution for development and refinancing activities relating to micro units. The purpose is to provide funding to non corporate small business sector. It will refinance all financiers engaged in financing of small businesses. vi. Recently RBI has granted licences to ten Small finance banks and eleven Payment banks. These banks will reach into unbanked areas and underserved sections of the population. Small finance banks can undertake basic banking operations in a limited geographical area. Payment banks can accept deposits and provide payment services, but cannot lend. This is regarded as the biggest banking revolution in India since nationalisation and termed as 'Banking Revolution 2.0 vii. Shift towards Digital economy and digital payments after demonetisation. The demand for digital payment options and mobile payments systems increased tremendously with the Governments support. viii. Establishment of a Monetary Policy Committee (MPC) with much role for the Government, which is responsible for fixing benchmark interest rates in India. The MPC replaces the current system where the RBI governor, with the aid and advice of his internal team and a technical advisory committee, has complete control over monetary policy decisions. 7  ix. Introduction of Goods and Service Tax in 2017, is the biggest tax reform in India since 1947. This will have a huge impact on various sectors of the Indian economy Role and Functions of Financial System In a market economy, the financial system performs a number of important functions influencing the efficiency of the economy as a whole. A dynamic financial system encourages savings to flow into money and monetary assets which promotes investment and capital formation and facilitate economic development. A good financial system ensures that savings are allocated in an efficient manner so that the scarce financial resources are effectively utilised. Important functions can be listed as follows: i. Mobilisation of savings and allocating them to projects. ii. Reallocation of accumulated old savings to projects and firms. iii. Organisation of the payment and settlement system to ensure sa and quick movement of funds iv. Provision of liquidity of financial claims and securities. v. Provision of a good corporate governance system vi. Generation of information for economic/financial deciston making vii. Creation of innovative schemes and features to make finan instruments attractive to investors ie., financial innovation viii. Management of uncertainty and risk associated with mobilicati of savings and allocation of credit. ix. Encourage investments by lowering cost of transactions and offering increased rate of return to investors. x. Facilitate judicious allocation of financial resources for the economi development of the nation. xi. Facilitate financial engineering (development of new and improves financial products or repack existing ones) in financial instruments, market, services etc. to ensure better performance of the system. xii. Promoting capital formation by channelising the flow of savings int productive investments. xiii. Facilitate the integration of the domestic economy with that of other foreign economies i.e., globalisation of the economy. Thus, it is clear that "without sound financial system economic progres will be impossible". CLASSIFICATION OF FINANCIAL MARKETS Financial Market is the market where financial securities like stocks, bonds etc are exchanged at efficient market prices. The trading of financial instruments in the financial market can take place directly between buyers (lenders) and sellers (borrowers) or by the medium of stock exchanges. There are various segments or sub-markets like equity markets, debt markets, derivative markets, foreign exchange markets etc with the respective primary and secondary wings/segments. The main organized financial markets in India are the money market and the capital market. 8 Types of Financial Markets  The Capital Market - It is a market for long-term equity and debt instruments.  The Money Market - It is a market for short-term debt instruments. CAPITAL MARKET Capital market is a market for long term capital. It is a comprehensive term consisting of all the facilities and institutional arrangements for borrowing and lending long term capital. Business enterprises, government and other organisations raise finance from this market to meet their long term requirements. The capital is collected through the issue of shars debentures and other financial instruments. Initially, shares are issued by company in the new issue market. These shares are traded in the Seconds market. Thus, new issue market (primary market) and Secondary Mari (Stock Exchanges) are two wings of capital market. Significance / Functions of Capital Market A well organised and regulated capital market facilitates sustainable development of the economy. They provide fund for investment and investors get returns. Thus, allocation of funds and flow of funds from less profitable to more profitable avenues, and the intermediation betwer savers and investors, are the major functions of the capital market. The functions performed by an efficient capital market are as follows: i. Capital market promotes capital formation and thereby economic growth. ii. It mobilises savings of the people for investment. iii. It chanalises the funds to the most productive sector. iv. It increases production and productivity and enhances economic welfare of the society. v. It makes possible the technological upgradation in the industrial sector with the chanalised funds. vi. It helps the corporate sector expand, grow and diversify leading to the growth of the economy. vii. The borrowers with deficit have funds from lenders with surplus in the capital market. Capital Market Instruments Financial instruments mean documents that evidence the claims and income or assets. The financial instruments through which corporate rand fund can be divided into Ownership instruments/securities and Creditorship instrument/securities. Ownership securities are equity shares and preference shares which represents ownership in the issuing company. They are also known as 'Capital Stock'. Creditorship securities include debentures, bonds etc and the holders of such instruments are the creditors of the issuing company. They are also referred to as 'Debt Capital'. 1. Equity Shares -Equity shares constitute the ownership capital of a company. Equity holders are the legal owners of a company. It is an instrument, a contract, which 9  guarantees a residual interest in the assets of an enterprise after deducting all its liabilities, including dividends on preference shares. Equity shares are regarded as the corner stones of the capital structure of a company. They are the source of permanent capital which does not have a maturity date. As the owners of equity shares, the equity shareholders participate in the management of the company through the elected board of directors, and through the voting rights in important decisions. They share the profits and assets in proportion to their holding in the net assets of the company. Equity shareholders are eligible for the entire balance of profit available after paying dividend to preference shareholders. Forms of Equity Shares a) Equity Shares with Detachable Warrants: Fully paid up shares can be issued with detachable warrants. This will enable the warrant holder to apply for specified number of equity shares at pre determined price within a given time. Detachable warrants are registered separately with the stock exchange and traded separately. b) Shares with Differential Voting Rights (SWDVR): Shares with differential voting rights are shares which 'carry more votes than ordinary shares do. Section 86 of the Companies Act permits the issue of equity shares with DVRs, subject to conditions. Tata Motors Ltd. (November 2008) became the first company to issue equity shares with differential voting rights in India. c) Non-Voting Shares (NVS): Non-Voting Shares (NVS) do not carry voting rights. But the holder of NVS is eligible for higher dividend for sacrificing the voting rights. d) SWEAT Equity Shares: These are equity shares issued by the Smpany to its employees or directors at a discount of the consideration other than cash as recognition for providing the know-how, intellectual property rights or other value additions to the company. Employees will be given an option to purchase shares of the company on favourable terms. The scheme of offering SWEAT equity shares is called Employee Stock Option Plan (ESOP). 2. Preference Shares The Companies Act (Sec 85) describes preference shares as those which i. Carry a preferential right to payment of dividend during the life time of the company. ii. Carry a preferential right for repayment of capital in the event of winding up of the company. Preference shares have the features of equity capital and features of fixed income like debentures. Preference shareholders get priority to dividend. They are paid a fixed dividend before any dividend is declared to the equity holders. Preference shares are non-participatory. This means that the holders of such shares are not entitled for a share in the extra profit earned by creditors. Preference shares are given preference in next to creditors. Preference share holders have no voting right on ordinary matters of corporate 10 Types of preference shares a) Redeemable preference shares: These shares are redeemed after a given period. Such shares can be repaid by the company on certain conditions, viz. ✓ The shares must be fully paid up. ✓ It must be redeemed either out of profit or out of reserve fund for the purpose. ✓ The premium must be paid, if any. b) Irredeemable preference shares: These shares are not redeemable except on the liquidation of the company. However, under the Indian Companies Act, a company cannot issue irredeemable preference shares. Because the Companies Act insists that the maximum tenure of preference shares should be 10 years. c) Convertible preference shares: Such shares can be converted to equity shares at the option of the holder. Hence, these shares are also known as quasi equity shares. d) Participating preference shares: These kinds of shares are entitled to get regular dividend at fixed rate. Moreover, they have a right for surplus of the company beyond a certain limit. e) Cumulative preference shares: The dividend payable for such shares is fixed. The dividend not paid in a particular year can be cumulated for the next year in this case. f) Preference shares with warrants: This instrument has a certain number of warrants. The holder of such warrants can apply for equity shares at premium. g) Fully convertible cumulative preference shares: Part of such shares are automatically converted into equity shares on the date of allotment. The rest of the shares will be redeemed at par or converted in to equity after a lock in period at the option of the investors. 3. Debenture Debenture is an instrument under seal, evidencing debt. The essence of debenture is admission of indebtedness. It is a debt instrument issued by a company with a promise to pay interest and repay the principal on maturity. Debenture holders are creditors of the company. Debenture includes debenture stock, bonds and other securities of company. It is customary to appoint a trustee, usually an investment bank, to protect the interests of the debenture holders. This is necessary a debenture deed would specify the rights of the debenture holders and the obligations of the company. Types of debentures a) Secured debentures:-Debentures which create a charge on the property of the company is a secured debenture. The charge may be floating or fixed. The floating charge is not attached to any particular asset of the company. Fixed charge debentures are those where specific asset or group of assets is pledged as security. The details of these charges are to be mentioned in the trust deed. 11 b) Unsecured debentures: These are not protected through any charge by any property or assets of the company. They are also known as naked debentures. c) Bearer debentures: Bearer debentures are payable to bearer and are transferable by mere delivery. Interest coupons are attached to the debenture certificate. As interest date approaches, the appropriate coupon is 'clipped off by the holder and deposited in his bank for collection. Such debentures are negotiable by delivery. d) Registered debentures: In the case of registered debentures the name and address of the holder and date of registration are entered in a book kept by the company. The holder of such a debenture bond has nothing to do except to wait for interest payment which is automatically sent to him on every payment date. e) Redeemable debentures: When the debentures are redeemable, the company has the right to call them before maturity. f) Convertible debentures: When an option is given to convert debentures in to equity shares after a specific period, they are called convertible debentures. g) Non-convertible debentures with detachable equity warrants: The holders of such debentures can buy a specified number of shares from the company at a predetermined price. The option can be exercised only after a specified period. 4. Bonds -Bonds are debt instruments that are issued by companies/governments to raise funds for financing their capital requirements. By purchasing a bond, an investor lends money for a fixed period of time at a predetermined interest (coupon) rate. Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, half-yearly or annually. Interest is calculated as a certain percentage of the face value and known as 'coupon payment. Bonds can be issued at par, at discount or at premium. A bond, whether issued by a government or a corporation, has a specific maturity date, which can range from a few days to 20-30 years or even more. Both debentures and bonds mean the same. In India, debentures are issued by corporates and bonds by government or semi-government bodies. But now, corporates are also issuing bonds which carry comparatively lower interest rates and preference in repayment at the time of winding up, comparing to debentures. The government, public sector units and corporates are the dominant issuers in the bond market. Bonds issued by corporates and the Government of India can be traded in the secondary market. Banks, Mutual Funds, Insurance Companies, Provident Funds, Primary Dealers, FIIs, etc., are the major investors in bonds. Basically there are two types of bonds viz. 1. Government Bonds are fixed income debt instruments issued by the government to finance their capital requirements (fiscaldeficit) or development projects 2. Corporate Bonds are debt securities issued by public or private corporations that need to raise money for working capital or for capital expenditure needs. 12 The different types of bonds can be classified as follows: a) Zero Coupon Bonds: Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. These types of bonds are also known as Deep Discount Bonds. b) Mortgage bonds are secured by physical assets of the corporation such as their building or equipment. c) Convertible Bonds: This type of bond allows the bond holder to convert their bonds into shares of stock of the issuing corporation Conversion ratio (number of equity shares in lieu of a convertible hond) and the conversion price are pre-specified at the time of bonds issue. d) Step-up Bonds: A bond that pays a lower coupon rate for an initial period which then increases to a higher coupon rate. e) Callable and Non-Callable Bonds: If a bond can be called (redeemed) prior to maturity, the bond is said to be callable. If a bond cannot be called prior to maturity, it is said to be non-callable. f) Option Bonds: In this type, the investors have the option to choose between cumulative or non-cumulative bonds. In the case of cumulative bonds interest is accumulated and is payable on maturity only. In non-cumulative type interest is paid periodically. g) Bonds with Warrants: A warrant allows the holder to buy a number of equity shares at a pre-specified price in future. Bonds are issued with warrants to make it more attractive. h) Floating Rate Bonds: Floating rate bonds are bonds wherein the interest rate is not fixed and is linked to a benchmark rate. ΜΟΝΕΥ MARKET Money market is a market for borrowing and lending short term funds. This is one wing of the financial system dealing in short term financial assets and debt instruments like treasury bills, commercial papers etc. Banks, Financial Institutions (Fls), Companies ete use these short term debt instruments to meet their short term requirements either by lending or through borrowing. These instruments can be readily converted into cash without loss. They are also considered near substitutes of money because of their high liquidity. They are of short term nature extending from few days to few months but less than one year. The major players in the money market are Reserve Bank of India (RBI), Discount and Finance House of India (DFHI) (now SBI DFHI), banks, financial institutions, mutual funds, government and big corporate houses. The basic aim of dealing in money market instruments is to fill the gap of short-term liquidity problems or to deploy the short-term surplus to gain income on that. RBI defines money market as "a market for short term financial assets that are close substitute for money, and facilitates the exchange of money in primary and secondary market". 13  Features of Money Market i. Money market has no geographical constraints as that of a stock exchange.. The financial institutions dealing in monetary assets may be spread over a wide geographical area. ii. It is a wholesale market of short-term debt instruments. iii. It relates to all dealings in money or monetary assets iv. It is a market purely for short-term funds v. It is not a single homogeneous market. There are various sub-markets such as call money market, Bill market, etc. i.e., it is a collection of markets for various instruments. vi. Money market establishes a link between RBI and banks and provides bi for implementation of monetary policy and liquidity management. vii. No fixed place for conduct of operations, transactions can be conducted even over the phone. viii. Transactions can be conducted with or without the help of brokers. ix. Variety of short-term debt instruments with maturity period less than one year are traded in money market. Objectives of Money Market A well developed money market serves the following objectives/functions: i. Providing parking place for temporary employment of surplus fund. ii. Providing facility to overcome short term deficits. iii. Enabling the central bank to influence and regulate liquidity and interest rates in the economy. Money Market Instruments Money market instruments facilitate transfer of large sums of money quickly and at low cost from one economic unit (business, government banks, non-banks and others) to another for relatively shorter period of time. The instruments of the money market are liquid assets, and interest bearing debts that mature within a short period of time. The maturity period of these instruments may vary from one day to one year. The important money market instruments are:  Commercial Papers (CPs)  Certificate of Deposits (CDs)  Treasury Bills (T-Bills)  Commercial Bills (CBs)  Call Money  Repurchase Agreements (REPOS) The markets where these instruments are traded are known as the sub- markets of money market. It consists of call money market, commercial bills market, discount market, 14  acceptance market, treasury bill market, Certificate of deposits market etc. All these sub markets are collectively known as money market. 1. Commercial Papers (CPs) Commercial Paper is an unsecured promissory note issued by a company with a fixed maturity, and approved by RBI. This was introduced in India in 1990. The period of maturity may range from 7 days to one year. The instrument is negotiable by endorsement and delivery. It is usually issued at a discount on the face value. It is a debt instrument issued by large credit-worthy companies as a means for short term finance (working capital needs). The total amount of CP issue should not exceed the working capital limits sanctioned by banks or financial institutions. In addition to highly rated corporates (CRISIL P-2 or equivalent rated), primary dealers and all India financial institutions are also allowed to access short-term finance through CPs. The minimum size of issue shall be ₹5 lakhs and multiples there of. Manufacturing companies, Leasing and Finance Companies, Mutual Funds and Financial Institutions are the major issuers of commercial papers. The net worth of the issuing company shall be ₹ 4 crores (as per latest audited balance sheet) or more. CPs can be issued to individuals, bank NRIs and FIIs. However, scheduled banks are major investors in CPs. Advantages of CPS i. The issue and transaction of a commercial paper is simple. The is not much documentation between the issuer and investor ii. It is a flexible instrument. The maturity date can be tailored as the cash flow of the company. iii. Corporates get direct and quick access to institutional investon They can issue CPs directly to investors; hence it is also calle Direct Paper iv. Commercial paper is an attractive source of working capital fund because of low cost. v. It assures high return to investors. The investors of CP prefer to hold them till maturity, so there is lit activity in the secondary market for CP. 2. Certificate of Deposits (CDs) Certificate of Deposits (CDs) is a negotiable money market instrument issued in dematerialised form, for funds deposited at a bank or with othe eligible financial institution for a specified time period. It is usually issue at discount. It is a debt instrument and bearer certificate which is negotiable in th market. It is issued by banks/financial Institutions (FIs) against deposits kep by individuals, companies and institutions. It is a document of title to time deposit. Unlike traditional time deposits (Fixed 15 Deposits) these are freel negotiable instruments and are often referred to as Negotiable Certificat of Deposits (NCDs). In Indian market RBI introduced this in 1989. The Transaction A CD pays the depositor a specified amount of interest during the term of the certificate, plus the purchase price of the CD at maturity. Today negotiable CDs are sold in large denominations and can be resold in the secondary market. This makes negotiable CDs highly liquid. The original purchaser need not hold the CD to maturity. CDs can be issued by scheduled commercial banks (excluding RRBs and Local Area Banks) and selected all India financial institutions permitted by RBI (IDBI, IFCI, SIDBI, EXIM bank etc). Banks can offer CDs which have maturity between 7 days and 1 year. CDs from financial institutions have maturity between 1 and 3 years. CDs are available in the denominations of 1 Lakh and in multiple thereafter. CDs are issued in dematerialised form. Advantages of CDS i. CDs are the most convenient instruments to depositors as they enable their short term surpluses to earn higher return. ii. CDs also offer maximum liquidity as they are transferable by endorsement and delivery. iii. This is an ideal instrument for the banks with short term surplus fund to invest. Since the interest rate is high, investors hold CDs till maturity, so the secondary market for CDs is not so active. 3. Treasury Bills (T-Bills) Treasury bills are short term promissory notes issued by RBI on behalf of the central government to bridge the deficit between the revenue and expenditure in the budget. It is usually issued at a discount for a specified period, namely, 91 days, 182 days and 364 days. The government promises to pay the specified amount mentioned therein to the bearer of the instrument on the due date. It does not carry regular interest payments as it is issued at a discount. The difference between the purchase price and the face value is the return from buying the T-Bill. The Participants The participants in the T-bills market includes RBI, commercial banks, state governments, financial institutions, primary dealers, provident funds, corporate customers, mutual funds, foreign banks, FIIS, Public etc. State governments and commercial banks are the dominant users of T-bills than the afore-said participants. T-bills are the important money market instruments used by the Govt. to raise funds. T-bills are zero risk instruments since they are backed by the Government. They are negotiable 16 instruments. At present, the Governme Of India issues three types of treasury bills viz., 91- day, 182-day and 364 day bills. The Transaction Treasury bills are sold through an auction process conducted by RBI. The instrument price is quoted at a discount price to the par value of Rs.100 considering the return needed. At present, auction of all the T-Bills are based on multiple price auction (French auction) method. In this method RBI decides cut-off price and everybody who has bid above the cut- off price will get the t-bills. Treasury bills are available for a minimum amount of ₹25,000 and multiples there of. Advantages of T-Bills i. T-bills help in effective cash management of the Government ii. It is an important tool for the central bank for market interventio and to control liquidity and short-term interest rates. iii. Treasury bills offer short-term investment opportunities, general up to one year. iv. The yield is assured and risk is zero as the T-bills are backed Government. v. They are highly liquid as there exists an active secondary market. vi. The transaction cost is very low. vii. No tax will be deducted at source from the maturity value on T- bills. viii. Commercial banks can maintain their SLR and CRR requirements by using T-bills 4. Commercial Bills Commercial bills arise out of trade transactions. The maturity period of the bills varies from 30 days to 90 days depending on the eredit given. These bills are transferable by endorsement and delivery and can be discounted or rediscounted. In a bill market the bill of exchanges are bought and sold. Commercial banks, co-operative banks, financial institutions, mutual funds ete can participate in the bill market. Thus, the seller can get payment are immediately by discounting the bills with commercial banks or other dfinancial intermediaries. At maturity date the intermediary claims the amount of money from the person who has accepted the Bill. 5. Call/Notice Money Call/Notice means a loan for very short period i.e., one to fourteen days. The loans are repayable on demand at the option of either the lender or the borrower. Call money is 'money at call. Call money market is a market where short-term surplus funds of commercial banks, and other financial institutions, are traded. The participants, usually, borrow and lend call/notice money for one day/for a period up to 14 days 10. The call money market is the highly liquid market, and accounts for a major share of the total turnover of the money market. 17 In Call money market, if money is lent for a day it is called call money (money at call) or overnight money. On the other hand, if it is for a period of more than one day and less than 14 days, it is called notice money or money at short notice. This market¹ is governed by the Reserve Bank of India which issues guidelines for the various participants in the call/notice money market. Participants in call/notice money market currently include banks, both scheduled commercial banks (excluding RRBs) and co-operative bank, (other than Land Development Banks) and Primary Dealers (PDs), both borrowers and lenders. Scheduled commercial banks are the large-scale borrowers and lenders in the call money market. The Processs The deals are conducted both on telephone as well as on the NDS Call system, which is an electronic screen based system set up by the RBI dete for negotiating money market deals between entities permitted to operate in the money market. As the money can be called back at any time, call money is highly liquid. The commercial banks can, thus, meet large sudden payments and remittances. It is highly profitable also, if they have surplus, as the call As rates (interest rates) are high. It also enables the commercial banks to ba maintain their statutory reserve requirements. However, volatility of call re money rates (varies from day-to-day, hour-to-hour, minute-to-minute etc.) is a drawback. 6. Repurchase Agreements (REPOS) A Repurchase agreement, also known as a Repo is the sale of securities together with an agreement by the seller to buy back the securities on a future date at a pre-determined price. It is a secured short-term loan in which the security (repo securities) serves as collateral. The Process The party who sells a security under a repurchase agreement is borrower and the party who buys the security is the lender. The collateral security in the form of SGL is transferred from the seller (borrower) to the buyer (lender). Only RBI approved securities (repo securities) can be traded in this way. They include Central and State government bonds, Treasury bills, 39 Corporate bonds, Bonds of Public Sector Units etc. A reverse repo is the mirror image (exact opposite) of a repo, in a reverse repo, securities are acquired with a simultaneous commitment to resell at a specified time and period. In other words, the same transaction is repo for one party (seller/borrower) and reverse repo for the other party (Buyer/lender). Hence whether a transaction is repo or reverse repo is determined only in terms of who initiated the first leg of the transactions The difference between the sale and repurchase price expressed in percentage of sale price is known as repo rate /reverse repo rate. 18 A repo is combination of a secured cash loan and a forward contract. As it is a means of funding by selling a security held on a spot (ready) basis and repurchasing the same on a forward basis, it is also called a ready forward deal. Types of Repo Two types of repos are currently in operation in India - Market repos (inter-bank repos) and RBI repos. Inter-bank repo is the repo/reverse repo transactions entered in to between banks among themselves. As part of its Open Market Operations (OMOs) RBI also undertakes repo/reverse repo deals with primary dealers and scheduled commercial banks to control liquidity in the market. This is called RBI Repo. The need/relevance When commercial banks are in need of short term finance, they sell Govt. securities owned by them to RBI with an agreement to purchase it on a future date at a pre-determined price. The rate at which banks borrow money from RBI under a repurchase (repo) agreement is called repo rate. Likewise, when commercial banks have surplus fund they can lend it to RBI by purchasing Govt. securities from RBI under a reverse repo agreement. Reverse repo ratels is the rate at which RBI accepts depo from other banks for short term duration. Repos are usually entered in to with a maturity of 1-14 days. Advantages of Repos/Reverse Repos i. Repos are safer than call or notice or term money and inter-corporate deposit markets, because repos enable collateralized short term borrowings backed by securities. ii. For the buyer (Lender). a repo is an opportunity to invest cash for a customized period of time (other investments typically for limit tenures) iii. Central banks can use repo as an integral part of their open marke operations with the objective of injecting/withdrawing into and from the market and also to reduce volatility in money markets. iv. Repo transactions facilitate banks to invest surplus cash for adjusting CRR position and also for adjusting SLR positious Indian Money Market The India money market is a monetary system that facilitates the lending and borrowing of short-term funds. Though it is not a developed mone market, it is a leading money market among the developing countries Reserve Bank of India (RBI) plays a major role in regulating and controlling the Indian money market. An important function of Indian money market is to facilitate the interventions of the RBI. Thus, RBI influence the liquidity in the financial system and implement other monetary policy measure through the money market. 19  Structure of Indian Money Market Indian money market can be broadly classified into two; Organised (formal) and Unorganized (Informal). Both these consists of differen players and components. RBI is at the head of the organized Indian money market. The control extends to all those operating in the money market including financia institutions, banks, mutual funds, individuals and companies. The main constituents in a money market are the lenders who supply the money and the borrowers who demand short term credit. The players in money market include; Government, Central Bank (i.e., RBI), Banks, Discount and acceptance houses, Financial institutions, Corporate houses, Mutual Funds, FIls etc. RBI, SBI and its subsidiaries, high rated corporations, financial institutions etc., supply short term fund. Central government, State Government, local bodies, companies, mutual funds, insurance companies and commercial banks are the main borrowers. Unorganised Money Market The unorganized money market in India is not under the direct control of RBL. The unorganised sector consisting of numerous indigenous bankers and village money lenders also supply funds. The financing gap (i.e., the requirements of unsatisfied borrowers in the organised market) is met by the unorganised market. The interest rate in this segment is generally higher than that in the organised market. Characteristics of Indian Money Market- i. Dichotomic Structure - It has a simultaneous existence of both the organized money market as well as unorganised money markets. ii. Seasonality - The demand for money in Indian money market is of a seasonal nature. iii. Multiplicity of interest rates - Interest rates differ from bank to bank, from period to period, in organised and unorganised markets etc. iv. Lack of organized bill market In the Indian money market, the organized bill market is not prevalent. v. Absence of integration - There is a lack of coordination among different components of the money market. RBI has full control over the components in the organized segment but it cannot control the components in the unorganized segment. vi. Limited instruments - It is in fact a defect of the Indian money market. In order to meet the varied requirements of borrowers and lenders, it is necessary to develop numerous instruments. Components/Sub-Markets of Indian Money Market a) Call money market: It refers to the market for extremely short period loans (1 to 14 days). It an important sub market of the Indian money market. b) Commercial bills market: It is a market for commercial bills arising out of trade transactions. Demand and usance bills, clean bills and documentary bills, inland and foreign bills etc are the different types of bills circulating in this market. It has two 20  segments viz., Discount market and Acceptance market. Discount market refers to the market where short term trade bills are discounted by financial intermediaries like banks. Acceptance market is the market where short term trade bills are accepted by financial intermediaries. c) Treasury bill market: A market where treasury bills are bought and sold. Treasury bill constituted the main instrument for short term borrowing by the Government. d) Market for Certificate of Deposits (CDs): It is again an important segment of the Indian money market. The certificate of deposits is issued by the commercial banks. e) Market for Commercial Papers (CPs): It is the market where the commercial papers are traded. f) Short Term Loan Market: It is a market where the short term loan requirements of corporates are met by the Commercial banks. Banks provide short term loans to corporates in the form of cash credit or in the form of overdraft. g) Repo Market: It is market for repurchase agreements (repos). In India the commercial banks are the sellers and RBI is the buyer in repo transactions. Weaknesses of Indian Money Market a) Undeveloped Market: Indian Money Market is not well developed. The essential characteristics of a developed money market such as the ones in London or New York are integrated structures between sub- markets, free flow of funds as between sub-markets or segments of the same sub-market, a high degree of specialization with regard to dealings in instruments by various institutions and a single price for each of the instruments traded. b) No Active Secondary Market: There is no active secondary market for many instruments like Treasury Bills, Commercial Bills, CPs and CDs, etc in India. Recently, the RBI has initiated schemes for the development of secondary market in commercial paper and for trading in certificates of deposits and participation certificate. c) Seasonality: An important aspect of the Indian money market is the seasonality in the demand for funds following the agriculturs operations. The busy season for funds extends from November to Ap and the slack season from May to October. d) No Foreign Players: Besides, the Indian money market is als characterized by insulation from the foreign money markets due to the operation of exchange controls in the economy, despite some liberalization recently and freeing of the rupee. Another importan aspect of the money market is the dichotomy between the organised and unorganised markets. e) Lack of Integration: Unlike developed money markets, the Indian market is not characterized by a high degree of integration and cohesion Multiple interest rates, shortage of investment instruments, less number of dealers etc are also defects of Indian money market. Diference between Money Market & Capital Market Basis Money Market Capital Market Objective Arranging short tem fund for period less than 1 Arrange long term fund for a period year of 1 year or more Instruments Short term instruments Long term instruments 21 Regulators Central bank Government, SEBI & Ministry of finance Safety Highest safety, less risky, return is assured Not so safe Accessibility Less accessible to individual investors. More accessible to individual Basically institutional market. investors. Liquidity of Highly liquid Not so liquid instruments Nature Supplies fund for Working capital requirement Supplies fund for Fixed capital requirement Trading Place No fixed place. Deals done over Phone or Formal places like stock exchanges other electronic device. Secondary market No active secondary market Very active secondary market Speculation No speculation High speculations THE ROLE OF FINANCIAL INSTITUTIONS IN ECONOMIC DEVELOPMENT Financial institutions form the backbone of a nation's economic development, playing a multifaceted role in fostering growth, stability, and prosperity. These institutions, ranging from banks and credit unions to central banks and investment firms, serve as intermediaries that facilitate the efficient allocation of resources in the economy. 1. Capital Mobilization and Formation: One of the primary functions of financial institutions is to mobilize savings from individuals, businesses, and other entities within the economy. By encouraging savings, these institutions accumulate a pool of funds that can be channelled into productive investments. This capital formation is instrumental in providing the financial resources necessary for economic expansion, innovation, and infrastructure development 2. Investment Facilitation: Financial institutions are pivotal in channelling funds towards productive investments. Whether through loans, equity investments, or other financial instruments, these institutions provide the necessary capital for businesses and entrepreneurs to undertake projects, expand operations, and drive economic growth. By efficiently matching savers with borrowers, financial institutions contribute to the vitality of various sectors within the economy. 3. Risk Management and Diversification: The management of financial risks is inherent to the operations of financial institutions. Through diversification of their portfolios and the use of risk management tools, these institutions mitigate the impact of potential financial losses. This risk-bearing function is crucial as it encourages a broader spectrum of investors and entrepreneurs to participate in economic activities, fostering a climate conducive to development. 4. Payment Systems and Financial Infrastructure: Efficient payment systems are essential for the smooth functioning of economic transactions. Financial institutions, particularly banks, provide the necessary infrastructure for electronic funds transfer, credit cards, and other payment mechanisms. This not only facilitates day-to-day transactions but also contributes to the overall efficiency of 22 5. Intermediation and Efficiency: Financial intermediation is a core function of banks and financial institutions. By acting as intermediaries between savers and borrowers, they ensure that funds are allocated to their most productive uses. This process enhances the efficiency of capital allocation in the economy, directing resources toward activities that contribute significantly to economic development. 6. Credit Creation and Monetary Policy Transmission: Financial institutions, particularly commercial banks, have the ability to create credit through the fractional reserve banking system. This credit creation, when managed prudently, contributes to the expansion of the money supply, stimulating economic activities. Moreover, financial institutions, including central banks, play a crucial role in transmitting monetary policies that influence interest rates, inflation, and overall economic stability. 7. Long-Term Investments and Infrastructure Financing: Economic development often requires substantial investments in long-term projects and infrastructure. Financial institutions, such as development banks, specialize in providing financing for large-scale infrastructure projects. By facilitating these investments, financial institutions contribute to the creation of essential foundations for sustained economic growth. 8. Financial Inclusion and Social Impact: Financial institutions play a pivotal role in promoting financial inclusion by expanding access to banking and financial services. This is particularly important in developing economies, where a significant portion of the population may be unbanked or under banked. Through innovative financial products and services, financial institutions contribute to poverty reduction and inclusive economic growth. 9. Technology and Innovation: The rapid advancement of technology has transformed the financial sector. Financial institutions are embracing fintech innovations, such as digital banking, blockchain, and artificial intelligence, to enhance efficiency, reduce costs, and improve customer experiences. These technological advancements not only benefit the institutions themselves but also contribute to the overall productivity and competitiveness of the economy. 10. Global Financial Integration: Financial institutions facilitate global economic integration by connecting domestic markets with the international financial system. Cross-border investments, foreign direct investment, and international trade rely on the services provided by financial institutions. This integration opens up opportunities for economic growth through access to international capital, markets, and expertise. 11. Hedging and Risk Management: Financial institutions provide essential tools for hedging and managing various types of risks in the financial markets. Businesses are exposed to risks such as currency fluctuations, interest rate changes, and commodity price volatility. Financial institutions offer derivative products, insurance, and other risk management instruments to help businesses mitigate these risks. By providing these services, financial institutions contribute to the stability of businesses and the broader economy, encouraging investment and expansion. 12. Facilitating Small and Medium-sized Enterprises (SMEs): Small and medium-sized enterprises (SMEs) are often considered the backbone of many economies. Financial institutions play a crucial role in providing financing and support to SMEs. They offer 23  loans, credit lines, and other financial products tailored to the needs of these businesses, enabling them to grow, create jobs, and contribute significantly to economic development. Moreover, financial institutions may provide advisory services to help SMEs improve their financial management and operational efficiency. 13. Wealth Management and Asset Allocation: Financial institutions, including asset management firms and private banks, assist individuals and institutions in managing their wealth. They offer a range of investment products, such as mutual funds, pension funds, and private equity, allowing clients to diversify their portfolios and optimize their asset allocation. Effective wealth management not only preserves and grows individual wealth but also directs investments towards productive sectors, contributing to overall economic development. 14. Education and Financial Literacy: Financial institutions play a pivotal role in promoting financial education and literacy. They offer educational programs, workshops, and materials to help individuals and businesses understand financial concepts, investment strategies, and risk management. By enhancing financial literacy, these institutions empower individuals to make informed decisions about savings, investments, and debt management. A financially literate population is better equipped to participate in the economy, make sound financial choices, and contribute to economic growth. 15. Liquidity Provision and Central Bank Functions: Central banks, as key financial institutions, play a critical role in maintaining monetary stability and providing liquidity to the financial system. They control the money supply, set interest rates, and act as lenders of last resort during financial crises. By ensuring the stability of the banking system and providing liquidity when needed, central banks contribute to overall economic stability and confidence. This, in turn, encourages investment, consumption, and economic development. 16. Corporate Governance and Ethical Practices: Financial institutions influence corporate governance and ethical practices within the business community. Banks and other financial intermediaries often impose certain standards and requirements on the companies they finance. This includes criteria related to transparency, ethical behaviour, and adherence to environmental and social responsibility. By promoting good governance and ethical business practices, financial institutions contribute to sustainable development, reduce the risk of financial scandals, and foster a positive economic environment. 24