_Sctwol of Distance Education CONTENTS PAGE MODULE I FINANCIAL SYSTEM 5 MODULE II MONEY MARKET 18 MODULE Il ‘CAPITAL MARKET 38 MODULE IV FINANCIAL INSTITUTIONS 74 MODULE V REGULATORY INSTITUTIONS 94 Tndian Financial Management PagesTndian Financial Management _Sctwol of Distance Education PagetSchool of Distance Education MODULE I FINANCIAL SYSTEM An introduction The economic development of a nation is reflected by the progress of the various economic units, broadly classified into corporate sector, government and household sector. There are areas or people with surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities. Financial system comprises of set of subsystems of financial institutions, financial markets, financial instruments and services which helps in the formation of capital. It provides a mechanism by which savings are transformed to investment Financial System; Flom of fonds (savings) ‘The word “system”, in the term "financial system", implies a set of complex and closely connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the econemy. The financial system is concerned about money, credit and finance -the three terms are intimately related yet are somewhat different from each other. Indian financial system consists of financial market, financial instruments and financial intermediation. ‘Meaning of Financial System A financial system functions as an intermediary between savers and investors. It facilitates the flow of funds from the areas of surplus to the areas of deficit. It is concerned about the money, credit and finance. These three parts are very closely interrelated with each other and depend on each other. Tedian Financial Management ‘Pages_Sctwol of Distance Education A financial system may be defined as a set of institutions, instruments and markets which promotes savings and channels them to their most efficient use. It consists of individuals (savers), intermediaries, markets and users of savings (investors). In the worlds of Van Horne, “financial system allocates savings efficiently in an economy to ultimate users either for investment in real assets or for consumption”. According to Prasanna Chandra, “financial system consists of a variety of institutions, markets and instruments related in a systematic manner and provide the principal means by which savings are transformed into investments”. Thus financial system is a set of complex and closely interlinked financial institutions, financial markets, financial instruments and services which facilitate the transfer of funds. Financial institutions mobilise funds from suppliers and provide these funds to those whe demand them. Similarly, the financial markets are also required for movement of funds from savers to intermediaries and from intermediaries to investors. In short, financial system is a mechanism by which savings are transformed into investments. Functions of Financial System The financial system of a country performs certain valuable functions for the economic growth of that country. The main functions of a financial system may be briefly discussed as below: 1. Saving function: An important function of a financial system is to mobilise savings and channelize them into productive activities. It is through financial system the savings are transformed into investments. 2. Liquidity function: The most important function of a financial system is to provide money and monetary assets for the production of goods and services. ‘Monetary assets are those assets which can be converted into cash or money easily without loss of value. All activities in a financial system are related to liquidity-either provision of liquidity or trading in liquidity. 3. Payment function: The financial system offers a very convenient mode of payment for goods and services. The cheque system and credit card system are the easiest methods of payment in the economy. The cost and time of transactions are considerably reduced. 4. Risk funetion: The financial markets provide protection against life, health and income risks. These guarantees are accomplished through the sale of life, health insurance and property insurance policies. ‘ndian Finaneial Management Pages_Sctwol of Distance Education 5. Information function: A financial system makes available price-related information. This is a valuable help to those who need to take economic and financial decisions. Financial markets disseminate information for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment or holding a particular asset. 6. Transfer function: A financial system provides a mechanism for the transfer of the resources across geographic boundaries. 7. Reformatory functions: A financial system undertaking the functions of developing, introducing innovative financial assets/instruments services and practices and restructuring the existing assts, services etc, to cater the emerging needs of borrowers and investors (financial engineering and re engineering). 8. Other functions: It assists in the selection of projects to be financed and also reviews performance of such projects periodically. It also promotes the process of capital formation by bringing together the supply of savings and the demand for investible funds. Role and Importance of Financial System in Economic Development 1. It links the savers and investors. It helps in mobilizing and allocating the savings efficiently and effectively. It plays a crucial role in economic development through saving-investment process. This savings — investment process is called capital formation 2. It helps to monitor corporate performance. 3. It provides a mechanism for managing uncertainty and controlling risk. 4. It provides a mechanism for the transfer of resources across geographical boundaries. 5. It offers portfolio adjustment facilities (provided by financial markets and financial intermediaries). 6. It helps in lowering the transaction costs and increase returns. This will motivate people to save more. 7. It promotes the process of capital formation. 8. It helps in promoting the process of financial deepening and broadening. Financial deepening means increasing financial assets as a percentage of GDP and financial broadening means building an increasing number and variety of participants and instruments. In short, a financial system contributes to the acceleration of economic development. It contributes to growth through technical progress. Tndian Financial Management Page?_Sctwol of Distance Education Structure of Indian Financial System Financial structure refers to shape, components and their order in the financial system. The Indian financial system can be broadly classified into formal (organised) financial system and the informal (unorganised) financial system. The formal financial system comprises of Ministry of Finance, RBI, SEBI and other regulatory bodies. The informal financial system consists of individual money lenders, groups of persons operating as funds or associations, partnership firms consisting of local brokers, pawn brokers, and non-banking financial intermediaries such as finance, investment and chit fund companies. The formal financial system comprises financial institutions, financial markets, financial instruments and financial services. These constituents or ‘components of Indian financial system may be briefly discussed as below: ‘COMPONENTS OF INDIAN FINANCIAL SYSTEM 4 Financia institetions Financial Maskets Financislinetruments Financial Services ert ee, en es, Banking Non Banking MoneyMid Capital Mit Tem Type FundBused Fee based Instittions institution | | | Call money matket | Short tem = Leasing. Commercisl Cooperative | - Treasury bills < Medaar term Hie Purchase Banks Banks - Comaseteial Bills Langtterm ~ Factoring Public Sector Primary Musket —-Frimary ceeusties — - Merchant Banking Private sector = Secondary Macket Secondary securities _- Creda Rating RRBs = Denivative Maiket Innovative Instruments - Mergers Fotvign Bands (Organised Sinancial uneeginazed financial Inctingione inettteiors I. Financial Institutions Financial institutions are the participants in a financial market. They are business organizations dealing in financial resources. They collect resources by accepting deposits from individuals and institutions and lend them to trade, industry and others. They buy and sell financial instruments. They generate financial instruments as well. They deal in financial assets. They accept deposits, grant loans and invest in securities. Tndian Financial Management Pages_Sctwol of Distance Education Financial institutions are the business organizations that act as mobilises of savings and as purveyors of credit or finance. This means financial institutions mobilise the savings of savers and give credit or finance to the investors. They also provide various financial services to the community. They deal in financial assets such as deposits, loans, securities and so on. On the basis of the nature of activities, financial institutions may be classified as: (a) Regulatory and promotional institutions, (b) Banking institutions, and (c) Non-banking institutions. 1, Regulatory and Promotional Institutions: Financial institutions, financial markets, financial instruments and financial services are all regulated by regulators like Ministry of Finance, the ‘Company Law Board, RBI, SEBI, IRDA, Dept. of Economic Affairs, Department of ‘Company Affairs etc. The two major Regulatory and Promotional Institutions in India are Reserve Bank of India (RBI) and Securities Exchange Board of India (SEBN. Both RBI and SEB! administer, legislate, supervise, monitor, control and discipline the entire financial system. RBI is the apex of all financial institutions in India. All financial institutions are under the control of RBI. The financial markets are under the control of SEBI. Both RBI and SEBI have laid down several policies, procedures and guidelines. These policies, procedures and guidelines are changed from time to time so as to set the financial system in the right direction. 2. Banking Institutions: Banking institutions mobilise the savings of the people. They provide a mechanism for the smooth exchange of goods and services. They extend credit while lending money. They not only supply credit but also create credit. There are three basic categories of banking institutions. They are commercial banks, co-operative banks and developmental banks. 3. Non-banking Institutions: The non-banking financial institutions also mobilize financial resources. directly or indirectly from the people. They lend the financial resources mobilized. They lend funds but do not create credit. Companies like LIC, GIC, UTI, Development Financial Institutions, Organisation of Pension and Provident Funds etc. fall in this category. Non-banking financial institutions can be categorized as investment companies, housing companies, leasing companies, hire purchase companies, specialized financial institutions (EXIM Bank ete.) investment institutions, state level institutions etc. Financial institutions are financial intermediaries. They intermediate between savers and investors. They lend money. They also mobilise savings. ‘ndian Finaneial Management Page?_Sctwol of Distance Education I Financial Markets Financial markets are another part or component of financial system. Efficient financial markets are essential for speedy economic development. The vibrant financial market enhances the efficiency of capital formation. It facilitates the flow of savings into investment. Financial markets bridge one set of financial intermediaries with another set of players. Financial markets are the backbone of the economy. This is because they provide monetary support for the growth of the economy. The growth of the financial markets is the barometer of the growth of a country’s economy. Financial market deals in financial securities (or financial instruments) and. financial services. Financial markets are the centres or arrangements that provide facilities for buying and selling of financial claims and services. These are the markets in which money as well as monetary claims is traded in. Financial markets exist wherever financial transactions take place. Financial transactions include issue of equity stock by a company, purchase of bonds in the secondary market, deposit of money in a bank account, transfer of funds from a current account to a savings account ete. ‘The participants in the financial markets are corporations, financial institutions, individuals and the government. These participants trade in financial products in these markets. They trade either directly or through brokers and dealers. In short, financial markets are markets that deal in financial assets and credit instruments. Functions of Financial Markets: ‘The main functions of financial markets are outlined as below: 1. To facilitate creation and allocation of credit and liquidity. 2. To serve as intermediaries for mobilisation of savings. 3. To help in the process of balanced economic growth. 4. To provide financial convenience. 5. To provide information and facilitate transactions at low cost. 6 To cater to the various credits needs of the business organisations. Classification of Financial Markets: ‘There are different ways of classifying financial markets. There are mainly five ways of classifying financial markets. Tndian Financial Management Page 10_Sctwol of Distance Education 1. Classification on the basis of the type of financial claim: On this basis, financial markets may be classified into debt market and equity market. Debt market: This is the financial market for fixed claims like debt instruments, Equity market: This is the financial market for residual claims, i.e., equity instruments. 2. Classification on the basis of maturity of claims: On this basis, financial markets may be classified into money market and capital market. Money market: A market where short term funds are borrowed and lend is called money market. It deals in short term monetary assets with a maturity period of one year or less. Liquid funds as well as highly liquid securities are traded in the money market. Examples of money market are Treasury bill market, call money market, commercial bill market ete. The main participants in this market are banks, financial institutions and government. In short, money market is a place where the demand for and supply of short term funds are met. Capital market: Capital market is the market for long term funds. This market deals in the long term claims, securities and stocks with a maturity period of more than one year. It is the market from where productive capital is raised and made available for industrial purposes. The stock market, the government bond market and derivatives market are examples of capital market. In short, the capital market deals with long term debt and stock. 3. Classification on the basis of seasoning of claim: On this basis, financial markets are classified into primary market and secondary market. Primary market: Primary markets are those markets which deal in the new securities. Therefore, they are also known as new issue markets. These are markets where securities are issued for the first time. In other words, these are the markets for the securities issued directly by the companies. The primary markets mobilise savings and supply fresh or additional capital to business ‘units. In short, primary market is a market for raising fresh capital in the form of shares and debentures. Secondary market. Secondary markets are those markets which deal in existing securities. Existing securities are those securities that have already been issued and are already outstanding. Secondary market consists of stock exchanges. Stock exchanges are self regulatory bodies under the overall regulatory purview of the Govt. /SEBI._Sctwol of Distance Education 4. Classification on the basis of structure or arrangements: On this. basis, financial markets can be classified into organised markets and unorganized markets. Organised markets: These are financial markets in which financial transactions take place within the well established exchanges or in the systematic and orderly structure. Unorganised markets: These are financial markets in whieh financial transactions take place outside the well established exchange or without systematic and orderly structure or arrangements. 5. Classification on the basis of timing of delivery: On this basis, financial markets may be classified into cash/spot market and forward / future market Cash / Spot market: This is the market where the buying and selling of commodities happens or stocks are sold for cash and delivered immediately after the purchase or sale of commodities or securities. Forward/ Future market. This is the market where participants buy and. sell stocks/commodities, contracts and the delivery of commodities or securities ‘occurs at a pre-determined time in future. 6. Other types of financial market: Apart from the above, there are some other types of financial markets. They are foreign exchange market and derivatives market, Foreign exchange market: Foreign exchange market is simply defined as a market in which one country’s currency is traded for another country’s currency. It is a market for the purchase and sale of foreign currencies. in hedging risk. The individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to accept the risk for a price. A common place where such transactions take place is called the derivative market. It is a market in which derivatives are traded. In short, it is a market for derivatives. ‘The important types of derivatives are forwards, futures, options, swaps, etc: Ill. Financial Instruments (Securities) Financial instruments are the financial assets, securities and claims. They may be viewed as financial assets and financial liabilities. Financial assets represent elaims for the payment of a sum of money sometime in the future (repayment of principal) and/or a periodic payment in the form of interest or dividend, Financial liabilities are the counterparts of financial assets. They represent promise to pay some portion of prospective income and wealth to Tndian Financial Management Page 12School of Distance Education others. Financial assets and liabilities arise from the basic process of financing, ‘Some of the financial instruments are tradable/ transferable. Others are non tradable/non-transferable. Financial assets like deposits with banks, companies and post offices, insurance policies, NSCs, provident funds and pension funds are not tradable. Securities (included in financial assets) like equity shares and debentures, or government securities and bonds are tradable. Hence they are transferable. In short, financial instruments are instruments through which a company raises finance. The financial instruments may be capital market instruments or money market instruments or hybrid instruments. The financial instruments that are ‘used for raising capital through the capital market are known as capital market instruments. These include equity shares, preference shares, warrants, debentures and bonds. These securities have a maturity period of more than one year. ‘The financial instruments that are used for raising and supplying money in. a short period not exceeding one year through money market are called money market instruments. Examples are treasury bills, commercial paper, call money, short notice money, certificates of deposits, commercial bills, money market mutual funds Hybrid instruments are these instruments which have both the features of equity and debenture. Examples are convertible debentures, warrants etc. Financial instruments may also be classified as cash instruments and derivative instruments. Cash instruments are financial instruments whose value is determined directly by markets. Derivative instruments are financial instruments which derive their value from some other financial instrument or variable, Financial instruments can also be classified into primary instruments and. secondary instruments. Primary instruments are instruments that are directly issued by the ultimate investors to the ultimate savers. For example, shares and debentures directly issued to the public. Secondary instruments are issued by the financial intermediaries to the ultimate savers. For example, UTI and mutual funds issue securities in the form of units to the public. Characteristics of Financial Instruments ‘The important characteristics of financial instruments may be outlined as below: 1. Liquidity: Financial instruments provide liquidity. These can be easily and. quickly converted into cash. Tedian Financial Management ‘Page 13_Sctwol of Distance Education 2. Marketing: Financial instruments facilitate easy trading on the market. They hhave a ready market. 3. Collateral value: Financial instruments can be pledged for getting loans. 4. Transferability: Financial instruments can be easily transferred from person to person. 5S. Maturity period: The maturity period of financial instruments may be short term, medium term or long term. 6. Transaction cost: Financial instruments involve buying and selling cost. The buying and selling costs are called transaction costs. These are lower. 7. Risk: Financial instruments carry risk. This is because there is uncertainty with regard to payment of principal or interest or dividend as the case may be. 8. Future trading: Financial instruments facilitate future trading so as to cover risks due to price fluctuations, interest rate fluctuations ete. IV. Financial Services The development of a sophisticated and matured financial system in the country, especially after the early nineties, led to the emergence of a new sector. ‘This new sector is known as financial services sector. Its objective is to intermediate and facilitate financial transactions of individuals and institutional investors. The financial institutions and financial markets help the financial system through financial instruments. The financial services include all activities connected with the transformation of savings into investment. Important financial services include lease financing, hire purchase, instalment payment systems, merchant banking, factoring, forfaiting etc. Growth and Development of Indian Financial System At the time of independence in 1947, there was no strong financial institutional mechanism in the country. The industrial sector had no access to the savings of the community. The capital market was primitive and shy. The private and unorganised sector played an important role in the provision of liquidity. On the whole, there were chaos and confusions in the financial system. After independence, the government adapted mixed economic system. A scheme of planned economic development was evolved in 1951 with a view to achieve the broad economic and social objective. The government started cfeating new financial institutions to supply finance both for agricultural and industrial development. It also progressively started nationalizing some important financial institutions so that the flow of finance might be in the right direction. The following developments took place in the Indian financial system: Tndian Financial Management Page 1#_Sctwol of Distance Education 1. Nationalisation of financial institutions: RBI, the leader of the financial system, was established as a private institution in 1935. It was nationalized in 1949. This was followed by the nationalisation of the Imperial bank of India, ‘One of the important mile stone in the economic growth of India was the nationalisation of 245 life insurance Corporation in 1956. As a result, Life Insurance Corporation of India came into existence on 1* September, 1956. Another important development was the nationalisation of 14 major commercial banks in 1969. In 1980, 6 more banks were nationalized. Another landmark was the nationalisation of general insurance business and setting up of General Insurance Corporation in 1972. 2. Establishment of Development Banks: Another landmark in the history of development of Indian financial system is the establishment of new financial institutions to supply institutional credit to industries. In 1949, RBI undertook a detailed study to find out the need for specialized institutions. The first development bank was established in 1948. That was Industrial Finance Corporation of India (IFCI), In 1951, Parliament passed State Financial Corporation Act. Under this Act, State Governments could establish financial corporation’s for their respective regions. The Industrial Credit and Investment Corporation of India (ICICI) were set up in 1955. It was supported by Government of India, World Bank etc. The UTI was established in 1964 as a public sector institution to collect the savings of the people and make them available for productive ventures. The Industrial Development Bank of India (IDB!) was established on 18t July 1964 as a wholly owned subsidiary of the RBL ‘On February 16, 1976, the IDBI was delinked from RBI. It became an independent financial institution. It co-ordinates the activities of all other financial institutions. In 1971, the IDBI and LIC jointly set up the Industrial Reconstruction Corporation of India with the main objective of reconstruction and rehabilitation of sick industrial undertakings. The IRCI was converted into a statutory corporation in March 1985 and renamed as Industrial Reconstruction Bank of India. Now its new name is Industrial Investment Bank of India (IIBD). In 1982, the Export-Import Bank of India (EXIM Bank) was set up to provide financial assistance to exporters and importers. On April 2, 1990 the Small Industries. Development Bank of India (SIDBI) was set up as a wholly owned subsidiary of IDBI. The SIDBI has taken over the responsibility of administrating the Small Industries Development Fund and the National Equity Fund. Tndian Financial Management Page 15_Sctwol of Distance Education 3. Establishment of Institution for Agricultural Development: In 1963, the RBI set up the Agricultural Refinance and Development Corporation (ARDC) to provide refinance support to banks to finance major development projects, minor irrigation, farm mechanization, land development ete. In order to meet credit needs of agriculture and rural sector, National Bank for Agriculture and Rural Development (NABARD) was set up in 1982. The main objective of the establishment of NABARD is to extend short term, medium term and long term finance to agriculture and allied activities. 4. Establishment of institution for housing finance: The National Housing Bank (NHB) has been set up in July 1988 as an apex institution to mobilise resources for the housing sector and to promote housing finance institutions. 5. Establishment of Stock Holding Corporation of India (SHCIL): In 1987, another institution, namely, Stock Holding Corporation of India Ltd. was set up t@ strengthen the stock and capital markets in India. Its main objective is to provide quick share transfer facilities, clearing services, support services etc. to investors. 6. Establishment of mutual funds and venture capital institutions: Mutual funds refer to the funds raised by financial service companies by pooling the savings of the public and investing them in a diversified portfolio. They provide investment avenues for small investors who cannot participate in the equities of big companies, Venture capital is a long term risk capital to finance high technology projects. The IDBI venture capital fund was set up in 1986. The ICICI and the ‘UTI have jointly set up the Technology Development and Information Company of India Ltd. in 1988 to provide venture capital. 7. New Economic Policy of 1991: Indian financial system has undergone massive changes since the announcement of new economic policy in 1991. Liberalisation, Privatisation and Globalisation has transformed Indian economy from closed to open economy. The corporate industrial sector also has undergone changes due to delicensing of industries, financial sector reforms, capital markets reforms, disinvestment in public sector undertakings etc. Since 1990s, Government control over financial institutions has diluted in. a phased manner. Public or development financial institutions have been converted inte companies, allowing them to issue equity/bonds to the public. Government has allowed private sector to enter into banking and insurance sector. Foreign companies were also allowed to enter into insurance sector in India. ‘Weaknesses of Indian Financial System Even though Indian financial system is more developed today, it suffers from certain weaknesses. These may be briefly stated below: Tndian Financial Management Page 16