COURSECONTENTS

UnitI
INTRODUCTORY: Nature and role of financial system - Financial System and financial
markets. An economic analysis of financial system in India. Indian financial system - A
critical analysis.
FINANCIAL MARKETS: Money and capital markets. Money market Instruments: Call money,
treasury bills, certificates of deposits, commercial bills, trade bills, etc. Capital market:
Government securities market, Industrial security market, Role of SEBI - and overview;
Recent developments National Depository Securities Ltd. (NDSL). Market- Makers.
UnitII
MONEY MARKET INSTITUTIONS: Central bank: Functions and its role in money
creation,Commercial banks; Present structure. Introduction to International and
Multinational banking.
NON- BANKING INSTITUTIONS: Concept, role of financial institutions, sources of funds,
Functions and types of non-banking financial institutions.
UnitIII
MUTUAL FUNDS: Theevaluationofmutualfunds,regulationof
mutualfunds(withspecialreferenceto SEBI guidelines), Performance evaluation, Design and
marketing of mutual funds scheme; Latest mutual fund schemes in India - An overview.
Evaluating of mutual funds.
MERCHANT BANKING: Concept, function, growth, government policy regarding Merchant
banking business and Future of merchant banking in India.
UnitIV
Changing Role of Financial Institutions : Role of banking, financial sector reforms, financial
and promotional role of financial institutions, universal banking; concept and
consequences.
References:
Auerbach, Robert D, Money, Banking and Financial Markets; Macmillan Publishing Co; New
York and Collier MacMillan Publisher; London.
Avadbani,V.A.,InvestmentandSecuritiesMarketinIndia;HimalayaPublishingHouse;Bombay..
Khan, M.Y., Indian Financial System -Theory and Practice; Vikas Publishing House; New
Delhi.
Mishkin,Frederics,S.,TheEconomicsofMoneyBankingandFinancialMarkets;HarperCollins
Publisher; New York.

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 Lesson-1
IndianFinancialSystem

STRUCTURE
LearningObjectives
Introduction
ParadigmShiftinFinancialMarkets
IndianFinancialSystem
FunctionsoftheFinancialSystem
FinancialInstitutions
FinancialMarkets
CorporateSecuritiesMarket
ProblemAreasintheFinancialSystem
FinancialMarkets:EmergingTrends
RationalofFinancialMarketReforms
IndianFinancialSystem:AnEconomicAnalysis
selfAssessmentExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthischapteryoushouldbeableto:
1. Understandthefinancialsystemsanditsfunctions.
2. Explaintheperfectcapitalmarket.
3. Knowthedifferentmarketstobefound inthefinancial system.
INTRODUCTION
The rapid economicgrowth and globalization of financial marketsis perhapsone of the most
significant developments at the international level. The past two decades have witnessed
a process ofaccelerating changes in the global financial markets. Driven by an interacting
process of liberalization and innovation, controls and regulations have been removed, new
financial products have emergedand old boundaries between financial intermediaries have
blurred. Financial innovations have brought many advantages. A large number of financial
assets and liabilities are not available to end-users. The
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costs of financial intermediation have fallen. Risk management tools have become
increasingly sophisticated. Global economics have found new ways to mobilize domestic
and international savings.
In comparison with newly industrializing countries and ASEAN countries, India’s economic
growth may not measure up to the potential. Nonetheless, the liberalization policies have
definitely helped the country in recording better performance. However, the significant
policy pronouncement that has been made since the middle of 1991 had certainly
improved the growth and performance of the economy during the last few years.
With the objective of bringing about a highly competitive system and promoting efficiency
in the real sectors of the Indian economy, recently economic reforms in the areas of trade,
industry, and the exchange rate system have been undertaken to correct economic
imbalances and bring aboutstructural adjustments. The liberalization and supportive
policies of the Government have gained momentum on the last few years with major plan
of diversification, expansion and modernization of the industrial sector in the country. This
has led to an increased demand for funds and encouraged authorities to find out
alternative source of finance for industry. Since the conventional budgetary support
cannot be of anypositive helpto the public section,andat the sametime theprivate helpof
the public sector, andat the same timethe private corporate sectorwhich used
todependheavily onbanks and financial institutions in the past, now collects funds from the
capital markets.
The Indian financial markets play a crucial role in economic development through the
saving- investment process, also known as capital formation. A vibrant and competitive
financial market is a necessary concomitant to gain the benefits of liberalization policies
and to sustain the ongoing reforms. Many financial reforms were undertaken to improve
the efficiency and stability of the financial system.
The process of liberalization initiated by the Government has not been new but prior
piecemeal efforts were not stable and widespread. The structural reforms initiated during
the period 1991-95 years have had a 'positive impact on the investment climate of the
country. The new economic policies aimed to liberalization and globalizations are all
embracing consistent and appear to be irreversible. The country has pursued
conservative, inward looking policiesforalmostfourdecades. The positive effectsof these
policies may be there, but they are outweighed by their negative impact of inefficiency,
corruption, delays and the non-competitive nature of the industrial/economic environment.
May mightily socialists economics have crumbled under their own weight and India could
very well imagine what is in store for it, if it did not change its course.
In its bid to open up the country’s economy, the Government of the India has geared up
the financial sector to meet the Global challenges. As such, Indian financial markets are
undergoing a process of rapid change,whichhas transformed theentire complexion of
thefinancial system. TheGovernment of India during the last several years announced a
number of measures to make the Indian financial markets more potent and. capable of
raining vast resources from the .domestic market and abroad.
PARADIGMSHIFTINFINANCIALMARKETS
Financial marketsplaya vital role in mobilization and collection of savings in the
economythat provides useful inputs for formulation, implementation of policies and thus
facilitate liquidity management, which is consistent with the macro-economic policy
objectives. In Indian context, Government of India, ReserveBankof
India,SecuritiesandExchangeBoardof Indiaarethe major regulators ofthefinancial market,
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which play crucial role both pro-actively and recovery in the development of financial
market. Financial sector reforms viz., localization, liberalization and deregulation along
with technological advancement has integrated international markets which has facilitated
the scope for uninterrupted mobility of funds in various financial markets of the world.
Financial services are in a process of acquiring new meanings and dimensions. In this
context, the law of
survivalofthefittestwouldapplyandthusonlythosewhorespondtothechangesintheenvironmen
t
andsuitablymodifytheirStructure,organization,proceduresandprocesscanthinkofgrowthand

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survival. As it is well known that Indian financial system was tailored keeping in view the
requirements of the mixed economy. But the domestic as Well as global contexts have
dramatically changed during nineties. Therefore, it would be relevant to have a look at the
status and future of financial sector and thusaccordingly the changing role of market
regulator. Thechallengesbeforevarious intermediaries of financial sector and also the
regulators arise because something has happened which tells us that things cannot go as
they used to go in the past.

INDIANFINANCIALSYSTEM
The financial system consists of a variety of institutions, markets and instruments. It
provides the principal means by which savings arc transformed into investments. Given its
role in the allocation of resources, the efficient functioning of the financial system is of
critical importance to a modemeconomy. The Figure. 1 presents atypical structure of
financial system in any economy.
FUNCTIONSOFTHEFINANCIALSYSTEM
Inmodemeconomy,thefinancialsystemperformsthefollowingfunctions.
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a) Itprovidesapaymentsystemfortheexchangeofgoodsandservices.

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 b) Itenablesthepoolingoffundsforundertakinglargescaleenterprises.
c) Itprovidesamechanismforspatialandtemporaltransferof resources.
d) Itprovidesawayformanaginguncertaintyandcontrollingrisk.
e) Itgeneratesinformationthathelpsincoordinatingdecentralizeddecision-making.
f) Ithelpsindealingwiththeproblemsofinformationalasymmetry.
A well-developed financial system offers a variety of instruments that enable economic agents to
pool price and exchange risk. It provides opportunities for risk pooling and risk sharing for
both household and business firms. As Robert Merton says:
“It facilitates efficient life-cycle risk bearing by households, and it allows for the separation of the
providers of working capital for real investments (i.e., personnel, plant and equipment)
from the providers of risk capital who bear the financial risk of those investments.”
Mainly, financial instruments, financialinstitutions, andfinancialmarkets constitute
thefinancialsystem. Financial instruments range from the common (coins, currency notes,
demand deposits, corporate debentures, gilt-edged securities, equity shares, units, agro-
bonds) to the more exotic (future-and options). Financial instruments may be viewed as
financial assets and financial liabilities.
Financial assets represent claims against the future income and wealth of others. Financial
liabilities, the counterparts of financial assets, represent promise to pay some portion of
prospective income and wealth to others. Financial assets and liabilities emanate from the
basic process of financing. They distribute the returns and risks of economic activities to a
variety of participants.
Theimportantfinancialassetsandliabilities,claimsandpromises,inIndiaareasfollow:-
a) Money
b) DemandDeposit
c) Short-termDebt.
d) Intermediate-termDebt
e) LongtermDept
f) EquityStock
g) Futuresandoptions
h) Financialderivatives
i) Bonds
FINANCIALINSTITUTIONS
The primary role of afinancial institution isto serve asan intermediarybetween lenders
andborrowers. Financial institutions in the organized sector come under the regulatory
purview of RBI/Securities and Exchange Board of India. In India there are till India Financial
Institution like IDBI, ICICI, IFCI etc. and the State level Financial Corporation set up under
State Financial Corporation Act. 1993.
FINANCIALMARKETS
A real transaction that involves exchanges of money for real goods or services, whereas a
financial transaction involves creation or transfer of a financial asset. Financial
transactions includes issue of equity stock by a company purchased of bonds in the
secondary market, deposit of money in a bank account, transfer of funds from a current
account to a saving account. The financial transactions are very pervasive throughout the

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 economic system.
Hence financial markets, which exist where ever financial transactions occur, are equally
pervasive. There are two broad segments, of the financial market, viz. the money market
and the capital market. Themoneymarketdealswithshort-
termdebt,whereasthecapitalmarketdealswithlong-termdebt

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and stock (equity and preference). Further, each of these markets has a primary segment
and a secondary segment. New financial assets are issued in the primary market, whereas
outstanding financial assets are traded in the secondary segment.

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CORPORATESECURITIES MARKET
The capital market is the market of financial assets that have long or indefinite maturity.
The Figure 2 depicts the components of India Corporate Securities Market.When a
company wishes to raise capital by issuing securitiesorother entityintendsto raise
fundsthroughunits, debt instruments,bonds, etc., it
goestotheprimarymarketwhichisthesegmentof
thecapitalmarketwhereissuersexchangefinancial securities for long-term funds. The
primary market facilities the formation of capital.
There are three ways in which a company may raise capital in the primary viz., market-
public issue, right issue, and private placement. Public issue, which involves sale of
securities to members of the public, is the most important mode of raising long-term
funds. Rights issue is the method of raising further capital from existing shareholder by
offering additional securities to them on a pre-emptivebasis. Private placement is a way of
selling securities privately to a small group of investors.
The secondary market of India, where outstanding securities are traded, consists of the
stock exchanges which are self-regulatory bothes under the overall regulatory purview of
the government/SEBI. Recently, SEBI has proposed the trading in futures and options
(capital market derivatives): Accordingly, the definition of securities under SCRA will have
to be amended.
The government has accorded powers to the Securities and Exchange Board of India
(SEBI), as an autonomous body, to oversee the functioning of the securities market and
the operations of intermediaries like mutual funds and merchant bankers, underwriter’s
portfolio managers, debenture trustee, hankers to an issue, sub brokers. FIIs (Foreign
Institutional Investors), plantation companies schemes including rating agencies and also
to prohibit insider trading.
PROBLEMAREASINTHEFINANCIAL SYSTEM
One of the basic problem with the financial system is that “it continues to the fragmented
by artificial barriers hindering smooth flow of resources making it inefficient (although the
present economy has taken the initiatives in the trisection of taking away these barriers
and to make financial markets/systems smooth and progressing) and expensive. Although,
the financial sector reforms seeks to address the problem of a fragmented system yet
there is a scone for further improvement in the system.
Hence to conclude Financial Markets. Services and institution in India are taking shape for.
turbulent times and various intermediaries, market participants and institutions are
gearing themselves to meet the challenges of change.
FINANCIALMARKETS:EMERGINGTRENDS
The rapid growth and globalization of financial markets is perhaps one of the most
significant developments in the world economy. This development has far reaching
consequences, not only for financial markets per se but the growth and direction of world
business. No other development has contributed so much to |the growth of inter-
dependence among the nations. Total volume of fundsmade available through these
markets for exceed the flows of the un sponsored international financial institutions.
In itsbid to open up the country’smoney, the Government of India hasgeared up
thefinancialsectorto meet the challenges, which economy is likely to face. As such Indian
financial market is undergoing a process of rapid change which as transformed the entire
1
0
complexion of financial system. The Government of India during last few years have
announced a number of measures to make the Indian financial markets more potent and
capable of raising vast resources from the domestic market and abroad. This chapter
discusses some of these aspects emerging from structural changes in financial markets.

1
1
Financial deregulation and innovations have changed the whole structure and functioning
of financial markets of many industrialized countries since the beginning of 1970s.
This trend also influenced the growth of financial systems of several countriesin the Asia
Pacificregion during 1980s and 1990s. The developments relating to globalization of
financial markets, market oriented financial structure, evolution of regional trading blocks
like EEC. Asia-Pacific, North America, etc. growth of investment banking, narrowing of
functional differentiation between banking etc. are in general the results of the above
changes.
In comparison with Newly Industrializing Countries and ASIAN countries, out-
economicgrowthmaynot measure up to the potential nonetheless the liberalization policies
have definitely helped the country in recording better performance in the 1980s. However
the significant policy pronouncements since the middle of 1991 onwards certainly
improved the growth of economy during the first subsequent years of reform process.
RATIONALEOFFINANCIALMARKETREFORMS
With the objective of bringing about a highly competitive system and promoting efficiency
in the real sectors of the Indian economy, recent economic reforms in the areas of trade,
industry and exchange rate system have been undertaken to coned the macro-economic
imbalances and to bring about the structural adjustments. The liberalization and
supportive policies of the Government have gained momentum in the last few years with
major plans of diversification, expansion and modernization of industrial sector in the
country. This has led to an increased demand for funds and encouraged authorities to find
out alternative sources of finance for the industry. Since the conventional budgetary
support cannot he of any positive help to the public sector and the private corporate
sector which used to depend heavily on banks and financial institutions in the past, now
collects funds from the capital markets.
The Indian financial markets play a crucial role in economic development through, saving
investment process, also known as capital formation. A vibrant and competitive financial
market is necessary concomitant of trade and industrial policy liberalization to sustain the
ongoing reform in the structural aspects of the real economy. Many financial sector
reforms were undertaken to improve the efficiency and stability of the financial system
and internal and external development which made it increasingly difficult to maintain a
rightly regulated financial system.
The process of liberalization initiated by the Government has not been new but prior
piecemeal efforts were not stable and widespread. The structural reforms initiated during
since 1991 have had a positive impact on the investment climate of the country. The new
economic policies aimed at liberalization and globalizations are all embracing, consistent
and appear to be irreversible. The country has pursued conservative, inward looking
policies for almost four decades. The positive effect of these policies may be many but
they are out weighed by their negative impact of inefficiency, corruption, delays and non
competitive nature of industrial / economic environment. Many mighty socialist economies
have crumbled under their dead weight and India could very well imagine what is in store
for it, if it does not change the course. The whole nation is in a mood for change at the
beginning of the new' century and liberalization process is getting a fair trial in spite of
scams and corruption charges.
Capita] market which is concerned with the supply of long-term funds in response to
gradual liberalization of economic and industrial policies since the beginning of eighties
resulted in a virtual capital market revolution. In its bid to open up the country’s economy,
1
2
the Government of India has geared up the financial sector to meet the challenges, which
economy is likely to face. As such Indian financial markets are undergoing a process of
rapid change which has transformed the entire complexion of financial system. The
Government of India during last few years have announced a number of measures to
make the Indian financial markets more potent and capable of raising vast resources from
the domestic market and abroad.

1
3
Thepurposeof this chapter is to examine thedevelopments in the Indianfinancial markets,
as a result of liberalized policy of the government The objective is to review the policy
changes initiated to tap the international resources for the development of the economy.
INDIANFINANCIALSYSTEM: ANECONOMICANALYSIS
The role ofmoney and finance in economic activities is a much discussed topic among
economists.The issue has been looked at differently in various branches of Economics. Is it
possible to influence the level of economic activities, that is the level of national income,
employment, and so on, through variations in the supply and volume of money and credit?
How far can economic fluctuations or business cycles be controlled by manipulating the
period of production on the one hand and the monetary factors on the other? How far is
development a matter of financing capital formation?
Although money and finance by themselves cannot bring about economic development, it
is now agreed that they do play a significant role in bringing, about economic
development. Given the real resources and suitable attitudes, a well-developed financial
system can contribute materially to the acceleration of economic development.
Thus, the role of financial system is to accelerate the rate of economic development, and
thereby improve the general standard of living, and increase the social welfare. This is
achieved through the mobilization and increase of savingsand investment, i.e.
bystimulating the accumulation of capitaland by allocating capital efficiently for socially
desirable and productive purposes. This, in turn, is achieved by financial markets by
performing a number of important and useful proximate functions or
byprovidinganumberofservicessuchas(i)enablingeconomicunitstoexercisetheirtimepreferen
ce,
(ii) separation, distribution, diversification, and reduction of risk, (iii) efficient operation of
payment mechanism, (iv) transmutation or transformation of financial claims so as to suit
preferences of the saversandborrowers,
(v)enhancingliquidityoffinancialclaimsthroughsecuritiestrading,and
(vi) portfolio management. Let us briefly describe the process through which the financial
system contributes to economic development.
Economic development is to a very great extent dependent on the rate of investment or
capital formation which, in turn, depends on whether finance is made available in time,
and the quantity of it, and the terms on which it is made available. In any economy, in a
given period of time, there are some people whose current expenditures are less than
their current incomes, while there are others whose current expenditures exceed ‘their
current incomes. In current terminology, the former are called the ultimate savers or
surplus-spending- units, and the latter are called the ultimate investors or the deficit-
spending-units.
Modern economies are characterized (a) by the ever-expanding nature of business
organizations such as joint-stock companies or corporations; (b) by the ever-increasing
scale of production; (c) by the separation of savers and investors; and (d) by the
differences in the attitudes of savers (cautious, conservative, arid usually averse to taking
risks) and investors (dynamic and risk-takers). In these conditions of what Samuelson calls
the dichotomy of saving and investment, it is necessary to connect the savers with the
investors. Otherwise, savings would be wasted (hoarded) for want of investment

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opportunities, and investment plans will have to be abandoned for want of savings. The
function of a financial system is to establish a bridge between the savers and the investors
and thereby help the mobilization of savings and thus enable the fructification of
investment ideas into realities. Figure.3 reflects such a role of the financial system in
economic development.
A financial system also directly helps to increase the volume and rate of savings by
supplying diversified portfolio of financial instruments, offering investment inducements
and choices which are in

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keeping with the array of savers’ preferences. It becomes possible for the deficit-spending
units to undertake more investment expenditures because the financial system
enabledthem to command more capital. As Schumpeter has said, without the transfer of
purchasing power to him, anentrepreneur cannot become the entrepreneur.
A financial system not only encourages investment, it also efficiently allocates resources in
different investment channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selective supporting of business units or borrowers through
project appraisal, feasibility stuthes, monitoring, and generally keeping a watch over the
execution and management of projects.

Fig.3Relationshipbetweenfinancialsystemandeconomicdevelopment

The contributionof afinancial system to the developmentprocess goes beyond merely

increasingprior saving based investment.
It plays a positive and catalytic role by providing finance or credit through creation of
credit in anticipation ofsavings. This, to a certain extent, ensures the independence
ofinvestment from saving in a given period of time. According to Schumpeter, Keynes, and
Kalecky, the investment financed through created credit generates the appropriate level
of income which, in turn leads to an amount of
savingswhichareequaltotheinvestmentalreadyundertaken.TheFirstFiveYearPlaninIndiaecho
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ed this view when it stated that the judicious credit creation in production and availability
of genuine savings has also a part to play in the process of economic development. It is
however, to be noted that

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this role assumes that investment out of created credit is not faulty and that it results in
prompt income generation. If thisassumption isnotfulfilled,the initial creditcreation
resultsinsustainedinflation rather than sustained growth.
Another contribution of a well-developed financial system is to facilitate the normal
production-process and exchange of goods, and to enlarge markets over space and time.
In other words, financial system enhances the efficiency of the function of medium of
exchange and thereby helps in economic development.
The relationship between economic development and financial development is symbiotic
or mutually reinforcing. While financial markets accelerate development, they, in turn,
grow with economic development. In the words of Schumpeter, “the money market is
always... the head quarters of the capitalist system, from which orders go out to its
individual divisions, and that which is debated and decided there is always in essence the
settlement of plans for further development. All kinds of credit requirements come to this
market; all kinds of economic project are first brought into relation with each other and
contend for their realization in it; all kinds of purchasing power flows to it to be sold.
Thisgives rise to a number of arbitrage operations and intermediate manoeuvres which
may easily veil the fundamentalthingThus, themainfunctionofthemoneyor capitalmarketis
tradingincredit for the
purpose of financial development. Development creates and nourishes this market. In the
course of development, it becomes the market for sources of income themselves.
SELFCHECKEXERCISE:-
1. Define‘FinancialMarket’.
2. Whatis‘FinancialSystem’?
3. Whatis‘SecurityMarket’?
4. Whatis‘FinancialStructure’?
SUMMARY
Indian financialmarkets are sub-divided broadly into money markets(that deal in short-
termfunds)and capital markets (that deal in long-term funds). Structurally, money market
comprises both organisedand unorganised sectors. Unorganised sector is normally made
up of indigenous money lenders and bankers who do not follow formal lines of business.
Their businesses are informal and thusindependent of the Reserve Bank of India or banks
for any fund support. This sector is shrinking but, during the period of economic reforms
launched after 1991, the activities of these institutions have become a matter of serious
concern and anxiety. The organised component of money market consists of the RBI,
commercial banks and cooperative banks. The RBI is the head of the financial
institutionsas well asthe monetaryauthorityof the country. In the diagram, we have not
shown anything about the RBI.
GLOSSARY
Bank: Bank is a financial institution where customers can save or borrow money. Banks
also invest money to build up their reserve of money. Banks may give loans to customers
under an agreement to pay the money back to the bank at a later time, with interest.
Finance: Finance is a broad term that describes activities associated with banking,
leverage or debt, credit, capital markets, money, and investments. Finance also
encompasses the oversight, creation, and studyof money,banking,credit,

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investments,assets,and liabilities that makeupfinancialsystems.
Financial Institution: Financial Institution is a company engaged in the business of dealing
with financial and monetary transactions such as deposits, loans, investments, and
currency exchange.

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Financial System: Financial system is a system that allows the exchange of funds
between lenders, investors, and borrowers. Financial systems allow funds to be
allocated, invested, or
movedbetweeneconomicsectors.Theyenableindividualsandcompaniestosharetheassoci
ated risks.
Monetary System: Monetary system is something related to money or currency. The
system wherein people pay with dollar billsand other paper money isan example of the
monetary system.
ANSWERSTOSELFCHECK EXERCISE
1. RefertoSection1.2
2. RefertoSection1.3
3. RefertoSection1.7
4. RefertoSection1.2
TERMINALQUESTIONS
1. Whatdoyouunderstandbyfinancial system?
2. Discussthefunctionsofthefinancialsystem?
3. Discussthefunctionsoffinancialmarket?
4. Discussthedifferentmarketstobefoundinthefinancialsystem?
ANSWERSTOTERMINALQUESTIONS
1. RefertoSection1.1,1.2&1.3
2. RefertoSection1.4
3. RefertoSection1.6&1.7
4. RefertoSection1.1&1.9
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. Gomez Clifford (2008). FinancialMarkets, Institutions and Financial Services. Prentice Hall
of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari (2012). FinancialServicesin India: Conceptand Application,
Sage publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.JainBook Agency,
Mumbai.

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 Chapter-2
Moneyand CapitalMarket

STRUCTURE
LearningObjectives
Introduction
FinancialMarkets
MoneyMarket
CharacteristicsoftheMoneyMarket
NeedforaMoneymarket
GoalsoftheMoneymarket investor
CapitalMarket
NatureandConstituents
GrowthofCapitalMarket
ComponentsoftheCapitalMarket
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
Suggested Readings
LEARNINGOBJECTIVES
Afterstudyingthischapteryoushouldbeableto:
1. Explaintheclassificationof thefinancialmarkets.
2. Describethefunctionsofthemoneymarket.
3. Knowthecomponentsandgrowthofthecapitalmarket.
INTRODUCTION
Each and every business unit must operate within the financial environment. The financial
system consists of a number of organizations, institutions and market. They secure the
needs of the consumers, firms and governments. If a firm invests the idle funds temporarily
in marketable securities, then it has to approach the financial market. Most of the firms
use the financial markets to finance their investments in assetsFinancial markets can be
defined as“All Institutionsand procedures for bringing buyers and sellers of the financial
instruments together”. They provide better facilities for buying and selling of all the
financial claims and services. All the participants trade in the financial products in the
markets either directly or through the brokers. Financial institutions, agents, brokers,
dealers, borrowers, lenders and savers participate both on demand and supply sides of the
financial markets. The demand for capital will be influenced by the business expectations
regarding the future state of the economy. The demand for goods is highly influenced by
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1
the prices, government policies, profitability, availability of internal funds, cost of funds
and technology changes. On the other hand, the

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supply of funds depends on its level of savings by the household sector, business sector
and government sectorina giveneconomy. The savingsof theparticipantsin the marketare
determined by anumberoffactors.Thefactorswilldependonthelevelof currentandexpected
income,distributionof income in the economy, degree of certainty in income, wealth,
inflation provision for old age, family members, rate of interest, availability of savings
media with required investment characteristics. The development banks and financial
institutions can alsoinfluence the supply of funds. The government will determine the
volume of supply of funds, allocation of funds, cost of funds and other factors.
FINANCIALMARKETS
The financial markets are characterized by many imperfections, restrictive practices,
existence of transactioncosts,lackof
information,limitednumberofoperators,directandindirectinterventionbythe authorities and
soon.
The financial markets may be categorized as the primary and secondary markets. The
Primary market is also known asthe Direct Market. The Secondary market isalso known
asthe indirect market Further the Direct market is called as the “NewIssue Market”. The
NIMdealswith thenewsecuritiesoffered by the newly established concerns or the existing
enterprises. On the other hand the Secondary market deals with securities that are
already issued by the Companies. The primary market creates the capital formation in
thecountry. It channelises the savings in a productive way. The secondary markets do not
contribute directly to the supply of the additional capital. But it will provide liquidity to the
primarymarket. Therefore the NIM and secondary markets have impact on each other.
Thefinancialmarketsarealsoclassifiedas:
(a) OrganizedandUnorganized.
(b) Formaland Informal.
(c) Officialand Parallel.
(d) DomesticandForeign.
The financial transactions which arise in a systematic manner in an organized system are
called as “Organized Markets”. The financial transactions which take place outside the
well-establishedexchange constitute the “Unorganised Markets”. The Unorganized markets
refer to the markets in rural areas. The “Informal markets” constitute the financial
transactions which arise between the individuals and small families.
Thefinancialmarketsarefurtherclassified as:
A. Moneymarket,and
B. Capitalmarket.
There is no difference between these two markets. Both of them perform the same
functions in the transferring of the financial assets. They provide a mechanism to sell the
financial assets.
MONEYMARKET
The Money market is a market for the short-term funds. It provides funds for less than a
period of one year. It isdominatedbythe CentralBank. The RBIisthe watch-dog of the
monetarysystem. It provides a channelfortheexchangeof thefinancialassetsformoney. The
money market is of very great help in the financing industry and commerce for their
working capital requirements. The money marketincludes money, capital and bill markets.
Markets consists of both money and capital markets. In the money market, the fund

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isbeing sold and purchased at a certain price. It is like the commodity market.It refers to
lending and borrowing activities of banking, financial institutions and individuals.
The Money market is defined by A. Crowther as “the money market is the collective name
given to various firms and institutions that deal with various grades of near money.” It
deals with the trade bills,
promissorynotes,andtreasurybillsforashortperiod.TheRBIdefinedthemoneymarketas“the

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money market is a marketforshort-termfinancialassets that are close
substitutesformoney,facilitates the exchange of money for the new financial claims in the
primary market and also for the financial claims, already issued in the secondary market.”
The Central Bank Act as a promotional and development banker in the money market. The
money market can be organized as the organized sector and unorganized sector. The
unorganized sector consists of indigenous bankers and village moneylenders. The
organized sector consists of the RBI, SBI, Mutual Funds, Companies, Cooperative Societies
and Financial Institutions. Geographically, the money market may be located or associated
with a particular place like Indian Money Market, NewYork Money Market,Bombay Money
Marketetc. In theBombay Money Market,theshort-term loanable fund is available for the
whole India. The London Money Market, on the other hand is a market of international
importance. It is known as the International Money Market. It attracts the short-term funds
from all over the world for redistribution among the borrowers. The demand for the short
period comes primarily from the Government, Business concerns and Private individuals.
The Government has become probably the biggest borrower; everywhere money is being
required to meet the current deficits. Individual and Commercial concerns borrow funds for
working capital needs. Sometimes they borrowto enable to carryadditionalinventories.
Theotherimportant privateborrowersincludethe stock exchange brokers, dealers in the
government and other security merchants, manufactures, fanners. Banks themselves may
require additional funds and may borrow from the Central Bank or from each other. The
supply of loanable funds in the money market comes mostly from the Central Bank of the
country, the Commercial Banks and other finance companies. The Central Bank is the
source of credit totheCommercialBankswhilethelatterconstitutethemostimportantsourceof
theshort-termcreditto the individual houses, business houses and the brokers.
CHARACTERISTICSOFTHEMONEYMARKET
Thefollowingarethecharacteristicsofthemoneymarket:
1. Itinvolvesinthearrangementoftheshort-termfunds.
2. Itisatoolforthepreparationofthemonetarypolicyandfiscalmanagement.
3. Itdealswiththehighliquidinstruments.
4. TheplayersinthismarketaretheRBI,CommercialBanksand Companies.
5. ItissubjectedtotheRBIregulations.
6. Ittellsaboutthetrendsintheliquidityandinterestrates.
7. Itprovidesfundsatlowtransactioncost.
8. Itsuitstherequirementsoftheborrowersfortheshort-termfunds.
9. Itencouragestheopenmarketoperations.
Different sub-marketsof a developed money market help in the properfunctioning of the
Central Bank. The money market and the short-term rates of interest serve as a good
barometer for monetary and banking conditions in the country. Thus they provide a
valuable guide in determining the Central Banking Policy, the developed money market
being a highly integrated structure enables the Central Bank to deal with the most
sensitive sub-markets also.
Themainborrowersoftheshort-termfundsinthemoneymarketare:
1. CommercialBanks.
2. CentralGovernment
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3. StateGovernment.
4. CorporateSector.

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 5. Local Bothes.
The money market isunable to meetthe long-term requirements of the industries. It consistsof
Central
Banks,CommercialBanks,CooperativeBanks,SavingsBanks,DiscountHouses,AcceptanceHou
ses, bill market, bullion market etc. The existence of a well-developed money market
ensures that themarket instruments can be converted into money without incurring much
loss.
NEEDFORAMONEYMARKET
1. Itisacoordinatorbetweenborrowersandlendersoftheshort-termfunds.
2. Itprovidesthetransmissionoffundsfromsurplusconcernstotheshortagefundsconcerns.
3. ItisadeviceoftheGovernmenttobalanceitscashinflowsand outflows.
4. Itisaweaponofthebusinessfirmstomeettheirshort-termfunds.
5. MoneyMarketcreates theminimumrateofreturnontheidlefundlyingatthedisposal ofthe
Corporate and Banking Sectors.
6. It is tool to the finance managers in more utilization of the funds to enhance the
share-holder’s wealth.
ThefollowingchartshowsthestructureoftheIndianMoneyMarket:

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GOALSOFTHEMONEY MARKETINVESTOR
1. Themainobjectiveoftheinvestorsinthemoneymarketisaboutthesafetyandliquidityoft
he principal amount. They also think about some gains along with their amount.
2. TheMoneymarketisaparkingplaceofanidlefund.
3. TheInvestorwiselyescapesfromthe long-termmarketrisks.
4. Moneymarketinstrumentsgenerallyoffermoreprotectionagainstthepoliticalriskandin
flation risk.
5. Inmoneymarket,theinvestorneverfacesdefaultrisk.
On overall evaluation of the money market, we can find that it is entirely dominated by the
RBI. All the policy matters of the sector will be finalized by the India’s Central Bank. The
SEBI and the other statutory organizations have been playing an important role in the
smooth functioning of the Money Market. It is a powerful weapon in the hands of the
Central Government. It is handled skillfully by the Ministry of Finance. Crores of rupees are
available in the market at the disposal of various large organizations within few hours.
Therefore the development of the Money Market can boost the wealthof a nation. It also
encourages the capital market.
CAPITALMARKET
Capital Market is the market for long-term funds. It deals long-term and medium term
funds. Capital market consists of shares, stocks, debentures and bonds. Securities dealt in
capital market are long- term securities. The funds which flows into the capital market
comes from the savers. It provides a market mechanism for those who have savings and
to those who need funds for productive investments. It diverts resources from wasteful
and unproductive channels to productive investments. Since 1951, the Indian Capital
Market has been broadening slowly. There is a steady improvement in the volume of
savings and investment. Many types of encouragement and tax relief exists in thecountry
to promote savings. Many steps have been taken to protect the interests of the investors.
The growth of capital market indicates the growth of Joint Stock Companies and corporate
enterprises. In 1951,there were 28,500 companies with a paid up capital of nearly Rs. 7.5
crores and as on 31-3- 1998, there were more than 2,00,000 companies with a paid up
capital of nearly Rs. 1,37,959 crores. The growth of investment has been quite
phenomenal in recent years in accordance with the accelerated tempo of development.
CapitalMarketcanbedefinedas“themarketforrelativelylong-termfinancialinstruments.”
According to Arun K. Datta the capital market may be defined as “the capital market is a
complex of institutions investment and practices with established links between the
demand for and supply of different types of capital gains.”
Further F. Livingston defined the capital market as “In a developing economy, it is the
business of the capital market to facilitate the main streamof command over capital to the
point of the highest yield. By doing so, it enables, controlover resources to pass into the
handsof those who can employ them must effectively thereby increasing production
capacity and spelling the national dividend.”
Capital market consists of gilt edged market and fire industrial securities market. The gilt
edged market refers to the market for government and semi-government securities
backed by the RBI. The securities traded in this market are stable in value and aremuch
sought afterby the bankerand otherinstitutions. The Industrial securities market refers to

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the market for equities and debentures of old and new companies. The industrial securities
market is further divided by the new issue market and further capital issue market. The
new issue market refers to the raising of capital by the new companies in the form of
shares and debentures. While further old issue capital deals with securities already issued
by theexisting companies. The twomarketsare equallyimportant. But the NIMismuch more
importantfor

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the capital formation in the country. However, the functioning of NIM will be facilitated
only when there are facilities for the transfer of the existing securities. Considerable
deregulation of financial markets whose taken place in India favouring the unbridled
growth of financialservices companies. The reforms have been increased competitiveness
within the financial sector by means of, interest rates, allowing new financial institutions
and instruments. As a consequence, the scope and activities of the banks,and non-banking
finance companies have expanded rapidly due to the liberalization drive, more particularly
since 1991, the non-banking finance companies have been competing and complementing
the services of the Commercial Banks. It has been observed that the growth of non-
banking finance companies are more pronounced than banking companies.
NATUREANDCONSTITUENTS
The capital markets consists of a number of individuals and institutions. The Government
is also an important player in the capital market. The players in the capital market
canalize the supply anddemand for the long term capital. The constituents of the capital
markets are the stock exchange, commercial banks, co-operative, banks, savings banks,
development banks, insurance companies, investment trusts and companies etc.
GROWTHOFTHECAPITALMARKET
The Indian financial system is both developed and integrated today. Integration has been
through a participatory approach in granting loans as well as in saving schemes. The
expansion in size and number of institutions has led to a considerable degree of
diversification and increase in the types of financial instruments in the financial sector
which are wholly owned by the government
The development banks in the Indian financial system have witnessed vast changes in the
planning periods.Nowthedevelopmentbanksconstitutethebackboneof
theIndiancapitalmarket.Therelevant of the development banks in the industrial financial
system is not merely qualitative, but they have overwhelming qualitative dimensions in
terms of their promotional and innovational functions. The growth of the capital market is
determined by the following factor:
• Economicdevelopment.
• Rapidindustrialization.
• Levelofsavingsandinvestmentof thehouseholdsector.
• Technologicaladvances.
• Corporateperformance.
• Regulatoryframework.
• Participationofforeigninstitutionalinvestorsinthecapitalmarket.
• Developmentoffinancialservices.
• Liquidityfactors.
• Politicalstability.
• Globalization.
• Financialinnovation.
• Economicandfinancialsectorreforms.

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• Internationaldevelopments.
• Agencycosts.
• Emergenceoffinancialintermediaries.

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 • Specializationamonginvestmentmanagers.
• Incentives.
• Speedinacquiring,processingandactinguponinformation.
• NRIsinvestment
COMPONENTSOFTHECAPITAL MARKET
In a capitalmarket,banksandfinancialinstitutionsare the important components. Theyact
ascatalysts in the economic development of any country. These institutions mobilize
financial savings from household, corporate and other sector of the economy and
channelise them into productive investments. They act as a Reservoir of resources and
form the backbone of theeconomic and financial system. The banking industry has
undergone a sea change during the last three decades. After the modernization of banks,
they not only lend for the social and economic causes but also participated in the
development programmes of the central government and state government. The main
components of the capital market in India are:
 New-IssueMarket(NIM)
 SecondaryMarket(Stockmarket)
SELFCHECKEXERCISE
1. Whatis‘Money Market’?
2. Define‘CapitalMarket’?
3. Define‘FinancialMarket’?
4. Whatis‘NewIssueMarket’?
SUMMARY
Money market basically refers to a section of the financial market where financial instruments
with high liquidity and short-term maturities are traded. The Money market has become a
component of the financialmarketforbuying and sellingof securitiesof short-
termmaturities,of one yearorless, such as treasury bills and commercial papers. Over-the-
counter trading is done in the money market and it is a wholesale process. It is used by
the participants as a way of borrowing and lending for the short term. Money market
consists of negotiable instruments such as treasury bills, commercial papers and
certificates of deposit. It is used by many participants, including companies, to raise funds
by selling commercial papers in the market. Money market is considered a safe place to
invest due to the high liquidity of securities. The money market is an unregulated and
informal market and not structured like the capital markets, where things are organised in
a formal way. Money market gives lesser return to investors who invest in it but provides a
variety of products.
GLOSSARY
BillMarket:Isamarketwhereshort-termpapersorbillsaretraded.Thesebillsincludebillsof exchange
and treasury bills.
Call/NoticeMoneyMarket:Isamarketwheretheday-to-daysurplusfunds,mostlyofbanksare traded.
Commercial Bill:Itisaninstrument usedintheIndianmoneymarkettofinancethemovement and
storage of agricultural and industrial goods in domestic and foreign trade.

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Commercial Paper: It enable highly rated corporate borrowers to diversify their sources of
short-term borrowing and also to provide an additional instrument to investors.

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Derivative PromissoryNotes: Underthisinstrument,banks werepermittedto
issuederivativeusance promissory note for a period not exceeding 90 days under the
strength of underlying bills.
DiscountHouses:Itperformsthefunctionofdiscounting/rediscountingthecommercialbillsandT-
Bills.
Money Market: Is a market for short-term funds and covers money and financial assets that
are close substitutes for money.
Repo: It refers to a transaction in which a participant acquires fund immediately by selling
securities and simultaneously agreeing for repurchase of the same or similar securities
after specified period of time at a given price.
ANSWERSTOSELFCHECK EXERCISE
1. RefertoSection2.3
2. RefertoSection2.7
3. RefertoSection2.2
4. RefertoSection 2.10
TERMINALQUESTIONS
1. Describethecharacteristicsofamoneymarket.
2. What istheneedfora moneymarket?
3. Explainthegrowthandcomponentsofthecapitalmarket.
ANSWERSTOTERMINALQUESTIONS
1. RefertoSection2.3&2.4
2. RefertoSection2.5
3. RefertoSection 2.10
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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 Lesson-3
MoneyMarketInstruments

STRUCTURE
LearningObjectives
Introduction
FeaturesofMoneyMarket
MoneyMarketInstruments
CallMoney Market
TermMoney Market
TreasuryBills
CertificatesofDeposits(CDs)
CommercialPaper
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
Suggested Readings
LEARNINGOBJECTIVES
Afterstudyingthislessonyoushouldknow:
1. Thefeaturesofthemoney market.
2. Thevariousmoneymarketinstruments.
INTRODUCTION
Money market is a very important segment of the Indian financial system. It is the market
for dealing in monetary assets of short-term nature. Short-term funds up to one year and
forfinancial assets that are close substitutes for money are dealt in the money market.
Money .market instruments have the characteristics of liquidity (quick conversion into
money), minimum transaction cost and no loss invalue. Excess funds are deployed in the
money market which in turn are availed of to meet temporary shortages of cash and other
obligations. Money market provides access to providers (financial and other institutions
and individuals)and users (comprising institutionsand government and individuals) of
short-term funds to fulfill their borrowings and investment requirements at an efficient
market clearing price. The rates struck between borrowers and lenders represent an array
of money market rates. The inter-bank overnight money rate is referred to as the call rate.
There are also a number of other rates such as yields on treasury bills of varied maturities,
commercial paper rate and rates offered on certificates ofdeposit Money market performs
35
the crucial role of providing an equilibrating mechanism

36
to even out short-term liquidity and in the process, facilitating the conduct of monetary
policy. Short- term surpluses and deficits are evened out. The money market is the major
mechanism through which the Reserve Bankinfluencesliquidityand thegenerallevelof
interest rates. The Bank’sinterventionsto influence liquidity serve as a signaling-device for
other segments of the financial system.
The Indian money market was segmented and highly regulated and lacked depth till the
late eighties. It was characterized by a limited number of participants, regulation of entry
and limited availability of instruments. The instruments were limited to call (overnight)
and short notice (up to 14 days) money, inter-bank deposits and loans and commercial
bills. Interest rates on market instruments were regulated. Sustained efforts for developing
and deepening the money market were made only after the initiation of financial sector
reforms in early nineties.
FEATURESOFMONEYMARKET
The money market is a wholesale market. The volumes are very large and generally
transactions are settled on a daily basis. Trading in the money market is conducted over
the telephone, followed by written confirmation from both the borrowers and lenders.
There are a large number of participants in the money market: commercial banks, mutual
funds, investment institutions, financial institutions and finally the Reserve Bank of India.
The bank’soperationsensure that the liquidityand short-terminterest ratesare maintained
at levelsconsistentwith the objective of maintaining price and exchange rate stability. The
central bank occupies a strategic position in the money market. The money market can
obtain funds from the central bank either by borrowing or through sale of securities. The
bankinfluences liquidity and interest rates by open market operations, REPO transactions
changes in Bank Rate, Cash Reserve Requirements and by regulating access to its
accommodation. A well-developed money market contributes to an effective
implementation of the monetary policy.
MONEYMARKETINSTRUMENTS
Themoneymarketinstrumentscompriseofcallmoney(whichisovernightandshortnoticeupto
14 days), term money (1,3 and 6 months), certificates of deposits (CD), participation
certificates, commercialpaper(CP), moneymarket mutualfunds, commercialbills,
treasurybillsand inter-corporate funds and Forward Rate Agreements (FRAs)/Interest Rate
Swaps (IRS). Of these instruments, call moneyand short notice money market and treasury
billsform the most important segment of the Indian money market. The major players in
this market are banks, financial institutions and primary dealers.
CALLMONEYMARKET
The call/notice money market was predominantly an inter-bank market until 1987, except
for UTI and LIC which were allowed to operate as lenders since 1971. Call rates were freed
from the ceiling rate in May, 1991 enabling price discovery. The Discount and Finance
House of India was set up on 1988, in order to provide reasonable access to users of short-
term money by promoting secondary market in money market instruments; and Securities
Trading Corporation of India (STCI) was set up in 1994 to provide an active secondary
market in government securities and public sector bonds. ‘Inter-bank liabilities were freed
from reserve requirements in April, 1997 to generate a smooth yield curve and reduce
volatility in call rates. The Bankhaswidened the market in1996-97 byincreasing the
number of participants. Apart from banks who traditionally formed the core, the bank
permitted Primary Dealers to participate in the call/notice money market as both
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borrowers and lenders. Eleven mutual funds set up in the private sector and approved by
the SEBI were also allowed to participate as lenders. The other participants were the QIC,
IDBI, NABARD, DFHI (1988) and STCI (1994) and corporate. Entities that could provide
evidence of surplus funds have been permitted to route their landings through PDs. The
minimum size of each transaction is Rs. 3 crore and the lender has to give an undertaking
that no outstanding loans exist from the banking sector and money market mutual funds.

38
The market practice is that borrowers/ lenders inform the DFHI about the funds required
by them or available with them at the negotiated interest rate. After DFHI and the
lender/borrower confirm the transaction, these indications are converted into firm
commitments. In case of borrowing by DFHI, a call-deposit-receipt is issued to the lender
against a cheque drawn on the Reserve Bank of India, representing the amount lent.When
DFHI lends, it issues the RBI cheque representing the amountlent to the borrower against
the call- deposit-receipt. The minimum size of operation per transaction is Rs. 10 crore.
The transaction is reversed the next day when the lender surrenders the deposit-receipt duly
discharged, against which the DFHl issues the RBI a cheque representing the principal
amounttogether with interest thereof. In the case of borrowing, a cheque drawn on the RBI
in favour of the DFHI is issued by the borrower representing the interest and principal, in
receipt of which the DFHI surrenders the deposit-receipt duly discharged. Lenders who wish
to renew, inform the DFHI early inthedayorthe nextdayoraftertheexpiry,of thefixeddeposit.
In case DFHIneedsfunds, it can confiim the extension of the transaction on the, deposit-
receipt by recording the date of renewal and the rate of interest. Renewals are allowedup to
14 days afterwhich the transactionhas to be reversed. Funds lent on notice or term basis
are reversed on the due dates. Cooperative banks also participate.
Measures were initiated in April, 1999 to enable non-bank participants to deploy their
short-term resources to develop and widen the repos market with proper regulatory
safeguards such as delivery versuspayment and uniformaccounting. Non-bank participants
were also allowed to accessshort-term moneymarket throughreposonparwithbanksand
PDstofacilitatetheircash management. The move is expected to facilitate nonbank
participants to move out of the call money market. A pure inter-bank call/notice/term
money market is likely to emerge where there would be no restriction on the maximum
periodforwhichreposcanbe undertaken. During1999-2000,the
dailypeakcallratesaveraged9.51%, whereasthe dailylowratesaveraged 8.39%.
Theaveragedailycallrateswere 9.09%. The introduction of Liquidity Adjustment Facility
(LAF) on 5.6.2000 in which rate of interest and amount are varied to respond to day-to-
dayliquidity conditions in the system is likelyto impart a greater degree of stability to the
short-term money market rates and facilitate the emergence of a short-term rupee yield
curve. The refinance rate (export credit and credit to PDs) would also influence the call
rates.
Various reform measures since May, 2001 have rendered the call money market into a
pure inter-bank market closing access of other participants, PDs, mutual funds. Corporate
through primary dealers, financial institutions and non-bank finance companies. To
moderate short-term liquidity, Liquidity Adjustment Facility was introduced in June, 2000.
It has emerged asan effective instrument to provide a corridor for the overnight call rate
movement. This has resulted in stability and orderly market conditions through clear
signaling.
Afewbanks tendedtobeoverly exposedto the call/notice money market imparting high
volatility tocall loans. They carried out banking operations and long-term asset creation
with the help of call money market. The CBSRrecommended that there mustbe
clearlydefined prudent limitsbeyond which banks should not be allowed to relyon call
money market and that accessto this market should essentially be for meeting unforeseen
mismatches and not as regular means of financing banks lending operation. After asset-
liability management system was put in place, the mismatches in cash flows in the 1—28
days bucket were kept under check. Participants operate now within limits on both lending
and borrowing operations. The call money market is now an inter-bank market with ALM
discipline for participants and prudential limits for borrowing and lending.
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In2003-
04,volatilityinthecallmoneymarketdeclinedalongwithturnover(Rs.9,809croreinFebruary,
2004 and Rs. 23,998 crore in October, 2003). The call money rates were in the range of
4.33%-1.91%. A part of the activity migrated to the repo market (outside LAF) and
Collateralized Borrowing and Lending Obligation (CBLO) segment on account of cheaper
availability of funds vis-a-vis call money market.

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TERMMONEY MARKET
The term money market in India has been dormant. The factors that have inhibited the
development of term money market are statutory preemptions on inter-bank liabilities,
regulated interest rate structure, high degree volatility in the call moneyrates,
availabilityof sector specific refinance, cash credit system of financing, absence of Asset
Liability management practices among banks and inadequate development of money
market instruments. RBI has gradually removed most of the constraints in the past
decade. Recent money market reforms encompassing development of the repo market,
introduction of exposure limits for banks in the call money market have infused vibrancy in
the various segments. The average daily turnover in the termmoneymarket rose by52% to
Rs. 519 crore in 2003- 04 from Rs. 341 crore in 2002-03. The volume of transactions has
picked up in response to policy measures to develop the market segments.
TREASURYBILLS
Treasury Bills of the Central Government have been issued since the inception of the bank.
They offer short-term investment opportunity financial institutions, banks under the
normal borrowing programme of the central government and market stabilization scheme
(MSS). They were issued for 91 days. The sales were occasionally suspended. Treasury
Bills are claims, against the government. They are negotiable securities and since they can
be rediscounted with the Bank, they are highly liquid. Their other features are absence of
default risk, easy availability, assured .yield, low transaction cost, eligibility for inclusion in
the securities for SLR purposes and negligible capital depreciation. There are 14-day, 91-
day, 182-day and 364-day treasury bills in vogue in 2005-06. They are not issued in scrip
form. The purchases and sales are affected through the Subsidiary General Ledger
Account.
14-day intermediate Treasury Bills: They are issued for deployment of short-term cash
surpluses by state government. The outstanding amount was Rs. 7,253 crore in 2005-06.
91-day Treasury Bills: There are two types of 91-day Treasury Bills, ordinary and ad-hoc.
Ordinary Treasury Bills are issued to the public and the RBI for enabling the Central
Government to meet the temporary requirement for funds.
TreasuryBillsweresoldontap,since1965,
throughouttheweektocommercialbanksandthepublicat a fixed rate. Under tap sale, bills
can be purchased on any day of the week and the actual rate of discount is not subject to
fluctuations as a result of weekly auctions.
TreasuryBills are repaid at paron maturity. Thedifferencebetweentheamountpaidbythe
tenderer at the time of purchase (which is less than the face value) and the amount
received on maturityrepresents the interest on the Treasury Bills and is known as the
discount.
In the 1992-93 auctions, a scheme was introduced for the issue of 91-day Treasury Bills
with a predetermined amount but with Reserve Bank participation. The notified amount of
each auction isRs. 100 crore. The cut-off yields were significantly higher than the fixed
discount rate of 4.6 per cent per anoum on such bills sold on tap. The notified amount for
weekly auction of 91-day treasury bills was raised to Rs. 500 crore during 2003-04.
182-Day Treasury Bills: These bills were reintroduced from the year 1999-2000 to enable
the development of a market for government securities. They are not rediscountable with
RBI. They are offered for sale on an auction basis. After discontinuing them they were
41
reintroduced with notified amount of Rs, 500 crore forfortnightlyauction in 2005-06. 364-
DayTreasury Bills Anew instrument in the form of 364 days Treasury Bills was introduced at
the end of April, 1992. They are a part of market loans. The auction of these bills on a
fortnightly basis has since then become a regular feature. On account of its relative
attractiveness and since it constituted a safe avenue for investors, the auction of

42
these bills evoked good response. These bills offer short-term investment opportunity to
financial institutions like banks and other parties. These bills are not rediscountable with
the Reserve Bank of India. They are offered periodically for sale on an auction basis by the
Reserve Bank of India in Bombay. The notified amount wasRs. 1,000 crore perauction
since 2002-03. Theoutstanding amount is placed at Rs. 12,996 crore.
PrimaryDealers: Primarydealersystemwasintroducedin1996withtheobjectiveof
strengtheningthe
securitiesmarketinfrastructureandimprovementinthesecondarymarkettrading,liquidityandt
urnover in government securities and also for encouraging voluntary holding amongst a
wider investor base. The obligations of PDs include
• participatingintheprimarymarketinasubstantialandconsistentmanner;
• servingasamarketmakerinthesecondarymarketbyprovidingtwowayquotes;and
• providingmarketrelatedinformationtothepublicdebtmanager.
There are 18 PDs and their bidding commitment for auctions other than those under MSS
for 2004-05 for dated securities was fixed at Rs. 1,20,300 crore (96.5%) of the issue
amount to be raised.
CERTIFICATESOFDEPOSITS(CDS)
CDs in eurodollar market: CDs are similar to the traditional term deposits but are negotiable
and can be traded in the secondary market. It is often a bearer security and there is a
single payment, principal and an interest, at the end of the maturity period.The bulkof the
deposits have a very short duration of 1, 3 or 6 months. For long-term CDs, there is a fixed
coupon or a floating rate coupon. For CDs with floating rate coupons, the life of CD is
subdivided into sub-periodsof usually 6 months. Interest is fixed at the beginning of each
period and is based on LIBOR or US Treasury Bill rate or prime rate.
InIndia CertificatesofDeposits are being issued since 1989,bybanks,eitherdirectlyto
theinvestors or through the dealers. CDs are documents of title to time deposits with
banks. They are interest bearing,maturitydatedobligationsofbanksandare
technicallyapartofbankdeposits. Theyrepresent bank deposit accounts which are
transferable. CDs are marketable or negotiable short-terminstruments in bearer form and
are known as Negotiable Certificates of Deposit. They represent securitized and tradeable
term deposits. CDs are a high cost liability and are issued only when deposit growth is
sluggish but credit demand is high. The minimum issue of CDs to a single investor is.Rs.10
lakh (April 15, 1994)and additional amount in multiples of Rs. 5 lakh each. CDs are in
bearerformand can be traded in the secondary market. Since they are not homogeneous
in terms-of issuer, maturity, interest rate and other features, secondary market has not
developed.
Therehasbeen a spurt in the growth of CDson account of issue of guidelinesbyRBIon
investment by banks in non-SLR debt securities, reduction in stamp duty on CDs effective
March 1, 2004 and greater opportunity for secondary market trading’.
CDs are issued at face value for periods varying between 2 weeks to 5 years. They are
commonly issued for 90 days. Banks tailor the maturity to suit corporate customers. The
outstanding amount of CDs varied in the range of Rs. 1,485, Rs. 4,656 crore in 2003-04 in
the range of 5% in 2003-04. Total CDs outstanding constituted 5.1% of the aggregate
deposits of issuing banks.
COMMERCIALPAPER
43
Commercial paper was introduced in January, 1990, to enable highly-rated corporate
borrowers to diversify their sources of short-term borrowings and also to provide an
additional instrument to the investor.’ The guidelines issued by the RBI regulating the
issue of commercial paper applies to all non- banking financial arid non-financial
companies. PDs have also been permitted to issue CPs to access short-term funds.

44
Issue of commercial paper Commercial paper can be issued by a company whose, (i)
tangible net worth (paid up capital plus free reserve) is not less than Rs. 5 crore; (ii) fund-
based working capital limitsare not lessthan Rs. 4 crore; (iii)sharesarelistedona
stockexchange; (iv)specified credit rating of P2 is obtained from Credit Rating Information
Services of India Ltd. (CRISILJ-and A2 in the case of Investment Information and Credit
Rating Agency of India Limited (ICRA);
(v)borroweraccountisclassifiedunderhealthcodeNo.1;and
(vi)currentratiois1.33 :1.
Usance Commercial paper should be issued for a minimum period of 7-days and a
maximum of one year. Nograceperiod isallowed forpayment andif the maturity datefalls
ona holiday it should bepaid on the previous working day. Every issue of commercial paper
is treated as a fresh issue.
Denomination Commercial paper is issued in the denomination of Rs. 5 lakh. But the
minimum lot or investment is Rs. 25 lakh (face value) per investor. The secondary market
transactions can be Rs. 5 lakh or multiplies thereof. Total amount proposed to be issued
should be taised within two weeks from thedateon which theproposalistakenon
recordbythebank.The papermaybe issuedina singleday or in parts on different dates in
which case each paper should have the same maturity date.
Ceiling The aggregate amount that can be raised by commercial paper by corporate is
100% of the working capital credit limit (November, 1996).
Mode of issue and discount rate Commercial paper should be in the form of usance
promissory note negotiable by endorsement and delivery. It can be issued at such
discount to face value as may be decided by the issuing company. Issue expenses Issue
expense consisting of dealer’s fees, rating agency fee and other relevant expenses should
be borne by the company.
Investors Commercial paper may be issued to any person, banks, companies and other
registered (in India) corporate bothes and unincorporated bothes. Issue to NRIs can only
be on a non-repatriable basis and is non- transferable. The paper issued to the NRI should
state that it is non-repatriable and non-endorsable.
Procedure for issue Commercial paper is issued only through the bankers who have
sanctioned working capital limits to the company. It is counted as a part of working
capital. Unlike public deposits, commercial paper really cannot augment working capital
resources. There is no increase in the overall short-term borrowing facilities.
Every company proposing to issue commercialpapershould submit the proposalin
theformprescribed bythe RBIto thebankwhichprovidesworking capitalalong with credit
rating of the company. Thebank scrutinizes the application and on being satisfied that the
eligibility criteria are met and conditions stipulated are complied with, takes the proposal
on record. The issue has to be privately placed within two weeks by the company or
through the good offices of a merchant banker. The initial investor pays the discounted
value of the paper to the account of the issuing company with the bank in writing. The
companyhastoadvisetheRBIthroughthebank,oftheamountofcommercialpaperissuedwithin 3
days.
Commercial paper proved popular as a money market instrument during periods of down
swing ofcredit growth when corporate are able to access the CP market at rates lower than
the PLRs of banks. The shareof manufacturing companiesin theamount of
45
CPsdeclinedovertime to 31%in2004-05; the share of leasing/ finance companies increased
to 56%; and FIS, 13%. Manufacturing companies enjoyed larger internalaccrualsand
introduction of sub PLRlending bankssaving on stamp duty, costs of demat and fees for
issuing and paying agents. The outstanding amount of CPs was Rs. 9,131 crore as on
March 31, 2004. The weighted average discount rate was 5.11% at the end of March,
2004.

46
Commercial bill market Trade bills are drawn by the seller (drawer) on the buyer (drawee)
for the value of goods delivered to him. Commercial banks as a part of the working capital
limits grant a component for discounting such bills. Normally, 20 per cent margin, is kept
and the trade bill when presented by the constituent proceeds to his account. These bills
can be for 30 days, 60 days or 90 days depending on the credit extended in the industry
to which the constituent belongs. Interest is charged for the time it takes to collect the bill.
Bill discounting is a part of money market and the bill as an instrument provides short-
term liquidity to banks in need of funds by getting them discounted by financial
institutions such as Banks, LIC, UTI, GIC, ICICI, IRBI and ECGC. Although the cost of bill
rediscounting is lower than the cost of inter-bank deposits and loans of 60/90 days, the
trade bill has hot become popular. Bills rediscounted by commercial banks with FIs
amounted to Rs. 735 crore at the end of February, 2000. The proportion of bills Rs. 37,066
crore to total bank credit of (bills plus cash credit), Rs. 2,40,144 crore onMarch 31,1999
was 15.3 per cent. There is hardly any secondary market.
SELFCHECKEXERCISE
1. Whatis‘CallMoney Market’?
2. Define‘TermMoneyMarket’?
3. Whatare‘TeasingBills’?
4. Whatare“CertificateofDeposits”?
SUMMARY
The Capital market is referred to as a place where saving and investments are done
between capital suppliers and those who are in need of capital. It is, therefore, a place
where various entities, trade differentfinancial instruments. The primary market is a new
issue market; it solelydealswith the issues of new securities. A place where trading of
securities is done for the first time. The main objective is capital formation for
government, institutions, companies, etc. also known as Initial Public Offer (IPO). The
secondarymarket isaplace where trading takesplaceforexisting securities. It isknown asa
stock exchange or stock market. Here the securities are bought and sold by the investors.
The main point of difference between the primary and the secondary market is that in the
primary market only new securities were issued, whereas in the secondary market the
trading is for already existing securities. There is no fresh issue in the secondary market.
The securities are traded in a highly regularised and legalized market withinstrict
rulesandregulations. Thisensuresthat theinvestorscan tradewithoutthe fear of being
cheated. In the last decade or so due to the advancement of technology, the secondary
capital market in India has seen a great boom.
GLOSSARY
Capital: Capitalisa large sumof moneywhich you use to starta business,orwhich you invest
in order to make more money. Capital is the part of an amount of money borrowed or
invested which does not include interest.
Capital Market: Capital Market deals in financial instruments and commodities that are
long-term securities. Thefundswill be used forproductive purposesand create wealth in
theeconomyin the long term.
Initial public offering (IPO): IPO or stock market launch is a type of public offering. Through
this process, a private company transforms into a public company. Initial public offerings
are used by companies to raise money for expansion and to become publicly traded
enterprises.
47
Stock Exchange: Stock Exchange share market or bourse is a place where people meet to
buy and sell shares of company stock. Some stock exchanges are real places (like the New
York Stock Exchange), others are virtual places (like the NASDAQ).

48
StockMarket: StockMarketisaplacewheresharesof pubiclistedcompaniesaretraded.
Theprimary market is where companies float shares to the general public in an initial
public offering (IPO) to raise capital.
Stock Market Works: Stock market works like an auction where investors who buy and sell
shares of stocks. These are a small piece of ownership of a public corporation.
ANSWERSTOSELFCHECK EXERCISE
1. RefertoSection 3.3.1
2. RefertoSection 3.3.2
3. RefertoSection 3.3.3
4. RefertoSection 3.3.4
TERMINALQUESTIONS
1. Definemoneymarketandspecifytheinstruments.
2. Whocanissuecommercialpaper?
3. DiscussthedifferenttypesofTreasuryBills.
ANSWERSTOTERMINALQUESTIONS
1. RefertoSection3.2&3.3
2. RefertoSection 3.3.5
3. RefertoSection 3.3.2
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall
ofIndia.
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress

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49
 Lesson-4
GovernmentSecuritiesMarket

STRUCTURE
LearningObjectives
Introduction
NatureofGovernmentSecuritiesMarket
Salient Features
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Bytheendofthischapter,youshouldbeabletoknow:
1. Thecompositionof thestockmarketinIndia.
2. Thesignificanceofthemarketingovernmentsecurities.
3. Thenatureofthegovernmentsecuritiesmarket.
INTRODUCTION
This chapter and the next are devoted to describing and analyzing working of stock
market. The stock market is composed of the newissue market which is a primary
marketforraisingfresh capital, andthe stock exchange which forms the secondary market
for securities. Each of these markets deals in two important groups of securities: (a)
Government and semi government securities, and (b) industrial securities. Although the
stock market is associated in the minds of most people with a market for industrial
securities, in fact these’ constitute a relatively small part of the stock market. Fresh funds
mobilized through the issue of government and semi government securities and the
private corporate securities accounted for 93 to 97 per cent and 3 to 7 per cent,
respectively, of the total amount of fresh funds mobilized through the issue of all securities
on the stock market during 1971-72 to 1977-78. The shareof government securities in the
totalcapitalraised variedbetween 94.1 and79.44percentduring 1986-87 to 1988-89.
Thusthemarket ingovernment securitieshappens tobeanoverwhelminglysignificantpartof
thestock marketinIndia.IntheUKalso,asinIndia,themarketin
governmentsecuritiesismuchlargerthanthat in industrial securities. In the USA, however, it
is the other way round. In this chapter we will discuss various aspects of the working of the
market in government securities in India.
NATUREOFGOVERNMENTSECURITIESMARKET

50
(i) Thesupply of governmentsecuritiesstems
fromtheissueofgovernment’smarketabledebt.These
securitiesareissuedbytheCentral government,Stategovernments,andsemi-
governmentauthorities

51
which include local government authorities like city corporations and municipalities,
autonomous institutions like port trusts, improvement trusts, state electricity boards,
metropolitan authorities, public sector corporations, and other government agencies such
as IDBI, IFCI, SFCs, SIDCs, NABARD,LDBs, housing boards, and the like. The Central
Government issues bonds, treasury bills, and special rupee securities in payment of India’s
subscriptions to IMF, IBRD, ADB, IDA, and so on. The special rupee securities are treated as
a part of internal floating debt of the government. They are non- negotiable and non-
interest bearing claims. The market for treasury bills has already been discussed. The
State governments and semi-government agencies issue bonds or debentures.
Certaingovernment agencies like IDBI are established to implement Government’s various
lending operations and they issue bonds to finance their activities. Originally, most of
them were financed bythe Treasury, but there hasbeen a trend towardstheir self-financing
through the issuing of debentures. This segment of the government securities market is,
therefore, an expanding one.
(ii) Government securities are a unique and important financial instrument in the financial
markets of any country. Unlike other instruments (except TBs), it is also held by the
central bank of the country, and the working of two of the major techniques of monetary
control of the central bank—open market operations and statutory liquidity ratio—are
closely connected with the dynamics of the market for this
instrument.Again,unlikeotherinstruments, its issuesare helpfulin implementing
thefiscalpolicy of the Government. Financial institutions like commercial banks are
required to maintain their secondary reserve requirements in the form of these securities.
It is also easier to obtain loans against the collateral of these securities. Commercial banks
in India can obtain accommodation from the RBI against the collateral of these securities.
As the RBI can issue currency notes against the backing,apart from gold and foreign
exchange, of the Central Government bonds, they constitute the ultimate source of
liquidity in the economy. As government security is a claim on the Government, it is an
absolutely secure financial instrument which guarantees the certainty of both income and
capital. It is, therefore, called a “gilt-edged” security or stock. It is true that many
alternative instruments likeindustrialdebentures,andstocksof
local“authoritiesarealsoquitesecure,buttheCentralGovernment securities are the safest of
all such claims.
(iii) These securities are normally issued in the denomination of Rs. 100 or Rs. 1000. The
face value which used to be 100 till the middle of the 1980s was raised to 1000 in the
recent past. The rate of interest on these securities is relatively lower because of their
being liquid and safe. In addition, it has been deliberatelymaintained at a low levelby
thegovernment in order to minimize the cost of servicing public debt. Yet, the market for
these securities has expanded every year because of the regulations, statutory or
otherwise, under which financial institutions are required to invest a certain proportion of
their investiblefunds in these, securities. At the rates of interest that can be earned on
these securities, any other borrower but government or government-backed organizations
would have been unable to raise funds on any significant scale, let alone on an increasing
scale.
(iv) The interest on government securities is payable half yearly. Interest in respect of
Central and State government securities, along with income in the form of interest or
dividends on other approved investments, is exempt from income-tax subject to a limit
The value of investments in these securities and other investments specified in the Wealth
Tax Act 1957 is exempt from wealth tax up to a limit. As individuals do not normally invest
in these securities, saving in tax liability does not seem to be an importantmotivation
behind investment in them. Unlike in the USA, interest on the securities of local authorities
52
is not exempt from tax in India.
(v) Although it is true that government securities are liquid and safe, securities of
different authorities differ in respect of the extent to which they possess these attributes.
The marketability of securities of State governments, and semi-governments is relatively
restricted; therefore, they are less liquid than Central government securities. There is no
active market, particularly in semi-government securities. There is no need for the
underwriting or guaranteeing the sale of Central and State government
securities.ThefactthattheRBIisalwaysreadytobuytheunsubscribed(bypublic)partofanyloan

53
issued amounts to underwriting of these issues. Around the 1950s, issues of State government
securities used to be underwritten, but, thereafter, such a need has not arisen. The
securities of semi- government agencies, however, mayneed to be underwritten. Theyare
also guaranteed by the Central or State government for repayment of principal and the
payment of interest.
(vi) There are three forms of Central and State government securities: (a) inscribed stock
or stock certificate (SC); (b) promissory note (PN); (c) bearer bond. While these days,
bearer bonds are not usually issued in India, stock certificates are not very popular with
investors. Consequently, most government securities currently are in the form of
promissory notes. Promissory notes of any loan can be converted into stock certificates of
any other loan or vice versa. In order to popularize the holding of stock certificates,
governments specially advertise the following advantages to distinguish them from
promissory notes: (a)they are safer than PNas the name of the holder is registered in the
booksof the Public Debt Office (PDO); (b) the stock certificate relating to the application
tendered at any branch of the SBIor its subsidiary is sent to the applicant directly by the
registered post by the PDO; (c) the. half- yearly interest is remitted to the holder directly
by an interest warrant drawn at par on any Treasury or SBI as stipulated by the holder or
is remitted byM.O. if so desired; (d) the holder, can sell it by signing the transfer form on
the reverse of the certificate. On the other hand, interest on PN is payable only on
thepresentation of thenote at theoffice at which it isenfaced. The major reason why SC
isnotpopular in spite of these advantages is its lack of quick transferability and
negotiability. It is not transferable by endorsement; the procedure for effecting its transfer
is much more complex. In the case of PN, the title is transferable by endorsement and
delivery and it is a negotiable financial instrument. This suggests that investors-who need
to borrow often against the collateral of government securities prefer, PN to SC. In a
relative sense, if SCs are often bought by investors like L1C, PF, etc., PNs are in demand
by banks.
(vii) Government securitiesare issued through the PDO of the RBI. The method of selling
them differs from that of selling TBs. Instead of selling them through auction, the issues
are notified a few days before they become open for subscription and they are kept open
for subscription for 2—3 days, but, they may be closed for subscription earlier if the
subscriptions approximate the amount of issue. The budgeted amount of issues in a given
year is raised in a number of tranches in that year. This is obviously to avoid flooding the
market with securities at a given time. However, as the issues aremostly bought by
institutional investors, there can be a small number of large issues. After the
announcement of new issue, the RBI suspends the sale of existing loans till the Closure
ofsubscriptions to new loans. The Government reserves the right to retain subscriptions up
to a specified percentage, say 10 per cent in excess of notified amounts. Applications for
loans are received at the offices of the RBI and at the branches of the SBI. In the case of
issues of State government securities, over-subscription to loans of one government is
transferable to the othergovernment whose loan isstill open for subscription, at the option
of the subscriber. Due to the seasonal character of the money market, issues are mostly
concentrated dining the slack seasons.
Because of the size of debt and the continuous need for raising fresh capital, the effective issue
and redemption on single dates ashappens in the case of industrialsecurities has become
impossible.The old method of issue of blocks of securities and their redemption on single
maturity dates continues in form, but, when the issue of bonds is announced, a part is
taken over by the RBI which sells theamount gradually through the stock exchanges in the
ensuing period. Similarly, “grooming” and “switching” implies that the RBI buys the
bondsgradually through the stock exchange until usually only a small proportion remains
54
to be paid off on the formal maturity date. Thus, in practice, the process of issue and
redemption have become continuous. This also means that securities are available on
“tap”, and the securities thus obtained may be called “tap stocks”,
(viii) The role of brokers and dealers in the process of marketing of government securities
in India is much more limited than in othercountries. The RBIdoeshave, it’sapproved
brokersandthe majorpart
oftheturnoverinthemarkettakesplacethroughthesebrokers.Butthescope for
participationinthe

55
market by other brokers is limited. A recent step taken by the RBI has also reduced the volume
of businessavailable to officialbrokers.Witheffectfrom June 1978, the RBI hasdiscontinued
the practice of charging differential interest rates for the purchase and sale of the Central
government securities to enable banks to approach it directly instead of through brokers.
As regards the dealers, it may bestated that the agency of dealer-banks is more active
than that of individual dealers. There are some half-a-dozen activefirmsof securitydealers
inBombay, but theirnumberelsewhere is limited. Theyare in daily contact with the RBI as
well as banks, LJC, and other institutional investors. They also keep in touch with each
other and as a result of their activities gilt-edged securities enjoyed the benefit of
extremely fine quotations. These dealers act mainly as jobbers. The gilt-edged market is
an “over-the- counter” market and each sale and purchase has to be separately
negotiated. Orders received locally by members of the stock exchange are passed on to
the security brokers and dealers who then try various sources, among which are banks.
The brokers and dealers explore the possibilities of business among themselves and with
their upcountry correspondents, but such business is limited and the market is confined
mainly to institutional investors.
The scope for individual dealer activity in the Government securities market in India is limited
perhaps because the volume of floating stock is limited. Most of the investors who
purchase government securities usually hold them till maturity. Commercial banks can buy
as much as they want, but they cannot sell securities beyond a limit due to the SLR
requirements. All such factors have restricted the growth of the secondary market which,
in turn, has restricted the scope for dealer activity. Commercial banks deal in securities as
they supply securities to the market. They also take up state loans and corporation bonds
when they are first floated, and sell them gradually when the market can absorb them.
The RBI acts as the biggest dealer through its OMOs. In other countries, the central bank
confines itsdealings mainly totreasury bills as apart of OMOs; thishas createda needforthe
services of dealers in government securities in those countries. In India, on the other hand,
continuous participation by the RBI in the government securities market has resulted in
the lack of growth of the institution of dealers. Further, dealers need funds for their
operations. Usually such funds are obtained from the commercial banks in other countries.
But the high cost of borrowing funds from banks compared with the low yield on
government securities has also inhibited the growth of dealers in this market.With the
tremendous growth of Government stocks however, there is a Scope for the growth of
dealers in the government securities market.
(ix) In any given year, both the Central and State governments need to raise funds
through public borrowings. The normal practice has been to sell their securities separately;
but in 1954-55 and 1963- 64 only consolidated loans were issued. The method of issuing
consolidated loans has, it was found, certain important disadvantages. First, it is difficult to
decide the share of various State is in a consolidated loan. Second, the centralized method
does not offer space for trapping local rsources.
The issue of securities may be undertaken for refunding, i.e, conversion or refinancing of
maturing securities; advance refunding of securities that have not yet matured (in India
this is known as reissueofloans) and cash financing. Refunding itselfcan be carried out
either by selling new securities for cash settlements and using the proceeds to retire old
issues, or by offering holders of the maturing securities the right to exchange (convert) old
securities for new issues. The objectives of conversionandreissueof loansistolengthenthe
maturitystructureofGovernmentdebt,andtoreducethevolume ofcashrepaymentof loans.It
mayberelevant here tomention twoother operationsusually carried out bythe RBIin
thegovernmentsecuritiesmarkettoachievethe objectivesjust mentionedand tofacilitate the
new issues of securities. They are “grooming” of the market and “switches” in the market.
56
While “grooming”maybe defined as“acquiring securitiesnearing maturitytofacilitate
redemption and making available on tap a variety of loans to broaden the gilt-edged
market”, switches are “purchases of one security against the sale of another security as
distinct from outright purchase or sale of security.”These operations are part of the OMOs
of the Central Bank and might be said to differ technically from “refunding” and “reissue”
in that they are undertaken in the secondary market, while the latter are undertaken in
the primary market for government securities.

57
(x) The RBI occupies a pivotal position in this market it is continuously in the market
selling Government securities and buying them mostly in switch operations and rarely for
cash. It purchases these securities out of the surplus funds of IDBI, EXIM Bank, and
NABARD under special arrangements. Switch operationsareusefulto banksandfinancial
institutionsto improve their yields on their investments in Government securities.
Sometimes, there are triangular switch transactions in which one investor’s sale or
purchase is matched by the purchase or sale transactions of another investor, the
RBIbeing the middle party. The RBIfixes annualquota, based on the size of the bank,for
switch transactionsforeachbankfromtime totime witha viewtopreventbanksfromexclusive
sales of low-yielding securities to the RBI. It maintains separate lists of securities for
purchase and sale transactions. Different scrip’s are included in the two lists having regard
to the stock of securities and dates of their maturities. One of file unique features of
trading in this market is the “voucher trading” or “voucher benefit”. The banks and
financial institutions whose earnings are taxed purchase thesecurities around the interest
due date and unload them in the market after availing themselves of the voucher for the
full year. This practice has activated trading in these securities, particularly around
interest due date. But this active trading is not a genuine trading. Therefore, Chakravarty
Committee has ‘asked the RBI to fix quotasfor switch transactions, and to, suspend trading
in a particular scrip for one month before interest due date.
SALIENTFEATURES
Certain salient features of the market in government securities that emerge from the
foregoing discussion may be summarized below:
(1) In “terms of size, it is much bigger than the industrial securities market. Due to the
growing requirement of funds by the government for developmental and non-
developmental needs, this market has been rapidly expanding. This is similar to the
situation obtaining in the UK, but not in the USA, where the market for industrial securities
is bigger than the market in government securities. This is so because of the difference in
the share of the public sector in investment in physical and financialassets.
(2) The ownership pattern of government securities also differs from that of industrial
securities. Although indirect ownership has increased with regard to both, the participation
by individuals is much greater in the industrial securities market. On the other hand,
government securities play a specialrole in the asset managementof
manyfinancialinstitutions.Asfaras individualownership is concerned,the situation in India is
largely similar to that in the UK, but it differs somewhat from the USA where government
securities are owned by individuals to a greater extent.
(3) Theaverage maturityof governmentdebt atfirstdecreasedtill1965, then it
increasedsubstantially. Thus, since the early 1970s, the risk of monetization of
government securities and the threat from that side to monetary policy have diminished.
(4) Unlike in the UK and the USA, the secondary market in government securities in India
is narrow and less active. Only commercial banks participate in this market onany
significant scale. In the UK and USA, the secondary market in government securities is
quite active and sophisticated, because of which the holders of government securities,
particularly large ones, can earn dealing profits by a policy of switchingfromone
stocktoanotherastemporaryprice differencesappear. The institution, of dealers is well-
established in those countries and institutional developments like securities repurchase
agreements between dealers and corporations have emerged in a country like America. In
India, there is no worthwhile connection between the call money market and the
government securities market.
(5) Interest rates in the government securities market are not aligned well with rates in

58
other financial markets, although the gap between rates in these markets has been
significantly narrowed during the 1980s. In the UK, movements in the yield on-government
bonds affect the entire structure of interest rates.
(6) The intervention of authorities in the government securities market in India has been
mainly for
supportingthemarketandforminimizingthecostofservicingpublicdebt.Thegrowingnational
debt

59
has also made it necessary for governments in the UK and the USA to intervene in this market
mainly for the same purpose.
SELFCHECKEXERCISE
1. Whatis‘StockMarket’?
2. Define‘GovernmentSecurities’?
SUMMARY
Government securities are the instruments issued by central government, state governments,
semi- government bothes, public sector corporations and financial institutions such as
IDBI, IFCI, State Financial Corporation’s (SFCs) etc. in the form of marketable debt.
Government securities form an important part of the stock market in India. Today, funds
mobilised through the issue of government securities account for more than 80% of the
totalamount of funds mobilised on the stock exchanges of India through the issue of all
securities including government and corporate). Funds mobilised are tired to meet the
short-term and long-term needs of the government. Central government securities are
considered to be the safest amongst all type of securities as regard to the payment of
interest and repayment of principal amount. They are free of default-risk or credit risk.
They are considered to be more liquid assets and ensure certainty of capital value not only
at maturity but also before maturity. Since the date of maturity as mentioned in the
securities, these are also known as dated government securities.
GLOSSARY
Government securities: government securities are the instruments issued by Central Government
Stategovernmentsand isgovernmentbothespublicsectorcorporationsand
FinancialInstitutionssuch as IDBI IFSC state financial corporations etc.
Primary dealers (PD): primary dealers are introduced by Reserve Bank of India for strengthen the
infrastructure in the GSM so as to make it more vibrant liquid and broad-based.
Satellite dealers (SD): Reserve Bank of India introduced the concept of satellite dealers in order to
provide supporting infrastructure in the Government Security market. Satellite dealers
help in trading and distribution of government securities.
ANSWERSTOSELFCHECK EXERCISE
1. Referto4.1
2. Referto4.2
TERMINALQUESTIONS
1. Describetheworkingofstockmarket.
2. Discussthenatureofgovernmentsecurities.
3. Explainthesalientfeaturesof themarketingovernmentsecurities.
ANSWERSTOTERMINALQUESTIONS:
1. Refereto Section4.1& 4.2
2. RefertoSection4.2
3. RefertoSection4.3&4.2
60
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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61
 Lesson-5
IndustrialSecuritiesMarket

STRUCTURE
LearningObjectives
Introduction
Organizationofthestockmarket
IndustrialSecurities
OrdinaryShares
PreferenceShares
DebenturesorBonds
SalientFeatureofIndustrialSecurities
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthislessonyoushouldbeableto:
1. Knowthesignificanceof theindustrialsecurities.
2. ExplaintheOrganizationofthestockmarket
3. Describethedifferenttypesof industrialsecuritiespremisinginIndia.
INTRODUCTION
Having discussed the market in government securities in the previous chapter, we will now
take up the market in industrial securities.
ORGANIZATION OFTHESTOCKMARKET
At the end of June 1989, there were eighteen recognized stock exchanges in India. Four of
these—in Bombay, Delhi, Calcutta, and Ahmadabad— accounted for about 90 per cent of
the overall business, and Bombay alone accounts for about 70 per cent of the total trading
business on all the stock exchanges put together. It accounts for 40 per cent of the total
listed issues, 67 per cent of paid-up capital, and 76 per cent of market value of issues
listed in India. The stock exchange at Bombay is distinguishednot onlyby its size, but it is
also the oldest marketand has been recognized permanently, while the recognition for
other markets is renewed every five years. Stock markets are organized either as
voluntary, non-profit-making associations (Bombay, Ahmadabad, Indore), or public limited
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companies (Calcutta, Delhi, Bangalore) or company limited by guarantee (Madras,
Hyderabad).Thus,

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unlike in the UK, there are in India separate, independent exchanges with diversity of
organizational structures, and there is neither the National Exchange nor provincial
exchanges in our country.In the UK there has been a move to create a unitary organization
of stock exchanges. In 1965, 22 separate provincial stock exchanges were merged into
three regional stock exchanges, and in 1973 these, in turn, were combined to form the
National Stock Exchange under the title of the Stock Exchange which has trading, floors in
many former provincial centre. In view of thelarge size of the country, to adopt such a
policy for India is not advisable.
The size of the industrial securities market in India is relatively much smaller than that in
other industrialized countries. This is so because of the industrial structure, investment
habits, and the levelof education of investors in India. During the planning period, the role
of public sector companies has much increased in the business activity of the country;
today, in terms of paid-up capital, government companies are much more important than
companies in the private sector. The shares of government joint stock companies are not
yet quoted on stock markets, although there is .a move to offer a part of capital (say, 25
per cent) of selected government companies for subscription to the public. Industrial
securities are not a major source of funds even for private sector industrial units. Nor are
they a very popular mode of savings for individuals. Savings in the form of industrial
securities were hardly one per cent of totalfinancial assetsof the household sector till the
end of 1960s. Subsequently, this sharewas about 3 per cent till 1984-85, and 4 to 6 per
cent thereafter. In short, the volume ofindustrial securities in relation to government
securities, their role in financing the private sector, and their significance as a savings
medium, indicatethatthe industrialsecurities marketcanhardlybe regarded asabarometer
of economic activity in India.
Movementsinequitypricesdonot reflect the state of Indian economy. The market in
equitiesin India is dominated by speculators; it thrives on scarcities and inflation. The
interest of stock market centres around the performance of a few industrial unitswhose
shares are valued by speculators. Hardly 30 to 40 scrips (2 per cent of listed stock) in the
cleared as well as non-cleared list account for the bulk of activity on the Bombay Stock
Exchange. In 1981, 17 leading scrips accounted for over 90 per cent of business in cleared
securities. In 1988, 25 scripsaccounted for 75 per cent of overall trading business.
We will not discuss here the details of membership rules, listing regulations, and trading
rules concerning stock market. Only a few important points may be noted here. Such
securities only are traded on the stockmarket asare “listed”. They (listed stock)are also
known asquoted securities. With effect from 13 February 1989, any company can list,
duelist and realist its securities by paying a stipulated fee, provided its equity capital is at
least Rs. 3 crores and at least Rs. 1.8 crores, i.e. 60 per cent of this capital, is offered for
public Asubscription. Earlier, minimum equity capital limit was Rs. 1 crore. Of this amount,
a maximum of 11 per cent may be reserved for the Government, their development
agencies, and financial institutions. The principal objective behind the listing-requirement
is to ensure proper supervision and control of dealings in securities, and to protect the
interests of share-holders and the general investing public. Another objective is to avoid
the concentration of economic power, to give promoters an opportunity to invest
sufficiently in the company for their own benefit, and to require promoters to have a
reasonable stake in the company.
Listed securities are classified as “cleared” or “specified” or “Group A” securities and
“non-cleared” or “unspecified” or “Group B” or “cash” securities. Cleared securities on a
given exchange are those that are included in the cleared list by the governing body of
that exchange after the securities havesatisfied the following conditions: they are folly
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paid-up equity shares; they must not be shares of banking companies; they must have
been admitted to dealings for at least three years on the given exchange; they must
notappear on the cleared list of anyother stockexchange; the companies whose shares
they are should be of public importance; the subscribed capital of these companies must
be at least Rs. 25 lakhs: theiraggregate valueatthe ruling marketprice shouldbeat least Rs.
1 crore;and at least 49 per cent of the capitalof the companiesmust beheld bythe public.
At present, there are about 120 shares in the specified group in Bombay, Delhi, Calcutta
and Ahmadabad exchanges;outof these

65
scrips, 70 are listed on the Bombay Stock Exchange alone. As far as Bombay is concerned,
the average monthly turnover of “A Group” securitieswas Rs. 600 crores whereas for
“Group B” it wasRs. 120 crores in 1987.
As the conditions laid down for inclusion in the cleared list are difficult to meet, cleared
securities are few in number and form only a small proportion of the total corporate
securities. But because of their characteristics, they are more actively traded in, and in
terms of the numberof sharestraded, business in them accounts for a major portion of the
total business on the stock exchanges in India.
Transactions on stock exchanges are carried out on either cash basis or carry over basis,
i.e. through “clearing”. Exchanges at Bombay, Calcutta, Madras and Ahmedabad have
their own clearing houses. The business in Group A securities is settled through clearing
houses in addition to other methods of settlement. The stock exchange year is divided into
periods called “accounts”. An account normallyruns into a fortnight, but sometimes it may
be for longer durations of 3 to 4 weeks. All transactionsmade during one account are to be
settled by payment for purchases and by delivery of share certificates in the case of sales
on notified days of the clearing programme of a given stock exchange. Transactions in
non-specified securities have to be settled compulsorily by delivery; carryover is permitted
only in respect of Group A securities. At the end of a settlement period, the investor in
specified shares has three options: (a) he can terminate his contract of sale or purchase by
a cross contract, i.e. by squaring up transaction; (b)he can completethe contract
bydeliveryorpayment asthe case may be; and (c) he can carry over the contract to the
next settlement. For example, if the investor who has purchased shares has no money to
pay for his purchases, he can arrange with his broker to carry forward his businessto the
next settlement account. His broker would thenfind out someone who would receive the
shareson behalf of thesaid investorand payforthemon the duedate, i.e.onpay-in- day. The
financier who advances the required funds will charge interest on the money loaned by
him, and this is known as “contango”or “badla”forthe fortnight till the next pay-in-day.
Sometimes the seller may also have to pay the charge to the buyer when the shares are
oversold and the buyers are in a demanding position; this is known as “backwardation
charge” or “undha badla”. The “badla” system plays a crucial role in the carry forward
transactions. The badla charges have the-approval of the stock exchange authorities who
may even fix badla charges under exceptional circumstances. Usually, special sessions are
held by the stock market at the end of each settlement period to determine the badla
charges of individual shares in the specified list in actual biddings.
Thetypesoftransactionsoncashbasisaccordingtoarrangementfordelivery(delivery-wise)are:
(a) spot delivery, the delivery and payment are made on the same day as the day of
contract or on the next day; (b) hand deliver, the delivery and payment are made when
stipulated or within 14 days whichever is shorter; (c) special delivery, the delivery and
payments are made beyond 14 days if permitted by the stock exchange authority.
The marketing of old or new securities on the stock markets can be done only through
members of the stock exchanges. These members are either individuals or partnership
firms. There are more individual members than partnership firms. In the UK the authorities
have allowed the entry of joint-stock companiesas brokersordealers,forthey can mobilize
large amounts of funds. In India also, inorderto rid stock exchanges of the stranglehold of
a few and powerful groups of brokers, and with a view to broadening the base of the
management ofstock exchanges, moves have been initiated to allow banks, mutual funds,
and other financial institutions to become members of the stock exchanges. It is
alsoexpectedthat individuals,partnerships,andfamily concernsof brokers
wouldorganizethemselves into corporate bothes. The stock exchange members act in One
66
or more capacity as: (a) commission broker, (b), floor broker, (c) Tarvaniwala, (d) jobber or
dealer, (e) odd lot dealer, (f) budliwala or financier, and (g) arbitrageur. With regard to
new issues, brokers do all that which is performed by specialized issuing houses in
theUK-’The practice of some commercial batiks managing issuesthrough their
merchantbankingdivisionsis also known to the market. The brokers advise promoters on
thecompositionofcapitalstructureandtheforminwhichthenewissueistobemade;theydraft

67
prospectus and application forms; they explore the possibilities of securing loans from
financial institutions; they arrange for underwriting, sub-underwriting, and placing of new
issues; they organize the preliminary distribution of securities; and they procure direct
subscription from investors. The commission rates of brokers are fixed by the stock
exchanges. The official brokerage for both types of issues is fixed at 1.5 percent. It is
found that some brokers offer commission as high as 4 to 5 per cent to their sub-brokers
to sell weak issues as attractive ones. This has detrimental effect on the interestsof
investors.
A part of the transactions on the stock exchanges is riot covered by any of the four
methods of setting transactions mentionedearlier. Thispart isknownasforward trading.In its
widersense,forwardtrading includes not only dealings in forward markets, but also all
orders given in advance and all long-term contracts. Similarly, forward trading is done not
only in shares but also in commodities, foreign exchange, and so on. It refers to entering
into contracts today (i.e. in advance) to buy or sell (i.e. demand and supply) certain goods
at some particular date in the future, the date being beyond acertain minimum period of
time fixed for settling spot transactions. In a market economy, forwardtrading is a device
to coordinate the price expectations and plans to buy arid sell by differentindividuals. It is
the uncertainty about the future and the desire to keep one’s hands free to meet that
uncertainty and profit from it which gives rise to forward trading. Forward markets are
usually made of hedgers, i.e. those who enterintoforward Contractsin orderto reduce the
riskarisingoutof uncertainty in regard to theirdesiretobuyorsellinafutureperiod,and
speculators, i.e. thosewho seekaprofitout of a discrepancy between the future price and
the spot price they expect to rule on the corresponding date. As opposed to the hedger,
the speculator puts himself in a more risky position as a result of his forward trading. The
forward market in shares is dominated by speculators rather than by hedgers. Forward
trading is said to be indispensable for ensuring price continuity, liquidity, free negotiability
of capital, and fair evaluation of securities. If this is so, a ban on forward trading should
adversely affect the activity connected with new issues. But in India, this has not actually
happened.
Transactions on forward markets are determined by the relationship between the current
spot price, currently fixed future price, and the expected spot price at a particular datein
the future. There is saidto be a Backwardation” if the future price is below the current spot
price, a “contango” in the reverse case. If the spot price is expected to be about the same
at some future dateas it is today, the future price for delivery at that date would be below
the spot price now ruling. On the other hand, contango can arise only when spot prices are
expected to rise sharply in the future; this usually means that current spot prices are
abnormally low.
With regard to the organization of the stock market, it is necessary to rememberthat the
entire working of the newissue market in India is governed bythe Controllerof
CapitalIssues (CCI)who exerciseshis powers in terms of the Capital Issues (Control) Act,
1947. The timing of the new issues by privatesector companies, the composition of
securities to be issued, interest (dividend) rates which can be offered on debentures and
preference shares, .the timings and frequency of bonus issues, the price of right issues,
the amount of prior allotment to promoters, floatation costs, premium to be charged on
securities are all subject to the regulation of the CGI. Over time, the CCI has liberalized the
rules and regulations. Effective from 1966, Private Ltd. Cos. and Government Companies
not making public issues, and banking and insurance companies have been exempted
from the prior consent of the CCI. Even in the case of non-financial non-government
companies, so long as they conform to certain prescribed norms pertaining to debt-equity

68
ratio, public participation, and premium size, they now merely needto informthe
authorities of theirintention to raise capitalforwhicha noobjection certificate is issued by
the CCI.
The extent of growth of listed stock can be gauged from Table 5.1. The number of
companies whose securities are listed on any one of the stock exchanges is very small, but
in terms of paid-up capital, listed companies constitute a major portion of the non-
government corporate sector. It can also be
observedthatintermsofvariousindicators,thegrowthoflistedstockhasoccurredatafasterrate

69
during the period after 1961. In fact, theproportion of listed paid-up capitalto the totalpaid-
up capital in the private sector declined during 1946-61, picked up again and exceeded its
original level subsequently.
Table
GrowthofListedStockinIndia, 1946-88
Item/Year 1946 1961 1977 1988
1 Numberoflistedcompanies 1125 1203 1996 5841
.
2 1aspercentageofnon-government 7 5 5 4
. companies
3 1aspercentageofnon-governmentpublic 11 18 26 32
. limited companies
4 No.ofstockissuesoflistedcompanies 1506 2111 3462 7694
.
5 No.ofshareunitsissuedbylistedcompanies 1565 4264 18910 ---
. (lakhs)
6 Paid-upcapitalof listedcompanies(Rs.Crores) 270 675 2538 21465
.
7 6aspercentageofpaid-upcapitalofnon- government 65 53 75 ---
. companies
8 6aspercentageofpaid-upcapitalofnon- government 88 71 90 ---
. public limited companies
9 Marketvalueof6(Rs.Crores) 971 1216 3276 51379
.
1 9aspercentageof 6 359.63 180.15 129.08 239.36
0
.

Source:BombayStockExchange,Stock ExchangeDirectory.
Another way to gauge the growth of stock market activity is to know the volume of
turnover on stock exchanges. Table 5.2.presents the annual turnover on all stock
exchanges in India and on Bombay stock exchange. It shows that the turnover has tripled
during the decade
Table5.2AnnualTurnoveronStockExchangesinIndia,1979-88(Rs. Crores)
Year All-India Bombay
1979 3159 2211
1960 3095 2166
1981 8279 5795
1962 6794 4756
1983 3430 2401
1954 6364 4455
1955 8763 6134
1986 19423 13596
70
 1987 12486 8740
1988 8695 6087
SOURCE:BombayStockExchange.

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1979-88; that the volumeof turnover is subject tofluctuations;that thepeak inturnover was
reached in 1986; and that Bombay stock exchange accounts for about 70 per cent of total
turnover in India.
INDUSTRIALSECURITIES
Business concerns raise capital through three major types of security. They are: (a)
ordinary shares or variable dividend securities or common stock, (b) preference shares,
and (c) debentures or bonds. Ordinary shares and preference shares are also known as
“equities.” Unlike bank deposits and units, these securities are the major primary
securities in the financial markets of any country. They differ in their investment
characteristics andas such satisfy different preferences of various investors and enjoy
differingdegreesofpopularity.Itisnecessarytonotethemajorcharacteristicsandthevariantsof
these security types as they prevail in India.
ORDINARYSHARES
Ordinary shares are ownership securities which have certain advantages in favour of the
issuing companies and investors depending on their attitude to risk-taking. Investment in
this financial instrument is permanent but not illiquid. Due to the existence of a fairly
active secondary market in shares, investors can turn their share holdings into cash fairly
quickly. Because of the high risk whichhe bears, the investor can participate in the
earnings and wealth of the company without limit. In a period of inflation since the value
of holdings increases, ordinary shares are expected to be a hedge against inflation.
Fromthepoint of viewof the company, it isadvantageousbecause dividendpayments on
ordinary shares are not mandatory and there is no need to refinance the capital raised
through the issueof ordinaryshares.Asinothercountries, thisinstrument isquite .popularwith
individualinvestors. The face value of ordinary shares in India varies from Rs. 1 to Rs. 1000
but the most common and popular denomination of shares is Rs. 100.
A special type of ordinary, share, called “deferred share”, was in vogue in India till the
1960s. The existence of this novel financial instrument was a result of the managing
agency system peculiar to India. Managing agency firms issued shares with a low
denomination, but, with disproportionate rightsin respect of voting, dividend, and
distribution of assetson winding-up of the company. Invariably these deferred shares were
allotted to the managing agents and their associates. The practice of issuing “deferred
shares” has now been discontinued.
PREFERENCESHARES
A preference share is a complex financial instrument with a number of modifications to its
general characteristics. Strictly speaking, it is an ownership security like an ordinary share,
but carries a fixed rate of return (dividend) like a debenture. The holders of preference
shares are entitled to income after the claims of creditors of the company have been met,
but before ordinary shareholders receive any income. Because of these modifications, one
comes across the following types of preference shares in themarket;(a)cumulativeandnon-
cumulative,(b)convertibleandnon-convertible,(c)redeemableand non-redeemable,
(d)participatingandnon-participating.On cumulativepreferenceshares,if dividend is skipped
in any period/periods, it has to be paid subsequently. Convertible preference shares can
be converted into ordinary shares on terms and conditions fixed at the time of issue of
such shares. A redeemable preference share matures in a fixed period of time and for all
practical purposes it is regarded as a debt security like a debenture. Participating
preference shareholders can earn a higher dividend than the fixed one if the company
makes good profits.

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Most preference shares in India are fixed rate dividend shares with cumulative rights. Both
redeemable and non-redeemable shares are in vogue in India, but many redeemable
shares are so, only at the discretion of the companies. Over a period of time, there has
been a trend towards increasing the proportion of redeemable shares to total preference
shares. The maturity period of redeemable shares is usually between 12 to 15 years. The
practice of issuing preference shares with participation and conversionrights is
notcommon.A studyof 189 issuesof preferencesharesduring1966-70by theRBI

73
indicated that only two of themwere convertible into equity. Preference shareholders have
voting rights only on those issues which vitally affect the rights attached to their shares or
when dividend has not been paid for a long period of time. The rate of dividend on these
shares is subject to a ceiling fixed by theControllerof
CapitalIssues.ThedenominationofpreferencesharesisknowntovarybetweenRs.1 and Rs.
1000, but the most common and popular one has been Rs. 100.
In theory, a preference share offers a perfect certaintyof income and, assuch, is lessrisky.
But “In fact our analysis of relative frequencies of dividend skipping on preference and
equity shares indicates that the degree of risk attached to preference shares was only a
shade less than that attached to equity shares.” Apart from this uncertainty of return, the
marketability and liquidity of preference shares arelow in practice because the market for
them is narrow and less active. The importance of preference share as a medium of
investment for individuals has declined and now they are mostly held by institutional
investors. Their relative importance as a method of financing for companies has also
declined. However, in the case of new companies, they still play a relatively greater
rolethan in the case of older companies.
DEBENTURESORBONDS
Unlike thetwo securitiesthat havebeen considered,debenture orbondisacreditor-
shipsecuritywith a fixed rate of return, fixed maturity period, perfect income certainty, and
low capital uncertainty. In the USA, while bonds are secured by tangible physical assets of
the company, debentures are securedonly by the general credit-worthiness of the
company. No such distinction prevails in the UK and India
whereindustrialdebenturemightbesecuredorunsecured.Therearedifferentkindsofdebentures
:
(a)registered,(b)bearer,(c)redeemable,(d)perpetual,(e)convertible,(f)right,
(g)nonconvertible,and
(h) partially convertible. Almost all the debentures which are listed on Indian stock
exchanges are mortgage registered debentures. Theirface value variesfrom Rs. 5 to Rs.
5000, but, the most common denomination is Rs. 100. The maturity period is up to 12
years, and the coupon rate is subject to the ceding fixed by the Controller of Capital Issues
(CCI). The CCl use to fix two rates, one for debentures up to 7-yearmaturity and the
otherfordebentureswith 7 to12 year maturity. Of late, the most common maturity period of
debentures in India has been 7 years and the ceiling rate is being fixed for these
debentures only.
An important development which has occurred in the field of bond financing during the
1970s is the emergence of the practice of issuing convertible debentures and rights
debentures. Convertible debenture is one that can be converted at the option of the holder
into ordinary shares of the same company under specified terms and conditions. In the UK
and USA, convertible debentures form a significant portion of the total amount of debt
securities. In India, although the issues of convertible debentures were not unknown till
1970, there were very few of them. It is only after 1970 that a greater possibility for
issuing convertible debentures has been noticed. The nature of this security can be
understood with the help of a case of convertible debentures issued by Reliance Textiles in
the second half of 1.979. These debentures were issued for cash at par for public
subscription in units of Rs. 500 each. An amount of Rs. 250 per debenture was payable on
application and the’ balance of Rs. 250 on allotment. Interest at the rate of 11 per cent per
annum was payable on the debentures at equal half- yearly installments. They were, if not
converted, redeemable at par in five equal annual installments on the expiry of the 8th,
9th, 10th, 11th and 12th year from ; the date of allotment. The debenture-holders were
74
entitled to convert 20 per cent of the face value of each debenture into four equity shares
of Rs.10each credited asfully paid-up at a premiumof Rs. 15pershare. The
optionforconversion was to be exercised during the two monthsfrom1 October to 30
November1980 by giving notice to the company to that effect. The total value of
debentures to be thus issued was Rs. 7 crores. The practice of issuing convertible
debentures has increased in India during the 1970s and 1980s,
Another innovation introduced on the stock market a few years back was the issue of right
debentures. Thiswasthoughtof asa solutiontotheproblemof restrictionsonacceptanceof
depositsbycompanies

75
from the public and from, their shareholders. The following characteristics bring out the
nature of this new financial instrument: (a) right debentures can be issued by public
limited companies to raisefinance for long-term working capital requirements; (b) they are
not issued to the public, but are issued on a right basis to the existing shareholders of the
issuing j company in a certain ratio to the ordinary shares held bythem. These j rights are
transferable and renounceable. The issues of right debentures, however,donot supplantthe
issuesof conventionaldebenturesto thepublic; (c)theirmaturityperiod is up to 12 years; (d)
their face value is Rs. 100; (e) they are listed on the stock exchanges; they are secured
mortgagedebentures, (f)the amount of capitala companycan raisethrough the issue of
these debentures cannot exceed 20 per cent of its current assets, loans advanced minus
the long-term fund available for financing working capital, or 20 per cent of the company’s
paid-up share capital, including
preferencecapitalandfreereserves,whicheverislowersubjecttoamaximumofRs.2.50crores;
(g) the debt/equity ratio, including proposed debenture issue, should not exceed 1:1; (h)
they can be issued only by a listed company and only if its equity shares were quoted at or
above the par value during the sixmonthsprior to the date of the application for the issue
of debentures; (t) debenturescan beactuallyallottedonlyaftera minimumsubscriptionof
75percent of theamount of debenturesissued has been secured; (/) although these
debentures are mostly non-convertible, there have been cases of companies who have
combined “convertibility” and “right” features in issuing their debentures. Rights
debentures have been subscribed mainly by financial institutions and charitable and other
trusts where these debentures have been declared as “public securities”by the respective
State governments. They have not been able to attract genuine small investors. Of late,
even financial institutions havedeveloped a reluctance to subscribe to these debentures
because of their low interest ratesand lack of liquidity. The lack of liquidity is due to the
absence of any good secondary market for debentures. Financial institutions would like
the ceiling rate of interest on these debentures to be raised. Most of these debenturesare
quotedat a discount. The amount of capital issued through these debentureshas been
quite small.
Whatever the actual trends on the new issue market, it is not desirable to rely significantly
on right debentures as a source of funds. The issue of right debentures, the conversion of
a part of loans from financial institutions into equity, and the practice of encouraging
share-holders by offering higherinterest rates to keep deposits with their own companies
have tended to make nonsense of the debt/equity ratio officially prescribed for the
corporate sector. They have tended to lower the security available to the holders of
creditor-ship securities. It is a sound principle of capital structure that an increase indebt
capitalisrequired to be backed byan increase inequitycapital. Thenormswith regard to
debt/equity ratio are prescribed in order to accord protection to the creditors. Now, when
the same investor is induced to provide both borrowed capital and equity capital in the
same company, he is required as the ownerof the company to protect his own capital as a
creditor. In other words, in such a situation, although the balance between equity and debt
capital may be maintained, there is no real protection available to the creditors.
So far we have described the principal types of industrial securities/Let us now see what
important innovations have occurred in India during the 1980s in respect of these
securities.
The instrument of ordinary debenture or Non-convertible Debenture (NCD) has now been
made extremely flexible as a result of the guidelines issued by the Government. Pursuant
to the recommendations made in 1981 by the N.N. Pai Working Group to develop primary
and secondary markets in debentures, the Government of India revised the guidelines

76
about issuing -debentures, as a resultof which NCDs havebecomequiteattractive, both to
the investors andthe issuing companies, in respect of return, maturity, liquidity, tax status,
and so on. The face value of NCDs is mostly Rs. 100 and their maturity period 7 years.
There was a ceiling rate of interest on them of 15 per cent between 1982 to 1986 which
was reduced to 14 per cent in 1987-88. These debentures have a buy-backfacility after a
lock-in period of one year. They are in most cases redeemed at 105 per cent of the face
value. Theyarefully secured; interest is paidquarterly orsix-monthly; andthe interest
incomefromthemup to

77
Rs. 2500 is not taxed at source. The companies are allowed to retain 50 per cent of
oversubscribed amount, to convert NCDs into equity shares, and to issue them not only for
meeting expansion, diversification, andlong-term working capital needs butalso to
meetalmostevery conceivableneed for funds. The companiesare mostlyreadyto
reviewinterest rate on these debenturesupwards, in case of an upward movement in
interest rates in the economy. It means that these debentures are variable or floating rate
debentures..
A few companies have issued linked NCDs”, i.e. they have issued ordinary share with
NCDs; in this casethe applicanthastoapply bothforshares and NCDs in the
specifiedproportion.When such linked issues of NCDs are made, the interest rate offered
on NCDs is lower than the i usual interest rate on them.
There have been cases of issuing “zero bonds” i.e. zero interest convertible bonds. One
company recently issued such bonds at par on right basis to employees arid shareholders
in the ratio of one debenture for 100 equity shares held. The debentures would be fully
convertible into equity shares at the end of 3years from allotment at a premium tobe
decidedby CCI whichwill not bemorethan Rs. 30 per share. The face value of the debenture
is Rs. 1000.
The Government approved in January 1989 a new instrument, namely, Partly Convertible
Debenture (PCD). It has a shorter maturity period of 5 years and the issuing company
provides buy-back facility relating to the residual non-convertible portion at the option of
the investors.
In addition to the private corporate sector debentures and Government bonds, the market
has become familiar since 1985 with the Public Sector Bonds (PSBs). According to the
guidelines issued by the Government in September 1985, the existing and new public
sector undertakings or Government corporate bothes can issue these bonds which have a
face value of Rs. 500 or Rs. 1000. Normally, these bonds will not be redeemable before the
expiry of 7 years; their maximum maturity is 10 years. The interest rate on these bonds is
fixed by the Union Finance Ministry; the maximum interest rate on them at present is
either 13 per cent or 9 per cent per annum; the interest can be cumulative or non-
cumulative. There is no deduction of tax at source on interest income, while 9 per
cent .10-year bonds are completely tax-free without limit, 13 per cent 7 to 10year bonds
are entitled to deduction underSOL of Income Tax Act. Both categories of bonds are
exempt from wealth-tax without limit. These bondsare transferableby endorsement and
delivery and they alsoenjoy buyback facility. The SBIbuys and sells these bonds at a small
price difference across the counter. These bonds are guaranteed by the Government; they
are traded on stock exchanges; the holders up to Rs. 40000 enjoy the buy-back facility
provided they hold these bondsfor at least 3 years. The “railway bonds” issued in the early
part of 1991 by the Indian Railway Finance Corporation are the latest example of public
sector bonds.”
The public financial institutions have been issuing “capital gains bonds or debentures.”
NHB, IDBI, and HUDCO are some of the examples of institutions issuing these bonds. They
carry the interest rate of 9 per cent per annum; they are available throughout the year at
a number of outlets. They are meant for investment of capital gains’ for the purpose of
exemption from capital gains tax to the extent of 100 per cent. Interest on them is
payable in advance or on a six monthly basis. Capital gains from the sale of long-term
assets such as land, buildings, shares, securities, jewellery can be invested in these bonds.
There is no deduction of tax at source on interest earned. Interest income is exempted
under SOL of Income Tax Act, and bondsenjoy wealth tax benefits. The maturityperiod of

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bondsis 3 years. There is an option to receivean advance paymentof interest forthe period
of full3 years on adiscountedbasis; in the case of NHB, this can be done at the rate of Rs.
240 per Rs. 1000invested and payable 3 months from the date of investment.
The bond market hasalso witnessed the issue of “NRI Bonds”. These are US
dollardenominated bank instruments in the form of promissory notes offered by the SBI to
NRIs. They serve the purpose of remitting to India dollar denominated funds of the NRIs.
The first series of these bonds was issued in 1988 which had collected $92 million from
NRIs in more than 70 countries. The second series of these

79
bonds, which ismore attractive, hasbeen issued in December1990. No interest ispayable if
the bonds are encased before theexpiryof one year. Thesebondscarryan interest rateof 11
percent perannum (11.5 per cent in the case of first series). The interest is payable on a
cumulative or non-cumulative basis; while in the case of the former, the interest is
compounded half-y early in. US dollars and paid along with the principalamount on
maturity, in the case of the latter, the interest is paid non-repatriable in Indian rupees. The
maturity period of bonds of both the series has been 7 years. The bonds are easily
transferable among NRIs by endorsement and delivery. The first series bonds could be
encased after a minimum lock-in period of three years; there is no such lock-in period in
the case of second series bonds. While the first series bonds could be gifted to lineal
descendants, the second series bonds can be gifted to any Indian resident. The interest on
bonds is free from income tax, wealth tax, and gift tax, but these tax concessions are not
available in the case of premature encashment. The denominations of bonds are, $500, $
1000, $5000, and $10000, and .the minimum investment is $500. It is feared that these
bonds might be used to convert black money into white money.
In the equities market, the Government introduced Cumulative Convertible Preference
Shares (CCPs) in August 1985. According to the Government guidelines, Indian public
limited companies can issue CCPs for the purposes of setting up new projects, expanding
and diversifying existing projects, and raising funds for normal capital expenditure and
working capital needs. CCPs are fully convertible into equity sharesbetween the3rd and5th
years of theirissueand aredeemed equityforpurposesof debt- equity ratio. The rate of
dividend, payable on the CCPs is fixed at 10 per cent per year. The guideline regarding the
ratio of1: 3 as between other preference shares and equity shares is not applicable
totheCCPs,the amountof issueof CCPscanbetotheextent of
equitysharesofferedbythecompanyto the public. The CCPs are compulsorily converted into
equity at the end of five years and no CCP is redeemable at any stage.
SALIENTFEATURESOFINDUSTRIALSECURITIES
Certainfeaturesofthemarketinindustrialsecuritiesmaybesummarizedbelow:
(a) Industrial securities market comprises the new issue (Primary) market and stock
exchange (Secondary market).
(b) There are 18 stockexchangesin Indiaat present; theBombayStockMarket among
themaccounts for about 70 percent of the total trading business of all stock exchanges put
together.
(c) The small volume of industrial securities in relation to Government securities, their
minor role in financing the private sector, and their marginal significance as a saving
medium indicate that industrial securities market in not really a barometer of economic
activity in India.
(d) Onlythe“listed”securitiescanbetradedonstockexchangesandthemarketingofoldaswellas
newsecuritiescanbedoneonlythroughthemembersofstockexchanges.
(e) TheentireworkingofthenewissuemarketinIndiaiscontrolledbycontrollerof capitalissue.
(f) During 1946 to 1988, the number of listed companies on stock marketshas increased
from 1125 to 5841 and their paid up capital has gone up from about Rs. 270 crores to
about Rs. 21465 crores.
(g) The annual turnover on all stock exchanges has tripled from Rs. 3159 crores in 1979 to
Rs. 8695 crores in 1988.
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(h) Business concerns reuse capital through three major types of security Ordinary shares,
preference shares, and debentures. The subtypes of these securitiesare: cumulative, non-
cumulative, convertible, non-convertible, participating, non-participating, redeemable,
non-redeemable, cumulative convertible preference shares; convertible, non-convertible,
partially convertible, rights, linked non-convertible,zero, public sector units, capital gains,
and NRI-bonds or debentures.

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 SELFCHECKEXERCISE
1. Whatis‘StockMarket’?
2. Whatare‘IndustrialSecurities’?
SUMMARY
Stock, market represents the secondary market where existing securities (shares and
debentures) are traded, Stock exchange provides an organised mechanismfor purchase
and sale of existing securities. By now, we have 24 approved stock exchange in our
country.
The investors want liquidity for their investments. The securities which they hold should easily be
sold when they need cash. Similarly there are others who want to invest in new securities.
There should bea place where the securitiesmaybe purchasedand sold. Stock exchanges
provide such a place where securities of different companies can be purchased and sold.
Stock exchange is a body of persons, whether incorporated or not, formed with, view to
helping, regulating and controlling the business of buying and seam of securities.
GLOSSARY
Stock Exchange: stock exchanges are market places where securities that have been listed on
May be bought and sold for either investment of speculation.
Listing of securities: listing of security means permission to court shares and debentures
officially on the trading floor of the stock exchange.
Jobbers: Job Bazar security merchants dealing in shares and debentures as independent
operators. They buy and sell securities on their own behalf and try to earn through price
changes.
ANSWERSTOSELFCHECK EXERCISE
1. Refersto5.1
2. Refersto5.3
TERMINALQUESTIONS
1. Describetheorganizationofthestockmarket.
2. Discussthefollowings:
(a) Ordinaryshares
(b) PreferenceShares
(c) Debentures
3. Explainthesalientfeaturesofindustrialsecurities.
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection5.1&5.2
2. (a)Refersto5.3.1
(b)Refersto 5.3.2
(c) Refersto5.3.3
3. Refersto5.4
82
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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83
 Lesson-6
NATIONALDEPOSITORYSECURITIESININDIA

STRUCTURE
LearningObjectives
TheDepositorySystem
BenefitsofADepositorySystem
TheDepositoryProcess
TheNationalSecuritiesDepositoryLimited
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthischapteryoushouldbe to:
1. Describethebenefitsofdepositorysystem
2. ExplainthedepositorysysteminIndia
3. Discussthenationalsecuritiesdepositorylimited
THEDEPOSITORYSYSTEM
Technologyhaschanged the face of the Indian stock marketsin thepost-liberalizationera.
Competition amongst the stock exchanges, increase in the number of players, and
changes in the trading system have led to a tremendous increase in the volume of
activity. The traditional settlement and clearing system have proved to be inadequate due
to operational inefficiencies. Hence, there has emerged a need to replace this traditional
system with a new system called the ‘depository system'.
Depository, in very simple terms, means a place where something is deposited for
safekeeping. A depository is an organization which holds securities of a shareholder in an
electronic form andfacilitates the transfer of ownership of securities on the settlement
dates. According to Section 2(e) of the DepositoriesAct, 1996, ‘Depositorymeansa
companyformed and registered under the Companies Act, 1956 and which has been
granted a certificate of registration under Section 12(1 A) of the Securities and Exchange
Board of India Act, 1992.'
The depository system revolves around the concept of paperless or scripless trading
because the sharesin a depository are held in the form of electronic accounts, that is, in
dematerialized form. This system is similar to the opening ofan account in a bank wherein

84
a bank will hold money on behalfof the investorand the investorhas to open an account
with the bank to utilize its services. Cash deposits andwithdrawals aremadeina bank,inlieu
ofwhichareceiptand bank passbook aregiven,whilein

85
depositories, scrips are debited and credited and an account statement is issued to the
investor from time to time. An investor in a bank deals directly with the bank while an
investor deals through a
depositoryparticipantinadepository.Adepositoryalsoactsasasecuritiesbank,wheredemateria
lized physical securities are held in custody.
An effective and fully developed depository system is essential for maintaining and
enhancing market efficiency, which is one of the core characteristics of a mature capital
market.
NeedforSetting-upaDepositoryin India
 Thisneedwasrealizedinthe1990sduetovariousreasonsasoutlinedbelow:
 Large-scale irregularities in thesecurities scam of1992exposedthe limitationsof the
prevailing settlement system.
 Alotoftimewasconsumedintheprocessofallotmentandtransferofshares,impedingthe
healthy growth of the capital market.
 With the opening up of the Indian economy, there was a widespread equity cult
which resultedin an increased volume of transactions.
 Mounting fiscal deficitmadethe governmentrealizethat
foreigninvestmentwasessential for the growth of the economy and that was being
stricted due to non-availability of depositories.
 Therewerevariousproblemsassociatedwithdealingiiphysicalshares,suchas
 problemsoftheft,fakeand/orforgedtransfers,
 sharetransferdelaysparticularlyduetosignaturemismatches;and
 paper work involved inbuying,selling,and transfer leadingto costsof
handling,storage, transportation, and other back office costs.
To overcome these problems, the Government of India, in 1996, enacted the Depositories
Act,1996 to start depository services in India.
Depository can be in two forms—dematerialized or immobilized. In dematerialization,
paper certificates are totally eliminated after verification by the custodians. In
immobilization, initial paper certificates are preserved in safe vaults by custodians and
further movement of papers are frozen.
Thedepositorysystemprovidesawiderangeofservices.
 Primarymarketservicesbyactingasalinkbetweentheissuersandtheprospective
shareholders.
 Secondary market services, byacting asa link between the investorsand the clearing
house of the exchange to facilitate the settlement of security transactions through
book-keeping entries.
 Ancillaryservices, byprovidingservicessuchas collectingdividends
andinterests,reporting corporate information, and crediting bonus, rights, shares.
These servicesleadtoa reductioninbothtimeand costwhich ultimatelybenefitsthe
investors,issuers, intermediaries, and the nation as a whole.
DifferenceBetweenaDematShareandaPhysicalShare
A demat share is held by the depository on behalf of theinvestor whereas a physical share
86
is held by the investor himself. The holding and handling of a demat share is done
electronically, whereas a physical share is in the form of a paper. The demat share can be
converted into a physical share on request. This is referred to as the rematerialization of
the share. The interface between the depository and the investor is provided by a market
intermediary called the depository participant (DP) with whom

87
an investor has to open an account and give all instructions. The demat share does not
have a folio number, distinctive number, or certificate number like a physical share.
Demant shares are fungible, that is, all the holdings of a particular security will be
identical and interchangeable. Though there is no stamp duty on the transfer of demat
shares from one account to another, the depository participant charges a transaction fee
and levies asset holding charges.
There is, however, no difference between demat shares and physical shares as far as the
beneficial interestsof ownershipof securitiesare concerned. Theowner
isentitledtoexactlythesamebenefits of ownership of a security no matter in what form it is
maintained.
BenefitsofaDepositorySystem
A depository system enables immediate allotment, transfer, and registration of securities,
thereby increasing the liquidityof stocks. It eliminates allproblems related with the holding
of shares in physical form, thereby increasing investor confidence. An investor saves in
terms of costs like stamp duty, postage, and brokerage charges (Table 18.1). Pledging of
shares and portfolio shuffling become convenient for an investor. This system enables
trading of even a single share, thereby eliminating the problem of odd-lot shares. Shares
get credited into the demat holder's account in a couple of days, unlike the physical mode
where it took an average of a month to transfer the shares.
Further, loans against the pledged demat shares come at interest rates that are lower by
0.25 per cent to 1.5 per cent in comparison to pledged physical shares. The limit of loan
against dematerialized security as collateral is double (at `20 lakh) of that against
collateralized physical security (`10 lakh).The Reserve Bank of India has also reduced the
minimum margin to 25 per cent for loans against dematerialized securities as against 50
per cent for loan against physical securities. Many brokerage firms have brought down
their brokerage to the extent of 0.5 per cent as the risk associated with bad delivery has
reduced.
This system has facilitated the introduction of the rolling settlement system which, in turn,
has led to shorter settlement cycles and a decrease in settlement risks and frauds. Lastly,
this system helps in integrating the domestic capital market with international capital
markets.
DepositorySysteminIndia
The move on to a depository system in India was initiated by the Stock Holding
Corporation of India Limited (SHCIL) in July 1992 when it prepared a concept paper on
‘National Clearance and Depository System’ in collaboration with Price Waterhouse under
a programme sponsored by the US Agency for International Development. Thereafter,
thegovernment of India constituted a technical group under the chairmanship of R.
Chandrasekaran, Managing Director, SHCIL, which submitted its report in 1993.
Subsequently, the Securities and Exchange Board of India (SEBI) constituted a seven-
member squad todiscussthevariousstructuralandoperationalparametersof
thedepositorysystem.TheGovernment of Indiapromulgatedthe DepositoriesOrdinance in
September1995,thuspaving the wayforsetting up of depositories in the country.
SomefeaturesoftheDepositoriesOrdinanceareasfollows:
 Thedepository isa registeredownerof thesharewhile the shareholderis
thebeneficialowner retaining all the economic and voting rights arising out of share
ownership.

88
 Sharesinthedepositorywillbefungible.
 Transferspertainingtosaleandpurchasewillbeeffectedautomatically.
 Anylossordamagecausedtotheparticipantwillbeindemnifiedbythedepository.
 Iftradesareroutedthroughdepository,thereisnoneedtopaystampduty.

89
The Depositories Act was passed by the Parliament in August 1996. It lays down the legislative
frame- work for facilitating dematerialization and book entry transfer of securities in a
depository. The act pro- vides that a depository is required to be a company under the
Companies Act, 1956 and depository participants(DPs)need to be registered with theSEBI.
The investors havethe option toholdsecurities in physical or dematerialized form or to
rematerialize securities previously held in dematerialized form.
The SEBI issued a consultative paper No. X on the draft regulationsfordepositoriesand
participants in October 1995 for wide consultation and notified the regulations in May
1996. The SEBI has allowed multiple depositories to ensure competition and transparency.
The Depositories Related Laws (Amendment) Ordinance, 1997, issued in January of that year
enabled units of mutual funds and UTI, securities of statutory corporations and public
corporations to be dealt through depositories. The Dhanuka Panel in its draft Depository
Act (Amendment) Bill, 1998 recommended empowering the SEBI to make trading in demat
shares mandatory. The SEBI laid down anelaboratetime schedule envisaging
thatbeginningJanuary 4, 1999,till March 26,2001, 3,145 listed scrips or 40 per cent of the
total listed securities would be traded compulsorily in the demat form. Besides equity, new
debt issues will also be in demat form. The minimum networth stipulated by the SEBI for a
depository is `100 crore.
It is mandatory for all listed companies to have their securities admitted for dematerialization
with both the depositories, viz, NSDL and CDSL. Securities include shares, debentures,
bonds, commercial paper, certificate of deposits, pass through certificates, government
securities and mutual fund units.
SEBI(Depositories and Participants) (Amendment) Regulations 2008 were notified on March
17,2008, which provided for the shareholding such as
1. sponsorshouldatalltimesholdatleast51percentsharesinthedepository;
2. no person, either singly or together with persons acting in concert, can hold more
than 5 per cent of the equity share capital in the depository;
3. the combined holding of all persons resident outside India in the equity share
capital of the depository willnotexceed, at m\ time. 40 percent of itstotalequityshare
capital, subjectfurther to the following:
a. the combined holdingsof such personsacquired throughtheforeigndirect investment
route’are not more than 26 per cent of the total equity share capital, at any time;
b. thecombinedholdingsofforeigninstitutionalinvestorsarenotmorethan23percentof
thetotal equal) share capital, at any time;
c. noforeigninstitutionalinvestoracquiressharesofthedepositoryotherwisethanthroughth
e secondary market.
TheDepositoryProcess
Thereare fourparties in a demat transaction: thecustomer, the depositoryparticipant (DP), the
deposi- tory and the share registrar and transfer agent (R&T).
Opening an Account An investor who wants to avail of the services will have to open an account
with the depository through a DP. who could either be a custodian, a bank, a broker, cr
individual with a minimum net worth of `1 crore. The investor has to enter into an agreement
with the DP after which he is issued a client account number or client ID number. PAN Card
is now mandatory tooperate a demat account. Theholderof ademat account iscalled
'beneficialowner’ (BO). He canopen more than one account with the same or multiple DPs.
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Dematerialization To convert his physical holdings of securities into the dematerialized
form, the investor: make an application to the DP in a dematerialization request form
(DRF). Within seven days, the DP forwards the form, along with the security certificates, to
me issuer or its registrar and transfer agent after electronically registering the request
with the depository.
The depository electronically forwards the demat request lo the respective issuer or its
registrar and transfer agent, who verifies the validity of the security certificates as well as
the fact that the DRF has been made by a person recorded as a member in its register of
members.
After verification, the issuer or its registrar and transfer agent authorises an electronic
credit for the security in favour of the client. Thereafter, the depository causes the credit
entries to be made in the account of the client.
Rematerialization To withdraw his security balance with the depository, the investor makes
an application to the depository through its DP. He requestsfor the withdrawalof balance in
his account in a rematerialization request form (RRF). On receipt of the RRF,the participant
checkswhethersufficient free relevant security balance is available in the client’s account.
If there is, the participant accepts the RRF and blocks the balance of the client to the
extent of the rematerialization quantity andelectronically forwards the request to the
depository.
On receipt of the request, the depository blocks the balance of the participant to the
extent of the rematerialization quantity in thedepository system. Thedepository
electronicallyforwardsthe accepted rematerialization application to the issuer or its
registrar agent, which is done on a daily-basis.
The registrar and transfer agent confirm electronically to the depository that the RRF has
been accepted.Thereafter,theissuerorregistrarandtransferagentdespatches
thesharecertificatesarising out of the rematerialization request within 30 days.
Distributing Dividend A company (issuer or its registrar and transfer agent shall make
known the depositor) of the Corporate actionssuch asdatesfor book closures, redemption
or maturity of security, conversion of warrant’s, and call money from time to time. The
depository will then electronicallyprovide a list of the holdings of the clients-as on the cut-
off date. The company can then distribute dividend, interest, and other monetary benefits
directly to the client on the basis of the list. If thebenefits are in the form of securities, the
company or its registrar and transfer agent may distribute these,provided
thenewlycreated securityisaneligible securityandthe clienthasconsented to receive the
benefits through depositor).
Closing an Account A client wanting to close an account shall make an application in the
format specified to that elfect to the participant. The client may close his account if no
balancesare outstanding to his credit in the account. If any balance exists, the account
may be dosed in thefallowing manner: (i) By rematerialization of all its existing balances in
his account and/or (ii) By transferring his security balances to his other account held either
with the same participant or with a different participant.
The participant shall ensure that all pending transactions have been adjusted before
dosing such an account. After ensuring that there are no balances in the client’s account,
the participant shall execute the request for closure of the client’s account.
Trading/SettlementofDematSecurities
The procedure for buying and selling dematerialized securities is similar to the one for

91
physical securities. In case of purchase of securities, the broker will receive his securities
in his account on the payout day and give instruction to its DP to debit his account and
credit investors account. Investorcan either give receipt instruction or standing instruction
to OP for receiving credit by filling appropriateform.Incaseofsale
ofsecurities,theinvestorwillgivedeliveryinstructiontoDPtodebithisaccount

92
andcreditthebroker'saccount.SuchinstructionshouldreachtheDP’sofficeatleast24hoursbefore
thepay-in.
THENATIONALSECURITIESDEPOSITORYLIMITED
The Indian capital market took a major step in its rapid modernization when the National
Securities Depository Limited (NSDL) was set up as the first depository in India. The NSDL,
promoted by the Industrial Development Bank of India, the Unit Trust of India (UTI), the
National Stock Exchange ofIndia Limited (NSE), and the State Bank of India (SBI) was
registered on June 7, 1996, with the SEBI and commenced operations in November 1996.
The NSDL is a public limited company formed under the Companies Act. 1956 with a paid-
up capital of `105 crore.
The NSDL interacts with investors and clearing members through market intermediaries
called depository participants (DPs). The NSDL performs a wide range of securities-related
functions through the DPs. These services are as follows:
1. Core services
a. Maintenanceofindividualinvestors‘beneficialholdingsinanelectronicform,
b. Trade settlement.
2. Specialservices
a. Automaticdeliveryofsecuritiestotheclearingcorporation.
b. Dematerializationandrematerializationofsecurities.
c. Accounttransferforsettlementoftradesinelectronicshares.
d. Allotmentsintheelectronicformincaseofinitialpublicofferings.
e. Distributionofnon-cashcorporateactions(bonusrights,etc).
f. Facilityforfreezing/lockingof investoraccounts.
g. Facilityforpledgeandhypothecationofsecurities.
h. DematofNationalSavingsCertificates(NSC)KisanVikasPatra (KVP).
i. InternetbasedservicessuchasSPEED-eandIDeAS.
BusinessPartnersofthe NSDL
An important link between the NSDL and an investor is a DP. A DP could be a public
financial institution, abank, acustodian, ora stockbroker.Corporateentitiesarenotallowed to
become DPsnor can they set up depositories. A DP acts as an agent of the NSDL and
functions like a securities bank'as an investor has to open an account with the DP. The
SHCIL was the first depository participant registered with the SEBI. The number of DPs
operational as on March end 2010 stood at 287 as against 24 in the end of March 1997
including ail custodians providing services to local and foreign institutions.
At present, the competition among DPs has increased and, in a bid to attract and retain
customers,DPs are exploring new avenues including latest technology for increasing their
efficiency. For instance, many DPs have launched interactive voice response (IVR) units.
They have also slashed their service charges and many of them are rendering free-market
and off-market buy services to them corporate clients.
Besides DPs, other business partners of the NSDL include issuing companies/their share
transfer agents, clearing corporations/houses, and clearing members. The NSDL facilitates
the settlement of trades carried out in the book entry segment of stock exchanges. The
actual settlement function is
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performedbytheclearingcorporation/housesofthestockexchanges.TheNSDLhasitsby-laws

94
regarding the powers and functions of board of directors, executive committee, rules of
business, participants, nomination of persons of eminence, safeguards for clients,
participants, and accounts by book entry. Trading in dematerialized securities commenced
on December 26, 1996, in the NSE.
The NSDL has achieved paperless trading in perhaps the shortest time in the world—a
little over three years. Today 99.9 per cent of all equity is traded in demat form. The NSDL
has more than 1.58 crore (Box 18.1) investor accounts and 268 DPs. making it the second
largest depository in the world.
The NSDLs computer system handles around eight to nine million messages (to debit and
credit indi- vidual investoraccounts)perday on an online basis, it links three types of data
bases—a central NSDL one those of 281 DPs as well as those of 8.338 companies.
Moreover, it has the ability to monitor everything that is happening in the computers of its
DPs.
The NSDL has undertaken a pilot project to dematerialize securities like National Savings
Certificates and Kisan Vikas Patra at select post offices. In addition, it also manages a
countrywide tax information networkforthe ministryoffinance. It hasalsobeen
appointedascentralRecord keepingagencyfor the New Pension System of the Government
of India.
The NSDL has created three pioneering systems: SPEED-e, STeADY and IDeAS. SPEED-e
allows users to execute delivery instructions using the Internet. STeADY (Securities
Trading—InformationEasy Access and Delivery) was launched by the NSDL or November
30, 2002 and it constitutes an internet-based infrastructure few facilitating straight-
through processing. It is a means of transmitting digitally signed trade information with
encryption across market participants electronically, through the Internet. This facility
enables brokers to deliver contract notes to custodians and or fund managers
electronically. ‘IDeAS’ (Internet-based DenialAccount Statement) enables itsaccount-
holders including clearing members to view their account balances and transactions of the
last five days. These systems reflect the continual process or sophistication of depository
services being undertaken by the NSDL.
SELFCHECKEXERCISE
1. DefineDepositarySystem.
2. Define“NationalSecuritiesDepositarySystem”.
SUMMARY
One of the biggest problem faced by the Indian capital market has been the manual and
paper based settlement system. Under this system, the clearing and settlement of
transactions take place only with the use of paper work. The system of physical delivery of
scrips poses many problems for thepurchaseras wellas the seller in theformof delayed
settlements, long settlement periods, high level of failed trade, high cost of transactions,
bad deliveries etc. In many cases transfer process takes much longertime than two
monthsasstipulated in section 113 of the CompaniesAct,1956 or section 22A of the
Securities Contracts (Regulations) Act, 1956. Moreover, a large number of transactions
end up as bad deliveries due to faulty compliance of paper work, mismatch of signatures
on transfer deeds with specimen record of the issuer or other procedural reasons. Besides,
theft, forgery, mutilation of certificates and other irregularities have also become rampant.
GLOSSARY
Depository participant: DP is an agent of the depository. If an investor wants to avail the
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services offered by the depository, the investor has to open an account with DP.
Beneficial owner: beneficial owner means a person whose name is recorded as such with
the depository. Beneficial owner is the real owner of the securities who has lost his
securities with the depository in the form of book entry.
Depository: a depository is a form where in the securities of an investor are held in
electronic form in the same way as Bank holds money.

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NationalsecuritiesdepositoryLimited (NSDL): NSDL
wasthefirstdepositoryorganisationpromoted by IDBI UTI and National Stock Exchange.
NSDL was set up to provide electronic depository facilities for securities being traded in
capital market.
Rematerialisation of shares : rematerialisation is the process of conversion of electronic
holding of securities into physical certificate form. For rematerialisation ofscripts the
investor has to fill up a Re mat request form and submit it to the Depository Participant.
ANSWERSTOSELFCHECK EXERCISE
1. Refersto6.1
2. Refersto6.4
TERMINALQUESTIONS
1. WhatdoyouunderstandbydepositarysysteminIndia?
2. Discussthebenefitsofdepositarysystem.
3. Explainthenationaldepositarysecuritieslimited.
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection6.1&6.2
2. ReferstoSection6.2
3. ReferstoSection6.4
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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97
 Lesson-7
CommercialBanking

STRUCTURE
LearningObjectives
Introduction
TheoreticalBasisofBankingOperations
PresentStructureof Banking
Roleof ForeignBanks
AdvantagesandDisadvantagesofForeignBanks
RoadMapforForeignBanksinIndia
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthislessonyoushouldbeableto
1. Describetheevolutionofcommercialbanking
2. Explainthepresentstructureofbanking
3. DiscusstheroleofforeignbanksinIndia
INTRODUCTION
Commercial banks are the oldest, biggest, and fastest growing financial intermediaries in
India. They are also the most important depositories of public saving and the most
important disbursers of finance. Commercialbanking in India isa unique system,the likeof
whichexistsnowhere in the world. The truth of
thisstatementbecomesclearasonestuthesthephilosophyandapproachesthathavecontributed
to the evolution of the banking policy, programmes and operations in India. This however
is too big a subject to be discussed here in detail. We will therefore confine ourselves to
presenting an outline of this philosophy and approaches.
The banking system in India works under the constraints that go with social control and
public
98
ownership.Thepublicownershipofbankshasbeenachievedinthreestages:1955,July1969,and

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April 1980. Not only the public sector banks but also the private sector and foreign banks
are requiredto meet targets in respect of sectoral deployment of credit, regional
distribution of branches, and regional credit-deposit ratios. The operations of banks have
been determined by Lead Bank Scheme, Differential Rate of Interest Scheme, Credit
Authorization Scheme, inventory norms and lending systems prescribed by the authorities,
the formulation of the credit plans, and Service Area Approach.
The focus of this chapter is on discussing the actual working of banks and not on the
philosophy and approaches behind that working.
THEORETICALBASISOFBANKINGOPERATIONS
Commercial banks ordinarily are simple business or commercial concerns which provide
various types of financial services to customers in return for payments in one form or
another, such as interest, discounts, fees, commission, and so on. Theirobjective is to
make profits. However, what distinguishes them from other business concerns (financial as
well as manufacturing) is the degree to which they have to balance the principle of profit
maximization with certain other principles. In India specially,banks are required to modify
their performance in profit-making if that clashes with their obligations in such areas as
social welfare, social justice, and promotion of regional balance in development. In any
case, compared to other business concerns, banks in general have to pay much more
attention to balancing profitability with liquidity. It is true that all business concerns face
liquidity constraint invarious areas of their decision making and, therefore, they have to
devote considerable attention to liquidity management. But with banks, the need for
maintenance of liquidity is much greaterbecause of the nature of their liabilities. Banks
deal in other people’s money, a substantial part of which is repayable on demand. That is
why for banks, unlike other business concerns, liquidity management is as important as
profitability management.
This is ‘reflected in themanagement and control ofreserves ofcommercial banks. They are
expected to hold voluntarily a part of their deposits in the form of ready cash which is
known as cash reserves; and the ratioof cash reservestodepositsisknown asthe
(cash)reserve ratio. Asbanksare likelyto be temptednot tohold adequate amountsof
reservesif theyare left to guide themselveson thispoint,and since the temptation may have
extremely destabilizing effect on the economy in general, the central bank in every
country is empowered to prescribe the reserve ratio that all banks must maintain. The
central bank also undertakes, as the lender of last resort, to supply reserves to banks in
times of genuine difficulties. It should be clear that the function of the legal reserve
requirements is two fold to make deposits safe and liquid, and to enable the central Bank
to control the amount of checking deposits or bank money which the banks can create.
Since the reserve banks are required to maintaina fraction of their deposit liabilities, the
modembanking system isalso known as the “fractional reserve banking”.
Another distinguishingfeature of banks is that while they can create as well as transfer
money (funds), other financial institutions can only transfer funds. In other words, unlike
other financial institutions, banks are not merely financial intermediaries. This aspect of
bank operations has been variously expressed. Banks are said to create deposits or credit
or money, or it is said that every loan given by banks creates a deposit. This has given rise
to the important concept of deposit multiplier or credit multiplier or money multiplier. The
import of this isthat banks add to the money supply in the economy, and since money
supply is an important determinant of prices, nominal national income, and other macro-
economic variables, banks become responsible in a major wayforchangesin economic
activity. Further, as indicated in chapter one, since banks can create credit, they can

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encourage investment for some time without prior increase in saving.
Let us briefly discuss the basis and process of the creation of money by banks. In modem
economies, almost all exchanges are effected with money. Money is said to be a medium
of exchange, a store of value, an unit of account. There is much controversy as to what, in
practice in a given year, is the measure of supply of money in any economy. We do not
need to go into that controversy here. Suffice

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it to say that everyone agrees that currency and demand deposits with banks are
definitely to be included in any measure of money supply. Thus, apart from the currency
issued by the Governmentand central bank, the demand or current or checkable deposits
with banks are accepted by the public as money. Therefore, since the loan operations of
banks lead to the creation of checkable deposits, they add to the supply of money in the
economy. To recapitulate, ,the money creating power of banks stems from the facts that
modem banking is a fractional reserve banking, and that certain liabilities of banks are
accepted (used) by the public as money.
The process of money creation works as follows: Assume that the legally required reserve
ratiois 10 per cent and that banks are maintaining just that ratio. Assume further that a
bank in the economy receives a brand new input of Rs. 1000 of reserves either as a
deposit or as proceeds of a sale of Government bond to the central bank or as some other
form. There is thus a creation of Rs. 1000 of bank money, but there is yet no multiple
expansion of money. If banks were required to keep 100 per cent cash reserve balances,
no bank would be in a position to create any extra money out of a new deposit of Rs. 1000
with it.
Butsinceabankisrequiredtoholdonly10percentofitsdepositsascashreserves,itnowhas Rs. 900
as excess reserves which it can utilize to invest or to give loan. Assume that the bank
gives a loanof Rs. 900, and theborrowerwho takesthe loan in cash orchequedeposits it
eitherwith the same bank or with some other bank. Either way, there has been a creation
of money and the total amount of bank money createdatthis stage is Rs.1000+900= Rs.
1900. This processof creation cancontinuetill no bank anywhere in the system has
reserves in excess of the required 10 per cent reserve, and the total money supply created
in the economy is Rs. 10,000. The ratio of new deposits to the original increase in reserves
is called the money multiplier or credit multiplier or deposit multiplier. Thismultiplier will
be equal to the reciprocal of the required reserve ratio.
The process of the creation of bank money does not work in practice to the full capacity or
the full potential as has been described. Banks may have a reserve ratio which is higher
than the required reserve ratio. There may also be leakages in the form of cash holding
when the banks make Joans.The process moves rather slowly and with jerks, and not as
promptly and smoothly as implied. Subject to such qualifications, there is no doubt that
modem banks can create money in the process of their working.”
With this theoretical background one should be in a position to understand the actual
working of commercial banks in India.
PRESENTSTRUCTUREOFBANKING
Tables 7.1 to 7.4 and Figures 7.1 and 7.2 present the growth and structure of Indian
banking system with varyingdetailsandfordifferent spansof time.Togethertheyshould
enablethe readerto assessall thepossibledimensionsof
thestructureandgrowthofbanksinIndia.Forlackofspace, onlythesalient features of these
aspects have been touched upon.

Table7.1.GrowthofCommercialBanksinIndiaDuringPost-NationalizationPeriod

Variables 1969 1989

1.TotalDeposits(Rs.Crores) 4667 145684
2.Deposits/NationalIncome(%) 15.5 49
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3.NumberofDepositAccounts(Million) 18 247
4.Depositsperoffice(Rs.lakhs) 57 252

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 5.RuralDeposits/TotalDeposits 3 15

6.TotalCredit(Rs.Crores) 3602 90185

7.NumberofCreditAccounts(Million) 1.1 25.6

8.Creditperoffice(Rs. lakhs) 44 156

9.CredittoPrioritySectors(Rs. crores) 504 36238

10.Prioritysectorcredit/TotalCredit(%) 14 40

11.Numberoftotalbranches(offices) 8187 57611

12.NumberofRuraloffices 1443 32873

13.RuralOffices/Totaloffices 18 57

14.Population servedperoffice 65000 12000

SOURCE:RBIBulletin,March1990.pp.198-99,andOctober1990.p.766.

Table7.2AnnualAverageRatesof GrowthofCommercialBanksinIndia1951-1986 (Percentages)

Period Numberofoffices Deposits Credit

1951-61 2.7 12.98 11.45
1961-69 9.96 19.33 22.92
1969-78 23.16 49.90 44.64

1978-86 5.9 37.92 33.06

1951-86 25.30 367.47 314,81

SURCE:BasedonTable7.3.
InSeptember1990,296schedule bankshad59388offices, Rs,1,87,469 croresofdeposits,and
d
Rs. 1,12,212 crores of credit. The corresponding figs, for 1951 were 93 banks, 2847
offices, Rs. 856 crores of deposits, and Rs. 459 crores of credit. In other words, compared
to 1951, the banking business in 1990 was 22 times in terms of offices, 219 times in terms
of deposits, and 244 times in terms of credit. Fig. 7.1.which is drawn with the ratio scale,
and Table 7.3 (column 5) reflect this phenomenal growth of Indian banking during a period
of 40 years. According to the latest available information, as on 22 March, 1991, the
aggregate bank deposits and bank credit were Rs. 1,91,189 crores and Rs. 1,16,184
crores, respectively.
Table.7.-1.concentrates on the growth of banking only during the post-nationalization
period but with many core indicators. The growth of banking has been far more rapid after
the nationalization than before it. Further the overall growth in business has been
accompanied by a significant increase in the share ofrural and priority sectors in the toted
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business. While the bank depositsto national income
ratiohasincreasedfromjust15percentin1969toashighas50percentin1989,thepopulation

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served per office has drastically- declined from 65000 to 12000 during the same period.
However,within the post-nationalization period, the annual rate of growth appears to have
slowed down in the 1980s compared to the 1970s. Table 7.2 shows the extent and time
pattern of this growth.

Table7.3.StructureandGrowthofCommercialBanksinIndia.1951to1986

Category India Foreig Tota NonSchedul Tota RegionalRural

of n n l e l
Banks Schedule Schedule Schedule Banks Banks
(3+4)
Variables Banks Banks Banks
(1) (2) (3) (4) (5) (6)
1.NumberofReportingBanks
1951 — — 92 474 566 —
(16.25)82 (83.74)210 (100)
1961 67 15 82 210 292 —
(22.94) (5.13) (28.08) (71.91) (100)
1969 58 13 71 14 85 —
(68.23). (15.2,9) (83.5) (16.47) (100)
1978 61 12 73 4 77 48
(79.22) (15.58) (94,80) (5.19) (100)
1986 58 21 79 3 82 194
(70.73) (25.6) (96.34) (3.65) (100)

2.NumberofOfficesinIndia
1951 — — 2647 1504 4151 +-
(63.76) (36.23) (100)
1961 4319 71 4390 622 5012 —
(86.17) (1.41) (87.58) (12.41) (100)
1969 8696 131 8826 181 9007 —
(96.54) (1.44) (97.94) (2.09) (100)
1978 27596 129 27725' 57 27782 1722
(99.33) (0.46) (99.79) (0.20) (100)
1986 40725 136 40861 42 40903 12846
(99.56) (0.33) (99.89) (0.1) (100)
3.TotalDeposits
(Rs.crores)
1951, — — — '— 909 —
1961 1792 257 2749 40 2089 —
(85.78) (12.30) (98.08) (1.91) (100) i'
1969 4808 487 5295 24 5319 —

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 (90.39) (9.15) (99.54) (0.45) (100)
1978 28084 1112 291% 10 29206 75

(96.15) (3,80) (99.96) (0.04) (100)

1986 114066 3725 117791 29 117820 1786
(96.81) (3.16) (99.97) (0.03) (100) '"-
4.TotalBankCredit
(Rs.crores)
1951 — — 681 46 727 —
(92.66) (7.33) (100)
1961 1090 230 1321 25 1345 '—
(81.15) (17.10) (98.21) (1.85) (100)
1969 3396 403 3799 12 3811 —
(89.11) (10.57) (99.8) (0.31) (100)
1978 18322 7% 19118 6 19124 91
(95.80) (4-16) (99.96) (0.04) (100)
1986 67013 2681 6%94 19 69713 1792
(96.13) (3.84) (99.97) (0.03) (100)

N.B.:(i)Figuresinbracketsarepercentagestothe totals.
(ii) Regional Rural Banks are also scheduled banks. They have been shown separately
because of their special position: Figures in columns 1,3,5 are exclusive of figures
in column 6.
SOURCE:RBI,StatisticalTablesRelatingtoBanksinIndia,variousIssues

Years
· DepositsRs. Crores ı Credit
* Inv. in Secu. • No of Offices
Fig.7.1.ThegrowthofscheduledbanksinIndia(Source:RBI,RCF,variousissues)
Note:Thefiguresinbracketsare%tototalscheduledbanks.
Source:RBIStatisticalTablesRelatingtoBanksinIndia,variousissued.

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Figure7.2.portraysthetypesofbankswhichconstitutetheIndianbankingsystemandTables7.3and
show the relative shares of these different types of banks in the total banking business
in terms of
fourindicators,namelythenumberofreportingbanksandbankoffices,andthevolumeofdeposits
and

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credit. One observes that the scheduled commercial banks presently account for virtually
the entire banking business. During early 1950s, there were many non-scheduled banks
and each of such banks had many offices, but they have since become quite unimportant
in every respect.

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11
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Among the scheduled banks, ‘the Indian scheduled banks’, excluding Regional Rural Banks
(RRBs), belonging to both the public mid private sectors have increased their share in the
total bankingbusiness during 1951 -90, and now they account for more than 95 per cent of
this business.

On the other hand, over the years the number of foreign (scheduled) banks has increased,
but their share in thetotalbusinesshas-declined.They nowaccountfor3 to 4percent of the
totalbankdeposits (credit) compared to 10 to 17 per cent till 1969.
The share in the totalbanking businessof the scheduledbanks in the public sector including
RRBshas increased, while that of the private sector banks has declined. This share of the
public sector banks is now more than 90 per cent, and that of the private sector banks is
between 4 to, 5 per cent. At present there are about 100 private sector banks, most of
which have just one or two branches. Of these, only 24 banksare large enough and 3 of
them account for about 70 per cent of the total businessof private sector banks.
Among the public sector banks, the State Bank of India (SBI) alone accounted for about 14
per cent of thetotalnumberof bank offices,21percent of
thetotalbankdeposits,and24percentof the totalbank credit in 1986. If the subsidiaries of
the SBI were included, the corresponding figures for the SBI group were 20 per cent, 27
per cent, and 30 per cent, respectively it that year. As on 14December, 1990also, the SBI
and the SBI group had shares in banking business very much similar to those that have
been discussed. The twenty nationalized banks other than the SBI and its subsidiaries
nowaccount for 50 to 60 per cent of the total banking business.
A beginning to set up the RRBs was made in the latter half of 1975 in accordance with the
recommendations of the Banking Commission. It was intended that the RRBs would
operateexclusively in rural areas and would provide credit and other facilities to small and
marginal farmers, agricultural labourers, artisans, and small entrepreneurs. They now
carry all types of banking business generallywithinone tofivedistricts. The RRBs can be set
up provided anypublic sectorbank sponsors them. The ownership' capital of these banks is

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held by the Central Government (50 per cent), concerned State Government (15 per cent),
and the sponsor bank (35 per cent). They are, in effect, ownedby theGovernment,
andthereis littlelocal participationintheownershipandadministrationof

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these banks also. Further, they have a large number of branches. In March 1990,196 RRBs
were operating in 369 districts with 14079 offices, Rs. 3119 crores of deposits, and Rs.
2919 crores of credit The RRBs make an important part of the banking structure, in terms
of the number of banks andoffices, but not in terms of deposits and credit. They accounted
for 71 per cent of the number of banks, 24 per cent of the total number of bank offices,
about 1.5 per cent of total deposits, and about 2.5 per cent of total bank credit in 1986.
There has been little change in this position since then.
The banking systems in India is thus characterized by excessive concentration of business
in a small number of scheduled public sector banks. The banking in India, as in the UK, is
entirely of the type called branch banking. If we exclude RRBs, just twenty-one banks (with
seven subsidiaries) are now operating a vast networkof about 45000 branches over a vast
geographical area: Thisconcentration of banking business has been brought about through
the policy of mergers and consolidation of banks, and their Government ownership. The
number of major operating bankshas been reduced from 566 in 1951 to about 75
exclusive of RRBs 'and to 270 inclusive of them in 1990. The phenomenon of branch
banking has aggravated the problem of organizational and operational inefficiency in the
bankingsector. There is a need to decide on the optimum size of a bank in Indian
conditions. Some of thebanks in India appear to have become too big to function
efficiently. The branch banking has accentuated another problem, namely, the drain of
resources fromthe rural to urban areas so much so that the authorities had to set different
targets of credit/deposit ratio for different geographical areas.
In view of the vastness of the country coupled with regional disparities in the structure and
level of economic development, and in order to avoid the drain of resources from the rural
areas, it would perhaps have been a wiser policy if the small local banks were
strengthened through suitable policy measures instead of liquidating them or merging
them with other banks. The policy of promoting and nurturing unit banking system would
perhaps have yielded better results. The working of many private sector banks today
support this viewpoint These banks are found to be compact in size which has facilitated
cutting of red tape, promoting good rapport between the staff and management,
motivating staff, and giving better service to the customers and community.
ROLEOFFOREIGNBANKS
It is now widely believed that for financial institutions to operate efficiently there is a need
to maintain competitive conditions. The empirical and theoretical literature in banking also
suggests that a competitive banking system is more efficient. It has therefore, been the
endeavour of the Government and the Reserve Bank to enhance competition through
entry of new private sector banks, increased presence of foreign banks and provision of
operational flexibility to public sector banks. To diversify ownership, public sector banks
were allowed to raise funds from the capital markets, subject to the Government
shareholding being retained at 51 percent. Various other restrictions hindering the
competitive process have also been, by and large, phased out.
In recognition of the emergence of foreign banks as key vehicles in the international
integration of the financial systems, a liberalized policy towards foreign banks’ entry has
become a high priority in policymakers agenda in various countries in recent years.
Liberalization of financial services byallowing foreign financial institutions to participate in
the domestic market improves competition,thereby facilitating better and cheaper
financial intermediation. Apart from increasing competition and efficiency through infusion
of technology and skill management, some of the other benefits of foreign banks’ entryare
said to include introduction of superior risk management practices and stronger capital

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base, which is also less sensitive to host Country’s business cycle.
India also liberalized the entry of foreign banks in the post-reform period. In the roadmap
by the Reserve Bank released in February 2005, the opening up of the domestic banking
sector to foreign banks was envisioned in two phases. The first phase envisaged that
foreign banks wishing to establish presence in India for the first time could either choose
to operate through branch presence or set up a 100 per cent wholly owned subsidiary
(WOS) following the one-mode presence criterion. In the second

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phase (April 2009 onwards), the policy on foreign banks is to be taken up for a review. At
that stage, variousissuesassociatedwiththeincreasedpresenceofforeignbankssuch
asimpactonthedomestic banks, supervisory and regulatory challenges in view of their
sophisticated operations and their involvement in complex and sophisticated products,
financial inclusion, credit to agriculture and SMEs, and public policy on credit delivery, cost
and allocation would need to be weighed. The issues relating to co-ordination between
home and host countries regulators would also pose a challenge.
ADVANTAGESANDDISADVANTAGESOFFOREIGNBANKS
The following are the commonly highlighted benefits of foreign bank entry. First, it
heightenscompetition and promotes efficiency leading to decline in costs or increase in
productivity. When a foreign bankenters through greenfield investment and setsup a
denovo institution, the increase inthe number of banks in the host country directly
enhances competition. Entry through merger and
acquisition,whichinfusesmoreskilledmanagementandupgradegovernancethroughintroducin
gmore advanced systems and risk management, may force other banks in the host
country to improve their efficiency in order to protect their market shares. Second, entry
of foreign banks improves credit allocation, as in making credit decisions, they apply
formal credit standards and risk-adjusted pricing and are not influenced by other
considerations.
Third, foreign banks help in the development of local financial markets since they have
both the incentives and the expertise to develop certain segments of local market, such as
funding, derivatives and securities markets. Foreign banks that lack a branch network to
guarantee deposit financing oftheir activities are more likely to turn to the inter-bank
market. Foreign banks can also contribute by
bringingprofessionalexpertisetothelocalforeigncurrencymarkets.Theyoftentryto
createmarketsor gain market share through product innovation, especially by offering a
variety of new financial services to corporate clients, including structured products.
Fourth, the overall soundness of domestic financial system is enhanced by introducing the
risk management practices of the foreign parent banks. Based on tighter credit review
policies and practices, they adopt more aggressive measures to address asset quality
deterioration and limit the build-up of non-performing assets in the financial system.
Fifth, foreign banks may exert a stabilizing influence in times of financial distress, as
stronger capitalization and the possibility of an injection of additionalfunds by the parent,
if needed, reducesthe probability of failure. For the same, foreign banks are less sensitive
to both home and host country business cycles, and consequently, lending to local
residents in the local market is likely to be more stable in times of stress than either cross-
border lending or the lending of indigenous banks in the markets. Further, when the
foreign banks continueto operate in a crisis, the probability of the systemas a whole
remaining functional increases.
Sixth, there could be long-term benefits from lower cost structures in the banking system.
Foreign banks, in general, are found to operate with lower administrative costs as has
been found in Latin America and most of other developing countries. However, in some
countries such as India, operating cost of foreign banks was found to be higher than that
of domestic banks.
Seventh, foreign ownership usually involves the transfer of human capital at both the
managerial and the operational level. Complementary to this is the transfer of soft
infrastructure such as back office routines or credit control systems. Such transfers have
gained importance to reap economies of scale through standardization of processes.
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Therecouldalsobeseveralcostsassociatedwiththeentryofforeignbanks.
First,entryofforeignbankscouldalsoleadtoconcentrationandlossof
competition.Inmanycountries, foreign banks entered the system mainly by acquiring
existing domestic banks, while in some countries domestic banks consolidation and
concentration occurred in response to foreign competition.

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Second, though foreign banks entry may lower interest margins and potentially foster the
process of financial intermediation, the impact would depend on the form it takes and may
not benefit all borrowers. The benefits would depend on whether the lower spread is the
result of a more aggressive pricing strategy across the board or the banks choosing to
lend only to the most transparent segments where there is more competition or at least
greater market contestability.
Third, the growing presence of foreign banks can increase the complexity of the tasks
facing supervisory authorities and thus lead to regulatory conflicts. This could be a
particular concern in countries where foreign commercial banks expand their operations
rapidly in the area of lion-bank financial services such as insurance, portfolio
management, and investment banking. Given the complex structure of many
internationally active banks, Integral issues within foreign banks are increasingly being
shown to be of potential systemic significance. Fourth, foreign banks expose the countryto
somedownside risks/ challengesattached with theirentry. More strikingly,domesticbanksin
emerging markets generally incur costs since they have to compete with large
international banks with better reputation, particularly in developing world.
Fifth, there is a general concern that as foreign banks have historically followed home-
country customers or specialized in servicing corporate customers, their entry would lead
to neglect of rural customers and small and medium sized firms. Another concern is that
with foreign banks using the inter-bank market for much of their funding, local banks could
divert their funds from domestic loans to the inter-bank market, thereby channeling fund
to large corporate at the expense of small companies.
Sixth, it is also argued that the presence of foreign banks may not necessarily yield a
more stable source of credit to domestic borrowers because foreign banks can, at times,
shift funds abruptly from one market to another for risk management purposes. Literature
also suggests that foreign banks will be more likely to shift their funds to more attractive
markets during a crisis if their parent banks are weak.
ROADMAPFORFOREIGNBANKSININDIA
With a view to delineate the direction and pace of reform process in this area and to
operationally the extant guidelines of March 4, 2004 in a phased manner, the RBI, on
February 28,2005, released the road map for presence of foreign banks in India. The
roadmap was divided into two phases.
Phase I: March2005 to March2009: During the first phase, foreign bankswere permitted to
establish presence by way of setting up a wholly owned banking subsidiary (WOS) or
conversion of the existing branches into a WOS. The guidelines covered, inter alia, the
eligibility criteria of the applicant foreign banks such asownership pattern, financial
soundness, supervisory rating and the international ranking. TheWOS was required to
have a minimum capital requirement of Rs. 300 crore and maintain a capital adequacy
ratio of 10 percent or as was prescribed from time to time on a continuous basis, from the
commencement of its operations. The WOS was treated on par with the existing branches
of foreign banksforbranchexpansionwith.flexibilitytogobeyondthe
existingWTOcommitmentsof12branches in a year and preference for branch expansion in
under-banked areas. During this phase, permissionfor acquisition of share holding in
Indian private sector banks by eligible foreign banks was limited to banks identified by the
RBI for restructuring. The RBI—if it was satisfied that such investment by the foreign bank
concerned was in the long-term interest of all the stakeholders in the invested bank—
permitted such acquisition. Where such acquisition was by a foreign bank having presence
in India, a maximum period of 6 months was given for conforming to the one form of
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presence concept.
Phase II: April 2009 onward: Phase II commenced in April 2009 after a review of the
experience gained and after due consultation with all the stakeholders in the banking
sector. The review examined issues concerning extension of national ‘treatment to WOS,
dilution of stake and permitting mergers/acquisitions of any private sector banks in India
by a foreign bank in Phase II.

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The parent foreign bank will continue to hold 100 percent equity in the Indian
subsidiaryfor a minimum prescribed period of operation. The composition of the-Board of
directors should, inter alia, meet the following requirements: (a) not less than 50 percent
of the directors should be Indian nationals resident in India and (b) not less than 50
percent of the directors should be non-executive directors.
SELFCHECKEXERCISE
1. Whatis‘Bank’?
2. Whatare‘CommercialBanks’?
3. Define‘Ferries’Banks’?
SUMMARY
The importance of Commercial banks and their contribution are discussed. An attempt is
made is to provide the effect of RBI banking regulations, demand supply theory of money,
interest and profitability of banks are explained. The risk management practices observed
by banks are discussed. The management of primary and secondary reserves, loan policy
formulation and issues involved are discussed. There is also discussion on the financial
institutions, which offer a variety of specialized to traditional services to the business and
act as mediators and agents of transfer of funds to createwealth to the society at some
charge for the service, which would be their source of revenue. Theyhave the obligation of
creating a qualitative Financial System and should cooperate with the regulatory bothes
engaged with various measures to discipline the economic system.
GLOSSARY
Credit or loan: Credit or loan refers to sum of money along with interest payable. Finance:
Finance is monetary resources comprising debt and ownership funds of the state,
company or person.
Financial Institutions: Financial Institutions are business organizations that act as mobilizes
and depositories of savings and as purveyors of credit or finance. They also provide
various financial services to the society.
FinancialSystem:FinancialSystemisconcernedaboutmoney,creditandfinance.
Money:Moneyreferstothecurrentmediumofexchangeormeansofpayment.
ANSWERSTOSELFCHECK EXERCISE
1. Refersto7.1
2. Refersto7.2
3. Refersto7.4
TERMINALQUESTIONS
1. WhatiscommercialBanking?
2. DiscussthegrowthandstructureofBanking.
3. Describetheroleofforeign Banks.
ANSWERSTOTERMINALQUESTIONS
1. Refersto7.1 &7.2
2. Refersto7.3
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3. Refersto7.4 &7.5

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SUGGESTED READINGS
1. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall
ofIndia.
2. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
3. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage
publications, New Delhi.
4. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.JainBook Agency,
Mumbai.

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 Lesson-8
MerchantBanking

STRUCTURE
LearningObjectives
Introduction
Originof theMerchantBankers
ObjectivesoftheMerchantBankingCompany
ObligationsandResponsibilities
CodeofConduct
MerchantBankinginIndia
ServicesRenderedbytheMerchantBanks
RegulationsforMerchantBanking
GuidelinesoftheSEBI
Guidelinesoftheministryoffinance
CompaniesAct.1956
Securitiescontract(Regulation)Act.1956
ListingGuidelinesofStockexchange
SelfCheckExercise
Summary
Glossary
AnswerstoSelfCheckExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthischapteryoushouldbeableto
1. Describemerchantbankanditsactivities
2. Statethegeneralobligationsandresponsibilitiesofamerchantbanker
3. Explaintheregulationsformerchantbanking
INTRODUCTION
Funds are tapped from the capital market to finance various mega industrial
projects. In attracting the public savings, the Merchant bankers play a vital role as
specialized agencies. The primary business of a merchant banker is the resource raising
function. The primary market hold the
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keyofrapidcapitalformation,growthinindustrialproduction,andexports.Therehastobe

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accountability to the end use of the funds raised from the market. The trends in the
primary market in India suggest that merchant bankers have been playing a very
significant role in the corporate sector’s driveformobilizing thefundsfromthe public. If the
numberof issues andamount increases thenumber of the merchant brokers also increase.
Therefore, the field becomesa highly competitive market where it requiresa special skill in
handling the situation. The financialassets that are sold to the public should
representthegenuine claimsonfuture cashflowsand viableassets. TheMerchant bankshavea
social responsibility in building the industrial structure in India.
Merchant banking is an essential part of financial sector when a developing economy
widens its industrial base. Originally, the merchant banking business was established in
Italy and France in the metheval period. A merchant banker in those days was a trader-
cum-entrepreneur who added banking business with trading. In the U.K., merchant
bankers came into existence by the end of the 18th century. In the U.S.A., a kind of
merchant banking activity emerged through investment bankers in the early twentieth
century.
In the Indian context, the Ministry of Finance defined merchant banker as “any person who
is engaged in the business of issue management either by making arrangements
regarding selling, buying or subscribing to securities as manager, consultant advisor or
rendering corporate advisory service in relation to such issue management.” There is a
thin distinction between merchant banking and investment banking. The former is purely
fee-based. The later is both fees as well as fund-based.
ORIGINOFTHEMERCHANTBANKERS
In the 19th century, a British merchant used to send an agent out to little known parts of
the world. The agent took with the manufactured goods that were produced in the home
country to sell and at thesame time he would buythe productsof that country and ship
themhome. Forthis trade, moneyhad to be remitted from one country to another, the bill
of exchange which was the instrument in usage throughout the Europe since a long time
came to be used more and more. The bill of exchange of London became the means of
financing the trade practically in the whole world. The well-established merchant agreed to
do for commission; and gradually the practice of accepting the bills to finance the hade of
others took the shape of accepting the bills to finance their own trade. These firms in
London
arestyledastheMerchantBanks.TheoldestmerchantbankersinLondonweretheBarringBrother
s.It was very prominent in Europe in the 19th century. The Industrial revolution made
England into a powerful trading nation. Rich merchant houses which made their fortunes in
the colonial trade had diversified into Banking. Theythemselves involved in the acceptance
of the Commercialbills pertaining to domestic as well as international trade.
Theybecameas“AcceptanceHouses,DiscountHousesandIssueHouses”.TheMerchantbanker
was primarily a merchant than a banker. The merchant banker was entrusted with the
funds by his customers.
OBJECTIVESOFTHEMERCHANTBANKING COMPANY
The Merchant Bankers render their specialized assistance in achieving the main
objectives. They are presented below:
1. To carryon the businessof the merchant banking, assist in the capitalformation,
manage advice, underwrite, provide stand by assistance, securities and all kinds of
investments issued, to be issued or guaranteed by any company corporation, society, firm,
trust, person, government, municipality, civic of body, public authority established in India.
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2. The main objective of the merchant banker is to create a secondary market for bills
and discount or rediscount bills and acts as an acceptance house.
3. Merchant bankers involve in assistance and promotion of economic endeavour,
identification of
projects,promoters,preparationofprojectreports,projectfeasibilitystuthes,marketresearch,pr
e-

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investmentstuthesandinvestigationofindustriesatmicroandmacro level.
4. They also provide services to the finance housing schemes for the Construction of
houses and buying of land.
5. They render the services like foreign exchange dealer, money exchanges, authorized
dealer and to buy and sell foreign exchange in all lawful ways in compliance with the
relevant laws in India.
6. They also involve in acquiring and holding one or more membership in stock
exchange/National Stock Exchange, trade associations, commodity exchange, clearing
houses, or associations in India or any part of the world.
7. They help to promote or procure in corporation formation or setting up to concerns
and undertakings as a company, body corporate, partnership or any other association or
person for engaging in any other association or persons in any industrial, commercial or
business activities.
8. Their objective is to perform financial services including factoring and syndication of
both theloans i.e. short-term and long-term with financial institutions, bank and others to
manage mutual funds and to provide financial software programme.
9. The objective of the merchant banking is to carry on the business of financing the
industrial enterprises.
10. They invest in buying and selling of transfers, hypothecate, and deal with the disposal
of shares, stocks, debentures, securities and properties of any other company.
OBLIGATIONSANDRESPONSIBILITIES
Merchantbankershasthefollowingobligationsandresponsibilities:
1. Merchantbankershouldmaintainproperbooksofaccounts,recordsandsubmithalf
yearly/annual financial statements to the SEBI within the stipulated period of time.
2. No Merchant banker should associate with another merchant banker who does not
register with the SEBI.
3. Merchant bankers should not enter into any transactions on the basis of unpublished
information available to them in course of their professional assignment.
4. Every Merchant banker must submit himself to the inspection by the SEBI when
required for and submit all the records.
5. EveryMerchant bankermust disclose informationtothe SEBI whenit requires
anyinformation from him
6. AllMerchantbankersmustabidebythecodeofconductprescribedforthem.
7. Every Merchant banker who acts as the lead manager must enter into an agreement
with the issuer settling out mutual rights, liabilities, obligations relating to such issues with
particular references to disclosers, allotment, refund etc.
CODEOFCONDUCT
Accordingtothe13RegulationoftheSEBIRegulations1992(Merchantbankers),everymerchant
banker should comply with the following code of conduct. They are:
(a) TheMerchantbankermustobservehighstandardofintegrityandfairnessinallhis dealings.
(b) Heshouldraideratalltimes

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highstandardofservices,exerciseduediligenceandindependent professional judgement
(c) If necessary,hemustdisclosetohisclientsthepossiblesourcesofconflictofdutiesand interests.

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 (d) Heshouldnotindulgeinunfairpracticeorcompetitionwithothermerchantbankers.
(e) Heshouldnotmakeanyexaggeratedstatementabouthiscapacityorachievement
(f) Heshouldalwaysendeavourtogivethebestpossibleadviceandprompt,effectiveandcost
effective service.
(g) He should maintain the secrecyof all confidential information received during the
courseof service to his clients.
(h) Heshouldnotengagein thecreationofafalsemarketorpriceriggingormanipulation.
MERCHANTBANKINGININDIA
After the termination of the managing agency System in India, there was a strong need of legal
and financial services to the corporate sector which required an alternative agency. On
such situation, Merchant banking emerged. The Merchant Banking system in India was
introduced by Grindlays Bank in 1967. It was the first bank which received licence from
the RBI. It started with the management of capital issues rendering the services according
to the needs of the emerging new class entrepreneurs
fordiversefinancialservicesrangingfromproduction to marketing research. It
alsoprovidedservicesto the large and medium range companies. The CITIbankestablished
its Merchant banking wing in 1970. Later on the Banking Commission which was
established in 1972 fell the need for the establishment of the merchant bank institutions
to offer services like syndication or financing, promotion of projects, investment
management, advisory services to the corporate sector. The SBI was the first commercial
bank of India to launch its merchant banking division in 1972 on the recommendation of
the banking commission in 1972. Later other commercial banks and financial institutions
like Indian Bank, Punjab NationalBank, Indian OverseasBank, Bankof Baroda,
SyndicateBank, CharteredBank,LIC, GIC, UTI etc.also started the merchantbanking
divisions.Some brokerage houseswere diversified intothisarea like J.M. Financial and
Investment Consultancy Services Pvt. Ltd., Tata Consultancy ServicesLtd., etc. Among the
development banks, the ICICI started the merchant banking activities in 1973. It was
followed by the IFCI in 1986 and the IDBI in 1991.
SERVICESRENDERED BYTHEMERCHANTBANKS
Merchant banks have been rendering diverse services and functions as organizing and extending
finance for the investments in projects, raising of EURO dollar loans, equipment leasing,
mergers and acquisitions, valuation of assets, investment management, and promotion of
investment trusts. Allthese services are not offered by all the merchant bankers. But
different merchant bankers are specialized in different services. The Merchant bank is a
multi-service oriented agency. Merchant banking is a creative activity. In India, the
merchant banks have been engaging in the following activities:
(a) CorporateFinanceServices(managementofpublicissues,creditsyndication).
(b) AdvisoryServices(projectcounseling,financing,capitalrestructuring).
(c) ServicestotheNRls.(evaluationofinvestmentportfolio,promotionofindustries).
(d) Leasing(equipment,machineryetc,)
REGULATIONSFORMERCHANTBANKING
MerchantbankingactivitiesareregulatedinIndiaby:
(a) GuidelinesoftheSEBI.

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(b) GuidelinesoftheMinistryof Finance.
(c) CompaniesAct,1956.

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 (d) SecuritiesContract(Regulation)Act,1956.
(e) ListingguidelinesoftheStockExchange.
GUIDELINESOFTHESEBI
After the abolition of the CCI, its place was occupied by a legal organ called ‘Securities and
Exchange Board of India’. The issue of capital and the pricing of issues by the companies
has become free from prior approval. The SEBI has issued guidelines for the issue of
capital by the companies. Theguidelines broadly cover the requirement of the first issue
by a new company or the first issue of a new company set up by the existing company.
The SEBI is the most powerful organization to control and leadthe primaryand
secondarymarkets.According to the SEBIguidelines, if anycompanyapproaches the public,
by the issue of share capital through the public issues, must be kept open for three
working days mid it should be mentioned in the prospectus. In the case of right issue, the
subscription time shouldnotbekept more than 60 days. Thegapbetweenthe rights
andpublic issues shouldnotexceed 30 days. The issued capital must he fully paid up within
12 months of the date of issue. The minimum amount of subscription by the investors in
the public issue either at par or premium has been fixed at Rs. 5000. The amount of the
issue should not exceed the amount specified in the prospectus.
Oversubscriptionamountretentionbythecompanyisnotpermittedunderany circumstances.
The SEBI has announced the new guidelines for the disclosures by the companies leading to the
investor protection. They are presented below:-
(a) Ifanycompany’sotherincomeexceeds10percentofthetotalincomethedetailsshouldbe
disclosed.
(b) The companyshoulddiscloseanyadverse situationthataffects the operationsof the
companyand that occurs within one year prior to the date of filling the offer document with
the registrar of the companies of the stock exchange.
(c) Thecompanyshoulddisclosetheinformationregardingtheutilizationoftheplantforthelast3
years.
(d) The promoters of the company must maintain their holding at least at 20 per cent of
the expanded capital.
(e) Theminimumapplicationmoneypayableshouldnotbelessthan25percentoftheissueprice.
(f) Thecompanyshoulddisclosethetimetakenforthedisposalofvarioustypesofinvestor’s
grievances.
(g) Thecompanycanmakefirmallotmentsinthepublicissuesasfollows:
1. IndianMutualFunds(20%).
2. FIIs(24%).
3. Regularemployeesofthecompany(10%).
4. FinancialInstitutions(20%).
(h) The company should disclose the safety net scheme or buy back arrangements of the
shares proposed in the public issue. This scheme is applicable to a limited number of 500
shares per allotted and theoffershouldbevalidforaperiod ofat least 6 monthsfromthedateof
dispatchof the securities.
(i) According to the guidelines, in case of the public issues at least 30 mandatory

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collection centres should be established.
(j) According to the SEBI guidelines, regarding the rights issue, the company should give
advertisements at least in 2 newspapers about the dispatch of letters of offer. No
preferential allotment

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 maybe madealongwithanyrights issue.
(k) The company should disclose about the fee agreed between the lead managers and
the company in the memorandum of understanding.
The guidelines will apply to all the issues to be made after the promulgation of the ordinance by
which the Capital Issues Act has been repealed. Further the SEBI issued guidelines for the
“disclosure and investor protection” as presented below (issued by the SEBI vide GL/IP No.
1/SEBI/PMD 92-93, dated 11-6-92).
(a) FirstIssueoftheNew Companies.
(b) FirstIssueoftheexistingprivate/closelyheldcompanies.
(c) PublicIssuebytheExistingListedCompanies.
(d) Underwriting.
(e) Issueof PCD/FCD/NCD.
(f) NewFinancialtestaments.
(g) ReservationinIssues.
(h) DeploymentofIssueProceeds.
(i) EmployeeStockOptionScheme.
(j) Promoter’sContributionandlock-inperiod.
(k) Bonusissues’.
(l) Guidelinesfortheprotectionoftheinterestofthedebenture holders,
(m) General.
(a) FirstIssueofNewCompanies
According to the guidelines, a new company is defined as: “one which has not completed 12
months of commercial operations and its audited operative results are not available,
where it is set up by the entrepreneurs without a track record.” They will be permitted to
issue the capital to the public only at par. If a new company is being set up by the existing
companies with a 5 years track record of consistent profitability. It will be free to price its
issue provided the participation of the promoting companies would investors uniformly
provided that the prospectus or offer documents would containthe justification for the
issue price.
A draft prospectus that contains the disclosures will be vetted by the SEBI, before a public issue
is made. No private placement of the promoter’s share should be made by the solicitation
of the share contribution from unrelated investors through any kind of market
intermediaries. The shares of the above companies can be listed on either the O.T.C. or
any other stock exchange.
(b) FirstIssuebytheExistingPrivate/CloselyheldCompanies
Accordingtothe guidelines, thefirst issuebytheexistingprivate companieswith3 yearstrackrecord
of consistent profitability should be permitted to freely price the issue and list their
securities on the stock exchanges. The pricing would be determined by the issuer and the
lead managers to the issue and would be on justification for the issue price.
(c) PublicIssuebytheExistingLimitedCompanies
The SEBI permitted these companies to raise the fresh capitalbyfreely pricing theirfurtherissues;
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The Issue price will be determined by the issuer in consultation with the lead managers.
The draft
prospectuswillbevettedbytheSEBItoensuretheadequacyofdisclosures.Theprospectusshould

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contain the net asset value of the company and a justification for the price of the issue. It
should also disclose high and low of the shares for the last 2 years.
(d) Underwriting
According to the SEBI guidelines underwriting is mandatory for the full issue and a
minimum requirement of 90 per cent subscription is also mandatory for each issue of
capital to the public. The number of underwriters would be decided by the issuing
company. If the company does not receive 90 per cent of the issued amount from the
public subscription plus accepted development from the underwriters, within 120 days
from the date of opening of the issue, then the company should refundthe amount of
subscription. The lead managers must satisfy themselves about the net worth of the
underwritersandtheoutstanding commitments shoulddisclosethesametotheSEBI.
Theunderwriting agreements may be filed with the stock exchanges.
(e) IssueofFCD/PCD/NCD
TheSEBIissuedguidelinesontheconvertibleandnon-convertibledebenturesareasfollows:
In case of the issue of fully convertible debentures, the debentures may be converted
after 36 months and the conversion is made optional with the put and call option. The
crediting should be made if the conversion period is after 18 months. In the prospectus,
the premium time of conversion stages should be indicated. The interest rate for the
debentures will be freely determined by the issuing company.
In case of the issue of debentures with the maturity of 18 months or less are exempted
from the requirement of appointment of the Debenture Trustee. The trust deed should be
executed within 6 months of the closure of the issues. The debenture holders are free in
case of conversion, if it takes place at or after 18 months from the date of allotment, but
before 36 months. The rating is compulsory in case of NCD/PCD if maturity period exceeds
18 months. The prospectus should inform all the information regarding premiumamount,
conversion period, rate of interest and all otherparticulars.The SEBI may prescribe
additional disclosure requirement from time to time after the due notice.
(f) NewFinancialInstruments
The Issue of Capital should made adequate disclosures regarding the terms and
conditions, redemption, security conversion, and any other relevant features of the
instruments such as deep discount bonds, debentures with warrants, secured premium
notes etc. Therefore, the investor can be made reasonable determination of the risks,
returns, safety and liquidity of the instalments. This disclosures should be vetted by the
SEBI in this regard.
(g) ReservationinIssues
ThereservationcanbemadebythecompanywiththeconsentoftheSEBIinthefollowingmanner.
In case of the issue of capital by the new companies, reservations to the employees,
promoting companies, associate companies, working directors on a suitable percentage
ispermitted to the share- holders of the group companies. In case of the existing
companies, it can be offered on a preferential basis. The shareholders of the promoters
companies should also be eligible for the preferential allotment. Reservations to the NRIs
should be made according to the schemes prescribed by the RBI from time to time.
(h) DeploymentoftheIssue Proceeds
After closing the issue, the company should report to the SEBI regarding the collection of
money. If the application money and the allotment amount together exceed Rs. 250
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crores, the company would voluntarily disclose and make arrangements for the use of the
proceedings of the issue as per. the disclosure to be monitored by one of the financial
institutions.In issue of the above size and beyond, the amount to be called upon the
application allotment and on various calls should not exceed 35 per cent of the total
quantum of issue.

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(i) EmployeeStockOptionScheme
The employee stock option is a voluntary scheme to motivate the employees to have a
higher participation in the company. A suitable percentage of reservation can be made by
the issue company for its employees. However the reservation amount should not exceed
5 per cent of the issue. Equal distribution of shares among the employees will contribute
to the smooth working of the scheme. The company may like to have the non-
transferability of shares at its discretion in the new issues. The allotted shares to
employees cannot be transferable for a period of 3 years.
(j) Promoter’sContribution
The promoter has the choice to contribute the share capital which is offered to the public.
The promoters, directors, his friends, his relatives and associates can contribute up to 25
per cent of the total issue of the equity capital and up to Rs. 100 crores and 20 per cent
for issuing the above 100 crores. In case of the fully convertible, 1/3rd of the issue amount
should be contributed by the prompters, directors, friends and associates in the form of
equity before the issue is made. In case of the PCDs, 1/3rd of the convertible portion
should be brought in as the contribution of promoter before the issue is made. The
minimum subscription by each of his friends/relatives and associates, shouldnot be less
than Rs. 1.00 lakh. The promoter must bring his full subscription to the issue in advance
before the public issue. The promoter’s contribution should not be diluted for a lock in
period of 5 years from the date of commencement of the production or date of allotment.
Further, all the firm allotments, preferential allotments to collaborators, share-holders of
the promoters companies whether corporate or individual should not be transferable for 3
years from the date of commencement of production or date of allotment. Theshare
certificates issued to the promoter andhis associates should carry the inspection “not
transferable” for a period of 3-5 years as may be applicable from the date of
commencement of production or date of allotment.
(k) BonusIssue
TheSEBIissued guidelinesincaseofthebonus issue.Thecompanyshouldensurethefollowingwhile
issuing the bonus shares:
1. Thebonusissueismadeoutoffreereservesorsharepremiumcollectedincash.
2. Thereservescreatedbytherevaluationofthefixedassetshouldnotbecapitalized.
3. The investment allowance reserve is considered as free reserve for the calculation of
the residual reserves.
4. Allcontingentliabilitieswouldbetakenintoaccountinthecalculationoftheresidualreserves.
5. Theresidualreservesaftertheproposedcapitalizationshouldbeatleast40percentofthe
increased paid capital.
6. Thedeclarationofthebonusissueinlieuofthedividendisnotmade.
7. Thebonusissueshouldbemadeonlyafterthefullpaymentofthesharecapital.
8. Thereshouldbeaprovisioninthearticlesofassociationforcapitalizingthereserves.
9. Thecompanyshouldgetaresolutionpassedinitsgeneralbodymeetingforthebonusissue.
10.Before the bonus issue, the company should not default in the payment of interest and
the dues to employees.
11.TheCompanyshouldimplementthebonusissuewithin6monthsaftertheapprovaloftheboard
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(l) ProtectionoftheDebenture Holders
TheSEBIissuedguidelinestoprotecttheinterestofthedebentureholdersintwoaspects.Theyare:

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1. Servicingofthe Debentures
As per the SEB1 guidelines, a debenture redemption reserve should be created by all the
companiesraising debentures on the following basis:
(a) Thecompanymayredeemthedebenturesingreaternumberof instalments.
(ii) Thecompanymaydistributedividendsoutofgeneralresourcesincertainyears.
(iii) A moratorium up to the date of the commercial production can be provided for the
creation of the DRR (Debenture Redemption Reserve).
(iv) TheCompanyshouldcreatetheDRRequivalentto50percentoftheamountofthedebenture
issue before the redemption commences.
(v) DrawalfromtheDRRimpermissibleonlyafter10percentofthedebentureliabilitieshasbeen
actually redeemed by the companies.
(vi) TheDRRmaybecreatedeitherinequalinstalmentsorhigheramountsifprofit permits.
(vii) IncaseofthePCDs,theDRRshouldbecreated.
(viii)Incaseoftheconvertibleissuesbythenewcompanies,thecreationoftheDRRshouldearn
profits from the year for the remaining life of debentures.
2. ProtectionoftheDebentureHoldersInterest
(i) The debentures are issued by the companies for the purpose of avoiding the shares
acquisition in other countries.
(ii) Thedebenture-holdershavetherighttoappointanomineedirectorontheboard.
(iii) Theleadbankofthecompanywillmonitorthedebenturesraisedforworkingthecapitalfunds.
(iv) Institutionaldebentureholdersshouldobtainacertificatefrom theCompany’sauditor.
(m) General
1. Thesubscription listshouldbe keptopenforatleast3daysto
thepublicissuesandupto60daysto rights issue.
2. Thequantumoftheissueshouldnotexceedtheamountspecifiedintheprospectus.
3. Noretentionofover-subscriptionispermittedunderanycircumstances.
4. Afterclosingtheissue,thecompanyshouldsubmitacompliancereportfromtheChartered
Accountant and forward it to the SEBI by the lead managers to the issue within 45 days.
5. The SEBI will have the full rights to prescribe further guidelines to bring transparency in
the primary market.
6. Anyviolationoftheguidelinesbytheissuers/intermediarieswillbepunishablethroughthe
prosecution by the SEBI under the Act.
7. TheprovisionsoftheCompaniesAct,1956andotherapplicablelawsshouldbecompiledin
connection with issue of shares and debentures.
8. The SEBI should have the right to issue necessary clarifications to these guidelines to
remove any difficulty in its implementation.
9. According to the RBI guidelines, the stock invest would now be restricted to the
individual investors and the Mutual funds only. (RBI, Press release. Dated 6-9-94).
TheMerchantbankers,irrespectiveoftheforminwhichtheyareorganizedaregovernedbythe
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MerchantBankrulesissuedbytheSEBIandtheMinistryofFinance.
GUIDELINESOFTHEMINISTRYOFFINANCE
TheMinistryof
Finance,DepartmentofEconomicAffairshasissuedguidelinesinApril1990.According to the
guidelines, any person or body proposing to engage in the business of merchant banking
would need authorization from SEBI. The guidelines indicated the following activities to be
performed by the merchant bankers:
(a) Issuemanagement
(b) Corporateadvisoryservices
(c) Underwriting
(d) Portfoliomanagement
(e) Managerstothe issue
(f) Consultantstotheissue
(g) Adviserstothe issue.
The guidelinesalsoprovided relating toauthorization criteria,termsof authorization etc. The
authorized merchant bankers are required to observe the guidelines, follow the code of
conduct and work as per the requirements of SEBI: The certificate of registration has been
made to be valid for the period of 3 yearsfromthedateofissueofthecertificate.If
merchantbankerswerealreadycarryingonactivitiesas registrars, share transfer agents,
bankers to the issue, debenture trustees. They were requiredseparate application to be
submitted for each of such activity. The government issued orders to the Registrar of
Companies for verification of prospectus, whether the prospectus has been drafted by the
authorized merchant bankers or not: Hence the merchant bankers in India should follow
the guidelines issued by the SEBI.
COMPANIESACT,1956
Companies raising funds from the market shall fulfil the regulatory compliances as per the
rules and regulations. The merchant banker should select the suitable form of organization
like soleproprietorship or partnership firm or Hindu Undivided family or a corporate
enterprise. The corporate formof enterprise ispreferredbyprofessionalswho have the
managerialexpertiseand skills. The scale of operations, borrowing facilities, better
resources position are the best advantages of the corporate sector. Hence such enterprise
may be incorporated under the Companies Act, 1956. A company canbe a private limited,
public limited or a government company. It can appropriately render category merchant
banking services. A detailed project report should be prepared before establishing the
company. Forforming a public companyat least 07 persons and forforming a private
company at least 02 persons are required as promoters. Sec. 12 of the Companies Act
deals with the registration formalitiesof the form of company. The membersshould
subscribe their names to the memorandum of association and comply with the Companies
Act. The promoters should take a approval from the Registrar of Companies. The
Memorandum of association, Articles of association and prospectus should submit to the
ROC to get the approval. A certificate of incorporation will be issued by the Registrar, after
fulfilment of all legal formalities. The Registrar will issue a commencement of business
certificate for public companies. A private company is prohibited from inviting public to
subscribe to its share capital.
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 SECURITIESCONTRACT(REGULATION)ACT,1956
Merchant bankers play a vital role in the capital market. They work as sponsors of the
capital issues. They render valuable services to the issuing company. They involve in
determining the composition of

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the capital structure of the issuing company. They involve in public issues right from
drafting of prospectus and application forms, compliance with legal formalities,
appointment of registrars, underwriters,bankerstoissue,listingof
securities,selectionofbrokers,publicityandadvertisingagents and printers. Hence the
merchant banker isa guiding force behind the company for making success of a public
issue. He has to work under many regulations of the various Acts. The Securities Contract
Act provides the broad framework of the functioning of stock exchanges in India. The
objectives of the Actis to prevent malpractice insecurities transactions by regulating the
business. Hence the merchant banker should fulfill all the conditions of the Securities
Contract Act. 1956.
LISTINGGUIDELINESOFTHESTOCKEXCHANGE
The Sees. 21-22A of Security Contract Regulation Act deal with the process of listing a
share with recognized stock exchange. Listing means, an admission of a scrip to trade on
stock exchangeofficially. Sec. 73 of the Companies Act reveals that listing of security is
compulsory, if a company makes public issue. The legal serviced to issuing company.
(a) Theprospectusshallcontainonlythefacts.
(b) Theprospectusshouldbeadvertisedintiremedia10daysbeforethe issue.
(c) Publicitymaterialshouldbefifedwithstockexchange.
(d) Thecompanyshouldabidebytheadvertisementcode.
(e) Theprospectusshallindicateaboutthemodeof payment.
(f) Themerchantbankersshouldtakeallprecautionsinprintingofforms.
(g) Theapplicationmustprovidespacefor“PAN”.
(h) TheMBshallmakearrangementsfortheacceptanceofformsthroughthebankers.
(i) TheMBshallalsomadearrangementsforsendingallotmentletters.
(j) TheMBshallsendthesharecertificateswithin2monthsor10weeksofclosingof issue.
(k) TheMBshallproduceacertificatefromtheauditorregardingallotmentof shares.
(l) Themerchantbankers shallinform tothestockexchangeaboutthedateof
completion,postingof refund orders, allotment letters, certificate of shares.
SELFCHECKEXERCISE
1. Define“MerchantBanking”.
2. Whatis“CodeofConduct”?
SUMMARY
The origin of merchant banking can be traced back to 13th century when a few family
owned and managed firms engaged in sale and purchase of commodities were also found
to be engaged in banking activity. These firms not only acted as bankers to the kings of
European States, financed coastaltradebut also borne exchange risk. Inordertoearnprofits,
theyinvested theirfundswhere they expected higher returns despite high degree of risk
involved. They charged very high ratesof interest for financing highly risky projects. In
turn, they suffered heavy losses and had to close down. Some of them restarted the same
activity after gaining financial strength. Thus merchant Banking survived and continued
during the 13th century.

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Later, merchant bankers were known as “commission agents” who handled the coastal
trade on commission basis and provided finance to the owners or supplier of goods. They
made investments in goods manufacturedbysellers andmadehugeprofits. They also
financedcontinentalwars.Thesole

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objectiveofthesemerchantbankerswasprofitmaximisationbymakinginvestmentsinriskyprojects.
GLOSSARY
Merchant banking: merchant banking has been so widely used that sometime it is lied to
banks who are not merchants sometimes two merchants who are not banks and
sometimes to thoseintermediaries who are neither merchants nor Bank.
Investment banking: investment banking channelization savings of individuals into the
investments in the securities issued by business Enterprises.
Corporatecounselling: thisserviceisusuallyprovidedfreeofchargetoacorporateunit.
Corporate counselling: this service is usually provided free of charge to a corporate unit
merchant bankers Randers advised to corporate enterprise from time to time in order to
improve performanceand build better image among investors.
Portfolio management: portfolio management is bus service provided by merchant banker
not onlytwo companies issuing the securities but also to the investors.
Stock Exchange: Stock exchanges are market places where securities that have been
listed onMay be bought and sold for either investment of speculation.
ANSWERSTOSELF CHECK EXERCISE
1. Refersto8.1
2. Refersto8.5
TERMINALQUESTIONS
1. Discusstheobjectivesofthemerchantbanking.
2. Describetheconceptandfunctionsofthemerchantbankingin India.
3. Discussthegovernmentpolicyandregulationsformerchantbankingin India.
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection8.2.&8.3
2. ReferstoSection8.6.&8.7
3. ReferstoSections8.8
SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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 Lesson-9
ReserveBankofIndia:CentralBanking

STRUCTURE
LearningObjectives
Introduction
CentralBanking
OrganizationandManagement
TheRoleandFunctions
NoteIssuingAuthority
GovernmentBanker
Banker’sBank
SupervisingAuthority
ExchangeControlAuthority
PromoteroftheFinancialSystem
RegulatorofMoneyand Credit
SelfAssessmentExercise
Summary
Glossary
AnswerstoSelf AssessmentExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthischapteryoushouldbeableto:
1. Explainthepatternof CentralBanking
2. AnalysisthemonetarypolicyoftheReserveBankofIndia.
3. DescribethefunctionsofaCentralBank.
INTRODUCTION
A study of financial institutions in India should appropriately begin with a brief discussion
of the functions, role, working, and policy of the Reserve Bank of India (RBI or Bank). The
RBI, as the central bank of the country, is the nerve centre of the Indian monetary system.
As the apex institution, the RBI has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the IFS since its inception. The purpose of this chapter is to help
the reader to understand the functioning of the RBI by highlighting the major aspects of its
working.
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CENTRAL BANKING
The pattern of central banking in India was based on the Bank of England. England had a
highly developed banking system in which the functioning of the central bank as a
banker’s bank and their regulation of moneysupplysetthepattern. The
centralbank’sfunctionas ‘a lenderof last resort wason the condition that the banks
maintain stable cash ratios as prescribed from time to time. The effective functioning of
the British model depends on an active securities market where open market operations
can be conducted at the discount rate. The effectiveness of open market operations
however depends on the member banks’ dependence on the central bank and the
influence it wields on interest rates. Later models, especially those in developing countries
showed that central banks play an advisory role and render technical services in the field
of foreign exchange, foster the growth of a sound financial system and act as a banker to
government.
ORGANIZATIONANDMANAGEMENT
The RBI is quite young compared with such central banks as the Bank of England,
Riksbank of Sweden, and the Federal Reserve Board of the USA. However, it is perhaps the
oldest among the central banks in the developing countries. It started functioning from 1
April 1935 in terms of the Reserve Bank of India Act, 1934.1twasaprivate shareholders’
institution till January 1949. After which it became a state-owned institution undo* the
Reserve Bank (Transfer to Public Ownership) of India Act, 1948. This Act empowers the
Central Government, in consultation with the Governor of the Bank, to issue such
directions to it as they might considernecessary in the public interest Further, the
Governor and all the Deputy Governors of the Bank are appointed by the Central
Government
The Bank is managed by the Central Board of Directors, four Local Boards of Directors, and
the Committee of the Central Board of Directors. The functions of the Local Boards are to
advise the CentralBoardon suchmatters asare referred to them; they
arealsorequiredtoperformsuch duties as are delegated to them. The final control of the
Bank vests in the Central Board which comprises the Governor, four Deputy Governors,
and fifteen Directors nominated by the Central Government. The Committee of the Central
Board consists of the Governor, the Deputy Governors, and such other Directors as may be
present at a given meeting.
The internal organizational set-up of the Bank has been modified and expanded from time
to time in order to cope with the increasing volume and range of the Bank’s activities. The
underlying principle of the internal organization is the functional specialization with
adequate coordination. In order to perform its various functions, the Bank has been
divided and sub-divided into a large number of Departments. Apart from the Banking and
Issue Departments, there are at present twenty Departments and three training
establishments at the Central Office of the Bank.
THEROLEAND FUNCTIONS
The RBI functions within the framework of mixed economic planning. The legal, economic,
and institutional factors in India have rendered the issue of the independence of the
central bank almost irrelevant. With regard to framing various policies, it is necessary to
maintain close and continuous collaboration between the Government and the RBI. In the
event of a difference of opinion or conflict, the Government view or position can always be
expected to prevail. Given this environment or setting, the Bank performs a number of
functions which are discussed in the following sections.

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NOTEISSUING AUTHORITY
The RBI has, since its inception, the sole right orAuthority or monopoly of issuing currency
notes other than one rupee notes and coins, and coins of smaller denominations. The
issue of currency notes is one of itsbasicfunctions. Although one rupee coins and notes,
and coinsof smaller denominationsare issued by the Government of India, they are put
into circulation only through the RBI. The currency notesissuedbytheBankarelegaltender
everywhereinIndiawithoutanylimit.Atpresent,theBank

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issues notes in the following denominations: Rs. 2,5,10,20,50,100, and 500. The
responsibility of the Bank is not only to put currency into, or withdraw it from, the
circulation but also to exchange notesand coins of one denomination into those of other
denominations as demanded by the public. All affairs of the Bank relating to note issue are
conducted through its Issue Department In order to discharge its currency functions, the
Bank maintains (at present) 14 local offices and the currency chests in whichthe stockof
newand reissuablenotes,and rupeecoinsare stored. The totalnumberof currencychests at
the end of March 1990 was 3791. Of these, 17 chests were with the RBI, 2745 with the SBI
and associate banks, 622 with nationalized banks, 402 with treasuries, and 5 with Jammu
and Kashmir Bank.
As stated elsewhere, the currency even today forms the major part of the money supply in
India. The currency as percentage of money supply (M t= currency + demand deposits with
banks) was 69.2% in 1950-51,71.1% in 1960-61,51.0% in 1975-76, and 59,0% in 1988-89.
The composition of currency in 1987 was: small coins=Rs. 440 crores; rupee coins=Rs.
423 crores; rupee notes=Rs. 300 crores; and Bank notes=Rs. 28,743 crores. The volume
of note issue (including one rupee notes) has increased from Rs. 1114 crores in 1952 to
Rs. 29043 crores in 1987.
The Bank can issue notes against the security of gold coins and gold bullion, foreign
securities, rupee coins, Government of India securities, and such bills of exchange and
promissory notes as are eligible for purchase by’ the Bank. The RBI notes have a cent per
cent backing or cover in these approved assets. Earlier, i.e. till 1956, not less than 40 per
cent of these assets was to consist of gold coin and bullion and sterling/ foreign securities.
In other words, (he proportional reserve system of note issue existed in India till1956.
Thereafter, thissystem wasabandoned and a minimumvalue of gold coinand bullion and
foreign securities as a part of total approved assets came to be adopted as a cover for the
note issue.
GOVERNMENTBANKER
The RBI is the banker to the Central and State Governments. It provides to the
Governments all banking services such as acceptance of deposits, withdrawal of funds by
cheques, receipts and collection of payments on behalf of the Government, transfer of
funds, making payments on Government behalf, and management of the public debt.
The Bank receives Government deposits flee of interest, and it is not entitled to any
remuneration for the conduct of the ordinary banking business of the Government. The
deficit or surplus in the Central Governmentaccount withthe RBIis
managedbythecreationandcancellationof Treasurybills (known as ad hoc treasury bills).
As a banker to the Government, the Bank can make “ways and means advances” (i.e.
temporary advances made in order to bridge the temporary gap between receipts and
payments) to both the Central and State Governments. The maximum maturity period of
these advances is three months. However, in practice, the gap between receipts and
payments in respect of the Central Government is met by the issue of ad hoc treasury bills,
while the one in respect of the State Governments is met by the ways and means
advances.
The ways and means advances to the State Governments are subject to some limits.
These advances areofthe followingtypes:(a)Normalorcleanadvances
i.e.advanceswithoutany collateralsecurity;
(b) Secured advances, i.e. those which are secured against the pledge of Central
Government securities; and (c) Special advances, i.e. those granted by the Bank at its

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discretion. The interest rate charged by the Bank on these advances did not, till May 1976,
exceed the Bank rate. Thereafter, the Bank has been operating a graduated scale of
interest based on the duration of the advance. ‘
Apart from the ways and means advances, the State Governments have made heavy use
of the overdrafts from the RBI. An overdraft refers to drawls of credit by the State
Governments from the RBI inexcessofthe
credit(waysandmeansadvances)limitsgrantedbytheRBI.Inotherwords,overdrafts

14
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are unauthorized ways and means advances drawn by the State Governments on the RBI.
At present, overdraftsup to arid inclusive of the seventh dayare charged at the Bank rate
and from .the eighthday onwards at 3 per cent above the Bank rate. The management of
the States’ overdrafts has gradually become one of the major responsibilities of the RBI on
account of the persistence oflarge proportions of those overdrafts.
The issue, management, and administration of the public (Central and State Governments)
debt are among the major functions of the RBI as the banker to the Government. The Bank
charges a commission from the Governments for rendering this service.
BANKERS’BANK
The RBI, like allcentralbanks, can be called a banker’s Bank because it hasa very
specialrelationship with commercial and co-operative banks, and the major part of its
business is with these banks. The Bank controls the volume of reserves of commercial
banks and thereby determines the deposits/credit creating ability of the banks. The banks
hold a part or all of their reserves with the RBI. Similarly, in times of their needs, the banks
borrowfundsfromthe RBI. It is, therefore, called thebankof last resort or the lender of last resort.
On the whole, the RBI is the ultimate source of money and credit in India.
SUPERVISINGAUTHORITY
The RBI has vast powers to supervise and control commercial and cooperative banks with
a view to developing an adequate and a sound banking system in the country. It has, in
this field, the following powers: (a)to issue licensesforthe establishment of new banks;
(b)to issue licenses for the setting up of the bank branches; (c) to prescribe minimum
requirements regarding paid-up capital and reserves, transfer to reserve fund, and
maintenance of cash reserves and other liquid assets; (d) to inspect the working of banks
in India as well as abroad in respect of their organizational set-up, branch expansion,
mobilization of deposits, investments, and credit portfolio management, credit appraisal,
region-wise performance, profit planning, manpower planning and training, and so on; (e)
to conduct ad hoc investigations from time to time into complaints, irregularities, and
frauds in respect of banks; (f) to control methods of operations of banks so that they do
not fritter away funds in improper investments and injudicious advances, (g) to control
appointment, reappointment, termination of appointment of the Chairman and chief
executive officers of the private sector banks; and (h) to approve or force amalgamations.
EXCHANGECONTROLAUTHORITY
One of the essentialfunctions of the RBI is to maintain the stability of the externalvalue of
the rupee. It pursues this objective through its domestic policies and the regulation of the
foreign exchange market. As far as the external sector is concerned, the task of the RBI
has the following dimensions: (a) to administerthe foreign Exchange Control (b)to choose
the exchange rate systemandfixor manage the exchange rate between the rupee and
other currencies; (c) to manage exchange reserves; and (d) to interact ornegotiate with
the monetaryauthoritiesof the Sterling Area, Asian Clearing Union, and other countries,
and with international financial institutions such as the IMF, World Bank and Asian
Development Bank.
The RBI administers the Exchange Control in terms of the Foreign Exchange Regulation Act
(FERA), 1947 which hasbeen replaced bya more comprehensive Foreign Exchange
Regulation Act, 1973. The objective of exchange control is primarily to regulate the
demand for foreign exchange within the limits set bytheavailable supply. Thisissought
tobeachievedbyconservingforeignexchange, byusing it in accordance with the plan
priorities, and by controlling flows of foreign capital. In India, during most of the years
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9
since 19S7, foreign exchange earnings have been far less than the demand for foreign
exchange, with the result that the latter had to be rationed in order to maintain exchange
stability. This isdonethroughExchangecontrolwhich isimposed both on
receiptsandpaymentsof foreignexchange

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0
on trade, invisible and capital accounts. The problem of foreign exchange shortage has
been so persistent and acute that the scope of exchange control in India has steadily
widened and the regulations have become progressively more elaborate over the years.
The Bank administers the control through authorized foreign exchange dealers.
FERA lays down that the exchange rates used for the conduct of foreign exchange
business must be those which are fixed by the RBI. The arrangements or the system under
which exchange rate is fixed by the RBIhasundergone many changes overtheyears.
Tillabout1971asa memberof the IMF, India had an exchange rate system of “managed
flexibility.” This arrangement changed during 1970s as a result of international monetary
crisis in 1971. Since 1975, the exchange rate of the rupee has been fixed in terms of the
“basket of currencies”. The different exchange rate systems in India will be discussed in
detail in chapter 21 on foreign exchange market.
The RBI is the custodian of the country’s foreign exchange reserves, and it is vested with
the responsibility of managing the investment and utilization of the reserves in the most
advantageous manner. The RBI achieves this through buying and selling of foreign
exchange from and to scheduled banks which are the authorized dealers in the Indian
foreign exchange market The Bank also manages the investment of reserves in gold
accounts abroad and the shares and securities issued by foreign governments and
international banks or financial institutions.
PROMOTEROFTHEFINANCIALSYSTEM
Apart from performing the functions already mentioned, the RBI has distinguished itself by
rendering “developmental” or “promotional” services which have strengthened the
country’s bankingand financial structure. This has helped in the mobilization of savings
and directing credit flows to desired channels, thereby helping to achieve the objective of
economic development with social justice. It has played a major role in deepening and
widening the financial system. As a part of its promotional role, the Bank has been pre-
empting credit for certain sectors at concessional rates.
In the money market, the RBI has continuously worked for the integration of its
unorganized and organized sectorsbytrying to bring indigenousbankersinto
themainstreamof thebanking business. In order to improve the quality of finance provided
by the money market, it introduced two Bill Market Schemes, one in 1952, and the other in
1970.With a viewto increasing the strength and viability of the banking system, it carried
out a programme of amalgamations and mergers of weak banks with the strong ones.
When the Social Control of banks was introduced in 1968, it was the responsibility of the
RBIto administerthe countryforachievingthedesired objectives.Afterthenationalization of
banks,the RBI’sresponsibilitytodevelop bankingsystemonthedesired lineshasincreased.It
hasbeen actingas a leader in sponsoring and implementing the Lead Bank scheme.With
the help of a statutory provision for licensing the branch expansion of banks, the RBI has
been trying to bring about an appropriate geographical distribution of bank branches. In
order to ensure the security of deposits with banks, the RBI took the initiative in 1962 in
creating the Deposits Insurance Corporation.
The RBI has rendered yeoman’s service in directing an increased flow of credit to the
agricultural sector. It has been entrusted with the task of providing agricultural credit in
terms of the ReserveBank of India Act, 1934. The importance with which the RBI takes this
function is reflected in the fact that since 1955, it has appointed a separate Deputy

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1
Governor in charge of rural credit It has undertaken systematic stuthes of the problem of
rural credit and has generated basic data and information in this area. Thiswasfirst done in
1954 by conducting an All-India Rural Credit Survey. And that wasfollowed by the stuthes
of the All-India Rural Credit Review Committee in 1968, the Committee to Review
Arrangements for Institutional Credit for Agriculture and Rural Development in 1978, and
theAgricultural Credit Review Committee in 1986.

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As a part of its efforts to increase the supply of agricultural credit, the Bank has been
striving to strengthen the cooperative banking structure through provision of finance,
supervision, and inspection. It provides the co-operative banks (through the State Co-
operative Banks) short term finance at a concessional rate for seasonal agricultural
operations and marketing of crops. It subscribes to the debentures of Land Development
Banks. It operates the National Agricultural Credit (Long-Team Operations) Fund, and foe
National Agricultural Credit (Stabilization) Fund, through which it provides long-term and
medium-termfinance to cooperative institutions. It established the Agricultural Refinance
Cooperation (now known as NABARD) in July, 1963 for providing medium-term and long-
term finance, for agriculture. It also helped in establishing an Agricultural Finance
Corporation.
The role of the Bank in diversifying the institutional structure for providing industrial
finance has been equally commendable. All the Special Development Institutions at the
Central and State levels and many other financial institutions were either created by the
Bank on its own or it advised and rendered help in setting up these institutions. The UTI,
for example, was originally an associate institution of the RBI. A number of institutions
providing financial and other services such as guarantees, technical consultancy, and so
on have come into being on account of the efforts of the RBI.
Through these institutions, the RBI has been providing short-term and long-term funds to
the agricultural and rural sectors, to small scale industries, to medium and large
industries, and to the export sector. It has helped to develop guarantee services in respect
of loans to agriculture, small industry, exports, and sick units. It also co-ordinates the
efforts of banks, financial institutions, and Government agencies to rehabilitate sick units.
The Bank has evolved and put through practice the consortium, cooperative, and
participatoryapproach to lending among banks, and other financial institutions, and among
other financial institutions. By developing the culture of inter-institutional participation, of
expertise pooling, and of geographical presence, it has helped to upgrade credit delivery
and service capability of the financial system. By issuing appropriate guidelines in 1977
regarding the transfer of loan accounts by the borrowers, it has evolved mutually
acceptable system of lending, so that the banking business should grow in a healthy
manner and without cutthroat competition.
REGULATOROFMONEYANDCREDIT
The function of formulating and conducting monetary policy is of paramount importance
for any central bank. Monetary policy refers to the use of techniques of monetary control
at the disposal of the central bank for achieving certain objectives.
SELFASSESSMENT EXERCISE
1. Define‘CentralBank’.
2. WhatisNoteIssuingAuthority?
3. Whatis‘BankersBank’?
4. “ExchangeControlAuthority”?
SUMMARY
The Reserve Bank of India (RBI) is India’s central bank, also known as the banker’s
bank. The RBIcontrolsmonetaryandotherbankingpoliciesof the Indian government.
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TheReserveBankof India (RBI) was established on April 1, 1935, in accordance with
The Reserve Bank of India Act, 1934. The Reserve Bank is permanently situated in
Mumbai since 1937. The Reserve Bank is
fullyownedandoperatedbytheGovernmentofIndia,heprimaryobjectivesofRBIareto

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supervise and undertake initiatives for the financial sector consisting of commercial
banks, financial institutions and non-banking financial companies (NBFCs). The
Preamble to theReserve Bank of India Act, 1934 (the Act), under which it was
constituted, specifies its objective as “to regulate the issue of Bank notes and the
keeping of reserves with a view to securing monetary stability in India and generally
to operate the currencyand credit system of the country to its advantage”. While
rising global integration has its advantages in terms of expanding the scope and
scale of growth of the Indian economy, it also exposes India to global shocks. Hence,
maintaining financial stability became an important mandate for the Reserve Bank.
GLOSSARY
Cash Reserve Ratio: Cash reserve ratio is the amount of funds that banks have to maintain
with the Reserve Bank of India (RBI) at all times. If the central bank decides to increase
the CRR, the amount available with the banks for disbursal comes down. The RBI uses the
CRR to drain out excessive money from the system.
Reserve Bank of India: RBI is the central bank of India, which was established on April 1935,
under the Reserve Bank of India Act. The Reserve Bank of India uses monetary policy to
create financial stability in India, and it is charged with regulating the country’s currency
and credit systems.
Repo Rate: Repo rate isthe rate at which the centralbank of a country (Reserve Bankof
India in case of India) lends money to commercial banks in the event of any shortfall of
funds.
Reverse Repo Rate: Reverse Repo rate is the rate at which the Reserve Bank of India
borrows funds from the commercial banks in the country. In other words, it is the rate at
which commercial banks in India park their excess money with Reserve Bank of India
usually for a short-term. Current Reverse Repo Rate as of February 2020 is 4.90%.
SLR: SLR is used by bankers and indicates the minimum percentage of deposits that the
bank has to maintain in form of gold, cash orotherapproved securities. Thus, we can
saythat it isratio of cashand some other approved liability (deposits). It regulates the
credit growth in India.
ANSWERSTOSELFASSESSMENTEXERCISE
1. ReferstoSection9.1
2. ReferstoSection9.4
3. ReferstoSection9.4.3
4. ReferstoSection9.4.5
TERMINALQUESTIONS
1. WhatdoyouunderstandbycentralBanking?
2. Discussthefunctionsofacentral bank.
3. WhatisthemonetarypolicyofReserveBankofIndia?
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection9.1&9.2

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2. ReferstoSection9.3&9.4
3. ReferstoSection9.4.7

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6
SUGGESTED READINGS
1. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall
ofIndia.
2. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
3. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage
publications, New Delhi.
4. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.JainBook Agency,
Mumbai.

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 Lesson-10
MutualFundinIndia- AnOverview

STRUCTURE
LearningObjectives
Introduction
MutualFundsinIndia
ResourceMobilizationbyMutualFunds
ObjectivesofMutualFunds
BenefitsofMutualFunds
Typesof MutualFunds
Closed-endFunds
Open-endfunds
TypesofSchemes
Offshorefunds
GETFs
RecommendationsoftheStudyGroup
SEBIsDirectivesforMutualFunds
SEBI’sMajorRegulatoryProvisions
PrivateMutualFunds
SponsorwithTrackRecord
AssetManagementCompany(AMC)
EvaluationofPerformanceofMutualFunds
ReturnperunitofRisk
SharpensIndex
Treynor’sIndex
DifferentialReturn(Alpha)
ProblemsofMutualFunds
CompetitionwithGovernmentSchemes
CompetitionwithInsurances
VolatilityofMutualFundPerformance
TaxSystemEncouragesshort-termobjectives
SelfAssessmentExercise
Summary

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 Glossary
AnswerstoSelfAssessmentExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthelessonyoushouldbeableto
1. UnderstandtheobjectivesofMutualFunds.
2. Analyzethedifferenttypesofmutualfunds.
3. Statetheguidelinesthatregulatemutualfunds.
INTRODUCTION
Mutual funds are financial intermediaries which collect the savings of investors and invest them
in a large and well diversified portfolio of securities such as money market instruments,
corporate and Government bonds and equity shares of joint stock companies. A mutual
fund is a pool of commingle funds invested by differentinvestors, whohavenocontact with
each other. Mutualfundsare conceived as institutions for providing small investors with
avenues of investment in the capital market. Sincesmall investors generally do not have
adequate time, knowledge, experience and resources for directly accessing the capital
market, they have to rely cm an intermediary which undertakes informed investment
decisions and provides the consequential benefits of professional expertise. The raison
d’etre of mutual funds is their ability to bring down the transaction costs. The advantages
for the investors are reduction in risk, expert professional management, diversified
portfolios, liquidity of investment and tax benefits. By pooling their assets through mutual
funds, investors achieveeconomiesof scale. The interestsof the investors are protectedby
the SEBIwhich acts as a watchdog. Mutual funds are governed by the SEBI (Mutual Funds)
Regulations, 1993.
MUTUALFUNDSININDIA
Thefirst mutualfundtobe setup wasthe Unit Trust of India in1964underan Act of Parliament.
During the years 1987-1992, seven new mutual funds were established in the public
sector. In 1993, the government changed its policy to allow fee entry of private corporate
and foreign institutional investors into the mutual fund segment. By fee end of March,
2005 there were 29 mutual funds, 8 in fee public sector and 21 in fee private sector.
The UTI dominated the mutual fund sector until 1994-95, accounting for 76.5 per cent of the total
mobilization. But there were large purchases by UTI in 1995-96 and 1996-97 which
resulted in reverse flow of funds. Meanwhile, fee numberof mutualfundsespecially infee
private sector have grown along wife fee number of schemes matching fee preferences of
investors. The year 1999-2000 was a watershed year in which mutual funds emerged as
an important investment conduit for investors at large. Net resource mobilization by all
mutual funds amounted to Rs. 21,972 crore. Growth was led mainly by private sector
mutual funds which witnessed an inflow of fee order of Rs. 17,171.0 crore.
Fiscal incentives provided in fee Union Budget 1999-2000 exempted all income received by fee
investors from UTI and other mutual funds from income tax. All open-ended equity
oriented schemes along wifefee US 64 scheme were exempted from dividend tax for three
years. Buoyant stock markets were also a contributory factor.

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The outstanding net assetsof all domestic schemes of mutualfunds, stood at Rs. 1,49,601 crore
atfee end of March, 2005. The share of UTI in outstanding assets was 13.9%, public sector
mutual funds 7.6% and private sector mutual funds 78.5%.

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RESOURCEMOBILIZATIONBYMUTUALFUNDS
(a) Mutual funds mobilized large resources in the eighties and in the first four years of
nineties registering an annualized growth of more than forty per cent. The growth was
aided mainly by the buoyant secondary market, setting up of new mutualfunds in the
second half of the eighties and tailor- made schemes introduced by them and UTI. Another
contributoryfactor was the assured rate of return offered by some mutual funds. In 1995-
96 and 1996-97 the subdued stock market conditions, alongwith a perceived lack, of
transparency in the functioning of mutual funds, delayed refunds, poor accountability and
lack of efficient service led to the poor performance of many mutual fund schemes
resulting in low or, even in negative returns, thereby eroding the investors confidence.
Consequently, the resource mobilization of mutual funds (other than UTI) during 199A96
and 1996-97 was poor. With respect tofoe UTI, there were large reverseflows,in viewof
substantialrepurchases. The mutualfunds had to get their act together by revamping their
operations, be responsive to the investors’ needs and infuse greater expertise and
efficiency in their operations, in order to earn the investor’s confidence.
(b) Aftersubduedperformance in 1997-98 and 1998-99 a sharp turnaround
waswitnessed in1999- 2000 when resource mobilization reacheda peakof Rs. 21,972 crore
mainlyledbyprivate sectorfunds which mobilized Rs. 17,171 crore through offer of more
than 44 new schemes to match investor preferences.
The overall mobilization was aided by the tax benefits announced in the Union Budget for
1999-2000 particularly those relating to equity oriented Schemes. The bullish trends in the
secondary market combined with attractive returns ort units of mutual funds had a
favourable influence on the investors.
OBJECTIVESOFMUTUALFUNDS
Mutual funds have specific investment Objectives, which are stated in their prospectus.
The main objectives are growth, growth-income, balanced income, and industry specific
funds. Growth funds strive for large capital gains, while growth-income funds seek both
dividend income and capital gains from the common stock. The balanced fund generally
holds at of diversified common stocks, preferred stocks and bonds with the hope of
realizing capital gains, dividend and interest, income while at the same time, conserving
the principal. Income funds concentrate heavily on high interest and high, dividend
yielding securities. The industry specific mutual funds obviously specialize in selected
industries such as chemicals, petroleum or power stocks. In general, growth funds seems
to have the highest risk balanced funds, the lowest risk and income growth finds,
intermediate risk.
BENEFITSOFMUTUALFUNDS
Tax shelter is the most important advantage, the mutual funds industry enjoys in India. A
mutual fund, set up by a public sector bank or a financial institution or one that is
authorized by the SEBI is exemputedfrom tax, under Section 10 (23D) of IT act, provided it
distributes 90 percent of its profits.
(c) The Union Budget for 1999-2000 granted tax exemption for a period of three years
for US 64 scheme and for all open-ended equity oriented schemesof UTI and other
mutualfunds with more than 50 per cent investment in equity. It also announced the
exemption from income tax of all income from UTI and other mutual funds received in the
hands of investors. The Budgetfor2000-01 however, raised the tax rate on income
distributed by debt-oriented mutual funds and UTI from 10% to 20%.

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As compared to direct investment, mutual funds offer firstly, reduced risk and diversified
investment. Mutual funds help small investor’s ill reducing risk by diversification,
economies of scale in transaction
costandprofessionalportfoliomanagementSecondly,mutualfundsofferrevolving typeof
investments. Automatic reinvestment of dividends and capital gains provide tax relief to
the members. Thirdly, selection and timing of investment are undertaken by mutual funds.
The fund as an organization, supplies expertise in stock selection and timing purchase and
sale of securities to investors on the investedfunds to generate higher returns to them.
Finally, mutualfundsassure liquidityand investment

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care. The units of mutual funds could be converted to cash without any loss of time,
relieving investors from various rules and regulations, which they have to comply with
indirect investments.
TYPESOFMUTUAL FUNDS
Two major fund categories of mutual funds are closed-end funds and the open-end funds.
Open-end funds are commonly referred to as the mutual funds. Mutual funds can be
further classified into equity funds,growthfunds, incomefunds, realestatefunds,
offshorefunds, leveragedfundsand hedgefunds. Such schemes are listed on the stock
exchanges for dealings in the secondary market.
CLOSED-ENDFUNDS
Closed-end mutual funds have the following characteristics. Firstly, closed-end fund
Investment Company cannot sell share units after its initial offering. Its growth in terms of
the number of shares is limited. The shares are issued like the new issues of any other
company, listed and quoted on a stock exchange.
Secondly, the shares of the closed-end hinds are not redeemable at their NAV as in the
case of open- end funds. On the other hand, these shares are traded in the secondary
market on a stock change, at market prices that may be above or below their Net Asset
Value (NAV). Thirdly, the objectives of the closed-end funds may differ from that of the
open-end funds. Fourthly, closed-end funds are canalized into the secondary market, for
the acquisition of corporate securities. Finally, the prices of closed-end mutual funds’
shares are determined by demand and supply and not by NAV as in the case of open- end
mutual fund shares. The minimum amount of the fund is Rs. 20 crore or 60% of targeted
amount. Redemption is after a specified period (4 to 7 years). Morgan Stanley’s scheme is
for 15 years.-Other examples are UTIs master share, SBls Magnum and Canbank’s can
double. In all there were 129close-ended schemes at the end of March 2006.
OPENENDFUNDS
The open-end mutual funds are characterized by the continual selling and redeeming of
shares. Inother words, mutual funds do not have a fixed capitalization. It sells its shares to
the investing public, whenever it can, at their Net Asset Value per share (NAV) and stands
ready to repurchase the same, directly from the investing public, at the net asset value
per share. Minimum amount of the fund is Rs. 50 crore or 60% of targeted amount.
Examples are UTIs Unit 64, Kothari/ Pioneer, Prima and LIC schemes. There were 463
open-ended schemes at end March 2006.
TYPESOFSCHEMES
Mutual funds offer growth, income, tax planning and miscellaneous schemes. The growth
schemes are usually closed-ended and listed on ‘the stock ‘exchange. Benefits of capital
appreciation and dividend exist. Examples are UTI’s Master share 86, Master gain 92 and
SBIMF’s Magnum. Income schemes can be closed-ended of open-ended. Monthly income
schemes are closed-ended. Regular dividends are paid since investment is primarily in
debt instruments. Generally income schemes are not listed but Unit 64 is listed on OTCEI
and NSE. Examples are UTIs’ Unit 64, SBIMFs’ Magnum, Bank of India MF s’ rising monthly
scheme. Equity linked savings schemes called tax planning schemes are closed- ended.
Investment up to Rs. 10,000 provides 20% tax rebate under section 99 of IT Act. They are
growth oriented and provide capital appreciation. The schemes are not listed on stock
exchange and before 3 years are not transferable. Redemption after 10 years on NAV with
20% deduction at source. Examples are Canbank’s Cahpep and SBIMFs tax gain. Finally,
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miscellaneous schemes have specific purpose and, are generally open-ended. Investment
matures on the fulfillment of the purpose, like Children’s Gift Growth ‘plan and Senior
Citizen’s plan. Specific purpose scheme units cannot be listed or pledged. Tax concessions
admissible as specified in the scheme. Examples are Canbank’s Canpep and SBIMFs Tax
Gain.

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To avoid any distortion in the unit holding pattern and its impact, minimum number of 20
investors in a scheme has been prescribed. No single investor should hold more than 25%
of the corpus of any scheme/ plan.
During 2005-06,592 schemes were in operation of which 463 schemes (78.2%) were open-
ended schemes. In terms of investment objectives income (debt oriented) schemes were
251(18.9%), growth (equity oriented) schemes 231 (39.0%) and balanced (equity and
debt) schemes 36 (6.0%).
OFFSHOREFUNDS
There were total of 12 offshore funds end-March, 2003. Of the 12 offshore funds, eight
belong to the public sector and remaining four to the private sector. The net assets of
public sector mutual fundswere Rs. 552.55 crore (66.7% of total) arid private sector Rs.
276.89 crore (33.3%).
The funds (Rs. 796.55 crore)are mainly deployed in equityrelated instruments (96%)and
debt/ money market instruments (3.97%).
GETFs
SEBInotifiedonJanuary12,2006the introductionof GoldExchange Traded Funds.
Anyhouseholdcan buy and sell gold units for Rs 100. The assets of the scheme have to be
kept in the custody of a bank which is registered as a custodian With SEBI. The wholesale
intermediary sells/buys gold units to mutual funds. The funds of any such scheme should
be invested only in gold or goldrelated instruments except to the extent necessary to
meet the liquidity requirements for honouringredemptions or repurchases. Gold Exchange
traded funds have only gold as the sole underlying asset. These spot instruments are
freely transferable among the participants through stock exchange. Unit holders have no
right on the underlying asset but are entitled to the accrued benefit on the scheme by way
of dividend and market arbitrage. GETF unitscan be used as collateral for loans.
RECOMMENDATIONSOFTHESTUDYGROUP
In 1991, a 10-member study group headed by Dr. S.A. Dave. Chairman of the Unit Trust of
India, was formed by the Government of India to study the functioning of mutual funds,
with a view to permit mutual funds in the private joint sectors. The major
recommendations’ of the study group are:
(i) Minimum amounttoberaised in theclosed end schemeshould beRs.20crore
andthatofthe open-end scheme is Rs. 50 crore.
(ii) Theprivatemutualfundsshould-enjoytaxbenefitssimilartotheUTT.
(iii) Nominimumreturnshouldbeguaranteed.
(iv) Distributionofatleast80percentearnings.
(v) AlimitofRs.200croreshouldbesetforborrowingovertwoyears.
SEBI’SDIRECTIVESFORMUTUAL FUNDS
The Government brought mutual funds in foe security market under the regulatory
framework of the Securities and Exchange Board of India (SEW) in foe year 199J3. SEBI
issued guideline^ in the year 1991 and a comprehensive set of regulations relating to the
organization and management of mutual funds in 1993.
SEBI’sMajorRegulatoryProvisions

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1. MutualfundsshallbeauthorizedforbusinessbytheSEBI.
2. Mutualfundsshallbesponsoredbytheregisteredcompanieswithsoundtrack,generalreput
ation and fairness in all their business transactions.

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 3. Mutual funds shall be established in the form of trusts under Indians Trusts Act. The
sponsoring institution will be free to work out the details regarding the Constitutions of the
Trust.
4. The Trust shall be authorized to float one or several different schemesunder which
units shall be issued to the investors.
5. Mutual funds shall be operated by separately established Asset Management
Companies (AMC) to be approved by the SEBI.
6. AMCcannotactastheTrusteeofUnitTrusts.
7. AMC cannot undertake any other business activity than management of mutual funds
and such otheractivitiesasfinancialservicesconstantly,exchange of research andanalysison
commercialbasis as long as these are not in conflict with the management activity itself.
8. ThemutualfundsshallusetheservicesofacustodianregisteredwiththeSEBI.
9. Thecustodianshallbetotallyde-linkedfromtheAMC.
10. EachauthorizedmutualfundsshallbeallowedtofloatdifferentschemesaslongastheAMC
concerned meets the required capital adequacy criteria.
11. EachschemefloatedbyamutualfundshallhavepriorregistrationwithSEBI.
12. Mutualfundscanstartandoperatebothclosed-endandopen-endschemes.
13. For each closed-end scheme, the mutual fund shall be required to raise at least Rs.20
crore and for each open-end scheme at least Rs.50 crore.
14. Mutual funds cannot keep closed-end schemes open for subscription for more than 45
days. For open-end schemes, the first 45 days ofthe subscription period should be
considered for determining the target figure or minimum size.
15. Mutual funds shall provide continuous liquidity. Closed-end scheme shall have to be
listed on exchanges.
For open-end schemes, mutual funds shall sell and repurchase, units at pre- determined prices
based on net asset value.
16. Mutual funds are allowed to invest only in transferable securities either in the money
market or in the capital market, including any privately-placed debentures or securitized
debt. Privately placed debentures, securitized debt and other unquoted debt instruments
holdings shall not exceed 10% in case of growth funds, and 40% in case of income funds.
17. Mutualfundsshallnotbeallowedtoprovidetermloansforanypurpose.
18. Noindividualschemeofthemutualfundshall investmorethan5percentofitscorpusinany-one
company’sshares.
19. No mutual fund under all its schemes shall own more than 5 per cent ofany
company’s paid-upcapital carrying voting rights.
20. Nomutualfundunderallitsschemestakentogethershallinvestmorethan10percentofits
funds in the shares or debentures or other securities of a single company.
21. No mutualfund underallitsschemestaken togethershallinvest more than 15 percent of
itsfunds in the shares or debentures of any specific industry.
22. NoschemeshallinvestinorlendtoanotherschemeunderthesameAMC.
23. The AMC may charge the mutual fund with investment management and advisory
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services which should have been disclosed fully in the prospectus subject to the following
ceiling:

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 a) 1.25%of
theweeklyaveragenetassetsoutstandinginthecurrentyearfortheschemeconcerned as long
as the net assets do not exceed Rs. 100 wore, and
b) 1%oftheexcessamountoverRs.100crore,wherenetassetssocalculatedexceedRs.100
crore, and
c) Allmutualfundsmustdistributeaminimumof90percentoftheirprofitsinanygivenyear.
The SEBI has recently allowed the Mutual funds to invest 100% of funds raised in Money Market
up to6 months and thereafter 30% of funds for 6 months to one year and only 25% in
Money Market and again 100% of funds in Money market, 6 months prior to repayment to
investors.
24. Everyschemeshouldhaveatleast20investorsandnosingleinvestorshouldholdmorethan25
percentofthefund’sassets.
25. Every mutualfund will have tofurnish to SEBIat leastthefollowing periodic
reports,inaddition to any other SEBI may ask for:
(a) Copiesof the dulyaudited annual statement of account including the balance sheet
and the profit and loss account for the funds and for each scheme, once a year.
(b) Six-monthlyun-auditedaccountsasabove.
(c) Astatementofmovementsinnetassetsforeachoftheschemesofthefunds,every quarter.
(d) Aportfoliostatement,includingchangesfromthepreviousperiods,foreachscheme,every
quarter.
26. All mutual funds are required to adopt a written code of ethics designed to deal with
the potential conflicts of interest that may arise from transition; by the affiliated persons
or companies.
27. Everymutualfund shallhaveto copywith a common advertising code laid down bythe
SEBI. The fund is expected to submit to the SEBI the texts oftire marketing literature and
advertisements issued to the investors.
Mutual funds shall have to disclose in their marketing and publicity brochures for each scheme,
the investment objectives, the method and periodicity of valuation of investment, the
exact method and periodicity of salesandpurchases andother details
consideredbytoSEBItobeessentialfor investors.
28. SEBI can,after due investigation, impose penalties on mutualfundsforviolating the
guidelinesas may be necessary. However, for cases of penalties of suspension or
deauthorisation of mutual fund entities, prior concurrence of the RBI and the government
is necessary.
The regulatoryframeworkfor mutual funds smacks of ineffective panning, clarity of thought and
suffers from several shortcomings. There does not seem to be any justification for
separate regulatory framework to govern the operations of the mutual funds the UTI Act
with comprehensive guidelines already in existence. It would have been more logical to
broaden the scope of the UTI Act to make it applicable to all the mutual funds. Some of the
guidelines issued by the RBI and SEBI arecontradictory. For instance, while the EBI
prohibits bank sponsored mutual funds from investing in finance companies, SEBI has
actually made reservations for mutual funds in public issues of finance
companies.Theexistingrulesandregulationsarequitecomprehensivetoensure
greater‘transparency about the operations of mutual funds. However, there is some scope

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of effectively curbing the malpractices, particularlyin thefield of distributionof mutualfund
productsbyregulating the activitiesof
intermediaries.Further,someoftherulesandregulations,viz.,restrictionsoninvestment,require
ments of underlying securities in the derivative market, individual investor’s
communication and recording ofall secondary transactions have been identified as very
stringent. Thesehave had an adverse impact, to some extent, on the performance of
mutual funds.

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SEBI rules regarding late trading and rapid trading are either ineffective or nonexistent
Although SEBI has introduced a specific regulation against late trading since March, 2004,
it has failed to check late trading.Asa result, there isrampant late tradingbymutualfundsto
thedetrimentof common investors. What is most disturbing to note is that there are still no
regulations to deter rapid trading in mutual funds, even though the regulator is aware of
how it can harm long-term investors. While late trading is nothing short of cooking the
books, rapid trading is not a crime but need to be discouraged.
PRIVATEMUTUAL FUNDS
Another keydevelopment in thefinancial sector was the opening up of mutualfundsto
private sector in early 1992. Though quite a few industrial groups and financial majors
evinced a keen interest in the setting up of mutualfunds, it took nearly two years for the
first private mutualfund to be launched. The first private sector mutual fund was launched
by the Madras based H.C. Kothari group which, in collaboration with the Pioneer group of
the US offered two schemes in 1994. This was followed by several mutual funds having
foreign tie-ups with renowned asset management companies— 20th century has
collaboration with Kemper Financial Services, the Tata with Kleinwort Bonson and ICICI
with J.P. Morgan.
The competition becomes intense when investors switch overfrom one fund to another,
based on their decisionson theperformanceof thefunds. Andthat should begin soonerthan
later, with as manyas29 mutualfunds in the field. The trend world over especially in the
USA, U.K. and Japan is for investors to switch over from secondary markets to mutual
funds. For thecompanies also, theretail routeis quite an expensive method of raising funds.
The trends in private funding of equity and bought out deals in our country, clearly
indicate that individual households, in their own interest (since they lack stock picking
drills and manage their own portfolios) should leave the job to professionals such as
mutual funds.
SPONSORWITHTRACKRECORD
A mutualfund in a private sector has to be sponsored by a limited company having a track
record. The mutual fund has to be established as trust under the Indian Trust Act, 1882.
The sponsoring company should have at least a 40 per cent stake in the paid up capital of
the asset management company. Mutual funds are required to avail off the services of a
custodian who has secured the necessary authorization from the SEBI.
ASSETMANAGEMENTCOMPANY(AMC)
A mutual fund is managed by an Asset Management Company that is appointed by the
sponsor company or by the trustees. The asset management company has to, be
registered under the CompaniesActand has to beapprovedby the SEBI. TheAMDmanages
theaffairs of the mutualfunds and its schemes. AMCs are registered by the Registrar of
Companies only after a draft memorandum and the articles of association are cleared by
the SEBI.
EVALUATIONOFPERFORMANCEOFMUTUALFUNDS
The performance of a portfolio is measured by combining the risk and return levels into a
single value. The differential return earned by a portfolio may be due to the difference in
the exposure risk from that of, say the stock market index. There are three major methods
of assessing a risk adjusted performance. Firstly the return per unit of risk, secondly,
differential return, and thirdly, the components of investment performance.
RETURNPERUNITOF RISK
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‘The first measure determines the performance of a fund in terms of the return per unit of
risk. The absolute level of return achieved is related to the level of risk exposure to
develop a relative risk
adjustedmeasureforrankingthefundperformance.Fundsthatprovidethehighestreturnperunit
of

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risk would be judged as having performed well while those providing the lowest return per
unit of risk would be judged as poor performers (see Fig. 10.1.).
ThereturnperunitofriskismeasuredbySharpe’sinvestmentperformanceindexandTreynor’s
portfolioperformkneeindex.
Sharpe’s Index Sharpe’s investment performance index is a risk adjusted rate of return
measure that iscalculated bydividingtheassetsriskpremiums E(r)—R,
bytheirstandarddeviationsof returns.This indexisused to rankthe investment
performanceof different assets,Sharpe’sindexconsidersboth the average rates of return
and the risk. It assigns the highest scores to the assets that have the best risk
adjustedrateofreturn.Sharpe’srewardtovisibilityof returnissimply,theratioof
therewarddefinedas the realized portfolio return (rs) in excess of foe risk-free rate (rf) to
the variability of return, measuredby the standard deviation of return (op).
rf
Sharpe’sratiorp=rp
 p

where,(rp)istherealizedportfolioreturnortheassets’averagerateofreturn,
(rf)isthe risk-free rate,andpistheassets’SDofreturn.
In termsof thecapital market theory,thisportfolioperformance measureusesthe,total riskto
compare portfolios with the Capital Market Line (CML) [see Fig. 10.1]. A higher Sharpe’s
ratio value than the market portfolio would lie above the CML and would indicate superior
risk adjusted performance.

Fig.10.1:DifferentialReturnforFundsA,M&Z
Treynor’sIndex
An index of portfolio performance that is based on systematic risk, as measured by the
portfolio’s beta coefficients rather than on total risk as done by Sharpe’s measure was put
forward by Jack Treynor. Itis used to rank the investment performance of different assets.
It is a risk adjusted rate of return measure that is calculated by dividing the assets’ risk
premium E(r) – R, by their beta coefficients. The index of systematic risk is a Characteristic
of the Regression Line (CRL) and the beta coefficient. As with the individual assets, the
beta coefficient from a portfolio’s characteristic line is an index of the portfolio’s
systematicorundiversified risk. The systematicrisk remainsafter the unsystematicvariability
of retains of the individual assets average turns out to be zero. In view of this Treynor
suggested measuring a portfolio’s return, relative to its systematic risk rather than to its
total risk, as is done in the Sharpe’s measure:

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 rpr
Treynor’srati
f
o
p

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A larger TR value indicates a higher slope and a better; portfolio for all the investors.
Comparing a portfolio’s TR value to a similar measure for the market portfolio, indicates
whether the portfolio would plot above the Security Market line (SML) [see Fig. 10.1].
Deviation from the characteristic line
measurestherelativevolatilityoftheportfolio’sreturns,inrelationtothereturnsfortheaggregate
market or the portfolios beta coefficient.mequals 1.0, the market’s beta, which indicates
the slope of the SML.
TheTRvaluefortheaggregatemarketiscalculatedasfollows:

RmRf
T
m m
wher RM=Returnsfromthemarketportfolio.
e,
m=Systematicriskofthemarket.Inthisexpression,bequals1.0andthemarkets’beta
indicates the slope of the SML. Therefore; a portfolio with a higher TR value than foe
market portfolio would lie above foe SML. This would indicate a superior risk adjusted
performance. Comparison of Sharpe’s and Treynor’s Measures are similar in a way, since
they both divide the risk premium by a numerical risk measure. However, foe Sharpe’s
portfolio performance measure uses foe standard deviation of returns as the measure of
risk, whereas Treynor’s performance measure employs beta coefficient as a denominator.
Sharpe’s measure tanks the assets dominance m the CML’s risk return space while foe
Treynor’s measure ranks the dominance in foe CAPM’s risk return space. Both measures
assume that money can be freely borrowed and lent at R This assumption is required to
generate linear investment opportunities that emerge from Rand allow funds in different
risk classes to be compared and ranked. The standard deviation as a. measure of the total
risk is appropriate when evaluating foe ride return relationship for well diversified
portfolios. On the other hand; foe beta coefficient is foe relevant measure of risk when
evaluating less than fully diversified portfolios or individual stocks. In spite of the risk
measures they employ the Sharpe’s and Treynor’s portfolio performance measures yield
very similar ranking of portfolios in most cases.
Table. 9.2. illustrates the calculation of return per unit of ride under the two methods using
two hypothetical funds A and Z along with the market fond M, as a benchmark for
comparison. The market fund provided 0.26 return per unit of standard deviation and
exceeded the Sharpe’s ratio of 0.25 return provided for Z, but was below the Sharpe’s
ratio of 0.3 for fond A According to the reward to volatility
ratio,themarket,fundprovidedareturnperunitofbetaof 4,whichagainexceedstheTreynor’s
ratio of
3.7forfundZ,butwaybelowfoeTreynor’sratioof4.4derivedforfondA(Fig. 9.1)
The ranking of funds was identical under either measures and A was the best, Z the worst
while the markets fund M, an intermediate performer.
DIFFERENTIALRETURN(ALPHA)
A second category of risk adjusted performance measure is the Jenson’s measure. This
measure was developed by Michael Jenson and is sometimes referred to as the differential
return. This measure involves the calculation of returns that should be expected for the
fund, given the realized risk of the fund and compare that with the returns realized over
the period. It is assumed that the investor has a passive or naive alternative of
merelybuying themarket portfolioand adjusting forthe appropriate level of risk, by

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borrowing or lending at a risk-free rate. Given the assumption, the most commonly used
method of determining the return for a level of risk is by way of the alpha formulation:

 
N r p rfp mf


rp=rp-N rp

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ToevaluatetheperformanceofthefundAweinserttheappropriatevariablesintheformula:


N rp 30.67(73)5.68%

65.680.32%
Fund A would have been expected to have earned 5.68% over the period. The fund
actually earned 6.00%and thusprovided a differential return of risk adjusted to 0.32% (Fig.
vt). Jenson also provided a way of determining whether the differential return could have
occurred by change, or whether it was significantly different from zero in statistical sense.
It is possible to establish this, since Jenson’s measure is ordinarily derived by running a
regression of the monthly or quarterly returns of the fund, being evaluated against the
return of a market index, over the relevant performance period. The regression equation
is:
The form of the regression equation is similar to that of the previous equation, except that
an intercept term alpha and an error term (e) have been added. The error term enables in
assessing how well the regression equation fits the date, a low error indicating a well-
defined relationship and a high error indicating a poorly defined relationship. The intercept
measures the performance of the fund with either a negative value that indicates a below
average performance, or a positive value for above average performance.
 
rprfp p rmrf e

X The form of the regression equation is similar to that of theprevious equation, except
that an intercept terms alpha and an errorterm (e)have been added. The error term
enables in assessing how well the regression equation fits the data, a low error indicating
a well-defined relationship and a high error indicating a poorly defined relationship. The
intercept measures the performance of the fund with either a negative value that indicates
a below average performance, or a positive value for above average performance.
Table10.1CalculationofReturnPerUnitofRiskRatios
Fund Return Rp R-Rr S.D SR B TR
A 6 3 3 10 0.30 0.67 4.4
M 7 3 4 15 0.26 1.00 4.0
Z 8 3 5 20 0.25 1.33 3.7

PROBLEMSOFMUTUALFUNDS
India has a high household savings ratio. Indians, like most people anywhere, are
conservative in their habits, and it would take many years to change this behaviour,
particularly when it comes to the use of their savings. As in most countries, investment in
physical assets (mainly housing and gold) accounts for the most important percentage of
household assets. Owning a home is usually a first priority once a family has any
disposable income at all.
COMPETITIONWITHGOVERNMENTSCHEMES:
Mutual funds compete against a host of high yielding government-backed savings
schemes such as Public Provident Fund (PPF), National Savings Scheme (NSS), RBI Bonds,
and so on, as well as against life insuranceproductsand, inthefuture,againstthenewpension
schemesfortheunorganized sector. [1] The political and social reasons for keeping yields
higher than the market for small savers,
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particularlyretiredsavers,isunderstandable.Themarketisdistortedbysuchapolicy.Governmen
t

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should have the strategic aim of discontinuing over time or at least reducing the
availability of the unrealistically high yielding avenues for small savings. The objective of
widening and deepening ownership of mutual funds is unlikely to be met until this
happens.
Fixed income and balanced mutualfunds have offered a reasonably competitive rate of
return but they are not guaranteed,a key attraction to Indian investors. The net result
isthat mutualfunds fail to attract much moneyfrom retailinvestors, who preferto invest in a
no-risk, high return product, i.e. government saving schemes or provident funds or keep
their money safely in the bank.
Government -sponsored instruments crowd out mutual funds since for the majority of
Indians buying mutualfunds, before theyhave theirfullcomplementof government-backed
savings instruments, would be both wrong and foolish.
In most countries government guaranteed financial instruments offer returns that are
likely to be significantly lowerthan private sector investmentsavailablefrommutualfundsor
insurance companies. This is the penalty that investors areprepared to payforlittle orno
risk. However, Indian retailinvestors are not being asked to sacrifice any substantial
amount of return in exchange for a government guarantee. Conversely, returns on
government assured investmentsare often betterthan that available elsewhere. While
conventional government bonds do give lower returns than equivalent private sector
corporate bonds, theretail government assured products give higher returns for almost no
risk. Itis thushardly surprisingthataninvestorof modestmeanswould choosetoinvest
in,forinstance,national savings certificates, since he can thus obtain a better return for a
much lower risk. Any investor would be well advised to invest the maximum permitted in
the various government assured schemes before considering other forms of investment.
The reasons why the government is prepared to pay above market rates of interest on
certain financial products is understandable. At a time when interest rates have fallen
substantially from their previous levels, savers who had counted on the interest on their
savings to provide an income, particularly in retirement, are being subsidized. Given that
pension arrangements, particularly in the unorganized sector, are not widespread, such an
approach is reasonable and indeed most small savers are acting rationally when they
choose the low risk option. However, this approach conflictswith a desire to widen and
deepen participation in capital markets through mutual funds or other non-governmental
savings products by the less well-off sectors of the population.
COMPETITIONFROMINSURANCE:
The take up life assurance is growing rapidly and may be pre-empting some of the market
that mutual funds could aim at. Life assurance is an easier product to sell, since in the
mind of the investor the payment of a premium is often linked to a specific outcome, a
lump sum payment on death or a guaranteed minimum sum on maturity. It also pays
higher commissions to sales agents (typically the amount of the first 5 to 6 months
premium). Thus a sales agent will usually prefer to sell a life policy since it will reward him
better.
VOLATILITY OF MUTUAL FUND PERFORMANCE: There is a perception that mutual
funds have somehow let down their investors and given them poor returns. In July 2001
where UTI slashed down the dividend rates for the year 2000-01 and suspended sales and
repurchases of US-64 for a period of 6 months from July 2001 to December 2001, it
created a crisis of confidence among the investors with long-term effects.
TAXSYSTEMENCOURAGESSHORT-TERMOBJECTIVES:
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Mutual funds are regarded in most countries as a diversified, professionally managed and
well regulated vehicle for mobilizing household savings and are often accorded tax
privileges specifically in pursuit of a government policy goal to encourage long-term
savings, notably for retirement. [2] It is unusualfor such tax privileges to impel mutual-
funds towards short-term goals, which is what seems to

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be the case in India True, Indian unit trusts are diversified, professionally managed and
well-regulated, but they are certainly not serving long-term objectives.
The Mutual Fund Industry in India is quite sophisticated and successful. It is dominated by
good and reputable institutions, both Indian and International. Nevertheless improvements
are always possible and desirable in order to enhancefile abilityof the mutualfund industry
to mobilized savingson a wider scale and to contribute to the further development of
capital market.
Although reforms in the financial sector since 1991 have been successful in creating a
competitive environment, the growth of mutual fund has solved down, partially due to the
problems faced by UTI.
SELFASSESSMENT EXERCISE
1. Define‘MutualFund’
2. Define‘OffshoreFunds’.
3. Whatis‘AssetManagementCompany’?
4. Define‘GETF”.
SUMMARY
A mutual fund is a trust that pools the savings of a number of investors who share a
common financial goal. The money, thus, collected is then invested in capital market
instruments such as shares, debentures and other securities. The income earned through
these investments and the capital appreciation realised are shared byits unit holders in
proportion to the number of units owned bythem. Thus, a mutual fund is the most suitable
investment for the common man as it offers an opportunity to invest in a diversified,
professionallymanagedbasket of securitiesat a relativelylowcost. Mutualfunds have proved
to be an attractive investment for many investors, the world over, since they provide them
a mixture of liquidity, return and safety in accordance with their performance. Further, the
investor obtains these benefits without having to directly a diversified portfolio, which is
handled by specialists. The interestsof variousinvestorsare generallyprotected through
mutualfunds. Asindividual investors, they may not hold much clout in companies whose
shares they hold, but by being part of institutional investors like mutual funds, their
bargaining power is enhanced.
GLOSSARY
Mutual Fund: A mutualfund isa kind of investment that uses moneyfrom investors to invest
in stocks, bonds or other types of investment.
Close-ended Funds: These funds are fixed in size as regards the corpus of the fund and the
numberof shares.
Growth-oriented Funds: Thesefunds do not offer fixed, regular returns but provide
substantial capital appreciation in the long run. The pattern of investment in general is
oriented towards shares of high growth companies.
Income-oriented Funds: These funds offer a return much higher than the bank deposits but
with less capital appreciation.
NAV:NAVisthemarketvalueofthefund’sassetsdividedbythenumberofoutstandingshares/unitsof
thefund.
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Open-endedFunds:Inopen-endedfunds,thereisnolimittothesizeofthefunds.Investorscan invest
asand when theylike. The purchase price is determined on the basisof Net Asset Value (NAV).

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Specialised Funds or Industry Funds: These funds are invested in a particular industry like
cement, steel, jute, power or textile, etc.
TaxReliefFunds:Thesefundsareraisedforprovidingtaxrelieftothoseinvestorswhoseincome comes
under taxable limits.
ULIPs:ULIPsareacategoryofgoal-basedfinancialsolutionsthatcombinethesafetyofinsurance
protection with wealth creation opportunities.
ANSWERSTOSELFASSESSMENTEXERCISE
1. ReferstoSection 10.1
2. ReferstoSection 10.8
3. ReferstoSection 10.13
4. ReferstoSection 10.9
TERMINALQUESTIONS
1. Discussthebenefitsandobjectivesofmutualfundsin India.
2. StatethedifferenttypesofmutualfundsprevailinginIndia?
3. DiscusstheSEBI’sregulatoryprovisionsforMutualFunds.
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection10.3,10.4&10.5
2. ReferstoSection10.6 &10.7
3. ReferstoSection10.11
SUGGESTED READINGS
1. Cohen,Jerome,B.:Zinbarg,EdwardD.,andZeikel,Arthur(2006).InvestmentAnalysisand
Portfolio Management. Homewood.
2. Cottle,C.C., and Whitman, W.T.(1953). InvestmentTiming:the formulaplanapproach.New
York, McGraw Hill.
3. Curley,AnthonyJ.andBear,RobertM.(2003).InvestmentAnalysisandManagement.NY,
Harper & Row.
4. D. Ambrosio, Charles A. (1970). Guide to Successful Investing. Englewood Cliffs, NJ
Prentice- Hall.

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 Chapter-11
FinancialRegulationsandReforms

STRUCTURE
LearningObjectives
RegulationoftheCapitalMarket
TheSecuritiesandExchangeBoardofIndia(SEBI)
RegulationsandGuidelinesIssuedbytheSEBI
RegulationoftheSecuritiesMarket
Needthefinancial reforms
Majorreformsafter1991
SelfAssessmentExercise
Summary
Glossary
AnswerstoSelf AssessmentExercise
TerminalQuestions
AnswerstoTerminalQuestions
SuggestedReadings
LEARNINGOBJECTIVES
Afterstudyingthechapteryoushouldbeable to:
1. Explaintheregulationofthecapitalmarket.
2. Describetheneedforfinancial reforms.
3. Discussthemajorreformsafter 1991.
REGULATIONOFTHECAPITAL MARKET
The securities market is regulated by various agencies such as the Department of
Economics Affairs (DEA), the Department of CompanyAffairs (DCA), the Reserve Bank of
India (RBI), and the SEBI. The activities of these agencies are coordinated by a high level
committee on capital and financial markets. The High Level Co-ordination Committee for
Financial Markets (HLCCFM) discusses various policy level issues which require inter-
regulatory coordination between the regulators in the financial market, viz., RBI, SEBI,
Insurance Regulatory and Development Authority (IRDA), and Pension Fund Regulatory
and Development Authority (PFRDA). The Committee is chaired by the Governor, RBI,
Secretary-Ministry of Finance, Chairman—SEBI, Chairman—IRDA and Chairman—PFRDA
are members of the committee.
The capital market, i.e., the market for equity and debt securities is regulated by the
Securities and Exchange Boardof India (SEBI). The SEBI hasfull autonomyand authorityto
regulate anddevelop the capital market. The government has framed rules under the
Securities Contracts (Regulation) Act (SCRA). The SEBI Act and the Depositories Act. The
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SEBI hasframed regulationsunder the SEBI Act
andtheDepositoriesActforregistrationandregulationofallmarketintermediaries,forprevention
of

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unfair trade practices, and insider trading. Under the acts, the Government and the SF.BI
issue notifications, guidelines, and circulars which need to be complied with by market
participants. All the rulesand regulationsare administered bythe SEBI. The powers in
respect of the contractsforsale and purchase of government securities, money market
securities and ready forward contracts in debt securities are exercised concurrently by the
RBI.
Thefourmainlegislationsgoverningthecapitalmarketareasfollows:
 The SEBI Act, 1992 which establishes the SEBI with four-fold objectives of protection
of the interests of investors in securities, development of the securities market,
regulation of the securities market and matters connected therewith and incidental
thereto.
 The Companies Act, 1956 which deals with issue, allotment and transfer of
securities, disclosures to be made in public issues^ underwriting, rights and bonus
issues and payment of interest and dividends.
 The Securities Contracts (Regulation) Act, 1956 which provides for regulations
of .securities trading and the management of stock exchanges.
 The Depositories Act 1996 which provides for establishment of depositories tor
electronic maintenance and transfer of ownership of demat securities.
THESECURITIESANDEXCHANGEBOARDOF INDIA(SEBI)
With the announcement of the reforms package in 1991,the volume ofbusiness in both the
primary and secondary segments of the capital market increased. A multicrore securities
scam rocked the Indian financial system in 1992. The then existing regulatory framework
was found .to be fragmented and inadequate and hence a need for an autonomous,
statutory, and integrated organization to ensure the smooth functioning ofcapital market
was felt. To fulfill this need, the Securities and Exchange Boardof India(SEBI),
whichwasalready inexistencesinceApril1988,wasconferred statutorypowers to regulate the
capital market.
ObjectivesofSEBI
 Protecttheinterestoftheinvestorinsecurities.
 Promotethedevelopmentofsecuritiesmarket.
 Regulatingthesecuritiesmarket
The SEBI got legal teeth through an ordnance issued on January 30, 1992. The ordinance
conferred wide-ranging powers on the SEBI, including the authority to prohibit ‘insider
trading’ and ‘regulate sub- stantialacquisitionof shares’and ‘takeoverof business’.With this,
the CapitalIssues (Control)Actwas repealed and the office of the Controller of Capital
Issues (CCl) was abolished in 1992. The SEBI Was set up with statutory powers on
February 21, 1992. The objectives defined by the ordinance for the board were: (i) investor
protection; and (ii) promotion and development of the capita! market while simultaneously
regulating the functioning of the securities market. The function of market development
includes containing risk, broad basing, maintaining market integrity and promoting long-
terminvestment.
The ordinance was repealed by the SEBI Act on April 4, 1992. The Securities and Exchange
Board of India Act, 1992, provides for the establishment of the board to: protect the
interest of the investors in securities, promote the development of and regulate the
securities market and matters connected therewith orincidentalto Certain powersunder
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certain sectionsof the SecuritiesContracts (Regulation) Act and the Companies Act were
delegated to the SEBI. The regulatory powers of the SEBI were increased through the
Securities Laws (Amendment) Ordinance of January 1995, which was
subsequentlyreplacedbyanactorparliament.TheSEBIworksundertheMinistryofFinance.Ithas

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been given a status of an independent organization regulating each and every aspect of
the securities market backed by a statute and accountable to the parliament
ManagementoftheSEBIUndertheSEBIAct,1992
Section 4 of the act laysdown the constitution of the management of the SEBI. The board
of members of the SEBI shall consist of a chairman, two members from amongst the
officials of the ministries of the central government dealing with finance and law; one
member from amongst the officials of the RBI constituted under Section 3 of the RBI Act,
1934; two other members to be appointed by the central government, who shall be
professionals and, inter alia, have experience or special knowledge relatingto the
securities market.
Figure11.1providesanoverviewofregulatorystructureoffinancialinstitutionsandmarkets.

REGULATORS

ReserveBan InsuranceRegulato Securities and State SIDBI NABRD

k of India ry and ExchangeBoardo Governmen
Development f India ts
Authority
UrbanCo- Rural
operative Banks Co-
Insurance Capital Market,
operative
Companies: Capitalmarket
Banks
Public Sector IntermediariesMut
Regional
and Private ual Funds, State Financial
Rural Banks
SectorLifean Including UTI II, Corporations State
d Non-life Venture Capital IndustrialDevelopm
Fits, Corporate ent Corporate
Bond Market,
Comedies Market

Commercial Urban State and AllIndia Non-banking Government Foreign

Banks Co-operative District Financial Finance Securities Exchang
e
Banks Central Institution Companie Marketan Market
Cooperativ s: IFCI, s d Money
e Banks IIBI, Cooperativ Market
Exix Bank e Including
TFCI,SIDBI, Primary
NABARD. Dealers,
and.NHB MFIs

PowersandFunctionsoftheSEBI
Section 11 (1) of the act casts upon the SEBI the duty to protect the interests of investors
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in securities and to promote the development of and to regulate the securitiesmarket
through appropriate measures. These measures provide for the following:
 Regulatingthebusinessinstockexchangesandanyothersecuritiesmarkets;

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  Registering and regulating the working of stock brokers, sub—brokers, share
transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue,
merchant bankers, underwriters portfolio managers, investment advisers and such
other intermediaries who maybe associated with securities markets in any manner,
 Registeringandregulatingtheworkingof thedepositories,participants,custodiansof
securities, foreign institutional investors, credit rating agencies and such other
intermediaries as the Board may, by notification, specify in this behalf;
 Registeringandregulatingtheworkingofventurecapitalfundsandcollectiveinvestments
chemes, including mutual funds:
 Promotingandregulatingself-regulatoryorganisations,
 Prohibitingfraudulentandunfairtradepracticesrelatingtosecuritiesmarkets;
 Promotinginvestors’educationandtrainingofintermediariesofsecuritiesmarkets;
 Prohibitinginsidertradinginsecurities;
 Regulatingsubstantialacquisitionofsharesandtakeoverofcompanies;
 Callingfor informationfrom, undertaking inspection, conducting inquiries andauditsof
the stock exchanges, mutual funds, other persons .associated with the securities
market, intermediaries and self-regulatory organisations in the securities market;
 Calling for information and records from any person including any bank or any other
authorityor boardorcorporationestablishedorconstituted by orunderany central,
orstate act which, in the. opinion of the Board, shallbe relevant to any investigation
or inquiry by the Board in respect of any transaction-in securities;-
 Calling for information from, or furnishing information to, other authorities, whether in
India or outside India, having functions similar to those of the Board, in the matters
relating to the prevention ordetection of violations in respect of securitieslaws,
subject to the provisionsof other laws for the time being in force in this regard.
 Provided that the Board, for the purpose of furnishing any information to any
authority outside India, may enter into an arrangement or agreement or
understanding with such authority withthe prior approval of the central government;
 Performing such functions and exercising such powers under the provisions of the
Securities Contracts ( Regulation) Act, 1956 (42 of 1956), as may be delegated to it
by the central government;
 Levyingfeesorotherchargesforcarryingoutthepurposesofthissection;
 Conductingresearchfortheabovepurposes;
 Calling from or furnishing to any such agencies, as may be specified by the Board,
such information as may be considered necessary by it for the efficient discharge of
itsfunctions.
 Performingsuchotherfunctionsasmaybeprescribed.
The SEBI exercises powers under Sections 11 and 11B of the SEBI Act, 1992, and 17 other
regula- tions. TheSEBI. with its powers, can carry out the following functions:
 Askanyintermediaryormarketparticipanttorinformation.
 Inspectbooksofdepositoryparticipants,issuersorbeneficiaryowners.

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  Suspendorcancelacertificateofregistrationgrantedtoadepositoryparticipantorissuer.
 RequesttheRBItoinspectbooksofabankertoanissue.Andsuspendorcancelthe
registration of the banker to an issue.
 Suspendorcancelcertificationissuedtothecustodianofsecurities.
 Suspendorcancelregistrationissuedtoforeigninstitutionalinvestors.
 Investigateandinspectbooksofaccountsandrecordsofinsiders.
 Investigateanacquirer,aseller,ormerchantbankerforviolatingtakeoverrules.
 Suspendorcanceltheregistrationofamerchantbanker.
 Investigatetheaffairsofmutualfunds,theirtrusteesandassetmanagementcompanies.
 Investigateanypersondealinginsecuritiesoncomplaintofcontraventionoftradingregulation
.
 Suspendorcanceltheregistrationoferrantportfoliomanagers;
 Cancelthecertificationofregistrarsandsharetransferagents.
 Cancel the certification of brokers who fail to furnish information of transactions in
securities or' who furnish false information.
REGULATIONSANDGUIDELINES ISSUEDBYTHESEBI
Regulations
 SEBI(StockBrokersandSubBrokers)Regulations, 1992.
 GuidancenotetoSEBI(ProhibitionofInsiderTrading)Regulations,2015.
 SEBI(MerchantBankers)Regulations,1992.
 SEBI(PortfolioManagers)regulations,1993.
 SEBI(RegistrarstoanIssueandShareTransferAgents)Regulations,1993.
 SEBI(Underwriters)Regulations,1993.
 SEBI(DebentureTrustees)Regulations,1993.
 SEBI(BankerstoanIssue)Regulations,1994.
 SEBI(ForeignPortfolioInvestors)Regulations,2014.
 SEBI(CustodianofSecurities)Regulations1996.
 SEBI(DepositoriesandParticipants)Regulations,1996.
 SEBI(MutualFoods)Regulations,1996.
 SEBI(SubstantialAcquisition-ofSharesandTakeovers)Regulations,1997.
 SEBI(BuybackofSecurities)Regulations,1998.
 SEBI(CreditRatingAgencies)Regulations,1999.
 SEBI(CollectiveInvestmentSchemes)Regulations,1999.
 SEBI(ForeignVentureCapitalInvestors)Regulations,2000.
 SEBI(ProcedureforBoardMeeting)Regulations,2001.

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  SEBI(IssueofSweatEquity)regulations.2002.
With a view to making markets more competitive and compliant, the SEBI brought in the
following new regulations:
 SEBI(ProhibitionofFraudulentandUnfairTradePracticesrelatingtoSecuritiesMarket)
Regulations, 2003.
 SEBI(Ombudsman)Regulations,2003.
 SEBI(CentralDatabaseforMarketParticipants)Regulations,2003.
 SEBI(SelfRegulatoryOrganizations)Regulations,2004.
 SEBI(IssueandListingofDebtSecuritiesbyMunicipalities)Regulations,2015.
 SEBI(ListingObligationsandDisclosureRequirements)Regulations,2015.
 SEBI(ProcedureforSearchandSeizure)RepealRegulations,2015.
 SEBI(InfrastructureInvestmentTrusts)Regulations,2014.
 SEBI(RealEstateInvestmentTrusts)Regulations,2014.
 SEBI(ResearchAnalysts)Regulations,2014.
 SEBI(SettlementofAdministrativeandCivilProceedings)Regulations,2014.
 SEBI(ShareBasedEmployeeBenefits)Regulations.2014.
 SEBI(InvestmentAdvisers)Regulations,2013.
 SEBI(IssueAndListingOfNon-ConvertibleRedeemablePreferenceShares)Regulations,
2013,
 SEBI(AlternativeInvestmentFunds)Regulations,2012.
 SecuritiesContracts(Regulation)
(StockExchangesandClearingCorporations)Regulations, 2012.
 SEBI{KYC(KnowYourChent)RegistrationAgency}Regulations,2011.
 SEBI(DelistingofEquityShares)Regulations,2009.
 SEBI(InvestorProtectionandEducationFund)Regulations,2009.
 SEBI(IssueofCapitalandDisclosureRequirements)Regulations,2009.
 *SEBI(Intermediaries)Regulations,2008.
 SEBI(IssueandListingofDebtSecurities)Regulations,2008.
 SEBI(PublicOfferandListingofSecuritisedDebtInstruments)Regulations,2008.
 SEBI(CertificationofAssociatedPersonsintheSecuritiesMarkets)Regulations,2007.
 SEBI(Regulator)FeeonStockExchanges)Regulations,2006.
Asameasureof regulatoryproductiveness,theexistingregulationsarefrequently
reviewedand amendments notified. Regulations are superior to guidelines as the former have
a stronger legal force.
Regulations are passed by the SEBI, tabled in the Parliament and are subject to explicit
penalties and remedial actions.

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Guidelines
• Guidelinesforopeningoftradingterminalsabroad.
• GuidelinesforAnti-moneylaunderingmeasures.
• SEBI(EmployeeStockOptionSchemeandEmployeeStockPurchaseScheme)Guidelines1999.
• Framework for recognition and supervision of stock exchanges/platforms of stock
exchanges forsmall and medium enterprises.
• SEBI(AidforLegalProceedings)Guidelines,2009.
• SEBI(InternationalFinancialServicesCentres)Guidelines,2015.
The orders of the SEBI under the securities laws are appealable before a securities
appellate tribunal. (SAT) the body that hears appeals against the SEBI’s orders. The orders
of the SAT are appealable before the high court or the Supreme Court.
An order passed by the SEBI against market participants such as brokers, custodians,
depositories, or mutual funds can be challenged before the SAT. The market participants
can move the high court orthe Supreme Court if they are not happy with the SAT order.
The entire process can takeyears beforea case is finally resolved. There is a provision for
out-of-court settlements in the SEBI guidelines. The out-of-court settlement system
attempts to resolve administrative, civil, and criminal disputes with the consent of the
involved parties and the SEBI. This system saves time, efforts and money of both the
involved parties and the regulator as they do not have to go through long range of legal
proceedings.
Under SEBI guidelines,-the proposal to settle a dispute is first placed before a high-
powered advisory committee of the regulator. If the proposal gets the committee’s
approval, the terms of settlement are drafted and orders are passed by a panel of tub
whole-time directors of the SEBI after the cause and nature of violation is established. The
panel normally imposes penalty on the offenders and can also temporarily suspend a
market participant. If a case is pending before the SAT, the committee files the terms of
settlement before the tribunal. It is mandatory for the accused to give an undertaking to
the regulatordialitwillrefrainfromtakinganylegalactionagainstit.If
theaccusedviolatesanyconditionof the settlement, the regulator can revive its legal action.
REGULATIONOFTHESECURITIESMARKET
TheSEBIhaspowerstoregisterandregulateallmarketintermediaries.TheSEBIhaspowerspenalize
themincaseofviolationsoftheprevisionsoftheact,rulesandregulationsmadethereunder.
Itcanconductenquiries,audits,andinspection ofallmarketintermediariesandadjudicate offences
under the SEBI Act, 1992.
The SEBI registers and regulates the intermediaries in the primary market. Some of the
major inter- mediaries it regulates are merchant bankers, underwriters, bankers to an
issue, registrars to an issue and share transfer agents and debenture trustees. The SEBI
registers and regulates various. intermediaries in the secondary market such as brokers,
subbrokers, stock exchanges, foreign institutional investors (FTIs) custodians, depositories,
mutual funds, and venture capital funds.
NEEDFORFINANCIAL REFORMS
The need for financial reforms had arisen because the financial institutions and markets
were in a bad shape. Thebanking sectorsufferedfromlack of competition, lowcapitalbase,
lowproductivityandhigh intermediation costs. The role of technology was minimal and the
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quality of service did not receive adequate attention. Proper risk management system was
not followed and prudential norms wereweak. All these resulted in poor assets quality.
Development financial institutions operated in a over-
protectedenvironmentwithmostofthefundingcomingfromassuredsources.Therewaslittle

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competition in insurance and mutual funds industries. Financial markets were
characterised by control over pricing of financial assets, barriers to entry and high
transactions costs. The banks were running either at a loss or on very low profits and
consequently were unable to provide adequately for loan defaults and build their capital.
There had been organisational inadequacies the weakening of management and control
functions, the growth of restrictive practices, the erosion of work culture and flaws in
credit management. The strain on the performance of the banks had emanated party from
the imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and
directed credit programmes forthe priority sector-allat belowmarket or concessionalor
subsidised interest rates. This apart from affecting bank profitability adversely, had
resulted in the low or repressed or depressed interest rates on deposits and in higher
interest rates on loans to the larger borrowers from business and industry.
Thephenomenon of cross-subsidisationhadgotbuilt into thesystem where concessional
rates provided to some sectors were compensated by higher rates charged to non-
concessional borrowers.
Further, the functioning of the financial system and the credit delivery as well as recovery
process had decode profoinocised which damaged the quality of lending and the culture of
repaying loans. The widespread or across the board write 0ffs of the loans had seriously
jeopardised the viability of banks. As the closure of sick industrial units was discouraged
by the government, banks had to continue to finance non-viable sick units. This further
compromised their own viability. The legal system was not of much help in recovering
loans. There was a lack of transparency in preparing statements of accounts by banks.
In order words, the reforms had become imperative on account of the facts that despite its
impressive quantitative growth and achievements, the financial health, integrity,
autonomy, flexibility and vibrancy in the financial sector had deteriorated over the past
many years. The allocation of resources had become severely distorted the portfolio
quality had deteriorated and productivity, efficiency and profitability had been eroded in
the system. Customer service was poor, work technology remained outdated and
transaction costswere high. The capitalbaseof the system remained low, theaccounting
and disclosure practices were faulty, and the administrative expenses had greatly soared.
The system suffered also from a lack of delegation of authority, inadequate internal
controls and poorhousekeeping.
It was felt by many that all this was the consequence of policy-induced rigidities of
excessive degree of centralisedadministrativedirectionof
investments,creditallocationsandinternalmanagementofbanks and financial institutions
massive branch expansion, overstaffing and union pressures and excessive political
intervention interference and pressures.
For a long time an alarming increase of sickness in the Indian financial system had
required urgent remedial measures or reforms which were ultimately introduced in 1991.
The key words describing reforms have beers liberalisation, deregulation, marketisation,
privatisation, and globalisation, all of which convey reforms objectives in a succinct
manner. The basic proxies underlying the reforms has been that the state ownership and
regulation have harmed the financial system, particularly the banks and the investors, and
that such regulation is no longer relevant and adequate. To use the well-known academic
terminology, the objective of financial reforms has been to correct and eliminate financial
repression; and so transform a financially repressed system into a free system. At the
same time, it has been held that the deregulation does not imply total absence of
regulation; instead, it assumes sophisticated form of prudential, supervisory structure

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which would “protect the financial system without unnecessarily restraining it”. The
reforms are said to be directed towards “stringent prudential regulation” in a “deregulated
environment”.
Financial sector reforms are said to be grounded in the belief that the competitive
efficiency in the real sectors of the economy cannot be realized so it’s full extent unless
the locative efficiency of the private
sectorwasimproved.Themainthrustoffinancialsectorreformswasonthecreationofefficientand

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stable financialinstitutionsand markets, the removal if structuralbottlenecks, introduction
of new player and instruments, introduction of free pricing of financial assets, relaxation of
quantitative restrictions, improvement in trading, clearing, and settlement practices,
promotion of institutional infrastructure, refinement of market micro-structure, creation of
liquidity, depth, and the efficient price discovery process, and ensuring technological up
gradation.
The approach or strategy of reforms has been such that they are being effected by
adapting the old institutions in the new tasks and ethos. A careful attempt has been made
at crisis-avoidance and at creating an environment' which promotes greater efficiency in
the delivery of financial services. The financial sector reforms have been operating in
conjunction with a larger set of goals relating to eco- nomic stability and growth. The
reforms have been introduced at a gradual pace combined witheffective and appropriate
regulation and intervention policy. Effortshave also been made to fulfil (meet) the
“commandments” (prerequisites) of financial sector reforms, namely, carrying out a
macro- economic stabilisation programme, introducing supportive fiscal and external
sector policies, and implementing wide-ranging reforms in oilier sectors simultaneously.
MAJORREFORMSAFTER1991
The reforms have had a broad sweep encompassing operational matters, banking, primary
and secondary stock markets, government securities market, external sector policies, and
the system as a whole. Some people have classified them into three areas: issues relating
to creating a resilientbanking system; development of institutions such as private sector
banks and mutual funds; and monetary policy instruments such as interest rates, reserve
ratios, and refinancing facilities. In other words, reforms relate to the issues of ownership
and control, competition, and policy and regulation stance.
While presenting a list of reforms, it needs u» be pointed out that sometimes a distinction
between normal policy changes which are specific to tune and economic conditions, and
reforms proper is not maintained: the former are included in the latter, which makes the
list of reforms unduly and unmanageably long. To reforms meansto make (improve)
orbecome better bythe removal of faults or errors or abuses. It is primarily in this sense
that the major reforms are listed below in terms of certain categories.
(i) SystemicPolicyReforms
 Most of the interest rates in the economy deregulated; a beginning made to move
towards market rates on government securities; the system of administered interest
rates largely dismantled; and the structure of interest, rates greatly simplified.
 The pre-emption of banks’ resources through SLR in favour of the government was
brought down and the rate of return on SLR securities is maintained by and large at
market rates. The SLR on incremental net domestic and time liabilities (NDTL) of
banks reduced from 38.5 per cent in 1991-92 to 25 per cent now.
 The incremental CRR of 10 per cent removed, and the average CRR reduced from !5
per centin 1991-92 to !0 per cent in 1995-96. The CRR of FCNR (B) and NRNR
deposit accounts removed. The CRRon NREdeposits outstanding as on27.10.1995
reducedfrom14percent to 10 per cent and the CRR on an increase in NRE deposits
removed.
 Capital adequacy norms for banks, financial institutions, and virtually all market
intermediaries introduced. The Basie Committee framework for capital adequacy
adopted.

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 A Board of Financial Supervision (BPS) with an advisory council and an
independentdepartment of supervision established in RBI. It would supervise, apart
from banks, all-India financialinstitutionsandnon-
bankingfinancialcompaniesfromApril-July1995-Anew

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8
Supervisory Reporting System, introduced in February 1995, will focus attention on
criticalareas such as capital adequacy, assets quality, management, earnings, and
liquidity.
 Recovery of Debts Due to Banks and Financial Institutions Act, 1993 passed to set
up Special Recovery Tribunals to facilitate quicker recovery of loan arrears.
 In order to moderate or minimise the automatic monetisation of the budget deficit,
theagreement to impose a ceiling on the issue of ad hoc Treasury' Bills (TBs) and to
phase them out in due course signed by the Government of India (GOI) and RBI in
September 1994. Sub- sequently, the system of ad hoc treasury bills abolished and
replaced by the system of waysand means advances effective April 1, 1997.
 The private sector allowed to set up banks, mutual funds, money market mutual
funds,
insurancecompanies,etc.,publicsectorbankspermitteddiversifiedownershipbylawsubj
ectto
51 per cent holding of government/RBI. SBI, IFCI and IRBI converted into public limited
companies. The Industrial Development Bank of India Act, 1964 amended to allow
IDBI to raise capital up to 49 per cent of its paid-up capital from the public and to
induct private participationin its Board of Directors. The policy of permitting foreign
banks to open branches liberalised.
 Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital
Issues abolished.
 Securities and Exchange Board of India (SEBI) made a statutory body in February
1992 and armed with necessary authority and powers for regulation and reform of
the capital market.
 Convertibilityclauseisnolongerobligatoryinthecaseof
assistancesanctionedbytermlending institutions.
 Floating interest rate on financial assistance (linked to interest rate on 364-day TBs)
introduced by all-India development banks.
 The Reserve Bank of India (Amendment) Act 1997 passed requiring all non-bank
financial companies (NBFCs) with net-owned funds of Rs.25 lakh and more to
register with the RBL
 Over the Counter Exchange of India (OTCEI) and the National Stock Exchange (NSE)
with nationwide stock trading and electronic display, clearing and settlement
facilities establishedand made operational.
 Twin objectives of “maintaining price stability” and “ensuring availability of
adequate credit to
productivesectorsoftheeconomytosupportgrowth”continuetogovernthestanceof
monetary policy, though the relative emphasis on these objectives has varied
depending on the importance of maintaining an appropriate balance.
 Reflecting the increasing development or financial market and greater liberalisation,
use of broad money as an intermediate target has been de-emphasised and a
multiple indicator approach has been adopted.
 Emphasis has been put on development of multiple instruments to transmit liquidity
and interest rate signals in the short-term m a flexible and bi-directional manner.
 Interlink age between various segments of the financial market including money,
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9
 government security and force markets instruments has increased.
 There has been a move from direct instruments (such as, administered interest
rates, reserve requirements, selective credit control) to indirect instruments (such
as, open market operations, purchase and repurchase of government securities) for
the conduct of monetary policy.

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0
  Liquidity adjustment facility (LAF) has been introduced, which operates through
repo and reverse repo auctions, effectively provide a corridor for short-term interest
rate. LAF has emerged as the tool for both liquidity management and also as a
signalling devise for interest rate in the overnight market.
 Use of open market operations are used to dealwith overall market liquidity
situation especially those emanating from capital flows.
 There has been introduction of Market Stabilisation Scheme (MSS) as an additional
instrument to deal with enduring capital inflows without affecting short-term
liquidity management role of LAF.
 Automatic monetisation has been discontinued through an agreement between the
government and the Reserve Bank.
 Introductionofdeliveryversuspaymentsystemanddeepeningofinter-bankrepomarket.
 Primary dealers are introduced in the government securities market to play the role
of market
maker.SecuritiesContractsRegulationAct(SCRA),hasbeenamendedtocreatetheregulat
ory framework.
 Government securities market has been deepened by making the interest rates on
such securities market related.
 Auctionofgovernmentsecuritieshasbeenintroduced.
 Arisk-freecredibleyield curvehas been developedinthe government securities
market as a benchmark for related markets.
 Apureinter-bankcallmoneymarkethasbeen developed.
 Non-bankparticipantsareallowedtoparticipateinothermoneymarketinstruments.
 Automatedscreen-basedtradingingovernmentsecuritieshasbeenintroducedthrough
negotiated dealing system (NDS).
 Settingupofrisk-freepaymentsandsystemingovernmentsecuritiesthroughClearing
Corporation of India Limited (CCIL).
 TherehasbeenPhasedintroductionofrealtimegrosssettlement(RTGS)system.
 Forexmarkethasbeendeepenedandautonomyofauthoriseddealershasincreased.
 Technical advisory committee on monetary policy with outside experts has been set
up toreview macroeconomic and monetary developments and advise the Reserve
Bank on the Stance of Monetary Policy.
 AseparatefinancialmarketdepartmentwithintheRBIhasbeencreated.
(ii) BankingReforms
 Interest rates on deposits and advances of ail co-operative banks including urban
co-operative banks deregulated. Similarly interest rates on commercial bank loans
above Rs. 2 lakh, and or, domestic term depositsabove two years, and Non Resident
(External) Rupee Accounts[NRNR] depositsdecontrolled. The numberof administered
interest rateson commercialbankadvances reduced from more than 20 in 1989-90
to 2 in 1994-95. Banks allowed to set their own interest rate on post-shipment
export credit in rupees for over 90 days.
 The State Bank of India and other nationalised banks enabled to access the capital
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1
market for debt and equity.

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2
 Prudential norms for income recognition, classification of assets and provisioning for
bad debts for commercial banks, including regional rural banks and financial
institutions introduced. They are required to adopt uniform and sound accounting
practices in respect of these matters, and the valuation of investments. Banks are
required to mark to market the securities held by them.
 The Performance Obligations and Commitments (PQ & C) obtained by RBI from each
bank;they provide tor essential quantifiable performance parameters which lay
emphasis onincreased but low-cost deposits, quality lending, generation of more
income and profits, compliance withpriority; sectorsandexport lending
requirements, improvement in the qualityof investments, reduction in expenditure,
and stepping up of staff productivity. The PO & C are meant to ensure a high level of
portfolio qualify so that problems such as heavy losses, low profits, erosion of equity
do not recur. The non-fulfilment of PO & C entail penalty in the form of higher
CRR/SLR, stoppage of RBI refinance facility, stoppage of further capital contribution
by the government, etc.
 Banks required to make their balance sheets fully transparent and make full
disclosures in keeping with International Accounts Standards Committee.
 Banks given greater freedom to open, shift, and swap branches as also to open
extension counters.
 Theperceivedconstraintsonbanks suchaspriorcreditauthorisation, inventoryand
receivables norms, obligatory' consortium lending and curbs in respect of project
finance relaxed.
 Thebudgetarysupportextendedforrecapitalisationofweakpublicsectorbanks.
 BankingOmbudsmanScheme1995introducedtoappoint15ombudsmen(byRBI)tolookinto
 Publand resolve customers' grievances in a quick and inexpensive manner. Most of
the recommendations of Goiporia Committee in connection with improving
customer service by banks implemented.
 BankssetfreetofixtheirownforeignexchangeopenpositionlimitsubjecttoRBIapproval.
 Loan system introduced for delivery of bank credit. Banks required to bifurcate the
maximum permissible bank finance into loan component (short-term working
capital loan) and cash credit component, and the policy of progressively increasing
the share of the former introduced.
 Operationalautonomyhasbeengrantedtopublicsectorbanks.
 Public ownership in public sector banks are reduced by allowing them to raise
capital fromequity market up to 49 per cent of paid-up capital.
 Transparent norms have been issued for entry of Indian private sector,foreign and
joint-venture banks and insurance companies, permission for foreign investment in
the financial sector in the form of foreign direct investment (FDI) as well as portfolio
investment, permission to banks to diversify product portfolio and business
activities.
 Roadmap has been developed for presence of foreign banks and guidelines an
issued for mergers and amalgamation of private sector banks and banks and NBFCs.
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3
 Guidelinesonownershipandgovernanceinprivatesectorbanksaredeveloped.
 Sharp reductioninpre-
emptionthroughreserverequirement,marketdeterminedpricingforgov-

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4
ernment securities, disbanding of administered interest rates with a few exceptions and
enhanced transparency and disclosure norms to facilitate market discipline.
 Introduction of pure inter-bank call money market, auction-based repos-reverse
repos for short term liquidity management, facilitation of improved payments and
settlement mechanism.
 Significant advancement in dematerialisation and markets for securitised assets are
being developed.
 Introduction and phased implementation of international best practices and norms
on risk- weighted capital adequacy requirement, accounting, income recognition,
provisioning and exposure.
 Measures to strengthen risk management through recognition of different
components of risk, assignment of risk-weights to various asset classes, norms on
connected lending, risk concentration, application of marked-to-market principle for
investment portfolio and limits on deployment of hind in sensitive activities.
 ‘Know Your Customer’ and ‘Anti Money Laundering’ guidelines, roadmap Sat Basel II
introduc- tion of capital charge for market risk higher graded provisioning for NPAs,
guidelines for owner- ship and governance, securitisation and debt restructuring
mechanisms norms etc.
 Setting up of lok adalats (people’s courts), debt recovery tribunals, asset
recommuction companies, settlement advisory committees, corporate debt
restructuring mechanism, etc. for quicker recovery/restructuring.
 Promulgation of Securitisation and Reconstruction of Financial Assets and
Enforcement of Securities Interest (SARFAESI) Act, 2002 and its subsequent
amendment to ensure creditor rights.
 Setting up of Credit Information Bureau of India Limited (CIBIL) for information
sharing on defaulters as also other borrowers.
 Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter
party for facilitating payments and settlement system relating to fixed income
securities and money market instruments.
 Establishment of the board for financial supervision as the apex supervisory
authority for commercial banks, financial institutions and non-banking financial
companies.
 Introduction of CAMELS supervisory rating system, move towards risk-based
supervision, con- solidated supervision of financial conglomerates, strengthening of
offsite surveillance through control returns.
 Recasting of the role of statutory auditors, increased internal control through
strengthening of internal audit.
 Strengtheningcorporategovernance,enhancedduediligenceonimportantshareholders
,fitand proper tests for directors.
 Setting up of INFINET as the communication backbone for the financial sector,
introduction of negotiated dealing system (NDS) foe screen-based trading in

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5
government securities and real time gross settlement (RTGS) system.

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6
(iii) PrimaryandSecondaryStockMarket Reforms
 A norm of five shareholders for every Rs.1 lakh of freshissues of capital and to
shareholders for every Rs 1 lakh of offer for sale prescribed as an initial and
continuing listing requirement.
 Thepaymentofanydirectorindirectdiscountsorcommissionstopersonsreceivingfirm
allotment prohibited.
 Debt issuesnot accompanied byan equity component permitted to be
soldentirelybythe book- building process.
 Housing finance companies considered to be registered for issue purposes, provided
they are eligible for refinance from the National Housing Bank
 Issuersallowedtolistdebtsecuritiesonstockexchangeswithouttheirequitybeinglisted.
 Mutualfundspermittedtounderwritepublicissues.
 The stock exchanges required to disclose, carry forward position scrip-wise and
broker-wise at the beginning of airy forward session.
 A ceiling of Rs 10 crore imposed on stock market members doing business of
financing carry forward transactions.
 Depositories Act, 1996 passed to provide a legal framework for the establishment of
depositories to record ownership details in bookentryform, and to facilitate
dematerialisation of securities. The Depositories Related Laws (Amendment), 1997
issued through an Ordinancewill now allow banks, mutual funds and IDBI to
dematerialise their scrips.
 Stock lending scheme without attracting capital gains introduced. Under this
scheme, short sellers can borrow securities through an intermediary before making
such sales.
 Stock exchanges asked to modify listing agreements in order to provide for the
payment of interest by companies to investors from the 30th day of the closure of
public issue
 Allstockexchangesrequiredtoinstitutethebuy-inorauctionprocess
 Stockexchangesasked to collect 100 per cent daily margin ; cr. the notionallossof a
brokerfor every scrip, to restrict gross traded value to 33.33 times the broker’s base
minimumcapital, and to impose quarterly margins on the basis of concentration
ratios.
 The stock exchanges are being modernised; many of them have introduced
electronic trading system; the Bombay Stock Exchange has started its on-line
trading system, BOLT.
 The Bombay Stock Exchange and other exchanges with screen-based trading
system allowedto expand their trading terminals to locations where no stock
exchange exists, and to others subject to an understanding with the local stock
exchange.
 Both short and long sales are required to be disclosed to the exchange at the end of

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7
 each day, and they are to be regulated through the imposition of margins.
 There are many other stock market reforms which have been introduced during the
past five to six years. The important ones among them are listed in Chapter 7.
 SEBIframed guidelines relating to disclosure of grading of the Initial publicoffer (IPO)
by issuer
companieswhomaywanttooptforgradingoftheirIPOsbytheratingagencies.Iftheissuer

20
8
companies opt for grading, then they are required to disclose the grades, including the
unaccepted ones, in the prospectus.
 SEBI issued directions for the issuing companies, relating to qualified institutions’
placement, to pave the path for a fast and cost-effective way of raising resources
from Indian securitiesmarket.
 In order to further strengthen Know- Your Client (KYC) norms in the cash market and
to generate a reliable audit trail, PAN was made mandatory for all transactions in
the cash market with effect from January 01. 2007.
 PAN was made mandatory for all demat accounts, opened after April 01, 2006,
pertaining to all categories including minors, trusts, foreign corporate bothes,
banks, corporates. FIIs, and NRIs For demat accounts that existed prior to April 01,
2006, time for furnishing and verification of PAN card details was extended upto
December 31. 2006.
 Procedure for re-introductionof derivatives contracts and modified position limits
were reviewed by the Secondary Market Advisory Committee (SMAC). Further,
based on a decision taken by SEB1 board, Derivatives Market Review Committee
was set up to carry out a comprehensive review of developments and to suggest
future directions for derivatives market in India.
 The investment limit for Fills to government securities (including treasury bills)
wasraised from , USD 2 billion to USD 2.6 billion by RBI. Tire list of eligible
investment categories of Fills was enlarged to allow more participation in Indian
securities market
 SEBI Board approved the draftguidelines for real estate mutual funds (REMFs). REMF
meansa schemeof a mutualfund which hasinvestment,objectivesto
investdirectlyorindirectlyin real estate property and shall be governed by the
provisions and guidelines under SEBI (Mutual Funds) Regulations.
(iv) GovernmentSecuritiesMarketReforms
 A364-daytreasurybill(TB)replacedthe182-dayTBin1992-93,anditisbeingsoldby
fortnightly auction since April 1992.
 Auctionof91-dayTBcommencedfromJanuary1993.
 Maturity period for new issues of Central government securities shortened from 20
to 10 years and that for state government securities from 15 to 16 years.
 Funding ofAuctionTBs into fixedcoupon dated securities at the option of holders
introducedsince April 19, 1993.
 Sixnewinstrumentsintroduced:(a)zerocouponbondson18.1.94,(b)tapstockon29.7.94,
(c) partly-paid government stock on 15.11.94, (d) an instrument combining the features of
tap and partly-paid stocks on 11-9-95, (e) floating rate bonds on 29.9.95, and (f)
capital indexed bonds in 1997.
 State governments and provident funds allowed to participate in 9i-day TB auctions
on a non- competitive basis from August 1994.
 A scheme for auction of government securities from RBI’s own portfolio as a part of
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9
its open market operations announced to March 1995.

21
0
 Theinstitutionofprimarydealerstogovernmentsecuritiesmarketestablishedandguideli
nesfor them issued in March 1995.
 A systemof Delivery vs. Payment (DVP) in Subsidiary GeneralLedger
(SGL)transactionsintro- duced in Bombay in July 1995.
 ReverserepofacilitywithRBItogovernmentdatedsecuritiesextendedtoDiscountandFina
nce House of India (DFHI) and Securities Trading Corporation of India (STCI).
 Administeredinterest rates on government securities werereplaced by an auction
system farprice discovery.
 Automatic monetisationoffiscal deficitthroughtoeissueofadhoc treasury billswas
phased out.
 Primarydealers(PD)wereintroducedasmarketmakersinthegovernmentsecuritiesmarket.
 Forensuringtransparencyinthetradingofgovernmentsecurities,deliveryversuspaymen
t (DvP) settlement system was introduced.
 Repurchaseagreement(repo)wasintroducedasatoolofshort-termliquidityadjustment.
 Subsequently, the liquidity adjustment facility (LAF) was introduced. LAF operates
through repo and reverse repo auctions and provide a corridor for short-term
interest rate. LAF has emerged as the tool for both liquidity management and also
signalling device for interest rates in the overnight market. The Second LAF (SLAF)
was introduced in November 2005.
 Market stabilisation scheme (MSS) has been introduced, which has expanded the
instruments available to the Reserve Bank for managing the enduring surplus
liquidity in the system.
 Effective April 1, 2006, RBI has withdrawn from participating in primary market
auctions of government paper.
 Banks have been permitted to undertake primary dealer business while primary
dealers are being allowed to diversify their business.
 Short sales in government securities is being permitted in a calibrated manner while
guidelines for "when issued’ market have been issued recently.
 91-day treasury bill was introduced for managing liquidity and benchmarking. Zero
coupon bonds, floating rate Bonds, capital indexed bonds were issued and
exchange traded interestrate futures were introduced. OTC interest rate derivatives
like IRS/ FRAs were introduced.
 Outright sale of Central Government dated security that are not owned have been
permitted. subject to the same being covered by outright purchase from the
secondary market within the same trading day subject to certain conditions.
 Repo status has been granted to State Government securities in order to improve
secondary market liquidity.
 Foreign Institutional Investors (Fills) were allowed to invest in government securities
subject to certain limits.
 Introduction of automated screen-based trading in government securities through

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1
negotiated dealing system (NDS).

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2
  Settingupofrisk-
freepaymentsandsettlementsystemingovernmentsecuritiesthroughClearing
Corporation of India Limited (CCIL).
 Phasedintroductionof reallimegrosssettlementsystem(RTGS).
 Introduction of trading in government securities on stock exchanges for promoting,
retailing insuch securities, permitting non-banks to participate in repo market.
 RecentmeasuresincludeintroductionofNDS-OMandT+1settlementnorms.
(v) ExternalFinancialMarketReforms
 Flexibleexchangeratesystemintroducedandexchangecontrolslargelydismantled.
 Foreign Institutional Investors (Fils) allowed access to Indian capital market on
registration with SEBI. Fils permitted to invest up to 10 per cent in equity of any
company, to invest in unlisted companies, to set up pure (100 per cent) debt funds,
and to invest in government securities. Foreign endowment funds, university funds,
foundations and charitable trusts/societies are allowed to register as Fils.
 Indian companies permitted to access international capital markets through various
instruments including euro-equity issues.
 The Union Budget 1997-98 proposed the replacement of Foreign Exchange
Regulation Act (FERAV 1972 by a Foreign Exchange Management Act (FEMA) to
facilitate easy capital flows.
 Rupee made convertible on current account and a considerable progress made in
introducing capital account convertibility.
 The rate of long-term capital gains tax on portfolio investments by NRIs reduced
from 20 per cent to 10 per cent and brought on par with the rate for Fils.
 NRIs, OCBs Fils permitted to invest up to 24 per cent in equities of Indian companies
engaged in all activities except those of agriculture and plantation.
In case of medium and long-term external commercial borrowings (ECBs), on

lending or the proceeds of development finance institutions to different borrowers
at different immaturities permuted. All corporates, institutions, railways,
telecommunications permitted to utilise the foreign currency proceeds upto US $3
million for incurring roper expenditure with a minimum simple maturity of 3 years.
Telecommunications and oil exploration; and development(excluding refining
companies permitted to raise ECBs at a minimum of 5 years averagematurity
instead of 7 years even for borrowings exceeding US $15 million equivalent
Exporters permitted to raise ECB for wasting project-related rupee expenditure upto
the equivalent ofUS
$15 million, or the average; annual exports of the previous three years, whichever is
fewer. All infrastructure and greenfield projects permitted to avail of ECBs to the
extent of 35 precent of project cost (50 per cent for telecommunication sector).
 Companiespermitted to retaineuro-issueproceedsasforeign currencydepositswith
banksand public financial institutions in India. Further, companies permitted to remit
funds into India in anticipation of the use of funds for general corporate
restructuring and working capital needs. Euro issues are now treated as direct

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3
foreign investment in the issuing companies. Restrictions on the number of issues to
be floated by a company or group of companies in a given year moved. Banks,
financial institutions, NBFCs registered with the RBI made eligible for GDRissue,
without reference to the end-use.

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4
  RBI made a single-window agency for receipt and disposal of proposals for overseas
investments by Indian companies.
 The Foreign Investment Promotion Board (EIPB) reconstituted and Foreign
Investment Promotion Council (FIPC) set up to promote foreign direct investment in
India.
 Evolutionof exchange rateregimefroma single-currencychangeratesystemtofixingthe
value of rupee against a basket of currencies and further to market-determined
floating exchange rate regime.
 Adoptionof convertibilityof rupeeforcurrentaccounttransactionswithacceptanceof
ArticleVIII of the Articles of Agreement of the IMF. De Facto full capital account
convertibility for non residentsandcalibrated liberalisationof
transactionsundertakenfor capitalaccount purposes in the case of residents
 Developmentofrupee-foreigncurrencyswapsmarket.
 Introductionofadditionalhedginginstruments,suchas,foreigncurrency-rupeeoptions.
 Authorised dealers permitted to use innovative products like cross-currency options;
interestrate swaps (IRS) and currency swaps, caps/coilars and forward rate
agreements (FRAs) in the international forex market.
 Authorised dealers permitted to initiate trading positions, borrow and invest in
overseas; market subject to certain specifications and ratification by respective
Banks’ Boards. Banks are also permitted to fix interest rates on non-resident
deposits. subject to certain specifications, use derivative products forasset-liability
management and fix overnight open position limits and gap limits in the foreign
exchange market, subject to ratification by RBI.
 Permission to various participants in foe foreign exchange market, including
exporters. Indians investing abroad. Fils, to avail forward cover and enter into swap
transactions without any limit subject to genuine underlying exposure.
 Fils and NRIs permitted to trade in exchange-traded derivative contracts subject to
certain conditions.
 Foreign exchange earners permitted to maintain foreign currency accounts.
Residents are permitted to open such accounts within the general limit of US $
25.000 per year.
SELFASSESSMENT EXERCISE
1. Whatdoyou meanby‘Capital Market’?
2. Define‘SEBI’.
3. Whatis‘FinancialReforms’?
SUMMARY
SEBI plays an important role in regulating all the players operating in the Indian capital markets.

21
5
It attempts to protect the interest of investors and aims at developing the capital markets
by enforcing
variousrulesandregulations.SEBIisastatutoryregulatorybodyestablishedonthe12thofApril,19
92.

21
6
It monitorsand regulatesthe Indian capitaland securities market while ensuring to protect
the interests of the investors formulating regulations and guidelines to be adhered to. The
head office of SEBI is in Bandra Kurla Complex, Mumbai. SEBI has a corporate framework
comprising various departments each managed by a department head. There are about
20+ departments under SEBI. Some of these departments are corporation finance,
economic and policy analysis, debt and hybrid securities, enforcement, human resources,
investment management, commodity derivatives market regulation, legal affairs, and
more.
GLOSSARY
Capital: Capitalisa large sumof moneywhich you use to starta business,orwhich you invest
in order to make more money. Capital is the part of an amount of money borrowed or
invested which does not include interest.
Debt security: Debt security refers to money borrowed that must be repaid that has a fixed
amount, a maturity date(s), and usually a specific rate of interest. Some debt securities
are discounted in the original purchase price. Examples of debt securities are treasury
bills, bonds and commercial paper.
Security: Security is any proof of ownership or debt that has been assigned a value and
may be sold. For the holder, a security represents an investment as an owner, creditor or
rights to ownership on which the person hopes to gain profit. Examples are stocks, bonds
and options.
Securities Exchange Board of India (SEBI): Securities Exchange Board of India (SEBI) is a
regulatory authority, for the investment market in India. Its main objective is to protect the
interests of the investors in the new issue market and stock exchange and to regulate,
develop and improve the quality of the securities market in India.
Security Value: Security Value means the monetary value placed on security by a lender in
determining the extent to which it can make loans against such security.
ANSWERSTOSELFASSESSMENTEXERCISE
1. ReferstoSection 11.1
2. ReferstoSection11.2
3. ReferstoSection11.5
TERMINALQUESTIONS
1. What are the guidelines issued by securities exchange board of India with regard to
the capital market?
2. DiscusstheneedforfinancialreformsinIndia.
3. Describethemajorreformsinfinancialsectorafter1991.
ANSWERSTOTERMINALQUESTIONS
1. ReferstoSection11.1& 11.2
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2. ReferstoSection11.5
3. ReferstoSection11.6

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 SUGGESTED READINGS
1. PathakBharati(2018).IndianFinancialSystem.PearsonEducation;Fifthedition.
2. GomezClifford(2008).Financial Markets,InstitutionsandFinancialServices.Prentice
Hall of India,
3. MeirKohn(2013).FinancialInstitutionsandMarkets.OxfordUniversityPress
4. RajeshKothari(2012).FinancialServicesinIndia:ConceptandApplication.Sage
publications, New Delhi.
5. MadhuVij&SwatiDhawan(2000).MerchantBankingandFinancialServices.Jain Book
Agency, Mumbai.

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Assignment:
Attempt75%ofthe assignment
1. Whatdoyouunderstandbythefinancialsystem?Discussitsfunctions?

2. ExplaintheworkingofstockmarketinIndia.

3. Whatiscommercialbanking?Discussthegrowthandstructureof banking?

4. DiscusstheSEBI'sregulatoryprovisionsforMutualFunds.

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