BANKING AND INDIAN FINANCIAL SYSTEMS

OBJECTIVES:
 To get an insight into the constitutions, structure, objectives and working of the Banking
Institutions in India.
 To evaluate the performance of Banking Institutions and their contribution to the
growth of Indian Corporate Sector.
 To have a Bird’s view of the Indian Financial System and in the context of Global Indian
Banking System.
UNIT 1
BANKING SYSTEMS: Definitions- Functions- Types- Central Banking – Structureof Banking
System- Rural Financing- Banker and Customer Relationship – DepositMobilization- Loans and
Advances- Assets and Liabilities Management- SecuredAdvances- Endorsement and Crossing of
Cheques- Payment of Cheques- Collection ofCheques.
BANKING SYSTEMS
A bank is a financial institution that provides banking and other financial services to
their customers. A bank is generally understood as an institution which provides fundamental
banking services such as accepting deposits and providing loans. There are also nonbanking
institutions that provide certain banking services without meeting the legal definition of a bank.
Banks are a subset of the financial services industry.
A banking system also referred as a system provided by the bank which offers cash
management services for customers, reporting the transactions of their accounts and
portfolios, throughout the day. The banking system in India should not only be hassle free but it
should be able to meet the new challenges posed by the technology and any other external and
internal factors. For the past three decades, India’s banking system has several outstanding
achievements to its credit. The Banks are the main participants of the financial system in India.
The Banking sector offers several facilities and opportunities to their customers. All the banks
safeguard the money and valuables and provide loans, credit, and payment services, such as
checking accounts, money orders, and cashier’s cheques. The banks also offer investment and
insurance products. As a variety of models for cooperation and integration among finance
industries have emerged, some of the traditional distinctions between banks, insurance
companies, and securities firms have diminished. In spite of these changes, banks continue to
maintain and perform their primary role—accepting deposits and lending funds from these
deposits.
Definition of a Banking System
A banking system is a group or network of institutions that provide financial services for
us. These institutions are responsible for operating a payment system, providing loans, taking
deposits, and helping with investments.
Banking system is defined as the accepting purpose of lending or investment of
deposits, money from the public, repayable on demand or otherwise and withdrawal by
cheque, draft, and order or otherwise.
Features of banking system
1. The bank accepts deposits of money which are withdrawable by cheques,
2. The bank uses the deposits for lending.
3. To be recognized as bank the institution must use the deposits to give loans to the
general public.
If an institution accepts deposits withdraw able by cheques but uses the deposits for its
own purpose, such an institution cannot be regarded as a bank. Post office, savings banks are
not banks, because they accept chequable deposits but do not sanction loans. In the same way,
LIC is not bank because it does not grant loans in general. LITI, LIC, IDBI etc. are regarded as the
non- banking financial institutions as they do not create money.

Need of the banking system

Before the establishment of banks, the financial activities were handled by money
lenders and individuals. At that time the interest rates were very high. Again there were no
security of public savings and no uniformity regarding loans. So as to overcome such problems
the organized banking sector was established, which was fully regulated by the government.
The organized banking sector works within the financial system to provide loans, accept
deposits and provide other services to their customers. The followingfunctions of the bank
explain the need of the bank and its importance:
• To provide the security to the savings of customers.
• To control the supply of money and credit
• To encourage public confidence in the working of the financial system, increasesavings
speedily and efficiently.
• To avoid focus of financial powers in the hands of a few individuals andinstitutions.
• To set equal norms and conditions (i.e. rate of interest, period of lending etc.) to
alltypes of customers.
Functions of banking system
Banking systems perform several different functions, depending on the network of
institutions. For example, payment and loan functions at commercial banks allow us to deposit
funds and use our checking accounts and debit cards to pay our bills or make purchases. They
can also help us finance our cars and homes. By comparison, central banks or systems distribute
currency and establish money-related policies.
1. Issue of money, in the form of banknotes and current accounts subject to check or
payment at the customer's order. These claims on banks can act as money because they are
negotiable or repayable on demand, and hence valued at par. They are effectively transferable
by mere delivery, in the case of banknotes, or by drawing a check that the payee may bank or
cash.
2. Netting and settlement of payments – banks act as both collection and paying agents
for customers, participating in interbank clearing and settlement systems to collect, present, be
presented with, and pay payment instruments. This enables banks to economize on reserves
held for settlement of payments, since inward and outward payments offset each other. It also
enables the offsetting of payment flows between geographical areas, reducing the cost of
settlement between them.
3. Credit intermediation – banks borrow and lend back-to-back on their own account as
middle men.
 4. Credit quality improvement – banks lend money to ordinary commercial and personal
borrowers (ordinary credit quality), but are high quality borrowers. The improvement comes
from diversification of the bank's assets and capital which provides a buffer to absorb losses
without defaulting on its obligations. However, banknotes and deposits are generally
unsecured; if the bank gets into difficulty and pledges assets as security, to rise the funding it
needs to continue to operate, this puts the note holders and depositors in an economically
subordinated position.
5. Asset liability mismatch/Maturity transformation – banks borrow more on demand
debt and short term debt, but provide more long term loans. In other words, they borrow short
and lend long. With a stronger credit quality than most other borrowers, banks can do this by
aggregating issues (e.g. accepting deposits and issuing banknotes) and redemptions (e.g.
withdrawals and redemption of banknotes), maintaining reserves of cash, investing in
marketable securities that can be readily converted to cash if needed, and raising replacement
funding as needed from various sources (e.g. wholesale cash markets and securities markets).
6. Money creation – whenever a bank gives out a loan in a fractional-reserve banking
system, a new sum of virtual money is created.
Types of banking system
(a) Organized banking and unorganized banking.
That part of Indian banking system which does not fall under the control of our central
bank (i.e. Reserve Bank of India) is called as un-organized banking. For example: Indigenous
banks. Whereas, organized banking system refers to that part of the Indian banking system
which is under the influence and control of the Reserve Bank of India. For example: Commercial
Banks, Industrial Banks, and Agricultural Banks.

(b) Scheduled and Non-scheduled banks:

Under the Reserve Bank of India Act, 1934, banks were classified as scheduled banks
and non-scheduled banks. The scheduled banks are those which are entered in the second
schedule of RBI Act, 1934. Scheduled banks are those banks and which have a paid up capital
and reserves of aggregate value of not less than Rs 5 lakhs and which satisfy RBI.
 All Commercial Banks, Regional Rural Banks, State Cooperative Banks are scheduled
banks. On the other hand, non-schedule banks are those banks whose total paid up capital is
less than Rs 5 lakh and RBI has no specific control over these banks. These banks are not
included in the second schedule of RBI Act, 1934.
(c) Indigenous Bankers:
From very ancient day’s indigenous banking as different from the modern western
banking has been organized in the form of family or individual business. They have been called
by various names in different parts of the country as Shroffs, Sethus, Sahukars, Mahajans,
Chettis and so on. They vary in their size from petty money lenders substantial shroffs.
(d) Central Bank:
In each country there exists central bank which controls a country’s money supply and
monetary policy. It acts as a bank to other banks, and a lender of last resort. India Reserve Bank
of India (RBI) is the Central Bank.
(e) Commercial Bank:
A bank dealing with general public, accepting deposits from making loans to large
numbers of households and firms. Through the process of accepting deposits and lending,
commercial banks create credit in the economy. Some examples (commercial banks in India are
State Bank India (SBI), Punjab National Bank (PNB) etc.
(f) Development Banks:
Development banks are specialised financial institutions. To promote economic
development, development banks provide medium term and long term loans the
entrepreneurs at relatively low rate o interest rates. Some examples of development banks in
India are Industrial Development Bank of India (IDBI), Industrial Financial Corporation of India
(IFCI), Industrial Credit and Investment Corporation of India (ICICI) etc.
(g) Co-Operative Banks:
Co-operative banks are organised under the provisions of the Co- operative societies law
of the state. These banks were originally set up in India to provide credit to the farmers at
cheaper rates. However, the co-operative banks function also in the urban sectors.
(h) Land Mortgage Banks:
 The primary objective of these banks is to provide long-term loans to farmers at low
rates in matters related to land, The land mortgage banks are also known as the Land
Development Banks.
(i) Regional Rural Banks:
Regional Rural Banks (RRBs) are established in the rural areas to meet the needs of the
weaker section of the rural population.
(j) National Bank for Agricultural and Rural Development (NABARD):
This bank was established in 1982 in India in view of providing the rural credit to the
farmers. Actually, it is an apex institution which coordinates the functioning of different
financial institutions working in the field of rural credit. NABARD has been making continuous
efforts through its micro-finance programme or improving the access of the rural poor to
formal institutional credit. The self-help group (SHG) – Bank linkage programme was introduced
in 1992 as a mechanism to provide financial services to the rural poor people on a sustainable
basis.
(k) Exchange Banks:
These banks are engaged in buying and selling foreign exchange. These banks help the
growth of international trade.

(i) Exim Bank:

It is popularly known as ‘Export Import Bank’. Such banks provide long term financial
assistance to the exporters and importers.
CENTRAL BANKING IN INDIA
The Reserve Bank of India is India's central banking institution, which controls the
monetary policy of the Indian rupee. It commenced its operations on 1 April 1935 during the
British Rule in accordance with the provisions of the Reserve Bank of India Act, 1934. The
original share capital was divided into shares of 100 each fully paid, which were initially owned
entirely by private shareholders. Following India's independence on 15 August 1947, the RBI
was nationalised on 1 January 1949.
 The RBI plays an important part in the Development Strategy of the Government of
India. It is a member bank of the Asian Clearing Union. The general superintendence and
direction of the RBI is entrusted with the 21-member Central Board of Directors: the Governor
(Dr. RaghuramRajan), 4 Deputy Governors, 2 Finance Ministry representatives, 10 government-
nominated directors to represent important elements from India's economy, and 4 directors to
represent local boards headquartered at Mumbai, Kolkata, Chennai and New Delhi. Each of
these local boards consists of 5 members who represent regional interests, and the interests of
co-operative and indigenous banks. The bank is also active in promoting financial inclusion
policy and is a leading member of the Alliance for Financial Inclusion (AFI).
Main functions
 Financial Supervision
The Reserve Bank of India performs this function under the guidance of the Board for
Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the
Central Board of Directors of the Reserve Bank of India. Primary objective of BFS is to undertake
consolidated supervision of the financial sector comprising commercial banks, financial
institutions and non-banking finance companies.
The Board is constituted by co-opting four Directors from the Central Board as members
for a term of two years and is chaired by the Governor. The Deputy Governors of the Reserve
Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of
banking regulation and supervision, is nominated as the Vice-Chairman of the Board. The Board
is required to meet normally once every month. It considers inspection reports and other
supervisory issues placed before it by the supervisory departments.
BFS through the Audit Sub-Committee also aims at upgrading the quality of the
statutory audit and internal audit functions in banks and financial institutions. The audit sub-
committee includes Deputy Governor as the chairman and two Directors of the Central Board
as members. The BFS oversees the functioning of Department of Banking Supervision (DBS),
Department of Non-Banking Supervision (DNBS) and Financial Institutions Division (FID) and
gives directions on the regulatory and supervisory issues.
 Regulator and supervisor of the financial system
 The institution is also the regulator and supervisor of the financial system and prescribes
broad parameters of banking operations within which the country's banking and financial
system functions. Its objectives are to maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services to the public. The Banking
Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI) for effective
addressing of complaints by bank customers. The RBI controls the monetary supply, monitors
economic indicators like the gross domestic product and has to decide the design of the rupee
banknotes as well as coins.
 Managerial of exchange control
The central bank manages to reach different goals of the Foreign Exchange
Management Act, 1999. Objective: to facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange market in India
 Issue of currency
The bank issues and exchanges currency notes and coins and destroys the same when
they are not fit for circulation. The objectives are to issue bank notes and giving public
adequate supply of the same, to maintain the currency and credit system of the country to
utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic
structure of the country so that it can achieve the objective of price stability as well as
economic development, because both objectives are diverse in themselves. For printing of
notes, the Security Printing and Minting Corporation of India Limited (SPMCIL), a wholly owned
company of the Government of India, has set up printing presses at Nashik, Maharashtra and
Dewas, Madhya Pradesh. The Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL),
a wholly owned subsidiary of the Reserve Bank, also has set up printing presses at Mysuru in
Karnataka and Salboni in West Bengal. In all, there are four printing presses.And for minting of
coins, SPMCIL has four mints at Mumbai, Noida (UP), Kolkata and Hyderabad for coin
production.
 Banker's bank
RBI also works as a central bank where commercial banks are account holders and can
deposit money.RBI maintains banking accounts of all scheduled banks. Commercial banks
create credit. It is the duty of the RBI to control the credit through the CRR, bank rate and open
market operations. As banker's bank, the RBI facilitates the clearing of cheques between the
commercial banks and helps inter-bank transfer of funds. It can grant financial accommodation
to schedule banks. It acts as the lender of the last resort by providing emergency advances to
the banks. It supervises the functioning of the commercial banks and take action against it if
need arises.
 Detection of fake currency
In order to curb the fake currency menace, RBI has launched a website to raise
awareness among masses about fake notes in the market.www.paisaboltahai.rbi.org.in
provides information about identifying fake currency.
This move from the Reserve Bank is expected to unearth black money held in cash. As
the new currency notes have added security features, they would help in curbing the menace of
fake currency.
 Developmental role
The central bank has to perform a wide range of promotional functions to support
national objectives and industries. The RBI faces a lot of inter-sectoral and local inflation-related
problems. Some of these problems are results of the dominant part of the public sector.
 Related functions
The RBI is also a banker to the government and performs merchant banking function for
the central and the state governments. It also acts as their banker. The National Housing Bank
(NHB) was established in 1988 to promote private real estate acquisition. The institution
maintains banking accounts of all scheduled banks, too. RBI on 7 August 2012 said that Indian
banking system is resilient enough to face the stress caused by the drought like situation
because of poor monsoon this year.
 Banking Structure in India

Reserve Bank of India (RBI):

The country had no central bank prior to the establishment of the RBI. The RBI is the
supreme monetary and banking authority in the country and controls the banking system in
India. It is called the Reserve Bank’ as it keeps the reserves of all commercial banks.
Commercial Banks:
Commercial banks mobilize savings of general public and make them available to large
and small industrial and trading units mainly for working capital requirements.
Scheduled Commercial Banks are categorized as follows –
1) Public Sector Banks: – are those banks in which majority of stake are held by the
government. Eg.SBI, PNB, Syndicate Bank, Union Bank of India etc.
2) Private Sector Banks: – are those banks in which majority of stake are held by
private individuals. Eg. ICICI Bank, IDBI Bank, HDFC Bank, AXIS Bank etc.
3) Foreign Banks: – are the banks with Head office outside the country in which they
are located. Eg. Citi Bank, Standard Chartered Bank, Bank of Tokyo Ltd. etc.
4) Regional Rural Banks: - Regional Rural Banks (RRBs) were established during 1976-
1987 with a view to develop the rural economy. Each RRB is owned jointly by the Central
Government,concerned State Government and a sponsoring public sector commercial bank.
Commercial banks in India are largely Indian-public sector and private sector with a few
foreign banks. The public sector banks account for more than 92 percent of the entire banking
business in India—occupying a dominant position in the commercial banking. The State Bank of
India and its 7 associate banks along with another 19 banks are the public sector banks.
Scheduled and Non-Scheduled Banks:
The scheduled banks are those which are enshrined in the second schedule of the RBI
Act, 1934. These banks have a paid-up capital and reserves of an aggregate value of not less
than Rs. 5 lakhs, hey have to satisfy the RBI that their affairs are carried out in the interest of
their depositors.
 All commercial banks (Indian and foreign), regional rural banks, and state cooperative
banks are scheduled banks. Non- scheduled banks are those which are not included in the
second schedule of the RBI Act, 1934. At present these are only three such banks in the
country.
Regional Rural Banks:
The Regional Rural Banks (RRBs) the newest form of banks, came into existence in the
middle of 1970s (sponsored by individual nationalized commercial banks) with the objective of
developing rural economy by providing credit and deposit facilities for agriculture and other
productive activities of all kinds in rural areas.
The emphasis is on providing such facilities to small and marginal farmers, agricultural
labourers, rural artisans and other small entrepreneurs in rural areas.
Other special features of these banks are:
(i) their area of operation is limited to a specified region, comprising one or more
districts in any state; (ii) their lending rates cannot be higher than the prevailing lending rates of
cooperative credit societies in any particular state; (iii) the paid-up capital of each rural bank is
Rs. 25 lakh, 50 percent of which has been contributed by the Central Government, 15 percent
by State Government and 35 percent by sponsoring public sector commercial banks which are
also responsible for actual setting up of the RRBs.
These banks are helped by higher-level agencies: the sponsoring banks lend them funds
and advise and train their senior staff, the NABARD (National Bank for Agriculture and Rural
Development) gives them short-term and medium, term loans: the RBI has kept CRR (Cash
Reserve Requirements) of them at 3% and SLR (Statutory Liquidity Requirement) at 25% of their
total net liabilities, whereas for other commercial banks the required minimum ratios have
been varied over time.
Cooperative Banks:
Cooperative banks are so-called because they are organised under the provisions of the
Cooperative Credit Societies Act of the states. The major beneficiary of the Cooperative Banking
is the agricultural sector in particular and the rural sector in general.
 The cooperative credit institutions operating in the country are mainly of two kinds:
agricultural (dominant) and non-agricultural. There are two separate cooperative agencies for
the provision of agricultural credit: one for short and medium-term credit, and the other for
long-term credit. The former has three tier and federal structure.
At the apex is the State Co-operative Bank (SCB) (cooperation being a state subject in
India), at the intermediate (district) level are the Central Cooperative Banks (CCBs) and at the
village level are Primary Agricultural Credit Societies (PACs).
Long-term agriculture credit is provided by the Land Development Banks. The funds of
the RBI meant for the agriculture sector actually pass through SCBs and CCBs. Originally based
in rural sector, the cooperative credit movement has now spread to urban areas also and there
are many urban cooperative banks coming under SCBs.
 Rural financing
Rural finance comprises credit, savings and insurance (or insurance substitutes) in rural
areas, whether provided through formal or informal mechanisms. The word 'credit' tends to be
associated with enterprise development, whereas rural finance also includes savings and
insurance mechanisms used by the poor to protect and stabilize their families and livelihoods
(not just their businesses).
An understanding of rural finance helps explain the livelihood strategies and priorities of
the rural poor. Rural finance is important to the poor. The poorest groups spend the highest
proportion of their income on food – typically more than 60% and sometimes as much as 90%.
Under these circumstances, any drop in earnings, or any additional expenditure (health or
funeral costs, for instance) has immediate consequences for family welfare – unless savings or
loans can be accessed. Financial transactions are therefore an integral part of the livelihood
system of the poor.
Rural finance consists of informal and formal sectors. Examples of formal sources of
credit include: banks; projects; and contract farmer schemes. Reference is often made to micro-
credit. Micro underlines the small loan size normally associated with the borrowing
requirements of poor rural populations, and micro-credit schemes use specially developed pro-
poor lending methodologies. Rural populations, however, are much more dependent on
informal sources of finance (including loans from family and friends, the local moneylender, and
rotating or accumulating savings and credit associations).
Rural Finance is a set of financial services that are not limited to credit only. Financial
services in rural finance include: loans, savings, investment, guarantee funds, remittance
services, inventory credit, trader finance and insurance.
Definition:
The Consultative Group to Assist the Poor (CGAP) defines rural finance as 'financial
services offered and used in rural areas by people of all income levels', and agricultural finance
as 'a sub-set of rural finance dedicated to financing agriculture-related activities, such as input,
supply, production, distribution and wholesaling, and marketing' (Pearce, 2003).
 Schmidt and Kropp (1987), rural finance is treated in this paper as encompassing all the
savings, lending, financing and risk minimising opportunities (formal and informal) and related
norms and institutions in rural areas.
This definition recognises that rural financial markets are part of the domestic financial
system and are therefore affected by government and central bank policies. Rural financial
markets tend to be fragmented (Germidis, 1990; Besley, 1994) and consist of formal, semi-
formal and informal financial intermediaries. The definition also acknowledges that the rural
population requires a range of financial services, including the following:
Intermediation, which involves mobilising and transferring savings from surplus to
deficit units and provides safe, liquid and convenient savings (deposit) facilities and access to
credit facilities tailored to the needs of the rural population (World Bank, 2004);
Savings facilities, which allow wealth to be kept in a form that preserves its value and is
liquid and readily accessible;
Credit for consumption smoothing and investment in agricultural production, marketing,
processing and input supplies (Gonzalez-Vega, 2003); systems for effecting payments and
transfer of remittances (Orozco, 2003; Sanders, 2003); and
General insurance and cover against variability in output (especially as agriculture is
largely weather-dependent), price and marketing uncertainty (Skees, 2003; Von Pischke, 2003).
Rural finance comes in three major forms:
1. Informal financial institutions which are not regulated by banking sector such as
rotating and savings groups, church groups or similar groupings of people
2. Semi-formal institutions which are not regulated by banking sector but are usually
licensed and supervised by another government agency such as self-help groups, NGOs
involved in provision of financial services and microfinance organizations (in some instances).
3. Formal institutions which are subject to banking regulations and supervision such as
microfinance institutions, banks. In order to enhance the quality of rural livelihoods a more
holistic approach to development is needed. Governments need to design and implement
agriculture friendly policies that will encourage the development of financial sector and market
oriented enterprises. Governments and donors need to invest into human and institutional
development in rural areas.
Microfinance: financial services (savings, credit, payment transfers, insurance) for the
poor and low-income people.
Agricultural finance: sub-set of rural finance dedicated to financing agriculture-related
activities, such as input supply, production, distribution and wholesaling, and marketing.
Rural finance: financial services offered and used in rural areas by farm and non-farm
population of all income levels through a variety of formal, informal and semiformal
institutional arrangements and diverse type of products and services, such as loans, deposits,
insurance, and remittances. Rural finance includes agriculture finance and microfinance and is a
sub sector of the larger financial sector.
Financial services for the rural poor are represented by the shaded overlap of
microfinance with rural and agricultural finance. It includes financial services for all purposes
and from diverse sources tailored to the needs of poor people in rural areas. Providers include
both financial institutions, such as banks, credit unions and non-financial mechanisms. State-
owned banks include agricultural development banks, regional development banks, savings
banks, and postal banks. Often they have extensive rural networks of branches or outlets.
Privatized state banks may also have significant rural outreach, although in many cases the
privatization process has reduced rural branch coverage.
Statement of the Problem
In general there are many differences between rural and urban settings. The following
Problems in rural settings:
 Dispersed demand - due to low levels of economic activity and population
density; on the other hand paralleled by larger family sizes and higher population
growth rates;
 High information and transaction costs - linked to poor infrastructure (roads,
institutional, telecommunications) and lack of client information (no personal
identification or functioning asset registries);
  Weak institutional capacity - related to the limited availability of educated and
well trained people in smaller rural communities;
 Crowding-out effect - due to subsidized and/or directed credit from state-owned
banks or donor projects;
 Low economy: the range of income-generating activities and the degree of
economic diversification is lower, agriculture predominates, low profitability of
economic activities;
 Seasonality – because of agricultural activities and long maturation periods for
others, resulting in variable demand for savings and credit, uneven cash flow
and, lags between loan disbursal and repayments;
 Farming risks - such as variable rainfall, pests and diseases, price fluctuations,
and small farmers' poor access to inputs, advice and (national) markets;
 Lack of usable collateral - due to ill-defined property and land-use rights, costly
or lengthy registration procedures, and poorly functioning judicial systems.

It should be noted that these features can vary greatly from one or the other rural area. In
some countries absolute poverty may even be more severe in cities. As a result of the above
mention constraints, most MFIs have their working area mostly in urban areas. In this situation,
the researcher probes further to find the possible avenues for rural finance to develop the
people who are residing in rural and around Erode district.
Sustainable financial institutions require:
- Mobilization of own resources through savings,
- Working through savings based member-owned SHGs operating at low costs
- Serving rural clients engaged in both farm and non-farm activities
- High repayment rates
- Covering costs from operational income
- Earning enough profits to offset effects of inflation
- Financing expansion from profits and savings mobilized.
 7Ps’ Framework
Product strategy: For catering to the varied needs of small ticket size transactions, whether a
bouquet of diversified products and services can be developed without compromising on the
flexibility, continuous availability and convenience of the products? Which types of financial
products have the greatest impact on reducing poverty and lifting growth rates in deprived
districts and regions?
Processes: What kinds of business processes can help banks to reach underserved segments
and provide hassle-free near doorstep service to the customers without jeopardising financial
viability? How do we design an efficient hub & spoke model to overcome the hurdles in the
agent led branchless banking?
Partnerships: What are the constraints faced by the underserved and/or excluded segments in
accessing financial services from different types of service providers? Are the bank - non-bank
partnerships, such as, Business Correspondents, SHGs, MFIs, etc. working efficiently in easing
the accessibility and availability of financial services?
Protection: What measures and mechanisms are needed to protect both the providers and the
receivers of rural finance from abuse and misuse of such services? Whether enough risks
mitigates are there for the borrowers given the higher vulnerability in the sector? Are lenders
protected against ebb & flow of uncertainty in credit culture?
Profitability: Whether the business strategies and delivery models are geared to provide
affordable and acceptable services to the rural clientele while ensuring that rural finance
service providers function profitably on a sustained basis? How do we tap into the customer
willingness to pay through an appropriate pricing model?
Productivity: How do we increase the productivity of financial services provided in the rural
areas? What are the strategies needed to synergize other resources with finance (say, under a
“credit plus” approach) to ensure more productive and optimal use of financial services?
People: Are the frontline staff of the financial service providers well-equipped to meet the
needs of driving the process of financial inclusion in terms of knowledge, skill and attitude? Do
these people have the capacity, comprehension and commitment to identify potential
customers and offer them timely advice and comprehensive services?
Trends in capital formation in agriculture and agricultural credit
In any discourse on rural development, agriculture is put on the top of development
agenda and for valid reasons too. Around 50 per cent of population depends on agriculture for
its livelihood. A positive relationship has been found between agriculture growth and poverty
reduction. Also, improved growth in agriculture tends to trigger rural non-farm activities which
can bring down rural unemployment. Further, there are various forward and backward linkages
of agricultural sector with other sectors of the economy. In the past couple of decades, a rapid
decline in the share of agriculture in GDP, however, has been witnessed without a
commensurate decline in labour force dependent on agriculture. Another sign of concern has
been a deceleration in the growth of gross capital formation (GCF) in agriculture in real terms in
the recent past.

Banker and Customer Relationship

Banker According to Section 3 of the Negotiable Instruments Act the term ‘banker’ includes any
person acting as a banker.
According to Halsbury’s Laws of England a banker as "an individual, partnership or corporation
whose sole predominating business is banking, that is the receipt of money on current account
or deposit account and the payment of cheques drawn by and the collection of cheques paid in
by the customer."
A banker is one who in the ordinary course of his business, honors cheques drawn upon
him by persons from and for whom he receives money on their account. No person or body
corporate can be a banker who does not (1) take deposit accounts and current accounts, (2)
issue and pay cheques and (3) collect cheques crossed and uncrossed for its customers. One
claiming to be a banker must acknowledge he to be one, and the public must accept him as
such; his main business must be that of banking from which normally he should be able to earn
his livelihood.
A customer is a person who has some kind of account, such as deposit or current with a
bank and from this it follows that any person may become a customer by opening a deposit or
current account or having some similar relation with a bank." To constitute a customer, there
must be some identifiable course or habit of dealing in the nature of regular banking business.
It is difficult to settle the idea of a single transaction with that of a customer. A customer is a
person; he should have some kind of an account with the bank. The initial transaction in
opening an account will not create the relation of a banker and customer. According to the
‘duration theory’ the relation of a banker and customer begins as soon as the first cheque is
paid in and accepted for collection.
In simple words a customer can be any person for whom the bank agrees to conduct an
account.
Legal Requirements to be qualified as Customer:
 Customer should be a major
 Customer be of sound mind
 He should not be debarred under any law
 There must be an offer and acceptance of the proposal.
Things to be noted:
 A single transaction can constitute a customer
 Every customer should have an account
 There should be some frequency in transactions
 All the dealing must be of banking nature
 The customer can be a person, a company, a society or a legal entity.
General Relationship between the Banker and Customer
Bellow given is the general relationship between a banker and customer
Debtor and Creditor Relationship
When customer deposits money with a bank the relationship of debtor and creditor will be
established, in this case Banker is the Debtor and Customer is the Creditor. It is the basic rule of
banking law that in the case of a general deposit of money in the bank, the moment the money
is deposited it becomes the property of bank; here the bank and the depositor assume the legal
relation of debtor and creditor.
Creditor and Debtor
When a bank grants loan and other credit facilities to the customer, the relationship between
the banker and customer is reversed, that is
Customer is Debtor and Banker is Creditor. In such cases banker doesn’t carry/ hold the money
of the customer but it is the money of the bank in the hands of the customer. In all such cases
when a customer’s account is over drawn, the customer does not cease to be a customer.
Principal and Agent
In some situations, the banker serves as agent of the customer (principal). Some of the agency
activities of a banker are specified below:
 Collecting cheques on behalf of the customer
 Collecting dividends and bills of exchange
 Acting as an attorney, representative or executor of a customer
 Buying and selling securities on behalf of his customer.
 Duties of the Agent (Banker):
Some of the important duties of an agent are given below:
 To follow the instructions given by principal
 To show required skill and carefulness
 Duty to provide proper accounts
 Duty to pass on any benefits derived from agency
 Duties of Principal (customer):
 The principal should pay remuneration to the agent
 The principal should not prevent his agent from performing the duties/ acts assigned to
him under the contract and for which remuneration is payable.
 Any lawful expenses which have been incurred by the agent in the course of
performance of his duties are to be indemnified by the principal.
Bailor and BaileeRelationship:
Bailment is the delivery of goods by one person to another for some purpose, upon a contract
that they shall, when the purpose is fulfilled, be returned or disposed of according to the
directions of the person delivering them. The person delivering the goods is called the "bailor"
and the person to whom these are delivered is called the "bailee". Bailment is also an important
type of relations between the banker and customer. It may arise in the following situations:
 Availing safe custody services (lockers)
 Pledge of stocks as security for availing credit from bank
 In these cases Customer is the Bailor and the Bank is the Bailee
Pledger and Pledgee Relationship
Pledge means the bailment of goods as security for payment of a debt or performance of a
promise. When credit facility is provided by a bank to its customers against collateral security of
movable property, the Relationship of Pledger and Pledgee is established.
In this case customer is the Pledger and banker is the pledgee.
Mortgagor and Mortgagee Relationship
Mortgage means the transfer of an interest in specific immoveable property for the purpose of
getting the payment of money advanced or to be advanced by way of loan, an existing or future
debt, or the performance of an engagement which may give rise to a financial liability.
When credit facility is provided by the bank to a customer against the security of immovable
property, the relationship of Mortgagor and Mortgagee is established.
In this situation:
Mortgagor - Customer
Mortgagee – Bank

Deposit Mobilization

Traditionally banks in India have four types of deposit accounts, namely Current
Accounts, Saving Banking Accounts, Recurring Deposits and, Fixed Deposits. However, in
recent years, due to ever increasing competition, some banks have introduced new products,
which combine the features of above two or more types of deposit accounts. These are known
by different names in different banks, e.g 2-in-1 deposits, Smart Deposits, Power Saving
Deposits, and Automatic Sweep Deposits etc. However, these have not been very popular
among the public.
What is a Current Account? Who uses current accounts? Current Accounts in Banks
Current Accounts are basically meant for businessmen and are never used for the purpose of
investment or savings. These deposits are the most liquid deposits and there are no limits for
number of transactions or the amount of transactions in a day. Most of the current accounts
are opened in the names of firm / company accounts. Cheque book facility is provided and the
account holder can deposit all types of the cheques and drafts in their name or endorsed in
their favour by third parties. No interest is paid by banks on these accounts. On the other
hand, banks charge certain service charges, on such accounts.
Features of Current Accounts:
(a) The main objective of Current Account holders in opening these accounts is to enable them
(mostly businessmen) to conduct their business transactions smoothly.
(b) There are no restrictions on the number of times deposit in cash / cheque can be made or
the amount of such deposits;
(c) Usually banks do not have any interest on such current accounts. However, in recent times
some banks have introduced special current accounts where interest (as per banks' own
guidelines) is paid
(d) The current accounts do not have any fixed maturity as these are on continuous basis
accounts
What is a Savings Bank Account? Who uses Saving Bank Accounts?
These deposits accounts are one of the most popular deposits for individual accounts. These
accounts not only provide cheque facility but also have lot of flexibility for deposits and
withdrawal of funds from the account. Most of the banks have rules for the maximum number
of withdrawals in a period and the maximum amount of withdrawal, but hardly any bank
enforces these. However, banks have every right to enforce such restrictions if it is felt that
the account is being misused as a current account. Till 24/10/2011, the interest on Saving Bank
Accounts was regulared by RBI and it was fixed at 4.00% on daily balance basis. However, wef
25th October, 2011, RBI has deregulated Saving Fund account interest rates and now banks are
free to decide the same within certain conditions imposed by RBI. Under directions of RBI,
now banks are also required to open no frill accounts (this term is used for accounts which do
not have any minimum balance requirements). Although Public Sector Banks still pay only 4%
rate of interest, some private banks like Kotak Bank and Yes Bank pay between 6% and 7% on
such deposits. From the FY 2012-13, interest earned up toRs 10,000 in a financial year on
Saving Bank accounts is exempted from tax.
What are Recurring Deposit Accounts? Who use Recurring Deposit Accounts? Or RD accounts
These are popularly known as RD accounts and are special kind of Term Deposits and are
suitable for people who do not have lump sum amount of savings, but are ready to save a small
amount every month. Normally, such deposits earn interest on the amount already deposited
(through monthly installments) at the same rates as are applicable for Fixed Deposits / Term
Deposits. These are best if you wish to create a fund for your child's education or marriage of
your daughter or buy a car without loans or save for the future.
Under these type of deposits, the person has to usually deposit a fixed amount of money every
month (usually a minimum of Rs,100/- p.m.). Any default in payment within the month
attracts a small penalty. However, some Banks besides offering a fixed installment RD, have
also introduced a flexible / variable RD. Under these flexible RDs the person is allowed to
deposit even higher amount of installments, with an upper limit fixed for the same e.g. 10 times
of the minimum amount agreed upon.
These accounts can be funded by giving Standing Instructions by which bank withdraws a fixed
amount on a fixed date of the month from the saving bank of the customer (as per his
mandate), and the same is credited to RD account.
Recurring Deposit accounts are normally allowed for maturities ranging from 6 months to 120
months. A Pass book is usually issued wherein the person can get the entries for all the
deposits made by him / her and the interest earned. Banks also indicate the maturity value of
the RD assuming that the monthly installments will be paid regularly on due dates. In case
installment is delayed, the interest payable in the account will be reduced and some nominal
penalty charged for default in regular payments. Premature withdrawal of accumulated
amount permitted is usually allowed (however, penalty may be imposed for early withdrawals).
These accounts can be opened in single or joint names. Nomination facility is also available.
The RD interest rates paid by banks in India are usually the same as payable on Fixed Deposits,
except when specific rates on FDs are paid for particular number of days e.g. 500 days, 555
days, 1111 days etc i.e. these are not ending in a quarter.
What are Fixed Deposit Accounts in India or Term Deposits?
All Banks in India (including SBI, PNB, BoB, BoI, Canara Bank, ICICI Bank, Yes Bank etc.) offer
fixed deposits schemes with a wide range of tenures for periods from 7 days to 10 years.
These are also popularly known as FD accounts. However, in some other countries these are
known as "Term Deposits" or even called "Bond". The term "fixed" in Fixed Deposits (FD)
denotes the period of maturity or tenor. Therefore, the depositors are supposed to continue
such Fixed Deposits for the length of time for which the depositor decides to keep the money
with the bank. However, in case of need, the depositor can ask for closing (or breaking) the
fixed deposit prematurely by paying a penalty (usually of 1%, but some banks either charge less
or no penalty). (Some banks introduced variable interest fixed deposits. The rate of interest
on such deposits keeps on varying with the prevalent market rates i.e. it will go up if market
interest rates go and it will come down if the market rates fall. However, such type of fixed
deposits has not been popular till date).
The rate of interest for Fixed Deposits differs from bank to bank (unlike earlier when the same
were regulated by RBI and all banks used to have the same interest rate structure. The present
trends indicate that private sector and foreign banks offer higher rate of interest.
The earlier trend that private sector and foreign banks offer higher rate of interest is no more
valid these days. However, now day’s small banks are forced to offer higher rate of interest to
attract more deposits. Usually a bank FD is paid in lump sum on the date of maturity.
However, most of the banks have also facility to pay/ credit interest in saving account at the
end of every quarter. If one desires to get interest paid every month, then the interest paid will
be at a marginal discounted rate. In the changed computerized environment, now the Interest
payable on Fixed Deposit can also be easily transferred on due dates to Savings Bank or Current
Account of the customer.
  Financial institutions provide the system through which savers deposit their money and
borrowers can access those resources. The process by which deposits are transformed
by the banking sector into real productive capital is at the core of financial
intermediation.Banks ensure the efficient transformation of mobilised deposit funds
into productive capital.
 Deposit mobilisation is therefore a key first step in the financial intermediation process.
Banks simply cannot function without deposits from savers in the economy. Many
developing countries suffer from low domestic savings rates.
 Domestic deposits traditionally provide a cheap and reliable source of funds for
development, which is of great value developing countries, especially when the
economy has difficulty raising capital in international markets.
Studies around the world have shown that banks should fund more of their loan books with
customer deposits in order to stand more robustly against liquidity squeezes and contribute to
the stability of the banking system.
 When banks resort less deposit funding and rely more on open market funding, this is
widely seen as negative for financial stability.
 Market funding requires that the bank continually rolls over bills and bond issues and
renews its borrowings from other financial institutions.
 In general these bond issues will be offered to both domestic and foreign investors.
These funding sources have generally proved to be less stable than customer deposits,
and reliance on market funding has thus made the banks’ liquidity positions more
vulnerable to external shocks.
 In an effort to mobilise deposits in an economy, banks develop various forms of
products that can be enjoyed by the clients.
 The most important deposit products are those that make it easier for clients to turn
small amounts of money into “useful lump sums” enabling them to smooth
consumption and mitigate the effects of economic shocks. These are typically provided
by banks in the form of savings accounts.
Consequences of failing to mobilize deposits in the economy
 Any decline in amount of deposits at the banks raises important questions about
whether the banks will be able to remain successful and meet the credit needs of the
economy.
 Banks will typically experience a temporary liquidity dips due to a decline in the amount
of deposits. The most important step for banks in addressing this problem would be to
develop strategies that are consistent with the needs of the savers in the economy.
When the deposit base in the economy shrinks, banks will respond in a variety of ways.
 Banks will become aggressive in maintaining their local base of depositors and the
underlying customer relationships. Banks will offer incentives to depositors in the form
of higher interest rates and other attractive conditions in order to retain depositors on
their books.
 Many banks will look for other funding sources and will compete more directly for
market based funds. In this respect interbank funding becomes an option.
 The banks also look at ways of creating new funding sources and better ways to manage
banking assets.
 An option that banks can adopt is to lend on a more selective basis whenever funds are
tight – either by raising credit standards or increasing loan rates and fees.
 Although this strategy could result in better credit quality and perhaps higher net
interest margins as loan demand increases, it could also mean curtailing the amount of
credit extended to creditworthy customers.
 On a broader level, this could translate into economic stagnation as some sectors
grappled with working and long term capital challenges as they fail to access loans and
overdrafts from the banks. Those who are lucky to access the resources run the risk of
failing to repay as a consequence of the high cost of the funds.
It is important to keep in mind that every time one makes a deposit with the bank, they are
providing part of the lifeblood for the economy as it is deficit units of the economy that benefit
from the actions of depositors.Putting the little resources that you have under the pillow
implies that you are depriving a struggling household or a firm somewhere in the economy of a
vital lifeline.

Loans and advances

Lending involves elements of risks. The element of risk, in the main operations of a
bank, leads to the necessity of credit investigation. It presupposes right selection of borrower,
which needs complete and comprehensive investigation of all the facts. As a matter of fact,
much of the worries of the lending banker is over if correct type borrowers can be selected. To
arrive at a decision about selection of a borrower the banker needs to collect a long chain of
information about the borrower. Usual loan application forms when filled in by the applicant
provide the banker with almost all the required particulars pertaining to the advance. The
banker’s responsibility is to verify and correlate those statements and to prepare a credit
report, which is expected to give a complete, clear, correct and reliable record of the character,
means and business integrity of the borrower. On the basis of credit information and credit
report, the banker may arrive at a reasonably correct decision about the proposed advance.
Credit investigation is, therefore, a sacred and obligatory job of a lending banker for
administering his lending operations with success.
Sound Principles of Lending:
It is a fundamental precept of banking everywhere that advances are made to customers in
reliance on his promise to repay, rather than the security held by the banker. Although all
lending involves some degree of risks, it is necessary for any bank to develop sound and safe
lending policies and new lending techniques in order to keep the risk to a minimum. As such,
the banks are required to follow certain principles of sound lending.

 Safety
 Liquidity
 Purpose
 Profitability
  Security
 Spread/ Diversity
 National interest
Safety: Advances should be expected to come back in the normal course. The repayment of the
loan depends upon the borrower’s capacity to pay and willingness to pay. The capacity depends
upon the tangible assets of the borrower. The willingness to pay depends upon the honesty and
character of the borrower.
Liquidity: Liquidity is the availability of bank funds on short notice. The borrower must be in a
position to repay within a reasonable time. Liquidity also signifies that the assets should be
salable without any loss.
Profitability: A banker has to see that major portion of the assets owned by it is not only liquid
but also aim at earning a good profit. The difference between the interest received on advances
and the interest paid on deposits constitutes a major portion of bank’s income. Besides, foreign
exchange business is also highly remunerative.
Purpose: A banker would not throw away money for any purpose for which the borrower
wants. The purpose should be productive so that the money not only remains safe but also
provides a definite source repayment.
Security: Security serves as a safety valve for an unexpected emergency. The security offered
for an advance is a cushion to fall back upon in case of need. An element of risk is always
present in every advance however secured it might appear to be.
Spread/ Diversity: The advances should be as much broad-based as possible and must be in
keeping with the deposit structure. The advances must not be in one particular direction or to
one particular industry. Again, advances must not be granted in one area alone.
National Interest: Bank has significant role to play in the economic development of a country.
The banker would lend if the purpose of the advance is for overall national development.
Credit Investigation:
Different phases of Credit Investigation:
 Collection of information of the entrepreneur
 Preparation and analysis of this information in order to determine creditworthiness of
the borrower/ entrepreneur
 Making decisions and recommendations about the borrower
 Furnishing credit information to other bankers
 Retention of the information for future use
Sources of information for credit investigation:
 Personal Interview:
 Refreezing:
 Assessing attitudes of the entrepreneur:
 Assessing overall knowledge about the project:
 Assessing management skill:
 Borrower’s Loan Application: Loan application entails a detailed questionnaire where
from borrowers answer provide some basic information
 Bank’s own record: Bank’s own record provides applicant’s transaction behavior. In case
of old borrower information are available regarding previous borrowings and the
repayments were made as per sanction stipulation.
 Reports obtained through friends or rivals: Banks may obtain information about the
borrowers in the same line of trade or business.
 Confidential Report/ Status Report from fellow bank
 Spot verification
 Market reports
 Financial statement of the applicant
 Income Tax statement
 Report from CIB
 Trade checking
 Reports from Chamber of Commerce and Industry
  Reports from Registrar of Joint Stock Company in case of Limited Company
 Personal visit to the applicant’s business, plant or trade center
Other sources:
a). Press reports regarding purchase, sale, auction of property
b). Registration records, municipal records etc.

In selecting the borrower, the following aspects should be considered

 Past behavior of the borrower requires to be studied. Enquiry should be made whether
the applicant has availed of any loan previously from other bank and whether his
dealings with that bank are regular or not.
 Work experiences of the intending borrower—what are the activities undertaken by him
—his successes and failures along with analysis of the underlying factors.
 Whether the work area has any relevance to the project proposed to be undertaken y
him.
On investigation and enquiry the banker reaches his conclusion to select a borrower that
qualifies the 5(five) essentials, which may be termed as five C’s:
 Character
 Capacity
 Capital
 Condition
 Collateral
Character: Character denotes integrity of the borrower i.e. he should have willingness to repay
the money borrowed. The banker should investigate every aspect of the character factor and
should convince himself that despite adverse conditions, the applicant will make every effort to
discharge his debt as per terms.
Capacity: Capacity means the ability to employ the funds profitably accordind to the terms and
conditions. The capacity of the borrower has to be determined to find out his experiences in
the line in which he is working.
Capital: Capital denotes financial soundness. The borrower must have his own stake in the
business which creates a sense of involvement in the mind of the borrower. Capital is the
financial strength of a risk as measured by the equity or net worth of the business.
Condition: Condition refers to the general business condition and the conditions in the
particular industry in which the borrower is engaged. The banker should exercise prudence
whether the business establishments are existent and continuing their business.
Collateral: Collateral implies the additional securities taken to offset weaknesses that are
apparent. All of the collateral that may be made available to the bank will not make a bad loan
good but it will make good loan better. While assessing valuation of collateral securities bankers
need to take extra care by sampling survey and by examining information from land revenue
office and also enquiring people nearby. The documents of the collateral securities are to be
verified from the concerned Sub-Registered Office and other related office.

Asset liability management (ALM)

Asset liability management (ALM) can be defined as the comprehensive and dynamic
framework for measuring, monitoring and managing the financial risks associated with
changing interest rates, foreign exchange rates and other factors that can affect the
organisation’s liquidity.
ALM relates to management of structure of balance sheet (liabilities and assets) in such
a way that the net earnings from interest is maximised within the overall risk-preference
(present and future) of the institutions. Thus the ALM functions includes the tools adopted to
mitigating liquidly risk, management of interest rate risk / market risk and trading risk
management. In short, ALM is the sum of the financial risk management of any financial
institution.
In other words, ALM is all about managing three central risks:
 Interest Rate Risk
 Liquidity Risk
 Foreign currency risk
For banks with forex operations, it also includes managing
  Currency risk
Through ALM banks try to match the assets and liabilities in terms of Maturities and Interest
Rates Sensitivities so as to minimize the interest rate risk and liquidity risk.
Overview of what are asset liabilitiesmismatches:
The Assets and Liabilities of the bank’s B/Sheet are nothing but future cash inflows & outflows.
Under Asset Liability Management i.e. ALM, these inflows & outflows are grouped into different
time buckets. Then each bucket of assets is matched with the corresponding bucket of liability.
The differences in each bucket are known as mismatches.
Is complete matching of Assets & Liabilities in the Balance sheet necessary?
No, because banks can even make money as a result of such mismatches sometimes. Alam
Greenspan, ex-Chairman of US Federal Reserve has once observed “risk taking is necessary
condition for wealth creation”. However, it is a risky proposition to keep large mismatches as it
can lead to massive losses in a volatile market. Therefore, in practice, the idea is to limit the
mismatches rather than aim at zero mismatches.
Evolution of ALM in Indian Banking System:
In view of the regulated environment in India in 1970s to early 1990s, there was no
interest rate risk as the interest rate were regulated and prescribed by RBI. Spreads between
deposits and lending rates were very wide. At that time banks’ Balance Sheets were not being
managed by banks themselves as they were being managed through prescriptions of the
regulatory authority and the government. With the deregulation of interest rates, banks were
given a large amount of freedom to manage their Balance sheets. Thus, it became necessary to
introduce ALM guidelines so that banks can be prevented from big losses on account of wide
ALM mismatches.
Reserve Bank of India issued its first ALM Guidelines in February 1999, which was made
effective from 1 st April 1999. These guidelines covered, inter alia, interest rate risk and
liquidity risk measurement/ reporting framework and prudential limits. Gap statements were
required to be prepared by scheduling all assets and liabilities according to the stated or
anticipated re-pricing date or maturity date. The Assets and Liabilities at this stage were
required to be divided into 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days;
181-365 days, 1-3 years and 3-5 years and above 5 years), based on the remaining period to
their maturity (also called residual maturity).. All the liability figures were to be considered as
outflows while the asset figures were considered as inflows.
As a measure of liquidity management, banks were required to monitor their cumulative
mismatches across all time buckets in their statement of structural liquidity by establishing
internal prudential limits with the approval of their boards/ management committees. As per
the guidelines, in the normal course, the mismatches (negative gap) in the time buckets of 1-14
days and 15-28 days were not to exceed 20 per cent of the cash outflows in the respective time
buckets
Later on RBI made it mandatory for banks to form ALCO (Asset Liability Committee) as a
Committee of the Board of Directors to track, monitor and report ALM.
It was in September, 2007, in response to the international practices and to meet the
need for a sharper assessment of the efficacy of liquidity management and with a view to
providing a stimulus for development of the term-money market, RBI fine-tuned these
guidelines and it was provided that the banks may adopt a more granular approach to
measurement of liquidity risk by splitting the first time bucket (1-14 days at present) in the
Statement of Structural Liquidity into three time buckets viz., 1 day (called next day) , 2-7 days
and 8-14 days. Thus, banks were asked to put their maturing asset and liabilities in 10 time
buckets.
Thus as per October 2007 RBI guidelines, banks were advised that the net cumulative
negative mismatches during the next day, 2-7 days, 8-14 days and 15-28 days should not
exceed 5%, 10%, 15% and 20% of the cumulative outflows, respectively, in order to recognize
the cumulative impact on liquidity. Banks were also advised to undertake dynamic liquidity
management and prepare the statement of structural liquidity on a daily basis. In the absence
of a fully networked environment, banks were allowed to compile the statement on best
available data coverage initially but were advised to make conscious efforts to attain 100 per
cent data coverage in a timely manner. Similarly, the statement of structural liquidity was to
be reported to the Reserve Bank, once a month, as on the third Wednesday of every month.
The frequency of supervisory reporting of the structural liquidity position was increased to
fortnightly, with effect from April 1, 2008. Banks are now required to submit the statement of
structural liquidity as on the first and third Wednesday of every month to the Reserve Bank.
Boards of the Banks were entrusted with the overall responsibility for the management
of risks and required to decide the risk management policy and set limits for liquidity, interest
rate, foreign exchange and equity price risks.
Asset-Liability Committee (ALCO), the top most committee to oversee the implementation of
ALM system is to be headed by CMD /ED. ALCO considers product pricing for deposits and
advances, the desired maturity profile of the incremental assets and liabilities in addition to
monitoring the risk levels of the bank. It will have to articulate current interest rates view of the
bank and base its decisions for future business strategy on this view.
Progress in Adoption of Techniques of ALM by Indian Banks: ALM process involve in
identification, measurement and management of risk Parameter. In its original guidelines RBI
asked the banks to use traditional techniques like Gap analysis for monitoring interest rates and
liquidity risk. At that RBI desired that Indian Banks slowly move towards sophisticated
techniques like duration, simulation and Value at risk in future. Now with the passage of time,
more and more banks are moving towards these advanced techniques.
Asset- Liability Management Techniques:
ALM is bank specific control mechanism, but it is possible that several banks may employ
similar ALM techniques or each bank may use unique system.
Gap Analysis: Gap Analysis is a technique of Asset – Liability management. It is used to assess
interest rate risk or liquidity risk. It measures at a given point of time the gaps between Rate
Sensitive Liabilities (RSL) and Rate Sensitive Assets (RSA) (including off balance sheet position)
by grouping them into time buckets according to residual maturity or next re-pricing period,
whichever is earlier. An asset or liability is treated as rate sensitive if;
i) Within time bucket under consideration is a cash flow.
ii.) The interest rate resets/reprises contractually during time buckets
iii.) Administered rates are changed and
iv.) It is contractually pre-payable or withdrawal allowed before contracted maturities.
Thus;
GAP=RSA-RSL
GAP Ratio=RSAs/RSL
• Mismatches can be positive or negative
• Positive Mismatch: M.A.>M.L. and vice-versa for Negative Mismatch
• In case of +ve mismatch, excess liquidity can be deployed in money market instruments,
creating new assets & investment swaps etc.
• For –vemismatch, it can be financed from market borrowings (call/Term),
Billsrediscounting, repos& deployment of foreign currency converted into rupee. Gap analysis
was widely used by financial institutions during late 1990s and early years of present century in
India.
Duration Gap Analysis:
This is an alternative method for measuring interest-rate risk. This technique examines the
sensitivity of the market value of the financial institution’s net worth to changes in interest
rates. Duration analysis is based on Macaulay’s concept of duration, which measures the
average lifetime of a security’s stream of payments.
We know that Duration is an important measure of the interest rate sensitivity of assets and
liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and
liabilities. It is the weighted average time to maturity of all the preset values of cash flows.
Duration basically refers to the average life of the asset or the liability. DP /p =D ( dR /1+R) The
above equation describes the percentage fall in price of the bond for a given increase in the
required interest rates or yields.
The larger the value of the duration, the more sensitive is the price of that asset or liability to
changes in interest rates. Thus, as per this theory, the bank will be immunized from interest
rate risk if the duration gap between assets and the liabilities is zero. The duration model has
one important benefit. It uses the market value of assets and liabilities.
Duration analysis summarises with a single number exposure to parallel shifts in the term
structure of interest rates.
It can be noticed that both gap and duration approaches worked well if assets and liabilities
comprised fixed cash flows. However options such as those embedded in mortgages or callable
debt posed problems that gap analysis could not address. Duration analysis could address these
in theory, but implementing sufficiently sophisticated duration measures was problematic.
Scenario Analysis:
Under the scenario analysis of ALM several interest rate scenarios are created during
next 5 to 10 years. Such scenarios might specify declining interest rates, rising interest’s rates, a
gradual decrease in rates followed by sudden rise etc. Different scenarios may specify the
behavior of the entire yield curve, so there could be scenarios with flattening yield curve,
inverted yield curves etc. Ten to twenty scenarios might be specified to have a holistic view of
the scenario analysis. Next assumptions would be made about the performances of assets and
liabilities under each scenario. Assumptions might include prepayment rates on mortgages and
surrender rates on insurance products. Assumptions may also be made about the
firms’performance. Based upon these assumptions the performance of the firm’s balance sheet
could be projected under each scenario. If projected performance was poor under specific
scenario the ALCO might adjust assets or liabilities to address the indicated exposure. A short
coming of scenario analysis is the fact that it is highly dependent on the choice of scenario. It
also requires that many assumptions be made about how specific assets or liabilities will
perform under specific scenario.
Value at Risk
VaR or Value ar Risk refers to the maximum expected loss that a bank can suffer over a target
horizon, given a certain confidence interval. It enables the calculation of market risk of a
portfolio for which no historical data exists. It enables one to calculate the net worth of the
organization at any particular point of time so that it is possible to focus on long term risk
implications of decisions that have already been taken or that are going to be taken. It is used
extensively for measuring the market risk of a portfolio of assets and/or liabilities.

Secured advances
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or
property) as collateral for the loan, which then becomes a secured debt owed to the creditor
who gives the loan. The debt is thus secured against the collateral — in the event that the
borrower defaults, the creditor takes possession of the asset used as collateral and may sell it
to regain some or all of the amount originally loaned to the borrower, for example, foreclosure
of a home. From the creditor's perspective this is a category of debt in which a lender has been
granted a portion of the bundle of rights to specified property. If the sale of the collateral does
not raise enough money to pay off the debt, the creditor can often obtain a deficiency
judgment against the borrower for the remaining amount.
The opposite of secured debt/loan is unsecured debt, which is not connected to any
specific piece of property and instead the creditor may only satisfy the debt against the
borrower rather than the borrower's collateral and the borrower. Generally speaking, secured
debt may attract lower interest rates than unsecured debt due to the added security for the
lender; however, credit history, ability to repay, and expected returns for the lender are also
factors affecting rates.

Purpose
There are two purposes for a loan secured by debt. In the first purpose, by extending the loan
through securing the debt, the creditor is relieved of most of the financial risks involved
because it allows the creditor to take the property in the event that the debt is not properly
repaid. In exchange, this permits the second purpose where the debtors may receive loans on
more favorable terms than that available for unsecured debt, or to be extended credit under
circumstances when credit under terms of unsecured debt would not be extended at all. The
creditor may offer a loan with attractive interest rates and repayment periods for the secured
debt.
Types
 A mortgage loan is a secured loan in which the collateral is property, such as a home.
 A nonrecourse loan is a secured loan where the collateral is the only security or claim
the creditor has against the borrower, and the creditor has no further recourse against
the borrower for any deficiency remaining after foreclosure against the property.
 A foreclosure is a legal process in which mortgaged property is sold to pay the debt of
the defaulting borrower.
  Repossession is a process in which property, such as a car, is taken back by the creditor
when the borrower does not make payments due on the property. Depending on the
jurisdiction, it may or may not require a court order.

Endorsement
Checks are negotiable instruments that permit the transfer of money from remitter to
payee. Checks are considered a promise to pay; meaning, they are not guaranteed forms of
payment like Money Orders or Cashier’s Checks. Since it is a promise to pay, many factors
determine if a check can be accepted for deposit or cash. One of those factors is having a
correct endorsement.
The remitter is the person who wrote and signed the check. The payee is the person
getting paid. The payee signs the back of the check. This signature, or endorsement, concludes
the negotiation of the check. This means the transaction is finalized.
To assure that a check is processed without delay or failure, it is important to endorse
the checks exactly as intended by the remitter. The bank accepting the check should be looking
for the correct endorsement, but here is a run-down of basic rules for personal checks.
The most common type of endorsement is a when the payee signs the back of the check
and then presents it for cash or deposit. This is called a blank endorsement. Ironic, I know. It is
considered “blank” because there are no additional instructions or limitations; the check can be
deposited or cashed.
Instead of signing your name on the endorsement line, another option is to write “For
deposit only” on the back of the check. This is called a restrictive endorsement because it is
declaring the check limited to deposits, meaning it cannot be cashed. You may choose to
present the check for deposit without providing an endorsement of your own. In this case, the
depositing bank may mark the check with a stamp. Verbiage will vary, but will read along the
lines of, “Pay to the account credited within Name of Bank.” This is similar to the payee writing
“For deposit only” and is considered a restrictive endorsement.
A special endorsement is used when the payee wants to give their check to a person not
named by the remitter. The payee must first endorse the check and then write, “Pay to the
order of First Last name.” The new payee then endorses the check and presents it for payment.
Due to the risks involved with cashing such checks, it is up to the financial institution’s
discretion whether or not to accept the check, and how to do so.
When there is only one payee named on a check, that one person alone has the right
and responsibility to endorse the check. However, when multiple payees are listed, ownership
of the funds depends on how the remitter wrote the check. If the names are connected by the
word “AND,” all payees must endorse the check. If the names are connected by the word “OR,”
then only one of the payees must sign. This is the same rule if the check reads “AND/OR;” one
or all payees may sign. If names are simply listed, perhaps connected with commas but no
words, it is at the bank’s discretion to interpret this payee designation as either “AND” or as
“OR.” It may be safe to have all payees sign, but whenever it’s up to your bank’s discretion, it’s
always best to make a call to your local branch and find out its policy. Like I love to say,
knowledge is power!
Crossing of cheques
A crossed cheque is a cheque that has been marked to specify an instruction about the
way it is to be redeemed. A common instruction is to specify that it must be deposited directly
into an account with a bank and not immediately cashed by a bank over the counter. The
format and wording varies between countries, but generally two parallel lines and/or the words
'Account Payee' or similar may be placed either vertically across the cheque or in the top left
hand corner. By using crossed cheques, cheque writers can effectively protect the cheques they
write from being stolen and cashed
Cheques can be open (uncrossed) or crossed.
Open cheque
An open cheque is a cheque that is not crossed on the left corner and payable at the counter of
the drawee bank on presentation of the cheque.
Crossed cheque
A crossed cheque is a cheque that is payable only through a collecting banker and not directly
at the counter of the bank. Crossing ensures security to the holder of the cheque as only the
collecting banker credits the proceeds to the account of the payee of the cheque.
When two parallel transverse lines, with or without any words, are drawn generally, on the left
hand top corner of the cheque. A crossed cheque does not affect the negotiability of the
instrument.
Types of crossing
Cheque crossed generally
A cheque crossed generally is a cheque that bears two parallel transverse lines across its face,
optionally with the words 'and company' (or any abbreviation thereof) or 'not negotiable'
between the lines. Such a cheque can be credited to any account without endorsement but
through a banking account, so that the beneficiary can be traced.
Account-payee or restrictive crossing
This crossing can be made in both general and special crossing by adding the words 'account
payee' or 'A/C payee only'. In this type of crossing, the collecting banker is supposed to credit
the amount of the cheque to the account of the payee the name mentioned only The cheque
remains transferable but the collecting banker has more liability if he credits the cheque
proceeds to someone other than the payee and the endorsement in favour of the last payee is
proved forged. Thus, the collecting banker must first investigate the title of the last endorsee
from the original payee named in the cheque, before collecting
Not-negotiable crossing
The words 'not negotiable' can be added to general-crossing as well as special-crossing and a
crossing with these words is known as not negotiable crossing. The effect of such a crossing is
that it removes the most important characteristic of a negotiable instrument: the transferee of
such a crossed cheque cannot get a better title than that of the transferor (cannot become a
holder in due course) and cannot convey a better title to his own transferee, but the instrument
remains transferable.
Consequence of a bank not complying with the crossing
A bank's failure to comply with the crossings amounts to a breach of contract with its customer.
The bank may not be able to debit the drawer's account and may be liable to the true owner for
his loss.
 UNIT II

CENTRAL BANKING SYSTEM: Nature- Organization and Management Functions- Methods of

Credit Controls- Objects of Monetary Policy- Autonomy of Central Bank Systems- Indian Money
Market- Indian Capital Market- New Issue Market- Banking Legislations in India.

Nature of central banking system in India

The Reserve Bank of India is India's central banking institution, which controls the
monetary policy of the Indian rupee. It commenced its operations on 1 April 1935 during the
British Rule in accordance with the provisions of the Reserve Bank of India Act, 1934. The
original share capital was divided into shares of 100 each fully paid, which were initially owned
entirely by private shareholders. Following India's independence on 15 August 1947, the RBI
was nationalised on 1 January 1949.
The RBI plays an important part in the Development Strategy of the Government of
India. It is a member bank of the Asian Clearing Union. The general superintendence and
direction of the RBI is entrusted with the 21-member Central Board of Directors: the Governor
(Dr. RaghuramRajan), 4 Deputy Governors, 2 Finance Ministry representatives, 10 government-
nominated directors to represent important elements from India's economy, and 4 directors to
represent local boards headquartered at Mumbai, Kolkata, Chennai and New Delhi. Each of
these local boards consists of 5 members who represent regional interests, and the interests of
co-operative and indigenous banks.The bank is also active in promoting financial inclusion
policy and is a leading member of the Alliance for Financial Inclusion (AFI).
a central bank is “a bank which constitutes the apex of the monetary and banking
structure of its country and which performs as best as it can in the national economic interest,
the following Nature: (i) The regulation of currency in accordance with the requirements of
business and the general public for which purpose it is granted either the sole right of note
issue or at least a partial monopoly thereof, (ii) The performance of general banking and agency
for the state, (iii) The custody of the cash reserves of the commercial banks, (iv) The custody
and management of the nation’s reserves of international currency, (v) The granting of
accommodation in the form of re-discounts and collateral advances to commercial banks, bill
brokers and dealers, or other financial institutions and the general acceptance of the
responsibility of lender of the last resort, (vi) The settlement of clearance balances between the
banks, (vii) The control of credit in accordance with the needs of business and with a view to
carrying out the broad monetary policy adopted by the state.

Organization and management

The Central Board of Directors is the main committee of the Central Bank. The
Government of India appoints the directors for a 5-year term. The Board consists of a Governor,
and not more than 4 Deputy Governors, 4 Directors to represent the regional boards, 2 from
the Ministry of Finance and 10 other directors from various fields. RBI wants to create a post of
Chief Operating Officer (COO) and re-allocate work between the five of them(4 Deputy
Governor and COO).
The bank is headed by the Governor and the post is currently held by economist
RaghuramRajan. There are 4 Deputy Governors H R Khan, DrUrjit Patel, R Gandhi and S
SMundra. Two of the four Deputy Governors are traditionally from RBI ranks, and are selected
from the Bank's Executive Directors. One is nominated from among the Chairpersons of public
sector banks and the other is an economist. An Indian Administrative Service officer can also be
appointed as Deputy Governor of RBI and later as the Governor of RBI as with the case of Y.
Venugopal Reddy. Other persons forming part of the central board of directors of the RBI are
Dr. NachiketMor, Y C Deveshwar, Prof DamodarAcharya, Ajay Tyagi and AnjulyDuggal.

Branches and support bodies

The Reserve Bank of India has four zonal offices at Chennai, Delhi, Kolkata and
Mumbai.It has 19 regional offices and 10 sub-offices. Regional offices are located in
Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, Chennai, Delhi, Guwahati,
Hyderabad, Jaipur, Jammu, Kanpur, Kochi, Kolkata, Lucknow, Mumbai, Nagpur, Patna and
Thiruvananthapuram. It also has 9 sub-offices located in Agartala, Dehradun, Gangtok, Panaji,
Raipur, Ranchi, Shillong, Shimla and Srinagar. Recently the RBI has opened two more sub-office
at Aizawal and Imphal.

The Reserve Bank of India has four regional representations: North in New Delhi, South
in Chennai, East in Kolkata and West in Mumbai. The representations are formed by five
members, appointed for four years by the central government and serve—beside the advice of
the Central Board of Directors—as a forum for regional banks and to deal with delegated tasks
from the central board.

The bank has also two training colleges for its officers, viz. Reserve Bank Staff College,
Chennai and College of Agricultural Banking, Pune. There are three autonomous institutions run
by RBI namely National Institute of Bank Management (NIBM), Indira Gandhi Institute for
Development Research (IGIDR), Institute for Development and Research in Banking Technology
(IDRBT). There are also four Zonal Training Centres at Mumbai, Chennai, Kolkata and New Delhi.

The Board of Financial Supervision (BFS), formed in November 1994, serves as a CCBD
committee to control the financial institutions. It has four members, appointed for two years,
and takes measures to strength the role of statutory auditors in the financial sector, external
monitoring and internal controlling systems. The Tarapore committee was set up by the
Reserve Bank of India under the chairmanship of former RBI deputy governor S.S.Tarapore to
"lay the road map" to capital account convertibility. The five-member committee
recommended a three-year time frame for complete convertibility by 1999–2000. On 1 July
2007, in an attempt to enhance the quality of customer service and strengthen the grievance
redressal mechanism, the Reserve Bank of India created a new customer service department.

Functions of Central bank

Central banking functions have evolved gradually over decades. Their evolution has
been guided by ever-changing need to find new methods of regulating, guiding and helping the
financial system (particularly, the banks). In other words, the evolution of central banking
functions has tended to coincide with the evolution of the financial systems of the world
economies. Let us recount the leading functions.
1. Note Issue:
It is considered one of the primary functions of a central bank. The entire financial system of a
country, with ever-increasing volume and variety of the financial instruments, institutions and
markets, needs a stable supply of legal tender money. This legal tender should tend to vary,
both in volume and composition to the changing requirements of the economy. Accordingly,
the central bank of the country is granted the sole right to issue currency (including that of the
government of the country) and (ii) a monopoly of issuing bank notes (which are its promises to
pay).
2. Banker's Bank:
The second main function of a central bank is that of being a bank of the banks. This function
includes the following interrelated sub-functions.

(a) The first sub-function is its being a custodian of the cash reserves of the commercial banks.
The exact form of this function has varied from country to country and in terms of legal
provisions. Historically, commercial banks discovered that it was convenient and economical to
hold deposit balances with the central bank for making payments to each other. In some
countries, however, the banks are compelled by law to hold deposit balances with the central
bank and this gives it an additional tool to regulate credit creation by them. The legal provision
to this effect was first introduced in US. Later, it was adopted in India also. RBI has found it a
very effective regulatory tool and has used it very extensively.

To begin with, bank deposits were categorised into demand deposit liabilities and time deposit
liabilities. The minimum cash balances to be maintained with RBI were to be between 2% and
8% of the time deposit liabilities and between 5% and 20% of demand deposit liabilities. The
choice of exact percentages and their revision was left to the discretion of the RBI. Later on, the
provision relating to minimum cash balances (called 'cash reserve ratio', or CRR) was modified
to the effect that now a uniform percentage (between 3% and 15%) is applicable to all bank
deposits. Again, the choice of exact percentage and its revision is left to the discretion of the
RBI.

(b) The second sub-function is that of clearance. When individual banks maintain deposit
balances with the central bank and use them to make payments to each other, the system of
interbank clearance emerges. The interbank clearance and remittances result in appropriate
adjustments in the deposit balances of the banks with the central bank. Actually, the basic
motive, which induces the commercial banks in maintaining deposit balances with the central
bank, is the convenience and economy of making payments to each other. This function was
first developed by the Bank of England in mid-19th century. Currently, it is one of the primary
functions of every central bank of the world.

3. The Central Bank:

The central bank is the final source of the supply of legal tender. It is the lender of the last
resort. For this reason, it should be able to adjust the availability of currency with the market in
line with the changing needs of the latter. When the economy expands and it needs additional
money and credit, the central bank can adopt a policy of pumping in additional currency in the
market. Similarly, it can try to curtail the supply of available currency when the economy in a
phase of contraction. The central bank adjusts the volume of currency in two ways.

(i) The banks can approach it for cash loans. It can tighten the terms of issue of such loans
(including the rate of interest to be charged) if it wants to restrict the money supply.
Alternatively, it can make it easier and cheaper for the banks to borrow if it wants to increase
the supply of money and credit.

(ii) The amount of money needed by the market is also reflected in the bills drawn by the seller
upon the buyers and the central bank can take steps to alter the money supply in the market by
adjusting the volume of bills discounted/ re-discounted by it. For example, when the volume of
bills drawn is increasing during an expansionary phase of the economy, the central bank can
adopt the policy of discounting more of them and pumping additional currency in the market.
Similarly, when the economy is passing through a phase of contraction, the volume of bills had
drawn decreases. In this case, the central bank can drain the market of excess money supply by
collecting the earlier discounted bills and discounting less of fresh bills. In addition, it can also
adopt the policy of adjusting its discount rate to encourage or discourage the discounting of
bills, as the need be.

4. Banker to the Government:

The central bank of the country happens to be a banker to the government. This function
normally involves two things: (i) providing ordinary banking services to the government, and (ii)
being a public debt agent and underwriter to the government. Let us consider each of these
with reference to the Reserve Bank of India.

5. Custodian of Foreign Exchange Reserves:

Central bank of a country is also a custodian of its official foreign exchange reserves. This
arrangement helps the authorities in managing and co-ordinating the monetary matters of the
country more effectively. This is because there is a direct association between foreign exchange
reserves and quantity of money in the market. The foreign exchange reserves are influenced by
international capital movements, international trade credits and so on. Because of the
interaction between the domestic money supply, price level and exchange reserves, the central
bank frequently faces several contradictory tendencies which have to be reconciled.

6. Regulation of Exchange Rate:

A related function, which is assigned to the central bank, is the regulation and stabilization of
the exchange rate. This task is facilitated when the central bank is also the custodian of official
foreign exchange reserves. The need for a stable exchange rate is more in the case of a paper
standard than under a metallic standard. In this context, we should specifically note two things:
(i) the justification for having a stable exchange rate and avoiding violent and wide fluctuations
in it; and (ii) the need to assign this task to an expert and competent agency.

As regards expertise and competence central bank of the country is the best agency to which
the task of regulating and stabilizing exchange rate should be assigned. The central bank
happens to be the apex institution of the entire financial system of the country. It is in
possession of maximum data and has the expertise 'of estimating the financial trends and the
type of corrective measures needed. Moreover, it possesses several regulatory powers over the
financial system. It can contemplate and take the complementary measures needed for
ensuring the success off the steps taken in the area of exchange rate.

A stable exchange rate is of great help in promoting external trade and orderly capital flows.
The volatility of exchange rate tends to increase if there is complete capital convertibility (that
is, capital can flow in and out of the country without specific permission of the authorities). If
the central bank is given the authority to regulate the use of foreign exchange (that is, if it has
the authority to apply exchange control to the extent it decides), the task of stabilising
exchange rate becomes easier for it.

7. Credit Control:

Over the years, credit control has become a leading function of a modern central bank. In
earlier days, the term credit control referred to the regulation of only the "volume" of money
and credit. Currently, the term is used in a wider meaning and covers not only the "volume" of
money and credit, but also its components, its flows, its allocation between alternative uses
and borrowers, terms and conditions attached to credit and so on.
The need for credit control arises because it is observed that "money cannot manage itself. Left
to unregulated market forces, flows of money and credit have the tendency to accentuate
cyclical fluctuations. Moreover, in underdeveloped countries, unregulated credit flows
strengthen inter-sectoral imbalances, speculative forces and other distortions. Details of credit
control and instruments used by the central bank will be discussed later in this Unit.

8. Other Functions:

It is believed that an underdeveloped country requires an all-frontal approach in solving its

problems of poverty and growth. Though regulation of the volume of money and credit and its
other dimensions, the central bank plays a key role in its growth policy, much more is needed to
make it really effective. Viewed in this manner, the functions of a central bank come to cover a
much wider field than is conventionally considered in the case of central banks of developed
countries.

RBIs methods of credit control

The various methods employed by the RBI to control credit creation power of the
commercial banks can be classified in two groups, viz., quantitative controls and qualitative
controls. Quantitative controls are designed to regulate the volume of credit created by the
banking system qualitative measures or selective methods are designed to regulate the flow of
credit in specific uses.

Quantitative or traditional methods of credit control include banks rate policy, open market
operations and variable reserve ratio. Qualitative or selective methods of credit control include
regulation of margin requirement, credit rationing, regulation of consumer credit and direct
action.
I. Quantitative Method:

(i) Bank Rate:

The bank rate, also known as the discount rate, is the rate payable by commercial banks on the
loans from or rediscounts of the Central Bank. A change in bank rate affects other market rates
of interest. An increase in bank rate leads to an increase in other rates of interest and
conversely, a decrease in bank rate results in a fall in other rates of interest.

A deliberate manipulation of the bank rate by the Central Bank to influence the flow of credit
created by the commercial banks is known as bank rate policy. It does so by affecting the
demand for credit the cost of the credit and the availability of the credit.

An increase in bank rate results in an increase in the cost of credit; this is expected to lead to a
contraction in demand for credit. In as much as bank credit is an important component of
aggregate money supply in the economy, a contraction in demand for credit consequent on an
increase in the cost of credit restricts the total availability of money in the economy, and hence
may prove an anti-inflationary measure of control.

Likewise, a fall in the bank rate causes other rates of interest to come down. The cost of credit
falls, i. e., and credit becomes cheaper. Cheap credit may induce a higher demand both for
investment and consumption purposes. More money, through increased flow of credit, comes
into circulation.

A fall in bank rate may, thus, prove an anti-deflationary instrument of control. The effectiveness
of bank rate as an instrument of control is, however, restricted primarily by the fact that both in
inflationary and recessionary conditions, the cost of credit may not be a very significant factor
influencing the investment decisions of the firms.
(ii) Open Market Operations:

Open market operations refer to the sale and purchase of securities by the Central bank to the
commercial banks. A sale of securities by the Central Bank, i.e., the purchase of securities by the
commercial banks, results in a fall in the total cash reserves of the latter.

A fall in the total cash reserves is leads to a cut in the credit creation power of the commercial
banks. With reduced cash reserves at their command the commercial banks can only create
lower volume of credit. Thus, a sale of securities by the Central Bank serves as an anti-
inflationary measure of control.

Likewise, a purchase of securities by the Central Bank results in more cash flowing to the
commercials banks. With increased cash in their hands, the commercial banks can create more
credit, and make more finance available. Thus, purchase of securities may work as an anti-
deflationary measure of control.

The Reserve Bank of India has frequently resorted to the sale of government securities to which
the commercial banks have been generously contributing. Thus, open market operations in
India have served, on the one hand as an instrument to make available more budgetary
resources and on the other as an instrument to siphon off the excess liquidity in the system.

(iii) Variable Reserve Ratios:

Variable reserve ratios refer to that proportion of bank deposits that the commercial banks are
required to keep in the form of cash to ensure liquidity for the credit created by them.

A rise in the cash reserve ratio results in a fall in the value of the deposit multiplier. Conversely,
a fall in the cash reserve ratio leads to a rise in the value of the deposit multiplier.
A fall in the value of deposit multiplier amounts to a contraction in the availability of credit,
and, thus, it may serve as an anti-inflationary measure.

A rise in the value of deposit multiplier, on the other hand, amounts to the fact that the
commercial banks can create more credit, and make available more finance for consumption
and investment expenditure. A fall in the reserve ratios may, thus, work as anti-deflationary
method of monetary control.

The Reserve Bank of India is empowered to change the reserve requirements of the commercial
banks.

The Reserve Bank employs two types of reserve ratio for this purpose, viz. the Statutory
Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR).

The statutory liquidity ratio refers to that proportion of aggregate deposits which the
commercial banks are required to keep with themselves in a liquid form. The commercial banks
generally make use of this money to purchase the government securities. Thus, the statutory
liquidity ratio, on the one hand is used to siphon off the excess liquidity of the banking system,
and on the other it is used to mobilise revenue for the government.

The Reserve Bank of India is empowered to raise this ratio up to 40 per cent of aggregate
deposits of commercial banks. Presently, this ratio stands at 25 per cent.

The cash reserve ratio refers to that proportion of the aggregate deposits which the commercial
banks are required to keep with the Reserve Bank of India. Presently, this ratio stands at 9
percent.
II. Qualitative Method:

The qualitative or selective methods of credit control are adopted by the Central Bank in its
pursuit of economic stabilisation and as part of credit management.

(i) Margin Requirements:

Changes in margin requirements are designed to influence the flow of credit against specific
commodities. The commercial banks generally advance loans to their customers against some
security or securities offered by the borrower and acceptable to banks.

More generally, the commercial banks do not lend up to the full amount of the security but
lend an amount less than its value. The margin requirements against specific securities are
determined by the Central Bank. A change in margin requirements will influence the flow of
credit.

A rise in the margin requirement results in a contraction in the borrowing value of the security
and similarly, a fall in the margin requirement results in expansion in the borrowing value of the
security.

(ii) Credit Rationing:

Rationing of credit is a method by which the Central Bank seeks to limit the maximum amount
of loans and advances and, also in certain cases, fix ceiling for specific categories of loans and
advances.

(iii) Regulation of Consumer Credit:

Regulation of consumer credit is designed to check the flow of credit for consumer durable
goods. This can be done by regulating the total volume of credit that may be extended for
purchasing specific durable goods and regulating the number of installments through which
such loan can be spread. Central Bank uses this method to restrict or liberalise loan conditions
accordingly to stabilise the economy.
(iv) Moral Suasion:
Moral suasion and credit monitoring arrangement are other methods of credit control. The
policy of moral suasion will succeed only if the Central Bank is strong enough to influence the
commercial banks.

In India, from 1949 onwards, the Reserve Bank has been successful in using the method of
moral suasion to bring the commercial banks to fall in line with its policies regarding credit.
Publicity is another method, whereby the Reserve Bank marks direct appeal to the public and
publishes data which will have sobering effect on other banks and the commercial circles.

Effectiveness of Credit Control Measures:

The effectiveness of credit control measures in an economy depends upon a number of factors.
First, there should exist a well-organised money market. Second, a large proportion of money in
circulation should form part of the organised money market. Finally, the money and capital
markets should be extensive in coverage and elastic in nature.

Extensiveness enlarges the scope of credit control measures and elasticity lends it adjustability
to the changed conditions. In most of the developed economies a favourable environment in
terms of the factors discussed before exists, in the developing economies, on the contrary,
economic conditions are such as to limit the effectiveness of the credit control measures.
 Monetary policy

Meaning:
Monetary policy is concerned with the measures taken to regulate the supply of money,
the cost and availability of credit in the economy. Further, it also deals with the distribution of
credit between uses and users and also with both the lending and borrowing rates of interest of
the banks. In developed countries the monetary policy has been usefully used for overcoming
depression and inflation as an anti-cyclical policy.

However, in developing countries it has to play a significant role in promoting economic

growth. As Prof. R. Prebisch writes, “The time has come to formulate a monetary policy which
meets the requirements of economic development, which fits into its framework perfectly.”
Further, along with encouraging economic growth, the monetary policy has also to ensure price
stability, because the excessive inflation not only has adverse distribution effect but hinders
economic development also.

Monetary policy of India

Monetary policy is the process by which monetary authority of a country, generally a

central bank controls the supply of money in the economy by its control over interest rates in
order to maintain price stability and achieve high economic growth. In India, the central
monetary authority is the Reserve Bank of India (RBI). It is so designed as to maintain the price
stability in the economy.
Other objectives of the monetary policy of India, as stated by RBI, are:-
Price Stability
Price Stability implies promoting economic development with considerable emphasis on price
stability. The center of focus is to facilitate the environment which is favourable to the
architecture that enables the developmental projects to run swiftly while also maintaining
reasonable price stability.
Controlled Expansion of Bank Credit
One of the important functions of RBI is the controlled expansion of bank credit and money
supply with special attention to seasonal requirement for credit without affecting the output.

Promotion of Fixed Investment

The aim here is to increase the productivity of investment by restraining non-essential fixed
investment.

Restriction of Inventories and stocks

Overfilling of stocks and products becoming outdated due to excess of stock often results in
sickness of the unit. To avoid this problem the central monetary authority carries out this
essential function of restricting the odds of the economy and all social and economic class of
people

To Promote Efficiency

It is another essential aspect where the central banks pay a lot of attention. It tries to increase
the efficiency in the financial system and tries to incorporate structural changes such as
deregulating interest rates, ease operational constraints in the credit delivery system, to
introduce new money market instruments etc.

Reducing the Rigidity

RBI tries to bring about the flexibilities in the operations which provide a considerable
autonomy. It encourages more competitive environment and diversification. It maintains its
control over financial system whenever and wherever necessary to maintain the discipline and
prudence in operations of the financial system.

Monetary operations
Monetary operations involve monetary techniques which operate on monetary magnitudes
such as money supply, interest rates and availability of credit aimed to maintain Price Stability,
Stable exchange rate, Healthy Balance of Payment, Financial stability, Economic growth. RBI,
the apex institute of India which monitors and regulates the monetary policy of the country
stabilizes the price by controlling Inflation. RBI takes into account the following monetary
policies:

Major Operations

Open Market Operations

An open market operation is an instrument of monetary policy which involves buying or selling
of government securities from or to the public and banks. This mechanism influences the
reserve position of the banks, yield on government securities and cost of bank credit. The RBI
sells government securities to control the flow of credit and buys government securities to
increase credit flow. Open market operation makes bank rate policy effective and maintains
stability in government securities market.

Cash Reserve Ratio

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep
with RBI in the form of reserves or balances. Higher the SLR with the RBI lower will be the
liquidity in the system and vice versa. RBI is empowered to vary CRR between 15 percent and 3
percent. But as per the suggestion by the Narsimham committee Report the CRR was reduced
from 15% in the 1990 to 5 percent in 2002. As of September 2015, the CRR is 4.00 percent.

Statutory Liquidity Ratio

Every financial institution has to maintain a certain quantity of liquid assets with themselves at
any point of time of their total time and demand liabilities. These assets have to be kept in non-
cash form such as G-secs precious metals, approved securities like bonds etc. The ratio of the
liquid assets to time and demand assets is termed as the statutory liquidity ratio. There was a
reduction of SLR from 38.5% to 25% because of the suggestion by Narshimam Committee. The
current SLR is 21.5 %( w.e.f.03/02/15).

Bank Rate Policy

The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for
providing funds or loans to the banking system. This banking system involves commercial and
co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved
financial institutes. Funds are provided either through lending directly or discounting or buying
money market instruments like commercial bills and treasury bills. Increase in Bank Rate
increases the cost of borrowing by commercial banks which results into the reduction in credit
volume to the banks and hence declines the supply of money. Increase in the bank rate is the
symbol of tightening of RBI monetary policy. As of September 29, 2015, the Bank Rate stands
adjusted by 50 basis points from 8.25 per cent on June 2, 2015 to 7.75 per cent.

Credit Ceiling
In this operation RBI issues prior information or direction that loans to the commercial banks
will be given up to a certain limit. In this case commercial bank will be tight in advancing loans
to the public. They will allocate loans to limited sectors. Few examples of ceiling are agriculture
sector advances, priority sector lending.

Credit Authorization Scheme

Credit Authorization Scheme was introduced in November, 1965 when P C Bhattacharya was
the chairman of RBI. Under this instrument of credit regulation RBI as per the guideline
authorizes the banks to advance loans to desired sectors.

Moral Suasion
Moral Suasion is just as a request by the RBI to the commercial banks to take so and so action
and measures in so and so trend of the economy. RBI may request commercial banks not to
give loans for unproductive purpose which does not add to economic growth but increases
inflation.

Repo Rate and Reverse Repo Rate

Repo rate is the rate at which RBI lends to commercial banks generally against government
securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate
and increase in Repo rate discourages the commercial banks to get money as the rate increases
and becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the
commercial banks. The increase in the Repo rate will increase the cost of borrowing and lending
of the banks which will discourage the public to borrow money and will encourage them to
deposit. As the rates are high the availability of credit and demand decreases resulting to
decrease in inflation. This increase in Repo Rate and Reverse Repo Rate is a symbol of
tightening of the policy. Autonomy of Central bank in India

Central Banking autonomy

The central banking functions typically include not only creation of money or more broadly
monetary management, but, also often, management of public debt of Government, regulation
and supervision of banking entities, financing of developmental activities and other associated
functions.

While discussing the issue of autonomy, it is necessary to recognize that the function of debt
management is essentially performed by a central bank as an agent of Government and the
issue of autonomy does not arise. In fact, this function could be in conflict with autonomy in the
conduct of monetary policy.

As regards the function of regulation and supervision, the argument for involvement of a
central bank emerges from the role of lender of last resort and the obligation to smoothly
operate the payments system. In this regard, the autonomy that the central bank exercises is
no different from autonomy of any regulator in the financial system.

As far as the developmental role is concerned, close coordination with Government necessarily
arises, which in some ways impinges on autonomy as it is in a way linked to money creation.

What is uniquely relevant for a central bank’s independence is its exercise of the power to
modulate the creation of money and the price of money, which impacts on the value of money,
both domestic and external. In this context, the critical issue relates to the degrees of freedom
the central bank has in deciding whether or not to fund the Government’s expenditure out of
created money.

The view that central banks should be largely independent of political power and that the
central bank credit to government should be formally limited is generally believed to have
emerged only in 20th century. It would, however, be inappropriate to conclude that the
importance of central bank’s independence was recognised only as recently as 20th century
since Napoleon Bonaparte is reported to have commented in 1806, on Bank of France; "I want
the bank to be in the hands of the Government, but not too much".

As a result of monetary consequences of deficit financing that had afflicted many countries
during the First World War, the international financial community, in a series of Conferences
organised by League of Nations recognised such independence as contributing to price stability.
The recent revival of interest in the subject is attributable to several factors viz. the reforms in
centrally planned economies, the establishment of new European Central Banking
arrangements and importance of price stability in a world characterised by large cross border
financial flows.
 What is Central Bank Independence?

Central bank independence generally relates to three areas viz. personnel matters;
financial aspects; and conduct of policy.
Personnel independence refers to the extent to which the Government distances itself
from appointment, term of office and dismissal procedures of top central bank officials and the
governing board. It also includes the extent and nature of representation of the Government in
the governing body of the central bank.
Financial independence relates to the freedom of the central bank to decide the extent
to which Government expenditure is either directly or indirectly financed via central bank
credits. Direct or automatic access of Government to central bank credits would naturally imply
that monetary policy is subordinated to fiscal policy.
Finally, policy independence is related to the flexibility given to the central bank in the
formulation and execution of monetary policy.

Pros and Cons in Theory

Three different theories, which are by no way mutually exclusive, have been advanced in
support of autonomy of central banks, viz., dynamic or time inconsistency theory, theory of
political business cycle and the theory of public choice.

First, the most prominent argument for central bank independence is based on the time
inconsistency problem. Time inconsistency arises when the best plan currently made for some
future period is no longer optimal when that period actually starts. In the context of monetary
policy, the time inconsistency problem arises because there are incentives for a politically
motivated policymaker to try to exploit the short-run trade-off between employment and
inflation. Expansionary monetary policy may produce higher growth and employment in the
short run, and, therefore, policymakers may be tempted to pursue this policy, even in the short
run although there is no guarantee that there would be a favourable output impact. In the long
run, however, such an expansionary monetary policy will necessarily lead to higher inflation
with deleterious consequences for the economy. In order to solve the time inconsistency
problem, two distinct approaches have been advanced. The 'conservative central banker
approach' postulates the appointment of a conservative central banker whose aversion to
inflation is well known which would result in low inflation because of the economic agents'
belief in the reputation of the central banker. The 'optimal contract approach' postulates the
existence of an optimal contract between the central banker and the Government. The central
banker's tenure in office is conditional upon his performance of achieving low inflation, failure
of which would lead to the repudiation of the contract of tenure. Historically, there are
successful examples of both types of models of central bank independence – while US is often
seen as an example of conservative Central Bank, New Zealand is characterised as a follower of
optimal contract approach.

Second, the political business cycle theory studies the interaction between economic policy
decisions and political considerations. The best known prediction of the theory is that the
business cycle mirrors the timetable of the election cycle. Incumbent governments, in general,
will use restrictive policies early in their elected tenure raising unemployment to reduce
inflation, as the election approaches. The theory highlights the tendencies of incumbent
governments to generate pre-election booms through expansionary fiscal policies. Once the
incumbents get re-elected, the policy priorities could change towards inflation control rather
than employment generation. In this respect, the theory in a way highlights the time
inconsistency behaviour of governments. As monetary policy affects the economy with long and
variable lags, even if the central bank nullifies the fiscal stimulus through monetary tightening,
its impact would typically be felt during the post-election period when the incumbents may
happen to be back in power.

Finally, the fusion of politics and economics over the last thirty years has resulted in the theory
of public choice, establishing itself as an important proponent of central bank independence. In
the context of reducing budget deficit, the primary solution offered in public choice theory is a
constitutional amendment for a pre-specified stipulation on central bank credit to government.
Nevertheless, in recent years, as a secondary solution to the deficit problem, some public
choice theorists put forward the case of an independent central bank. The basic contentions of
these economists are: unless there are constitutional or institutional constraints to the
contrary, a democracy contains a bias towards deficit finance; thus they operate within the
premise that politicians do not necessarily pursue public interest but are more concerned with
their personal or political agenda. In this context, some economists explicitly talk about central
bank independence by providing a solution which will ensure not only low inflation but also act
as an effective institutional constraint.

Disadvantages of autonomy

First, detractors of autonomy argue that an independent central bank lacks democratic
legitimacy. Curiously, such detractors derive strength from Milton Friedman’s statement that
money is too important an issue to be left to the whims of central bankers.

Secondly, independence may lead to frictions between the fiscal and the monetary authorities
and the resulting costs of these frictions between monetary and fiscal policy may be somewhat
costly for society, thus inhibiting the development process.

Thirdly, there may be significant divergence in the preference pattern of independent central
banks and the society at large. A strong central bank may impose its outlook on society
resulting in a sub-optimal state in terms of economic welfare. Adequate sources of
accountability can, however, counteract and circumvent these problems. In fact, the opinions in
this context differ widely on the relative importance between growth vis-à-vis inflation as
objectives of monetary policy.

At a pragmatic level, the basic issue is one of reconciling adequate independence with
appropriate accountability to ensure that central banks are responsive to societal concerns.
Central Bank Independence and Economic Performance

An inverse relationship between central bank independence and the level of inflation is
supported by most empirical studies during the post Bretton-Woods period. The proponents for
central bank independence generally cite empirical evidences of negative cross-country
correlation between average inflation and the degree of central bank independence. It is,
however, possible to question the veracity of this relationship. As already mentioned, there are
significant measurement problems relating to central bank independence. Furthermore,
researchers argue that the causal relationship observed between central bank independence
and low and stable inflation might be influenced by some other common factors such as the
extent of inflation averseness and the credibility that the central bank enjoys. While many Latin
American countries changed the legal and operational framework, the change was prompted by
people's aversion to high and chronic inflation. The causality between the rate of inflation and
the degree of independence of the central bank may be viewed as bi-directional, since it would
be argued that persistent high inflation led to changes in the operational framework in many
countries.

It needs to be emphasized that central bank, independence by itself cannot ensure monetary
policy credibility, which, to an extent, depends on the overall credibility of Government policy
as a whole. Central bank independence is a means, the end being an appropriate division of
responsibility between the monetary and the fiscal authority and policy coordination. There is a
need to articulate the division of responsibility and policy priorities to the economic agents.
Such articulation reduces uncertainties often inherent in economic decisions. If an institutional
structure is not in place, there is a chance that policy coordination would depend entirely upon
the personal equations among policymakers and the risk of it breaking down subsequently with
changes in the persons at top cannot be ruled out.
 INDIAN MONEY MARKET

MEANING OF MONEY MARKET

A money market is a market for borrowing and lending of short-term funds. It deals in
funds and financial instruments having a maturity period of one day to one year. It is a
mechanism through which short-term funds are loaned or borrowed and through which a large
part of financial transactions of a particular country or of the world are cleared.

It is different from stock market. It is not a single market but a collection of markets for
several instruments like call money market, Commercial bill market etc. The Reserve Bank of
India is the most important constituent of Indian money market. Thus RBI describes money
market as “the center for dealings, mainly of a short-term character, in monetary assets, it
meets the short-term requirements of borrowers and provides liquidity or cash to lenders”.

PLAYERS OF MONEY MARKET

In money market, transactions of large amount and high volume take place. It is dominated by
small number of large players. In money market the players are :-Government, RBI, DFHI
(Discount and finance House of India) Banks, Mutual Funds, Corporate Investors, Provident
Funds, PSUs (Public Sector Undertakings), NBFCs (Non-Banking Finance Companies) etc. The
role and level of participation by each type of player differs from that of others.

FUNCTIONS OF MONEY MARKET

1) It caters to the short-term financial needs of the economy. 2) It helps the RBI in effective
implementation of monetary policy. 3) It provides mechanism to achieve equilibrium between
demand and supply of short-term funds. 4) It helps in allocation of short term funds through
inter-bank transactions and money market Instruments. 5) It also provides funds in non-
inflationary way to the government to meet its deficits. 6) It facilitates economic development.
STRUCTURE OF INDIAN MONEY MARKET

Indian money market is characterised by its dichotomy i.e. there are two sectors of money
market. The organised sector and unorganized sector. The organised sector is within the direct
purview of RBI regulations. The unorganisedsector consists of indigenous bankers, money
lenders, non-banking financial institutions etc.

I. Organised Sector of Money Market: -Organized Money Market is not a single market, it
consist of number of markets. The most important feature of money market instrument is that
it is liquid. It is characterized by high degree of safety of principal. Following are the instruments
which are traded in money market

1) Call and Notice Money Market: - The market for extremely short-period is referred as
call money market. Under call money market, funds are transacted on overnight basis. The
participants are mostly banks. Therefore it is also called Inter-Bank Money Market. Under
notice money market funds are transacted for 2 days and 14 days period. The lender issues a
notice to the borrower 2 to 3 days before the funds are to be paid. On receipt of notice,
borrower has to repay the funds. In this market the rate at which funds are borrowed and lent
is called the call money rate. The call money rate is determined by demand and supply of short
term funds. In call money market the main participants are commercial banks, co-operative
banks and primary dealers. They participate as borrowers and lenders. Discount and Finance
House of India (DFHI), Non-banking financial institutions like LIC, GIC, UTI, NABARD etc. are
allowed to participate in call money market as lenders. Call money markets are located in big
commercial centres like Mumbai, Kolkata, Chennai, Delhi etc. Call money market is the
indicator of liquidity position of money market. RBI intervenes in call money market as there is
close link between the call money market and other segments of money market.
2) Treasury Bill Market (T – Bills):- This market deals in Treasury Bills of short term duration
issued by RBI on behalf of Government of India. At present three types of treasury bills are
issued through auctions, namely 91 day, 182 day and364day treasury bills. State government
does not issue any treasury bills. Interest is determined by market forces. Treasury bills are
available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Periodic auctions
are held for their Issue.

T-bills are highly liquid, readily available; there is absence of risk of default. In India T-bills have
narrow market and are undeveloped. Commercial Banks, Primary Dealers, Mutual Funds,
Corporates, Financial Institutions, Provident or Pension Funds and Insurance Companies can
participate in T-bills market.

3) Commercial Bills: - Commercial bills are short term, negotiable and self-liquidating money
market instruments with low risk. A bill of exchange is drawn by a seller on the buyer to make
payment within a certain period of time. Generally, the maturity period is of three months.
Commercial bill can be resold a number of times during the usance period of bill. The
commercial bills are purchased and discounted by commercial banks and are rediscounted by
financial institutions like EXIM banks, SIDBI, IDBI etc.

In India, the commercial bill market is very much underdeveloped. RBI is trying to develop the
bill market in our country. RBI has introduced an innovative instrument known as “Derivative
.Usance Promissory Notes, with a view to eliminate movement of papers and to facilitate
multiple rediscounting.

4) Certificate Of Deposits (CDs):- CDs are issued by Commercial banks and development
financial institutions. CDs are unsecured, negotiable promissory notes issued at a discount to
the face value. The scheme of CDs was introduced in 1989 by RBI. The main purpose was to
enable the commercial banks to raise funds from market. At present, the maturity period of
CDs ranges from 3 months to 1 year. They are issued in multiples of Rs. 25 lakh subject to a
minimum size of Rs. 1 crore. CDs can be issued at discount to face value. They are freely
transferable but only after the lock-in-period of 45 days after the date of issue.

In India the size of CDs market is quite small. In 1992, RBI allowed four financial institutions
ICICI, IDBI, IFCI and IRBI to issue CDs with a maturity period of. One year to three years.

5) Commercial Papers (CP):- Commercial Papers were introduced in January 1990. The
Commercial Papers can be issued by listed company which has working capital of not less than
Rs. 5 crores. They could be issued in multiple of Rs. 25 lakhs. The minimum size of issue being
Rs. 1 crore. At present the maturity period of CPs ranges between 7 days to 1 year. CPs are
issued at a discount to its face value and redeemed at its face value.

6) Money Market Mutual Funds (MMMFs):- A Scheme of MMMFs was introduced by RBI in
1992. The goal was to provide an additional short-term avenue to individual investors. In
November 1995 RBI made the scheme more flexible. The existing guidelines allow banks, public
financial institutions and also private sector institutions to set up MMMFs. The ceiling of Rs. 50
crores on the size of MMMFs stipulated earlier, has been withdrawn. MMMFs are allowed to
issue units to corporate enterprises and others on par with other mutual funds. Resources
mobilised by MMMFs are now required to be invested in call money, CD, CPs, Commercial Bills
arising out of genuine trade transactions, treasury bills and government dated securities having
an unexpired maturity upto one year. Since March 7, 2000 MMMFs have been brought under
the purview of SEBI regulations. At present there are 3 MMMFs in operation.

7) The Repo Market; - Repo was introduced in December 1992. Repo is a repurchase
agreement. It means selling a security under an agreement to repurchase it at a predetermined
date and rate. Repo transactions are affected between banks and financial institutions and
among bank themselves, RBI also undertake Repo.
In November 1996, RBI introduced Reverse Repo. It means buying a security on a spot basis
with a commitment to resell on a forward basis. Reverse Repo transactions are affected with
scheduled commercial banks and primary dealers.

In March 2003, to broaden the Repo market, RBI allowed NBFCs, Mutual Funds, Housing
Finance and Companies and Insurance Companies to undertake REPO transactions.

8) Discount and Finance House of India (DFHI) In 1988, DFHI was set up by RBI. It is jointly
owned by RBI, public sector banks and all India financial institutions which have contributed to
its paid up capital. It is playing an important role in developing an active secondary market in
Money Market Instruments. In February 1996, it was accredited as a Primary Dealer (PD). The
DFHI deals in treasury bills, commercial bills, CDs, CPs, short term deposits, call money market
and government securities.

II. Unorganized Sector of Money Market: - The economy on one hand performs through
organised sector and on other hand in rural areas there is continuance of unorganised, informal
and indigenous sector. The unorganised money market mostly finances short-term financial
needs of farmers and small businessmen. The main constituents of unorganised money market
are:-

1) Indigenous Bankers (IBs) Indigenous bankers are individuals or private firms who receive
deposits and give loans and thereby operate as banks. IBs accept deposits as well as lend
money. They mostly operate in urban areas, especially in western and southern regions of the
country. The volume of their credit operations is however not known. Further their lending
operations are completely unsupervised and unregulated. Over the years, the significance of IBs
has declined due to growing organised banking sector.

2) Money Lenders (MLs)they are those whose primary business is money lending. Money
lending in India is very popular both in urban and rural areas. Interest rates are generally high.
Large amount of loans are given for unproductive purposes. The operations of money lenders
are prompt, informal and flexible. The borrowers are mostly poor farmers, artisans, petty
traders and manual workers. Over the years the role of money lenders has declined due to the
growing importance of organised banking sector.

3) Non – Banking Financial Companies (NBFCs)they consist of:-

1. Chit Funds Chit funds are savings institutions. It has regular members who make periodic
subscriptions to the fund. The beneficiary may be selected by drawing of lots. Chit fund is more
popular in Kerala and Tamilnadu. Rbi has no control over the lending activities of chit funds.

2. Nidhis: -Nidhis operate as a kind of mutual benefit for their members only. The loans are
given to members at a reasonable rate of interest. Nidhis operate particularly in South India.

3. Loan Or Finance Companies Loan companies are found in all parts of the country. Their
total capital consists of borrowings, deposits and owned funds. They give loans to retailers,
wholesalers, artisans and self-employed persons. They offer a high rate of interest along with
other incentives to attract deposits. They charge high rate of interest varying from 36% to 48%
p.a.

4. Finance Brokersthey are found in all major urban markets especially in cloth, grain and
commodity markets. They act as middlemen between lenders and borrowers. They charge
commission for their services.

FEATURES OF INDIAN MONEY MARKET

Indian money market is relatively underdeveloped when compared with advanced markets like
New York and London Money Markets. Its’ main features / defects are as follows
1. Dichotomy:- A major feature of Indian Money Market is the existence of dichotomy i.e.
existence of two markets: -Organised Money Market and Unorganised Money Market.
Organised Sector consists of RBI, Commercial Banks, and Financial Institutions etc. The
Unorganised Sector consists of IBs, MLs, Chit Funds, Nidhis etc. It is difficult for RBI to integrate
the Organised and Unorganised Money Markets. Several segments are loosely connected with
each other. Thus there is dichotomy in Indian Money Market.

2. Lack of Co-ordination And Integration:- It is difficult for RBI to integrate the organised and
unorganised sector of money market. RBT is fully effective in organised sector but unorganised
market is out of RBI’s control. Thus there is lack of integration between various sub-markets as
well as various institutions and agencies. There is less co-ordination between co-operative and
commercial banks as well as State and Foreign banks. The indigenous bankers have their own
ways of doing business.

3. Diversity in Interest Rates: - There are different rates of interest existing in different
segments of money market. In rural unorganised sectors the rate of interest are high and they
differ with the purpose and borrower. There are differences in the interest rates within the
organised sector also. Although wide differences have been narrowed down, yet the existing
differences do hamper the efficiency of money market.

4. Seasonality of Money Market: - Indian agriculture is busy during the period November to
June resulting in heavy demand for funds. During this period money market suffers from
Monetary Shortage resulting in high rate of interest. During slack season rate of interest falls &s
there are plenty of funds available. RBI has taken steps to reduce the seasonal fluctuations, but
still the variations exist.

5. Shortage ofFunds: - In Indian Money Market demand for funds exceeds the supply. There is
shortage of funds in Indian Money Market an account of various factors like inadequate
banking facilities, low savings, lack of banking habits, existence of parallel economy etc. There is
also vast amount of black money in the country which has caused shortage of funds. However,
in recent years development of banking has improved the mobilisation of funds to some extent.

6. Absence ofOrganized Bill Market: - A bill market refers to a mechanism where bills of
exchange are purchased and discounted by banks in India. A bill market provides short term
funds to businessmen. The bill market in India is not popular due to overdependence of cash
transactions, high discounting rates, problem of dishonour of bills etc.

7. Inadequate Banking Facilities: - Though the commercial banks have been opened on a
large scale, yet banking facilities are inadequate in our country. The rural areas are not covered
due to poverty. Their savings are very small and mobilisation of small savings is difficult. The
involvement of banking system in different scams and the failure of RBI to prevent these abuses
of banking system shows that Indian banking system is not yet a well organised sector.

8. Inefficient and Corrupt Management: - One of the major problems of Indian Money
Market is its inefficient and corrupt management. Inefficiency is due to faulty selection, lack of
training, poor performance appraisal, faulty promotions etc. For the growth and success of
money market, there is need for well trained and dedicated workforce in banks. However, in
India some of the bank officials are inefficient and corrupt.

CAPITAL MARKET IN INDIA

Capital market deals with medium term and long term funds. It refers to all facilities and
the institutional arrangements for borrowing and lending term funds (medium term and long
term). The demand for long term funds comes from private business corporations, public
corporations and the government. The supply of funds comes largely from individual and
institutional investors, banks and special industrial financial institutions and Government.
STRUCTURE CAPITAL MARKET:-

Capital market is classified in two ways

1) CAPITAL MARKET IN INDIA
a) Gilt – Edged Market:-
Gilt – Edged market refers to the market for government and semi-government securities,
which carry fixed rates of interest. RBI plays an important role in this market.

b) Industrial Securities Market: - It deals with equities and debentures in which shares and
debentures of existing companies are traded and shares and debentures of new companies are
bought and sold.

c) Development Financial Institutions:- Development financial institutions were set up to

meet the medium and long-term requirements of industry, trade and agriculture. These are
IFCI, ICICI, IDBI, SIDBI, IRBI, UTI, LIC, GIC etc. All These institutions have been called Public Sector
Financial Institutions.

d) Financial Intermediaries :-Financial Intermediaries include merchant banks, Mutual

Fund, Leasing companies etc. they help in mobilizing savings and supplying funds to capital
market.

2) The Second way in which capital market is classified is as follows :-

a) Primary Market: - Primary market is the new issue market of shares, preference shares
and debentures of non-government public limited companies and issue of public sector bonds.

b) Secondary Marketthis refers to old or already issued securities. It is composed of

industrial security market or stock exchange market and gilt-edged market.
ROLE AND IMPORTANCE OF CAPITAL MARKET IN INDIA

Capital market has a crucial significance to capital formation. For a speedy economic
development adequate capital formation is necessary. The significance of capital market in
economic development is explained below:-

1. Mobilisationof Savings and Acceleration of Capital Formation: -In developing countries like
India the importance of capital market is self-evident. In this market, various types of securities
help to mobilise savings from various sectors of population. The twin features of reasonable
return and liquidity in stock exchange are definite incentives to the people to invest in
securities. This accelerates the capital formation in the country.

2. Raising Long – Term Capital: - The existence of a stock exchange enables companies to raise
permanent capital. The investors cannot commit their funds for a permanent period but
companies require funds permanently. The stock exchange resolves this dash of interests by
offering an opportunity to investors to buy or sell their securities, while permanent capital with
the company remains unaffected.

3. Promotion of Industrial Growth: - The stock exchange is a central market through which
resources are transferred to the industrial sector of the economy. The existence of such an
institution encourages people to invest in productive channels. Thus it stimulates industrial
growth and economic development of the country by mobilising funds for investment in the
corporate securities.

4. Ready And Continuous Market: - The stock exchange provides a central convenient place
where buyers and sellers can easily purchase and sell securities. Easy marketability makes
investment in securities more liquid as compared to other assets.
5. Technical Assistance: - An important shortage faced by entrepreneurs in developing
countries is technical assistance. By offering advisory services relating to preparation of
feasibility reports, identifying growth potential and training entrepreneurs in project
management, the financial intermediaries in capital market play an important role.

6. Reliable Guide toPerformance: -The capital market serves as a reliable guide to the
performance and financial position of corporates, and thereby promotes efficiency.

7. Proper ChannelisationofFunds: - The prevailing market price of a security and relative yield
are the guiding factors for the people to channelise their funds in a particular company. This
ensures effective utilisation of funds in the public interest.

8. Provision of Variety ofServices: - The financial institutions functioning in the capital market
provide a variety of services such as grant of long term and medium term loans to
entrepreneurs, provision of underwriting facilities, assistance in promotion of companies,
participation in equity capital, giving expert advice etc.

9. Development of Backward Areas:-

Capital Markets provide funds for projects in backward areas. This facilitates economic
development of backward areas. Long term funds are also provided for development projects in
backward and rural areas.

10. Foreign Capital: - Capital markets makes possible to generate foreign capital. Indian firms
are able to generate capital funds from overseas markets by way of bonds and other securities.
Government has liberalised Foreign Direct Investment (FDI) in the country. This not only brings
in foreign capital but also foreign technology which is important for economic development of
the country.
11. Easy Liquidity: - With the help of secondary market investors can sell off their holdings and
convert them into liquid cash. Commercial banks also allow investors to withdraw their
deposits, as and when they are in need of funds.

12. Revival of Sick Units: - The Commercial and Financial Institutions provide timely financial
assistance to viable sick units to overcome their industrial sickness. To help the weak units to
overcome their financial industrial sickness banks and FIs may write off a part of their loan.

FACTORS CONTRIBUTING TO THE GROWTH AND DEVELOPMENT OF CAPITAL MARKET

1) Growth Of Development Banks And Financial Institutions:-

For providing long term funds to industry, the government set up Industrial Finance
Corporation in India (IFCI) in 1948. This was followed by a number of other development banks
and institutions like the Industrial Credit and Investment Corporation of India (ICICI) in 1955,
Industrial Development Bank of India (IDBI) in 1964, Industrial Reconstruction Corporation of
India (IRCI) in 1971, Foreign Investment Promotion Board in 1991, Over the Counter Exchange
of India (OTCEI) in 1992 etc. In 1969, 14 major commercial banks were nationalised. Another 6
banks were nationalised in 1980. These financial institutions and banks have contributed in
widening and strengthening of capital market in India.

2) Setting Up Of SEBI:-

The Securities Exchange Board of India (SEBI) was set up in 1988 and was given statutory
recognition in 1992.

3) Credit Rating Agencies:-

Credit rating agencies provide guidance to investors / creditors for determining the credit risk.
The Credit Rating Information Services of India Limited (CRISIL) was set up in 1988 and
Investment Information and Credit Rating Agency of India Ltd. (ICRA) was set up in 1991. These
agencies are likely to help the development of capital market in future.

4) Growth of Mutual Funds:-

The mutual funds collect funds from public and other investors and channelise them into
corporate investment in the primary and secondary markets. The first mutual fund to be set up
in India was Unit Trust of India in 1964. In 2007-08 resources mobilised by mutual funds were
Rs. 1,53,802crores.

5) Increasing Awareness:-

During the last few years there has been increasing awareness of investment opportunities
among the public. Business newspapers and financial journals (The Economic Times, The
Financial Express, Business India, and Money etc.) have made the people aware of new long-
term investment opportunities in the security market.

6) Growing Public Confidence

A large number of big corporations have shown impressive growth. This has helped in building
up the confidence of the public. The small investors who were not interested to buy securities
from the market are now showing preference in favour of shares and debentures. As a result,
public issues of most of the good companies are now over-subscribed many times.

7) Legislative Measures: - The government passed the companies Act in 1956. The Act gave
powers to government to control and direct the development of the corporate enterprises in
the country. The capital Issues (control) Act was passed in 1947 to regulate investment in
different enterprises, prevent diversion of funds to non-essential activities and to protect the
interest of investors. The Act was replaced in 1992.

8) Growth Of Underwriting Business:-

The growing underwriting business has contributed significantly to the development of capital
market.

9) Development Of Venture Capital Funds:-

Venture capital represents financial investment in highly risky projects with a hope of earning
high returns After 1991, economic liberalisation has made possible to provide medium and long
term funds to those firms, which find it difficult to raise funds from primary markets and by way
of loans from FIs and banks.

10) Growth of Multinationals (MNCs):-

The MNCs require medium and long term funds for setting up new projects or for expansion
and modernisation. For this purpose, MNCs raise funds through loans from banks and FIs. Due
to the presence of MNCs, the capital market gets a boost.

11) Growth ofEntrepreneurs:-

Since 1980s, there has been a remarkable growth in the number of entrepreneurs. This created
more demand for short term and long term funds. FIs, banks and stock markets enable the
entrepreneurs to raise the required funds. This has led to the growth of capital market in India.

12) Growth of Merchant Banking:-

The credit for initiating merchant banking services in India goes to Grindlays Bank in 1967,
followed by Citibank in 1970. Apart from capital issue management, merchant banking divisions
provide a number of other services including provision of consultancy services relating to
promotion of projects, corporate restructuring etc.

REFORMS / DEVELOPMENTS IN CAPITAL MARKET SINCE 1991:-

The government has taken several measures to develop capital market in post-reform period,
with which the capital market reached new heights. Some of the important measures are

1) Securities and Exchange Board of India (SEBI):- SEBI became operational since 1992. It was
set with necessary powers to regulate the activities connected with marketing of securities and
investments in the stock exchanges, merchant banking, portfolio management, stock brokers
and others in India. The objective of SEBI is to protect the interest of investors in primary and
secondary stock markets in the country.

2) National Stock Exchange (NSE):- The setting up to NSE is a landmark in Indian capital
markets. At present, NSE is the largest stock market in the country. Trading on NSE can be done
throughout the country through the network of satellite terminals. NSE has introduced inter-
regional clearing facilities.

3) Dematerialisation Of Shares :-Demat of shares has been introduced in all the shares traded
on the secondary stock markets as well as those issued to the public in the primary markets.
Even bonds and debentures are allowed in demat form. The advantage of demat trade is that it
involves Paperless trading.

4) Screen Based Trading: - The Indian stock exchanges were modernised in 90s, with
Computerised Screen Based Trading System (SBTS), It cuts down time, cost, risk of error and
fraud and there by leads to improved operational efficiency. The trading system also provides
complete online market information through various inquiry facilities.

5) Investor Protection :- The Central Government notified the establishment of Investor

Education and Protection Fund (IEPF) with effect from 1st Oct. 2001: The IEPF shall be credited
with amounts in unpaid dividend accounts of companies, application moneys received by
companies for allotment of any securities and due for refund, matured deposits and debentures
with companies and interest accrued there on, if they have remained unclaimed and unpaid for
a period of seven years from the due date of payment. The IEPF will be utilised for promotion of
awareness amongst investors and protection of their interests.

6) Rolling Settlement: - Rolling settlement is an important measure to enhance the efficiency

and integrity of the securities market. Under rolling settlement all trades executed on a trading
day (T) are settled after certain days (N). This is called T + N rolling settlement. Since April 1,
2002 trades are settled’ under T + 3 rolling settlement. In April 2003, the trading cycle has been
reduced to T + 2 days. The shortening of trading cycle has reduced undue speculation on stock
markets. ?

7) The Clearing Corporation Of India Limited (CCIL):- The CCIL was registered in 2001, under
the Companies Act, 1956 with the State Bank of India as the Chief Promoter. The CCIL clears all
transactions in government securities and repos and also Rupee / US $ forex spot and forward
deals All trades in government securities below Rs. 20 crores would be mandatorily settled
through CCIL, white those above Rs. 20 crores would have the option for settlement through
the RBI or CCIL.

8) The National Securities Clearing Corporation Limited (NSCL):- The NSCL was set up in 1996.
It has started guaranteeing all trades in NSE since July 1996. The NSCL is responsible for post-
trade activities of NSE. It has put in place a comprehensive risk management system, which is
constantly monitored and upgraded to pre-expect market failures.
9) Trading In Central Government Securities: - In order to encourage wider participation of all
classes of investors, including retail investors, across the country, trading in government
securities has been introduced from January 2003. Trading in government securities can be
carried out through a nationwide, anonymous, order-driver, screen-based trading system of
stock exchanges in the same way in which trading takes place in equities.

10) Credit Rating Agencies:- Various credit rating agencies such as Credit Rating Information
services of India Ltd. (CRISIL – 1988), Investment Information and credit Rating Agency of India
Ltd. (ICRA – 1991), etc. were set up to meet the emerging needs of capital market. They also
help merchant bankers, brokers, regulatory authorities, etc. in discharging their functions
related to debt issues.

11) Accessing Global Funds Market: - Indian companies are allowed to access global finance
market and benefit from the lower cost of funds. They have been permitted to raise resources
through issue of American Depository Receipts (ADRs), Global Depository Receipts (GDRs),
Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs).
Further Indian financial system is opened up for investments of foreign funds through Non-
Resident Indians (NRIs), Foreign Institutional investors (FIls), and Overseas Corporate Bodies
(OCBs).

12) Mutual Funds: - Mutual Funds are an important avenue through which households
participate in the securities market. As an investment intermediary, mutual funds offer a variety
of services / advantages to small investors. SEBI has the authority to lay down guidelines and
supervise and regulate the working of mutual funds.

13) Internet Trading: - Trading on stock exchanges is allowed through internet, investors can
place orders with registered stock brokers through internet. This enables the stock brokers to
execute the orders at a greater pace.
14) Buy Back Of Shares: - Since 1999, companies are allowed to buy back of shares. Through
buy back, promoters reduce the floating equity stock in market. Buy back of shares help
companies to overcome the problem of hostile takeover by rival firms and others.

15) Derivatives trading: - Derivatives trading in equities started in June 2000. At present,
there are four equity derivative products in India Stock Futures, Stock Options, Index Futures,
and Index Options. Derivative trading is permitted on two stock exchanges in India i.e. NSE and
BSE. At present in India, derivatives market turnover is more than cash market.

16) PAN Made Mandatory: - In order to strengthen the “Know your client” norms and to
have sound audit trail of transactions in securities market, PAN has been made mandatory with
effect from January 1, 2007.

New issues market

The primary market is the part of the capital market that deals with issuing of new security
finance securities. Companies, governments or public sector institutions can obtain funds
through the sale of a new stock or bond issues through primary market. This is typically done
through an investment bank or finance syndicate of securities dealers.
The process of selling new issues to investors is called underwriting. In the case of a new stock
issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the
price of the security offering, though it can be found in the prospectus. Primary markets create
long term instruments through which corporate entities borrow from capital market.
Once issued the securities typically trade on a secondary market such as a stock exchange, bond
market or derivatives exchange.
Features
Features of primary markets are:
  This is the market for new long term equity capital. The primary market is the market
where the securities are sold for the first time. Therefore it is also called the new issue
market (NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation in the
economy.
 The new issue market does not include certain other sources of new long term external
finance, such as loans from financial institutions. Borrowers in the new issue market
may be raising capital for converting private capital into public capital; this is known as
"going public."
Companies raise funds to finance their projects through variousmethods. The promoters can
bring their own money ofborrow from the financial institutions or mobilize capital byissuing
securities. The funds may be raised through issue offresh shares at par or premium, preferences
shares, debenturesor global depository receipts. The main objectives of a capitalissue are given
below:
· To promote a new company
· To expand an existing company
· To diversify the production
· To meet the regular working capital requirements
· To capitalise the reserves
New Issue Market (Primary Market)
Stock available for the first time is offered through new issuemarket. The issuer may be a new
company or an existingcompany. These issues may be of new type or the security usedin the
past. In the new issue market the issuer can be consideredas a manufacturer. The issuing
houses, investment bankers andbrokers act as the channel of distribution for the new
issues.They take the responsibility of selling the stocks to the public.
The main function of the New Issue Market, i.e. channeling of investible funds, can be divided,
from the operational stand-point, into a triple-service function:
(a) Origination
(b) Underwriting
(c) Distribution
The institutional setup dealing with these can be said to constitute the New Issue Market
organisation. Let us elucidate a little on all of these.
(a) Origination:
Origination refers to the work of investigation and analysis and processing of new proposals.
This in turn may be:
(i) A preliminary investigation undertaken by the sponsors (specialised agencies) of the issue.
This involves a/careful study of the technical, economic, financial and/legal aspects of the
issuing companies to ensure that/it warrants the backing of the issue house.
(ii) Services of an advisory nature which go to improve the quality of capital issues. These
services include/advice on such aspects of capital issues as: determination of the class of
security to be/issued and price of the issue in terms of market conditions; the timing and
magnitude of issues; method of flotation; and technique of selling and so on.
The importance of the specialised services provided by the New Issue Market organisation in
this respect can hardly be over-emphasized. On the thoroughness of investigation and
soundness of judgement of the sponsoring institution depends, to a large extent, the allocative
efficiency of the market. The origination, however, thoroughly done, will not by itself guarantee
success of an issue. A second specialised service i.e. “Underwriting” is often required.

(b) Underwriting:
The idea of underwriting originated on account of uncertainties prevailing in the capital market
as a result of which the success of the issue becomes unpredictable. If the issue remains
undersubscribed, the directors cannot proceed to allot the shares, and have to return money to
the applicants if the subscription is below a minimum amount fixed under the Companies Act.
Consequently, the issue and hence the project will fail.
Underwriting entails an agreement whereby a person/organisation agrees to take a specified
number of shares or debentures or a specified amount of stock offered to the public in the
event of the public not subscribing to it, in consideration of a commission the underwriting
commission.
If the issue is fully subscribed by the public, there is no liability attaching to the underwriters;
else they have to come forth to meet the shortfall to the extent of the under- subscription.
The underwriters in India may broadly be classified into the following two types:
(i) Institutional Underwriters;
(ii) Non-Institutional Underwriting.
Institutional Underwriting in our country has been development oriented. It stands as a major
support to those projects which often fail to catch the eye of investing public. These projects
rank high from the points of view of national importance e.g. steel, fertilizer, and generally
receive higher priority by such underwriters.
Thus institutional underwriting may be broadly recognised, in the context of development
credit, as playing a decisive role in directing the economic resources of the country towards
desired activities.
This does not mean that they are barred entrance in the issue market from so called glamorous
issues to which public can be expected to readily subscribe. They may be underwriting in such
cases, but what is expected of them is their support to projects in the priority sector.
One of the principal advantages they offer is that resource-wise they are undoubted. They are
in a position to fulfill their underwriting commitments even in the worst foreseeable situations.
The public financial institutions namely IDBI, IFCI, ICICI, LIC and UTI, underwrite a portion of the
issued capital. Usually, the underwriting is done in addition to granting term finance by way of
loans on debentures. These institutions are usually approached when one or more of the
following situations prevail:

(i) The issue is so large that broker-underwriting may not be able to cover the entire issue.
(ii) The gestation period is long enough to act as distinctive
(iii) The project is weak, inasmuch as it is being located in a backward area.
(iv) The project is in the priority sector which may not be able to provide an attractive return on
investment.
(v) The project is promoted by technicians.
(vi) The project is new to the market.
The quantum of underwriting assistance varies from institution to institution according to the
commitments of each of them for a particular industry.
However, institutional underwriting suffers from the following two drawbacks:
1. The institutional handling involves procedural delays which sometimes dampen the initiative
of the corporate managers or promoters.
2. The other disadvantage is that the institutions prefer to wait and watch the results to fulfill
their obligations only where they are called upon to meet the deficit caused by under
subscription.
(c) Distribution :
The sale of securities to the ultimate investors is referred to as distribution; it is another
specialised job, which can be performed by brokers and dealers in securities who maintain
regular and direct contact with the ultimate investors. The ability of the New Issue Market to
cope with the growing requirements of the expanding corporate sector would depend on this
triple-service function.
Banking Legislations in India.
The banking system in India is regulated by the Reserve Bank of India (RBI), through the
provisions of the Banking Regulation Act, 1949. Some important aspects of the regulations
which govern banking in this country, as well as RBI circulars that relate to banking in India, will
be dealt with in this article:
Exposure limits
Lending to a single borrower is limited to 15% of the bank’s capital funds (tier 1 and tier 2
capital), which may be extended to 20% in the case of infrastructure projects. For group
borrowers, lending is limited to 30% of the bank’s capital funds, with an option to extend it to
40% for infrastructure projects. The lending limits can be extended by a further 5% with the
approval of the bank's board of directors. Lending includes both fund-based and non-fund-
based exposure.
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
Banks in India are required to keep a minimum of 4% of their net demand and time liabilities
(NDTL) in the form of cash with the RBI. These currently earn no interest. The CRR needs to be
maintained on a fortnightly basis, while the daily maintenance needs to be at least 95% of the
required reserves. In case of default on daily maintenance, the penalty is 3% above the bank
rate applied on the number of days of default multiplied by the amount by which the amount
falls short of the prescribed level.
Over and above the CRR, a minimum of 22% and maximum of 40% of NDTL, which is known as
the SLR, needs to be maintained in the form of gold, cash or certain approved securities. The
excess SLR holdings can be used to borrow under the Marginal Standing Facility (MSF) on an
overnight basis from the RBI. The interest charged under MSF is higher than the repo rate by
100 bps, and the amount that can be borrowed is limited to 2% of NDTL. (To learn more about
how interest rates are determined, particularly in the U.S., see: Who Determines Interest
Rates.)
Provisioning
Non-performing assets (NPA) are classified under 3 categories: Substandard, Doubtful and Loss.
An asset becomes non-performing if there have been no interest or principal payments for
more than 90 days in the case of a term loan. Substandard assets are those assets with NPA
status for less than 12 months, at the end of which they are categorized as doubtful assets. A
loss asset is one for which the bank or auditor expects no repayment or recovery and is
generally written off the books.

For substandard assets, it is required that a provision of 15% of the outstanding loan amount
for secured loans and 25% of the outstanding loan amount for unsecured loans be made. For
doubtful assets, provisioning for the secured part of the loan varies from 25% of the
outstanding loan for NPA’s which have been in existence for less than one year to 40% for
NPA’s in existence between one and three years to 100% for NPA’s with a duration of more
than three years, while for the unsecured part it is 100%.

Provisioning is also required on standard assets. Provisioning for agriculture and small and
medium enterprises is 0.25% and for commercial real estate it is 1% (0.75% for housing), while
it is 0.4% for the remaining sectors. Provisioning for standard assets cannot be deducted from
gross NPA’s to arrive at net NPA’s. Additional provisioning over and above the standard
provisioning is required for loans given to companies that have unhedged foreign exchange
exposure.
Priority sector lending
The priority sector broadly consists of micro and small enterprises, and initiatives related to
agriculture, education, housing and lending to low-earning or less privileged groups (classified
as "weaker sections"). The lending target of 40% of adjusted net bank credit (ANBC)
(outstanding bank credit minus certain bills and non-SLR bonds) -- or the credit equivalent
amount of off balance sheet exposure (sum of current credit exposure + potential future credit
exposure that is calculated using a credit conversion factor), whichever is higher -- has been set
for domestic commercial banks and foreign banks with greater than 20 branches, while a target
of 32% exists for foreign banks with less than 20 branches.

The amount that is disbursed as loans to the agriculture sector should either be the credit
equivalent of off balance sheet exposure, or 18% of ANBC -- whichever of the two figures is
higher. Of the amount that is loaned to micro-enterprises and small businesses, 40% should be
advanced to those enterprises with equipment that has a maximum value of 200,000 rupees,
and plant and machinery valued at a maximum of half a million rupees, while 20% of the total
amount lent is to be advanced to micro-enterprises with plant and machinery ranging in value
from just above 500,000 rupees to a maximum of a million rupees and equipment with a value
above 200,000 rupees but not more than 250,000 rupees. The total value of loans given to
weaker sections should either be 10% of ANBC or the credit equivalent amount of off balance
sheet exposure, whichever is higher. Weaker sections include specific castes and tribes that
have been assigned that categorization, as well as small farmers etc. There are no specific
targets for foreign banks with less than 20 branches.

The private banks in India until now have been reluctant to directly lend to farmers and other
weaker sections. One of the main reasons is the disproportionately higher amount of NPA’s
from priority sector loans, with some estimates indicating it to be 60% of the total NPA’s. They
achieve their targets by buying out loans and securitized portfolios from other non-banking
finance corporations (NBFC) and investing in the Rural Infrastructure Development Fund (RIDF)
to meet their quota.
New bank license norms
The new guidelines state that the groups applying for a license should have a successful track
record of at least 10 years and the bank should be operated through a non-operative financial
holding company (NOFHC) wholly owned by the promoters. The minimum paid-up voting equity
capital has to be five billion rupees, with the NOFHC holding at least 40% of it and gradually
bringing it down to 15% over 12 years. The shares have to be listed within 3 years of the start of
the bank’s operations.

The foreign shareholding is limited to 49% for the first 5 years of its operation, after which RBI
approval would be needed to increase the stake to a maximum of 74%. The board of the bank
should have a majority of independent directors and it would have to comply with the priority
sector lending targets discussed earlier. The NOFHC and the bank are prohibited from holding
any securities issued by the promoter group and the bank is prohibited from holding any
financial securities held by the NOFHC. The new regulations also stipulate that 25% of the
branches should be opened in previously unbanked rural areas.
Willful defaulters
A willful default takes place when a loan isn’t repaid even though resources are available, or if
the money lent is used for purposes other than the designated purpose, or if a property
secured for a loan is sold off without the bank's knowledge or approval. In case a company
within a group defaults and the other group companies that have given guarantees fail to honor
their guarantees, the entire group can be termed as a willful defaulter. Willful defaulters
(including the directors) have no access to funding, and criminal proceedings may be initiated
against them. The RBI recently changed the regulations to include non-group companies under
the willful defaulter tag as well if they fail to honor a guarantee given to another company
outside the group.
 UNIT III

INDUSTRIAL AND AGRICULTURAL BANKING SYSTEMS: All Indian Development Banks-

Investment Institutions- State Level Institutions- Specialized Financial Institutions- International
Finance Institutions- IBRD- IFC- IDA- NABARD- NHB-Micro Financing Institutions.

All Indian Development Banks

The major objectives of development banks in India are as follows:

Development Banks are those financial institutions that provide funds and financial
assistance to new and upcoming business enterprises. Development bank helps in According to
Willian Diamond, "development bank is a financial institution to promote and finance
enterprises in private sector."
Development banks like IDBI, SIDBI, and IFCI etc. were set up to meet long term and
short term capital requirements of the industry. Development banks coordinate the activities of
those institutions, engaged in financing, promoting and developing industries. They help in
accelerating industrial and economic growth.
The following are the objectives of development banks:
1. Rapid Industrial growth:
Industrial sector is the dynamic sector of the Indian economy. This sector contributes to the
generation of employment and income in the country. Funds are provided by the development
banks to start a new business venture, expansion and diversification of the business in new
sector etc.
These funds are utilised to achieve several objectives that leads to accelerate industries and
economic growth. Development banking supports the programmes of industrialisation of the
country, by promoting entrepreneurial activities.
2. Encouraging entrepreneurs:
Industrialisation helps in curbing economic and social problems thereby making economies
progress. Emerging entrepreneurs are encouraged to give shape to their ideas. Development
bank helps those entrepreneurs by providing funds for commencing new business.
Government has recognised the importance of entrepreneurs in the industrial development
and thus providing number of facilities and incentives to motivate them for undertaking
industrial projects.
3. Balanced regional development:
There has been always an issue related to regional disparities. Development bank helps in
curbing these regional disparities by providing funds to the entrepreneurs at low rate of
interest if the organisation is planned in the backward areas. This would lead to the
development of all areas thereby making balanced regional development.
4. Filling gaps:
It is not possible for the commercial banks to fulfill all financial needs of all the customers.
Absence of organised capital market, absence of adequate facilities for financing industries
arise the problem of slow development of industrialisation. Such development banks can fulfill
the credit gap. They provide long- term funds for industries where gestation period may be
longer.

5. Helps government:
Government formulates financial policies with the help of development banks. They also help in
implementing these policies. For example, NABARD bank is set up as an apex development
bank for extending support to the rural areas. It helps the government in matters relating to the
rural development, offers training and research facilities for banks working in the field of rural
development, and acts as a regulator for co-operative banks and RRB's.
Development banks in India are classified into following four groups:
A. Industrial Development Banks: It includes, for example, Industrial Finance Corporation
of India (IFCI), Industrial Development Bank of India (IDBI), and Small Industries Development
Bank of India (SIDBI).

i. IFCI: The IFCI was the 1st specialised financial institution setup in India to provide term
finance to large industries in India. It was established on 1st July, 1948 under The Industrial
Finance Corporation Act of 1948.
Objectives of IFCI:
The main objective of IFCI is too provide medium and long term financial assistance to large
scale industrial undertakings, particularly when ordinary bank accommodation does not suit the
undertaking or finance cannot be profitably raised by the concerned by the issue of shares.
Functions of IFCI:
1) For setting up a new industrial undertaking.
2) For expansion and diversification of existing industrial undertaking.
3) For renovation and modernisation of existing concerns.
4) For meeting the working capital requirements of industrial concerns in some exceptional
cases.

ii. IDBI: Industrial Development Bank of India (IDBI)

The Industrial Development Bank of India (IDBI) was established on 1 July 1964 under an
Act of Parliament as a wholly owned subsidiary of the Reserve Bank of India. The main objective
was to promote and finance the development of industries. In 16 February 1976, the ownership
of IDBI was transferred to the Government of India and it was made the principal financial
institution for coordinating the activities of institutions engaged in financing, promoting and
developing industry in the country. Although Government shareholding in the Bank came down
below 100% following IDBI’s public issue in July 1995, the former continues to be the major
shareholder.

iii. SIDBI: Small Industries Development Bank of India is an independent financial

institution aimed to aid the growth and development of micro, small and medium-scale
enterprises in India. Set up on April 2, 1990 through an act of parliament, it was incorporated
initially as a wholly owned subsidiary of Industrial Development Bank of India. Current
shareholding is widely spread among various state-owned banks, insurance companies and
financial institutions. It is the Principal Financial Institution for the Promotion, Financing and
Development of the Micro, Small and Medium Enterprise (MSME) sector and for Co-ordination
of the functions of the institutions engaged in similar activities. Mr. SushilMahnot is the
chairman of SIDBI since April 4, 2012.
B. Agricultural Development Banks: It includes, for example, National Bank for Agriculture
& Rural Development (NABARD).

• National Bank for Agriculture and Rural Development (NABARD) is an apex

development bank in India having headquarters based in Mumbai (Maharashtra) and other
branches are all over the country. It was established on 12 July 1982 by a special act by the
parliament and its main focus was to uplift rural India by increasing the credit flow for elevation
of agriculture & rural non-farm sector. NABARD is the apex institution in the country which
looks after the development of the cottage industry, small industry and village industry, and
other rural industries.
Role:
• Undertakes monitoring and evaluation of projects refinanced by it.
• NABARD refinances the financial institutions which finances the rural sector.
• It regulates the institution which provides financial help to the rural economy.
• It provides training facilities to the institutions working in the field of rural upliftment.
• It regulates the cooperative banks and the RRB’s.

C. Export-Import Development Banks: It includes, for example, Export-Import Bank of

India (EXIM Bank).
• The Export-Import Bank of India (Exim Bank) is a public sector financial institution
created by an Act of Parliament, the Export-import Bank of India Act, 1981. The business of
Exim Bank is to finance Indian exports that lead to continuity of foreign exchange for India. The
Exim Bank extends term loans for foreign trade.

D. Housing Development Banks: It includes, for example, National Housing Bank (NHB).
• National Housing Bank: The National Housing Bank (NHB) is a state owned bank and
regulation authority in India, created on July 8, 1988 under section 6 of the National Housing
Bank Act (1987). The headquarters is in New Delhi. The institution, owned by the Reserve Bank
of India, was established to promote private real estate acquisition. The NHB is regulating and
re-financing social housing programs and other activities like research etc. Its vision is
promoting inclusive expansion with stability in housing finance market.
 State Level Institutions

Several financial institutions have been set up at the State level which supplements the
financial assistance provided by the all India institutions. They act as a catalyst for promotion of
investment and industrial development in the respective States. They broadly consist of 'State
financial corporations' and 'State industrial development corporations'.
State Financial Corporations (SFCs):- are the State-level financial institutions which play a
crucial role in the development of small and medium enterprises in the concerned States. They
provide financial assistance in the form of term loans, direct subscription to equity/debentures,
guarantees, discounting of bills of exchange and seed/ special capital, etc. SFCs have been set
up with the objective of catalyzing higher investment, generating greater employment and
widening the ownership base of industries. They have also started providing assistance to
newer types of business activities like floriculture, tissue culture, poultry farming, commercial
complexes and services related to engineering, marketing, etc.
There are 18 State Financial Corporations (SFCs) in the country:-
 Andhra Pradesh State Financial Corporation (APSFC)
 Himachal Pradesh Financial Corporation (HPFC)
 Madhya Pradesh Financial Corporation (MPFC)
 North Eastern Development Finance Corporation (NEDFI)
 Rajasthan Finance Corporation (RFC)
 Tamil Nadu Industrial Investment Corporation Limited
 Uttar Pradesh Financial Corporation (UPFC)
 Delhi Financial Corporation (DFC)
 Gujarat State Financial Corporation (GSFC)
 The Economic Development Corporation of Goa ( EDC)
 Haryana Financial Corporation ( HFC )
 Jammu & Kashmir State Financial Corporation ( JKSFC)
 Karnataka State Financial Corporation (KSFC)
 Kerala Financial Corporation ( KFC )
  Maharashtra State Financial Corporation (MSFC )
 Odisha State Financial Corporation (OSFC)
 Punjab Financial Corporation (PFC)
 West Bengal Financial Corporation (WBFC)
State Industrial Development Corporations (SIDCs):- have been established under the
Companies Act, 1956, as wholly-owned undertakings of State Governments. They have been set
up with the aim of promoting industrial development in the respective States and providing
financial assistance to small entrepreneurs. They are also involved in setting up of medium and
large industrial projects in the joint sector/assisted sector in collaboration with private
entrepreneurs or wholly-owned subsidiaries. They are undertaking a variety of promotional
activities such as preparation of feasibility reports; conducting industrial potential surveys;
entrepreneurship training and development programmes; as well as developing industrial
areas/estates.
The State Industrial Development Corporations in the country are:-
 Assam Industrial Development Corporation Ltd (AIDC)
 Andaman & Nicobar Islands Integrated Development Corporation Ltd (ANIIDCO)
 Andhra Pradesh Industrial Development Corporation Ltd (APIDC)
 Bihar State Credit and Investment Corporation Ltd. (BICICO)
 Chhattisgarh State Industrial Development Corporation Limited (CSIDC)
 Goa Industrial Development Corporation
 Gujarat Industrial Development Corporation (GIDC)
 Haryana State Industrial & Infrastructure Development Corporation Ltd. (HSIIDC)
 Himachal Pradesh State Industrial Development Corporation Ltd. (HPSIDC)
 Jammu and Kashmir State Industrial Development Corporation Ltd.
 Karnataka State Industrial Investment & Development Corporation Ltd. (KSIIDC)
 Kerala State Industrial Development Corporation Ltd. (KSIDC)
 Maharashtra Industrial Development Corporation (MIDC)
 Manipur Industrial Development Corporation Ltd. (MANIDCO)
 Nagaland Industrial Development Corporation Ltd. (NIDC)
  Odisha Industrial Infrastructure Development Corporation
 Omnibus Industrial Development Corporation (OIDC), Daman & Diu and Dadra & Nagar
Haveli.
 Pudhucherry Industrial Promotion Development and Investment Corporation Ltd.
(PIPDIC)
 Uttar Pradesh State Industrial Development Corporation
 Punjab State Industrial Development Corporation Ltd. (PSIDC)
 Rajasthan State Industrial Development & Investment Corporation Ltd. (RIICO)
 Sikkim Industrial Development & Investment Corporation Ltd. (SIDICO)
 Tamil Nadu Industrial Development Corporation Ltd. (TIDCO)
 State Infrastructure & Industrial Development Corporation of Uttaranchal Ltd. (SIDCUL)
 Tripura Industrial Development Corporation Ltd. (TIDC)

Specialized Financial Institutions (SFIs)

Specialized Financial Institutions (SFIs):- are the institutions which have been set up to serve
the increasing financial needs of commerce and trade in the area of venture capital, credit
rating and leasing, etc.
* IFCI Venture Capital Funds Limited (IVCF): formerly known as Risk Capital & Technology
Finance Corporation Ltd (RCTC), is a subsidiary of IFCI Ltd. It was promoted with the objective of
broadening entrepreneurial base in the country by facilitating funding to ventures involving
innovative product/process/technology. Initially, it started providing financial assistance by way
of soft loans to promoters under its 'Risk capital scheme'. Since 1988, it also started providing
finance under 'Technology finance and Development scheme' to projects for commercialization
of indigenous technology for new processes, products, market or services. Over the years, it has
acquired great deal of experience in investing in technology-oriented projects.
* ICICI Venture Funds Ltd: formerly known as Technology Development & Information
Company of India Limited (TDICI), was founded in 1988 as a joint venture with the Unit Trust of
India. Subsequently, it became a fully owned subsidiary of ICICI. It is a technology venture
finance company, set up to sanction project finance for new technology ventures. The industrial
units assisted by it are in the fields of computer, chemicals/polymers, drugs, diagnostics and
vaccines, biotechnology, environmental engineering, etc.
* Tourism Finance Corporation of India Ltd. (TFCI):- is a specialized financial institution set up
by the Government of India for promotion and growth of tourist industry in the country. Apart
from conventional tourism projects, it provides financial assistance for non-conventional
tourism projects like amusement parks, ropeways, car rental services, ferries for inland water
transport, etc.

The international financial institutions (IFIs)

The international financial institutions (IFIs) are financial institutions that have been
established (or chartered) by more than one country, and hence are subjects of international
law. Their owners or shareholders are generally national governments, although other
international institutions and other organizations occasionally figure as shareholders. The most
prominent IFIs are creations of multiple nations, although some bilateral financial institutions
(created by two countries) exist and are technically IFIs. The best known IFIs were established
after World War II to assist in the reconstruction of Europe and provide mechanisms for
international cooperation in managing the global financial system.
A multilateral development bank (MDB)
A multilateral development bank (MDB) is an institution, created by a group of countries that
provides financing and professional advising for the purpose of development. MDBs have large
memberships including both developed donor countries and developing borrower countries.
MDBs finance projects in the form of long-term loans at market rates, very-long-term loans
(also known as credits) below market rates, and through grants.
 The following are usually classified as the main MDBs:
 World Bank
 International Fund for Agricultural Development (IFAD)
 European Investment Bank (EIB)
 Islamic Development Bank (IsDB)
  Asian Development Bank (ADB)
 European Bank for Reconstruction and Development (EBRD)
 CAF - Development Bank of Latin America (CAF)
 Inter-American Development Bank Group (IDB, IADB)
 African Development Bank (AfDB)
 Asian Infrastructure Investment Bank (AIIB)
There are also several "sub-regional" multilateral development banks. Their membership
typically includes only borrowing nations. The banks lend to their members, borrowing from the
international capital markets. Because there is effectively shared responsibility for repayment,
the banks can often borrow more cheaply than could any one member nation. These banks
include:
 Caribbean Development Bank (CDB)
 Central American Bank for Economic Integration (CABEI)
 East African Development Bank (EADB)
 West African Development Bank (BOAD)
 Black Sea Trade and Development Bank (BSTDB)
 Economic Cooperation Organization Trade and Development Bank (ETDB)
 Eurasian Development Bank (EDB)
 New Development Bank (NDB)
There are also several multilateral financial institutions (MFIs). MFIs are similar to MDBs but
they are sometimes separated since they have more limited memberships and often focus on
financing certain types of projects.
 European Commission (EC)
 International Finance Facility for Immunisation (IFFIm)
 International Fund for Agricultural Development (IFAD)
 Nordic Investment Bank (NIB)
 OPEC Fund for International Development (OPEC Fund)
 NederlandseFinancieringsmaatschappijvoorOntwikkelingslanden NV (FMO)
 International Investment Bank (IIB)
  The Arab Bank for Economic Development in Africa (BADEA).

IBRD
The International Bank for Reconstruction and Development was created in 1944 to help
Europe rebuild after World War II. Today, IBRD provides loans and other assistance primarily to
middle income countries.IBRD is the original World Bank institution. It works closely with the
rest of the World Bank Group to help developing countries reduce poverty, promote economic
growth, and build prosperity.
IBRD is owned by the governments of its 188 member countries, which are represented
by a 25-member board of 5 appointed and 20 elected Executive Directors.
The institution provides a combination of financial resources, knowledge and technical services,
and strategic advice to developing countries, including middle income and credit-worthy lower
income countries.
Specifically, IBRD:
 Supports long-term human and social development that private creditors do not finance
 Preserves borrowers' financial strength by providing support in times of crisis, when
poor people are most adversely affected
 Promotes key policy and institutional reforms (such as safety net or anti-corruption
reforms)
 Creates a favorable investment climate to catalyze the provision of private capital
 Facilitates access to financial markets often at more favorable terms than members can
achieve on their own
IBRD’s Services
 The World Bank Group works with middle income countries simultaneously as clients,
shareholders, and global actors. As this partnership evolves, IBRD is providing innovative
financial solutions, including financial products (loans, guarantees, and risk management
products) and knowledge and advisory services (including on a reimbursable basis) to
governments at both the national and subnational levels.
  IBRD finances projects across all sectors and provides technical support and expertise at
various stages of a project.
 IBRD’s financial products and services help countries build resilience to shocks by
facilitating access to products that mitigate the negative impact of currency, interest
rate, and commodity price volatility, natural disasters and extreme weather.
 Unlike commercial lending, IBRD’s financing not only supplies borrowing countries with
needed financing, but also serves as a vehicle for global knowledge transfer and
technical assistance.
 Advisory services in public debt and asset management help governments, official sector
institutions, and development organizations build institutional capacity to protect and
expand financial resources.
 IBRD supports government efforts to strengthen not only public financial management,
but to also improve the investment climate, address service delivery bottlenecks, and
other policy and institutional actions.

IFC
The International Finance Corporation (IFC) is an international financial institution that
offers investment, advisory, and asset management services to encourage private sector
development in developing countries. The IFC is a member of the World Bank Group and is
headquartered in Washington, D.C., United States. It was established in 1956 as the private
sector arm of the World Bank Group to advance economic development by investing in strictly
for-profit and commercial projects that purport to reduce poverty and promote development.
The IFC's stated aim is to create opportunities for people to escape poverty and achieve better
living standards by mobilizing financial resources for private enterprise, promoting accessible
and competitive markets, supporting businesses and other private sector entities, and creating
jobs and delivering necessary services to those who are poverty-stricken or otherwise
vulnerable. Since 2009, the IFC has focused on a set of development goals that its projects are
expected to target. Its goals are to increase sustainable agriculture opportunities, improve
health and education, increase access to financing for microfinance and business clients,
advance infrastructure, help small businesses grow revenues, and invest in climate health.

The IFC is owned and governed by its member countries, but has its own executive
leadership and staff that conduct its normal business operations. It is a corporation whose
shareholders are member governments that provide paid-in capital and which have the right to
vote on its matters. Originally more financially integrated with the World Bank Group, the IFC
was established separately and eventually became authorized to operate as a financially
autonomous entity and make independent investment decisions. It offers an array of debt and
equity financing services and helps companies face their risk exposures, while refraining from
participating in a management capacity. The corporation also offers advice to companies on
making decisions, evaluating their impact on the environment and society, and being
responsible. It advises governments on building infrastructure and partnerships to further
support private sector development.

IDA
The International Development Association (IDA) is an international financial institution
which offers concessional loans and grants to the world's poorest developing countries. The IDA
is a member of the World Bank Group and is headquartered in Washington, D.C., United States.
It was established in 1960 to complement the existing International Bank for Reconstruction
and Development by lending to developing countries which suffer from the lowest gross
national income, from troubled creditworthiness, or from the lowest per capita income.
Together, the International Development Association and International Bank for Reconstruction
and Development are collectively generally known as the World Bank, as they follow the same
executive leadership and operate with the same staff.
The association shares the World Bank's mission of reducing poverty and aims to
provide affordable development financing to countries whose credit risk is so prohibitive that
they cannot afford to borrow commercially or from the Bank's other programs. The IDA's stated
aim is to assist the poorest nations in growing more quickly, equitably, and sustainably to
reduce poverty. The IDA is the single largest provider of funds to economic and human
development projects in the world's poorest nations. From 2000 to 2010, it financed projects
which recruited and trained 3 million teachers, immunized 310 million children, funded $792
million in loans to 120,000 small and medium enterprises, built or restored of 118,000
kilometers of paved roads, built or restored 1,600 bridges, and expanded access to improved
water to 113 million people and improved sanitation facilities to 5.8 million people. The IDA has
issued a total $238 billion USD in loans and grants since its launch in 1960. Thirty-six of the
association's borrowing countries have graduated from their eligibility for its concessional
lending. However, eight of these countries have relapsed and have not re-graduated.

NABARD
National Bank for Agriculture and Rural Development (NABARD) is an apex development
bank in India, having headquarters in Mumbai (Maharashtra) and other branches are all over
the country. The committee to review arrangements for institutional credit for agriculture and
rural development (CRAFICARD), set up by the Reserve Bank of India (RBI) under the
chairmanship of Shri B. Sivaraman, conceived and recommended the establishment of National
Bank for Agriculture and Rural Development (NABARD). It was established on 12 July 1982 by a
special Act of parliament and its main focus was on upliftment of rural India by increasing the
credit flow for elevation of agriculture & rural non-farm sector and completed its 25 years on 12
July 2007. It has been entrusted with "matters concerning policy, planning and operations in
the field of credit for agriculture and other economic activities in rural areas in India". RBI sold
its stake in NABARD to the Government of India, which now holds 99% stake. NABARD is active
in developing financial inclusion policy and is a member of the Alliance for Financial Inclusion.
Role
NABARD is the apex institution in the country which looks after the development of the cottage
industry, small industry and village industry, and other rural industries. NABARD also reaches
out to allied economies and supports and promotes integrated development. NABARD
discharge its duty by undertaking the following roles :
  Serves as an apex financing agency for the institutions providing investment and
production credit for promoting the various developmental activities in rural areas
 Takes measures towards institution building for improving absorptive capacity of the
credit delivery system, including monitoring, formulation of rehabilitation schemes,
restructuring of credit institutions, training of personnel, etc.
 Co-ordinates the rural financing activities of all institutions engaged in developmental
work at the field level and maintains liaison with Government of India, state
governments, Reserve Bank of India (RBI) and other national level institutions concerned
with policy formulation
 Undertakes monitoring and evaluation of projects refinanced by it.
 NABARD refinances the financial institutions which finances the rural sector.
 NABARD partakes in development of institutions which help the rural economy.
 NABARD also keeps a check on its client institutes.
 It regulates the institutions which provide financial help to the rural economy.
 It provides training facilities to the institutions working in the field of rural upliftment.
 It regulates the cooperative banks and the RRB’s, and manages talent acquisition
through IBPS CWE.
NABARD's refinance is available to state co-operative agriculture and rural development
banks (SCARDBs), state co-operative banks (SCBs), regional rural banks (RRBs), commercial
banks (CBs) and other financial institutions approved by RBI. While the ultimate beneficiaries of
investment credit can be individuals, partnership concerns, companies, State-owned
corporations or co-operative societies, production credit is generally given to individuals.
NABARD has its head office at Mumbai, India.
NABARD Regional Office [RO] has a Chief General Manager [CGMs] as its head, and the
Head office has several top executives viz the Executive Directors[ED], Managing Directors
[MD], and the Chairperson. It has 336 District Offices across the country, one special cell at
Srinagar. It also has 6 training establishments.
NABARD is also known for its 'SHG Bank Linkage Programme' which encourages India's
banks to lend to self-help groups (SHGs). Largely because SHGs are composed mainly of poor
women, this has evolved into an important Indian tool for microfinance. By March 2006, 22 lakh
SHGs representing 3.3 core members had to be linked to credit through this programme.[9]
NABARD also has a portfolio of Natural Resource Management Programmes involving
diverse fields like Watershed Development, Tribal Development and Farm Innovation through
dedicated funds set up for the purpose.

NHB
National Housing Bank (NHB), a wholly owned subsidiary of Reserve Bank of India (RBI),
was set up on 9 July 1988 under the National Housing Bank Act, 1987. NHB is an apex financial
institution for housing. NHB has been established with an objective to operate as a principal
agency to promote housing finance institutions both at local and regional levels and to provide
financial and other support incidental to such institutions and for matters connected
therewith.NHB registers, regulates and supervises Housing Finance Company (HFCs), keeps
surveillance through On-site & Off-site Mechanisms and co-ordinates with other Regulators.
Objectives
NHB has been established to achieve, inter-Alia, the following objectives –
 To promote a sound, healthy, viable and cost effective housing finance system to cater
to all segments of the population and to integrate the housing finance system with the
overall financial system.
 To promote a network of dedicated housing finance institutions to adequately serve
various regions and different income groups.
 To augment resources for the sector and channelize them for housing.
 To make housing credit more affordable.
 To regulate the activities of housing finance companies based on regulatory and
supervisory authority derived under the Act.
 To encourage augmentation of supply of buildable land and also building materials for
housing and to upgrade the housing stock in the country.
 To encourage public agencies to emerge as facilitators and suppliers of serviced land, for
housing.
 Micro Financing Institutions
Micro Finance Institutions, also known as MFIs, a microfinance institution is an
organization that offers financial services to low income populations. Almost all give loans to
their members, and many offer insurance, deposit and other services. A great scale of
organizations is regarded as microfinance institutes. They are those that offer credits and other
financial services to the representatives of poor strata of population (except for extremely poor
strata).
MFIs go for NBFC licenses
An Increasing number of microfinance institutions (MFIs) are seeking non-banking finance
company (NBFC) status from RBI to get wide access to funding, including bank finance.
Exemptions granted to NBFCs engaged in microfinance activities
The Task Force on Supportive Policy and Regulatory Framework for Microfinance set up by
NABARD in 1999 provided various recommendations. Accordingly, it was decided to exempt
NBFCs which are engaged in micro financing activities, licensed under Section 25 of the
Companies Act, 1956, and which do not accept public deposits, from the purview of Sections
45-IA (registration), 45-IB (maintenance of liquid assets) and 45-IC (transfer of profits to the
Reserve Fund) of the RBI Act, 1934.
MFIs & SHG-Bank linkage programme
In a joint fact-finding study on microfinance conducted by the Reserve Bank of India and a few
major banks, the following observations were made:
Some of the microfinance institutions (MFIs) financed by banks or acting as their intermediaries
or partners appear to be focusing on relatively better banked areas, including areas covered by
the SHG-Bank linkage programme. Competing MFIs were operating in the same area, and trying
to reach out to the same set of poor, resulting in multiple lending and overburdening of rural
households.Many MFIs supported by banks were not engaging themselves in capacity building
and empowerment of the groups to the desired extent. The MFIs were disbursing loans to the
newly formed groups within 10–15 days of their formation, in contrast to the practice
Obtaining in the SHG – Bank linkage programme, which takes about six to seven months for
group formation and nurturing? As a result, cohesiveness and a sense of purpose were not
being built up in the groups formed by these MFIs.
Banks, as principal financiers of MFIs, do not appear to be engaging them with regard to their
systems, practices and lending policies with a view to ensuring better transparency and
adherence to best practices. In many cases, no review of MFI operations was undertaken after
sanctioning the credit facility.
MFIs of India
Forbes magazine named seven microfinance institutes in India in the list of the world's top 50
microfinance institutions.
Bandhan, as well as two other Indian MFIs—Microcredit Foundation of India (ranked 13th) and
SaadhanaMicrofin Society (15th) – have been placed above Bangladesh-based Grameen Bank
(which along with its founder Mohammed Yunus, was awarded the Nobel Prize). Besides
Bandhan, the Microcredit Foundation of India and SaadhanaMicrofin Society, other Indian
entries include GrameenKoota (19th), Sharada's Women's Association for Weaker Section
(23rd), SKS Microfinance Private Ltd (44th) and AsmithaMicrofin Ltd (29th).
Criticisms
Recently, microfinance has come under fire in the state of Andhra Pradesh due to allegations of
MFIs using coercive recollection practices and charging usurious interest rates. These charges
resulted in the state government's passing of the Andhra Pradesh Microfinance Ordinance on
October 15, 2010. The Ordinance requires MFIs to register with the state government and gives
the state government the power, suomoto, to shut down MFI activity. A number of NBFCs have
been affected by the ordinance, including sector heavyweight SKS Microfinance.
Top 25 Microfinance Institutions in India 2014
 Annapurna Microfinance Pvt Ltd
 Arohan Financial Services Pvt Ltd
 Asirvad Microfinance Pvt Ltd
 Bandhan Financial Services Pvt Ltd
 BSS Microfinance Pvt Ltd
 Cashpor Micro Credit
 DishaMicrofinPvt Ltd
 Equitas Microfinance Pvt Ltd
 ESAF Microfinance and Investments Pvt Ltd
 Fusion Microfinance Pvt Ltd
 GramaVidiyal Micro Finance Ltd
 Grameen Financial Services Pvt Ltd
 Janalakshmi Financial Services Pvt Ltd
 Madura Micro Finance Ltd
 RGVN (North East) Microfinance Limited
 Satin Creditcare Network Ltd
 Shree KshetraDharmasthala Rural Development Project
 SKS Microfinance Ltd
 S.M.I.L.E Microfinance Ltd
 Sonata Finance Pvt Ltd
 Suryoday Micro Finance Pvt Ltd
 SV CreditlinePvt Ltd
 SwadhaarFinServePvt Ltd
 Ujjivan Financial Services Pvt Ltd
 Utkarsh Micro Finance Pvt Ltd
 UNIT IV

FINANCIAL SYSTEMS: Introduction- Overview of Indian Financial System – savings and Financial
Intermediation- financial Markets- Listing Regulations- Primary Markets- Secondary Markets-
Mutual Funds- Indian Fiscal Systems.

Introduction to Indian financial systems

Financial System of any country consists of financial markets, financial intermediation and
financial instruments or financial products. This paper discusses the meaning of finance and
Indian Financial System and focus on the financial markets, financial intermediaries and
financial instruments. The brief review on various money market instruments are also covered
in this study.
INDIAN FINANCIAL SYSTEM
The economic development of a nation is reflected by the progress of the various economic
units, broadly classified into corporate sector, government and household sector. While
performing their activities these units will be placed in a surplus/deficit/balanced budgetary
situations.
There are areas or people with surplus funds and there are those with a deficit. A financial
system or financial sector functions as an intermediary and facilitates the flow of funds from
the areas of surplus to the areas of deficit. A Financial System is a composition of various
institutions, markets, regulations and laws, practices, money manager, analysts, transactions
and claims and liabilities.

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy. The financial system is concerned about money, credit and finance-
the three terms are intimately related yet are somewhat different from each other. Indian
financial system consists of financial market, financial instruments and financial intermediation.
These are briefly discussed below;
FINANCIAL MARKETS
A Financial Market can be defined as the market in which financial assets are created or
transferred. As against a real transaction that involves exchange of money for real goods or
services, a financial transaction involves creation or transfer of a financial asset. Financial Assets
or Financial Instruments represents a claim to the payment of a sum of money sometime in the
future and /or periodic payment in the form of interest or dividend.

Money Market- The money market ifs a wholesale debt market for low-risk, highly-liquid, short-
term instrument. Funds are available in this market for periods ranging from a single day up to
a year. This market is dominated mostly by government, banks and financial institutions.
Capital Market - The capital market is designed to finance the long-term investments. The
transactions taking place in this market will be for periods over a year.
Forex Market - The Forex market deals with the multicurrency requirements, which are met by
the exchange of currencies. Depending on the exchange rate that is applicable, the transfer of
funds takes place in this market. This is one of the most developed and integrated market
across the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey short, medium and
long-term loans to corporate and individuals.

SAVINGS
The term saving refers to the activity by which claims to resources, which might be put
to current consumption, are set aside and so become available for other purposes. It represents
the excess of income over current consumption. The total volume of savings in an economy,
therefore, depends mainly upon the size of its material income and its average propensity to
consume, which, in its turn, is determined by the level and distribution of the incomes, tastes
and habits of the people, their expectations about the future, etc. As the size of the national
income increases, the volume and ratio of savings may generally be expected to rise, unless
the marginal propensity to consume is either equal to, or higher than the average propensity.
This is very likely to be the case in countries where the standards of living are very low, and
where the development policy places a heavy emphasis on the social objectives of raising the
living standards of the poorer sections of the community, or where the spending habits of the
people are strongly influenced by the "demonstration effect)
A higher domestic saving rate makes larger investment possible in an economy and hence is a
necessary condition for economic development. Also, in an open economy framework,
domestic savings are supplemented by foreign savings.
Since foreign savings may imply liability to the domestic economy, it is necessary that domestic
savings rates should be increased and resort to foreign savings should be minimized.
Experiences indicate that a saving rate of up to 20 per cent is essential for any economy to
achieve a respectable growth rate.
Rate of Saving:
Rate of saving is measured as a proportion of GDP at market prices. The rate of saving in India
in 1950-51 was 10.2 per cent of the GDP. Over the next twenty years, its trend varied
marginally, to touch a rate of 16.3 per cent in the year 1972-73. During the decade of 1970s,
there was a significant improvement in the savings rate which rose to 26.0 per cent in 1979-80.
In light of this, the late 1970s was referred to as the golden era in the Indian savings scene.
These rates of saving were not, however, sustained as it dropped substantially during the
1980s: it fell to 18.2 per cent in 1984-85. In the subsequent years, although it recovered
somewhat to reach 22 per cent in 1992-93 arid reached its late 1980s level of 26.9 per cent in
1995-96, it declined again to below 25 per cent mark in late 1990s. The saving rate began to
increase steadily in the 2000s with the Tenth Plan average (for 2002-07) registering 31.4 per
cent.
The growth in saving is attributed to factors like:
i. Rising per capita income;
ii. Continued deepening of the financial system; and
iii. The diminishing share of agriculture in GDP.

Sectoral Composition of Saving:

Domestic savings accrue from three sectors, viz.
i. Government or public sector
ii. Private corporate sector
iii. The household sector

The public sector includes government administration, departmental undertakings, government

companies and statutory corporations. The private corporate sector comprises of non-
government non-financial corporate enterprise. The rest is termed household sector. Thus, the
household sector, being residual in character, includes a host of economic agents who engage
in production/consumption activity as shown in Table 5.2 below.
Among the three sectors, as in most other countries, the household sector in India too
contributes the bulk-more than two-third of the total savings. The government sector and the
corporate sector contribute the balance, i.e. about one-third of total saving in the country.
Source of savings:
Main sources of savings in India are as follows:
(1) Household Savings:
The household sector is the largest contributor to domestic saving. It is important as it reflects
how efficiently savings are converted into investment with the role of financial sector’s
intermediation in the process. These sectors include the saving of:
(a) Households (families),
(b) Non-Profit institutions like collage, hospitals, etc., and
(c) Non-corporate business unit.
Household savings can be divided into three parts, as follows:
(a) Physical Assets:
The physical assets include housing, machinery, furniture, fixture and real estate.
(b) Financial Assets:
This takes the form of currency, bank deposits, shares and debentures, claims on government,
mutual funds, national savings certificates, life insurance funds and provident and pension
funds.
(c) The Unaccounted Savings of the Household Sector:
The unaccounted savings of the household sector are always kept in the form of gold, silver and
durable goods on which information is very scanty. However, on the basis of estimates the
proportion of these assets is placed in a range of 3 to 10 per cent of the GNP in any year.
(2) Government Savings:
Government savings come from surpluses of public enterprises and other public financial
institutions. Government savings formed 7.4 per cent of GDP in the economy in the year 2008-
09, which increased to 8.2 per cent in 2009-2010. Since then there has been a steady decline in
government savings which touched 7.9 per cent in 2010-11.
Among the factors responsible for this trend, the most important are:
(a) Deterioration in the overall tax GDP ratio, and
(b) The increasing losses over time made by public sector utilities such as state Electricity and
Water Boards, State Road transport Corporation, and the Railways.
(3) Private Corporate Savings:
The share of private corporate sector in total savings was 9.4 per cent in 2007-08. This,
however, came down to 7.4 per cent in 2008-09. But it has been moving upwards since then,
reaching at of 8.24 per cent in 2009-10.
In developed countries, the corporate sector has contributed, significantly to national savings,
while it has not done so in India, in spite of the development within the secondary and tertiary
sectors of the economy and the significant increase in manufactured output.
This is attributed to the following factors:
(a) Massive increase in the use of loan capital in Indian industry and the fall in the share of
profits in factor incomes;
(b) Significant position of the unincorporated private sector in Indian manufacturing and
commerce which is reflected in household savings and not in the ‘private corporate savings’;
and
(c) The taxation policy, which discourages the accumulation of undistributed profits in
companies and corporations coupled with a low profitability syndrome.

FINANCIAL INTERMEDIATION
Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When the borrower
of funds approaches the financial market to raise funds, mere issue of securities will not suffice.
Adequate information of the issue, issuer and the security should be passed on to take place.
There should be a proper channel within the financial system to ensure such transfer. To serve
this purpose, financial intermediaries came into existence. Financial intermediation in the
organized sector is conducted by a wide range of institutions functioning under the overall
surveillance of the Reserve Bank of India. In the initial stages, the role of the intermediary was
mostly related to ensure transfer of funds from the lender to the borrower. This service was
offered by banks, FIs, brokers, and dealers. However, as the financial system widened along
with the developments taking place in the financial markets, the scope of its operations also
widened. Some of the important intermediaries operating ink the financial markets include;
investment bankers, underwriters, stock exchanges, registrars, depositories, custodians,
portfolio managers, mutual funds, financial advertisers financial consultants, primary dealers,
satellite dealers, self-regulatory organizations, etc. Though the markets are different, there may
be a few intermediaries offering their services in more than one market e.g. underwriter.
However, the services offered by them vary from one market to another.
FINANCIAL INSTRUMENTS
Money Market Instruments
The money market can be defined as a market for short-term money and financial assets that
are near substitutes for money. The term short-term means generally a period upto one year
and near substitutes to money is used to denote any financial asset which can be quickly
converted into money with minimum transaction cost.
Some of the important money market instruments are briefly discussed below;
1. Call/Notice Money
2. Treasury Bills
3. Term Money
4. Certificate of Deposit
5. Commercial Papers
1. Call /Notice-Money Market
Call/Notice money is the money borrowed or lent on demand for a very short period. When
money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening holidays
and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and repaid on
the next working day, (irrespective of the number of intervening holidays) is "Call Money".
When money is borrowed or lent for more than a day and up to 14 days, it is "Notice Money".
No collateral security is required to cover these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as the term money
market. The entry restrictions are the same as those for Call/Notice Money except that, as per
existing regulations, the specified entities are not allowed to lend beyond 14 days.
3. Treasury Bills.
Treasury Bills are short term (up to one year) borrowing instruments of the union government.
It is an IOU of the Government. It is a promise by the Government to pay a stated sum after
expiry of the stated period from the date of issue (14/91/182/364 days i.e. less than one year).
They are issued at a discount to the face value, and on maturity the face value is paid to the
holder. The rate of discount and the corresponding issue price are determined at each auction.
4. Certificate of Deposits
Certificates of Deposit (CDs) is a negotiable money market instrument nd issued in
dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or other
eligible financial institution for a specified time period. Guidelines for issue of CDs are presently
governed by various directives issued by the Reserve Bank of India, as amended from time to
time. CDs can be issued by (i) scheduled commercial banks excluding Regional Rural Banks
(RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been
permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI. Banks
have the freedom to issue CDs depending on their requirements. An FI may issue CDs within the
overall umbrella limit fixed by RBI, i.e., issue of CD together with other instruments viz., term
money, term deposits, commercial papers and intercorporate deposits should not exceed 100
per cent of its net owned funds, as per the latest audited balance sheet.
5. Commercial Paper
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper the
debt obligation is transformed into an instrument. CP is thus an unsecured promissory note
privately placed with investors at a discount rate to face value determined by market forces. CP
is freely negotiable by endorsement and delivery. A company shall be eligible to issue CP
provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is
not less than Rs. 4 crore; (b) the working capital (fund-based) limit of the company from the
banking system is not less than Rs.4 crore and (c) the borrowal account of the company is
classified as a Standard Asset by the financing bank/s. The minimum maturity period of CP is 7
days. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other
agencies.
Capital Market Instruments
The capital market generally consists of the following long term period i.e., more than one year
period, financial instruments; in the equity segment Equity shares, preference shares,
convertible preference shares, non-convertible preference shares etc. and in the debt segment
debentures, zero coupon bonds, deep discount bonds etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of instruments is
called as hybrid instruments. Examples are convertible debentures, warrants etc.

Financial market
A financial market is a market in which people trade financial securities, commodities,
and other fungible items of value at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities include precious metals or
agricultural products.
In economics, typically, the term market means the aggregate of possible buyers and
sellers of a certain good or service and the transactions between them. The term "market" is
sometimes used for what are more strictly exchanges, organizations that facilitate the trade in
financial securities, e.g., a stock exchange or commodity exchange. This may be a physical
location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks
takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange,
while any two companies or people, for whatever reason, may agree to sell stock from the one
to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds
trade on a stock exchange, and people are building electronic systems for these as well, similar
to stock exchanges.
Types of financial markets
Within the financial sector, the term "financial markets" is often used to refer just to the
markets that are used to raise finance: for long term finance, the Capital markets; for short
term finance, the Money markets. Another common use of the term is as a catchall for all the
markets in the financial sector, as per examples in the breakdown below.

Capital markets which consist of:

 Stock markets, which provide financing through the issuance of shares or common
stock, and enable the subsequent trading thereof.
 Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of financial risk.
 Futures markets, which provide standardized forward contracts for trading products at
some future date; see also forward market.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign exchange.
The capital markets may also be divided into primary markets and secondary markets.
Newly formed (issued) securities are bought or sold in primary markets, such as during initial
public offerings. Secondary markets allow investors to buy and sell existing securities. The
transactions in primary markets exist between issuers and investors, while secondary market
transactions exist among investors.
Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers
to the ease with which a security can be sold without a loss of value. Securities with an active
secondary market mean that there are many buyers and sellers at a given point in time.
Investors benefit from liquid securities because they can sell their assets whenever they want;
an illiquid security may force the seller to get rid of their asset at a large discount.
Raising capital
Financial markets attract funds from investors and channel them to corporations—they thus
allow corporations to finance their operations and achieve growth. Money markets allow firms
to borrow funds on a short term basis, while capital markets allow corporations to gain long-
term funding to support expansion (known as maturity transformation).
Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in
this process. Banks take deposits from those who have money to save. They can then lend
money from this pool of deposited money to those who seek to borrow. Banks popularly lend
money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their
agents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a stock
exchange. A company can raise money by selling shares to investors and its existing shares can
be bought or sold.
Lenders
The lender temporarily gives money to somebody else, on the condition of getting back the
principal amount together with some interest/profit or charge.

Individuals & Doubles

Many individuals are not aware that they are lenders, but almost everybody does lend money
in many ways. A person lends money when he or she:
 puts money in a savings account at a bank;
 contributes to a pension plan;
 pays premiums to an insurance company;
 invests in government bonds;
Companies
Companies tend to be lenders of capital. When companies have surplus cash that is not needed
for a short period of time, they may seek to make money from their cash surplus by lending it
via short term markets called money markets. Alternatively, such companies may decide to
return the cash surplus to their shareholders (e.g. via a share repurchase or dividend payment).
Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to
help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernization or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up
this difference, they need to borrow. Governments also borrow on behalf of nationalized
industries, municipalities, local authorities and other public sector bodies. In the UK, the total
borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).
Governments borrow by issuing bonds. In the UK, the government also borrows from
individuals by offering bank accounts and Premium Bonds. Government debt seems to be
permanent. Indeed, the debt seemingly expands rather than being paid off. One strategy used
by governments to reduce the value of the debt is to influence inflation.
Municipalities and local authorities may borrow in their own name as well as receiving funding
from national governments. In the UK, this would cover an authority like Hampshire County
Council.
Public Corporations typically include nationalized industries. These may include the postal
services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with
the aid of Foreign exchange markets.
Borrowers having similar needs can form into a group of borrowers. They can also take an
organizational form like Mutual Funds. They can provide mortgage on weight basis. The main
advantage is that this lowers the cost of their borrowings.
Derivative products
During the 1980s and 1990s, a major growth sector in financial markets was the trade in so
called derivative products, or derivatives for short.
In the financial markets, stock prices, bond prices, currency rates, interest rates and dividends
go up and down, creating risk. Derivative products are financial products which are used to
control risk or paradoxically exploit risk.[2] It is also called financial economics.
Derivative products or instruments help the issuers to gain an unusual profit from issuing the
instruments. For using the help of these products a contract has to be made.
Derivative contracts are mainly 4 types
Future
Forward
Option
Swap
Seemingly, the most obvious buyers and sellers of currency are importers and exporters of
goods. While this may have been true in the distant past, when international trade created the
demand for currency markets, importers and exporters now represent only 1/32 of foreign
exchange dealing, according to the Bank for International Settlements.

Role (Financial system and the economy)

One of the important sustainability requisite for the accelerated development of an economy is
the existence of a dynamic financial market. A financial market helps the economy in the
following manner.
Saving mobilization: Obtaining funds from the savers or surplus units such as household
individuals, business firms, public sector units, central government, state governments etc. is an
important role played by financial markets.
Investment: Financial markets play a crucial role in arranging to invest funds thus collected in
those units which are in need of the same.
National Growth: An important role played by financial market is that, they contribute to a
nation's growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for
productive purposes is also made possible.
Entrepreneurship growth: Financial market contributes to the development of the
entrepreneurial claw by making available the necessary financial resources.
Industrial development: The different components of financial markets help an accelerated
growth of industrial and economic development of a country, thus contributing to raising the
standard of living and the society of well-being.
Functions of Financial Markets
Intermediary Functions: The intermediary functions of financial markets include the following:
Transfer of Resources: Financial markets facilitate the transfer of real economic resources from
lenders to ultimate borrowers.
Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus
invisible funds, thus contributing to the enhancement of the individual and the national income.
Productive usage: Financial markets allow for the productive use of the funds borrowed. The
enhancing the income and the gross national production.
Capital Formation: Financial markets provide a channel through which new savings flow to aid
capital formation of a country.
Price determination: Financial markets allow for the determination of price of the traded
financial assets through the interaction of buyers and sellers. They provide a sign for the
allocation of funds in the economy based on the demand and to the supply through the
mechanism called price discovery process.
Sale Mechanism: Financial markets provide a mechanism for selling of a financial asset by an
investor so as to offer the benefit of marketability and liquidity of such assets.
Information: The activities of the participants in the financial market result in the generation
and the consequent dissemination of information to the various segments of the market. So as
to reduce the cost of transaction of financial assets.
Financial Functions
 Providing the borrower with funds so as to enable them to carry out their investment
plans.
 Providing the lenders with earning assets so as to enable them to earn wealth by
deploying the assets in production debentures.
 Providing liquidity in the market so as to facilitate trading of funds.
 Providing liquidity to commercial bank
  Facilitating credit creation
 Promoting savings
 Promoting investment
 Facilitating balanced economic growth
 Improving trading floors
Constituents of Financial Market
Based on market levels
Primary market: Primary market is a market for new issues or new financial claims. Hence it’s
also called new issue market. The primary market deals with those securities which are issued
to the public for the first time.
Secondary market: It’s a market for secondary sale of securities. In other words, securities
which have already passed through the new issue market are traded in this market. Generally,
such securities are quoted in the stock exchange and it provides a continuous and regular
market for buying and selling of securities.
Simply put, primary market is the market where the newly started company issued shares to
the public for the first time through IPO (initial public offering). Secondary market is the market
where the second hand securities are sold.
Based on security types
Money market: Money market is a market for dealing with financial assets and securities which
have a maturity period of up to one year. In other words, it’s a market for purely short term
funds.
Capital market: A capital market is a market for financial assets which have a long or indefinite
maturity. Generally it deals with long term securities which have a maturity period of above one
year. Capital market may be further divided into: (a) industrial securities market (b) Govt.
securities market and (c) long term loans market.
Equity markets: A market where ownership of securities are issued and subscribed is known as
equity market. An example of a secondary equity market for shares is the Bombay stock
exchange.
Debt market: The market where funds are borrowed and lent is known as debt market.
Arrangements are made in such a way that the borrowers agree to pay the lender the original
amount of the loan plus some specified amount of interest.
Derivative markets: A market where financial instruments are derived and traded based on an
underlying asset such as commodities or stocks.
Financial service market: A market that comprises participants such as commercial banks that
provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is
known as financial service market. Individuals and firms use financial services markets, to
purchase services that enhance the working of debt and equity markets.
Depository markets: A depository market consist of depository institutions that accept deposit
from individuals and firms and uses these funds to participate in the debt market, by giving
loans or purchasing other debt instruments such as treasure bills.
Non-Depository market: Non-depository market carry out various functions in financial markets
ranging from financial intermediary to selling, insurance etc. The various constituencies in non-
depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.

Listing

Listing means admission of securities to dealings on a recognized stock exchange. The securities
may be of any public limited company, Central or State Government, quasi-governmental and
other financial institutions/corporations, municipalities, etc.
The objectives of listing are mainly to:
• provide liquidity to securities;
• mobilize savings for economic development;
• Protect interest of investors by ensuring full disclosures.
A company, desirous of listing its securities on the Exchange, shall be required to file an
application, in the prescribed form, with the Exchange before issue of Prospectus by the
company, where the securities are issued by way of a prospectus or before issue of 'Offer for
Sale', where the securities are issued by way of an offer for sale.
Delisting of securities means permanent removal of securities of a listed company from the
stock exchange where it was registered. As a result of this, the company would no longer be
traded at that stock exchange.
Rules and guidelines for listing of securities:
• Securities Contract (Regulation) Act, 1956.
S. 21. of the Act deals with the listing of the public companies.
• Securities Contract (Regulation) Rules 1957.
S. 19 of the Act deals with the requirements and documents to be submitted with respect to
the listing of securities on a recognized stock exchange and i.e.
a) Memorandum and articles of association and, in case of a debenture issue, a copy of the
trust deed.
b) Copies of all prospectuses or statements in lieu of prospectuses issued by the company at
any time.
c) Copies of offers for sale and circulars or advertisements offering any securities for
subscription or sale during the last five years.
d) Copies of balance sheets and audited accounts for the last five years, or in the case of new
companies, for such shorter period for which accounts have been made up.
e) A statement showing-
(i) Dividends and cash bonuses, if any, paid during the last ten years (or such shorter period as
the company has been in existence, whether as a private or public company).
(ii) Dividends or interest in arrears, if any.
f) Certified copies of agreements or other documents relating to arrangements with or
between:-
(i) Vendors and/or promoters,
(ii) Underwriters and sub-underwriters,
(iii) Brokers and sub-brokers.
g) Certified copies of agreements with-
(i) Managing agents and secretaries and treasurers,
(ii) Selling agents,
(iii) Managing directors and technical directors,
(iv) General Manager, sales manager, manager or secretary.
h) Certified copy of every letter, report, balance sheet, valuation contract, court order or other
document, part of which is reproduced or referred to in any prospectus, offer for sale, circular
or advertisement offering securities for subscription or sale, during the last five years.
i) A statement containing particulars of the dates of, and parties to all material contracts,
agreements (including agreements for technical advice and collaboration), concessions and
similar other documents (except those entered into in the ordinary course of business carried
on or intended to be carried on by the company) together with a brief description of the terms,
subject-matter and general nature of the documents.
j) A brief history of the company since its incorporation giving details of its activities including
any reorganization, reconstruction or amalgamation, changes in its capital structure
(authorized, issued and subscribed) and debenture borrowings, if any.
k) Particulars of shares and debentures issued (i) for consideration other than cash, whether in
whole or part, (ii) at a premium or discount, or (iii) in pursuance of an option.
l) A statement containing particulars of any commission, brokerage, discount or other special
terms including an option for the issue of any kind of the securities granted to any person.
m) Certified copies of-
(i) Letters of consent of the Controller of Capital Issues
n) Particulars of shares forfeited.
o) A list of highest ten holders of each class or kind of securities of the company as on the date
of application along with particulars as to the number of shares or debentures held by and the
address of each such holder.
p) Particulars of shares or debentures for which permission to deal is applied for:
• Companies Act, 1956
As per S. 73 of the companies Act, 1956, a company seeking listing of its securities on a stock
exchange is required to submit a Letter of application to all the stock exchanges where it
proposes to have its securities listed before filing the prospectus with the registrar of
companies.
• SEBI Guidelines.
 A company is required to complete the allotment of securities offered to the public
within 30 days of the date of closure of the subscription list and approach the
designated stock exchange for approval of the basis of allotment.
 Issuer Company to complete the formalities for trading at all the stock exchanges where
the securities are to be listed within 7 working days of finalization of the basis of
allotment.
 Companies making public/rights issues are required to deposit 1 % of the issue amount
with the designated stock exchange before the issue price.

• Stock Exchange guidelines

In addition to all these rules, regulation and compliance every stock exchange have a set of
guidelines of its own for the companies to be listed on them. For example they may provide for
the minimum issue size and market capitalization of the company.
A company has to enter into a listing agreement before being given permission to be listed on
the exchange. Under this agreement the company undertakes amongst other things, to provide
facilities for prompt transfer, registration, sub-division and consolidation of securities: to give
proper notice of closure of transfer books and record dates, to forward 6 copies of unabridged
Annual reports, balance sheets and profit & loss accounts, to file shareholding patters and
financial results on quarterly basis and to intimate promptly to the exchange the happenings
which are likely to materially affect the financial performance of the company and its stock
price and to comply with the conditions of Corporate governance.
The companies are also required to pay to the exchange some listing fee as prescribed by the
exchange every financial year.
A company not complying with these requirements are may face some disciplinary action,
including suspension/ delisting of their securities.
In case the exchange does not give permission to the company for listing of securities, the
company cannot proceed with the allotment of shares. However the company may file an
appeal before SEBI under S. 22 of SCRA, 1956.
A company delisted by a stock exchange and seeking relisting at the same exchange is required
to make a fresh public offer and comply with the extant guidelines of the exchange.

Secondary market

The market for long term securities like bonds, equity stocks and preferred stocks is divided into
primary market andsecondary market. The primary market deals with the new issuesof
securities. Outstanding securities are traded in the secondarymarket, which is commonly
known as stock market predominantly deals in the equity shares. Debt instruments like
bondsand debentures are also traded in the stock market. Wellregulated and active stock
market promotes capital formation.
Growth of the primary market depends on the secondarymarket. The health of the economy is
reflected by the growth ofthe stock market.

Functions of Stock Exchange

 Maintains Active Trading
 Shares are traded on the stock exchanges, enabling the investors
 To buy and sell securities. The prices may vary from transaction
 To transaction. A continuous trading increases the liquidity or
 Marketability of the shares traded on the stock exchanges.
 Fixation of Prices
 Price is determined by the transactions that flow from investors’
 Demand and supplier’s preferences. Usually the traded prices are
 Made known to the public. This helps the investors to make
 Better decisions.
 Ensures Safe and Fair Dealing
 The rules, regulations and by-laws of the stock exchanges’
 Provide a measure of safety to the investors. Transactions are
  conducted under competitive conditions enabling the investors
 To get a fair deal.
 Aids in Financing the Industry
A continuous market for shares provides a favorable climate forraising capital. The negotiability
and transferability of thesecurities helps the companies to raise long-term funds. Whenit is easy
to trade the securities, investors are willing to subscribeto the initial public offerings. This
stimulates the capitalformation.
Dissemination of Information
Stock exchanges provide information through their variouspublications. The publish the share
prices traded on daily basisalong with the volume traded. Directory of Corporate informationis
useful for the investors’ assessment regarding thecorporate. Handouts, handbooks and
pamphlets provideinformation regarding the functioning of the stock exchanges.
Performance Inducer
The prices of stock reflect the performance of the tradedcompanies. This makes the corporate
more concerned with itspublic image and tries to maintain good performance.
Self-regulating Organization
The stock exchanges monitor the integrity of the members,brokers, listed companies and
clients. Continuous internal auditsafeguards the investors against unfair trade practices. It
settlesthe disputes between member brokers, investors and brokers.
Regulatory Framework
A comprehensive legal framework was provided by theSecurities Contract Regulation Act, 1956
and the Securities andExchanges Board of India Act, 1992. A three tire regulatorystructure
comprising the Ministry of Finance, the Securities andExchanges Board of India and the
Governing Boards of theStock Exchanges regulates the functioning of stock exchanges.
The Governing Board
The Governing Board of the stock exchange consists of electedmember directors,
government nominees and public representatives.Rules, byelaws and regulations of the stock
exchangeprovide substantial powers to the Executive Director formaintaining efficient and
smooth day to day functioning of thestock exchange. The governing Board has the
responsibility tomaintain and orderly and well regulated market.The governing body of the
stock exchange consists of 13 members of which (6 members of the stock exchange areelected
by the members of the stock exchange (b) centralgovernment nominates not more than three
members. (c) Theboard nominates three public representatives (d) SEBI nominatespersons not
exceeding three and (e) the stock exchangeappoints one Executive Director.
One third of the elected members retire at annual generalmeeting. The retired member
can offer himself for election if heis not elected for two consecutive years. If a member serves
inthe governing body for two years consecutively, he shouldrefrain from offering himself for
another two year.The members of the governing body elect the President andvice-president. It
needs no approval from the Central Governmentor the Board. The office tenure for the
President andVice-President is one year. They can offer themselves for reelection,if they have
not held office for two consecutive years.In that case they can offer themselves for re-election
after gap of one-year period.
The Stock Exchanges
The names of the stock exchanges are given below
· Ahmedabad Stock Exchange
· Bangalore Stock Exchange
· Bhubaneswar Stock Exchange
· Bombay Stock Exchange
· Calcutta Stock Exchange
· Cochin Stock Exchange
· Coimbatore Stock Exchange
· Delhi Stock Exchange
· Guwahati Stock Exchange
· Hyderabad Stock Exchange
· Indore Stock Exchange
· Jaipur Stock Exchange
· Kanpur Stock Exchange
· Ludhiana Stock Exchange
 · Madras Stock Exchange
· Magadh Stock Exchange
· Mangalore Stock Exchange
· Pune Stock Exchange
· Saurashtra Stock Exchange
· Vadodara Stock Exchange
· NSE
· OTCEI
· Inter Connected Stock Exchange
Stock exchanges normally function between 10:00 a.m. and 3:45p.m. on the working days.
Badla sessions are held on Saturdays.
Member of the Stock Exchange
The Securities Contract Regulation Act of 1956 has provideduniform regulation for the
admission of members in the stockexchanges. The qualifications for becoming a member of
arecognized stock exchange are given below
 The minimum age prescribed for the members is 21 years.
 He/she should be an Indian Citizen.
 He should be neither a bankrupt nor compounded with thecreditors.
 He should not be convicted for fraud or dishonesty.
 He should not be engaged in any other business connected witha company.
 He should not be a defaulter of any other stock exchange.
 The minimum required educational qualification is a pass in12th examination.
The Mumbai and Calcutta stock exchanges have set up traininginstitutes to enable the
members to understand the complexitiesof the stock trading. In recent day’s highly qualified
personssuch as Company secretaries, charted accountants and MBA’sare becoming members.
Corporate membership is alsopermitted now. The members transacting business throughtheir
appointed members. The governing board has to approvethe partnership and the appointed
membership in other stockexchanges. If he applies before the completion of five years hehas to
relinquish the If membership of the present membershipbefore accepting the other.

Buying and Selling Shares

To buy and sell shares the investor has to locate a registeredbroker or sub broker who can
render prompt and efficientservice to him. Then orders to buy or sell the specified numberof
shares of a company of the investor’s choice are placed withthe broker. The order may be of
any of the above mentionedtype. After receiving the order, the broker tries to execute theorder
in his computer terminal. Once matching order is found,the order is executed
Share Groups
The listed shares are divided into three categories: Group Ashares (specified shares) B1 shares
and B shares. The last twogroups are referred to cleared securities or no-specified shares.The
shares that come under specified group can avail the carryforward transactions. In ‘A’ group,
shares are selected on thebasis of equity, market capitalization and public holding.Further it
should have a good track record and a dividendpaying company. It should have good growth
potential too.The trading volumes and the investor’s base are high in ‘A’group share. Any
company when it satisfies these criteria wouldbe shifted from ‘B’ group to “A” group.
Settlement Cycle
A settlement cycle consists of five days trading period withinwhich any transaction buy/sell
must be completed. There aretwo types of settlement: fixed and rolling. A fixed cycle starts ona
particular day and ends after five days. For example, in theMumbai stock exchange the
settlement cycle starts on Mondayand ends of Friday. In the NSE it starts on Wednesday of
oneweek and ends on the Tuesday of the following week.
Rolling Settlement
SEBI introduced rolling settlement from Jan 10, 2000. Tenstocks are selected for rolling
settlement. They are BFL Software,Citicorp Securities, Cybertech Securities, Hitech Drilling,
LupinLaboratories, Mars Software, and More pen labs, Sri AdhikariBrothers, Tata Infotech and
Visuals Soft. SEBI has announceda list of 156 stocks which would be included in rolling
settlementmade by the first fortnight of May 2000.

Mutual Funds
 Mutual funds are in the form of Trust (usually called Asset Management Company) that
manages the pool of money collected from various investors for investment in various classes
of assets to achieve certain financial goals. We can say that Mutual Fund is trusts which pool
the savings of large number of investors and then reinvests those funds for earning profits and
then distribute the dividend among the investors. In return for such services, Asset
Management Companies charge small fees. Every Mutual Fund / launches different schemes,
each with a specific objective. Investors who share the same objectives invest in that particular
Scheme. Each Mutual Fund Scheme is managed by a Fund Manager with the help of his team
of professionals (One Fund Manage may be managing more than one scheme also).

Where does Mutual Funds usually invest their funds:

The Mutual Funds usually invest their funds in equities, bonds, debentures; call money etc.,
depending on the objectives and terms of scheme floated by MF. Now days there are MF
which even invests in gold or other asset classes.
What is NAV? Define NAV:
NAV means Net Asset Value. The investments made by a Mutual Fund are marked to market
on daily basis. In other words, we can say that current market value of such investments is
calculated on daily basis. NAV is arrived at after deducting all liabilities (except unit capital) of
the fund from the realizable value of all assets and dividing by number of units outstanding.
Therefore, NAV on a particular day reflects the realizable value that the investor will get for
each unit if the scheme is liquidated on that date. This NAV keeps on changing with the
changes in the market rates of equity and bond markets. Therefore, the investments in
Mutual Funds is not risk free, but a good managed Fund can give you regular and higher returns
than when you can get from fixed deposits of a bank etc.
WHAT ARE VARIOUS TYPES OF MUTUAL FUNDS?
A common man is so much confused about the various kinds of Mutual Funds that he is afraid
of investing in these funds as he cannot differentiate between various types of Mutual Funds
with fancy names. Mutual Funds can be classified into various categories under the following
heads:-
(A) ACCORDING TO TYPE OF INVESTMENTS: - While launching a new scheme, every Mutual
Fund is supposed to declare in the prospectus the kind of instruments in which it will make
investments of the funds collected under that scheme. Thus, the various kinds of Mutual Fund
schemes as categorized according to the type of investments are as follows :-
(a) EQUITY FUNDS / SCHEMES
(b) DEBT FUNDS / SCHEMES (also called Income Funds)
(c) DIVERSIFIED FUNDS / SCHEMES (Also called Balanced Funds)
(d) GILT FUNDS / SCHEMES
(e) MONEY MARKET FUNDS / SCHEMES
(f) SECTOR SPECIFIC FUNDS
(g) INDEX FUNDS
B) ACCORDING TO THE TIME OF CLOSURE OF THE SCHEME : While launching new schemes,
Mutual Funds also declare whether this will be an open ended scheme (i.e. there is no specific
date when the scheme will be closed) or there is a closing date when finally the scheme will be
wind up. Thus, according to the time of closure schemes are classified as follows:-
(a) OPEN ENDED SCHEMES
(b) CLOSE ENDED SCHEMES
Open ended funds are allowed to issue and redeem units any time during the life of the
scheme, but close ended funds cannot issue new units except in case of bonus or rights issue.
Therefore, unit capital of open ended funds can fluctuate on daily basis (as new investors may
purchase fresh units), but that is not the case for close ended schemes. In other words we can
say that new investors can join the scheme by directly applying to the mutual fund at applicable
net asset value related prices in case of open ended schemes but not in case of close ended
schemes. In case of close ended schemes, new investors can buy the units only from secondary
markets.
C) ACCORDING TO TAX INCENTIVE SCHEMES: Mutual Funds are also allowed to float some tax
saving schemes. Therefore, sometimes the schemes are classified according to this also:-
(a) TAX SAVING FUNDS
(b) NOT TAX SAVING FUNDS / OTHER FUNDS
(D) ACCORDING TO THE TIME OF PAYOUT: Sometimes Mutual Fund schemes are classified
according to the periodicity of the pay outs (i.e. dividend etc.). The categories are as follows:-
(a) Dividend Paying Schemes
(b) Reinvestment Schemes
The mutual fund schemes come with various combinations of the above categories. Therefore,
we can have an Equity Fund which is open ended and is dividend paying plan. Before you
invest, you must find out what kind of the scheme you are being asked to invest. You should
choose a scheme as per your risk capacity and the regularity at which you wish to have the
dividends from such schemes
How Does a Mutual Fund Scheme Different from a Portfolio Management Scheme?
In case of Mutual Fund schemes, the funds of large number of investors is pooled to form a
common investible corpus and the gains / losses are same for all the investors during that given
period of time. On the other hand, in case of Portfolio Management Scheme, the funds of a
particular investor remain identifiable and gains and losses for that portfolio are attributable to
him only. Each investor's funds are invested in a separate portfolio and there is no pooling of
funds.
Are MFs suitable for Small Investors or Biginvestors? Why Should I invest in a Mutual Fund
when I can Invest Directly in the Same Instruments?
We have already mentioned that like all other investments in equities and debts, the
investments in Mutual funds also carry risk. However, investments through Mutual Funds are
considered better due to the following reasons:-
(a) Your investments will be managed by professional finance managers who are in a better
position to assess the risk profile of the investments;
(b) In case you are a small investor, then your investment cannot be spread into equity shares
of various good companies due to high price of such shares. Mutual Funds are in a much better
position to effectively spread your investments across various sectors and among several
products available in the market. This is called risk diversification and can effectively shield the
steep slide in the value of your investments.
Thus, we can say that Mutual funds are better options for investments as they offer regular
investors a chance to diversify their portfolios, which is something they may not be able to do if
they decide to make direct investments in stock market or bond market. These are particularly
good for small investors who have limited funds and are not aware of the intricacies of stock
markets. For example, if you want to build a diversified portfolio of 20 scrip’s, you would
probably need Rs 2, 00,000 to get started (assuming that you make minimum investment of
Rs10000 per scrip). However, you can invest in some of the diversified Mutual Fund schemes
for an low as Rs.10, 000/-
What are risks by investing funds in Mutual Funds?
We are aware that investments in stock market are risky as the value of our investments goes
up or down with the change in prices of the stocks where we have invested. Therefore, the
biggest risk for an investor in Mutual Funds is the market risk. However, different Schemes of
Mutual Funds have different risk profile, for example, the Debt Schemes are far less risk than
the equity funds. Similarly, Balance Funds are likely to be more risky than Debt Schemes, but
less risky than the equity schemes.
What is the difference between Mutual Funds and Hedge Funds?
Hedge Funds are the investment portfolios which are aggressively managed and use advanced
investment strategies, such as leveraged, long, short and derivative positions in both domestic
and international markets with a goal of generating high returns. In case of Hedged Funds, the
number of investors is usually small and minimum investment required is large. Moreover,
they are more risky and generally the investor is not allowed to withdraw funds before a fixed
tenure.
Some other important Terms Used in Mutual Funds
Sale Price: It is the price you pay when you invest in a scheme and is also called "Offer Price". It
may include a sales load.
Repurchase Price: - It is the price at which a Mutual Fund repurchases its units and it may
include a back-end load. This is also called Bid Price.
Redemption Price: It is the price at which open-ended schemes repurchase their units and
close-ended schemes redeem their units on maturity. Such prices are NAV related.
Sales Load / Front End Load: It is a charge collected by a scheme when it sells the units. Also
called, ‘Front-end’ load. Schemes which do not charge a load at the time of entry are called ‘No
Load’ schemes.
Repurchase / ‘Back-end’ Load: It is a charge collected by Mutual Funds when it buys back /
Repurchases the units from the unit holders.

Fiscal System in India

A country's fiscal system is the complete structure of government revenue and

expenditures and the framework within which its agencies collect and disburse those funds.
This system is governed by a nation's economic policy, which comes from decisions made by
the governing body.
Fiscal policy is the means by which a government adjusts its spending levels and tax
rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy
through which a central bank influences a nation's money supply. These two policies are used in
various combinations to direct a country's economic goals.
There are 3 parts of the fiscal policy
1. Public Revenue.
2. Public expenditure.
3. Public debt.
Revenues: are the source of income realized by the government and are divided into:
1. Revenue receipts:which consists of revenue from regular sources like Taxation revenues:
e.g., receipts from corporate tax, income tax, excise tax, Excise duty, custom duty, service tax
etc.? On tax revenue: which include interest on loans, dividends from Public sector units, Fees
and stamp duties?
2. Capital receipts: Which refer to those inflows to government that are not in the nature of
regular income, But are repayments / recoveries, or proceeds from sale of assets? Other
receipts like Disinvestment (selling some shares of a PSU) come under this head. Borrowings
are simply the deficit which can be covered by taking loans from market.
Expenditure: are the expenses incurred by govt and are divided into:
Non plan expenditure: These are ongoing expenditure not covered under the 5 - year plans.
Non-plan revenue expenditure is accounted for by interest payments, subsidies (mainly on food
and fertilizers), wage and salary payments to government employees, grants to States and
Union Territories governments, pensions, police, economic services in various sectors, other
general services such as tax collection, social services, and grants to foreign governments. Non-
plan capital expenditure mainly includes defense, loans to public enterprises, loans to States,
Union Territories and foreign governments.
Plan expenditure: India has adopted economic planning as a strategy for economic develop-
ment. For stepping up the rate of economic development five-year plans have been formulated.
So far ten five-year plans have been completed. The expenditure incurred on the items relating
to five year plans is termed as plan expenditure. Such expenditure is incurred by the Central
Government.
A provision is made for such expenditure in the budget of the Central Government. Assistance
given by the Central Government to the State Governments and Union Territories for plan
purposes also forms part of the plan expenditure. Plan expenditure is subdivided into Revenue
Expenditure and Capital Expenditure.This expenditure involves funding for programmes and
projects covered by the 5 - year plans as decided by the various ministerial bodies.
Under the above heads there are two components:
Revenue expenditure - It is payments incurred for day - to - day running of government
departments and various services offered to citizens. This also comprises of spending towards
subsidies, interest payments. This spurs consumption in economy.
Capital expenditure: This expenditure spurs asset creation, resulting in increased investment
with spending diverted towards cost associated with acquisition of assets that may include
investments in shares, infrastructure as well as loans and advances given out by government.
Other Important Terms:
Public debt: The money borrowed by the government is eventually a burden on the people of
India, and is, therefore, called public debt. It is split into two heads: internal debt (money
borrowed within the country) and external debt (funds borrowed from non-Indian sources).
Usually the government spends more than what it earns through various sources. This shortfall,
which is met with borrowed funds, is called fiscal deficit. Technically, it is the excess of
government expenditure over 'non-borrowed receipts' — revenue receipts plus loan
repayments received by the govt plus miscellaneous capital receipts. Fiscal deficit for FY13 is
estimated at INR.5.64 lakh crore, revenues of INR 9.18 lakh crores less expenditure of INR 14.82
lakh crores.
Fiscal deficit is measured as a percentage of GDP, hence INR 5.64 lakh crore / GDP of INR
100.74 lakh crores work out to estimated fiscal deficit of 5.6% of GDP.
Revenue Deficit: It is the excess of revenue expenditure over revenue receipts. All expenditure
on revenue account should ideally be met from receipts on revenue account; the revenue
deficit should be zero. In such a situation, the government borrowing will not be for
consumption but for creation of assets.
Effective revenue deficit: This is an even tighter number than the revenue deficit. It is revenue
deficit less grants for creation of capital assets.
Primary deficit: It is the fiscal deficit less interest payments made by the government on its
earlier borrowings.
Deficit and GDP: Apart from the numbers in rupees, the budget document also mentions deficit
as a percentage of GDP. This is because in absolute terms, the fiscal deficit may be large, but if
it is small compared to the size of the economy, and then it's not such a bad thing, especially if
it is being used to create production capacities.
Types of fiscal policy
Fiscal policy has an effect on each of these categories. There are two types of fiscal policy:
Expansionary and Contractionary.

Expansionary Fiscal Policy

When an economy is in a recession, expansionary fiscal policy is in order. Typically this
type of fiscal policy results in increased government spending and/or lower taxes. A recession
results in a recessionary gap – meaning that aggregate demand (ie, GDP) is at a level lower than
it would be in a full employment situation. In order to close this gap, a government will typically
increase their spending which will directly increase the aggregate demand curve (since
government spending creates demand for goods and services). At the same time, the
government may choose to cut taxes, which will indirectly affect the aggregate demand curve
by allowing for consumers to have more money at their disposal to consume and invest. The
actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve
to the right, which would result closing the recessionary gap and helping an economy grow.
Contractionary Fiscal Policy
Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an
economy is in a state where growth is at a rate that is getting out of control (causing inflation
and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable
level. If an economy is growing too fast or for example, if unemployment is too low, an
inflationary gap will form. In order to eliminate this inflationary gap a government may reduce
government spending and increase taxes. A decrease in spending by the government will
directly decrease aggregate demand curve by reducing government demand for goods and
services. Increases in tax levels will also slow growth, as consumers will have less money to
consume and invest, thereby indirectly reducing the aggregate demand curve.

UNIT V
FOREIGN INVESTMENTS: Foreign Capital- Foreign Collaboration- Foreign Direct Investment-
foreign Institutional Investors- Offshore Country Funds- Overseas Venture Capital Investments-
International Capital Market

Foreign Capital in India: Need and Forms of Foreign Capital

Everywhere in the world, including the developed countries, governments are vying
with each other to attract foreign capital. The belief that foreign capital plays a constructive
role in a country’s economic development, it has become even stronger since mid-1980.
The experience of South East Asian Countries (1986-1995) has especially confirmed this belief
and has led to a progressive reduction in regulations and restraints that could have inhibited
the inflow of foreign capital.

1. Need for Foreign Capital:

The need for foreign capital arises because of the following reasons. In most developing
countries like India, domestic capital is inadequate for the purpose of economic growth. Foreign
capital is typically seen as a way of filling in gaps between the domestically available supplies of
savings, foreign exchange, government revenue and the planned investment necessary to
achieve developmental targets. To give an example of this ‘savings-investment’ gap, let us
suppose that planned rate of growth output per annum is 7 percent and the capital-output
ratio is 3 percent, then the rate of saving required is 21 percent.
If the saving that can be domestically mobilized is 16 percent, there is a shortfall or a savings
gap of 5 percent. Thus the foremost contribution of foreign capital to national development is
its role in filling the resource gap between targeted investment and locally mobilized savings.
Foreign capital is needed to fill the gap between the targeted foreign exchange requirements
and those derived from net export earnings plus net public foreign aid. This is generally called
the foreign exchange or trade gap.
An inflow of private foreign capital helps in removing deficit in the balance of payments over
time if the foreign-owned enterprise can generate a net positive flow of export earnings.
The third gap that the foreign capital and specifically, foreign investment helps to fill is that
between governmental tax revenue and the locally raised taxes. By taxing the profits of the
foreign enterprises the governments of developing countries are able to mobilize funds for
projects (like energy, infrastructure) that are badly needed for economic development.
Foreign investment meets the gap in management, entrepreneurship, technology and skill. The
package of these much-needed resources is transferred to the local country through training
programmes and the process of learning by doing’. Further foreign companies bring with them
sophisticated technological knowledge about production processes while transferring modern
machinery equipment to the capital-poor developing countries.
In fact, in this era of globalization, there is a great belief that foreign capital transforms the
productive structures of the developing economics leading to high rates of growth. Besides the
above, foreign capital, by creating new productive assets, contributes to the generation of
employment a prime need of a country like India.
2. Forms of Foreign Capital:
Foreign Capital can be obtained in the form of foreign investment or non-concessional
assistance or concessional assistance.
1. Foreign Investment includes Foreign Direct Investment (FDI) and Foreign Portfolio
Investment (FPI). FPI includes the amounts raised by Indian corporate through Euro Equities,
Global Depository Receipts (GDR’s), and American Depository Receipts (ADR’s).
2. Non-Concessional Assistance mainly includes External Commercial Borrowings (ECB’s), loans
from governments of other countries/multilateral agencies on market terms and deposits
obtained from Non-Resident Indians (NRIs).
3. Concessional Assistance includes grants and loans obtained at low rates of interest with long
maturity periods. Such assistance is generally provided on a bilateral basis or through
multilateral agencies like the World Bank, International Monetary Fund (IMF), and International
Development Association (IDA) etc. Loans have to be repaid generally in terms of foreign
currency but in certain cases the donor may allow the recipient country to repay in terms of its
own currency.
Grants do not carry any obligation of repayment and are mostly made available to meet some
temporary crisis. Foreign Aid can also be received in terms of direct supplies of agricultural
commodities or industrial raw materials to overcome temporary shortages in the economy.
Foreign Aid may also be given in the form of technical assistance.

FOREIGN COLLOBORATION

The major features of foreign collaboration for the growth of business are as follows:
1. Agreement:
Foreign collaboration is an agreement or contract between two or more companies from
different countries for mutual benefit. The collaborating agreement can be between:
a. Domestic and foreign private firm.
b. Domestic and foreign public firm.
c. Domestic Public and foreign private firm.
d. Domestic government and foreign government.
2. Government consent:
Foreign collaboration is now recognized as an important driver of growth in the country.
Foreign collaboration requires Government approval, as the collaboration involves partnership
between two countries. Some legal formalities are to be fulfilled to enter into a contract. That
requires government permission.
3. World integration:
Globalisation means integration of world economy, where the world becomes a single market.
Foreign collaboration allows different countries to enter into partnership and reap the benefit.
It helps both the developed and developing countries to come together to achieve the common
objectives and maintains international peace.

4. Growth of industrial sector:

Foreign collaboration leads to growth of industries of the countries coming into contract.
Foreign collaboration develops industries and increases employment opportunities, thereby
improving the working conditions of the masses. Foreign collaboration encourages domestic
and international entrepreneurs to invest in business activities and accelerates industrial
growth.
5. Gives legal Identity:
Foreign collaboration is a legal entity between two or more parties for a particular purpose or
venture.
6. Helps to meet out requirements:
As no country in the world is self-sufficient in itself. All countries need to be dependent on each
other to meet out the requirements. Interdependence among countries is a common
phenomenon these days. Foreign collaboration is very useful in meeting out the deficiencies of
the resources and in getting advanced technology with competitive price.
The following are the types of collaboration:
1. Technical collaboration:
Technical collaboration is a contract whereby the developed country agrees to provide
technical know-how, sophisticated machinery and any kind of technical assistance to the
developing country. Technical collaboration enables to undertake research and development
activities and innovation.
2. Marketing collaboration:
Marketing collaboration is the agreement where the foreign collaborator agrees to market the
products of the domestic company in the international market. Marketing collaboration creates
value for customers and builds strong customer relationship. Marketing collaboration promotes
export.
3. Financial collaboration:
When the foreign contribution is in the form capital participation, that contract is known as
foreign collaboration. When the foreign company agrees to provide capital or financial
assistance to the domestic company that collaboration is known” as financial collaboration.
4. Consultancy collaboration:
A Consultant is a professional who provides advice in a particular area of expertise such as
management, accountancy, human resource, marketing, finance etc. Consultancy collaboration
is the agreement between the foreign and the domestic company where the company agrees
to provide managerial skills and expertise to the domestic company. This type of collaboration
bridges the information gap.
a. Joint Venture:
Joint venture is a legal entity formed between two or more parties to undertake an economic
activity together. In joint venture companies agree to share capital, technology, human
resources, risks and rewards in a formation of a new entity under shared control.
A joint venture takes place when two parties come together to undertake one project. It is a
temporary partnership between the two organisations for achieving common goals. Once the
goal is achieved, joint venture comes to an end.
b. Amalgamation:
Amalgamation means bringing of two or more business into single entity. In other words,
amalgamation means blending together two or more undertakings into one undertaking. In this
type of growth strategy two or more companies come together to form a new company. In
amalgamation companies lose their individual identity.
For example: one company called ABC. Another company called BCD. Now, ABC is running loss
and BCD also running loss, so these two companies agreed to Amalgamate and a new company
ABCD is formed.
c. Merger:
Merger is a combination of two companies into one company where one company loses its
identity. It is an arrangement whereby the assets of two companies become vested under the
control of one company.
Merger happens when two firms, often of about the same size, agree to go forward as a single
new company rather than remain separately owned and operated. The process of mergers and
acquisitions has gained substantial importance in today’s corporate world. For example: Tata
Steel acquired Corus Group.
d. Take Over/Acquisition:
Acquisition is a growth strategy in which a strong company acquires all the assets and liabilities
of another company. When one company takes over another company and clearly established
itself as the new owner, the purchase is called an acquisition.
Takeover is a form of acquisition. There are two types of acquisitions; Friendly acquisitions and
Hostile acquisitions. In a friendly acquisition the target company is formally informed about the
acquisition and there is an agreement on corporate management and finance control.
In a hostile acquisition, the owner loses their ownership and control of the company against
their wishes.

FDI

What is the meaning of FDI?

The Foreign Direct Investment means “cross border investment made by a resident in one
economy in an enterprise in another economy, with the objective of establishing a lasting
interest in the investee economy.
FDI is also described as “investment into the business of a country by a company in another
country”. Mostly the investment is into production byeither buying a company in the target
country or by expanding operations of an existing business in that country”. Such investments
can takeplace for many reasons, including to take advantage of cheaper wages, special
investment privileges (e.g. tax exemptions) offered by the country.
Why Countries Seek FDI?
(a) Domestic capital is inadequate for purpose of economic growth;
(b) Foreign capital is usually essential, at least as a temporary measure, during the period
when the capital market is in the process of development;
(c) Foreign capital usually brings it with other scarce productive factors like technical know-
how, business expertise and knowledge
What are the major benefits of FDI?
(a) Improves forex position of the country;
(b) Employment generation and increase in production;
(c) Help in capital formation by bringing fresh capital;
(d) Helps in transfer of new technologies, management skills, intellectual property
(e) Increases competition within the local market and this brings higher efficiencies
(f) Helps in increasing exports;
(g) Increases tax revenues
Why FDI is opposed by Local People or Disadvantages of FDI:
(a) Domestic companies fear that they may lose their ownership to overseas company
(b) Small enterprises fear that they may not be able to compete with world class large
companies and may ultimately is edged out of business;
(c) Large giants of the world try to monopolise and take over the highly profitable sectors;
(d) Such foreign companies invest more in machinery and intellectual property than in wages
of the local people;
(e) Government has less control over the functioning of such companies as they usually work
as wholly owned subsidiary of an overseas company;
What is the procedure for receiving Foreign Direct Investment in an Indian company?
An Indian company may receive Foreign Direct Investment under the two routes as given
under:
i. Automatic Route
FDI is allowed under the automatic route without prior approval either of the Government or
the Reserve Bank of India in all activities/sectors as specified in the consolidated FDI Policy,
issued by the Government of India from time to time.
ii. Government Route
FDI in activities not covered under the automatic route requires prior approval of the
Government which is considered by the Foreign Investment Promotion Board (FIPB),
Department of Economic Affairs, and Ministry of Finance.
What is Scope of FDI in India? Why World is looking towards India for Foreign Direct
Investments:
India is the 3rd largest economy of the world in terms of purchasing power parity and thus
looks attractive to the world for FDI. Even Government of India, has been trying hard to do
away with the FDI caps for majority of the sectors, but there are still critical areas like retailing
and insurance where there is lot of opposition from local Indians / Indian companies.
Some of the major economic sectors where India can attract investment are as follows:-
Telecommunications
Apparels
Information Technology
Pharma
Auto parts
Jewelry
Chemicals
In last few years, certainly foreign investments have shown upward trends but the strict FDI
policies have put hurdles in the growth in this sector. India is however set to become one of the
major recipients of FDI in the Asia-Pacific region because of the economic reforms for
increasing foreign investment and the deregulation of this important sector. India has technical
expertise and skilled managers and a growing middle class market of more than 300 million and
this represents an attractive market.
FDI is prohibited under the Government Route as well as the Automatic Route in the
following sectors:
i) Atomic Energy
ii) Lottery Business
iii) Gambling and Betting
iv) Business of Chit Fund
v) Nidhi Company
vi) Agricultural (excluding Floriculture, Horticulture, Development of seeds, Animal Husbandry,
Pisciculture and cultivation of vegetables, mushrooms, etc. under controlled conditions and
services related to agro and allied sectors) and Plantations activities (other than Tea
Plantations)
vii) Housing and Real Estate business (except development of townships, construction of
residential/commercial premises, roads or bridges to the extent specified in notification
viii) Trading in Transferable Development Rights (TDRs).
ix) Manufacture of cigars , cheroots, cigarillos and cigarettes , of tobacco or of tobacco
substitutes.
Name the authorities Dealingwith Foreign Investment:
(a) Foreign Investment Promotion Board (popularly known as FIPB) : The Board is responsible
for expeditious clearance of FDI proposals and review of the implementation of cleared
proposals. It also undertakes investment promotion activities and issue and review general and
sectoral policy guidelines;
(b) Secretariat for Industrial Assistance (SIA): It acts as a gateway to industrial investment in
India and assists the entrepreneurs and investors in setting up projects. SIA also liaison with
other government bodies to ensure necessary clearances;
(c) Foreign Investment Implementation Authority (FIIA): The authority works for quick
implementation of FDI approvals and resolution of operational difficulties faced by foreign
investors;
(d) Investment Commission
(e) Project Approval Board
(f) Reserve Bank of India

What are the instruments for receiving Foreign Direct Investment in an Indian company?
Foreign investment is reckoned as FDI only if the investment is made in equity shares, fully and
mandatorily convertible preference shares and fully and mandatorily convertible debentures
with the pricing being decided upfront as a figure or based on the formula that is decided
upfront. Any foreign investment into an instrument issued by an Indian company which: gives
an option to the investor to convert or not to convert it into equity or does not involve upfront
pricing of the instruments a date would be reckoned as ECB and would have to comply with the
ECB guidelines.
The FDI policy provides that the price/ conversion formula of convertible capital instruments
should be determined upfront at the time of issue of the instruments. The price at the time of
conversion should not in any case be lower than the fair value worked out, at the time of
issuance of such instruments, in accordance with the extant FEMA regulations [the DCF method
of valuation for the unlisted companies and valuation in terms of SEBI (ICDR) Regulations, for
the listed companies].
26% FDI is permitted in
· Defense (In July 2013, there has been no change in FDI limit but higher investment may be
considered in state of the art technology production by CCS)
· Newspaper and media
· Pension sector (allowed in October 2012 as per cabinet decision)
· Courier Services (through automatic route)
· Tea Plantation (up to 49% through automatic route; 49-100% through FIPB route)
(B) 49% FDI is permitted in:
Banking
Cable network
DTH
Infrastructure investment
Telecom
Insurance (in July 2013 it was raised to 49% from 26% subject to Parliament approval)
Petroleum Refining (49% allowed under automatic route)
Power Exchanges (49% allowed under automatic route)
Stock Exchanges, Depositories allowed under automatic route up to 49%
49% (FDI & FII) in power exchanges registered under the Central Electricity Regulatory
Commission (Power Market) Regulations 2010 subject to an FDI limit of 26 per cent and an FII
limit of 23 per cent of the paid-up capital is now permissible. [Permitted in September 2012]
(C) 51% is permitted in
Multi-Brand Retail (Since September 2012)
Petro-pipelines
(D) 74% FDI is permitted in
Atomic minerals
Science Magazines /Journals
Petro marketing
Coal and Lignite mines
Credit information companies (rose from 49% to 74% in July, 2013)
(E) 100% FDI is permitted in
Single Brand Retail (100% FDI allowed in single brand retail; 49% through automatic route; 49-
100% through FIPB)
Advertisement
Airports
Cold-storage
BPO/Call centers
E-commerce
Energy (except atomic)
Export trading house
Films
Hotel, tourism
Metro train
Mines (gold, silver)
Petroleum exploration
Pharmaceuticals
Pollution control
Postal service
Roads, highways, ports.
Township
Wholesale trading
Telecom (raised from 74% to 100% in July, 2013 by GoI)
Asset Reconstruction Companies (increased from 74% to 100 in July, 2013. Out of this up to
49% will be under automatic route)
Government initiatives
The Government of India has amended FDI policy to increase FDI inflow. In 2014, the
government increased foreign investment upper limit from 26% to 49% in insurance sector. It
also launched Make in India initiative in September 2014 under which FDI policy for 25 sectors
was liberalized further. As of April 2015, FDI inflow in India increased by 48% since the launch of
"Make in India" initiative. India was ranking 15th in the world in 2013 in terms of FDI inflow, it
rose up to 9th position in 2014 while in 2015 India became top destination for foreign direct
investment.
Sectors
During 2014–15, India received most of its FDI from Mauritius, Singapore, Netherlands, Japan
and the US. On 25 September 2014, Government of India launched Make in India initiative in
which policy statement on 25 sectors were released with relaxed norms on each sector.
Following are some of major sectors for Foreign Direct Investment.
Infrastructure
10% of India's GDP is based on construction activity. Indian government has plans to invest $1
trillion on infrastructure from 2012–2017. 40% of this $1 trillion is to be funded by private
sector. 100% FDI under automatic route is permitted in construction sector for cities and
townships.
Automotive
FDI in automotive sector was increased by 89% between April 2014 to February 2015. India is
7th largest producer of vehicles in the world with 17.5 million vehicles annually. 100% FDI is
permitted in this sector via automatic route. Automobiles shares 7% of the India's GDP.
Pharmaceuticals
Indian pharmaceutical market is 3rd largest in terms of volume and 13th largest in terms of
value. Indian pharma industry is expected to grow at 20% compound annual growth rate from
2015 to 2020. 100% FDI is permitted in this sector.
Service
FDI in service sector was increased by 46% in 2014–15. Service sector includes banking,
insurance, outsourcing, research & development, courier and technology testing. FDI limit in
insurance sector was raised from 26% to 49% in 2014.
Railways
100% FDI is allowed under automatic route in most of areas of railway like High speed train,
railway electrification, passenger terminal, mass rapid transport systems etc.[25][26] Mumbai-
Hyderabad high speed corridor project is single largest railway project in India, other being
CSTM-Panvel suburban corridor. Foreign investment more than 90000 crore (US$13 billion) is
expected in these projects.

Chemicals
Chemical industry of India earned revenue of $ 155–160 billion in 2013. 100% FDI is allowed in
Chemical sector under automatic route. Except Hydrocynic acid, Phosgene, Isocynates and their
derivatives, production of all other chemicals is de-licensed in India. India’s share in global
specialty chemical industry is expected to rise from 2.8% in 2013 to 6–7% in 2023.
Textile
Textile is one major contributor to India's export. Nearly 11% of India's total export is textile.
This sector has attracted about $ 1647 million from April 2000 to May 2015. 100% FDI is
allowed under automatic route. During year 2013–14, FDI in textile sector was increased by
91%. Indian textile industry is expected reach up to $ 141 billion till 2021
Apart from being a critical driver of economic growth, foreign direct investment (FDI) is a major
source of non-debt financial resource for the economic development of India. Foreign
companies invest in India to take advantage of relatively lower wages, special investment
privileges such as tax exemptions, etc. For a country where foreign investments are being
made, it also means achieving technical know-how and generating employment.
The Indian government’s favourable policy regime and robust business environment have
ensured that foreign capital keeps flowing into the country. The government has taken many
initiatives in recent years such as relaxing FDI norms across sectors such as defence, PSU oil
refineries, telecom, power exchanges, and stock exchanges, among others.
Market size
According to Department of Industrial Policy and Promotion (DIPP), the total FDI inflows soared
by 24.5 per cent to US$ 44.9 billion during FY2015, as compared to US$ 36.0 billion in FY2014.
FDI into India through the Foreign Investment Promotion Board (FIPB) route shot up by 26 per
cent to US$ 31.9 billion in the year FY2015 as against US$ 25.3 billion in the previous year,
indicating that government's effort to improve ease of doing business and relaxation in FDI
norms is yielding results.
Data for FY2015 indicates that the increase in the FDI inflows was primarily driven by
investments in infrastructure and services sector. Within Infrastructure, Oil & Gas, Mining and
Telecom witnessed higher FDI inflows, whereas IT services and trading (wholesale, cash & carry)
drove the services inflows. Most recently, the total FDI inflows for the month of June 2015
touched US$ 2.05 billion as compared to US$ 1.9 billion in the same period last year.
During FY2015, India received the maximum FDI equity inflows from Mauritius at US$ 9.03
billion, followed by Singapore (US$ 6.74 billion), Netherlands (US$ 3.43 billion), Japan (US$ 2.08
billion) and the US (US$ 1.82 billion). Healthy inflow of foreign investments into the country
helped India’s balance of payments (BoP) situation and stabilised the value of rupee.
According to the data released by Grant Thornton India, the total merger and acquisitions
(M&A) and private equity (PE) deals in the month of August 2015 were valued at US$ 2.6 billion
(151 deals), which is 62 per cent higher in volume as compared to August 2014.
Investments/ developments
Based on the recommendations of Foreign Investment Promotion Board (FIPB), the
Government, in a meeting held on September 29, 2015, approved 18 proposals of FDI
amounting to approximately Rs 5,000 crore (US$ 770 million).
Government Initiatives
The Government of India has amended the FDI policy regarding Construction Development
Sector. The amended policy includes easing of area restriction norms, reduction of minimum
capitalisation and easy exit from project. Further, in order to provide boost to low cost
affordable housing, it has indicated that conditions of area restriction and minimum
capitalisation will not apply to cases committing 30 per cent of the project cost towards
affordable housing.
Relaxation of FDI norms is expected to result in enhanced inflows in Construction Development
sector consequent to easing of sectoral conditions and clarification of terms used in the policy.
It is likely to attract investments in new areas and encourage development of plots for serviced
housing given the shortage of land in and around urban agglomerations as well as the high cost
of land. The renewed policy is also expected to encourage development of low cost affordable
housing in the country and of smart cities.
The Government of India recently relaxed the FDI policy norms for Non-Resident Indians (NRIs).
Under this, the non-repatriable investments made by the Persons of Indian Origin (PIOs),
Overseas Citizens of India (OCI) and NRIs will be treated as domestic investments and will not
be subject to FDI caps.
The government has also raised FDI cap in insurance from 26 per cent to 49 per cent through a
notification issued by the DIPP. The limit is composite in nature as it includes foreign
investment in the form of foreign portfolio investment, foreign institutional investment,
qualified foreign investment, foreign venture capital investment, and non-resident investment.
The Cabinet Committee on Economic Affairs (CCEA) has raised the threshold for foreign direct
investment requiring its approval to Rs 3,000 crore (US$ 469 million) from the present Rs 1,200
crore (US$ 187 million). This decision is expected to expedite the approval process and result in
increased foreign investment inflow.
India’s cabinet cleared a proposal which allows 100 per cent FDI in railway infrastructure,
excluding operations. Though the initiative does not allow foreign firms to operate trains, it
allows them to invest in areas such as creating the network and supplying trains for bullet trains
etc.
India is likely to grant most favoured nation (MFN) treatment to 15 countries that are in talks
regarding an agreement on the Regional Comprehensive Economic Partnership (RCEP),which
would result in significant easing of investment rules for these countries.
The Government of India plans to further simplify rules for Foreign Direct Investment (FDI) such
as increasing FDI investment limits in sectors and include more sectors in the automatic
approval route, to attract more investments in the country.

FII
 Foreign Institutional Investor (FII) means an institution established or incorporated
outside India which proposes to make investment in securities in India. They are registered as
FIIs in accordance with Section 2 (f) of the SEBI (FII) Regulations 1995. FIIs are allowed to
subscribe to new securities or trade in already issued securities. This is just one form of foreign
investments in India, as may be seen here:

However, FII as a category does not exist now. It was decided to create a new investor class
called "Foreign Portfolio Investor" (FPI) by merging the existing three investor classes viz. FIIs,
Sub Accounts and Qualified Foreign Investors. Accordingly, SEBI (Foreign Portfolio Investors)
Regulations, 2014 were notified on January 07, 2014 followed by certain other enabling
notifications by Ministry of Finance and RBI. In order to ensure the seamless transition from FII
regime to FPI regime, it was decided to commence the FPI regime with effect from June 1, 2014
so that the requisites systems and procedures are in place before migration to the new FPI
regime.

With the new FPI regime, which has commenced from 1 June 2014, it has now been decided to
dispense with the mandatory requirement of direct registration with SEBI and a risk based
verification approach has been adopted to smoothen the entry of foreign investors into the
Indian securities market.
FPIs have been made equivalent to FIIs from the tax perspective, vide central government
notification dated 22nd January 2014.

FII Vs FDI: International standards and Indian definition

According to IMF and OECD definitions, the acquisition of at least ten percent of the ordinary
shares or voting power in a public or private enterprise by non-resident investors makes it
eligible to be categorized as foreign direct investment (FDI). In India, a particular FII is allowed
to invest up to 10% of the paid up capital of a company, which implies that any investment
above 10% will be construed as FDI, though officially such a definition does not exist. However,
it may be noted that there is no minimum amount of capital to be brought in by the foreign
direct investor to get the same categorized as FDI.
Given this backdrop, in the Union Budget 2013-14, announced on 28 February 2013, vide para
95, Honourable FM announced his intention to go by the internationally accepted definition for
FIIs and FDIs, as stated below:
"In order to remove the ambiguity that prevails on what is Foreign Direct Investment (FDI) and
what is Foreign Institutional Investment (FII), it is proposed to follow the international practice
and lay down a broad principle that, where an investor has a stake of 10 percent or less in a
company, it will be treated as FII and, where an investor has a stake of more than 10 percent, it
will be treated as FDI. A committee will be constituted to examine the application of the
principle and to work out the details expeditiously."
Meanwhile, to rationalize/harmonize various foreign portfolio investment windows and to
simplify procedures, SEBI had formed a “Committee on Rationalization of Investment Routes
and Monitoring of Foreign Portfolio Investments” under the chairmanship of Shri K. M.
Chandrasekhar, former Cabinet Secretary. The Committee submitted its report on June 12,
2013.
In accordance with the budget announcement, a committee has been constituted under the
chairmanship of Secy (DEA), to examine and work out the details of the application of the
principle followed internationally for defining FDI and FII. The committee submitted its report in
June 2014.
In India, FDI and FII are defined in Schedule 1 and 2 respectively of the Foreign Exchange
Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations
2000.
Myths about FIIs
There are certain myths / beliefs about FIIs which are not necessarily true.
Myth -1:- FIIs do not invest in unlisted entities. They participate only through stock exchanges
Myth -2:- FIIs cannot invest at the time of initial allotment. Foreign investors investing in initial
allotment of shares (say IPOs or when a group of entities come together to float a company) are
categorized as FDIs
Truth on 1 and 2:- As per Section 15 (1) (a) of the SEBI FII Regulations, 1995, a Foreign
Institutional Investor (FII) may invest in the securities in the primary and secondary markets
including shares, debentures and warrants of companies unlisted, listed or to be listed on a
recognized stock exchange in India. In fact FIIs are very active in the over the counter (OTC)
markets and in the IPO market in India.
Myth 3:- FDI has more direct involvement in technology, management etc while FIIs are
interested in capital gain and momentary price differences. Generally direct investment
involves a lasting interest in the management of an enterprise and includes reinvestment of
profits. In contrast, FIIs do not generally influence the management of the enterprise.
Truth on 3:- To some extant this notion is true and is emphasized in policy documents. For
instance, consolidated FDI Policy of Department of Industrial Policy and Promotion (DIPP) states
that “foreign Direct Investment, as distinguished from portfolio investment (FII), has the
connotation of establishing a ‘lasting interest’ in an enterprise that is resident in an economy
other than that of the investor”.
However, of late, there have been occasions where FIIs come together to influence decisions in
companies where they hold shares. The difference between FDI and FII, except for the fact that
the latter necessarily has to be an institution (FDI can come from an individual also), rather lies
in the registration or approval process and to some extent in the individual investment limits or
lock-in conditions specified for each category.
Globally also, the acquisition of at least ten percent of the ordinary shares or voting power in a
public or private enterprise by non-resident investors makes it eligible to be categorized as FDI,
rather than the purpose of the investments, as intimated or stated by the investing foreigner
due to difficulty in assessing it and also for statistical consistency.
Regulation of FIIs
The regulations for foreign investment in India have been framed by the Reserve Bank of India
in terms of Sections 6 and 47 of the Foreign Exchange Management Act, 1999 and notified vide
Notification No. FEMA 20/ 2000-RB dated 3rd May 2000 viz. Foreign Exchange Management
(Transfer or issue of Security by a person Resident outside India) Regulations 2000, as amended
from time to time. In line with the said regulations, since 2003, the Securities and Exchange
Board of India (SEBI) has been registering FIIs and monitoring investments made by them
through the portfolio investment route under the SEBI (FII) regulations 1995. SEBI acts as the
nodal point in the registration of FIIs.
Who can get registered as FII?
Following foreign entities / funds are eligible to get registered as FII:
 Pension Funds
 Mutual Funds
 Investment Trusts
 Banks
 Insurance Companies / Reinsurance Company
 Foreign Central Banks
 Foreign Governmental Agencies
 Sovereign Wealth Funds
 International/ Multilateral organization/ agency
 University Funds (Serving public interests)
 Endowments (Serving public interests)
 Foundations (Serving public interests)
 Charitable Trusts / Charitable Societies (Serving public interests)
Thus it may be seen that sovereign wealth funds (SWFs) are also regulated under FII regulations
only, and no separate regulation exists for SWFs. Further, following entities proposing to invest
on behalf of broad based funds, are also eligible to be registered as FIIs:
 Asset Management Companies
 Investment Manager/Advisor
 Institutional Portfolio Managers
 Trustee of a Trust
 Bank
Foreign individuals can register as sub-accounts of FII to make investments in Indian securities.
What FIIs can do?
A Foreign Institutional Investor may invest only in the following:-
Securities in the primary and secondary markets including shares, debentures and warrants of
companies unlisted, listed or to be listed on a recognised stock exchange in India; andunits of
schemes floated by domestic mutual funds including Unit Trust of India, whether listed on a
recognised stock exchange or notunits of scheme floated by a collective investment
schemedated Government Securitiesderivatives traded on a recognised stock exchange
 Commercial paper
 Security receipts
 Indian Depository Receipt
FIIs are allowed to trade in all exchange traded derivative contracts subject to the position
limits as prescribed by SEBI from time to time. Clearing Corporation monitors the open
positions of the FII/ sub-accounts of the FII for each underlying security and index, against the
position limits, at the end of each trading day.
How do they invest?
A SEBI registered FII (as per Schedules 2 of Foreign Exchange Management (Transfer or Issue of
Security by a Person Resident Outside India) Regulations 2000) can invest/trade through a
registered broker in the capital of Indian Companies on recognised Indian Stock Exchanges. FIIs
can purchase shares / convertible debentures either through private placement or through
offer for sale.
An FII can also invest in India on behalf of a sub-account (means any person outside India on
whose behalf investments are proposed to be made in India by a FII) which is registered as a
sub-account under Section 2 (k) of the SEBI (FII) Regulations, 1995.

Also, an FII can issue off-shore derivative instruments (ODIs) to persons who are regulated by
an appropriate foreign regulatory authority and after compliance with Know Your Client (KYC)
norms.
Every FII/sub-account is required to appoint a domestic Indian custodian to hold in custody its
Indian securities. Custodian of Securities is a registered and regulated entity by SEBI. The
FII/sub-account is also required to ensure that the domestic custodian it has appointed
monitors the investments made by it in India, reports its transactions in securities to SEBI on a
daily basis and preserve records of transactions for a specified period. The FII/sub-account is
also required to suitably enable the custodian to furnish reports pertaining to its activities, to
SEBI, as and when required by SEBI.
Authorized dealer banks (i.e. the bank which is authorized by RBI to deal in foreign currency)
can offer forward cover (i.e., to minimize the impact of currency fluctuations, banks offer them
the option to sell / purchase foreign currency on a fixed future date at a rate specified today) to
FIIs to the extent of total inward remittances of liquidated investments.
FII investment limits
Investment by individual FIIs/ sub-accounts (excluding foreign corporates and individuals)
cannot exceed 10 per cent of paid up capital of a company. Investment by foreign corporates or
individuals registered as sub accounts of FII cannot exceed 5 per cent of paid up capital. All FIIs
and their sub-accounts taken together cannot acquire more than 24 per cent of the paid up
capital of an Indian Company. An Indian Company can raise the 24 per cent ceiling to the
Sectoral Cap / Statutory Ceiling, as applicable, by passing a resolution by its Board of Directors
followed by passing a Special Resolution to that effect by their General Body.
Economies like India, which offer relatively higher growth than the developed economies, have
gain favour among investors as attractive investment destinations for foreign institutional
investors (FIIs). Investors are optimistic on India and sentiments are favourable following
government’s announcement of a series of reform measures in recent months.
According to a poll conducted by Bank of America Merrill Lynch (BofA-ML) recently, in which 50
investors participated, India was the most favourite equity market for the global investors for
the year 2015 at 43 per cent, followed by China at 26 per cent. The global investment bank is of
the view that India remains to be in a structural bull market.
India is poised to become the second biggest ecosystem option after the US in the next two
years on account of the ongoing high growth rates. Several technology based start-ups have
received over US$ 2.3 billion in funding since 2010, while over 70 private equity (PE) and
venture capital (VC) funds remain active in the segment.
Market Size
FII’s net investments in Indian equities and debt have touched record highs in the past financial
year, backed by expectations of an economic recovery, falling interest rates and improving
earnings outlook. FIIs have invested a net of US$ 89.5 billion in 2014-15— expected to be their
highest investment in any fiscal year. Of this, a huge amount—US$ 57.2 billion—was invested in
debt and it is their record investment in the asset class, while equities absorbed US$ 32.3
billion.
India continues to be a preferred market for foreign investors. India-focused offshore equity
funds contributed US$ 0.5 billion, whereas India-focused ETFs added a much higher US$ 1.2
billion of the total net inflows of about US$ 1.7 billion into the India-focused offshore funds and
ETFs during the quarter ended June 2015.
The total Mergers and Acquisitions (M&A) transaction value for the month of July 2015 was US$
4.57 billion involving a total of 46 transactions. In the M&A space, energy and natural resources
was the dominant sector amounting to 56 per cent of the total transaction value.
In Private Equity, a total of 110 deals worth disclosed value of US$ 2.15 billion were reported in
July 2015.
Government Initiatives
Government of India has accepted the recommendation of A.P. Shah Committee to not impose
minimum alternate tax (MAT) on overseas portfolio investors retrospectively for the years prior
to April 01, 2015, thereby providing significant relief to foreign portfolio investors (FPIs).
The RBI has also allowed a number of foreign investors to invest, on repatriation basis, in non-
convertible/redeemable preference shares or debentures issued by Indian companies listed on
established stock exchanges in India. The investment should be within the overall limit of US$
51 billion allocated for corporate debt. Long-term investors registered with SEBI will also be
deemed as eligible investors.

OFFSHORE FUNDS
 An offshore fund refers to a mutual fund that invests its assets abroad and not in India.
Offshore funds offer investors access to international markets and major exchanges. They are
similar to traditional mutual funds.
According to VidhataBhide, research analyst, PersonalFN, offshore funds are typically
structured to take economic advantage present in respective foreign nation(s). In India, any
fund that invests at least 65% of the assets in domestic equities would be treated as a domestic
equity oriented fund and not an offshore fund though it has exposure to foreign markets.
Some of the offshore funds
Franklin US Opportunities Fund, Reliance US Dollar Fund, DSP Black Rock US Flexible Equity
Fund, DWS Gold and Precious Metal Offshore fund, HSBC Brazil Equity Fund and ICICI Prudential
US Blue-chip Equity Fund.
Advantages
SankaranNaren, chief investment officer-equity, ICICI Prudential Asset Management
Company, says, “Offshore funds provide country and sector diversification. Investors investing
in offshore funds would get direct access to the global brands, which benefit from a global
business and consumption. However, one has to have a long-term horizon for investing in
offshore funds to beat inflation.”
“Every country has strengths and weaknesses in terms of industrial leadership. For example,
Korea has leadership in electronic goods. India has a leadership in services industries such as IT
and offshoring services. Russia and Brazil are mineral rich nations hence the mining sector is
strong. Germany has a leadership in automation and engineering,” says Bhide.
He adds, “An Indian investor investing only in Indian equities would have limited options while
investing in energy sector. But if he has been given a chance to invest globally, he may invest in
Lukoil (Russia) which alone contributes to 2.2% of global oil production. Quality is a global
phenomenon and shouldn’t be constrained by limited universe of stocks.”
While several potential benefits to investing overseas exist, tax breaks are frequently one of
the most important advantages for investors. Offshore mutual funds are usually established in
countries that provide significant tax benefits to foreign investors. As a result, these investors
are often able to reduce the amount of taxes they pay. Some popular countries for offshore
investments include the Isle of Man, the Bahamas, Bermuda and the Cayman Islands.
Another advantage associated with offshore mutual funds is that they are often set up in
countries with less investment regulations which bring down the cost in managing the fund.
Disadvantages
There are some risks involved while investing in offshore funds such as price and volume
volatility in the capital markets, interest rates, currency exchange rates, changes in government
policies, taxation laws and other political and economic developments.
“On the whole, the currency risk is the biggest risk. Unfavorable movement of currency has the
potential to erase gains earned overseas. It is important to note that some offshore funds are
thematic and some are country-specific and others are both—asset-specific and country-
specific. They involve the highest risk. For example, there may be a fund investing in global
mining stock. There may be a fund focused on equities in Brazil. Finally, the other variation
could be a fund investing only in Brazilian mining companies,” says Bhide.
Tax benefits
HimanshuPandya, vice president & head-product development & delivery, ICICI Prudential
AMC, said, “Offshore funds—which have an exposure to foreign assets—would be classified as
debt mutual funds for the purpose of taxation in India. Hence, the fund will bear a tax which is
similar to fixed income fund. The dividend option in the fund will attract dividend distribution
tax.”
He adds, “If the fund is redeemed within one year, then it will attract short term capital gains
which will be added to the income. If the fund is redeemed after one year, it will attract long
term capital gain of 10% without indexation and 20% with indexation.”
Bhide elaborates, “While investing in offshore funds, it is vital that you have some basic
understanding of both economic and political situations of the country in which fund house is
investing your money. You may want to de-risk your domestic mutual fund portfolio by taking
advantage of the economic synergy in foreign countries (which intend to offer high growth and
other fundamental strengths),but you need to ensure that you are allocating only a very small
portion initially.” While investing in offshore funds, you need to prefer those funds which take
broader exposure to international opportunities or emerging markets as a whole, rather than
acute country-specific exposure.
Pandya points out, “Investors should also take into consideration that one fund from an
emerging market should not invest in another emerging market. They need to make sure that a
fund from emerging market is investing in a developed market.”
Investors should educate themselves before investing in an offshore fund. When investing
overseas, investors should generally select well-known funds that have a reputation for being
fiscally strong and fully compliant in their dealings. While foreign countries with lenient tax and
investment laws may present some advantages, investors should do their homework before
parting with any capital.

Venture Capital

'Venture Capital' is an important source of finance for those small and medium-sized
firms, which have very few avenues for raising funds. Although such a business firm may
possess a huge potential for earning large profits in the future and establish itself into a larger
enterprise. But the common investors are generally unwilling to invest their funds in them due
to risk involved in these types of investments. In order to provide financial support to such
entrepreneurial talent and business skills, the concept of venture capital emerged. In a way,
venture capital is a commitment of capital, or shareholdings, for the formation and setting up of
small scale enterprises at the early stages of their life cycle.
Venture capitalists comprise of professionals of various fields. They provide funds
(known as Venture Capital Fund) to these firms after carefully scrutinizing the projects. Their
main aim is to earn huge returns on their investments, but their concepts are totally different
from the traditional moneylenders. They know very well that if they may suffer losses in some
project, the others will compensate the same due to high returns. They take active participation
in the management of the company as well as provide the expertise and qualities of a good
banker, technologist, planner and managers. Thus, the venture capitalist and the entrepreneur
literally act as partners.
The venture capital recognizes different stages of financing, namely:-
Early stage financing - This is the first stage financing when the firm is undertaking production
and need additional funds for selling its products. It involves seed/ initial finance for supporting
a concept or idea of an entrepreneur. The capital is provided for product development, R&D
and initial marketing.
Expansion financing - This is the second stage financing for working capital and expansion of a
business. It involves development financing so as to facilitate the public issue.
Acquisition/ buyout financing - This later stage involves:-
Acquisition financing in order to acquire another firm for further growth
Management buyout financing so as to enable the operating groups/ investors for acquiring an
existing product line or business and
Turnaround financing in order to revitalize and revive the sick enterprises.
In India, the venture capital funds (VCFs) can be categorized into the following groups:-
Those promoted by the Central Government controlled development finance institutions, for
example:-
 ICICI Venture Funds Ltd.
 IFCI Venture Capital Funds Limited (IVCF)
 SIDBI Venture Capital Limited (SVCL)
Those promoted by State Government controlled development finance institutions, for
example:-
 Gujarat Venture Finance Limited (GVFL)
 Kerala Venture Capital Fund Pvt Ltd.
 Punjab Infotech Venture Fund
 Hyderabad Information Technology Venture Enterprises Limited (HITVEL)
Those promoted by public banks, for example:-
 Can bank Venture Capital Fund
 SBI Capital Markets Limited
Those promoted by private sector companies, for example:-
 IL&FS Trust Company Limited
  Infinity Venture India Fund
Those established as an overseas venture capital fund, for example:-
 Walden International Investment Group
 SEAF India Investment & Growth Fund
 BTS India Private Equity Fund Limited
All these venture capital funds are governed by the Securities and Exchange Board of India
(SEBI). SEBI is the nodal agency for registration and regulation of both domestic and overseas
venture capital funds. Accordingly, it has made the following regulations, namely, Securities and
Exchange Board of India (Venture Capital Funds) Regulations 1996 and Securities and Exchange
Board of India (Foreign Venture Capital Investors) Regulations 2000. These regulations provide
broad guidelines and procedures for establishment of venture capital funds both within India
and outside it; their management structure and set up; as well as size and investment criteria's
of the funds.

What Are International Capital Markets?

A capital markets is basically a system in which people, companies, and governments

with an excess of funds transfer those funds to people, companies, and governments that have
a shortage of funds. This transfer mechanism provides an efficient way for those who wish to
borrow or invest money to do so. For example, every time someone takes out a loan to buy a
car or a house, they are accessing the capital markets. Capital markets carry out the desirable
economic function of directing capital to productive uses.

International capital markets are the same mechanism but in the global sphere, in which
governments, companies, and people borrow and invest across national boundaries. In
addition to the benefits and purposes of a domestic capital market, international capital
markets provide the following benefits:
Higher returns and cheaper borrowing costs.These allow companies and governments to tap
into foreign markets and access new sources of funds. Many domestic markets are too small or
too costly for companies to borrow in. By using the international capital markets, companies,
governments, and even individuals can borrow or invest in other countries for either higher
rates of return or lower borrowing costs.
Diversifyingrisk. The international capital markets allow individuals, companies, and
governments to access more opportunities in different countries to borrow or invest, which in
turn reduces risk.
For companies, the global financial, including the currency, markets (1) provide stability and
predictability, (2) help reduce risk, and (3) provide access to more resources. One of the
fundamental purposes of the capital markets, both domestic and international, is the concept
of liquidity, which basically means being able to convert a noncash asset into cash without
losing any of the principal value. In the case of global capital markets, liquidity refers to the
ease and speed by which shareholders and bondholders can buy and sell their securities and
convert their investment into cash when necessary. Liquidity is also essential for foreign
exchange, as companies don’t want their profits locked into an illiquid currency.
Major Components of the International Capital Markets
International Equity Markets
Companies sell their stock in the equity markets. International equity markets consist of all the
stock traded outside the issuing company’s home country. Many large global companies seek to
take advantage of the global financial centers and issue stock in major markets to support local
and regional operations.
For example, ArcelorMittal is a global steel company headquartered in Luxembourg; it is listed
on the stock exchanges of New York, Amsterdam, Paris, Brussels, Luxembourg, Madrid,
Barcelona, Bilbao, and Valencia. While the daily value of the global markets changes, in the past
decade the international equity markets have expanded considerably, offering global firms
increased options for financing their global operations. The key factors for the increased growth
in the international equity markets are the following:
Growth of developing markets. As developing countries experience growth, their domestic
firms seek to expand into global markets and take advantage of cheaper and more flexible
financial markets.
Drive to privatize. In the past two decades, the general trend in developing and emerging
markets has been to privatize formerly state-owned enterprises. These entities tend to be large,
and when they sell some or all of their shares, it infuses billions of dollars of new equity into
local and global markets. Domestic and global investors, eager to participate in the growth of
the local economy, buy these shares.
Investment banks. With the increased opportunities in new emerging markets and the need to
simply expand their own businesses, investment banks often lead the way in the expansion of
global equity markets. These specialized banks seek to be retained by large companies in
developing countries or the governments pursuing privatization to issue and sell the stocks to
investors with deep pockets outside the local country.
Technology advancements. The expansion of technology into global finance has opened new
opportunities to investors and companies around the world. Technology and the Internet have
provided more efficient and cheaper means of trading stocks and, in some cases, issuing shares
by smaller companies.
International Bond Markets
Bonds are the most common form of debt instrument, which is basically a loan from the holder
to the issuer of the bond. The international bond market consists of all the bonds sold by an
issuing company, government, or entity outside their home country. Companies that do not
want to issue more equity shares and dilute the ownership interests of existing shareholders
prefer using bonds or debt to raise capital (i.e., money). Companies might access the
international bond markets for a variety of reasons, including funding a new production facility
or expanding its operations in one or more countries. There are several types of international
bonds, which are detailed in the next sections.
Foreign Bond
A foreign bond is a bond sold by a company, government, or entity in another country and
issued in the currency of the country in which it is being sold. There are foreign exchange,
economic, and political risks associated with foreign bonds, and many sophisticated buyers and
issuers of these bonds use complex hedging strategies to reduce the risks. For example, the
bonds issued by global companies in Japan denominated in yen are called samurai bonds. As
you might expect, there are other names for similar bond structures. Foreign bonds sold in the
United States and denominated in US dollars are called Yankee bonds. In the United Kingdom,
these foreign bonds are called bulldog bonds. Foreign bonds issued and traded throughout Asia
except Japan, are called dragon bonds, which are typically denominated in US dollars. Foreign
bonds are typically subject to the same rules and guidelines as domestic bonds in the country in
which they are issued. There are also regulatory and reporting requirements, which make them
a slightly more expensive bond than the Eurobond. The requirements add small costs that can
add up given the size of the bond issues by many companies.
Eurobond
A Eurobond is a bond issued outside the country in whose currency it is denominated.
Eurobonds are not regulated by the governments of the countries in which they are sold, and as
a result, Eurobonds are the most popular form of international bond. A bond issued by a
Japanese company, denominated in US dollars, and sold only in the United Kingdom and France
is an example of a Eurobond.
Global Bond
A global bond is a bond that is sold simultaneously in several global financial centers. It is
denominated in one currency, usually US dollars or Euros. By offering the bond in several
markets at the same time, the company can reduce its issuing costs. This option is usually
reserved for higher rated, creditworthy, and typically very large firms.
Offshore Centers
The first tier of centers in the world is the world financial centers, which are in essence central
points for business and finance. They are usually home to major corporations and banks or at
least regional headquarters for global firms. They all have at least one globally active stock
exchange. While their actual order of importance may differ both on the ranking format and the
year, the following cities rank as global financial centers: New York, London, Tokyo, Hong Kong,
Singapore, Chicago, Zurich, Geneva, and Sydney.