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Indian Financial System

Financial System
An institutional framework existing in a country to
enable financial transactions
Three main parts
Financial assets (loans, deposits, bonds,
equities, etc.)
Financial institutions (banks, mutual funds,
insurance companies, etc.)
Financial markets (money market, capital
market, forex market, etc.)
Regulation is another aspect of the financial
system (RBI, SEBI, IRDA,)

FUNCTIONS OF FINANCIAL
SYSTEM
The

financial system transfer resources across


time, sectors, and regions.
The financial system manages risks for the
economy-(Fire Insurance)
The financial system pools and subdivides
funds depending upon the need of the individual
saver or investor.
Performs an important clearinghouse function,
which facilitates transactions between payers
and payees.

Financial Assets/Instruments

Enable channelising funds from surplus units to


deficit units
There are instruments for savers such as deposits,
equities, mutual fund units, etc.
There are instruments for borrowers such as loans,
overdrafts, etc.
Like businesses, governments too raise funds
through issuing of bonds, Treasury bills, etc.
Instruments like PPF, KVP, etc. are available to
savers who wish to lend money to the government

Major Financial Instruments


Money
Savings

account
Credit market Instruments-bonds, mortgages
Common Stocks
Money market funds and mutual funds
Pension funds
Financial Derivatives

Purchase of
Govt. Bonds

Financial flows in the economy


Financial markets
Financial markets
Bonds,
IPO

Savers
Savers

Save
salary

Mutual funds
buys
diversified
portfolio of
stocks

Financial
Intermediaries

Investors

Business
borrows

Financial Institutions
Includes

institutions and mechanisms which

Affect generation of savings by the community


Mobilisation of savings
Effective distribution of savings

Institutions

are banks, insurance companies,


mutual funds- promote/mobilise savings
Individual investors, industrial and trading
companies- borrowers

Financial Markets
Money

Market- for short-term funds (less


than a year)

Organised (Banks)
Unorganised (money lenders, chit funds, etc.)

Capital

Market- for long-term funds

Primary Issues Market


Stock Market
Bond Market

Organised Money Market


Call

money market
Bill Market

Treasury bills
Commercial bills

Bank

loans (short-term)
Organised money market comprises RBI,
banks (commercial and co-operative)

Purpose of the money market


Banks

borrow in the money market to:

Fill the gaps or temporary mismatch of funds


To meet the CRR and SLR mandatory
requirements as stipulated by the central bank
To meet sudden demand for funds arising out of
large outflows (like advance tax payments)

Call

money market serves the role of


equilibrating the short-term liquidity position of
the banks

Call money market (1)


Is

an integral part of the Indian money market


where day-to-day surplus funds (mostly of
banks) are traded.
The loans are of short-term duration (1 to 14
days). Money lent for one day is called call
money; if it exceeds 1 day but is less than 15
days it is called notice money. Money lent for
more than 15 days is term money
The borrowing is exclusively limited to banks,
who are temporarily short of funds.

Call money market (2)

Call loans are generally made on a clean basis- i.e.


no collateral is required
The main function of the call money market is to
redistribute the pool of day-to-day surplus funds of
banks among other banks in temporary deficit of
funds
The call market helps banks economise their cash
and yet improve their liquidity
It is a highly competitive and sensitive market
It acts as a good indicator of the liquidity position

Call Money Market Participants


Those

who can both borrow and lend in the


market RBI , banks and primary dealers
Once upon a time, select financial institutions
viz., IDBI, UTI, Mutual funds were allowed in
the call money market only on the lenders
side
These were phased out and call money
market is now a pure inter-bank market
(since August 2005)

Developments in Money Market

Prior to mid-1980s participants depended heavily on


the call money market
The volatile nature of the call money market led to
the activation of the Treasury Bills market to reduce
dependence on call money
Emergence of market repo and collateralised
borrowing and lending obligation (CBLO)
instruments
Turnover in the call money market declined from Rs.
35,144 crore in 2001-02 to Rs. 14,170 crore in
2004-05 before rising to Rs. 21,725 crore in 2006-07

Bill Market

Treasury Bill market- Also called the T-Bill market


These bills are short-term liabilities (91-day, 182-day,
364-day) of the Government of India
It is an IOU of the government, a promise to pay the
stated amount after expiry of the stated period from
the date of issue
They are issued at discount to the face value and at
the end of maturity the face value is paid
The rate of discount and the corresponding issue price
are determined at each auction
RBI auctions 91-day T-Bills on a weekly basis, 182day T-Bills and 364-day T-Bills on a fortnightly basis
on behalf of the central government

Money Market Instruments (1)


Money

market instruments are those which


have maturity period of less than one year.
The most active part of the money market is
the market for overnight call and term money
between banks and institutions and repo
transactions
Call money/repo are very short-term money
market products

Money Market Instruments(2)

Certificates of Deposit
Commercial Paper
Inter-bank participation certificates
Inter-bank term money
Treasury Bills
Bill rediscounting
Call/notice/term money
CBLO
Market Repo

Certificates of Deposit

CDs are short-term borrowings issued by all scheduled banks


and are freely transferable by endorsement and delivery.
Introduced in 1989
Maturity of not less than 7 days and maximum up to a year.
FIs are allowed to issue CDs for a period between 1 year and
up to 3 years
Subject to payment of stamp duty under the Indian Stamp Act,
1899
Issued to individuals, corporations, trusts, funds and
associations
They are issued at a discount rate freely determined by the
market/investors

Commercial Papers

Short-term borrowings by corporates, financial institutions,


primary dealers from the money market
Can be issued in the physical form (Usance Promissory Note)
or demat form
Introduced in 1990
When issued in physical form are negotiable by endorsement
and delivery and hence, highly flexible
Issued subject to minimum of Rs. 5 lacs and in the multiple of
Rs. 5 lacs after that
Maturity is 7 days to 1 year
Unsecured and backed by credit rating of the issuing company
Issued at discount to the face value

Market Repos

Repo (repurchase agreement) instruments enable


collateralised short-term borrowing through the selling of
debt instruments
A security is sold with an agreement to repurchase it at a
pre-determined date and rate
Reverse repo is a mirror image of repo and reflects the
acquisition of a security with a simultaneous commitment
to resell
Average daily turnover of repo transactions (other than
the Reserve Bank) increased from Rs.11,311 crore
during April 2001 to Rs. 42,252 crore in June 2006

Collateralised Borrowing and


Lending Obligation (CBLO)

Operationalised as money market instruments by


the CCIL in 2003
Follows an anonymous, order-driven and online
trading system
On the lenders side main participants are mutual
funds, insurance companies.
Major borrowers are nationalised banks, PDs and
non-financial companies
The average daily turnover in the CBLO segment
increased from Rs. 515 crore (2003-04) to Rs. 32,
390 crore (2006-07)

Evolution of banking services


in India
British brought the modern concept of Banking to India
But the concept of banking was known to us
Banking was used in synonymous with money lending
Vedic literature records the details of banking
transactions
Manusmrithi speaks about deposits, pledge, loans
and interest rates etc.,
Sons pious obligation to discharge the loan of the
father

Indian modern banking


Alexander & Company a leading agency house started
managing the Bank of Hindustan in 1770s.
The Bank of Calcutta was established by the East India
Company in 1806
Commercial Bank in 1819
The concept of limited liability was not known hence, till
1860 banks had to either obtain a special charter from
the crown or had to operate under unlimited liability
1921 three Presidency Banks at Calcutta, Bombay and
Madras were merged into the Imperial Bank (vide
Imperial Bank of India Act, 1920)

Reserve Bank of India was established in 1934

It was given the right of note issue;

Was also to act as bankers bank;

However, Imperial Bank was allowed to operate as the


agent of RBI, especially in those places where RBI had
no branches.

The RBI was initially a shareholders bank but was


nationalized in 1948 [vide Reserve Bank (Amendment)
Act, 1948] State Bank of India Act, 1955

Imperial Bank was taken over by SBI

Bank Nationalization an
important milestone
Nationalization was perceived as a major step
in achieving the socialistic pattern of society
July 19, 1969 14 major banks were
nationalized
1980 6 more banks were nationalized
A detailed scheme of objectives, regulations,
management etc., was drawn-up for these
banks

the branch network which was 8262 in June 1969


expanded to 60000 by1992 with major expansion (80%) in
rural areas. The average number of people served by a
branch came down from 60000 to 11000.
the development of credit is more widely spread all over the
country as against only in advanced states. In 1969
deposits amounted to 13% of GDP and advances to
10%. By 1990 deposits grew to 30% and advances to
25% of the GDPDeposits grew from a figure of
Rs.4669 crores in July 1969 to Rs.2,75,000 crores on
31.3.1993. More than 45% of the total credit was
directed to the priority sector. More than 45% of the
total deposits were used by the government to fund its
five year plans

Types of banking services in


India
CENTRAL

BANK
NON-BANKING FIS
INSTITUTIONAL BANKS
COMMERCIAL BANK
SPECIALIZED BANKS

Commercial banking service


include
(i) Receiving various types of deposits;
(ii) Giving various types of loans
(iii) Extending some non-banking facilities
(i) Locker;
(ii) Electricity bill;
(iii) Payment of insurance premium etc.,
Examples:
SBI AND ASSOCIATE BANKS
NATIONALIZED BANKS
PRIVATE BANKS

Many

institutions are established for carrying


on non-banking financial services but to a
great extent resemble the banking activity Ex:
Mutual funds, financial institutions acting as
portfolio managers

Special banking
Special

banking institutions are established


for definite specialized banking services
The types of banks accept all types of
deposits but mobilize the amount in its
specially focused area
SPECIALIZED BANKS
LAND MORTGAGE
RURAL CREDIT
IND.. DEVELOPMENT
CO-OPERATIVE
HOUSING FINANCE
EXPORT IMPORT

INSTITUTIONAL BANKS
IFCI
SFCS
IDBI
ICICI
NABARD
HDFC

The

Narasimham Committee

1990s India had traumatic moments Banks were


burdened with large percentage of nonperforming loans .
Customer service had suffered and out-moded
practices were in vogue .
Overall re-hauling was needed for entire
financial systems in general and banking sector
in particular
The Narasimham Committee was set up to
recommend changes in financial system

Committee recommends

Overall emphasis upon de-regulation


No further nationalization to be adhered to
No distinction between public and private sector banks
Control of banking sector to be centralized (and not to be
divided between RBI and Dept. of Banking)
SLR and CRR should be reduced to prudent levels
Concessional lending to be phased out
The capital base of banks should meet international
standards
the appointment of Chief Executive of the banks to be depoliticized

Role of a commercial and central


bank -Commercial bank
There is no specific definition (although Banking
Regulation Act defines banking)
The banker is one who deals in money
Two essential functions of banking
1. Borrowing (accepting of deposits) of money; &
2. Lending of money for needy purposes Besides
these essential function a banking company also
performs
Other agency and
General utility functions

a commercial bank mobilizes the savings of the


society.This money is then provided to those who are in
need of it by granting overdrafts or fixed loans or by
discounting bills of exchange or promissory notes. In short,
the primary function of a commercial bank is that of a
broker and a dealer in money. By discharging this
function efficiently and effectively, a commercial bank
renders a very valuable service to the community by
increasing the productive capacity of the country and
thereby accelerating the pace of economic development.
It gathers the small savings of the people, thus reducing
to the lowest limits the quantity of idle money

the banker should always bear in mind that it


is the guardian of a very delicate mechanism
which paves the way for failure of economic
development and which, if disturbed, will
create monetary disequilibrium with all the evil
effects incidental thereto

Indian Banking System


Central Bank (Reserve Bank of India)
Commercial banks (222)
Co-operative banks
Banks can be classified as:

Scheduled (Second Schedule of RBI Act, 1934) - 218


Non-Scheduled - 4

Scheduled banks can be classified as:

Public Sector Banks (28)


Private Sector Banks (Old and New) (27)
Foreign Banks (31)
Regional Rural Banks (133)

Indigenous bankers

Individual bankers like Shroffs, Seths, Sahukars,


Mahajans, etc. combine trading and other business
with money lending.
Vary in size from petty lenders to substantial shroffs
Act as money changers and finance internal trade
through hundis (internal bills of exchange)
Indigenous banking is usually family owned
business employing own working capital
At one point it was estimated that IBs met about
90% of the financial requirements of rural India

RBI and indigenous bankers (1)

Methods employed by the indigenous bankers are


traditional with vernacular system of accounting.
RBI suggested that bankers give up their trading
and commission business and switch over to the
western system of accounting.
It also suggested that these bankers should develop
the deposit side of their business
Ambiguous character of the hundi should stop
Some of them should play the role of discount
houses (buy and sell bills of exchange)

RBI and indigenous bankers (2)

IB should have their accounts audited by certified


chartered accountants
Submit their accounts to RBI periodically
As against these obligations the RBI promised to
provide them with privileges offered to commercial
banks including

Being entitled to borrow from and rediscount bills with RBI

The IBs declined to accept the restrictions as well as


compensation from the RBI
Therefore, the IBs remain out of RBIs purview

Development Oriented
Banking

Historically, close association between banks and


some traditional industries- cotton textiles in the
west, jute textiles in the east
Banking has not been mere acceptance of deposits
and lending money; included development banking
Lead Bank Scheme- opening bank offices in all
important localities
Providing credit for development of the district
Mobilising savings in the district. Service area
approach

Progress of banking in India (1)

Nationalisation of banks in 1969: 14 banks were


nationalised
Branch expansion: Increased from 8260 in 1969 to
71177 in 2006
Population served per branch has come down from
64000 to 16000
A rural branch office serves 15 to 25 villages within
a radius of 16 kms
However, at present only 32,180 villages out of 5
lakh have been covered

Progress of banking in India (2)


Deposit

mobilisation:

1951-1971 (20 years)- 700% or 7 times


1971-1991 (20 years)- 3260% or 32.6 times
1991- 2006 (11 years)- 1100% or 11 times

Expansion

of bank credit: Growing at 20-30%


p.a. thanks to rapid growth in industrial and
agricultural output
Development oriented banking: priority sector
lending

Progress of banking in India (3)


Diversification

in banking: Banking has


moved from deposit and lending to

Merchant banking and underwriting


Mutual funds
Retail banking
ATMs
Internet banking
Venture capital funds
Factoring

Profitability of Banks(1)
Reforms

have shifted the focus of banks from


being development oriented to being
commercially viable
Prior to reforms banks were not profitable
and in fact made losses for the following
reasons:

Declining interest income


Increasing cost of operations

Profitability of banks (2)


Declining

interest income was for the


following reasons:

High proportion of deposits impounded for CRR


and SLR, earning relatively low interest rates
System of directed lending
Political interference- leading to huge NPAs

Rising

costs of operations for banks was


because of several reasons: economic and
political

Profitability of Banks (3)

As per the Narasimham Committee (1991) the


reasons for rising costs of banks were:

Uneconomic branch expansion


Heavy recruitment of employees
Growing indiscipline and inefficiency of staff due to trade
union activities
Low productivity

Declining interest income and rising cost of


operations of banks led to low profitability in the 90s

Bank profitability: Suggestions


Some

suggestions made by Narasimham


Committee are:

Set up an Asset Reconstruction Fund to take over


doubtful debts
SLR to be reduced to 25% of total deposits
CRR to be reduced to 3 to 5% of total deposits
Banks to get more freedom to set minimum
lending rates
Share of priority sector credit be reduced to 10%
from 40%

Suggestions (contd)

All concessional rates of interest should be removed


Banks should go for new sources of funds such as
Certificates of Deposits
Branch expansion should be carried out strictly on
commercial principles
Diversification of banking activities
Almost all suggestions of the Narasimham
Committee have been accepted and implemented in
a phased manner since the onset of Reforms

NPA Management
The

Narasimham Committee
recommendations were made, among other
things, to reduce the Non-Performing Assets
(NPAs) of banks
To tackle this the government enacted the
Securitization and Reconstruction of Financial
Assets and Enforcement of Security Act
(SARFAESI) Act, 2002
Enabled banks to realise their dues without
intervention of courts

SARFAESI Act

Enables setting up of Asset Management Companies to


acquire NPAs of any bank or FI (SASF, ARCIL are
examples)
NPAs are acquired by issuing debentures, bonds or any
other security
As a second creditor can serve notice to the defaulting
borrower to discharge his/her liabilities in 60 days
Failing which the company can take possession of assets,
takeover the management of assets and appoint any
person to manage the secured assets
Borrowers have the right to appeal to the Debts Tribunal
after depositing 75% of the amount claimed by the second
creditor

The Indian Capital Market (1)


Market

for long-term capital. Demand comes


from the industrial, service sector and
government
Supply comes from individuals, corporates,
banks, financial institutions, etc.
Can be classified into:

Gilt-edged market
Industrial securities market (new issues and stock
market)

The Indian Capital Market (2)

Development Financial Institutions

Industrial Finance Corporation of India (IFCI)


State Finance Corporations (SFCs)
Industrial Development Finance Corporation (IDFC)

Financial Intermediaries

Merchant Banks
Mutual Funds
Leasing Companies
Venture Capital Companies

Industrial Securities Market


Refers

to the market for shares and


debentures of old and new companies
New Issues Market- also known as the
primary market- refers to raising of new
capital in the form of shares and debentures
Stock Market- also known as the secondary
market. Deals with securities already issued
by companies

Financial Intermediaries (1)

Mutual Funds- Promote savings and mobilise funds


which are invested in the stock market and bond
market
Indirect source of finance to companies
Pool funds of savers and invest in the stock
market/bond market
Their instruments at savers end are called units
Offer many types of schemes: growth fund, income
fund, balanced fund
Regulated by SEBI

Financial Intermediaries (2)

Merchant banking- manage and underwrite new


issues, undertake syndication of credit, advise
corporate clients on fund raising
Subject to regulation by SEBI and RBI
SEBI regulates them on issue activity and portfolio
management of their business.
RBI supervises those merchant banks which are
subsidiaries or affiliates of commercial banks
Have to adopt stipulated capital adequacy norms
and abide by a code of conduct

There

are other financial intermediaries such


as NBFCs, Venture Capital Funds, Hire and
Leasing Companies, etc.
Indias financial system is quite huge and
caters to every kind of demand for funds
Banks are at the core of our financial system
and therefore, there is greater expectation
from them in terms of reaching out to the vast
populace as well as being competitive.