financial · 2018. 10. 17. · printed at : rose fine art, mumbai. ... economy are mobilised from...

FINANCIALMARKETS

(As Per the Revised Syllabus of S.Y. BBI, 2017-18, Semester III, University of Mumbai)

Prof. Pawan JhabakM.Com., P.G.D.Ed.M.

Ex Vice Principal, Rustomjee Business School,Dahisar (W), Mumbai - 68.

Ex Visiting Faculty:Vivekanand Education Society, Lala Lajpatrai College,

Rajiv Gandhi Institute of Technology,Amity Business School, Narsee Monjee College,

Usha Pravin Gandhi, Bhavan’s College (Andheri),Rizvi College, S.K. Somaiya College,Akbar Peerbhoy, Bhurani College,

Poddar College, Mumbai Education Trust,Sydhnem Institute of Management, etc.

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DTP by : Nilima Jadhav

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Preface

“Genius is the ability to reduce the complicated to the simple”…Albert Einstien

I earnestly hope that the book will make complicated subject Financial Markets, simple tounderstand and SCOrE high marks in exams. The book has maximum number and variety of problemswith solutions.

I look forward for constructive suggestion from the readers.I am thankful to one and all who have contributed directly or indirectly to make this book

possible.This book is user-friendly and different. As one goes through the book one will feel the

difference, and this will help to master finance in an enjoyable manner, with lifetime utility.This book covers ‘University’ syllabus with practical dimensions!! Lets’s learn!!

Best Wishes!!Million Thanks.

Author

Syllabus

Modules at a GlanceSr. No. Modules No. of Lectures

1 Indian Financial System 152 Financial Markets in India 153 Commodity Market 154 Derivatives Market 15

Total 60

Sr. No. Modules/Units1 Introduction to Financial Market

Indian Financial System – Introduction, Meaning, Functions of Financial System, IndianFinancial System from Financial Neutrality to Financial Activism and from FinancialVolatility to Financial Stability, Role of Government in Financial Development, Overview ofPhases of Indian Financial System Since Independence (State Domination – 1947-1990,Financial Sector Reforms 1991 till Financial Sector Legislative Reforms Commission 2013),Monitoring Framework for Financial Conglomerates.Structure of Indian Financial System – Banking and Non-Banking Financial Institutions,Organised and Unorganised Financial Markets, Financial Assets/Instruments, Fund Based andFee Based Financial Services.

2 Financial Markets in India Indian Money Market – Meaning, Features, Functions, Importance, Defects, Participants,

Components of Organised and Unorganised Markets and Reforms. Indian Capital Market – Meaning, Features, Functions, Importance, Participants,

Instruments, Reforms in Primary and Secondary Market. Indian Stock Market – Meaning and Functions of Stock Exchange, NSE and BSE. Equity Market – Primary Market, IPO, Book Building, Role of Merchant Bankers, ASBA,

Green Shoe Option, Issue of Bonus Shares, Right Shares, Sweat Equity Shares, ESOP. Indian Debt Market – Market Instruments, Listing, Primary and Secondary Segments.

3 Commodities MarketIntroduction to Commodities Market – Meaning, History and Origin, Types ofCommodities Traded, Structure of Commodities Market in India, Participants in CommoditiesMarket, Trading in Commodities in India (Cash and Derivative Segment), CommodityExchanges in India and Abroad and Reasons for Investing in Commodities.

4 Derivatives MarketIntroduction to Derivatives Market – Meaning, History and Origin, Elements of a DerivativeContract, Factors Driving Growth of Derivatives Market, Types of Derivatives, Types ofUnderlying Assets, Participants in Derivatives Market, Advantages and Disadvantages ofTrading in Derivatives Market, Current Volumes of Derivative Trade in India, Differencebetween Forwards and Futures.

Question Paper Pattern

Maximum Marks: 75 Duration: 2 ½ HoursQuestions to be Set: 05All questions are compulsory carrying 15 Marks each.

Question No. Particulars Marks

Q.1 Objective QuestionsSub-questions to be asked (10) and to be answered any (08)Sub-questions to be asked (10) and to be answered any (07)(*Multiple Choice/True or False/Match the Columns/Fill in the Blanks)

15 Marks

Q.2

Q.2

Full Length Practical QuestionORFull Length Practical Question

15 Marks

15 Marks

Q.3

Q.3


15 Marks

15 Marks

Q.4

Q.4


15 Marks

15 Marks

Q.5

Q.5

Theory QuestionsTheory QuestionsORShort NotesTo be asked (05)To be answered (03)

08 Marks07 Marks

15 Marks

Note: Practical question of 15 Marks may be divided into two sub-questions of 7/8 and 10/5Marks. If the topic demands, instead of practical questions, appropriate theory question may be asked.

Contents

ChapterNo. Name Page No.

Unit 1: Introduction to Financial Market1. Indian Financial System 1 – 18

2. Structure of Financial System in India 19 – 32

Unit 2: Financial Markets in India3. Indian Money Market 33 – 44

4. Indian Capital Market 45 – 70

5. Indian Stock Market 71 – 81

6. Equity Market 82 – 107

7. Indian Debt Market 108 – 124

8. Regulatory Framework 125 – 128

Unit 3: Commodities Market9. Introduction to Commodities Market 129 – 140

Unit 4: Derivatives Market10. Introduction to Derivatives Market 141 – 143

Introduction and Meaning of Indian Financial System

Financial System is a set of institutional arrangements through which financial surpluses in theeconomy are mobilised from surplus units and transferred to deficit spenders.

The institutional arrangements include all conditions and mechanisms governing the production,distribution, exchange and holding of financial assets or instruments of all kinds and the organisationsas well as the manner of operations of financial markets and institutions of all descriptions.

Functions of Financial System

The financial system helps production, capital accumulation and growth by: (i) encouragingsavings, (ii) mobilising them and (iii) allocating them among alternative uses and users. Each of thesefunctions is important and the efficiency of a given financial system depends on how well it performseach of these functions.

(i) Encourage SavingsFinancial system promotes savings by providing a wide array of financial assets as stores of value

aided by the services of financial markets and intermediaries of various kinds. For wealth holders, allthis offers ample choice of portfolios with attractive combinations of income, safety and yield.

With financial progress and innovations in financial technology, the scope of portfolio choice hasalso improved. Therefore, it is widely held that the savings-income ratio is directly related to bothfinancial assets and financial institutions, i.e., financial progress generally insures larger savings out ofthe same level of real income.

As stores of value, financial assets command certain advantages over tangible assets (physicalcapital, inventories of goods, etc.), they are convenient to hold or easily storable, more liquid (i.e.,more easily encashable), more easily divisible and less risky.

A very important property of financial assets is that they do not require regular management ofthe kind most tangible assets do. The financial assets have made possible the separation of ultimateownership and management of tangible assets. The separation of savings from management hasencouraged savings greatly.

Savings are done by households, businesses and government. Following the official classificationadopted by the Central Statistical Organisation (CSO), Government of India, we reclassify saversinto—household sector, domestic private corporate sector and the public sector.

The household sector is defined to comprise individuals, non-government, non-corporate entitiesin agriculture, trade and industry, and non-profit making organisations like trusts and charitable andreligious institutions.

Indian Financial System1

UNIT I - INTRODUCTION TO FINANCIAL MARKET

2 Financial Markets

The public sector comprises Central and State governments, departmental and non-departmentalundertakings, the RBI, etc. The domestic private corporate sector comprises non-government publicand private limited companies (whether financial or non-financial) and corrective institutions.

Of these three sectors, the dominant saver is the household sector, followed by the domesticprivate corporate sector. The contribution of the public sector to total net domestic savings is relativelysmall.

(ii) Mobilisation of SavingsFinancial system is a highly efficient mechanism for mobilising savings. In a fully-monetised

economy, this is done automatically when, in the first instance, the public holds its savings in the formof money. However, this is not the only way of instantaneous mobilisation of savings.

Other financial methods used are deductions at source of the contributions to provident fund andother savings schemes. More generally, mobilisation of savings take place when savers move intofinancial assets, whether currency, bank deposits, post office savings deposits, life insurance policies,bill, bonds, equity shares, etc.

(iii) Allocation of FundsAnother important function of a financial system is to arrange smooth, efficient and socially

equitable allocation of credit. With modern financial development and new financial assets,institutions and markets have come to be organised, which are replaying an increasingly important rolein the provision of credit.

In the allocative functions of financial institutions lies their main source of power. By grantingeasy and cheap credit to particular firms, they can shift outward the resource constraint of these firmsand make them grow faster.

On the other hand, by denying adequate credit on reasonable terms to other firms, financialinstitutions can restrict the growth or even normal working of these other firms substantially. Thus, thepower of credit can be used highly discriminately to favour some and to hinder others.

Definition

Concept of Financial SystemThe financial system process includes savings, finance and investment. All these are regulated to

ensure that all transactions are fair and square. Let us look at the inter-relationship between differentparts of the economy.

In essence, financial system refers to a bundle of connected activities and services, which worktogether to achieve a predetermined goal. This financial system includes markets, institutions,instruments, services and mechanisms. All of these influence savings, investment, capital formationand growth.

According to Robinson, a financial system is meant “to provide a link between saving andinvestment for the creation of new wealth and to permit portfolio adjustment in the composition of theexisting wealth.”

A strong financial system is the backbone of an economy. This is because it is interplay of manyresources. It incorporates all factors that are relevant to good functioning of a modern economy. Using

Indian Financial System 3

a reliable and acceptable mode of exchange brings down transactions costs and facilitates trade. Thisenables specialisation and greater productivity in the economy.

Lets look at the concept of financial system:

Overview of Phases of Indian Financial System Since Independence(State Domination – 1947-1990)

Phase I: Pre-1951 OrganisationThe organisation of the Indian Financial System before 1951 had a close resemblance with the

theoretical model of a financial organisation in a traditional economy, as formulated by R.L. Bennett.A traditional economy, according to him, “is one in which the per capita output is low and constant.”The principle feature of the pre-1951 financial system were aptly described by L.C. Gupta as: “theprinciple feature of the pre-independence industrial organisation are the closed circle character ofIndustrial Entrepreneurship; a semi-organised and narrow industrial securities market, devoid ofissuing institution and in the long term of financing of the industry.” As a result, the industry had veryrestricted access to outside savings. The fact that the industry had no easy access to the outside savingis another way of saying that the financial system was not responsive to opportunities of industrialinvestment. Such a financial system was clearly incapable of sustaining a high rate of industrialgrowth, particularly the growth of new and innovating enterprises .

Phase II: 1951 to Mid-eightiesIn sharp contrast to the position around 1951, when the organisation of the financial system left

much to be desired, the ability of the system to supply finance and credit to varied enterprise in diverseforms be desired was greatly strengthened during the second phase. The organisation of the Indianfinancial system during post-1951 period evolved in response to the imperatives of planned economicdevelopment. In pursuance of the broad economic and social aims to the state to secure economicgrowth with social justice as enshrined in the Indian constitution, under the directive principle of statepolicy of the scheme of planned economic development was initiated in 1951. The introduction ofplanning had important implication for the financial system. With adoption of the mixed economy asthe pattern of industrial growth there is need for an alignment of the financial economic policies. In

Indian Financial System

FormalFinancialsystem

Informal FinancialSystem

Individual MoneylendersGroup of PersonsPartnership firms

Components1. Financial Institutions

2. Financial Markets3. Financial Instruments

4. Financial Services

RegulatorsMoFSEBIRBI

IRDA

4 Financial Markets

other words, planning signified the distribution of resource by the financial system to be in conformitywith the priorities of the five years plans. The requirement to allocate fund in keep with goals patternimplied governmental control over distribution of credit and finance. The main element of thefinancial organisation in planned economic development could be categorised into four broad groups:

Government ownership of the financial institution, Fortification of the institution structure, Protection to investors, and Participation of the financial institution in corporate management.

Public Ownership of Financial Institution

The one aspect of the evolution of the financial system in India during this phase was progressivetransfer of its important constituent from private ownership to public control. Important segment of thefinancial mechanism were assigned to the direct control of public authorities through nationalisationmeasures as well as through the creation of entirely new institution in the public sector.

Nationalisation

The nationalisation of the Reserve Bank of India (RBI) in 1948 marked the beginning of thetransfer of the important financial intermediaries to governmental control. This was followed in 1956by the setting up of State Bank of the India. In the same year, 245 life insurance companies werenationalised and merged into the state owned monolithic Life Insurance Corporation of India. The year1969 was a landmark in the history of public control of private financial system, when 14 majorcommercial banks were brought under the direct ownership of the Government of the India. Yetanother measure, which deserve mentions in this connection, was the setting up of the GeneralInsurance Corporation in 1972 as a result of nationalisation of general insurance companies. Finally,six more commercial banks were brought under the public ownership in 1980.

Indian Financial System from Financial Neutrality to Financial Activism

The views on neutrality of financial intermediaries to economic growth, however, came underattack during the late 1960s. It was pointed out that there exists a strong positive correlation betweenfinancial development and economic growth of a country. Financial experts started emphasising thenegative impact of financial repression under which the government determined the quantum,allocation and price of credit, on the growth process. They argued that credit is not just another inputand instead, credit is the engine of growth.

The world of finance has changed markedly over the last 30 years or so. The change has beenbrought about by a number of events and circumstances. The growing dissatisfaction with the workingof the fixed exchange rate system during the 1960s led many countries, especially of the industrialisedworld, to adopt a floating exchange rate system by the early 1970s. There was also a growingrealisation that for achieving sustained growth with stability, it would be necessary to have freer trade,liberalised external capital movements, and a relatively flexible use of domestic monetary policy. Withtrade being subject to market economies took steps to liberalism capital movements across countriessince about the middle of the 1970s. Simultaneously, efforts were made to remove distortions in thedomestic financial sector through elimination or containment of reserve requirements and interest rateregulations. These initiatives coincided with the rapid technological improvements in electronic


payments and communication systems. The interaction among these factors helped the process ofinternationalisation of financial markets.

Under the impact of economic liberalisation, the industrialised countries, as a group, improvedtheir relative economic position in the world economy, and posted high growth rates in the 1980s andthereafter. This experience has confirmed the release of growth impulses following financialliberalisation.

Developing countries, on their part, have been adopting, since the early 1980s, market-orientedstrategies of financial development, partly supported by international financial institutions, and partlyto avail of the large pool of resources available in international financial markets. They eitherdismantled or sharply contained financial repression and undertook financial reforms with a view toenhancing allocative efficiency and competitiveness.

Financial development required the deepening and widening of the existing financial markets aswell as the introduction of new products and instruments to cater to the needs of savers and investors.Financial development depends on market-based regulatory framework and incentives (disincentives)that promote market discipline. If market discipline is not well understood or not complied with, therewould arise possibilities of inefficiencies and/or volatilities in asset prices and capital movements.Financial stability, therefore, is a pre-requisite for sustained financial development which in turnwould impact growth rate positively.

Indian Financial System from Financial Volatility to Financial StabilityThe process of deregulation and globalisation of financial markets gained momentum in the

1990s, expanded the choices for investors, and helped to improve the prospects of reducing the costsof financial transactions and improving operational and allocative efficiency of the financial system. Anumber of developing countries, especially in Asia, that moved early on to the path of economicliberalisation had experienced large capital inflows through the 1980s and the first half of the 1990s.Large capital inflows, however, carry the risk of financial sector vulnerability, where the use of suchflows is not administered by application of appropriate mix of macroeconomic measures. The currencyand financial crises in Mexico and Thailand, followed by Korea and Indonesia, provide many insightsabout the problems that would arise when exchange rates are inflexible and banking and financialsystem are weak. The experience of the crisis-affected countries highlights the need for setting in placeregulatory and supervisory frameworks to ensure the safety and stability of financial systems. Theirexperience also underscores the premise that financial development is only a necessary condition forsustainable growth, and by no means a sufficient condition.

In view of the costs of financial crises falling on the sovereign governments, financial stabilityhas come to occupy a centre stage in formulating public policy for economic development.

Role of Government in Financial Development

An important aspect of the process of financial development has been the role of the government.In many developing economies, the governments traditionally played a significant role in fosteringfinancial development. In the context of developing countries, this role is all the more importantbecause financial systems in these countries are characterised by nascent accounting frameworks andinadequate legal mechanisms.

6 Financial Markets

Several developing countries, therefore, undertook programmes for reforming their financialsystem. In the initial stages of the development process, the financial sector in developing countrieswas characterised by directed credit allocation, interest rate restrictions, lending criteria based onsocial needs, etc. These policies retarded the nature of financial intermediation in developing countriesand the recognition of the same paved the way for financial sector reforms. Since the late 1970s andthe 1980s, financial sector reforms encompassing deregulation of interest rates, revamping of directedcredit and measure to promote competition in the financial services became an integral part of theoverall structural adjustment programmes in many developing economies.

The interface between financial system and economic development revolves around on a widerange of issues, the following being more prominent.

1. Extant of state ownership of financial entities vis-à-vis private sector ownership.2. Corporate governance in banks and other segments of the financial system.3. Transparency of policies and practices of monetary and financial agencies.4. Prudential requirements of market participants.5. Maintenance of best practices in accounting and auditing.6. Comprehensive and efficient regulation and supervision of the financial system.7. Collection, processing and dissemination of information to meet the market needs.

The commonality among these concerns has given rise to a wide recognition and acceptance ofhaving a set of international standards and best practices the every country should strive to foster andimplement.

An Overview of Indian Economy (1991-2013)

The economy of India is the tenth largest in the world by nominal GDP and the third largest bypurchasing power parity (PPP). The country is one of the G-20 major economies and a member ofBRICS. On a per capita income basis, India ranked 140th by nominal GDP and 129th by GDP (PPP)in 2011, according to the IMF.

Back in 1991, India saw itself battling its most critical economic and currency crisis ever. Thegovernment then did not have many options but to take up some tough reforms. Many barriers andrestrictions were taken off. The new economic policy of 1991 was characterised by liberalisation,globalisation and privatisation. What followed these radical changes is now history.

Two decades have passed since then. And the ghosts of 1991 have come again to haunt us. Take thetwin deficits during both these period. The fiscal deficit was at 5.39% p.a. of GDP in 1991-92. In 2011-12,it was at 6.9% p.a.. Similarly, the current account deficit was at 3% p.a. of GDP in 1991. The same stoodtall at 4.3% p.a. in March 2012. Short-term external debt has shot up from 10% p.a. of GDP in 1991 to22% p.a. currently. 1990s and 2000s witnessed major changes in the Indian economy due to economicliberalisation in India. This revitalisation took place in the whip of balance-of-payment emergency. TheGovernment of India allowed private infusions in Indian market which facilitated monetary infusion fromFDI and FII. As per the estimate by Ministry of Statistics and Programme Implementation, GDP of Indiain the year 1990 stood at 5,542,706 in comparison to 842,210 in 1975.

Of course, it would be an overstatement to liken the current scenario to the 1991 crisis. TheIndian economy has indeed come a long way since then. Back in 1991, India had foreign exchangethat would not last beyond two weeks. With current reserves of about US$ 290 billion, the economycan meet its import requirements of about 7 months. India’s domestic savings rate has gone up from


20% p.a. of GDP to 31.6% p.a. during this intervening period. Even Indian companies are in muchbetter financial health today than in 1991.

But there are also several new challenges now that did not exist back then. One very majordifference is the state of the global economy. Back in 1991, the overall economic environment in theglobal arena was favourable. Today, we are quite integrated with the global economy. This hastremendously increased our vulnerability to external shocks.

As a fledgling democracy, India’s economic experiment of planned development was held out asan example to many aspiring low-income countries in the 1950s. While some countries raced ahead inthe development process, India lagged behind. This is evident from the fact that it took 40 long yearsfrom 1950-51 for India’s real per capita GDP to double by 1990-91. But, 1991-92 was a definingmoment in India’s modern economic history as a severe balance of payments (BOP) crisis promptedfar-reaching economic reforms, unlocking its growth potential.

Economic Progress Post -1991The initiation of economic reforms in the 1990s saw India gradually breaking free of the low

growth trap which was euphemistically called the “Hindu growth rate” of 3.5% p.a. Real GDP growthaveraged 5.7% p.a. in the 1990s, which accelerated further to 7.3% p.a. in 2000s. This was becausethere was no notable technological breakthrough after the “green revolution” of the mid-1960s whichsaw sharp increase in yields of cereal production particularly in northern part of India. By the 1990s,the momentum of “green revolution” had died down. Consequently, the yield increases in the 2000swere much lower than those experienced even in the 1990s. Notably, the decade of the 2000sencompassed the inflexion point in the growth trajectory with an annual average GDP growth of about9% for the 5-year period 2004-08. Growth in all the sub-sectors of the economy, including agriculture,accelerated during this period. However, this growth process was interrupted by the global financialcrisis. Subsequently, the average growth slowed down to 7.8% p.a. during 2009-11 with a noticeableslowdown in both agriculture and industry. The slowdown in GDP growth in FY12 can mainly beattributed to high interest rates, inflation and a significant contraction in industrial production.

The growth dynamics altered the structure of the Indian economy with a decline in the share ofagriculture from 28.4% in the 1990s to about 15% in 2009-11. There was corresponding gain in theshare of services, including construction, from 52% to 65% during the same period. What is, however,of concern is that the share of industry has remained unchanged at around 20% of GDP. This suggeststhat India’s growth acceleration during the last two decades has been dominated by the services sector.The pace of average annual industrial growth had nevertheless picked up from 5.7% during the 1990sto 9% during 2004-08 before being interrupted by the global financial crisis.

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8 Financial Markets

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Fig. 1.4While the share of industry in GDP remained stagnant, there was noteworthy structural

transformation in manufacturing over the period. As a process of restructuring, while the gross value


added in organised manufacturing increased by 8% p.a. at current prices, employment fell by 1.5% p.a.during 1995-2003. Subsequently, during 2004-09, gross value added growth accelerated to 20% p.a. atcurrent prices; but significantly, employment also increased by 7.5% p.a.

With work participation rate of 39.2%, India had a workforce of 400 million in 2009-10. Of this,53% was in agriculture and the rest 47% in non-agricultural activity.While the bulk of the employmentis in agricultural sector despite its shrinking share, the noteworthy feature of the employment structurehas been their for the first time in the absolute workforce of agriculture declined in the latter half ofthe 2000s.The overall unemployment rate in the economy also declined from 8.3% in 2004-05 to 6.6%in 2009-10.

Fig. 1.5The attractiveness of India as a preferred investment destination could be ascertained from the

large increase in FDI inflows to India, which rose continuously from year to year (depicted in Figure1.6). The significant increase in FDI inflows to India reflected the impact of liberalisation of theeconomy since the early 1990s as well as gradual opening up of the capital account. As part of thecapital account liberalisation, FDI was gradually allowed in almost all sectors, except a few ongrounds of strategic importance, subject to compliance of sector-specific rules and regulations. FDIpeaked in year FY 2007-08 and only marginally declined in the following years of economic crisis.

Fig. 1.6

–– Direct Investment –– Portfolio Investment ––Total

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2006-072007-08 2008-09

2009-102010-11

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Manufacturing

Services

Construction, Real Estateand Mining

Others

10 Financial Markets

From a sectoral perspective, FDI in India mainly flowed into services sector (with an averageshare of 41% in the past five years) followed by manufacturing (around 23% p.a.). (See Figure 1.6).However, the share of services declined over the years from almost 57% in 2006-07 to about 30% in2010-11 while the share of manufacturing and others largely comprising electricity and other powergeneration increased over the same period.

Table 1.1Countries 2004 2005 2006 2007 2008 2009 2010 2011 (Jan-Sep)Mauritius 26.7 48.5 43.9 40.3 42.8 42.7 34.3 34.2Singapore 1.7 7.4 7.6 7.6 11.4 11.3 10.1 15.4USA 17.3 10.8 4.6 4.6 5.4 7.6 6.7 3.0Japan 3.1 3.9 3.5 3.5 1.2 4.7 6.2 9.7Netherlands 13.2 2.7 3.6 3.6 3.0 3.1 5.5 4.5Cyprus 0.1 1.6 2.8 2.8 4.0 6.0 4.4 4.0Switzerland 1.8 1.9 1.1 1.1 0.4 0.5 4.2 0.8UK 3.8 5.0 2.5 2.5 5.1 1.7 3.6 12.5France 3.1 0.7 0.7 0.7 1.4 1.1 3.6 2.0Germany 4.2 1.9 1.8 1.8 2.4 2.2 0.9 6.2UAE 0.8 1.1 1.1 1.1 0.9 2.3 1.7 0.7Total (US$ bn) 3.8 4.4 19.2 19.2 33.0 27.0 21.0 22.5

The geographical spread of source countries for FDI in India is heavily skewed by tax rules.Mauritius has the highest share in total FDI inflows in India because of the Double TaxationAvoidance Treaty (DTAA) between the two countries. Apart from Mauritius, Singapore and Cyprushave similar tax status, and they figure prominently on the list of source countries. FDI mainly routedthrough Mauritius (with an average share of 43% in the past five years) followed by Singapore(around 11%). FDI from Mauritius and Singapore recorded the largest decline in 2010, with inflowsfalling by 37% and 27% from 2009, respectively. FDI from the US, Germany, and Cyprus also sawdeclines, while FDI from European countries increased.

Fig. 1.7

Oil Price Shock Large monetaryexpansion,

Fiscal Dominance BoP crisis,currency

depreciation

Food andOil Shock

Food Price Shock,Deficient Monsoon

30.0

25.0

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0.0

-5.0

-10.0

-15.0


Decadal average inflation rates were dominated by primary goods and fuel (FPLL) inflation.Liberalisation, and the effect of competition from abroad, reduced primary good and manufacturinginflation in 2000s, but the severe international food and oil price shocks pushed it up in the last yearsof the decade.

Fig. 1.8Figure 1.8 traces the trends in deficits of central government over the past four decades. The

gross fiscal deficit as a per cent of Gross Domestic Product (GDP) increased from 3.04% of GDP in1970-71 to the peak of 8.37% in 1986-87 and then declined to 4.84% in 1996-97. It was around 7% ofGDP during 1987-88 to 1990-91. During the 1990s, the average fiscal deficit as a per cent of GDP was5.67%. However, after 2003-04, central governments contained the fiscal deficit from 4.48% of GDPto its all-time minimum of 2.54% in the year 2007-08. Then it increased to 6.48% in 2009-10 anddeclined to 5.89%. Similarly, primary deficit, which is fiscal deficit excluding interest payment hasincreased from 1.74% in 1970-71 to a peak of 5.43% in 1986-87 and declined to 0.53% of GDP in1996-97. Primary deficit was dissolved from the year 2003-04 to the year 2007-08 except the year2005-06. It was 2.78% during the year 2011-12.

After 1991-92, primary deficit has declined much due to the rising interest payment, and to someextent, a decline in fiscal deficit. Revenue deficit was incurred in the period 1971-72 and 1972-73. Itwas 0.57% in 1979-80; after that, it increased to 3.26% in 1990-91. It reached maximum of 5.25% ofGDP in 2009-10. The average of revenue deficit as a percentage of GDP in 1980s, 1990s and 2000shas been 1.72%, 3.02% and 3.40% respectively. It was 4.46% of GDP during the period 2011-12.

Table 1.2: Evolution of India’s Trade Balances

(` in crores)Period Exports Imports Trade Balance Trade Balance as % of GDP1991-92 32,553 43,198 –10,645 2.11996-97 118,817 138,920 –20,103 1.61997-98 130,100 154,176 –24,076 1.71998-99 139,753 178,332 –38,580 2.41999-00 159,561 215,236 –55,675 3.1

-2.001970 -71 1975 -76 1980 -81 1985 -86 1990 -91 1995 -96 2000 -01 2005 -06 2010 -11

YEAR

0.00

2.00

4.00

6.00

8.00

10.00 Gross Fiscal Deficit Gross Primary Deficit Revenue Deficit


2000-01 203,571 230,873 –27,302 1.42001-02 209,018 245,200 –36,181 1.72002-03 255,137 297,206 –42,069 1.82003-04 293,367 359,108 –65,741 2.62004-05 375,340 501,065 –125,725 4.42005-06 456,418 660,409 –203,991 6.22006-07 571,779 840,506 –268,727 7.1

20007-08 655,864 1,0123,12 –356448 7.820008-09 840,755 1,374,436 –533,680 10.12009-10 845,534 1,363,736 –518,202 8.5

The rapid growth of demand for imports led to chronic current account deficit. It can be seen inTable 1.2. The trade balance was negative in all years from 1991 to 2010. It peaked as a percentage ofGDP in the years of India’s first post-independence “balance of payments crises” in 1956-57 at 4.8%of GDP, remained in the 3-4% range in the 1960s, rose again as a response to the oil and commodityprice increases of the early 1970s and again in that range in the 1980s.

ConclusionIn conclusion, we can say that Indian economy performed well after 1991 but currently Indian

economy going through another turbulent phase. It is hard to believe the fact that, we have definitelygrown since 1991 but the main imbalances then – fiscal deficit and current account deficit – are inreckoning again and have become the main concerns of today. People have started drawing parallelsbased on similarities in the economy like – Current Account Deficit in 2012 is 4% p.a. as compared to3% p.a. of 1991. Fiscal Deficit is 6% p.a. in 2012 as compared to 8% p.a. in 1991.

Monitoring Framework for Financial Conglomerates

The Reserve Bank of India defines a financial conglomerate (FC) as a cluster of companiesbelonging to a group which has significant presence in at least two financial market segments out ofbanking business, insurance business, mutual fund business and NBFC business (deposit taking andnon-deposit taking).

Need for Identifying Financial ConglomeratesRegulation and supervision of such large and diversified financial institutions assumes special

significance considering the system-wide damage that their failure could potentially cause. Fears ofsuch damage lead to costly bank bail-outs by governments, as was seen in the United States andWestern Europe during the course of the global financial crisis.

Thus, it may be potent to look at the institutions perceived as “too big and complex to fail” in adifferent league, requiring specific measures to reduce the systemic risks these institutions pose.Measures used by financial regulators include specific additional capital, liquidity and other prudentialrequirements as well as other measures to reduce the complexity of group structures and, whereappropriate, encourage stand-alone subsidiaries.


Defining “Too Big to Fail” – FSB’s Definition on SIFIsWhat is “too big and complex to fail” was left to the judgment of the regulators and governments.

When the US Government bailed out the AIG and not Lehman Brothers, many questions were askedand debated on why this move; what kind of financial institutions are “too big to fail” or aresystematically important for the financial system.

Post the global financial crisis, the Financial Stability Board (FSB) undertook work in this areaand defined a systemically important financial institution (SIFIs) as financial institutions whosedistress or disorderly failure, because of their size, complexity and systemic interconnectedness, wouldcause significant disruption to the wider financial system and economic activity. In November 2011,the FSB published the first list of 29 global systemically important financial institutions (G-SIFIs),based on the methodology set out in the Basel Committee on Banking Supervision (BCBS).

International Efforts at Regulation and Supervision of Financial ConglomeratesThe Bank for International Settlements (BIS) set up a Joint Forum in 1996 under the aegis of the

BCBS, the International Organisation of Securities Commissions (IOSCO) and the InternationalAssociation of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities andinsurance sectors, including the regulation of financial conglomerates. The Joint Forum publishedvarious reports in February and December 1999 that together provided an initial framework for thesupervision of financial conglomerates (the “1999 Principles”). The Joint Forum’s objective inpreparing these Principles is to provide national regulators with a set of internationally agreedprinciples that support consistent and effective supervision of financial conglomerates, particularlythose financial conglomerates which have international presence. These principles cover issues insupervisory powers and authority, supervisory responsibility, capital adequacy and liquidity, corporategovernance and risk management. The Forum issued its final report on Principles for the Supervisionof Financial Conglomerates in September, 2012.

Until the outbreak of the global financial crisis in 2007-08, the work on the regulation andsupervision of financial conglomerates was progressing separately in different countries, with limitedinternational efforts, considering that there was no major pressure to expedite and streamline policies inthis regard. With an important role played by financial conglomerates in the precipitation of the globalcrisis, the design of policy towards financial conglomerates has now been largely subsumed under that forsystemically important financial institutions (SIFIs), referred commonly as “Too Big to Fail”.

Amongst the issues widely debated during the deliberations leading to the Dodd-Frank WallStreet Reform and Consumer Protection Act 2010 in the US was how to address risks posed by SIFIs.During the same period, the FSB issued a report titled “Reducing the Moral Hazard Posed bySystemically Important Financial Institutions”, addressing policy towards SIFIs. This set out aframework that is broadly consistent with the provisions of the Dodd-Frank Act.

The G20, at its Pittsburgh meeting of September, 2009, mandated the FSB to propose measuresto address the problems of “Too Big to Fail” associated with SIFIs. The FSB proposed a framework inresponse to this mandate, with the objective of improving the capacity to resolve SIFIs in financialdistress or insolvency, while minimising the costs to taxpayers; reducing the probability of SIFIfailures and their impact if they occur nonetheless; and strengthening the infrastructure of financialmarkets to reduce the risk of the spreading of contagion as a result of weaknesses of this infrastructure.

As pointed out above, in November, 2011, the FSB issued a list of G-SIFIs. It also announced apackage of policy measures for them, including, inter alia, a requirement that individual G-SIFIs have


recovery and resolution plans, informed by resolvability assessments, and that home and hostauthorities develop institution-specific cooperation agreements and cross-border crisis managementgroups. It also recommended improving data systems for risk management at SIFIs and assessments ofthe adequacy of supervisory resources. The group of G-SIFIs is updated annually based on new dataand published by the FSB each November. The 2014 list may be seen here.

The next steps for the SIFI projects are extension of the global SIFI framework to domestic SIFIsand the peer review council (PRC) framework.

The Indian ContextThe RBI set up an inter-regulatory Working Group in 2004 to propose a list of financial

conglomerates based on set criteria and advise on a monitoring/reporting system for them. The Groupsubmitted its report in June 2004. The basic building blocks of the new framework proposed by theGroup included identifying Financial Conglomerates that would be subjected to focused regulatoryoversight; capturing intra-group transactions and exposures (which are not being captured now)amongst entities within the identified financial conglomerate and large exposures of the groups toother financial conglomerate as well as outside counterparties; identifying a designated entity withineach financial conglomerate that would collate data in respect of all other group entities and furnishthe same to its regulator (principal regulator for the group); and formalising a mechanism for inter-regulatory exchange of information.

How and to what extent the recommendations of this group were implemented is not welldocumented. However, there is a RBI notification of January, 2010 which defines FC as a cluster ofcompanies belonging to a Group which has significant presence in at least two financial marketsegments out of banking business, insurance business, mutual fund business and NBFC business(deposit taking and non-deposit taking). What constitutes “significant presence” in each of the marketsegments is also defined. Size of the balance sheet (on-balance sheet and off-balance sheet items);volume of financial activities of the subsidiaries/associates and substantial nature of intra-grouptransactions and exposures are some indicators which determine the significance of financial groups inthe Indian context.

In March 2013, the financial sector regulators (Reserve Bank of India, Securities and ExchangeBoard of India, Insurance Regulatory and Development Authority and Pension Fund Regulatory andDevelopment Authority) signed a Memorandum of Understanding (MoU) for co-operation in the fieldof consolidated supervision and monitoring of financial groups identified as financial conglomerates.

Since India is a member of FSB, it is committed to pursuing the reforms agenda outlined by it inthe area, among others, of regulation and effective supervision of financial conglomerates in thecountry. This is a “work-in-progress’ under the FSB umbrella.

Exhibit

Phase II – Organisation of Indian Financial of the SystemI. Government ownership of financial institution

Nationalisation of: RBI SBI LIC


BANKS GICNew InstitutionDFIsUTI

II. Fortification of institutional structure: DFIs IFCI SFCs ICICI IDBI SIDCs SIICs IIBI

Banks Diversification of form of financing Enlargement of functional coverage Innovative banking

LIC and UTIIII. Investor Protection

Companies Act Capital Issue Act Securities Contract Act Monopolies and Restrictive Trade Practices Act Foreign Exchange Regulation Act

The Financial Sector Legislative Reforms Commission (FSLRC) is a body set up by theGovernment of India, Ministry of Finance, on 24 March 2011, to review and rewrite the legal-institutional architecture of the Indian financial sector.

Based on substantive research, extensive deliberations in the Commission and in its WorkingGroups, interaction with policy makers, regulators, experts and stakeholders; the Commission hasevolved a tentative framework on the legal-institutional structure required for the Indian financialsector in the medium to the long run. The broad contour of that framework is outlined by theCommission on 4 October 2012.

The Financial Sector Legislative Reforms Commission (FSLRC) was constituted by theGovernment of India, Ministry of Finance, vide a resolution dated 24 March 2011. The setting up ofthe FSLRC was the result of a felt need that the legal and institutional structures of the financial sectorin India need to be reviewed and recast in tune with the contemporary requirements of the sector.

The institutional framework governing the financial sector has been built up over a century.There are over 60 Acts and multiple rules and regulations that govern the financial sector. Many of the


financial sector laws date back several decades, when the financial landscape was very different fromthat seen today. For example, the RBI Act and the Insurance Act are of 1934 and 1938 vintagerespectively. The Securities Contract Regulation Act was enacted in 1956, when derivatives andstatutory regulators were unknown. The superstructure of the financial sector governance regime hasbeen modified in a piecemeal fashion from time to time, without substantial changes to the underlyingfoundations. These piecemeal changes have induced complex and cumbersome legislation, and raiseddifficulties in harmonising contradictory provisions. Such harmonisation is imperative for effectivelyregulating a dynamic market in the era of financial globalisation.

The piecemeal amendments have generated unintended outcomes including regulatory gaps,overlaps, inconsistencies and regulatory arbitrage. The fragmented regulatory architecture has led to aloss of scale and scope that could be available from a seamless financial market with all its attendantbenefits of minimising the intermediation cost. For instance, complex financial intermediation byfinancial conglomerates of today falls under the purview of multiple regulators with gaps and overlaps.A number of expert committees have pointed out these discrepancies, and recommended the need forrevisiting the financial sector legislations to rectify them. The need for complete review of the existingfinancial sector laws has been underlined to make the Indian financial sector more vibrant anddynamic in an increasingly interconnected world.

The remit of FSLRC, as contained in its Terms of Reference (ToR), comprises the following: Review, simplify and rewrite the legislations affecting the financial markets in India,

focusing on broad principles. Evolve a common set of principles for governance of financial sector regulatory institutions. Remove inconsistencies and uncertainties in legislations/Rules and Regulations. Make legislations consistent with each other. Make legislations dynamic to automatically bring them in tune with the changing financial

landscape. Streamline the regulatory architecture of financial markets.The FSLRC has been deliberating on these issues since April 2011 both internally and through

consultation/interaction with a wide spectrum of experts and stakeholders. This Approach Paper is theoutcome of these deliberations and substantive research work. It shows the contours of the legal-institutional framework that the FSLRC may recommend. It is a provisional document, and thethinking of FSLRC will evolve in coming months, utilising various inputs including the analysis ofthis document in the public domain.

Terms of Reference and Objectives

The Terms of Reference of the Commission include the following:1. Examining the architecture of the legislative and regulatory system governing the financial

sector in India.2. Examine if legislation should mandate statement of principles of legislative intent behind

every piece of subordinate legislation in order to make the purposive intent of the legislationclear and transparent to users of the law and to the Courts.

3. Examine if public feedback for draft subordinate legislation should be made mandatory,with exception for emergency measures.


4. Examine prescription of parameters for invocation of emergency powers where regulatoryaction may be taken on ex parte basis.

5. Examine the interplay of exchange controls under FEMA and FDI policy with otherregulatory regimes within the financial sector.

6. Examine the most appropriate means of oversight over regulators and their autonomy fromgovernment.

7. Examine the need for restatement of the law and immediate repeal of any outdatedlegislation on the basis of judicial decisions and policy shifts in the last two decades of thefinancial sector post-liberalisation.

8. Examination of issues of data privacy and protection of consumer of financial services in theIndian market.

9. Examination of legislation relating to the role of information technology in the delivery offinancial services in India and their effectiveness.

10. Examination of all recommendations already made by various expert committees set up bythe government and by regulators and to implement measures that can be easily accepted.

Summary of Recommendations

With a view to outlining and studying comprehensively the banking sector in India, the FinancialSector Legislative Reforms Commission (FSLRC) constituted this Working Group (WG).

Recommendation 1: The WG recommends that the definition of banking must be guided by theprinciple that all deposit taking activities (where the public places deposits with any entity, which areredeemable at par with assured rates of return) must be considered as banking. Consequently, entitiesundertaking such activities must obtain a bank license and/or be subject to the regulatory purview ofthe banking regulator.

Recommendation 2: On the definition of “banking”, the WG recommends that any entity thataccepts deposits has access to clearing and to the Reserve Bank of India (RBI)repo window is a bank.The primary activity of a bank is to accept deposits. Once an entity accepts deposits, it will haveaccess to clearing and discount window of RBI. There may be different categories of banks and therule of proportionality will be applied in their regulation by the banking regulator.

Recommendation 3: There will be no sub-regulators such as National Bank for Agriculture andRural Development, National Housing Bank and Small Industries Development Bank in the proposedregulatory architecture. The existing entities may function as financial service providers and will beregulated by the relevant regulator based on their functions.

Recommendation 4: On the issue of co-operatives which collect monies from members/shareholders, this WG recommends that any co-operative society accepting deposits exceeding aspecified value must fall within the regulatory purview of the banking regulator. Co-operative banksare currently regulated under Part V of the BR Act (1949), but many provisions in the BR Act (1949)are not applicable to them. This WG recommends that such exclusions be removed. Co-operativebanks must be treated at par with banking companies. This WG also endorses the policyrecommendations of the Malegam Report (2011). To deal with the problem of dual control, theCommittee recommends the creation of a new organisation structure for Urban Co-operative Banks(UCBs) consisting of a Board of Management (BOM) in addition to the Board of Directors (Board).The Boards would be elected in accordance with the provisions of the respective State Co-operative


Societies Acts or the Multi-State Co-operative Act, 2002 and would be regulated and controlled by theRegistrar of Co-operative Societies. The Boards would establish a BOM which shall be entrusted withthe responsibility for the control and direction of the affairs of the Bank assisted by a Chief ExecutiveOfficer (CEO) who shall have the responsibility for the management of the bank. RBI would havepowers to control and regulate the functioning of the bank and of its BOM and of the CEO in exactlythe same way as it controls and regulates the functioning of the Board and the Chief Executive in thecase of a commercial bank.

Recommendation 5: In case of foreign banks having branches in India, the WG recommendsthat all such foreign banks set up a wholly owned subsidiary (WOS) in India. Transition issues willneed to be addressed by the GOI so that they do not incur taxation from capital gains, or stamp duty,when they convert from branch operations to WOS.

Questions for Practice

I. Fill in the Blanks1. The financial system process includes savings, finance and __________.

(a) Growth (b) Development(c) Investment (d) None of the above

2. The __________ is a body set up by the Government of India, Ministry of Finance, on 24March 2011, to review and rewrite the legal-institutional architecture of the Indian financialsector.(a) BSE (b) FSLRC(c) SEBI (d) NSE

3. The main element of the financial organisation in planned economic development could becategorised into four broad groups:(i) Government ownership of the financial institution

(ii) Fortification of the institution structure(iii) Protection to investors(iv) Participation of the financial institution in corporate management(a) All of the above (b) None of the above

4. The year 1969 was a landmark in the history of public control of private financial system,when __________ major commercial bank were brought under the direct ownership of theGovernment of the India.(a) 15 (b) 6(c) 9 (d) 14

Ans: 1. (c), 2. (b), 3. (a), 4. (d)

II. Review Questions1. Explain the phase I and phase II of Indian Financial System2. Write the terms of reference and objectives of Indian financial system.3. Write a note on nationalisation.

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