Banking and Finance

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JNU, JaipurFirst Edition 2013

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Index

ContentI. ...................................................................... II

List of TablesII. ...........................................................VI

AbbreviationsIII. ....................................................... VII

Case StudyIV. ............................................................ 112

BibliographyV. ......................................................... 119

Self Assessment AnswersVI. ..................................... 122

Book at a Glance

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Contents

Chapter I ....................................................................................................................................................... 1Banking System in India ............................................................................................................................. 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 Need of the Banks .................................................................................................................................... 21.3 History of Indian Banking System ........................................................................................................... 2 1.3.1 Nationalisation ......................................................................................................................... 3 1.3.2 Liberalisation ........................................................................................................................... 3 1.3.3 Government Policy on Banking Industry ............................................................................... 4 1.3.4 Law of Banking ....................................................................................................................... 41.4 Regulations for Indian Banks ................................................................................................................... 51.5 Classification of Banking Industry in India ............................................................................................. 5 1.5.1 Reserve Bank of India .............................................................................................................. 6 1.5.2 Indian Scheduled Commercial Banks ...................................................................................... 7 1.5.3 NABARD ................................................................................................................................. 71.6 Services provided by Banking Organisations .......................................................................................... 8Summary ..................................................................................................................................................... 10References .................................................................................................................................................. 10Recommended Reading ............................................................................................................................. 10Self Assessment ............................................................................................................................................11

Chapter II ................................................................................................................................................... 13Budgetary Policy and Indian Financial System ...................................................................................... 13Aim .............................................................................................................................................................. 13Objectives .................................................................................................................................................... 13Learning outcome ........................................................................................................................................ 132.1 Introduction ............................................................................................................................................ 142.2 Indian Fiscal Policy ................................................................................................................................ 14 2.2.1 Budgetary Policy .................................................................................................................... 15 2.2.2 Budgetary System .................................................................................................................. 152.3 Indian Financial System ......................................................................................................................... 162.4 Impact of Budgetary Policy on Financial System .................................................................................. 16 2.4.1 Role of Budgetary Policy in the Growth of Financial Institutions ........................................ 16 2.4.2 Impact of Budgetary Policy on Banks ................................................................................... 17 2.4.3 Budgetary Policy and Financial Markets ............................................................................... 18 2.4.4 Budgetary Policy and the Financial Instruments ................................................................... 192.5 The Interest Rate Policy and the Financial System................................................................................ 20 2.5.1 Role of Budgetary Policy in the emerging new economic environment ............................... 212.6 Deficit Financing and Financial System ................................................................................................ 21Summary ..................................................................................................................................................... 23References ................................................................................................................................................... 23Recommended Reading ............................................................................................................................. 23Self Assessment ........................................................................................................................................... 24

Chapter III .................................................................................................................................................. 26Credit Rating Agencies in India ............................................................................................................... 26Aim .............................................................................................................................................................. 26Objectives .................................................................................................................................................... 26Learning outcome ........................................................................................................................................ 263.1 Introduction ............................................................................................................................................ 273.2 Meaning of Credit Rating ...................................................................................................................... 27

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3.3 The Determinants of Ratings ................................................................................................................. 273.4 Rating Methodology .............................................................................................................................. 283.5 Credit Rating Agencies in India ............................................................................................................. 293.6 Credit Rating Symbols ........................................................................................................................... 313.7 Benefits of Credit Rating ....................................................................................................................... 313.8 Rating and Default Risk ......................................................................................................................... 323.9 Ratings and Yields ................................................................................................................................. 333.10 Limitations of Credit Ratings ............................................................................................................... 34Summary ..................................................................................................................................................... 36References ................................................................................................................................................... 36Recommended Reading ............................................................................................................................. 36Self Assessment ........................................................................................................................................... 37

Chapter IV .................................................................................................................................................. 39Regulatory Framework for Banks and Non-banking Finance Companies .......................................... 39Aim .............................................................................................................................................................. 39Objectives .................................................................................................................................................... 39Learning outcome ........................................................................................................................................ 394.1 Introduction ............................................................................................................................................ 404.2 Reserve Bank of India: The Central Bank ............................................................................................. 404.3 Regulations over Commercial Banks ..................................................................................................... 414.4 Regulations over Co-operative Banks ................................................................................................... 444.5 Regulations over Non-Banking Finance Companies ............................................................................. 44 4.5.1 Reserve Bank of India Act, 1934 ........................................................................................... 45 4.5.2 NBFCs Acceptance of Public Deposits (Reserve Bank) Directions ...................................... 46 4.5.3 Prudential Norms for NBFCs ................................................................................................ 47Summary ..................................................................................................................................................... 48References ................................................................................................................................................... 48Recommended Reading ............................................................................................................................. 48Self Assessment ........................................................................................................................................... 49

Chapter V .................................................................................................................................................... 51Agricultural finance in India .................................................................................................................... 51Aim .............................................................................................................................................................. 51Objectives .................................................................................................................................................... 51Learning outcome ........................................................................................................................................ 515.1 Introduction ............................................................................................................................................ 525.2 Co-operative Credit Societies and Banks .............................................................................................. 52 5.2.1 Primary Agricultural Co-operative Credit Societies .............................................................. 53 5.2.2 Central Co-operative Banks ................................................................................................... 53 5.2.3 State Co-operative Banks ....................................................................................................... 53 5.2.4 Land Development Banks ...................................................................................................... 545.3 Commercial Banks ................................................................................................................................. 545.4 Types of Agricultural Finance ................................................................................................................ 555.5 Limitations of Commercial Banks ......................................................................................................... 565.6 Regional Rural Banks ............................................................................................................................ 565.7 National Bank for Agriculture and Rural Development (NABARD) .................................................... 58 5.7.1 Functions ................................................................................................................................ 58Summary ..................................................................................................................................................... 60References ................................................................................................................................................... 60Recommended Reading ............................................................................................................................. 60Self Assessment ........................................................................................................................................... 61

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Chapter VI .................................................................................................................................................. 63All India and State Level Term-Lending Financial Institutions ........................................................... 63Aim .............................................................................................................................................................. 63Objectives .................................................................................................................................................... 63Learning outcome ........................................................................................................................................ 636.1 Introduction ............................................................................................................................................ 646.2 Origin of Development Banks ............................................................................................................... 646.3 Industrial Finance Corporation of India (IFCI) ..................................................................................... 656.4 Industrial Credit and Investment Corporation of India (ICICI) ............................................................. 676.5 Industrial Development Bank of India (IDBI) ....................................................................................... 696.6 Other Development Banking Institutions .............................................................................................. 73 6.6.1 Industrial Reconstruction Bank of India (IRBI) .................................................................... 73 6.6.2 Small Industries Development Bank of India (SIDBI) .......................................................... 746.7 Evaluation of Development Banks in India ........................................................................................... 746.8 Critical Appraisal ................................................................................................................................... 746.9 Need for State Level Term-Lending Institutions ................................................................................... 756.10 State Financial Corporation (SFC) ....................................................................................................... 756.11 State Industrial Development Corporations (SIDCs) ........................................................................... 776.12 Technical Consultancy Organisations .................................................................................................. 78Summary ..................................................................................................................................................... 79References ................................................................................................................................................... 79Recommended Reading ............................................................................................................................. 79Self Assessment ........................................................................................................................................... 80

Chapter VII ................................................................................................................................................ 82Investment Institutions in India ............................................................................................................... 82Aim .............................................................................................................................................................. 82Objectives .................................................................................................................................................... 82Learning outcome ........................................................................................................................................ 827.1 Introduction ............................................................................................................................................ 837.2 Life Insurance Corporation of India ...................................................................................................... 837.3 General Insurance Corporation of India ................................................................................................ 857.4 Insurance Regulatory and Development Authority (IRDA) .................................................................. 857.5 Mutual Funds ......................................................................................................................................... 86 7.5.1 Schemes of Mutual Funds ...................................................................................................... 87 7.5.2 Types of Schemes .................................................................................................................. 877.6 Unit Trust of India .................................................................................................................................. 88 7.6.1 Unit Scheme, 1964 ................................................................................................................. 887.7 Other Mutual Funds ............................................................................................................................... 897.8 Governance of Mutual Funds ................................................................................................................. 907.9 Investment Restrictions .......................................................................................................................... 917.10 Performance of Mutual Funds in India ............................................................................................... 927.11 Risk Factors .......................................................................................................................................... 92Summary ..................................................................................................................................................... 94References ................................................................................................................................................... 94Recommended Reading ............................................................................................................................. 95Self Assessment ........................................................................................................................................... 96

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Chapter VIII ............................................................................................................................................... 98India and the Global Financial System .................................................................................................... 98Aim .............................................................................................................................................................. 98Objectives .................................................................................................................................................... 98Learning outcome ........................................................................................................................................ 988.1 Introduction ............................................................................................................................................ 998.2 International Financial Institutions ........................................................................................................ 99 8.2.1 International Monetary Fund ................................................................................................. 99 8.2.2 International Bank for Reconstruction and Development (IBRD) ...................................... 101 8.2.3 International Finance Corporation (IFC) ............................................................................. 102 8.2.4 International Development Association (IDA) .................................................................... 103 8.2.5 Asian Development Bank (ADB) ........................................................................................ 1038.3 European Monetary System ................................................................................................................. 1048.4 Euro Market ........................................................................................................................................ 1058.5 India and Foreign Currency ................................................................................................................. 105 8.5.1 External Commercial Borrowings (ECBs) .......................................................................... 106 8.5.2 Euro-issues ........................................................................................................................... 106 8.5.3 Foreign Direct Investments .................................................................................................. 107 8.5.4 Portfolio Investments ........................................................................................................... 108 8.5.5 Non-Resident Indians Deposits ........................................................................................... 108Summary ................................................................................................................................................... 109References ................................................................................................................................................. 109Recommended Reading ........................................................................................................................... 109Self Assessment ..........................................................................................................................................110

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List of Tables

Table 3.1 Credit rating analysis of CARE ................................................................................................... 31Table 3.2 (a) Rating Category of Credit Agency Firms ............................................................................... 32Table 3.2 (b) Rating Category of Credit Agency Firms ............................................................................... 33Table 3.3 Downgrades of ratings (in %) in 1997 ......................................................................................... 35Table 6.1 Assistance sanctioned and disbursed by IFCI .............................................................................. 67Table 6.2 Assistance sanctioned and disbursed by ICICI ............................................................................ 68Table 6.3 Assistance sanctioned and disbursed ............................................................................................ 71Table 6.4 Loan sanctions and disbursements of IRBI .................................................................................. 73Table 6.5 Assistance sanctioned and disbursed by AIFIs ............................................................................ 74Table 7.1 Controlled funds of LIC ............................................................................................................... 83Table 7.2 Revised investment avenue of LIC .............................................................................................. 83Table 7.3 Investments policies of LIC ......................................................................................................... 84Table 7.4 Investment scheme of GIC ........................................................................................................... 85Table 7.5 Investment of controlled funds .................................................................................................... 86Table 7.6 Cumulative resources mobilised by Mutual Funds ...................................................................... 92

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Abbreviations

ADB - Asian Development BankADRs - American Depository ReceiptsAMC - Asset Management CompanyARDC - AgricultureRefinanceandDevelopmentCorporationATM - Automated Teller Machine CRAR - Capital Risk Adjusted Assets RatioCRR - Cash Reserve RequirementDFHI - Discount and Finance House of IndiaECAFE - Economic Commission for Asia and Far EastECBs - External Commercial BorrowingsECSC - European Coal and Steel CommunityECU - European Currency UnitEDPs - Entrepreneurship Development ProgrammesEDRs - European Depository ReceiptsEEC - European Economic CommunityEMU - European Monetary UnionERM - Exchange-Rate MechanismEU - European UnionFCNR (B) - Foreign Currency Non-Resident (Banks) schemeFII - Foreign Institutional InvestorsFIPB - Foreign Investment Promotion BoardGDP - Gross Domestic ProductGDRs - Global Depository ReceiptsGIC - General Insurance Corporation of IndiaGOI - Government of IndiaIBRD - International Bank for Reconstruction and DevelopmentICICI - Industrial credit and Investment Corporation of IndiaIDA - International Development AssociationIDBI - Industrial Development Bank of IndiaIFC - International Finance CorporationIFCI - Industrial Finance Corporation of IndiaIMF - International Monetary FundIRBI - Industrial Reconstruction Bank of IndiaIRCI - Industrial Reconstruction Corporation of IndiaIRDA - Insurance Regulatory and Development AuthorityLDBs - Land Development BanksLIBOR - London Inter-Bank Offered RateLIC - Life Insurance Corporation of IndiaNABARD - National Bank for Agriculture and Rural Development NAV - Net Asset ValueNBFCs - Non-banking Finance CompaniesNRERA - Non-resident External Rupee AccountsNRNRRD - Non-resident (Non Repatriable) Rupee Deposits SchemeRBI - Reserve Bank of IndiaRRBs - Regional Rural BanksSAP - Structural Adjustment ProgrammeSCBs - State Co-operative BanksSDRs - Special Drawing RightsSEBI - Securities and Exchange Board of IndiaSEEUY - Self-Employment Scheme for Educated Unemployed YouthSFCs - State Financial Corporations

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SIA - Secretariat for Industrial AssistanceSIDBI - State Industries Development Bank of IndiaSIDC - State Industrial Development CorporationsSLR - Statuary Liquidity RequirementTCOs - Technical Consultancy OrganisationsUTI - Unit Trust of India

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Chapter I

Banking System in India

Aim

The aim of this chapter is to:

introduce banking system in India•

explain the need of banks•

explicate regulations for Indian Banks•

Objectives

The objectives of this chapter are to:

elucidate co-operative banks•

explain the government policy on banking industry•

explicate the Indian banking structure•

Learning outcome

At the end of this chapter, you will be able to:

describe law of banking •

identify services provided by banking organisations•

understand the concept of liberalisation•

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1.1 IntroductionAbankisafinancialinstitutionthatprovidesbankingandotherfinancialservicestotheircustomers.Abankisgenerally understood as an institution which provides fundamental banking services such as accepting deposits and providing loans. There are also non- banking institutions that provide certain banking services without meeting the legaldefinitionofabank.Banksareasubsetofthefinancialservicesindustry.

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 achievementstoitscredit.TheBanksarethemainparticipantsofthefinancialsysteminIndia.TheBankingsectoroffers several facilities and opportunities to their customers. All the banks safeguards 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 industrieshaveemerged,someof the traditionaldistinctionsbetweenbanks, insurancecompanies,andsecuritiesfirmshavediminished.Inspiteofthesechanges,bankscontinuetomaintainandperformtheirprimaryrole- accepting deposits and lending funds from these deposits.

1.2 Need of the BanksBeforetheestablishmentofbanks,thefinancialactivitieswerehandledbymoneylendersandindividuals.Atthattime the interest rates were very high. Again there were no security of public savings and no uniformity regarding loans. So to overcome such problems the organised banking sector was established, which was fully regulated by thegovernment.Theorganisedbankingsectorworkswithinthefinancialsystemtoprovideloans,acceptdepositsand provide other services to their customers. The following functions 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 theworking of the financial system, increase savings speedily and•efficientlyToavoidfocusoffinancialpowersinthehandsofafewindividualsandinstitutions•To set equal norms and conditions (i.e. rate of interest, period of lending etc) to all types of customers•

1.3 History of Indian Banking SystemThefirstbankinIndia,calledTheGeneralBankofIndiawasestablishedintheyear1786.TheEastIndiaCompanyestablished The Bank of Bengal/Calcutta (1809), Bank of Bombay (1840) and Bank of Madras (1843). The next bank was Bank of Hindustan which was established in 1870. These three individual units (Bank of Calcutta, Bank of Bombay, and Bank of Madras) were called as Presidency Banks. Allahabad Bank which was established in 1865 wasforthefirsttimecompletelyrunbyIndians.PunjabNationalBankLtd.wassetupin1894withheadquartersatLahore. Between 1906 and 1913, Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. In 1921, all presidency banks were amalgamated to form the Imperial Bank of India which was run by European Shareholders. After that the Reserve Bank of India was established in April 1935.

Atthetimeoffirstphasethegrowthofbankingsectorwasveryslow.Between1913and1948therewereapproximately1100 small banks in India. To streamline the functioning and activities of commercial banks, the Government of India came up with the Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965 (Act No.23 of 1965). Reserve Bank of India was vested with extensive powers for the supervision of banking in India as a Central Banking Authority. After independence, Government has taken most important steps in regard of Indian Banking Sector reforms. In 1955, the Imperial Bank of India was nationalised and was given the name “State Bank of India”, to act as the principal agent of RBI and to handle banking transactions all over the country. It was established under State Bank of India Act, 1955. Seven banks forming subsidiary of State Bank of India was nationalised in 1960. On 19th July, 1969, major process of nationalisation was carried out. At the same time 14 major Indian commercial banks of the country were nationalised.

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In 1980, another six banks were nationalised and thus raising the number of nationalised banks to 20. Seven more banks were nationalised with deposits over 200 Crores. Till the year 1980 approximately 80% of the banking segment in India was under government’s ownership. On the suggestions of Narsimhan Committee, the Banking Regulation Act was amended in 1993 and thus the gates for the new private sector banks were opened. The following are the major steps taken by the Government of India to Regulate Banking institutions in the country:

1949: Enactment of Banking Regulation Act•1955: Nationalisation of State Bank of India•1959: Nationalisation of SBI subsidiaries•1961: Insurance cover extended to deposits•1969: Nationalisation of 14 major Banks•1971: Creation of credit guarantee corporation•1975: Creation of regional rural banks•1980: Nationalisation of seven banks with deposits over 200 Crores•

1.3.1 NationalisationBy the 1960s, the Indian banking industry has become an important tool to facilitate the development of the Indian economy. At the same time, it has emerged as a large employer, and a debate has ensured about the possibility to nationalise the banking industry. Indira Gandhi, the-then Prime Minister of India expressed the intention of the Government of India (GOI) in the annual conference of the All India Congress Meeting in a paper entitled “Stray thoughts on Bank Nationalisation”. The paper was received with positive enthusiasm. Thereafter, her move was swift and sudden, and the GOI issued an ordinance and nationalised the 14 largest commercial banks with effect from the midnight of July 19, 1969. Jayaprakash Narayan, a national leader of India, described the step as a “Masterstroke of political sagacity”.

Within two weeks of the issue of the ordinance, the Parliament passed the Banking Companies (Acquisition and Transfer of Undertaking) Bill, and it received the presidential approval on 9 August, 1969. A second step of nationalisation of 6 more commercial banks followed in 1980. The stated reason for the nationalisation was to give the government more control of credit delivery. With the second step of nationalisation, the GOI controlled around 91% of the banking business in India. Later on, in the year 1993, the government merged New Bank of India with Punjab National Bank. It was the only merger between nationalised banks and resulted in the reduction of the number of nationalised banks from 20 to 19. After this, until the 1990s, the nationalised banks grew at a pace of around 4%, closer to the average growth rate of the Indian economy. The nationalised banks were credited by some;includingHomeministerP.Chidambaram,tohavehelpedtheIndianeconomywithstandtheglobalfinancialcrisis of 2007-2009.

1.3.2 LiberalisationIn the early 1990s, the then Narsimha Rao government embarked on a policy of liberalisation, licensing a small number of private banks. These came to be known as New Generation tech-savvy banks, and included Global TrustBank(thefirstofsuchnewgenerationbankstobesetup),whichlateramalgamatedwithOrientalBankofCommerce, Axis Bank(earlier as UTI Bank), ICICI Bank and HDFC Bank. This move along with the rapid growth in the economy of India revolutionised the banking sector in India which has seen rapid growth with strong contribution from all the three sectors of banks, namely, government banks, private banks and foreign banks. The next stage for the Indian banking has been setup with the proposed relaxation in the norms for Foreign Direct Investment, where all Foreign Investors in banks may be given voting rights which could exceed the present cap of 10%, at present it has gone up to 49% with some restrictions.

The new policy shook the banking sector in India completely. Bankers, till this time, were used to the 4-6-4 method (Borrow at 4%; Lend at 6%; Go home at 4) of functioning. The new wave ushered in a modern outlook and tech-savvy methods of working for the traditional banks. All this led to the retail boom in India. People not just demanded more from their banks but also received more. Currently, banking in India is generally mature in terms of supply, product range and reach-even though reach in rural India still remains a challenge for the private sector and foreign banks.

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In terms of quality of assets and capital adequacy, Indian banks are considered to have clean, strong and transparent balance sheets as compared to other banks in comparable economies in its region. The Reserve Bank of India is an autonomous body, with minimal pressure from the government. The stated policy of the Bank on the Indian Rupee istomanagevolatilitybutwithoutanyfixedexchangerate-andthishasmostlybeentrue.WiththegrowthintheIndian economy expected to be strong for quite some time-especially in its services sector-the demand for banking services, especially retail banking, mortgages and investment services are expected to be strong.

In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its stake in Kotak Mahindra Bank (a privatesectorbank)to10%.Thisisthefirsttimeaninvestorhasbeenallowedtoholdmorethan5%inaprivatesectorbank since the RBI announced norms in 2005 that any stake exceeding 5% in the private sector banks would need to be voted by them. In recent years critics have charged that the non-government owned banks are too aggressive in their loan recovery efforts in connection with housing, vehicle and personal loans. There are press reports that the banks’ loan recovery efforts have driven defaulting borrowers to suicide.

1.3.3 Government Policy on Banking Industry The Federal Reserve Act 1913 and the Banking Act of 1933 determines the government policy on banking industry. Banks operating in most of the countries must contend with heavy regulations, rules enforced by Federal and State agencies to govern their operations, service offerings, and the manner in which they grow and expand their facilities tobetterservethepublic.Abankerworkswithinthefinancialsystemtoprovideloans,acceptdeposits,andprovideother services to their customers. They must do so within a climate of extensive regulation, designed primarily to protect the public interests.

The main reasons why the banks are heavily regulated are as follows:To protect the safety of the public’s savings.•To control the supply of money and credit in order to achieve a nation’s broad economic goal.•Toensureequalopportunityandfairnessinthepublic’saccesstocreditandothervitalfinancialservices.•Topromotepublicconfidenceinthefinancialsystem,sothatsavingsaremadespeedilyandefficiently.•Toavoidconcentrationsoffinancialpowerinthehandsofafewindividualsandinstitutions.•Provide the Government with credit, tax revenues and other services.•To help sectors of the economy that they have special credit needs for eg. Housing, small business and agricultural •loans, etc.

1.3.4 Law of BankingBankinglawisbasedonacontractualanalysisoftherelationshipbetweenthebankandcustomerdefinedasanyentity for which the bank agrees to conduct an account. The law implies rights and obligations into this relationship as follows:

Thebankaccountbalanceisthefinancialpositionbetweenthebankandthecustomer:whentheaccountis•in credit, the bank owes the balance to the customer; when the account is overdrawn, the customer owes the balance to the bank.The bank agrees to pay the customer’s cheques up to the amount standing to the credit of the customer’s account, •plus any agreed overdraft limit.The bank may not pay from the customer’s account without a mandate from the customer, e.g. cheques drawn •by the customer.The bank agrees to promptly collect the cheques deposited to the customer’s account as the customer’s agent, •and to credit the proceeds to the customer’s account.The bank has a right to combine the customer’s accounts, since each account is just an aspect of the same credit •relationship.The bank has a lien on cheques deposited to the customer’s account, to the extent that the customer is indebted •to the bank.

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The bank must not disclose details of transactions through the customer’s account- unless the customer consents, •there is a public duty to disclose, the bank’s interests require it, or the law demands it.The bank must not close a customer’s account without reasonable notice, since cheques are outstanding in the •ordinary course of business for several days.

Theseimpliedcontractualtermsmaybemodifiedbyexpressagreementbetweenthecustomerandthebank.Thestatutes and regulations in force within a particular jurisdiction may also modify the above terms and/or create new rights, obligations or limitations relevant to the bank-customer relationship.

1.4 Regulations for Indian BanksCurrently in most jurisdictions commercial banks are regulated by government entities and require a special bank licensetooperate.Usuallythedefinitionofthebusinessofbankingforthepurposesofregulationisextendedtoinclude acceptance of deposits, even if they are not repayable to the customer’s order - although money lending, by itself,isgenerallynotincludedinthedefinition.

Unlike most other regulated industries, the regulator is typically also a participant in the market, i.e. a government-owned (central) bank. Central banks also typically have a monopoly on the business of issuing banknotes. However, in some countries this is not the case. In UK, for example, the Financial Services Authority licenses banks, and some commercial banks (such as the Bank of Scotland) issue their own banknotes in addition to those issued by the Bank of England, the UK government’s central bank.

Sometypesoffinancialinstitutions,suchasbuildingsocietiesandcreditunions,maybepartlyorwhollyexemptedfrom bank license requirements, and therefore regulated under separate rules. The requirements for the issue of a bank license vary between jurisdictions but typically include:

Minimum capital•Minimum capital ratio•‘FitandProper’requirementsforthebank’scontrollers,owners,directors,and/orseniorofficers•Approvalofthebank’sbusinessplanasbeingsufficientlyprudentandplausible.•

1.5 Classification of Banking Industry in IndiaIndian banking industry has been divided into two parts, organised and unorganised sectors. The organised sector consists of Reserve Bank of India, Commercial Banks and Co-operative Banks, and Specialised Financial Institutions (IDBI, ICICI, IFC etc). The unorganised sector, which is not homogeneous, is largely made up of money lenders and indigenous bankers.

An outline of the Indian Banking structure may be presented as follows:Reserve banks of India•Indian Scheduled Commercial Banks•

State Bank of India and its associate banks �Twenty nationalised banks �Regional rural banks �Other scheduled commercial banks �

Foreign banks•Non-scheduled banks•Co-operative banks•

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1.5.1 Reserve Bank of IndiaThe reserve bank of India is a central bank and was established in April 1, 1935 in accordance with the provisions of ReserveBankofIndiaAct1934.ThecentralofficeofRBIislocatedatMumbaisinceinception.Thoughoriginallythe Reserve Bank of India was privately owned, since nationalisation in 1949, RBI is fully owned by the Government of India. It was inaugurated with share capital of Rs. 5 Crores divided into shares of Rs. 100 each fully paid up.

RBI is governed by a central board (headed by a governor) appointed by the central government of India. RBI has 22 regionalofficesacrossIndia.ThereservebankofIndiawasnationalisedintheyear1949.Thegeneralsuperintendenceand direction of the bank is entrusted to central board of directors of 20 members, the Governor and four deputy Governors,oneGovernmentalofficialfromtheministryofFinance,tennominateddirectorsbythegovernmenttogive representation to important elements in the economic life of the country, and the four nominated director by the Central Government to represent the four local boards with the headquarters at Mumbai, Kolkata, Chennai and NewDelhi.LocalBoardconsistsoffivememberseachcentralgovernmentappointedforatermoffouryearstorepresent territorial and economic interests and the interests of co- operative and indigenous banks.

The RBI Act 1934 was commenced on April 1, 1935. The Act, 1934 provides the statutory basis of the functioning of the bank. The bank was constituted for the need of following:

To regulate the issues of banknotes.•To maintain reserves with a view to securing monetary stability•To operate the credit and currency system of the country to its advantage.•

FunctionsofRBIasacentralbankofIndiaareexplainedbrieflyasfollows:Bank of Issue: The RBI formulates, implements, and monitors the monitory policy. Its main objective is •maintainingpricestabilityandensuringadequateflowofcredittoproductivesector.Regulator:Supervisorofthefinancialsystem:RBIprescribesbroadparametersofbankingoperationswithin•whichthecountry’sbankingandfinancialsystemfunctions.Theirmainobjectiveistomaintainpublicconfidencein the system, protect depositor’s interest and provide cost effective banking services to the public.Manager of exchange control: The manager of exchange control department manages the foreign exchange, •according to the foreign exchange management act, 1999. The manager’s main objective is to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.Issuer of currency: A person who works as an issuer, issues and exchanges or destroys the currency and coins •thatarenotfitforcirculation.Hismainobjectiveistogivethepublicadequatequantityofsuppliesofcurrencynotes and coins and in good quality.Developmental role: The RBI performs the wide range of promotional functions to support national objectives •such as contests, coupons maintaining good public relations and many more.Related functions: There are also some of the related functions to the above mentioned main functions. They •are such as banker to the government, banker to banks etc.

Banker to government performs merchant banking function for the central and the state governments; also �acts as their banker.Banker to banks maintains banking accounts to all scheduled banks. �

Controller of Credit: RBI performs the following tasks:•It holds the cash reserves of all the scheduled banks. �It controls the credit operations of banks through quantitative and qualitative controls. �It controls the banking system through the system of licensing, inspection and calling for information. �It acts as the lender of the last resort by providing rediscount facilities to scheduled banks. �

Supervisory functions: In addition to its traditional central banking functions, the Reserve Bank performs certain •non-monetary functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve Bank Act 1934 and the banking regulation act 1949 have given the RBI wide powers of supervision and control over commercial and co-operative banks, relating to licensing and establishments, branch expansion,

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liquidity of their assets, management and methods of working, amalgamation, reconstruction and liquidation. The RBI is authorised to carry out periodical inspections of the banks and to call for returns and necessary information from them. The nationalisation of 14 major Indian scheduled banks in July 1969 has imposed new responsibilities on the RBI for directing the growth of banking and credit policies towards more rapid development of the economy and realisation of certain desired social objectives. The supervisory functions of the RBI have helped a great deal in improving the standard of banking in India to develop on sound lines and to improve the methods of their operation.Promotional functions: With economic growth assuming a new urgency since independence, the range of •the Reserve Bank’s functions has steadily widened. The bank now performs a variety of developmental and promotional functions, which, at one time, were regarded as outside the normal scope of central banking. The Reserve bank was asked to promote banking habit, extend banking facilities to rural and semi-urban areas, and establishandpromotenewspecialisedfinancingagencies.

1.5.2 Indian Scheduled Commercial BanksThe commercial banking structure in India consists of scheduled commercial banks, and unscheduled banks.

Scheduled banksScheduled Banks in India constitute those banks which have been included in the second schedule of RBI act 1934. RBI in turn includes only those banks in this schedule which satisfy the criteria laid down vide section 42(6a) of the Act. “Scheduled banks in India” means the State Bank of India constituted under the State Bank of India Act, 1955(23of1955),asubsidiarybankasdefinedinthesStateBankofIndia(subsidiarybanks)Act,1959(38of1959), a corresponding new bank constituted under section 3 of the Banking companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980), or any other bank being a bank included in the Second Schedule to the Reserve bank of India Act, 1934 (2 of 1934), but does not include a co-operative bank”. For the purpose of assessment of performance of banks, the Reserve Bank of India categories those banks as public sector banks, old private sector banks, new private sector banks and foreign banks, i.e. private sector, public sector, and foreign banks come under the umbrella of scheduled commercial banks.

Regional Rural BankThe government of India set up Regional Rural Banks (RRBs) on October 2, 1975. The banks provide credit to the weaker sections of the rural areas, particularly the small and marginal farmers, agricultural labourers, and small entrepreneurs.Initially,fiveRRBsweresetuponOctober2,1975whichwassponsoredbySyndicateBank,StateBank of India, Punjab National Bank, United Commercial Bank and United Bank of India. The total authorised capital wasfixedatRs.1CrorewhichhassincebeenraisedtoRs.5Crores.ThereareseveralconcessionsenjoyedbytheRRBsbyReserveBankofIndiasuchaslowerinterestratesandrefinancingfacilitiesfromNABARDlikelowercash ratio, lower statutory liquidity ratio, lower rate of interest on loans taken from sponsoring banks, managerial and staff assistance from the sponsoring bank and reimbursement of the expenses on staff training. The RRBs are under the control of NABARD. NABARD has the responsibility of laying down the policies for the RRBs, to oversee theiroperations,providerefinancefacilities,tomonitortheirperformanceandtoattendtheirproblems.

Unscheduled Banks“UnscheduledBank in India”means a banking company as defined in clause (c) of section5 of theBankingRegulation Act, 1949 (10 of 1949), which is not a scheduled bank”.

1.5.3 NABARDNABARD is an apex development bankwith an authorisation for facilitating credit flow for promotion anddevelopment of agriculture, small-scale industries, cottage and village industries, handicrafts and other rural crafts. It also has the mandate to support all other allied economic activities in rural areas, promote integrated and sustainable rural development and secure prosperity of rural areas. In discharging its role as a facilitator for rural prosperity, NABARD is entrusted with:

Providingrefinancetolendinginstitutionsinruralareas•Bringing about or promoting institutions development•Evaluating, monitoring and inspecting the client banks•

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Besides this fundamental role, NABARD also:Act as a coordinator in the operations of rural credit institutions•To help sectors of the economy that they have special credit needs for eg. Housing, small business and agricultural •loans etc.

1.6 Services provided by Banking OrganisationsBankingRegulationActinIndia,1949definesbankingas,“Accepting”forthepurposeoflendingorinvestmentof deposits of money from the public, repayable on demand and withdrawable by cheques, drafts, orders etc. as per theabovedefinitionabankessentiallyperformsthefollowingfunctions:

Accepting deposits or savings functions from customers or public by providing bank account, current account, •fixeddepositaccount,recurringaccountsetc.The payment transactions like lending money to the public. Bank provides an effective credit delivery system •for loanable transactions.Provide the facility of transferring of money from one place to another place. For performing this operation, •bank issues demand drafts, banker’s cheques, money orders etc. for transferring the money.The Bank also provides the facility of Telegraphic transfer or tele-cash orders for quick transfer of money.•A bank performs a trustworthy business for various purposes.•A bank also provides the safe custody facility to the money and valuables of the general public. Bank offers •various types of deposit schemes for security of money. For keeping valuables bank provides locker facility. The lockers are small compartments with dual locking system built into strong cupboards. These are stored in the bank’s strong room and are fully secured.Banks act on behalf of the Government to accept its tax and non-tax receipt. Most of the government disbursements •like pension payments and tax refunds also take place through banks.

There are several types of banks, which differ in the number of services they provide and the clientele (customers) they serve. Although some of the differences between these types of banks have lessened as they have begun to expand the range of products and services they offer, there are still key distinguishing traits. These banks are as follows:

Commercial banks, which dominate this industry, offer a full range of services for individuals, businesses, and •governments. These banks come in a wide range of sizes, from large global banks to regional and community banks.Global banks are involved in international lending and foreign currency trading, in addition to the more typical •banking services.Regional banks have numerous branches and automated teller machine (ATM) locations throughout a multi-•state area that provide banking services to individuals. Banks have become more oriented toward marketing and sales. As a result, employees need to know about all types of products and services offered by banks.Community banks are based locally and offer more personal attention, which many individuals and small •businesses prefer. In recent years, online banks—which provide all services entirely over the Internet- have entered the market, with some success. However, many traditional banks have also expanded to offer online banking, and some formerly Internet-only banks are opting to open branches.Savings banks and savings and loan associations, sometimes called thrift institutions, are the second largest group •ofdepositoryinstitutions.Theywerefirstestablishedascommunity-basedinstitutionstofinancemortgagesforpeople to buy homes and still cater mostly to the savings and lending needs of individuals.Credit unions are another kind of depository institution. Most credit unions are formed by people with a common •bond, such as those who work for the same company or belong to the same labour union or church. Members pool their savings and, when they need money, they may borrow from the credit union, often at a lower interest ratethanthatdemandedbyotherfinancialinstitutions.

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FederalReservebanksareGovernmentagenciesthatperformmanyfinancialservicesfor theGovernment.•Their chief responsibilities are to regulate the banking industry and to help implement our Nation’s monetary policysooureconomycanrunmoreefficientlybycontrollingtheNation’smoneysupply-thetotalquantityof money in the country, including cash and bank deposits. For example, during slower periods of economic activity, the Federal Reserve may purchase government securities from commercial banks, giving them more money to lend, thus expanding the economy. Federal Reserve banks also perform a variety of services for other banks. For example, they may make emergency loans to banks that are short of cash, and clear checks that are drawn and paid out by different banks. The money banks lend, comes primarily from deposits in checking and savingsaccounts,certificatesofdeposit,moneymarketaccounts,andotherdepositaccountsthatconsumersand businesses set up with the bank. These deposits often earn interest for their owners, and accounts that offer checking, provide owners with an easy method for making payments safely without using cash. Deposits in many banks are insured by the Federal Deposit Insurance Corporation, which guarantees that depositors will get their money back, up to a stated limit, if a bank should fail.

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SummaryAbankisafinancialinstitutionthatprovidesbankingandotherfinancialservicestotheircustomers.•Therearealsonon-bankinginstitutionsthatprovidecertainbankingserviceswithoutmeetingthelegaldefinition•ofabank.Banksareasubsetofthefinancialservicesindustry.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.Theorganisedbankingsectorworkswithinthefinancialsystemtoprovideloans,acceptdepositsandprovide•other services to their customers.By the 1960s, the Indian banking industry has become an important tool to facilitate the development of the •Indian economy. Bankinglawisbasedonacontractualanalysisoftherelationshipbetweenthebankandcustomerdefinedas•any entity for which the bank agrees to conduct an account.Currently in most jurisdictions commercial banks are regulated by government entities and require a special •bank license to operate.The reserve bank of India is a central bank and was established in April 1, 1935 in accordance with the provisions •of Reserve Bank of India Act 1934.

References CHAPTER 1 AN OVERVIEW OF THE BANKING SECTOR• .[Pdf]Availableat:<http://shodhganga.inflibnet.ac.in/bitstream/10603/2031/10/10_chapter%201.pdf> [Accessed 24 September 2013].Banking• . [Online] Available at: <http://www.ftkmc.com/banking.html> [Accessed 25 August 2013].Sharma, K. C., 2007. • Modern Banking in India. Deep and Deep Publications.Arora, K. K., 1992. • Development Banking in India. Atlantic Publishers & Dist.Ns Toor, 2013. • Indian Banking System. Available at: <https://www.youtube.com/watch?v=tYjiv3LrF0I> [Accessed 25 August 2013].Banking Conversation• , Growth opportunities in banking in India. Available at: <https://www.youtube.com/watch?v=lkTn45J7yIw> [Accessed 25 August 2013].

Recommended ReadingChoudhary, M., 2012. • The Principles of Banking. 1st ed., Wiley.Heffernan, S., 2005• . Modern Banking. 1st ed., Wiley.Gomez, C., 2013• . Banking and Finance: Theory, Law and Practice. PHI Learning Private Limited.

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Self AssessmentThere are also _______________ institutions that provide certain banking services without meeting the legal 1. definitionofabank.

non- bankinga. bankingb. financialc. managementd.

____________areasubsetofthefinancialservicesindustry.2. Banksa. Financial institutionsb. Banking servicesc. Financial servicesd.

A banking system also referred as a system provided by the bank which offers ____________ services for 3. customers, reporting the transactions of their accounts and portfolios, throughout the day.

financiala. monetary b. cash managementc. fiscald.

Which of the following is based on a contractual analysis of the relationship between the bank and customer 4. definedasanyentityforwhichthebankagreestoconductanaccount?

Financial lawa. Fiscal lawb. Economic lawc. Banking lawd.

Which of the following statement is true?5. Scheduled Banks in India constitute those banks which have been included in the second schedule of RBI a. act 1934.Unscheduled Banks in India constitute those banks which have been included in the second schedule of b. RBI act 1934.Banks in India constitute those banks which have been included in the second schedule of RBI act 1934.c. ScheduledBanksinIndiaconstitutethosebankswhichhavebeenincludedinthefirstscheduleofRBIactd. 1934.

Banks have become more oriented toward _________________.6. marketing and salesa. corporateb. businessc. economicsd.

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The Federal Reserve Act 1913 and the Banking Act of 1933 determines the __________ on banking industry.7. business policya. economic policyb. government policyc. banking policyd.

Which of the following statement is true?8. FinancialinstitutionsarethemainparticipantsofthefinancialsysteminIndia.a. BanksarethemainparticipantsofthefinancialsysteminIndia.b. The SBI formulates, implements, and monitors the monitory policy.c. Bank does not provide an effective credit delivery system for loanable transactions.d.

Currently in most jurisdictions _______________ banks are regulated by government entities and require a 9. special bank license to operate.

commerciala. non-commercialb. economicc. scheduled d.

Indian banking industry has been divided into two parts, _____________ sectors.10. scheduled and un-scheduleda. commercial and non-commercialb. organised and unorganisedc. legal and illegald.

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Chapter II

Budgetary Policy and Indian Financial System

Aim

The aim of this chapter is to:

introduce budgetary policy •

explainIndianfiscalpolicy•

explicateIndianfinancialsystem•

Objectives

The objectives of this chapter are to:

enlistthefinancialinstrumentsinaneconomy•

elucidateimpactofbudgetarypolicyonfinancialsystem•

explain the interest rate policy•

Learning outcome

At the end of this chapter, you will be able to:

identify money market and capital market•

understandthedeficitfinancingandfinancialsystem•

definebudget•

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2.1 IntroductionThefinancialsystemofaStateisinfluenced,toagreatdealbytheeconomicpolicyofacountry.Thefiscalpolicyas part of economic policy deals with taxation, public expenditure, public borrowing and debt management. The budgetarypolicyandthebudgetdocumentsareimportantpartsoffiscalpolicy.Thatiswhy,thebudgetarypolicyandthebudgetdocuments,toasignificantextent,influencethefunctioningofafinancialsystemofacountry.Hence,itisimportanttodiscusstheissuesrelatingtobudgetarypolicyandtheirbearingupontheIndianfinancialsystem.

2.2 Indian Fiscal PolicyIn theprocessofeconomicdevelopment,fiscalpolicyasan important instrumentofeconomicpolicyplaysanimportantroleinthedevelopmentandplanningsystemofacountry.Throughfiscalpolicy,theGovernmentprovidespublic services. At the same time, it is an instrument for re allocation of resources according to national priorities, re-distribution, promotion of private savings and investments and the maintenance of stability. Fiscal policy is concerned with the aggregate impacts of various policy measures on the prescribed set of objectives. Therefore, itisinabroaderframework,ameasuretoachievetheprescribedobjectivesinaneconomy.Inotherwords,fiscalpolicy is a mean to achieve the chosen objectives like, economic growth, generation of employment opportunities, distributive justice, removal of poverty, price stability, etc.

It isclear fromtheabovediscussion thatfiscalpolicyhasamulti-dimensionalrole.Providingsocial justice tovarioussegmentsisthemajorobjectiveofthispolicy.InadevelopingcountrylikeIndia,thefiscalpolicyhasanadded importance as it is assigned an important role to achieve full employment and economic stability, and thereby achieving meaningful growth rate. Fiscal policy, on the one hand, concentrates on the resource mobilisation in the economy. The system of taxes diverts funds from the private sector to the government sector. On the other side, the system of public expenditure diverts funds from government sector back to the people as they are spent for productive and welfare purposes. Public borrowings are also used for various purposes. Public debt management includesfunctionslikefloatingofgovernmentloans,paymentofinterestandredemptionofdebts.

Thefiscalpolicyisformulatedtofulfilthefollowingobjectives:Mobilisation of resources so as to increase the rate of investment and capital formation, which in turn, accelerates •the rate of economic growth.Reduction of inequalities of income and wealth, or redistribution of income, in other words, an equitable •distribution of income.Increase in employment opportunities.•Price stability.•

In order to achieve these objectives, the Government resorts to the following instruments:Taxation•Public Expenditure•Public Debt•

Theseinstrumentsaffectthefunctioningoffinancialsectorinthefollowingmanner:TaxationTaxation has a direct bearing on savings, investments and consumption. If the direct tax rates were high, there would be lesser savings and would also affect the consumption pattern. At the same time, if the tax rates are brought down, it would affect public investments. In such a contradictory situation, the Government has to take very precautionary step, as high corporate tax rate would affect the prices adversely. At one point of time, the corporate tax was quite high. However, with the process of liberalisation it has gradually been reduced. The reduction in corporate tax creates multiplebeneficialeffectsall-roundandalsoattractsforeigninvestments.

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Public expenditurePublicexpenditure,apartfrominfluencingtheeconomicgrowthprocess,hasitsrealbearingontheactivitiesoffinancialsector.Intheeventofmorespendingthroughpublicinvestments,varioussectorsoftheeconomyflourish,whichinturnraisethedemandforprivateinvestmentsfromfinancialsystem.Forexample,ifGovernmentdevelopsgoodinfrastructureinaparticularzone,moreindustrieswouldcomeupandwilldemandthefinancialassistancefrombanksandfinancialinstitutes.

Public debtThe public debt comprises of internal and external debt. Internal debt includes market loans, bank temporary loans bywayoftreasurybillsissuedtoRBIandcommercialbanks.Publicdebtpolicyaffectsfinancialsector.WhenGovernment has more borrowings, it adopts various tools such as increased level to statutory liquidity ratio to be imposedonbanks,issueoftreasurybillsetc.Allthesemeasuresreducethecreditcapacityoffinancialinstitutionsand these are left with less credit availability for productive purposes.

Thus,fiscalpolicyaffectssavings,investments,creditcapacity,demandforcreditinafinancialsystemetc.thathavedirectbearingonoperationsoffinancialsectorasawholeintheeconomy.

2.2.1 Budgetary PolicyBroadly speaking, budgetary policy is a policy through which the government uses its expenditure and revenue programmes to produce desirable results and avoid undesirable effects on national income, production and employment.Thus,budgetarypolicyhelpsinmeetingtheobjectivesset.upinthefiscalpolicy.Theobjectiveofbudgetarypolicycannotbedifferentfromtheobjectiveoffiscalpolicyandconsequentlyeconomicdevelopmentof the country. Both have to coincide.

2.2.2 Budgetary SystemThe document integrating the revenue and the expenditure of Government is called the ‘Budget’. A budget contains the actual estimates of revenue and expenditure of the Government of preceding year, revised estimates of the receipts and Payments of the Government for the current year and the estimates for the next year. It has a role to ensure that the tax burden is reasonably imposed. On the other side, it ensures justice in allocation of expenditure among various sectors of the economy.

The budgetary policy is essentially concerned with:Raising of revenue•Incurring of expenditure by the Government•

Thebudgetarypolicyhasbeenmodifiedfromtimetotimeandmademorepragmaticnotonlytoenhancethetaxresources but also to ensure that maximum people are brought within the tax net. The tax GOP ratio in India was just 6% in 1950-51, which increased nearly to 14% in 1999-2000. The Budget statement has been instrumental for providingspecialincentivesforprivatesavingsandalsoencouraginginvestmentsinspecifiedareaslikehousing.Thebudget strategies are revised every year keeping in view the overall economic growth of the country, requirements of resources, and allocation of funds according to priorities.

Strategies of the budget (2001-2002)The broad strategies of the Budget 2001-2002 were determined with the objective of the growth in mind and to ensure:

Speeding up of agricultural sector reforms and better management of the food economy.•Intensificationof infrastructure investment, continued reforms “in thefinancial sectors and capitalmarket•and deepening of structural reforms through removal of remaining tiresome controls constraining economic activity.Human development through better educational opportunities and programmes of social security.•

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Stringent expenditure control of non-productive expenditure, rationalisation of subsidies and improvement in •the quality of government expenditure.Acceleration of the privatisation process and restructuring of public enterprises.•Revenue enhancement through widening of tax base and administration of a fair and equitable tax regime.•

2.3 Indian Financial SystemThevariouscomponentsoftheIndianFinancialSystemaredescribedinthesectionbelow.TheIndianfinancialsystem consists of variety of institutions, markets and instruments that are closely related with each other. It provides the principal means by which savings are turned into investments. Given its role in the allocation of resources, the efficientfunctioningofthefinancialsystemisofcrucialimportanceinadevelopingeconomy,likeIndia.

Thefinancial institutions/financial intermediaries, as they are called, comprise commercial banks, insurancecompanies,mutualfunds,non-bankingfinancialcompanies,developmentfinancialinstitutionsetc.Thefinancialmarketscompriseofcapitalmarketandmoneymarket,whereasfinancialinstrumentsaredemanddeposits,short-term debt, intermediate term debt, long-term debt and equity, bonds etc.

Broadly,theimportantfunctionsoffinancialsystemcanbedescribedas:It enables the pooling of funds for setting up large-scale enterprises.•It provides a way for managing uncertainty and controlling risks.•It provides a mechanism for spatial and temporal transfer of resources.•It generates information that helps in coordinating decentralised decision-making.•It provides a payment system for exchange of goods and services.•It helps in dealing with information gap by handling sensitive information discreetly•

2.4 Impact of Budgetary Policy on Financial SystemThebudgetarypolicyprovidesaleewaytointegratevariousfinancialintermediariesandmakethefinancialsystemmore vibrant. There are various budgetary policy measures, which set the direction of savings, credit expansion and investments.Dependingonvariouspolicymeasures,theextentofgrowthoffinancialsystemisdetermined.

2.4.1 Role of Budgetary Policy in the Growth of Financial InstitutionsTheprimaryroleofafinancialinstitutionistoserveasanintermediarybetweenlendersandborrowers.TheseinstitutionsworkundertheoverallsupervisionoftheReserveBankofIndia.Thefundspooledbythefinancialinstitutionsare investedindiversifiedportfoliosoffinancialassets.Thetransactioncost is lower.Thefinancialinstitutionssupplytheultimatelenderswithliquidandlessriskyfinancialassets.Thus,financialinstitutionsactasintermediaries between investors and savers.

Theprocessoffinancialintermediationresultsin:Providingsaverswithdifferentvarietiesoffinancialassetstoinvesttheirfundsaccordingtotheirpreferences.•It enables them to increase their savings.Borrowersarealsobenefitedasfinanceisprovidedthroughtheinstitutionsasitisnoteasilypossibletoobtain•directly from savers.It raises the productivity of aggregate investment, by improving its allocation.Apart from this, financial•intermediaries also perform the important function of facilitating the normal production process and the exchange of goods and services.

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Thefinancial institutions, thus, play a vital role in the economicdevelopment of the economy.Broadly, theseinstitutionsareclassifiedintofollowingcategories:

Developmentfinancialinstitutions•Insurance companies•OtherPublicsectorfinancialinstitutions•Mutual Funds•Non-Banking Finance Companies•

Theobjectiveofbudgetarypolicy is to strengthen thefinancial baseof these institutions and toprovide themoperationalfreedom.AdistinctfeatureoftheIndianfinancialsystemisdominanceofpublicsectorinstitutions.Motivated by socio-economic considerations, the system has been subject to high degree of regulations. Both entry of a new entity and its expansion have remained under the control of State. There has been a mandatory allocation of credit amongst different sectors including the government. Concessional interest rates have also been introduced.

In the recent past, the following budgetary policy measures have been initiated:Thefinancialinstitutionshavebeengivenmoreautonomyintheiroperations.Theyhavealsobeenpermitted•toexpandtheiroperationsinthefinancialsectorbyopeningnewoutfits.Prudentialnormsrelatingtocapitaladequacy,incomerecognition,classificationofassetsandprovisioninghave•been made applicable to these institutions.Insurance sector has been opened to the private sector. This will not only provide healthy conditions but also •better risk cover and returns to investors. Insurance Regulatory and Development Authority has been set up to monitor the insurance institutions.Budgetary allocation has been made to expand the capital base of NABARD, which in turn will accelerate the •growth of agricultural sector and rural development.Certain tax incentives have been extended for investment in mutual funds.•

2.4.2 Impact of Budgetary Policy on BanksThebanksmobilisesurplusfundsthroughvariouschannelsofsavings.Theflowofsavingsintheeconomydirectlydepends on budgetary policy measures. As already indicated that taxation policy, public expenditure and public debtpolicyaffectconsumptionandsavings,theextentofsavingsismuchrelatedtofiscalmeasures.Likewise,the expansion of credit also depends on investment policy being pursued by the Government to encourage private investments.Iftherearemorefiscalincentivesforindustrialexpansion,itwillattractmoredemandforcredit.EvenGovernment’s demand to meet current expenditure would limit the availability of loanable funds from the banking system.

Thecommercialbankstransferfundsfromsurplusunitstodeficitunitsattheminimumoperatingcost.Today,wehave vast network of bank branches operating all over the country. The nationalisation of commercial bank in 1969 wasaturningpointinthehistoryofbankinginIndia.Therehavebeensignificantachievementsandpitfallsduringthis period. The budgetary policy has initiated a series of measures to make the banks more responsive to economic growth.

Some of the recent measures are as under:The banks are required to be more vibrant and their capital base has been strengthened. To meet the capital •adequacy norm of 8%, a budgetary support of over Rs. 20,000 crore is provided to weak banks.To make the bank credit cost effective, tax on loan interest has been withdrawn.•Inthebudgetdocument,throughrigorousexercises,attemptshavebeenmadetobringdownthedeficit,which•infacthashelpedbankstocontroltheflowofcredittogovernmentonconcessionalrateofinterest.To boost the export business, the government has set up Export Import Bank of India. The initial capital •contributed through budgetary resources.

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Banks have been facing serious problem with regard to recovery of their loans particularly the non-performing •assets. The government has set up Debt Recovery Tribunals to expedite the cases of banks and accelerate recovery process.Thebudgetarypolicyprovidedspecificprovisionsandincentivesforincreasingthecredittohigh-techagriculture•projects.The banking sector has been provided greater autonomy in their functions. The entry of private and foreign •sectorbankshasbeenpermittedtobringmorecompetitivenessandefficiencyintheworkingofbanks.For greater credit expansion and wider acceptability of banks in rural areas, the Regional Rural Banks (RRBs) •have been set up.The development of housing sector received prime attention in the budgetary policy. National Housing Bank •has been set up. Tax concessions have been provided to the borrowers.Thebudgetarypolicyhasinitiatedseveralotherpolicymeasuresforthebenefitofspecifiedsectorslikepoor•people, agriculturist, educational loans, etc.The Statuary Liquidity Requirement (SLR) and the Cash Reserve Requirement (CRR) of banks have been •reducedsignificantlytoreleasemoreloanablefundstothebanks.To reduce its stake in the ownership of nationalized banks, the Government has decided to reduce its equity to •33% in case of such banks.

Thus,thebudgetarypolicyhasprovidedgreaterflexibilityinbankingoperationsandhasmadethemstrongertoplayavitalroleinthefinancialsystem.

2.4.3 Budgetary Policy and Financial MarketsIntheIndianfinancialsystem,therearetwobroadsegmentsthatthefinancialmarketcanbedividedinto.Theyareexplained in the section below.

Money marketThe money market deals with short-term debt. The principal layers in the money market are the commercial and otherbanksinadditiontoLIC,UTI,MutualFunds,andnonbankingfinancialcompanies.Theseintermediarieslendfunds on a short-term basis to create an active inter-bank loan market. The Discount and Finance House of India provides liquidity to money market instruments by eating a secondary market.

Capital marketThe capital market deals with long-term debts and stock equity and preference. Each of these markets has a primary andsecondarysegment.Newfinancialassetsareissuedintheprimarymarketwhileexistingfinancialassetsaretradedinthesecondarymarket.Thegrowthofcapitalmarketisinfluenced,toagreatextent,byvariousbudgetarypolicymeasures.Forexample,thetaxationpolicyofcorporatetax,dividendtax,capitalgaintax,fiscalincentivesforsmall savings etc. have direct impact and set the direction of growth of capital market. On the other .hand, various fiscalincentivesforindustrialexpansionwouldcausemoredemandfromcapitalmarketbyindustrialsector.

The instruments of capital market have long period for maturity. It is a source of raising capital by issuing securities. The primary capital market facilitates the formation of capital. The secondary market consists of stock exchanges recognised by the government. The National Stock Exchange and Over the Counter Exchange of India provide liquidity to the securities. The Securities and Exchange Board of India (SEBI) oversees and monitors the functioning of securities market and operations of intermediaries like mutual funds and merchant banks. Besides, there is a market for government securities which deals with debt securities issued by central/state governments, all India financialinstitutionsandotherautonomousinstitutions.

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Thefollowingbudgetaryprovisionshelpedinwideningoffinancialmarketsandtheiroperations:With a view to encourage secondary market operations, the maximum coupon rate which was as low as 6.5 % •in 1977-78 was raised to 11.5 % in 1985-86 and thereafter restriction on maximum coupon rate was removed.Anumberofinstrumentswereintroducedinthemarketsuchas182-dayTreasurybill,certificateofdeposits,•commercial paper and inter- bank participations.The Discount and Finance House of India (DFHI) was set up in 1988 by Reserve Bank of India and other •financialinstitutionstofacilitatesmootheningofshort-termliquidityimbalancesandbringflexibilitytothemoney market.The interest rates have been largely deregulated.•Tax incentives have been provided for capital gains investment in mutual funds and investment in infra-structure •development bonds.Toprovidefurtherboosttomoneymarketoperations,banksandotherfinancialinstitutionshavebeenallowed•to set up money market mutual funds.Foreigninstitutionalinvestorshavebeenencouragedtoparticipateinthefinancialmarkets.•The concept of tax-free bonds was introduced for mobilising greater resources.•

2.4.4 Budgetary Policy and the Financial InstrumentsFinancialinstrumentsaregenerallydefinedasmonetaryobligationofaborroweroffunds(theissueroftheinstrument)totheholderoftheinstruments.Fortheissueroftheinstrument,itisaliabilityorinotherwordsfinancialobligation,fortheholderisafinancialasset.Financialinstrumentsmaybeissuedbyeconomicunits(privateaswellaspublic).Themajorfinancialinstrumentsinaneconomyareexplainedinthesectionbelow.

Demand depositsDemanddepositsarethefinancialinstrument,whicharepayableondemandtotheownerbytheholder.Itmayor may not carry interest. These are usually held by the banks by way of current and savings deposits and by post officesbywayofsavingsaccounts.

Short-Term debtThisisapromisetorepayaspecifiedsumalongwithagreedrateofinterestwithinashortperiodofoneyear.Treasurybills,commercialpapers,certificatesofdepositsandfewotherinnovativeinstrumentshavebeenintroducedinthesystem.

Long-Term debtThese are the debt instruments repayable over a period of 5 to 7 years in case of corporate sector and over 10 years incaseofgovernmentbonds.Theycarryaspecifiedcouponrate.Privateandpublicsectordebenturesandbondsfall in this category. The debt instruments have been made more lucrative with variety of options and reasonably better yield.

Equity stockThis is a popular means of raising resources as capital by the corporate sector. Being owners, the equity shareholders have residual interest in the income of the company as they receive dividend after the claims of all creditors are met. Thebudgetarypolicyhasaimedfromtimetotimethatvariousfinancialinstrumentsdependingonvarietyofneedsarebroughtintothesystem.Theyperformboththefunctionsoffinancialassetsandfinancialliabilities.

Inthisdirection,thebudgetarypolicyhasaveryimportantrolebecausethenatureofnewfinancialinstrumentsand their innovativeness depend on budgetary policy decisions. Such incentives are in the form of tax incentives to attract more savings, growth of investments to meet increased money supply and growth of capital market in tune with changes in policy measures for industrial growth.

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Thebudgetarypolicyhasmadethefinancialinstrumentsasdiscussedabove,moreacceptable.Someoftheotherfinancialcontractslikeforwardfutures,swaps,optionsandpensionfundshavebeenintroducedinthesystem.Thefollowing are some of budgetary policy measures, which have increased the utility of above instruments in the financialsystem.

The ceiling coupon rate on bonds has been abolished.•Somespecifiedbondssuchasinfrastructureandpowerdevelopmenthavebeengiventaxbenefit.•The volume of money market instruments has been increased.•Number of steps has been taken to make short-term debt instruments more acceptable. The eligibility norms •have been liberalised from time to time.Mutual funds investments have also been given certain rebate in tax.•Specificguidelineshavebeenissuedforoperationsofforwardfutures,swaps,optionsetc.•

2.5 The Interest Rate Policy and the Financial SystemThe interest rate policy basically aims at:

ensuring government borrowings at cheaper rates•supporting certain activities through concessional lending rates•mobilising substantial savings•ensuring stability in the macro-economic system•

The interest rates in India had, in the past, been substantially regulated by the Reserve Bank of India which had the following features:

Interest rates on deposits with commercial banks were subject to ceiling.•Interestratesonloansweresubjecttofloors.•Interest rates payable by companies on deposits were subject to a ceiling.•Interestrateschargedbydevelopmentfinancialinstitutionsweresubjecttofloors.•Interestrateswhichwerepayableonsmallsavingschemeswerefixedbythegovernment.•

The interest rate regime in India has undergone a rapid transformation during recent years. The structure of interest rates, which was extremely complex, has now been rationalised. Banks are now free to determine their own Prime Lending Rate and to prescribe the maximum spread over it. Loans up to Rs. 2 lakhs are to be granted at rates not exceeding the Prime Lending Rate of relevant maturity. The money market rates have been completely freed. So are the rates at which corporate entities can borrow funds from the capital market. Deposit rates have also been deregulated, except the interest rate on saving accounts, which is determined by the Reserve Bank of India.

Theinterestratederegulationhasinfluencedthegovernmentsecuritiesmarketalso.TheCentralGovernmenthasbeen able to meet its requirements from the market through the auction mechanism. The rates of interest settled at theauctionshavecometoreflectthemarketconditions.Thishasbeenprovedbothinrelationtodatedsecuritiesand treasury bills. With abundant liquidity, the interest rates have clearly shown a downward decline. The 364-day treasurybillsareincreasinglybeingusedasabenchmarkforfixingotherratesinthesystem.Withthedevelopmentof an active government securities market, where rates are more or less determined by the market, the emergence of the open market operations as an indirect instrument of monetary control will assume importance. Steps are being takentobringaboutsignificantinstitutionalchangesinthegovernmentsecuritiesmarket.

With the reform in the interest rate structure, an emphasis has been placed on widening and deepening of various segmentsofthefinancialsectorsofmoneymarketandcapitalmarket.Inthebudgetof2002-03,thegovernmenthad decided to link interest rate on small savings with the average yield on Government Securities of comparable maturity.

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2.5.1 Role of Budgetary Policy in the emerging new economic environmentIndia has been pursuing the policy of economic reforms since 1991-92. The major policy initiatives are:

Macroeconomicstabilisationthroughfiscalpolicies.•Trade policy reforms to provide stimulus to exports.•Industrial policy reforms to provide greater competitive environment to industries.•Widespreadreformsinfinancialsectorstoachievefinancialefficiency.•

Themonetaryandfiscalpoliciesaimatcontrollingaggregatedemandintunewiththegrowthoftheeconomy.Thesepolicies are known as stabilisation policies. The budgetary policies act as a link between both, the macroeconomic stabilisationandstructuralpolicies.Therefore,budgetarypolicyhasaverycrucialandsignificantroleincreatingan environment conducive to economic growth.

There have been a number of policy measures taken in the recent years to accelerate the process of economic reforms. These measures include:

Widerangeoffinancialsectorreformsincludingbankingsector,capitalmarketoperations,non-bankingfinancial•companiesandotherdevelopmentfinancialinstitutions.Seriousattemptshavebeenmadethroughbudgetarypolicytocorrectfiscalimbalances.•The tax laws have been rationalised to ensure:•

Lower personal and corporate taxes. �Broaden the tax base. �Inflationadjustmentoftaxrates. �

The policy has been adopted for progressive expansion of MODVAT system.•Continued rationalisation of custom tariffs structure.•Theneweconomicpolicyhaslentmoreemphasisonlargeflowofdirectforeigninvestment.•

The above analysis indicates that budgetary policy has an important contribution in achieving the goals and objectives of new economic policies.

2.6 Deficit Financing and Financial SystemAccordingtothePlanningCommission,theterm“DeficitFinancing”isusedtodenotedirectadditiontogrossnationalexpenditurethroughbudgetdeficitswhetherthedeficitisonrevenueoroncapitalaccount.Theessenceof such a policy lies, therefore, in government spending in excess of the revenue it receives in the shape of taxes, earnings of state enterprises, loans from public, deposits and funds and other miscellaneous sources.

Thegovernmentmaycoverthedeficit,eitherby:Running down its accumulated balance (withdrawing its cash balances)•Borrowing from the central bank•Borrowing from commercial banks•Creating new money by resorting to the printing press•

Inshort,deficitfinancingmeansincurringpublicexpenditureinexcessofpublicreceiptsfromallsources.Thequantumofdeficitfinancinginagivenperiodcanbemeasuredbyvariationsinthefinancialassetsandthenon-monetaryliabilitiesoftheRBIandofthetreasury.Thedeficitfinancinghasaffectedtheoperationsoffinancingsystemtoalargeextentasfinancialsystemespeciallythebanksweredirectedtoprovidesignificantcreditsupportfor government expenditure (current and capital both).

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Theperiodsinceearly1970swascharacterisedbyweakeningoffiscaldisciplineleadingtolargeexpansioninthecentralgovernment’sdomesticandforeigncurrencyborrowingrequirements.TheratioofthegrossfiscaldeficittoGDP increased from 3.5% in 1970-71 to 8.4% in 1990-91. The obligatory cash reserve requirements of scheduled banks (held at the central bank) and the statutory liquidity ratio (to be met through holdings of government and other approved securities), reduce the resources of banks. With a view to keeping the government’s borrowing costs down,theyieldonbothtreasurybillsandlong-termpaperwereleftartificiallylow.Thislimitedthedemandforgovernmentpaperbybanks(andotherfinancialintermediaries,suchasinsurancecompaniesandprovidentfunds).Residualfinancingneedsofthegovernmentwere,therefore,metbytheReserveBank.

Suchamixofpolicieshaddeleteriouslong-termeffectsas largefiscaldeficitsbecamechronicandcontinuousescalation of the above mentioned two ratios became necessary. In the early 1970s the cash reserve ratio for the banks was as low as 3% and the statutory liquidity ratio was 25%. By 1991-92, the CRR rose to 5% and SLR was 38.5%. At the same time, the Reserve Bank’s holding of Central Government debt (i.e., its monetisation of the Government deficit)ballooned.By1991,itwasclearthattheburdenofGovernmentdebtwasbecomingunsustainableandthatasignificantimprovementintheprimarydeficitwasneeded.

Sustainedfiscaladjustmentsmustunderpinfurtherreforms.Intheabsenceofcrediblefiscalcontrolandpricestability,there is some risk that interest rate deregulation could result in overshooting and disrupt the reform process. The GovernmentofIndiahascommitteditselftotheprocessofcontinuedreductioninitsgrossfiscaldeficitfromthelevelof5.7%reachedin1992-93.ThefiscaldeficitasaproportionofGDPwasbudgetedat4.7percentin2001-02comparedwith5.5percentin2000-01onthebasisoforiginalunauditedfigures.Trendsinthefinancialyearof1993-94weresomewhatworrying;withtheseasonallyunadjusteddeficitinthefirsthalfoftheyearrunningatanannualrateroughlytriplethetargetedlevel.Thisreflectsrevenueshortfallspartlyrelatedtosluggishindustrialactivity and delay in sale of equity in public enterprises. There has been an agreement between Reserve Bank and Governmentthatthisincrementaldeficitshouldnotbemonetised.Accordingly,Governmenthasresortedtoadditionalborrowing through treasury bills and zero-coupon bonds at market-related rates. Fortunately, this unplanned increase intheborrowingrequirementhasoccurredatthetimewhenthedomesticmarketisflushwithfunds,butthisisshort-term phenomenon that cannot be relied on. Nonetheless, the use of these market instruments has meant that themonetiseddeficitcanbekeptundercontrol.

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SummaryThefinancialsystemofaStateisinfluenced,toagreatdealbytheeconomicpolicyofacountry.•Thebudgetarypolicyandthebudgetdocumentsareimportantpartsoffiscalpolicy.•Intheprocessofeconomicdevelopment,fiscalpolicyasanimportantinstrumentofeconomicpolicyplaysan•important role in the development and planning system of a country.Fiscal policy is concerned with the aggregate impacts of various policy measures on the prescribed set of •objectives.Fiscal policy, on the one hand, concentrates on the resource mobilisation in the economy.•Taxation has a direct bearing on savings, investments and consumption.•Publicexpenditure,apartfrominfluencingtheeconomicgrowthprocess,hasitsrealbearingontheactivities•offinancialsector.The public debt comprises of internal and external debt. Internal debt includes market loans, bank temporary •loans by way of treasury bills issued to RBI and commercial banks.Broadly speaking, budgetary policy is a policy through which the government uses its expenditure and revenue •programmes to produce desirable results and avoid undesirable effects on national income, production and employment.The document integrating the revenue and the expenditure of Government is called the ‘Budget’.•Thebudgetarypolicyprovidesaleewaytointegratevariousfinancialintermediariesandmakethefinancial•system more vibrant.The banks mobilise surplus funds through various channels of savings.•Financialinstrumentsaregenerallydefinedasmonetaryobligationofaborroweroffunds(theissuerofthe•instrument) to the holder of the instruments.TheIndianfinancialsystemconsistsofvarietyofinstitutions,marketsandinstrumentsthatarecloselyrelated•with each other.AccordingtothePlanningCommission,theterm“DeficitFinancing”isusedtodenotedirectadditiontogross•nationalexpenditurethroughbudgetdeficitswhetherthedeficitisonrevenueoroncapitalaccount.

ReferencesFiscal Policy in India: Trends and Trajectory. • [Pdf]Availableat:<http://finmin.nic.in/workingpaper/FPI_trends_Trajectory.pdf> [Accessed 19 September 2013].Budget Concepts and Budget Process. • [Pdf]Availableat:<http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/concepts.pdf> [Accessed 19 September 2013].Gupta, J. R., 2007. • Public Economics in India Theory and Practice. Atlantic Publishers & Dist, New Delhi.Venugopal, K. R., 2007. • Fiscal and Monetary Reforms in India. I. K. International Pvt. Ltd, New Delhi.Fiscal Policy Lecture.mp4. • [Video online] Available at: <http://www.youtube.com/watch?v=D5KPxE18gOY> [Accessed 19 September 2013].Fiscal Policy and Economic Stability (Part- 1). • [Video online] Available at: <http://www.youtube.com/watch?v=lfn5AlP9E9A> [Accessed 19 September 2013].

Recommended ReadingJain, T.R., Trehan, M. and Trehan, R., • Indian Economy and Business Environment. VK Publications, New Delhi.Ahmad, E., 2006. • Handbook of Fiscal Federalism. Edward Elgar Publishing, UK. Prasad, K. N., 2001. • Development of India’s Financial System. Sarup & Sons, New Delhi.

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Self AssessmentThefinancialsystemofaStateisinfluenced,toagreatdealbythe_________policyofacountry.1.

statea. economicb. profitc. fiscald.

The budgetary policy and the budget documents are important parts of __________ policy.2. fiscala. budgetb. economicc. uniond.

Match the following3.

1. Taxation A.Ithelpsinmeetingtheobjectivessetupinthefiscalpolicy.

2. Public expenditure B. It comprises of internal and external debt.

3. Public debt C. It has a direct bearing on savings, investments and consumption.

4. Budgetary policy D.Itinfluencestheeconomicgrowthprocess,andhasitsrealbearingontheactivitiesoffinancialsector.

1-A, 2-B, 3-C, 4-Da. 1-C, 2-D, 3-B, 4-Ab. 1-B, 2-C, 3-A, 4-Dc. 1-D, 2-A, 3-D, 4-Bd.

__________debtmanagementincludesfunctionslikefloatingofgovernmentloans,paymentofinterestand4. redemption of debts.

Privatea. Publicb. Communityc. Communald.

Whichofthefollowingistheinstrumentwhichaffectsthefunctioningoffinancialsector?5. Budgeta. Economic policyb. Taxationc. Fiscal policyd.

The document integrating the revenue and the expenditure of Government is called the ‘__________’.6. Budgeta. Public debtb. Taxationc. Expenditured.

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Which of the following statement is false?7. Financial system enables the pooling of funds for setting up large-scale enterprises.a. Financial system provides a way for managing uncertainty and controlling risks.b. Financial system provides a mechanism for spatial and temporal safety of resources.c. Financial system generates information that helps in coordinating decentralised decision-making.d.

AdistinctfeatureoftheIndianfinancialsystemisdominanceof_________sectorinstitutions.8. privatea. communalb. municipalc. publicd.

Which of the following statement is true?9. The money market deals with short-term debt.a. The money market deals with long-term debt.b. The money market deals with public debt.c. The money market deals with private debt.d.

The __________ market deals with long-term debts and stock equity and preference.10. moneya. capitalb. fundsc. budgetd.

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Chapter III

Credit Rating Agencies in India

Aim

The aim of this chapter is to:

introduce the concept of credit rating•

explain determinants of rating•

explicate rating methodology•

Objectives

The objectives of this chapter are to:

explain credit rating agencies in India•

elucidate credit rating symbols•

explicatebenefitsofcreditrating•

Learning outcome

At the end of this chapter, you will be able to:

identify various ratings•

understand ratings and yields•

describe limitations of credit ratings•

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3.1 IntroductionThe removal of strict regulatory framework in recent years has led to a spurt in the number of companies borrowing directlyfromthecapitalmarkets.Therehavebeenseveralinstancesintherecentpastwherethe“fly-by-night”operatorshavecheatedunwaryinvestors.Insuchasituation,ithasbecomeincreasinglydifficultforanordinaryinvestor to distinguish between ‘safe and good investment opportunities’ and ‘unsafe and bad investments’. Investors findthataborrower’ssizeornamesarenolongerasufficientguaranteeoftimelypaymentofinterestandprincipal.Investors perceive the need of an independent and credible agency, which judges impartially and in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on -the relative capacities of the borrowers to meet their obligations. These Credit Rating Agencies, thus,assistandformanintegralpartofabroaderprogrammeoffinancialdisintermediationandbroadeninganddeepening of the debt market.

Credit rating is used extensively for evaluating debt instruments. These include long-term instruments, like bonds anddebenturesaswellasshort-termobligations,likeCommercialPaper.Inaddition,fixeddeposits,certificatesofdeposits, inter-corporate deposits, structured obligations including non-convertible portion of Partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irrespective of their maturity. However, earlier only debt issues of over 18 months maturity had to be compulsorily rated.

3.2 Meaning of Credit RatingCredit Rating Agencies rate the aforesaid debt instruments of companies. They do not rate the companies, but their individual debt securities. Rating is an opinion regarding the timely repayment of principal and interest thereon. It isexpressedbyassigningsymbols,whichhavedefinitemeaning.

Aratingreflectsdefaultriskonly,notthepriceriskassociatedwithchangesinthelevelorshapeoftheyieldcurve.It is important to emphasise that credit ratings are not recommendations to invest. They do not take into account manyaspects,whichinfluenceaninvestmentdecision.Theydonot,forexample,evaluatethereasonablenessofthe issue price, possibilities of earning capital gains or take into account the liquidity in the secondary market. Ratings also do not take into account the risk of prepayment by the issuer, or interest rate risk or exchange rate risks. Although these are often related to the credit risk, the rating essential is an opinion on the relative quality of the credit risk. It has to be noted that there is no privity of contract between an investor and a rating agency and the investor is not protected by the opinion of the rating agency. Ratings are not a guarantee against loss. They are simply opinions, based on analysis of the risk of default. They are helpful in making decisions based on particular preference of risk and return.

A company, desirous of rating its debt instrument, needs to approach a credit rating agency and pay a fee for this service. There is no compulsion on the corporate sector to obtain or publicize the credit rating except for certain instruments. A company can use the rating as another publicity exercise if it is a good one and to obliterate it from itsprospectusandpublicity,ifitisnotgood.TheCreditRatingAgenciesregularlyanalysethefinancialpositionof corporations and assign and revise the ratings for their securities. The different rating agencies seldom give different ratings for the same security. If two rating agencies do give the same security different ratings, it is called split rating; the few differences that occur are rarely more than one rating grade level apart. Accepted ratings are published in media, every week. In tune with the industrial practice in India, rating agencies do not publish ratings which are not accepted by issuers.

3.3 The Determinants of RatingsThe default-risk assessment and quality rating assigned to an issue are primarily determined by three factors:

The issuer’s ability to pay•The strength of the security owner’s claim on the issue•Theeconomicsignificanceoftheindustryandmarketplaceoftheissuer•

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Ratio analysis is used to analyse the present and future earning power of the issuing corporation and to get insight intothestrengthsandweaknessesofthefirm.Bondratingagencieshavesuggestedguidelinesaboutwhatvalueeach ratio should have within a particular quality rating. Different ratios are favoured by rating agencies. For any givensetofratios,differentvaluesareappropriateforeachindustry.Moreover,thevaluesofeveryfirm’sratiosvary in a cyclical fashion through the ups and downs of the business cycle.

To assess the strength of security owner’s claim, the protective provisions in the indenture (legal instrument specifying bond owners’ rights), designed to ensure the safety of bondholder’s investment, and are considered in detail. The factorsconsideredinregardtotheeconomicsignificanceandsizeofissuerincludes:natureofindustryinwhichissueris,operating(specificallyissueslikepositionintheeconomy,lifecycleoftheindustry,laboursituation,supplyfactors, volatility, major vulnerabilities, etc.), and the competition faced by the issuer (market share, technological, leadership,productionefficiency,financialstructure,etc.)

3.4 Rating MethodologyRating is a search for long-term fundamentals and the probabilities for changes in the fundamentals. Each agency’s ratingprocessusuallyincludesfundamentalanalysisofpublicandprivateissuer-specificdata,‘industryanalysis,andpresentationsbytheissuer’sseniorexecutives,statisticalclassificationmodels,andjudgement.Typically,therating agency is privy to the issuer’s short and long-range plans and budgets. The analytical framework followed for rating methodology is divided into two interdependent segments.

Thefirstsegmentdealswithoperationalcharacteristicsandthesecondonewiththefinancialcharacteristics.Besides,quantitative and objective factors; qualitative aspects, like assessment of management capabilities play a very important role in arriving at the rating for an instrument. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer.

Key areas considered in a rating include the following:Business risk: To ascertain business risk, the rating agency considers Industry’s characteristics, performance and •outlook, operating position (capacity, market share, distribution system, marketing network, etc.), technological aspects, business cycles, size and capital intensity.Financialrisk:Toassessfinancialrisk,theratingagencytakesintoaccountvariousaspectsofitsFinancial•Management(e.g.capitalstructure,liquidityposition,financialflexibilityandcashflowadequacy,profitability,leverage,interestcoverage),projectionswithparticularemphasisonthecomponentsofcashflowandclaimsthereon, accounting policies and practices with particular reference to practices of providing depreciation, income recognition, inventory valuation, off-balance sheet claims and liabilities, amortization of intangible assets, foreign currency transactions.Management evaluation: Management evaluation includes consideration of the background and history of the •issuer, corporate strategy and philosophy, organisational structure, quality of management and management capabilities under stress, personnel policies etc.Business environmental analysis: This includes regulatory environment, operating environment, national •economicoutlook,areasofspecialsignificancetothecompany,pendinglitigation,taxstatus,possibilityofdefault risk under a variety of scenarios.

Ratingisnotbasedonapredeterminedformula,whichspecifiestherelevantvariablesaswellasweightsattachedto each one of them. Further, the emphasis on different aspects varies from agency to agency. Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates.

Theratingagencyemploysqualifiedprofessionalstoensureconsistencyandreliability.ReputationoftheCreditRatingAgencycreatesconfidenceintheinvestor.RatingAgencyearnsitsreputationbyassessingtheclient’soperationalperformance,managerialcompetence,managementandorganisationalset-upandfinancialstructure.Itshouldbean independent company with its own identity. It should have no government interference. Rating of an instrument doesnotgiveanyfiduciarystatustothecreditratingagency.Itisdesirablethattheratingbedonebymorethanoneagencyforthesamekindofinstrument.Thiswillattractinvestor’sconfidenceintheratingsymbolgiven.

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A rating is a quality label that conveniently summarises the default risk of an issuer. The credibility of the issuer’s proposed payment schedule is complemented by the credibility of the rating agency. Rating agencies perform this certificationrolebyexploitingtheeconomiesofscaleinprocessinginformationandmonitoringtheissuer.Thereisanongoingdebateaboutwhethertheratingagenciesperformaninformationroleinadditiontoacertificationrole.Whether agencies have access to superior (private) information, or if agencies are superior processors of information; security ratings provide information to investors, rather than merely summarising existing information. Empirical researchconfirmstheinformationroleofratingagenciesbydemonstratingthatnewsofactualandproposedratingchanges affects the price of issuer’s securities. Most studies document numerically larger price effects for downgrades than for upgrades, consistent with the perceived predilection of management delaying bad news.

3.5 Credit Rating Agencies in IndiaThe Indian credit rating industry has evolved over a period of time. Indian credit rating industry mainly comprises of CRISIL, ICRA, CARE, ONICRA, FITCH and SMERA. CRISIL is the largest credit rating agency in India, with a market share of greater than 60%. It is a full service rating agency offering its services in manufacturing, service, financialandSMEsectors.SMERAistheratingagencyexclusivelyestablishedforratingofSMEs.

CRISILThis was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the instruments are being used. CRISIL’s market share is around 75%. It has launched innovative products for credit risks assessment viz., counter party ratings andbank loan ratings.CRISIL rates debentures,fixeddeposits, commercial papers,preference shares and structured obligations. Of the total value of instruments rated, debentures’ accounted for 31.1%,fixeddepositsfor42.3%andcommercialpaper6.6%.CRISILpublishesCRISILratinginSCANthatisaquarterly publication in Hindi and Gujarati, besides English.

CRISILevaluation iscarriedoutbyprofessionallyqualifiedpersonsand includesdatacollection,analysisandmeeting with key personnel in the company to discuss strategies, plans and other issues that may effect ,evaluation ofthecompany.Theratingprocessensuresconfidentiality.Oncethecompanydecidestouserating,CRISILisobligated to monitor the rating over the life of the debt instrument.

ACRISILratingreflectsCRISIL’scurrentopinionon therelative likelihoodof timelypaymentof interestandprincipal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer’s capacity to meetitsfinancialobligations.Sofar,CRISILhasrated30,000debtinstruments,coveringtheentiredebtmarket.

The debt obligations rated by CRISIL includes:Non-convertible debentures/bonds/preference shares•Commercialpapers/certificatesofdeposits/short-termdebt•Fixed deposits•Loans•Structured debt•

CRISIL Ratings’ clientele includes all the industry majors - 23 of the BSE Sensex constituent companies and 39 of the NSE Nifty constituent companies, accounting for 80 per cent of the equity market capitalisation, are CRISIL’s clients.

CRISIL’s credit ratings are an opinion on probability of default on the rated obligation. They are forward looking and specifictotheobligationbeingrated.Buttheyarenotacommentontheissuer’sgeneralperformance;anindicationof the potential price of the issuers’ bonds or equity shares; indicative of the suitability of the issue to the investor; a recommendation to buy/sell/hold a particular security; a statutory or non-statutory audit of the issuer; and an opinion ontheassociates,affiliates,orgroupcompanies,orthepromoters,directors,orofficersoftheissuer.

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CRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures comprehensiveness, standardisation, comparability, and effective communication of the ratings assigned and of every timely rating action. The assessment is based on the highest standards of independence and analytical rigour.

CRISIL rates a wide range of entities, including:Industrial companies•Banks•Non-bankingfinancialcompanies(NBFCs)•Infrastructure entities•Microfinanceinstitutions•Insurance companies•Mutual funds•State governments•Urban local bodies•

ICRAICRA was promoted by IFCI in 1991. During the year 1996-97, ICRA rated 261 debt instruments of manufacturing companies, finance companies andfinancial institutions equivalent toRs. 12,850 crore as compared to 293instruments covering debt volume of Rs. 75,742 crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for debentures (including long term instruments), 49.4% for Fixed Deposit programme (including medium- term instruments), and 22.1% for Commercial Paper Programme (including shortterminvestments).Thecorrespondingfiguresofamountinvolvedforthesethreebroadratedcategorieswas23.8%fordebentures,52.2%forfixeddeposits,and24.0%forCommercialPaper.

The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. The inherent protective factors, marketing strategies, competitive edge, competence and effectiveness of management, human resourcedevelopmentpoliciesandpractices,hedgingofrisks,trendsincashflowsandpotentialliquidity,financialflexibility,assetqualityandpastrecordofservicingofdebtaswellasgovernmentpoliciesaffectingtheindustryare examined.

Besides determining the credit risk associated with a debt instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity. This requires examination of almost all parameters pertaining to the fundamentals of the company including relevant sectoral perspectives. This qualitative analysis is reinforced and completed by way of the unbiased opinion and informed perspective of one analyst and wealth of judgement of committee members. ICRA opinions help the issuing company to broaden the market for their equity. As the name recognition is replaced by objective opinion, the lesser know companies are also able to access the equity market.

CARECARE is a credit rating and information services company promoted by IDBI jointly with investment institutions, banksandfinancecompanies.ThecompanycommenceditsoperationsinOctober1993.‘InJanuary1994,CAREcommenced publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the rationale of all accepted ratings, CAREVIEW often carries special features of interest to issuers of debt instruments, investors and other market players.

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Symbols Credit Rating Analysis

CARE-1 Excellent debt management capability. Such companies will normally be characterised as leaders in the respective industries.

CARE-2Very good debt management capability. Such companies would normally be regarded as close to the rated CARE-1, but with a lower capability to withstand changes in assumptions.

CARE-3 Good capability of debt management. Such companies are considered medium grade. Assumptions that do not materialise may impair debt management capability in future.

CARE-4 Barely satisfactory capability for debt management. The capacity to meet obligations is likely to be adversely affected by short term adversity or less favourable conditions.

CARE-5 Poor capability of debt management. Such companies are in default are likely to default in meeting their debt obligations.

Table 3.1 Credit rating analysis of CARE

3.6 Credit Rating SymbolsCreditRatingAgenciesrateaninstrumentbyassigningadefinitesymbol.Eachsymbolhasadefinitemeaning.These symbols have been explained in descending order of safety or in ascending order of risk of non-payment. For example, CRISIL has prescribed the following symbols for debenture issues:

AAA indicates highest safety of timely payment of interest and principal.•AA indicates high safety of timely payment of interest and principal.•A indicates adequate safety of timely payment of interest and principal•BBBofferssufficientsafetyofpaymentofinterestandprincipalforthepresent.•BB offers inadequate safety of timely payment of interest and principal.•B indicates great susceptibility to default.•C indicates vulnerability to default. Timely payment of interest and payment is possible only if favourable •circumstances continue.D indicates that the debenture is in default in payment of arrears of interest or principal or is expected to default •on maturity.

It has been observed that as the value of symbol is reduced say from AAA to AA, the safety of timely payment of interest and principal is decreased. While AAA indicates highest safety of timely repayment, D indicates actual default or expected default on maturity. Different symbols indicate different degrees of risk of repayment of principal and interest. It is the assessment of the Rating Agency based on the methodology already explained.

3.7 Benefits of Credit RatingRating serves as a useful tool for different constituents of the capital market. For different classes of persons, different benefitsaccruefromtheuseofratedinstruments.

InvestorsRating safeguards against bankruptcy through recognition of risk. It gives an idea of the risk involved in the investment. It gives a clue to the credibility of the issuer company. Rating symbols give information on the quality of instrument in a simpler way that can be understood by lay investor and help him in taking decision on investment without the help from broker. Both individuals and institutions can draw up their credit risk policies and assess the adequacy or otherwise of the risk premium offered by the market on the basis of credit ratings.

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Issuers of debt instrumentsA company whose instruments are highly rated has the opportunity to have a wider access to capital, at lower cost of borrowing.Ratingalsofacilitatesthebestpricingandtimingofissuesandprovidesfinancingflexibility.Companieswith rated instruments can use the rating as a marketing tool to create a better image in dealing with its customers, lenders and creditors. Ratings encourage the companies to come out with more disclosures about their accounting systems,financialreportingandmanagementpattern.Italsomakesitpossibleforsomecategoryofinvestorswhorequire mandated rating from reputed rating agencies to make investments.

Financial intermediariesFinancialintermediarieslikebanks,merchantbankers,andinvestmentadvisersfindratingasaveryusefulinputin the decisions relating to lending and investments. For instance, with high credit rating, the brokers can convince their clients to select a particular investment proposal more easily thereby saving on time, cost and manpower in convincing their clients.

Business counter-partiesThe credit rating helps business counter-parties in establishing business relationships particularly for opening letters of credit, awarding contracts, entering into collaboration agreements, etc.

RegulatorsRegulators can, with the help of credit ratings, determine eligibility criteria and entry barriers for new securities, monitorfinancial soundness of organisations andpromote efficiency in debt securitiesmarket.This increasestransparencyofthefinancialsystemleadingtoahealthydevelopmentofthemarket.

3.8 Rating and Default RiskMost investors prefer to use credit ratings to assess default risk. Internationally acclaimed credit rating agencies such as Moody’s, Standard and Poor’s and Duff and Phelps have been offering rating services to bond issuers over a very long time. The bond issuers pay the rating agency to evaluate the quality of the bond issue in order to increase theinformationflowtoinvestorsandhopefullyincreasethedemandfortheirbonds.Theratingagencydeterminesthe appropriate bond rating by assessing various factors. For example, Standard and Poor’s judges the credit quality ofcorporatebondslargelybylookingatthebondindenture,assetprotection,financialresources,futureearningpower,andmanagement.Morespecifically,StandardandPoor’sfocusesoncashflowstojudgeafirm’sfinancialviability. The bond categories are assigned letter grades. The highest grade bonds, whose risk of default is felt to be negligible, are rated triple A (Aaa or AAA). The rating agencies assign pluses or minuses (e.g., Aa + A+) when appropriate to show the relative standing within the major rating categories.

The following table gives the rating symbols and their explanation as employed by Moody’s and S & P, the well known rating agencies.

Moody’s ExplanationAaa Best qualityAa High qualityA Higher-medium gradeBaa Medium gradeBa Possess speculative elementsB Generally lack characteristics of desirable investmentCaa Poor standing; may be in defaultCa Speculative in a high degree; often in defaultC Lowest grade

Table 3.2 (a) Rating Category of Credit Agency Firms

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Standard & Poor’s Explanation

AAA Highest grade

AA High grade

A Upper medium grade

BBB Medium grade

BB Lower medium grade

B Speculative

CCC-CC Outright speculation

C Reserved for income bonds

DDD-DD In default, with rating indicating relative salvage value

Table 3.2 (b) Rating Category of Credit Agency Firms

Not all bonds are rated by the agencies. Small issues and those placed privately are generally not rated. For those bonds that are rated, the competing services generally rank the same bond in the same rating category; seldom do they disagree by more than one grade. The research has shown that there is a high degree of correlation between bondqualityratingsandactualdefaults.Largenumberoffirmswithlowratingsusuallydefaults.Thissuggeststhatknowledgeaboutcreditratingdoeshelpinassessingthefinancialrisksthatcanleadtodefault.

3.9 Ratings and YieldsThe ratings assigned to a bond issue directly affect its yield. Issuers of high-risk securities have to pay higher rates of return than issuers of low risk securities. Junk bonds, for instance, are a high risk and a high yield instrument. Investment may be limited in such instruments. A study of the average yields to maturity for different categories of bonds (bond index) over various time periods (1955-67, 1968-79 and 1981-85) reveals that market yields increase with increased risk. Investors dislike risk. Risk avoidance is visible not only in the long-run but also in short-run. Bonds rated poorly must pay higher yield in the market place to attract risk-averse investors. The higher the rating, the lower is the bond’s yield.

The difference in yield is termed as the yield spread. The yield spread between two rating categories provides a measure of the default risk premium. While yield spreads related to default risk are not constant over time, they do remain in the appropriate relative pattern. That is, AAA rated bonds always sell at lower yields than Aa bond, which in turn sell at lower yields than A-rated bonds, and so forth. Investors often use the highest rating category as a benchmark yield and compute yield spreads for lower-rated bonds.

In India, one can say, the relationship between ratings and cost of funds is, at best, tenuous. It has been observed thatmanytimessimilarratedcompaniesareaccessingfundsatwidelydisparateratesofinterest.Thissignifiesthatthe market perception of the investment risk of such companies ‘ is different even though credit rating agency has placed them in the same category (symbol). One can conclude that as ratings fail to capture the market’s perception of risk, there is indeed something wrong with ratings assigned to these companies.

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A number of research studies suggest that the determinants of credit rating and yield spread for corporate bonds include:

Debt ratios•Earnings-levels•Earnings-variability•Interest coverage•Pension obligations•

Since about 75% of yield spread and ratings variability are explained with these variables, other subjective factors may play an important role. The yield-spread pattern also changes in magnitude over the business cycle; yield spreads widen (narrows) during recessions (prosperous periods). A reasonable explanation of expanding and contracting yieldspreadsisthatduringrecession,defaultriskrisesmorethanproportionallyforlower-qualityfirmsbecauseofreducedcashflows.Also,investorsmaybecomerisk-averseastheirwealthdecreasesduringrecessions.

3.10 Limitations of Credit RatingsThereareseverallimitationsofcreditratings.First,creditratingsarechangedwhentheagenciesfeelthatsufficientchangeshaveoccurred.Theratingagenciesarephysicallyunabletoconstantlymonitorallthefirmsinthemarket.The opinions of rating agencies may turn wrong in the context of subsequent events that may have an adverse impact on asset quality of the issuer.

Second, the use of credit ratings imposes discrete categories on default risk, while in reality default risk is a continuous phenomenon. Moody’s recognised this way back in 1982 by adding numbers to the letter system, thereby increasing its number of rating categories from 9 to 19. Nevertheless, this limitation still pertains. The letter grades assigned by rating agencies serve only as a general, somewhat coarse form of discrimination.

Third, owing to time and cost constraints, credit ratings are unable to capture all characteristics for an issuer and issue. A borrowing company can reduce the cost of borrowing, if it obtains a higher rating for its contemplated issue. The stakes and pressures, consequently, to get a good quality rating are high. If the company comes to know that its issue is going to get a low quality rating, it may approach another agency and then use the best rating among them since it is not under obligation to disclose all ratings. According to the practice in the rating industry in India, acorporateentityhastheoptionofnotagreeingtothefirstratinggiventoitsdebtissueandcanchoosenottogetrated by that agency at all. In such a situation, the rating agency cannot divulge its assessment to anybody, and the corporate entity is free to go to any other agency.

Butoncethecorporateentityagreeswiththefirstrating,ithasnooptionofgettingoutoftheratingdisciplineimposed by the rating agency. This may tempt rating agencies to woo clients with the help of an initial favourable rating, but the freedom may eventually be misused by the rating agency because corporate client doesn’t have the option to differ with the agency, once it initially agrees to get rated by it. To ensure that corporate clients are not dependent on one rating agency, the system of compulsory dual ratings of all instruments could be considered. Sometimes, the rating agency may reduce the rigor of their criteria on their own to enlarge the business and improve profitsespeciallyiftheyarealistedcompany.

Investorsshould,therefore,notfollowblindlytheratingsofdifferentagenciesinregardtothesafetyoffixedincomeinstruments. The investors should explore other alternative evaluation sources so that they become aware of the true risks involved. The rating agencies have to be alert to ensure that their rating decisions are not driven by volume andprofitabilitywithaviewtoensurefavourableimpactonthepriceofitsshare.Itmaybeassertedthattheratingagencies should be judged by overall performance and not by one or two defaults. There are instances of default in the instruments rated as investment grade of high safety by top agencies of the world.

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Oncethecorporateagreeswiththefirstrating,theratingagencyisobligedtoassessthedebtissuetillitsmaturityand publish the rating as part of its surveillance system. It has been observed that rating agencies have miserably failed in predicting the brewing crisis and have continued to give investment grade rating to companies, which have eventually defaulted. It has been argued that CRB scam would not have taken place if we had a better credit rating agency that would have cautioned in time on the status of the company. After the crisis, rating agencies became overcautiousandresortedtodrasticdowngradesofratingsinrespectofspecificcompanies.

For instance, CRISIL, ICRA, and CARE downgraded respectively 140, 35 and 50 companies in 1997. Of the rating changes effected by CRISIL, ICRA, and CARE-36%, 40% and 64% respectively were by three or more notches.

CRISIL ICRA CARE

By one notch 35.0 28.6 22.0

By two notches 29.3 31.4 14.0

By three notches 12.9 8.6 20.0

By four notches 7.9 8.6 4.0

By more than four notches 15.0 22.9 40.0

Total downgrades 140 35 50

Table 3.3 Downgrades of ratings (in %) in 1997

The high proportion of companies whose investment grade rating was overnight changed to non-investment grade is not conducive for enhancing the faith of investors in ratings.

In India, as in the developed countries, rating changes often lag the variations in stock prices. Of the 157 rating downgrades made by the three rating agencies in 1997, in 130 companies, the change in ratings lagged the decline in share prices. Despite evidence that stock price movements do eventually lead to a change in ratings, there is reason to believe that further changes are urgently needed when the ratings of companies and their stock prices are compared. This need is more prominent in the case of the investment grade ratings granted to NBFCs by CRISIL and ICRA than to the companies which are trading below par, yet command investment grade rating.

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SummaryCredit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders •to form an opinion on the relative capacities of the borrowers to meet their obligations.TheCreditRatingAgencies, thus, assist and form an integral part of a broader programmeof financial•disintermediation and broadening and deepening of the debt market.Rating is a search for long-term fundamentals and the probabilities for changes in the fundamentals.•The analytical framework followed for rating methodology is divided into two interdependent segments.•Management evaluation includes consideration of the background and history of the issuer, corporate strategy •and philosophy.SMERA is the rating agency exclusively established for rating of SMEs.•CRISIL ratings are based on a robust and clearly articulated analytical framework, which ensures comprehensiveness, •standardisation, comparability, and effective communication of the ratings assigned and of every timely rating action.The factors that ICRA takes into consideration for rating depend on the nature of borrowing entity. •Besides determining the credit risk associated with a debt instrument, ICRA has also formed a group under •Earnings Prospects and Risk Analysis (EPRA).CARE is a credit rating and information services company promoted by IDBI jointly with investment institutions, •banksandfinancecompanies.Financialintermediarieslikebanks,merchantbankers,andinvestmentadvisersfindratingasaveryusefulinput•in the decisions relating to lending and investments.The investors should explore other alternative evaluation sources so that they become aware of the true risks •involved.The difference in yield is termed as the yield spread. The yield spread between two rating categories provides •a measure of the default risk premium.

ReferencesFrancis, J. C., 1993. • Management of Investments. 3rd ed., McGraw Hills, New Delhi.Khan, M. Y., 2000. • Financial Services. Vikas Publishing House, New Delhi.Report of the Committee on Comprehensive Regulation for Credit Rating Agencies. • [Pdf] Available at: <http://www.sebi.gov.in/cms/sebi_data/attachdocs/1288588001441.pdf> [Accessed 26 September 2013].LESSON 40: CREDIT RATING: AN • INTRODUCTION. [Pdf] Available at: <http://www.psnacet.edu.in/courses/MBA/Financial%20services/16.pdf> [Accessed 26 September 2013].Credit ratings agencies. • [Video online] Available at: <http://www.youtube.com/watch?v=FUFnW6x-gKc> [Accessed 26 September 2013].How Do Credit Ratings Work? • [Video online] Available at: <http://www.youtube.com/watch?v=d1TllXN2C0g> [Accessed 26 September 2013].

Recommended ReadingGuruswamy, S., 2009. • Indian Financial System. 2nd ed., Tata Mc-Graw Hill, New Delhi.Babu, G. R., 2005. • Financial Services in India. Concept Publishing, New Delhi.Kaptan, S. S., 2001. • New Instruments of Finance in India. Sarup & Sons, New Delhi.

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Self Assessment______________ is used to analyse the present and future earning power of the issuing corporation.1.

Ratio analysisa. Class analysisb. Credit analysisc. Rating analysisd.

Which of the following statement is false?2. The removal of strict regulatory framework in recent years has led to a spurt in the number of companies a. borrowing directly from the capital markets.Credit Rating Agencies assist lenders to form an opinion on the relative capacities of the borrowers to meet b. their obligations.TheCreditRatingAgenciesformanintegralpartofabroaderprogrammeoffinancialdisintermediationc. and broadening and deepening of the debt market.The Securities and Exchange Board of India (SEBI) has now decided to enforce mandatory rating of all d. credit instruments irrespective of their youth.

Rating is a search for _________ fundamentals and the probabilities for changes in the fundamentals.3. Short terma. long termb. mid termc. off termd.

Which of the following statement is true?4. TheCreditRatingAgenciesirregularlyanalysethefinancialpositionofcorporations.a. TheCreditRiskAgenciesregularlyanalysethefinancialpositionofcorporationsandassignandrevisetheb. ratings for their securities.TheCreditRatingAgenciesregularlyanalysethefinancialpositionofcorporationsandassignandrevisec. the ratings for their securities.TheCreditRatingAgencieswillnotanalysethefinancialpositionofcorporations.d.

_________ is the rating agency exclusively established for rating of SMEs.5. CRISILa. CAREb. SMERAc. ERAd.

The factors that ________ takes into consideration for rating depend on the nature of borrowing entity.6. CAREa. ICRAb. CRISILc. IDBId.

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Which of the following agency is a ‘credit rating and information services company’ promoted by IDBI?7. ICRAa. ICICIb. UTIc. CAREd.

Financialintermediariesfind_____asaveryusefulinputinthedecisionsrelatingtolendingandinvestments.8. rankinga. resultingb. ratingc. resultantd.

What is the full form of EPRA?9. Early Prospects and Risk Analysis a. Earnings Purchase and Risk Analysis b. Earnings Prospects and Rating Analysis c. Earnings Prospects and Risk Analysis d.

Match the following10.

1. AAA A. inadequate safety of timely payment of interest and principal.

2. BBB B. Highest safety of timely payment of interest and principal

3. BB C. High safety of timely payment of interest and principal

4. AA D.sufficientsafetyofpaymentofinterestandprincipalforthepresent.1-B, 2-D, 3-A, 4-Ca. 1-A, 2-B, 3-C, 4-Db. 1-C, 2-A, 3-D, 4-Bc. 1-D, 2-C, 3-B, 4-Ad.

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Chapter IV

Regulatory Framework for Banks and Non-banking Finance Companies

Aim

The aim of this chapter is to:

introduce the necessity of regulatory framework•

explain RBI as a central bank•

explicate Reserve Bank of India Act, 1934•

Objectives

The objectives of this chapter are to:

explain the regulations over commercial banks•

elucidate Statutory Liquid Ratio•

explicate management of banks•

Learning outcome

At the end of this chapter, you will be able to:

identify regulations over non-banking companies•

understand NBFCs acceptance of public deposits•

describe loan and investment companies•

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4.1 IntroductionNecessityofregulatoryframeworkforthefinancialsystemhasbeenuniversallyfelt,primarilytosafeguardtheinterestsofalargenumberofsavers/depositorsandalsotoensureproperandefficientfunctioningoftheinstitutionsthatarepartandparcelofthefinancialsystem.Wehave,inIndia,twoprincipalregulatoryauthorities,namely,theReserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). They are entrusted with the responsibilities of development and regulation of the money market and capital market respectively. These regulators derivetheirpowersfromvariouslegislativeenactmentsandexercisetheirdiscretionaswell.Thefinancialsystem,thus, functions within the regulatory framework.

The chapter deals with the regulatory environment for the money market and the participants therein, i.e. the CommercialBanks,theCo-operativeBanks,financialinstitutionsandthenonbankingfinancecompanies.

4.2 Reserve Bank of India: The Central BankReserve Bank of India, besides being the Central Bank of the country, is the principal regulatory authority in the Indian money market. It derives its powers from two principal enactments, namely the Reserve Bank of India Act, 1934 and the Banking Regulations act, 1949. The Reserve Bank of India Act, 1934, apart from providing for the Constitution management and functions of the RBI, also empowers it to exercise control and regulations over the CommercialBanks,thenon-bankingfinancecompaniesandthefinancialinstitutions.TheBankingRegulationAct1949 contains various provisions governing the Commercial Banks in India. Many of these provisions are also applicable to the Co-operative Banks. The State Bank of India, its subsidiary banks and the nationalised banks are also governed, by the status under which they have been incorporated.

First, we shall discuss the main functions performed by the Reserve Bank of India. The Reserve Bank of India was established on April 1, 1935 under the Reserve Bank of India Act, 1934. As the country’s Central Bank, the Reserve Bank of India performs the following function:

Issuer of Currency Notes: Reserve Bank of India is the sole authority to issue currency notes, except one-rupee •note and coins of smaller denominations. Within the RBI, all functions relating to the issuance of notes are ‘undertaken by the ‘Issue Department’, which is responsible for issue of notes and the maintenance of eligible assets of equivalent value to back the notes issued.Banker to the Government: RBI acts as banker to the Central Government under the Reserve Bank of India Act, •and to the State Governments, under agreements-with them. As the banker to the Government, RBI provides services, such as acceptance of deposits, withdrawal of funds, receipts and payments on behalf of the Government, transfer of funds and the management of public debt.Banker’s Bank: The Reserve Bank of India controls the volume of resources at the disposal of the Commercial •Banks through the various measures of credit control. This checks the ability of banks to create/squeeze credit to the industry, trade and commerce.Supervisory Authority: RBI has the powers to supervise and control Commercial Banks. It issues licenses for •starting new banks and for opening new branches. It has the power to vary the reserve ratios, to inspect the workingofbanks,andtoapprovetheappointmentofChairmanandChiefExecutiveOfficersofthebanks.Exchange Control Authority: The Reserve Bank of India regulates the demands for foreign exchange in terms •of the Foreign Exchange Management Act, besides maintaining the external value of Indian rupee.RegulationofCredit:OneofthemostimportantfunctionsoftheReserveBankofIndiaistoregulatetheflow•of credit to industry. This is achieved by measures such as the Bank rate, Reserve Requirements, Open Market Operations, selective credit controls and moral persuasion.

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4.3 Regulations over Commercial BanksMain provisions of the Banking Regulation Act, 1949, which govern the Commercial Banks, are as follows:EstablishmentIt is essential for every banking company-Indian or foreign, to acquire a licence from the Reserve Bank of India, beforeitcommencesitsbusinessinIndia.ReserveBankofIndiaissuesalicence,ifitissatisfiedthatthecompanyfulfilsthefollowingconditions:

the company is/ or will be in a position to pay its present or future depositors in full as their claims accrue•the affairs of the company are not being, or are not likely to be conducted in a manner detrimental to the interest •of its present or future depositorsthe general character of the proposed management of the company will not be prejudicial to the public interest, •or the interests, of its depositorsthe company has adequate capital structure and earning prospects•public interest will be served by the grant of a licence to the company to carry on banking business in India•the grant of licence would not be prejudicial to the operation•any other condition to ensure that the carrying on of the banking business in India by the company will not be •prejudicial to the public interest or the interests of the depositors

A foreign bank must, in addition, satisfy the following conditions:The carrying on of banking business by such company in India will be in the public interest.•The Government or the law of the country in which it is incorporated does not discriminate in any way against •banking companies in India.The company complies with all the provisions of the Act applicable to such companies.•

Opening of branchesEvery banking company (Indian as well as foreign) is required to take Reserve Bank’s prior permission for opening a new place of business in India or outside India, or to change the location of an existing place of business in India or outside. Reserve Bank, before granting its permission, takes into account:

Thefinancialconditionandhistoryofthecompany.•The general character of its management.•The adequacy of its capital structure and earning prospects.•Whether public interest will be served by the opening/change of location of the place of business.•

Business permitted and prohibitedSection 6 contains a list of businesses which may be undertaken by a banking company. Under Clause ‘0’, any other businessmayalsobespecifiedbytheCentralGovernmentasthelawfulbusinessofabankingcompany.

But, a banking company is prohibited from undertaking, directly or indirectly, trading activities and trading risks (except for the realisation of the amount lent or in connection with the realisation of bills for collection/negotiations).

Subsidiary companyA banking company may establish a subsidiary company for undertaking any business permitted under Section 6, or for carrying on the business of banking exclusively outside India, or for undertaking any other business, which in the opinion of Reserve Bank, would be conducive to the spread of banking in India or to be useful in public interest.

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Paid-up capitalThe Act stipulates the minimum aggregate value of its paid-up capital and reserves for banks established before 1962. Minimum amount of capital was raised to Rs. 5 Lakhs for banks set up after 1962. The revised guidelines issued by Reserve Bank for establishing new private sector banks prescribed minimum paid-up capital for such bank at Rs. 200 crore, which shall be increased to Rs. 300 crore in the next three years, out of which promoter’s contribution will be 25% (or 20% in case paid-up capital exceeds Rs. 100 crore). Non-Resident Indians may participate in the equity of a new bank to the extent of 40%.

The authorised capital of a nationalised bank is Rs. 1500 crore, which may be raised to Rs. 3000 crores. These banks allowed to reduce the capital also but nor below Rs. 1500 crore. These banks are permitted to issue shares to public also, but the share of the Central Government is not allowed to be less than 51% of the paid-up capital. The paid-up capital may be reduced at any time so as to render below 25% of the paid-up capital as on 1995.

Maintenance of liquid assetsSection 24 required every banking company to maintain in India in cash, gold or unencumbered approved securities an amount which shall not, at the close of business on any day, be less than 25% of the total of its net demand and time liabilities in India. Reserve Bank of India is empowered to step up this ratio, called Statutory Liquid Ratio (SLR), up to 40% of the net demand and time liabilities. When this ratio is raised, banks are compelled to keep largerportionoftheirdepositsinthesespecifiedliquidassets.

SLR is to be maintained on a daily basis. The amount of SLR is calculated on the basis of net demand and time abilities as on the basis of net demand and time liabilities as on the last Friday of the second preceding fortnight. Reserve Bank also possesses the power to decide the mode of valuation of the securities held by banks, i.e. valuation may be with reference to cost price, market price, and book value or face value as may be decided by Reserve Bank of India from time to time.

Approved securities mean the securities in which the trustees may invest trust funds under Section 20 of the Indian Trusts Act, 1882. The securities should be unencumbered i.e., free of charge in favour of any creditor. The Act also provides for penalties for default in maintaining the liquid assets under Section 24. At present SLR is to be maintained @ 25% of net demand and time liabilities (which excludes net interbank liabilities).

Maintenance of assets in IndiaSection 25 requires that the assets of every banking company in India at the close of business on the last Friday of every quarter shall not be less than 75% of its demand and time liabilities.

Inspection by Reserve BankUnder Section 35, the Reserve Bank may, either at its initiative or at the instance of the Central Government, cause aninspectiontobemadebyoneormoreoftheofficers,ofanybankingcompanyanditsbooksandaccounts.If,on the basis of the inspection report submitted by the Reserve Bank, the Central Government is of the opinion that the affairs of the banking company are conducted to detriment the interests of its depositors, it may prohibit the banking company from receiving fresh deposits or direct the Reserve Bank to apply for the winding up of banking company.

Reserve bank’s power to issue directionsReserve Bank of India is vested with wide powers under Section 35 A to issue direction to banking companies generally, or to any banking company, in particular:

In the public interest or in the interest of banking policy.•To prevent the affairs of any banking company being conducted in a manner detrimental to the interests of •depositors or in a manner prejudicial to the interests of the banking company.To secure proper management of any banking company, in general.•

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The banking company shall be bound to comply with such directions. Section 36 empowers the Reserve Bank to caution or prohibit banking companies against entering into any particular transaction or class of transactions and generally give advice to the banking company. Reserve Bank also possesses the powers to ask the ban company tocallameetingofBoardofDirectors,todeputeitsofficers,towatchtheproceedingsofthemeetingsofBoard,toappointitsofficersasobserversandtorequirethebankingcompanytomakechangesinthemanagementonsuggested lines.

Management of banksThe constitution of the Board of Directors of the private sector commercial banks must be in accordance with the provisions of the Banking Regulation Act, 1949. Section 10 A lays down the Board of Directors is constituted in such a way that not less than 51% of the total number of members shall consist of persons who satisfy the following two conditions:

They have special knowledge or practical experience in respect of accountancy, agriculture, rural economy, •banking,co-operation,economics,finance,law,smallscaleindustry,oranyotherrelatedmatter.Theydonothavesubstantialinterestin,orbeconnectedwithanycompanyorfirmwhichcarriesonanytrading,•commercial or industrial concern (this excludes those connected with small-scale industries or companies registered under Section 25 of the Companies Act).

Reserve Bank of India has conferred the power to direct a banking company to reconstitute the Board, if it is not constituted as above. It may remove a Director and appoint a suitable director also. A person cannot be a Director of two banking companies or a Director of a banking company, if he is a Director of companies which are entitled to exercising the voting rights in excess of 25% of the total voting rights of all shareholders of the banking company.

The Act also requires that the Chairman of a banking company shall be a person who has special knowledge and practicalexperienceoftheworkingofabankorfinancialinstitution,orthatoffinancial,economicorbusinessadministration.ButheshallnotbeaDirectorofacompany,partnerinafirmorhavesubstantialinterestinanycompanyorfirm.If,theReserveBankofIndiaisoftheopinionthatapersonappointedasChairmanisnotafit/properpersontoholdsuchoffice,itmayrequestthebanktoelectanotherperson.Ifitfailstodoso,theReserveBank of India is authorised to remove the said person and to appoint a suitable person in his place.

Reserve Bank’s approval is also required to appoint, re-appoint, or terminate the appointment of a Chairman, Director,orChiefExecutiveOfficer.ReserveBankhasthepowertoremovetopmanagerialpersonnelofthebankingcompanies, if the Bank feels it necessary in the public interest or for preventing the affairs of a banking company being conducted in a manner detrimental to the interests of the depositors. Reserve Bank may appoint a suitable person in place of the person so removed. Moreover, Reserve Bank is also empowered to appoint Additional Directors notexceedingfiveoronethirdofthemaximumstrengthoftheBoard,whicheverisless.

The Board of Directors of the nationalised banks is to be constituted in accordance with the provisions of Section 9 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 or 1980. It provides for appointment asDirectorsorofficialsofRBI,CentralGovernment,otherfinancialinstitutionsandfromamongsttheofficersandworkmen of the bank concerned. Moreover, six Directors are to be nominated by the Central Government, and two to six directors are to be elected by shareholders other than Central Government. These Directors are required to be experts in, or have practical experience in the subjects enumerated above in case of private banks Directors. If the Reserve Bank is of the opinion that any Director elected by the shareholders (other than Government) does notfulfiltheaforesaidrequirement,itcanremovesuchDirector,andtheBoardofDirectorsshallco-optanotherperson in his place.

The nationalised banks are under an obligation to comply with the guidance given by the Central Government. According to Section 8 of the (Nationalisation) Act, “every nationalised bank shall, in the discharge of its functions, be guided by such directions in regard to matters of policy, involving public interest as the Central Government may, after consultation with the Governor of the Reserve Bank, give”.

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Control over advancesSection 21 confers wide powers on the Reserve Bank of India to issue directive to the banking companies with regard to the advances to be granted by the banking companies either generally or by any of them in particular. These directions may relate to any or all of the following:

The purposes for which advances may, or may not be, granted.•The margins to be maintained in respect of secured advances.•Themaximumamountofadvancetoanyonecompany,firm,individualorassociationofpersons.•The maximum amount up to which guarantees may be given by the banking company on behalf of any company •orfirm.The rate of interest and other terms and conditions, on which advances may be made or guarantees may be •given.

The directive issued under this Section is called Selective Credit Control Directives, if they relate to advances on the security of selected commodities. Banks are bound to comply with these directives.

Restrictions on loans and advancesA banking company is prohibited from sanctioning loans and advances on the security of its own shares. Restrictions are also imposed under Section 20 on the loans granted by banks to the persons interested in the management of banks.

Maintenance of cash reserve with reserve bankSection 42 of the Reserve Bank Act, 1934 requires every scheduled bank to maintain with the Reserve Bank-of India an average daily balance, the amount of which shall not be less than 3% of the net demand and time liabilities of the bank in India. Reserve Bank of India is empowered to increase this rate up to 20% of the net demand and time liabilities. If a bank fails to maintain the cash balance as required by the Reserve Bank, penalty may be imposed as prescribed in the Act. This provision applies to all scheduled banks, commercial banks, state co-operative banks, and Regional Rural Banks.

4.4 Regulations over Co-operative BanksThe category of co-operative banks comprises of the central and state co-operative banks and urban co-operative banks. They are organised co-operative societies, which are registered and governed by State Governments under the respective Co-operative Societies Act. Thus, matters relating to registration, administration, recruitments, liquidation and amalgamation are controlled by State Governments. As they perform the functions of a bank, certain provisions of the Banking Regulation Act, 1949 also apply to them. Thus, they are regulated by Reserve Bank of India so far as matters relating to banking are concerned.

Reserve Bank’s supervision and control over urban co-operative banks is far weaker. They are subject to dual control, which remains a problem. Reserve Bank has, however, prescribed prudential norms relating to income recognition, assetclassificationandprovisioning.Exposurenorms,similartocommercialbanks,havealsobeenprescribedforurban co-operative banks.

4.5 Regulations over Non-Banking Finance CompaniesTheNon-BankingFinanceCompaniesperformvery importantfinancial intermediation function in India.Theysupplement the role of the banking institutions, as they cater to the needs of those borrowers who remain beyond thepurviewofthebankinginstitutionsandmobilisethesavingsfromthedepositors.Hirepurchasefinanceandleasingcompanies,loansandinvestmentcompaniesandhousingfinancecompaniesaretheimportantcategoriesof such Non-Banking

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Finance Companies (NBFCs).InviewofthesignificantroleplayedbyNBFCs,regulatoryframeworkhasbeendevised,particularlytosafeguardthe interests of the depositors. Chapter III B of the Reserve Bank of India Act, 1934 provides for such regulatory frameworkoverNBFCs.SignificantamendmentstothisChapterweremadeinJanuary,1997,vestingmorepowersintheReserveBankofIndiatoregulatetheactivitiesofsuchcompanies.WeshallfirstdealwiththeprovisionsofChapter III B, followed by the important provisions of the directives issued by the Reserve Bank of India in this regard.

4.5.1 Reserve Bank of India Act, 1934The powers vested in the Reserve Bank of India Act under Chapter III B of Reserve Bank of India Act, 1934 are as follows:To regulate or prohibit issue of prospectusIn the public interest, the Reserve Bank of India may regulate or prohibit the issue by any non-banking company of any prospectus or advertisement soliciting deposits of money from the public. The Bank may also give directions to these companies as to the particulars to be included in such advertisements.

To collect information as to deposits and to give directionThe Reserve Bank of India is empowered to direct every non-banking institution to furnish to it information or particulars relating to the deposits received by it. The Bank may also issue directions in the public interest, to such institutions generally, or to any institution in particular, or group of such institutions in particular, on any of the matters connected with the receipt of deposits. If any such institution fails to comply with any direction, the Bank may prohibit the acceptance of deposits by such institutions.

To conduct inspectionThe Reserve Bank of India may, at any time, create an inspection to be made for any non-banking institution to verify the correctness/completeness of the particulars furnished to the Bank or to obtain any such particulars, if not submitted.

The Reserve Bank of India (Amendment) Act, 1997The Reserve Bank of India (Amendment) Act, 1997, has conferred explicit powers on the Reserve Bank of India which are as follows:

A new NBFC cannot operate unless it is registered with Reserve Bank of India and has a minimum owned fund •of Rs. 25 lakhs. Reserve Bank has been vested with the power of enhancing the minimum Net Owned Funds (NOF) of NBFCs to Rs. 2 crore in case of companies which are incorporated on or after April 20, 1999, and which seek registration with Reserve Bank of India.EveryNBFCisrequiredtocreateaReserveFundandtransfernotlessthan20%ofitsnetprofiteachyearto•such fund before declaring any dividend.Reserve Bank of India is given the power to prescribe the minimum level of liquid assets, as a percentage of •the deposits, to be maintained in unencumbered approved securities (i.e., government securities/ guaranteed bonds).TheCompanyLawBoardhasbeenempoweredtodireNBFCstorepaydepositsthathavematured,ifitfinds•that the company is unable or unwilling to repay the depositors.Powers have been conferred upon the Reserve Bank of India to:•

Give directions to the NBFCs regarding prudential norm. �Give directions to the NBFCs and their auditors on matte relating to balance sheets and cause special audit �well as to impose penalty on erring auditors.Prohibit NBFCs from accepting deposits for violation the provisions of the RBI Act and to direct NBFCs �not to alienate their assets.File winding up petition against erring NBFCs. �Impose penalty directly on the erring NBFCs. �

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4.5.2 NBFCs Acceptance of Public Deposits (Reserve Bank) DirectionsIn exercise of the powers vested in it under Chapter III the Reserve Bank of India, issued these directions to NBFC regarding acceptance of deposits from the public. These directions were substantially revised in January, 1998 to include prudential norms to be followed by NBFCs. The salient features of RBI Directions, as further revised December, 1998 are as follows:

Forregulatorypurposes,NBFCshavebeenclassifiedintthreecategories:•Those accepting public deposits. �Thosenotacceptingpublicdeposits,butengagedfinancialbusiness. �Core investment companies, with 90% of their total asset in investments in the securities of their group/ �holding subsidiary companies.

The thrust of RBI regulation is on companies accepting public deposits (category (a) above).Publicdepositshavebeendefinedtoincludefixed/recurringdepositsreceivedfrompublic,depositsreceived•from relatives and friends, deposits from shareholders by a public limited company and money raised by issue of unsecure debentures and bonds to shareholders and the public. Public Deposits exclude money raised by way ofissuesecureddebenturesandbonds,borrowingsfrombanksandfinancialinstitutions(includingbywayofunsecured debentures), deposits from directors, inter-corporate deposits, deposits from foreign citizens, deposits received by private limited companies from their shareholders, security deposits from employees, advance receipt of lease and hire purchase installments.NBFCs with net owned funds (NOF) of less than Rs. 25 lakhs (with or without credit rating) are not allowed •to accept public deposits.Ceilings on public deposits for NBFCs, with NOF of Rs. 25 lakhs and above, have been prescribed as follows. •These ceiling limits were enforced in December, 1998. Prior to that, these limits were based on the credit rating (effective January, 1998).

Equipment Leasing and Hire Purchase Finance Companies: �- For unrated and under-rated (i.e. rating below the minimum investment grade) NBFCs-1.5 times of their NOF or Rs. 10 crore, whichever is less (provided their CRAR is 15%, or above, as per their last audited balance sheet).- For NBFCs with minimum investment grade credit rating-4 times of their NOF (provided they have CRAR of not less than 10% as on 31.3.1998 and not less than 12% as on 31.3.1999). They are required to increase CRAR to 15% as early as possible.Loan and Investment Companies �- Unrated and under-rated-not entitled to accept public deposits (irrespective of their NOF and CRAR).- With minimum Investment Grade Credit Rating-1.5 times of NOF (provided they have CRAR of 15% or above).Further, it has been stipulated that loan and investment companies which do not have minimum CRAR of 15% as on date, but otherwise comply with all the prudential norms and have credit rating of AAA may accept or renew public deposits up to the level outstanding as on December 18, 1998 or 1.5 times of the NOF whichever is more, subject to the condition that they should attain CRAR or 15% by 31st March, 2000 and bring down the excess deposits, if any, by December 31, 2000, and have credit rating of AA/ A may accept or renew public deposits as per the existing provisions of Directions (i.e. 0.5 or 1 time of their NOF), but they should attain the minimum CRAR of 15% on or before 31st March, 2000 as per their audited balance sheet, failing which they should regularise their position by repayment or otherwise by December 31, 2001. TheabovebenefitwillnotbeavailabletothosecompanieswhoseCRARispresently15%andabovebutslips down below the minimum level of 15% subsequently.

Themaximumpermissibleinterestrateonpublicdepositshasbeenfixedat16%perannum.NBFCscanpay•uniform maximum brokerage of 2% on deposits for 1 year to 5 years. Brokers may also be reimbursed other expenses not exceeding 0.5% of the collected deposits.Only those NBFCs, which are accepting public deposits, are required to submit to Reserve Bank annual statutory •returnsandfinancialstatements.OtherNBFCsareexemptedfromthisrequirement.

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4.5.3 Prudential Norms for NBFCsReserve Bank of India issued guidelines prescribing the prudential norms for NBFCs in June, 1994. Companies acceptingpublicdepositshavetocomplywithalltheguidelines,whileleasing,hirepurchasefinance,loanandinvestment companies, not accepting public deposits, are required to comply with prudential norms, other norms on capital adequacy and credit/investment concentration. Similarly, investment companies holding not less than 90% of their assets being securities of their group/ holding/ subsidiary companies and not accepting public deposits are exempted from prudential norms. These guidelines are as follows:

Income recognitionNBFCs are required not to take into books income due but not received within a period of six months, till it is actually received.

Classification of assetsNBFCs are required to classify their assets as non-performing assets if payment of principal/ installment is due but notreceivedwithinsixmonths.Forleasing,hirepurchasefinancecompaniessuchassetsaretobetreatedasNPAs,ifleaserentalsandhirepurchaseinstallmentsremainpastduefor12months.Guidelinesregardingclassificationofassets into 4 categories and provisioning issued to commercial banks, are applicable to NBFCs also.

Capital adequacy normIn January 1998, the capital adequacy requirement for NBFCs with net owned funds of Rs. 25 lakhs and above and having public deposits had been raised from 8% to 10% (effective 31.3.1998), and further to 12% (effective 31.3.1999). The composition of capital and risk weights attached to assets and conversion of off Balance Sheet items are the same as applicable to banks.

Credit/Investment concentration normsRegisteredfinancecompaniesarerequirednottolendmorethan15%oftheirnetownedfundstoasingleborrowerand not more than 25% of their owned funds to a group of borrowers. These limits are also applicable to investment in a single company or a single group of companies. Composite limits of credit to and investment in a single company or a single group of companies have been prescribed at 25% and, 40% respectively of its owned funds. NBFCs are not permitted to lend on the security of their own shares.

The ceiling on investment in unquoted shares of companies other than their group/ subsidiary companies has been fixedat10%of theirownedfundsforequipment leasingandhirepurchasefinancecompaniesand20%of theowned funds for loan and investment companies. NBFCs are advised not to invest more than 10% of their owned funds in land and building except for their own use. NBFCs are required to dispose off excess of the assets over the indicated ceilings within three years.

Liquid assetsNBFCs are required to maintain certain percentage of their deposits in liquid assets to ensure their liquidity and to safeguard the interests of the depositors. With effect from January 2, 1998, the ratio of liquid assets is uniform for all NBFCs accepting public deposits. It has been prescribed at 12.5% with effect from April 1, 1998 and at 15% with effect from April 1, 1999. The liquid assets are to be maintained with relation to public deposits only. NBFCs are required to keep Government securities and Government guaranteed bonds in the custody of a scheduled bank attheplaceofitsheadoffice.Thesesecuritiesarepermittedtobewithdrawnforrepaymenttodepositorsorforreplacing them by other securities or in the case of reduction of deposits.

The above account shows that the Reserve Bank of India has instituted a comprehensive regulatory framework for NBFCs. Out of 8802 applications of NBFCs which were eligible for registration on the basis of Minimum Net Owned Funds of Rs. 25 lakhs, registration has been granted to 7555 NBFCs. Out of them, only 584 NBFCs have been permitted to accept public deposits. Applications of 1030 companies have been rejected. 28676 companies with NOF below Rs. 25 lakhs have been given time up to January 8, 2000 to achieve the minimum NOF. Thus, an era of consolidating and strengthening the Non-Banking Financial Companies has commenced and better results may be expected in future.

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SummaryIn India, there are two principal regulatory authorities, namely, the Reserve Bank of India (RBI) and the Securities •and Exchange Board of India (SEBI).Reserve Bank of India, besides being the Central Bank of the country, is the principal regulatory authority in •the Indian money market.The Banking Regulation Act 1949 contains various provisions governing the Commercial Banks in India.•The Reserve Bank of India was established on April 1, 1935 under the Reserve Bank of India Act, 1934.•RBI acts as banker to the Central Government under the Reserve Bank of India Act, and to the State Governments, •under agreements-with them.The Government or the law of the country in which it is incorporated does not discriminate in any way against •banking companies in India.Reserve Bank of India is empowered to step up this ratio, called Statutory Liquid Ratio (SLR), up to 40% of •the net demand and time liabilities.The amount of SLR is calculated on the basis of net demand and time abilities as on the basis of net demand •and time liabilities as on the last Friday of the second preceding fortnight.Section 36 empowers the Reserve Bank to caution or prohibit banking companies against entering into any •particular transaction or class of transactions and generally give advice to the banking company.The Board of Directors of the nationalised banks is to be constituted in accordance with the provisions of Section •9 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 or 1980The category of co-operative banks comprises of the central and state co-operative banks and urban co-operative •banks.Publicdepositshavebeendefinedtoincludefixed/recurringdepositsreceivedfrompublic,depositsreceived•from relatives and friends, deposits from shareholders by a public limited company and money raised by issue of unsecure debentures and bonds to shareholders and the public.

ReferencesVarshney, P. N., 1999. • Indian Financial System and Commercial Banking. Sultan Chand & Sons, Delhi.Bhole, L. M., 2000. • Financial Institutions and Markets. Tata McGraw Hills, New Delhi.Strengthening Oversight and Regulation of Shadow Banking. • [Pdf]Availableat:<http://www.financialstability board.org/publications/r_130829c.pdf> [Accessed 25 September 2013].Non-Banking Financial Companies (NBFCs). • [Pdf]Availableat:<http://www.du.ac.in/fileadmin/DU/Academics/course_material/EP_19.pdf> [Accessed 25 September 2013].Banking & NBFC Sector Update: Budget Special. • [Video online] Available at: <http://www.youtube.com/watch?v=ae17Ra9-gms&list=PLB04D2569856F1EFD> [Accessed 25 September 2013].SunGard’sAmbit-GoingforGrowth:WhatistheroleofNBFCsinIndia’sfinancialsector?• [Video online] Available at: <http://www.youtube.com/watch?v=facmcUHioOE> [Accessed 25 September 2013].

Recommended ReadingMachiraju, H. R., 1998. • Indian Financial System. Vikas Publishing House, Delhi.Sundaram, K. P. M. and Varshney, P. N., 2000. • Banking and Financial System. Sultan Chand and Sons, Delhi.Varshney, P. N. and Mittal, D. K., 2002. • Indian Financial System. Sultan Chand & Sons, Delhi.

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Self AssessmentIn India, there are two principal regulatory authorities, namely, _________________ and the Securities and 1. Exchange Board of India.

Central Bank of Indiaa. Reserve Bank of Indiab. Oriental Bank of Commercec. State Bank of Indiad.

Which of the following statement is false?2. NBFCs are required to maintain certain percentage of their deposits in liquid assets to ensure their liquidity a. and to safeguard the interests of the depositors.NBFCs are advised not to invest more than 10% of their owned funds in land and building except for their b. own use.NBFCs are required to dispose off excess of the assets over the indicated ceilings within ten years.c. NBFCs are required to classify their assets as non-performing assets if payment of principal/ installment is d. due but not received within six months

The Banking Regulation Act 1949 contains various provisions governing the ___________ banks in India.3. commerciala. non-commercialb. statec. insuranced.

The Reserve Bank of India was established on ___________, 1935 under the Reserve Bank of India Act, 4. 1934.

April 9a. April 11b. April 10c. April 1d.

The category of ____________ banks comprises of the central, state and urban banks.5. co-operativea. non-operativeb. operativec. unco-operatived.

What is the full form of NFBC’s?6. National Banking Finance Companies (NBFCs).a. Nationalised Banking Finance Companies (NBFCs).b. Nationwide Banking Finance Companies (NBFCs).c. Non-Banking Finance Companies (NBFCs).d.

Which of the following statement is true?7. The directive issued under Section 22 is called Selective Credit Control Directives.a. The directive issued under Section 21 is called Selective Credit Control Directives.b. The directive issued under Section 23 is called Selective Credit Control Directives.c. The directive issued under Section 20 is called Selective Credit Control Directives.d.

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The Board of Directors of the nationalised banks is to be constituted in accordance with the provisions of 8. ____________ of the Banking Companies Act, 1970 or 1980.

Section 9a. Section 90b. Section 99c. Section 999d.

Reserve Bank of India is the sole authority to issue currency notes, except ______ rupee note and coins of 9. smaller denominations.

twoa. oneb. fivec. tend.

Themaximumpermissibleinterestrateonpublicdepositshasbeenfixedat16%perannum.10. 13%a. 14%b. 15%c. 16%d.

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Chapter V

Agricultural Finance in India

Aim

The aim of this chapter is to:

introduceagriculturalfinance•

explainimportanceofagriculturefinance•

explicate co-operative credit societies and banks•

Objectives

The objectives of this chapter are to:

explain commercial banks•

elucidate regional rural banks•

explicate national bank for agriculture and rural development (NABARD)•

Learning outcome

At the end of this chapter, you will be able to:

identify direct and indirect advances•

understandtypesofagriculturalfinance•

describe central co-operative bank•

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5.1 IntroductionThe importance of agriculture as an occupation of nearly 70% of the population needs no emphasis. It is a well known fact that the Indian peasant is poor, illiterate and heavily indebted. For the relief of agricultural indebtedness, the Government of India and the State Governments have tried to regulate money lending, restrict transfer of land fromagriculturaltonon-agriculturalclasses,andextenddirectfinancialassistanceintheformofTaccaviloans.Unfortunately, notwithstanding these sincere efforts on the part of the government, the economic conditions of agricultural masses have steadily deteriorated and the indebtedness increased. Before the advent of institutional credit, the major source of credit to the farmers was the village mahajan (money lender). Besides following many unfair practices, the village mahajans charge abnormal rates of interest.

With the breaking up of the village economy, loans were not available on personal security but on security of land. The new laws like the Indian Contract Act and the Civil Procedure Code were also in favour of money lender, and enabled him not only to secure his exorbitant claims but also to attach the debtor’s land, cattle and implements. Consequently, the farmer was ruined.

The Government of India realised the urgency of the situation and appointed various committees in recent years to suggest ways and means to provide banking facilities in rural areas to mop up surplus funds and also to help the farmerswithneededfinance.Ontheirrecommendationsco-operativebanks,commercialbanksandregionalruralbanks were created. The establishment of National Bank for Agriculture and Rural Development (NABARD) has further contributed to this process.

Dependingontheperiodforwhichfinancesarerequired,thefinancialneedsofthefarmermaybebroadlyclassifiedinto three categories as follows:

Short-term or seasonal credit: Short-term loan is required by the farmers for purchasing seeds and fertilizers, •paying wages and meeting other casual expenses such as payment of rent, interest on debt, etc. Short-term loan is generally repayable out of the proceeds of the next harvest.Medium-term credit: This is required by the farmers to purchase live stock, expensive implements and to carry out •landimprovementsofaverageduration.Theloanisrepayableininstalmentsspreadovertwotofiveyears.Long-term credit: This gives farmers the means to purchase land and agricultural machinery or to effect •permanent improvement on land such as drainage and irrigation. The returns from investments on such items are very slow and hence the farmers can repay the loan only in small amounts over a substantially long period (up to 30 years).

5.2 Co-operative Credit Societies and BanksCo-operative movement seeks to protect the agriculturist against economic evils as well as moral degeneration, while at the same time emphasising the importance of mutual help. The co-operative movement in India may be said to begin with the passing of Co-operative Credit Societies Act of 1904. The publication of Rural Credit Survey Report in December 1954 was a landmark in the history of co-operative movement in the country. The various recommendations made in the Report were accepted by the Government of India, and State Governments were directed to draft their proposals for development of the co-operative movement during the plan period. The Second Five Year Plan envisaged setting up of an integrated rural credit structure based on three fundamental principles:

State partnership at different levels.•Full coordination between credit and economic activities (especially marketing and processing).•Administration with adequate trained personnel responsive to the needs of the rural population.•

The medium and short-term co-operative credit structure in India has a three-tier structure: Primary Agricultural Co-operative Credit Societies at the village level.•Central Co-operative Banks at the district level.•State Co-operative Bank as an apex body at the state level.•

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TheStateCo-operativeBankssupplyfundstoaffiliateddistrictlevelco-operativebankswhichinturnlendmoneyto Village level co-operative credit societies. The other wing of co-operative credit structure provides long-term loans and it has a two-tier system:

The Primary Land Development Banks at the Taluka level.•Central Land Development Banks at the State level.•

5.2.1 Primary Agricultural Co-operative Credit SocietiesPrimary Agricultural Credit Societies constitute the pivot of the co-operative movement in India. A society can be formedbytenormorepersonsbyfilingwiththeRegistrarofCo-operativeSocietiesacopyofby-lawsandotherprescribed particulars. The area of operations is usually a village or a group of villages with a reasonably large membership and adequate share capital. The headquarters of a bigger primary credit society is conveniently located for the people of villages in its jurisdiction.

Primary Agricultural Credit Society has to play a vital role in the socio-economic development of the rural areas ofthecountry.Theyareservingasmini-bankstosupplyfinance,besidesservingascounterstosupplyagriculturalinputs and consumer goods. These societies also provide the facility of warehousing to preserve and store the food grains of the farmers. PACs are to be provided with adequate assistance in the form of subscriptions and grants by the higher level institutions such as Central Co-operative Bank and State Co-operative Bank within the federal structureofco-operativefinancingsystem.

The number of primary societies in India has been increasing over the years. By the end of 1983-84 the number of primary societies was 89,925, of which 83,766 societies were active and remaining were dormant. The working capital of these societies was Rs. 484.7 crore in 1983-84 while the loans issued during the year amounted to Rs. 415.44 crore of which Rs. 289 crore were for short-term purposes and Rs. 126.4 crore for medium term purposes.

5.2.2 Central Co-operative BanksThe central banking organisations are generally located at the district headquarters of other important towns in the districts. A Central Co-operative Bank derives funds for its working capital from two sources:

owned capital (comprising capital and reserves)•borrowed capital (comprising deposits and loans)•

Thebusinessofthesecentralco-operativebanksconsistsoffinancingprimarycreditsocieties.TheCentralBankof a predominantly agricultural country like India has a very special role to play. In India, the district central co-operative banks form the connecting link in the chain of co-operative credit structure. Progress of co-operative credit programme largely depends on the strength of these banks because the entire fund available from Reserve BankofIndiaforfinancingseasonalagriculturaloperationsandmarketingofagriculturalproduceareadvancedtothemonthebasisoftheirfinancialstrengthandstability.Theflowoffreshloansandadvancesduring1983-84from the central co-operative banks increased by Rs. 468.4 lakhs and working capital of these banks registered an increase of Rs. 465 crore during the last 13 years.

5.2.3 State Co-operative BanksAt the top of the co-operative movement, there is State Co-operative Bank. The need for establishing these banks was emphasised by the Maclagan Committee, which recommended the creation of a provincial co-operative bank capable of attracting deposits from the urban classes and channel them to agricultural sector through district central banks.

TheStateco-operativebanksfinance, coordinateandcontrol theworkingof centralbanks ineach state.Theyserveasclearing-housesoftheexcessesanddeficienciesoftheworkingcapitalofthesecentralbanks.Theyserve,moreover, as a link between the general money market and the co-operative primary societies in the villages. Generally speaking, the apex bank does not deal directly with primary societies but through central bank except in areas where central banks are not developed.

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Functionsoftheapexbanksincludegivingfinancialaccommodationtothecentralco-operativebanksandthroughthem to the primary societies. Besides the normal banking activities they have also, taken interest in other co-operativeactivitiessuchashelpingvariousco-operativeorganisationstocometogether,financingthesupplyanddistribution of essential commodities, etc.

5.2.4 Land Development BanksThe ordinary co-operative societies and banks cannot grant long-term loans to their members because the principle of co-operative lending demands that loan should be advanced on personal credit of members. But it is not possible to grant long-term, advances on personal security alone. The Land Development Banks, therefore, supply long-term credit to the cultivator who offers his land as a security. These banks also give long-term loans to their members for the partial repayment of their debts, for undertaking permanent improvements on their lands and for purchasing new plots of land. In Tamil Nadu and Maharashtra, the Central Land Development Banks issue debentures for obtaining finance.ThesedebenturesareusuallyguaranteedbytheStateGovernment.TheLDBsalsoacceptlong-termdepositsfromthepublic.ThesebanksgetfinancialassistancefromtheLifeInsuranceCorporationofIndiaalso.

Land development banking, as in the case of rural co-operative banking, has made some progress in the states of Maharashtra, Gujarat and Tamil Nadu. Like the primary co-operative banks, the land development banks have also been charging rather a high rate of interest on the loans which they advance to the cultivators. Moreover, there is considerable amount of delay in the sanctioning of loans because of shortage of trained staff. Due to these shortcomings, the LDBs in India are able to provide only a negligible proportion of the long-term credit required by the cultivators.

5.3 Commercial BanksIn spite of the fact that agriculture and allied activities were contributing about 40% to India’s national income and supporting almost three out of every four employed persons in the country, the contribution of commercial banks to agricultural development till 1955 was not even one per cent of their aggregate resources. Things have changed after nationalisation of commercial banks in 1969.

‘Therealinvolvementofbanksinagriculturalfinancingcoincidedwiththeintroductionofsocialcontrolin1967.The study group appointed under the Chairmanship of Professor D.R. Gadgil in October 1969, and the Committee of Bankers set up by the RBI in 1969 under the Chairmanship of F.K.F. Nariman recommended an Area Approach for providing banking facilities in unbanked districts. As a result, the Lead Bank Scheme was introduced by the RBI in December 1969. Under the scheme, various districts in the country came to be apportioned among all the public sector banks and three banks in the private sector. The banks were charged with the responsibility of preparing development programmes for their respective districts. The scheme, by introducing commercial banks to rural areas,involvedtheminfinancingagriculture.Nationalisationofthe14majorbanksinJuly1969acceleratedtheassociationofbankswithagriculturalfinance.

Apart from the three major forces (viz., the social control, the Lead Bank Scheme and , Bank Nationalisation) that areresponsiblefortheassociationofcommercialbankswithagriculturalfinancing,sharpriseinthenumberofbank branches in rural areas also contributed to the development of agriculture and related activities. There are three distinctphasesininvolvementofcommercialbanksinfinancingagriculture.Thefirstphase,spreadingroughlybetween1952and1967,wasaperiod,whenbankerswerethinkingthatfinancingagriculturewasnottheirjobandthatthisresponsibilitywouldbewithdrawnsoon.Nowonder,thegrowthinagriculturalfinancingwashaphazardduring these years. The second phase, commencing from 1967 till 1975, was the period when the banks realised thatagriculturalfinancinghascometostay.Duringthisperiodthebanksengagedinexperimentingwithvariousschemesandsettingthepaceforpromotingfarmfinance.Duringthisperiod,commercialbanksattainedvaluableexperienceinagriculturalfinance.Theyacquiredthenecessaryknowledgeoftheirclienteleasalsooftheareas,whichhelpedthemtoevolveasuitableapproachtowardsfinancingagriculture.Thethirdphase,commencingwith1975,markstheawarenessamongbanksthattheirowneffortswouldnotsuffice.Theyhaverealisedthemagnitudeof the task and are convinced that the cooperation of other agencies is essential. They are also experimenting in agriculturalfinancingwithorganisationsliketheFarmersServiceSocieties,theRegionRuralBanks,thePrimaryAgricultural Co-operative Societies, etc.

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5.4 Types of Agricultural FinanceThe commercial banks provide loans for all agricultural operations and allied purposes. These may broadly be classifiedinto:

Direct advances•Indirect advances•

Direct agricultural creditIt takes the form of short-term, medium term or long-term loans. Short-term loans may be in the form of crop loans, or production loans. Crop loans are required to meet the cost of raising annual crops such as cereals (like rice, wheat, etc.), oil seeds (such as groundnuts), and cash crops (such as: sugarcane, chillies, tobacco, cotton, etc.). Production loans cover the annual maintenance cost of perennial plantation crops such as tea, coffee, cardamom, etc.

Though short-term credit is mainly in the form of loans, yet in a few cases production credit is also granted in the form of cash credit limit. Short-term credit assistance granted by banks normally carries a stipulation for repayment within a month or two after the harvest of crops. In order to ensure recovery of funds lent and effective recycling of funds, the banks normally go in for a system of tie-up arrangements, wherever possible. For example, often tie-up arrangements are entered with sugar mills in the case of loans granted to sugarcane growers, with the Coffee Board forfinancialassistancegrantedtocoffeeplantations,etc.

Medium and long-term loans are generally granted to meet the investment costs relating to various agricultural developmentprogrammeswhicharecapitalintensiveandwhichensureflowofbenefitoveraperiodoftimerangingnormally from three years onwards, depending upon the type of project undertaken. The repayment schedule of term loans granted by banks ranges between 3 to 15 years, depending upon the nature and size of the project and thelikelycashflowtherefrom.Almostalltypesofinvestmentsinsuchagriculturalprojectswhichareotherwiseeconomically viable and technically feasible come within the ambit of banks credit portfolio.

Term lending is assuming greater importance in view of the need to bring additional area under the plough in the country and the consequent need to revitalise the existing cultivable area and thereby increase its productivity. However, the long-term credit requirements of agriculture are massive and hence cannot be fully met by commercial banksalone.However,inprovidingrefinanceassistancetobanksinrespectofmostofthetermloansgrantedbythem,NABARDhasprovidedthenecessaryfilliptocommercialbankstotaketoagriculturalfinancinginamassiveway.

Indirect advancesThe indirect advances include the following four types:

Advanceswhichfulfilthecriterialaiddownfordirectagriculturalcredit,butroutedthroughotheragencies(such•asfarmers’servicesocieties,primaryagriculturalcreditsocieties,etc.)whichinturnfinance-theirmembers.AdvancesmadetoStateElectricityBoardsforelectrificationandtherebyhelpingenergisingthepump-setsfor•agricultural purposes.Credit granted to dealers in fertilisers to meet their working capital requirements.•Advances made to co-operative milk societies, sheep rearing co-operative societies, etc., which in turn extend •credit assistance to their members for purchase of cattle, etc.

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5.5 Limitations of Commercial BanksDuring the last two decades the commercial banks have gone around their task of providing banking services in rural areas quite earnestly. However, in the process the commercial banks faced a number of problems, some of which are discussed below:

Thecommercialbankshaveprobablynotbeensufficientlyfranktobringtopublicnoticethecostofconducting•agricultural advances as they are incurring huge loss in opening and operating rural branches. They have also problems in training their staff to go to rural centres for making agricultural advances. Over the last twenty years anumberoftheirofficershavebeenfoundguiltyofmalpracticesand/orgrossnegligence.Of the 5.75 lakhs villages in the country, the commercial banks have spread their activities to 46,000 villages •only.The commercial banks are quite selective in their village adoption approach. The villages which are relatively •more backward and deserve immediate development assistance have not been adopted by them. Besides, farmers-engaged in dry land agriculture constituting about 75% of the Indian agricultural population has not got their due attention.Although small and marginal farmers have been included by commercial banks on their ‘target population’ •list, the rates of interest charged on advances are very high. In a number of commercial banks the old system and procedures of granting advances continue to exist. The farmers have to therefore, spend a lot of avoidable money and waste time in satisfying legal formalities.

Thus, there is still a large gap persisting between the demand and supply of rural credit in India. It calls for a long range,carefulandrealisticplanningtakingintoaccounttheexistingoperationaldeficienciesandproblems.

5.6 Regional Rural BanksThe Banking Commission in its report submitted to the Government in 1972 recommended the formation of rural banks. These rural banks were described as primary banking institutions for serving a compact group of Wages, covering a population of 5,000 to 20,000. In the context of the urgency for the liquidation of rural indebtedness, the Government was keen on establishing rural banks as quickly as possible. The Regional Rural Banks Ordinance was, therefore, enacted on September 26, 1975, and it came into force with immediate effect in the whole of India.

The main objective of the Ordinance is to provide for the establishment of Regional Rural Ranks for provision of credit and other facilities especially to the small and marginal farmers, agricultural labourers, artisans and small entrepreneurs in rural areas. The Central Government on the request of any bank (usually the Lead Bank of that area), called the ‘sponsor bank’ can establish in a State or Union Territory one or more rural banks. Each rural bank will operate within the local limits. If it is necessary, a rural bank might also establish branches or agencies at any placenotifiedbytheGovernment.

A sponsor bank will assist the rural bank in several ways. It will subscribe to the share capital of the rural bank, assist in its establishment, recruitment and training of its personnel during the initial period of functioning of the rural bank. According to the Ordinance, the authorised capital of each rural bank will be Rs. 1 crore. The issued capital of each rural bank will be Rs. 25 lakhs. Of the issued capital, 50% will be subscribed by the Central Government, 15% by the concerned State Government and 35% by the sponsored bank. There is a provision for increasing both the authorised and issued capital after consultation with the Reserve Bank and sponsored bank and with the prior approval of the Central Government.

The general supervision, direction and management of the rural banks is vested in a Board of Directors. In discharging its function, the Board should act on business principles and should have due regard to public interest. Besides the Chairman, the Board of Directors of a rural bank will consist of not more than three Directors to be nominated by the Central Government, not more than two Directors to be nominated by the concerned State Government and not more than three Directors to be nominated by the sponsor bank. The lending rates of rural banks will not be higher than the prevailing lending rates of co-operative societies in that particular State. The rural bank3 are permitted to give half a per cent higher interest on the deposits kept with them. The staff of rural banks will be composed of men who have knowledge of local conditions and are responsive to the rural needs.

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OnOctober2,1975thefirstfiveregionalruralbanksweresetupinWestBengal,U.P.,Rajasthan,andHaryana.Bythe end of 1985 there, were 187 regional rural banks with 12,000 branches covering 337 districts. The total deposits mobilised by these banks aggregated to over Rs. 1,159 crore and total I advances amounted to Rs. 1,333 crore.

It needs to be mentioned here that the Dantwala committee up by Reserve Bank of India in June 1977 to review the performance of regional rural banks came out strongly in favour of their continuance and extension. The Committee came to the conclusion that the establishment of regional rural banks should be encouraged as these are well suited forprogressivelyfillingupthecreditgapinruralareas.Itwasoftheviewthatcommercialbanksbepersuadedtoprogressively entrust their rural credit business, currently handled by their rural branches, to the regional rural banks keeping in view the RRBs capability to shoulder the responsibility. The Dantwala Committee was not in favour of total replacement of the rural branches of the commercial banks by the RRBs. It, however, suggested that steps be taken to initiate the process of making regional rural banks an integrated part of the rural credit structure.

Following the establishment ofNationalBank forAgriculture andRuralDevelopment (NABARD), refinancefacilities to RRBs (hitherto available from RBI) are now available from NABARD. During 1984-85 the NABARD’s refinancepolicyforRRBsunderwentachange.Thecompositelimit,hithertosanctionedtoRRBswasbifurcatedinto short-term limit and medium-term (non-schematic) limit. Under the new policy, RRBs-which have completed 5 years of existence as on July 1, 1984 are required to apply for separate limits under short-term and medium-term. Other regional rural banks are, however, eligible for a composite limit as hitherto. During 1984-85 the NABARD has sanctioned medium-term (non-schematic) loans aggregating Rs. 202.5 crore to 126 regional rural banks. The outstanding amounts against medium-term (non-schematic) limits were Rs. 124.7 crore and Rs. 182.7 crore in respect of short-term limits as on June 30, 1985.

The regional rural banks, which have been set up in rural India are designed to play a pivotal role in rural credit. They have been evolved as low cost and rural based institutions. Their operational area will be relatively small and the staffs are to be recruited locally so that they will be familiar with the local conditions and local languages. The regional rural banks, by bringing credit facilities very nearer to the door of the poorer sections of the rural people, will help to relieve them from the grip of the money-lender. Incidentally, it should be mentioned here that small/ marginal farmers, agricultural labourers, artisans and other weaker sections in rural areas constitute the main beneficiariesofloanassistancefromregionalruralbanks.

It should be noted here that the lead bank scheme and the proposal for the setting up of regional rural banks are complementary to each other. So far, the lead bank has been the sponsoring bank for the regional rural banks and as such, the establishment of the rural bank should be viewed as a suitable institution for strengthening the institutionalstructureinthedistrictwheretheleadbankisexpectedtoplayadominantroleinfinancing.Astherural banks are now taking up the implementation of all bankable schemes which concern the small and marginal farmers, rural artisans and landless labourers, it is desirable that these rural banks have their representatives in the district consultative committees in all the districts where these banks are operating. This will bring about greater involvement of the rural banks in the lead bank scheme.

Moreover, the opening of regional rural banks in the districts will help to remove the two big constraints which the banking system has hitherto been experiencing in implementing the lead bank scheme:

Inadequatenumberofbankingofficesinremotepartsofthecountry.•High cost of servicing small accounts.•

Studies undertaken by RBI in 1980 have brought out that it was not possible for some branches of RRBs to become economically viable owing to competition from commercial and co-operative banks and also because of their location at centres endowed with limited potentiality. Nevertheless, it is heartening to note that the RRBs had been able to fulfiltheprimeobjectiveofmeetingthecreditrequirementsofruralpoor.

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5.7 National Bank for Agriculture and Rural Development (NABARD)The NABARD came into existence on June 12, 1982 following the recommendations of the Committee to Review Arrangements for Institutional Credit for Agriculture and Rural Development (CRAFICARD). The Committee set upbytheRBIinMarch1979submitteditsfinalreportinMarch1981.ThesettingupofNABARDasanapexbodyfor rural credit could be construed as a logical step in the organisational evolution of Reserve Bank to decentralise its functions retaining the essential controls. Although NABARD has been entrusted with the task of overseeing the entire rural credit system, the organic link of RBI with NABARD has been retained by formally contributing half of its share capital and by nominating three of its Directors on the Board of NABARD with a Deputy Governor of RBI asChairman.NABARDhastakenoverentirefunctionsoftheAgricultureRefinanceandDevelopmentCorporation(ARDC)aswellastherefinancingroleofRBIvis-a-visStateCo-operativeBanksandRegionalRuralBanks.

The capital of the Bank is Rs. 100 crore subscribed by the Central Government and the RBI in equal proportions. For its term loans, the NABARD draws funds from the Government of India, World Bank and other multilateral and bilateral agencies as well as the domestic money market.

5.7.1 FunctionsThere are two types of functions-Financial functions and Coordinating, advisory and miscellaneous functions.

Financial functionsOne of the most important functions of NABARD is to extend production and marketing credit which include, inter alia,refinanceloansandadvancesrepayableoverperiodsnotexceeding18monthstoStateCo-operativeRanks,RegionalRuralBanksandotherfinancialinstitutions.Thisfacilityofloansandadvancesisavailableforagriculturaloperations and marketing of crops, marketing and distribution of agricultural inputs, marketing activities of artisans or small scale industries, etc. The NABARD is also empowered to extend loans and advances against the security of stocks and promissory notes. Incidentally, the short-term loans granted to state co-operative banks (SCBs), Regional RuralBanks(RRBs)andfinancialinstitutionsasapprovedbytheRBIcallbeconvertedintomedium-termloansfor a period not exceeding 7 years under conditions of famine and other natural calamities. Medium-term loans for periods not less than 18 months but not exceeding 7 years are granted to SCBs and RRBs for agriculture and rural development and some other purposes as the NABARD determines from time to time. The NABARD has been permitted by the Act to contribute to the share capital of or purchase and sale shares of, or invest in the securities of any institution engaged in agriculture and rural development.

In an effort to promote agriculture and rural development, the NABARD also grants long-term loans and advances toLandDevelopmentBanks(LDBs),RRBs,commercialbanks,SCBsandotherfinancialinstitution%.Furthermore,NABARD is entitled to extend loans and advances to the State Governments from the National Rural Credit (long-term operations) Fund for periods not exceeding 20 years to enable them to subscribe directly or indirectly to the share capital of a co-operative credit society.

Coordinating, advisory and miscellaneous functionsApart from being a source of different types of loans and advances, NABARD is also entrusted with the task of coordinatingtheoperationsofseveralinstitutionsengagedinthefieldofruralcreditandalsotomaintainexpertstaff for studying the problems besetting agriculture and rural development.

NABARD maintains a Research and Development Fund (RDF) to help and promote research in agriculture and rural development including the provision of research and training facilities. The Central Board of NABARD is also empoweredtoestablishaReserveFund’oranyotherfundasitdeemsfit.NABARDundertakestheinspectionofRRRs, besides the co-operative banks. Applications from these banks seeking permission for opening new branches are, however, submitted to the NABARD for onward transmission with comments to the RBI. Furthermore, the RRBs and the co-operative banks have to furnish to NABARD the copies of the returns which the former submit to the RBI under various sections of the Banking Regulations Act.

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5.7.2 PerformanceSinceitsinceptionin1982,theNABARDhasinitiatedanumberofmeasuresforaugmentingtheflowofcredittothe rural sector in general and to small and marginal farmers in particular through strengthening the institutional rural credit structure. Recently, the NABARD has also decided to liberalise the terms of lending in order to stimulate creditflowtotheruralnon-farmsector.Thequantumofrefinanceassistancetothecommercialbanks,co-operativebanks and RRBs has been stepped up from 90% to 100% of bank loans.

NABARD has helped in achieving the growth targets in farm and non-farm sectors. Its operations and objectives have been dovetailed into other national objectives like balanced regional growth, economic improvement of the weaker sectionsoftheruralsociety,etc.Aggregateshort-termcreditlimitsanctionedforfinancingseasonalagriculturaloperations to State Co-operative Banks amounted to Rs. 1,233 crore during 1984-85 as against Rs. 1,245 crore during 1983-84. The performance of NABARD in respect of medium and long-term credit was equally impressive. NABARD’s medium-term loans for approved agricultural purposes increased sharply from Rs. 32 crore at the end of June 1980 Rs. 158 crore at the end of June 1985. IRDP was the second important programme to which NABARD committed Rs. 302 crore and disbursed Rs. 291 crore during 1985-86.

NABARD has laid greater emphasis on agricultural credit. As a result, its assistance to agriculture and allied activitieshasgoneuptremendously.NABARDhasalsoprovidedsubstantialrefinanceforIRDPandforbringingaboutnecessaryimprovementsinlendingforpovertyalleviationprogrammes.Acloseanalysisoftheflowofruralcredit reveals that NABARD has met with little success in reducing imbalances in rural development, as North Easternregionaccountedforabout2.1%ofitsrefinancein1985-86asagainst2/3ofcumulativedisbursementsinNorthern, Southern and Western regions.

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SummaryThe importance of agriculture as an occupation of nearly 70% of the population needs no emphasis.•The Government of India realised the urgency of the situation and appointed various committees in recent years •to suggest ways and means to provide banking facilities in rural areas to mop up surplus funds and also to help thefarmerswithneededfinance.Co-operative movement seeks to protect the agriculturist against economic evils as well as moral degeneration, •while at the same time emphasising the importance of mutual help.The co-operative movement in India may be said to begin with the passing of Co-operative Credit Societies •Act of 1904.Primary Agricultural Credit Societies constitute the pivot of the co-operative movement in India.•The central banking organisations are generally located at the district headquarters of other important towns •in the districts.At the top of the co-operative movement, there is State Co-operative Bank.•The ordinary co-operative societies and banks cannot grant long-term loans to their members because the principle •of co-operative lending demands that loan should be advanced on personal credit of members.Short-term loans may be in the form of crop loans, or production loans.•The Banking Commission in its report submitted to the Government m 1972 recommended the formation of •rural banks.The NABARD came into existence on June 12, 1982 following the recommendations of the Committee to •Review Arrangements for Institutional Credit for Agriculture and Rural Development (CRAFICARD).One of the most important functions of NABARD is to extend production and marketing credit which include, •interalia,refinanceloansandadvancesrepayableoverperiodsnotexceeding18monthstoStateCo-operativeRanks,RegionalRuralBanksandotherfinancialinstitutions.The NABARD is also empowered to extend loans and advances against the security of stocks and promissory •notes.NABARD has helped in achieving the growth targets in farm and non-farm sectors.•

ReferencesGupta, S. B., 1982. • Monetary Economics. S. Chand & Co, New Delhi.Dutt, R., 2001. • Indian Economy. S. Chand and Company, New DelhiCHAPTER VII: FINDINGS, SUGGESTIONS AND CONCLUSION • [Pdf] Available at: <http://shodhganga.inflibnet.ac.in/bitstream/10603/4840/15/15_chapter%206.pdf>[Accessed26September2013].Flow of Credit to Agriculture Sector • [Pdf]Availableat:<http://www.iba.org.in/events/flowofcreditcover.pdf>[Accessed 26 September 2013].History of Financing in India • [Video online] Available at: <http://www.youtube.com/watch?v=1_YnwNsZhLw> [Accessed 26 September 2013].Agricultural credit Class1 • [Video online] Available at: <http://www.youtube.com/watch?v=SLoP2BL2o6I> [Accessed 26 September 2013].

Recommended ReadingMishra, S. K., 1990. • Money, Income and Financial Institutions. Pragathi Publications, Delhi.Mithani, D. M., 1990. • Money, Banking, International Trade and Public Finance. Himalaya Publishing House, Delhi.Sundaram, K. P. M., 1989. • Money, Income and Financial Institutions. Sultan Chand & Sons, New Delhi.

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Self AssessmentThe importance of agriculture as an _____________of nearly 70% of the population needs no emphasis.1.

employmenta. occupationb. livingc. activityd.

Short-term loan is generally _____________out of the proceeds of the next harvest.2. non-payablea. repayableb. payablec. allottedd.

Match the following3.

1. Short-term or seasonal credit

A. It in India may be said to begin with the passing of Co-operative Credit Societies Act of 1904.

2. Co-operative movement B.Theloanisrepayableininstalmentsspreadovertwotofiveyears.

3. Medium-term credit

C. This loan is required by the farmers for purchasing seeds and fertilizers, paying wages and meeting other casual expenses.

4. Long-term credit

D. This gives farmers the means to purchase land and agricultural machinery or to effect permanent improvement on land such as drainage and irrigation.

1-A, 2-B, 3-D, 4-Ca. 1-D, 2-C, 3-A, 4-Bb. 1-C, 2-A, 3-B, 4-Dc. 1-B, 2-D, 3-C, 4-Ad.

Asocietycanbeformedby____________ormorepersonsbyfilingwiththeRegistrarofCo-operativeSocieties4. a copy of by-laws and other prescribed particulars.

twoa. fiveb. tenc. twentyd.

The central banking organisations are __________located at the district headquarters of other important towns 5. in the districts

seldoma. generallyb. rarelyc. neverd.

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Whichofthefollowingisatypeofagriculturalfinance?6. Direct advancesa. Straight advancesb. Instant advancesc. Immediate advancesd.

Which of the following statement is false?7. At the top of the co-operative movement, there is State Co-operative Bank.a. The LDBs also accept long-term deposits from the public.b. The commercial banks do not provide loans for all agricultural operations and allied purposes.c. Direct agricultural credit takes the form of short-term, medium term or long-term loans.d.

OnOctober2,1975thefirst________regionalruralbanksweresetupinWestBengal,U.P.,Rajasthan,and8. Haryana.

eighta. fiveb. tenc. twelved.

During the last two decades the _________banks have gone around their task of providing banking services in 9. rural areas quite earnestly.

commerciala. privateb. allc. fewd.

Which of the following statement is true?10. A sponsor bank will not assist the rural bank in several ways.a. A sponsor bank will assist the rural bank in several ways.b. A sponsor bank will assist the rural bank in few ways.c. A sponsor bank will assist the urban bank in several ways.d.

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Chapter VI

All India and State Level Term-Lending Financial Institutions

Aim

The aim of this chapter is to:

introduce development bank•

explain the role of IDBI in nation development•

explicate functions of development banks•

Objectives

The objectives of this chapter are to:

explain origin of development banks•

elucidateindustrialfinancecorporationofIndia(IFCI)•

explicate industrial credit and investment corporation of India (ICICI)•

Learning outcome

At the end of this chapter, you will be able to:

identify industrial development bank of India•

understand evaluation of development banks in India•

describestatefinancialcorporations•

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6.1 IntroductionDevelopment banks are special financial institutions established for the supply of three basic ingredients ofdevelopment: capital, knowledge and entrepreneurship to the industry. They have been set up during the post World War II period in both developed and underdeveloped countries. They are designed as a catalyst for quickening industrial development. In an underdeveloped country, where there is scarcity of capital and dearth of entrepreneurship, a set of banks which do not restrict their activity to the conventional function of providing term capital to the entrepreneurs are needed.

These banks should also assume a promotional role by undertaking potential industrial surveys, identifying growth projects, and providing technical, managerial and other assistance to interested entrepreneurs right from the stage of project formulation to the commissioning and operation of the project. Thus, the concept of development banks emerged.

According to William Diamond, “A development bank is a hybrid institution which combines in itself the functions ofafinancecorporationanddevelopmentcorporation”.Afinancecorporationisaninstitutionwhichisconcernedprimarily with long-term loan capital, while a development corporation is concerned primarily with equity capital andwithfosteringandmanagingspecificcompaniesaswellasprovidingfinancialsupport.

Thus,developmentbankisafinancialagencyengagedinprovidingmediumandlong-termassistancetoindustrialundertakings in the form of loans. It guarantees loans in addition to undertaking of underwriting, and direct subscription to shares and debentures. It also provides technical knowhow and training to entrepreneurs.

6.2 Origin of Development BanksAlthoughtheterm‘Developmentbank’wasusedforthefirsttimeaftertheSecondWorldWar,similartypesofinstitutionswereinexistenceintheearlypartofthe19thCenturyinsomecountries.Thefirstdevelopmentbank,knownasSocieteGeneraledeBelgique,wasestablishedinBelgiumtofinancecommercialandindustrialventures.However, its activities did not arouse much interest. In 1852, French Credit Mobiliser was established. Later it became a model for similar investment banks in Germany, Austria, Belgium, the Netherland, Italy, Switzerland and Spain.

The post-Depression period witnessed the second phase of development banks during which the need to cater for small-scaleindustrieswasrecognised.Accordingly,specialfinancialinstitutionswereformedinseveralcountries.

In India, thefirst step towards buildingup a structure of developmentfinance institutionswas takenwith theestablishment of the Industrial Finance Corporation of India (IFCI) in 1948. The IFCI was established to provide mediumandlong-termcredittounitsinthecorporatesectorandindustrialco-operatives.Asetofparallel,financialinstitutions, known as the State Financial Corporations (SFCs), were set up at the State level in 1951 to extend the benefitsoflong-termloanstomediumandsmallsizedindustrialundertakingsintherespectivestates.TheIndustrialCredit and Investment Corporation of India (ICICI) was set up at all India level in 1955 as a joint stock company with support from the Government of India, the World Bank, the Commonwealth Development Finance Corporation andotherforeigninstitutions’tofinancetheforeignexchangecomponentsofindustrialprojectsparticularlyin,private sector.

State level institutions, namely the State Industrial Development Corporations (SIDCs) were established in the 1960s mainly for promoting medium scale industrial units. The State Small Industries Development Corporations were also established at state level during sixties for catering to the requirements of small scale units. For coordinating all the development banks at the national and the State levels, the Government of India established an apex institution known As Industrial Development Bank of India (IDBI) in 1964. The Government of India in 1990 established Small Industries Development Bank of India (SIDBI) as an apex Bank to meet the needs of small scale units exclusively. Thus, many development banks were set up in India both at the national and state levels.

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Functions of development banksThe following are the functions of development banks:

Sanction of loans: The important function of the most of the development banks is to provide long-term and •medium term loans to industrial concerns. Certain development banks grant loans in foreign currencies also.Guarantee of loans: They also provide guarantees for loans raised by business concerns from other sources. •They extend guarantees for deferred payments for purchase of capital goods from abroad.Underwriting of industrial securities: Another important function of development banks is to underwrite the •issue of shares, bonds or debentures of industrial concerns.Investment in shares and debentures: In addition to underwriting, the development banks also directly invest in •industrial undertakings by subscribing to their shares and debentures.Merchant banking: In the recent past some development banks have established subsidiary companies, for •undertaking various merchant banking activities.Development functions:Special financial institutions not only act as term lending institutions but also as•development banks. They formulate projects, conduct techno-economic surveys, provide training and consultancy to entrepreneurs, and improve management of industrial units.

6.3 Industrial Finance Corporation of India (IFCI)IndustrialFinanceCorporationofIndia(IFCI)isthefirstdevelopmentBankestablishedinIndia.ItwasestablishedinJuly,1948throughaSpecialActof theParliamentforprovidinglong-termfinancia1assistancetolargeandmedium scale undertakings.

ObjectivesThe primary object of the formation of this Corporation was to make medium and long-term credit facilities easily available to the industrial concerns especially in the areas, where normal bankin4 facilities are inappropriate or ‘recoursetocapitalissuemethodisimpracticable.ItprovidesfinancialassistancetothosecompaniesorCo-operativesocieties that have been registered in the country and are concerned with manufacturing, mining, shipping, hotel etc.Itdoesnotprovidefinancetosmallscaleindustriesandunregisteredcompanies.

Sources of fundsIts authorised capital is Rs. 250 crore. As on 31st March, 1990, its paid-up capital was Rs. 106 crore. Industrial Development Bank of India owns 50% of its paid-up capital and the balance by scheduled banks, co-operative banks, Insurance Corporations, Investment Trusts, etc. In addition, it borrows from market through bonds, gets loans from Central Government and obtains foreign credits.

Management and organisationIndustrial Finance Corporation of India (IFCI) is managed by a Board of Directors, which consists of partly elected and partly nominated directors. The Central Government appoints the whole-time Chairman of the Board in consultation with the Industrial Development Bank of India (IDBI). The Board consists of the following:

One Chairman: appointed by the Central Government•Two Directors: nominated by the Central Government•One Director: nominated by the Reserve Bank of India•Three Directors: nominated by Industrial Development Bank of India•Two Directors: elected by Insurance Concerns, Investment Trusts, etc.•Two Directors: elected by Co-operative Banks.•

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FunctionsThe important functions of Industrial Finance Corporation of India are as follows:

Grantingloansandadvancestoindustrialconcernsandsubscribingtodebenturesfloatedbythemwhichare•repayable within 25 years.Guaranteeing the loans raised by industrial concerns in the open market or from scheduled banks and co-•operative banks.Underwriting the issue of shares, debentures and bonds by industrial concerns. But it is required to dispose of •these securities within 7 years.Granting loans to industrial concerns.•Guaranteeing loans in foreign currency raised by industrial concerns from any bank or institution in a foreign •country. However, prior approval of the Central Government is required for this purpose.Acting as an agent for the Central Government and for the World Bank with regard to loans sanctioned by them •to industrial concerns in India.Guaranteeing credit purchase of capital goods from foreign manufacturers. With the approval of the Central •Government, the IFCI can guarantee the loans raise in foreign currency from foreign institutions.Subscribing directly to the shares issued by industrial concerns.•Providing assistance under the soft loan scheme to selected industries such as cement, cotton textiles, jute, •engineering, etc., to expedite modernisation, replacement and renovation of their plant and machinery.TheIFCIhasbeenundertakingvariouspromotionalactivitiesfinancedoutofitsbenevolentReserveFundand•allocations of Interest Differential Funds received from the Government. The corporation has been emphasising the development of backward areas and the helping and the developing of small and medium scale industrial entrepreneurs. It has been providing them with the needed guidance for the establishment and management of these units.

PerformanceIndustrial Finance Corporation of India had completed 42 years by June, 1990. During this period it acted as a pioneer intheprovisionofindustrialfinance.Itsanctionedfinancialassistancetovariousenterprisesofnationalimportance.The assistance sanctioned by the corporation since 1970-71 till recently can be observed from Table 6.1

Duringthe42yearsofitsexistence,thecorporationhadsanctionedanettotalfinancialassistanceofRs.6,570crore and disbursed Rs. 4,295 crore. In the recent past, the sanctions and disbursements of the corporation increased substantially. During 1988-89 itself, it sanctioned Rs. 1,005 crore. This shows the increasing importance of the CorporationintheprovisionofindustrialfinanceinIndia.

TheassistancegivenbytheCorporationintheearlyyearsofitsestablishmentmainlyconfinedtotraditionalindustrieslike sugar, textiles, jute, etc. But subsequently, in pursuance of the national priorities and objectives, it has extended considerable assistance in recent years to non-traditional industries like basic metals, fertilisers, chemicals and a wide range of engineering industries. During 1988-89, the maximum assistance was sanctioned to the fertiliser industry (Rs. 238 crore) followed by the basic metals (Rs. 161 crore), cement (Rs. 144 crore), electrical machinery (Rs. 134 crore), food products (Rs. 133 crore) and textile industries (Rs. 126 crore). These six industries together accounted for almost half of the total sanctions.

(Rs. in crores)Year Sanctions Growth rate % Disbursements Growth rate %1970-71 32.3 17.41971-72 28.7 (-) 11.1 23.3 33.91972-73 45.7 59.2 28.0 20.21973-74 41.9 (-)8.3 31.9 13.91974-75 29.2 (-)30.3 37.0 16.01975-76 51.3 75.7 34.7 (-)6.2

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1976-77 76.6 49.3 54.9 58.21977-78 113.4 48.0 57.5 4.71978-79 138.5 22.1 73.5 27.81979-80 137.9 (-)0.4 91.0 23.81980-81 206.6 49.8 108.9 19.71981-82 218.1 5.6 169.4 55.61982-83 230.2 5.5 196.1 15.81983-84 321.9 39.8 224.5 14.51984-85 415.4 29.0 272.9 21.61985-86 499.2 20.2 403.9 48.01986-87 798.0 59.9 451.6 11.81987-88 1025.1 28.5 660.0 46.11988-89 1095.6 85.9 1005.3 52.3Cumulative Up to March 1989 6569.8 4295.3 -

Table 6.1 Assistance sanctioned and disbursed by IFCI(Source: IDBI, Report on Development Banking in India. 1988-89.)

There is a little controversy on the performance of Industrial Finance Corporation of India. If we see the growth ofcapital,financialassistancesanctionedanddisbursedandalsoitsprofits,itsperformanceisimpressive.Butweget a different picture when we go deep into its operations. Many criticised the working of the corporation on the following grounds:

Despite the fact that the assistance to the backward regions has shown a remarkable increase in recent years, a •sizeableportionofthisassistancehasbeenconfinedtothebackwardprojectsofdevelopedstates.ItisdifficulttojustifyfinancialassistancetounderdevelopedareasindevelopedstateslikeMaharashtra,Gujarat,etc.,onpar with the ones located in backward states like Assam, Orissa, Kerala, Rajasthan, Madhya Pradesh, etc.AnothercriticismontheworkingoftheCorporationisthatitofferedfinancialassistancetobigconcernswhich•could easily raise resources from the capital market.It is failing in exercising its control over defaulting borrowers.•

6.4 Industrial Credit and Investment Corporation of India (ICICI)IndustrialCreditandInvestmentCorporationofIndia(ICICI)wasthesecondall-Indialevelfinancialinstitutiontobeestablished in India. It was established in January 1952. Unlike other development banks in India, this is a privately owned and operated corporation. The World Bank played a crucial role in the establishment of this corporation.

ObjectivesThe following are the objectives of the corporation.

Toprovidefinancialresourcestoindustrialconcernsfortheirpromotion,developmentandmodernisation.•Toencourageinflowandparticipationofforeigncapitalintheprivatesectorunits.•To encourage private ownership in industrial investment and to increase the scope, of investment market.•

ResourcesThe authorised capital of ICICI is Rs. 200 crore. The issued capital of ICICI as on March 31, 1990 was Rs.91.56 crore. Borrowings constitute a major source for ICICI. Its borrowings included those from the Government of India, the World Bank, the Development Loan Fund (now merged with the Agency for International Development), and the agency of the Government of Federal Republic of Germany, the British Government and Industrial Development Bank of India.

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ManagementOwnership and management of ICICI is vested in the hands of a Board of Directors consisting 12 directors. The Chairman and a managing director will be appointed by Government of India after consulting Industrial Development Bank of India.

Types of assistanceThefollowingarethevarioustypesoffinancialassistanceavailablefromICICI.

It provides loans repayable over a period of 15 years.•Itprovidesfinancethroughequityparticipation,•It sponsors and underwrites new issues of shares and other securities.•It makes funds available for investment by revolving investment as quickly as possible.•It guarantees loans from private investment sources.•It provides loans in foreign currency to import capital equipment.•It furnishes managerial, technical and administrative services to the industry.•It undertakes promotional activities with a view to fostering growth in the backward areas.•

PerformanceICICI is the only Corporation which specialises in securing assistance for industrial securities from abroad. It is helpinginasignificantwayforsettingupofindustrialunitsinprivatesector.Duringthelast35yearsitsfinancialassistancetotheprivatecorporatesectorwassubstantial.AsshowninTable6.2,thecumulativefinancialassistancesanctioned by the Corporation up to March 31, 1989 amounted to Rs. 9,3 13 crore and disbursements to Rs. 6,445 crore. In the recent past, the corporation increased its assistance. It sanctioned Rs. 2,056 crore and disbursed Rs. 1,085 crore during 1988-89.

(Rs. in crores)

Year Sanctions Growth rate % Disbursements Growth rate %

1970-71 43.9 - 28.91971-72 39.7 9.6 30.3 4.81972-73 49.4 24.4 39.7 31.01973-74 61.1 23.7 43.5 9.61974-75 62.9 2.9 45.4 4.41975-76 78.6 25.0 61.1 34.61976-77 98.7 25.0 67.3 10.11977-78 108.3 9.7 91.6 36.11978-79 182.8 68.8 109.2 19.21979-80 204.3 11.8 135.8 24.41980-81 314.1 53.7 185.3 36.51981-82 302.4 (-)3.7 264.7 42.81982-83 392.1 29.7 282.2 6.61983-84 507.6 29.5 334.2 18.41984-85 620.7 22.3 392.7 17.51985-86 708.2 14.1 482.2 22.81986-87 1118.3 57.9 695.5 44.21987-88 1283.3 14.8 771.2 10.91988-89 2056.1 60.2 1085.6 40.8

Cumulative Up to March 1989 9313.3 - 6445.0 -

Table 6.2 Assistance sanctioned and disbursed by ICICI(Source: IDBI Report on Development Banking in India, 1988-89, p. 28)

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Of the total sanctions of Rs. 2,056 crore during 1988-89, rupee loans amounted to RS. 1,400 crore followed by Rs. 539 crore in foreign currency loans, Rs. 19 crore for underwriting and direct subscription and Rs. 7.9 crore for guarantees.

Themajor recipientsof thefinancialassistance fromthecorporationare thenon-traditional industries, suchaschemicals, petro-chemicals, heavy engineering and metal products. While coming to the state-wise assistance, Maharashtra, Gujarat, Uttar Pradesh, Tamil Nadu and Andhra Pradesh received substantial assistance from this institution. However, in the recent past, the assistance to underdeveloped states like Orissa, Himachal Pradesh, etc., increased substantially.

During the year 1988-89, new projects continued to receive maximum assistance. But assistance to expansion/diversificationschemesrecordedthehighestgrowth.Whilecomingtothesector-wiseanalysis,theprivatesectorreceived maximum assistance (84%) followed by joint sector (12.9%), co-operative sector (2.3%) and public sector(0.9%).ICICIhadbeenplayingaveryimportantroleinprovidingfinancialassistancetotheindustrialunitsparticularly in private sector. Its pioneering work as the underwriting institution in this country has been widely acclaimed. The provision of foreign currency loans is another area where the corporation has distinguished it.

Despite the above achievements, the working of the corporation has been criticised due to the following reasons:TheICICIhasbeenconcentratinginprovidingfinancialassistancetoafewindustrieslikechemicals,textiles,•cement, fertilisers, etc.It is not working towards effectively balanced regional development of the country as per national priorities. •Forinstance,ofthecumulativefinancialassistancesanctioneduptotheendofMarch,1989,23.4%wenttoMaharashtra followed by Gujarat (14.8%), Uttar Pradesh (9.8%), Tamil Nadu (8.7%), and Andhra Pradesh (8.1%). It means that around 65% of the total assistance sanctioned (Rs. 7,923 crore) by the Corporation since itsinceptionwenttothesefivedevelopedStates.It has been assisting only larger units in private sector contrary to the policy of the Government.•

6.5 Industrial Development Bank of India (IDBI)Industrial Development Bank of India had come into existence on July 1964 by an Act of Parliament. This bank was a wholly owned subsidiary of the Reserve Bank of India. Since 16th February 1976 it has been delinked from the RBIand,madeanautonomouscorporation.Thiswasdonemainlytoenlargeitsroleasanapexfinancialinstitutiontoachieveeffectivecoordinationamongallthefinancialinstitutionsinthecountry.

ObjectivesThe principal objective of setting up the IDBI was to make a coordinated effort to achieve maximum industrial growth.Theoverall activities of theBankmaybe classified into three broad categories namely, coordination,financingandpromotion.

The objectives of the bank are summarised below:Toserveasanapexinstitutionfortermfinanceforindustry.•Tocoordinateworkingofinstitutionsengagedinfinancing,promotingordevelopingindustriesandtoassist•the development of these institutions.Toprovidetermfinancetoindustry.•Toplan,promoteanddevelopindustriestofillgapsintheindustrialstructureofthecountry.•To provide technical and administrative assistance for promotion and expansion of industry.•To undertake market and investment research and surveys as also technical and economic studies in connection •with the development of industry.Toactaslenderoflastresorttofinanceprojectsthatisinconformitywithnationalpriorities.•

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ResourcesAs on March, 1989 its authorised capital was Rs. 1,000 crore, while its paid-up capital stood at Rs. 540 crore. Its reserves as on date accounted fcfr Rs. 608 crore. Besides securing loans from RBI, Central Government, foreign sources, it also secured funds from internal capital market.

Management and organisationThe management of the IDBI is vested in a Board of Directors consisting of 22 directors including a full-time Chairman-cum-Managing Director appointed by the Central Government. The other Board members comprise a representativeoftheReserveBankofIndia,twoofficialsoftheCentralGovernment,5representativesoffinancialinstitutions,6representativesofpublicsectorbanksandSFCs,2employeesoffinancialinstitutions,and5personswith special knowledge and professional experience, nominated by the Government of India.

The Board has constituted an Executive Committee consisting of ten directors including the Chairman and Managing Director. The Board of Directors deal with the overall policy matters and the Executive Committee deals with proposalsfor thesanctionoffinancialassistanceandothermatters.Thecentralofficeof thebankis locatedinBombay.IthasfiveregionalofficesatCalcutta,Delhi,Madras,Bombay,andAhmedabad.Besidestheseregionaloffices,theIDBIhaselevenbranchesatBangalore,Bhopal,Bhubaneswar,Chandigarh,Cochin,Hyderabad,Jaipur,Jammu, Kanpur, Patna and Shimla.

FunctionsThe following are the functions of IDBI:

Directfinancing:Itprovidesdirectfinancialassistancetoindustrialconcernsbygivingthemlong-termloans•and advances.Guaranteeing of loans: It guarantees loan raised by industrial concerns in the open market or from banks or •otherfinancialinstitutions.Acceptance and discounting of bills: It accepts discounts and rediscounts bills of exchange, promissory notes, •hundis, etc., of industrial concerns.Direct subscriptions and underwriting: It subscribes to shares, bonds, and debentures issued by industrial •concerns. It also underwrites such issues.Refinancing:Itprovidesrefinancingfacilitiestoscheduledbanksaridotherfinancialinstitutions.Itsrefinances•include:

loansbetween3to25yearsgrantedbyIFCI,SFCsoranyotherfinancialinstitution �loans between 3 to 10 years granted by a scheduled or a co-operative bank to any industrial concern �export loans between 6 months to 10 years granted by a scheduled bank or a co-operative bank or any other �financialinstitution

Promotional activities: It provides and arranges technical and managerial assistance for an industrial concern •(or person) for promotion, management or expansion of any industry. It is also entrusted with the responsibility ofplanning,promotinganddevelopingindustrieswithaviewtofillinggapsintheindustrialstructure.Otherfunctions:Itundertakesresearchandsurveysinthefieldsofmarketingandinvestment.Itmayestablish•subsidiaries to carry out its functions and undertake any business which the Central Government may ask it to undertake.

PerformanceThe Industrial Development Bank of India is the leading development bank of India. Its progress if judged by its operations, has really been spectacular all through but more so during recent years. Let us now discuss the various activities of the bank under the following headings.

ThetotalfinancialassistancesanctionedanddisbursedbythebanksinceitsinceptioncanbeobservedFromTable.6.3.It can be seen from the table that the IDBI’s cumulative assistance up to the end of March. 1989 reached to Rs.34, 400 crore. During the same period the bank disbursed Rs. 25,112 crore. The assistance sanctioned and disbursed for thelatestthreeyearsissignificant.During1988-89itsanctionedRs.7,117croreanddisbursedRs.4,746crore.

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Industry-wiseanalysisoffinancialassistancesanctionedbyIDBIrevealsthattheservicesindustryreceivedmajor(17%) share in cumulative assistance sanctioned up to March, 1989 followed by Textiles ( 12.8%), electricity generation (10.69%), miscellaneous chemicals (6.6%), fertilisers (6.6%)).and food products (5.5%).

(Rs. in crores)

Year Sanctions Growth rate % Disbursements Growth rate %

1964-65 28.6 - 20.7 -1970-71 69.6 - 57.6 -1971-72 148.9 113.9 80.1 39.11972-73 96.6 (-)35.1 81.7 2.01973-74 167.0 72.9 137.0 67.71974-75 253.7 51.9 203.1 48.21975-76 304.6 20.1 223.5 10.01976-77 539.6 77.1 341.4 52.81977-78 679.5 25.9 410.3 20.21978-79 724.8 6.7 618.1 50.61979-80 1131.9 56.2 752.9 2181980-81 1291.2 14.1 1014.1 34.71981-82 1549.8 20.0 1217.9 20.11982-83 1800.2 16.2 1498.5 23.01983-84 2303.4 27.9 1774.3 18.41984-85 3342.0 45.1 2073.7 16.91985-86 3517.2 5.2 2783.9 34.21986-87 4427.0 25.9 3205.9 15.21987-88 4791.3 8.2 3613.6 12.71988-89 7117.6 48.6 4745.8 31.3

Cumulative Up to March 1989 34400.4 - 251122 -

Table 6.3 Assistance sanctioned and disbursed(Source: IDBI, Report on Development Banking in India, 1988-89)

A few developed States continued to receive major portion of the assistance sanctioned by the Bank. During 1989-90 Maharashtra (Rs. 737 crore), Gujarat (Rs. 845 crore), Tamil Nadu (Rs. 722 crore), Uttar Pradesh (Rs. 784 crore), Andhra Pradesh (Rs. 552 crore) and Rajasthan (Rs. 523 crore) received 60% of the total assistance sanctioned by IDBI. In fact, out of Rs. 32,942 crores cumulative assistance sanctioned, 61% went to these states only. However, in the recent past, the bank extended its assistance substantially to backward areas.

Assistance sanctioned to private sector projects accounted for three-fourths of the cumulative sanctions as at the end of March, 1989. Public enterprises, on the other hand, received Rs. 5,797 crore followed by joint sector Rs. 1.895 crore and co-operative sector Rs. 675 crore.

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The role of IDBI in nation developmentAs an apex bank, the IDBI has been playing a very important role in the nation building activities. Its contribution is noteworthy particularly from the following:

Creation of more employment opportunities: The Bank has given a big impetus to creation of employment •opportunities in the country. As a result of the assistance given by it to the enterprises, about 84.7 lakhs jobs were created so far since its inception.Assistancetoweakerunits:Itisespeciallyhelpfultoindustrialconcernswhich,foronereasonoranother,find•itdifficulttoraisefinancethroughnormalchannels.Development of small-scale units: The Bank took special interest, for the development of small-scale sector in •India until the establishment of small Industry Development Bank of India in 1990. It played crucial role in the establishment of this apex level institution for solving problems of small-scale sector.Assistance to11ewentrepreneurs: In addition to thegrantoffinanceon liberal terms, it hasdonea lot to•discover and encourage new entrepreneurial talent in the country. It provided a wide variety of services to the new entrepreneurs in addition to training facilities.Sponsoring of technical consultancy organisations: The bank has sponsored eight Technical Consultancy •Organisations (TCOs) in different parts of the country. The TCG scatter to the needs of new and small entrepreneursinareassuchasprojectidentification,projectformulation,marketsurveysandvariousreports.They also provide technical and managerial assistance. The TCOs are also making efforts to identify new entrepreneurs and provide training facilities to them.Development of backward regions: The bank has channelled a substantial portion of its funds to industries •established in backward regions. It is taking active role in correcting regional imbalances in the industrial development of the country.Soft loan scheme: The Bank provided soft loans to industrial units in selected industries, namely Cotton textiles, •Jute, Cement, Sugar and Engineering. Under the soft loan scheme the IDBI sanctions loans to industrial units of these industries to bring about the much neglected modernisation, replacement and renovation of plant and machinery.Coordinationbetweentermlendinginstitutions:Ithasbroughtabouteffectivecooperationamongtheterm-finance•institutionsinthecountry.Theproposalsforfinanceputupbyindustrialconcernsarenowjointlyappraised,processedandfinanced.Asaresult,thereisnooverlappingofactivities,risksarediversified,andfinancingisin tune with the national priorities.

CriticismIDBI achieved tremendous growth in loan sanctions, disbursement, assistance to small sector, assistance to backward areas during the period between 1964-65 and 1988-89. However, if we look at the things closely, we notice certain gaps-in the activities of IDBI:

Fall in disbursements: There was a steady growth in the loans sanctioned by IDBI in the 1980s. As against this, •there was a declining trend in disbursements during the same period. For instance sanctions as a percentage of total was 56.0% in 1980-81 which increased to 62.4% by 1984-85 as against a decline from 44% to 37.5% in the case of disbursements during the same period.Inadequate care on the development of backward areas: IDBI is criticised for its lenience towards backward •areas of developed states than the backward, states themselves. For instance, of its total assistance 46.8 % was shared by four developed states, Maharashtra (l3.5%), Gujarat (12.2%) Uttar Pradesh (1.0%) and Tamil Nadu (10.1%) by March, 1989. As against this, nine backward states received 2.4% only. Further, none of the backward states could get more than 1% in respect of percentage of total assistance of IDBI.’Urbanculture:Sinceitsheadoffice,regionalofficesandbranchofficesareat28metropolitancitiesandState•Capitals, it developed elitist and urban culture.Delay in disposal of applications: It is said that IDBI takes unduly long time in appraising and processing the •applicationsforfinancialassistancereceivedfromindustrialconcerns.No links with outside agencies: It has not made adequate efforts to establish close links with the outside agencies •like Asian Development Bank, World Bank and other such International agencies.

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6.6 Other Development Banking InstitutionsBesides IFCI, ICICI and IDBI, there are some other development banking institutions at national level. They are Industrial Reconstruction Bank of India and Small Industries Development Bank of India. Now let us discuss about these two institutions in detail.

6.6.1 Industrial Reconstruction Bank of India (IRBI)The Industrial Reconstruction Bank of India (IRBI) was established as a statutory corporation on 20th March, 1985 to take over the operations of the Industrial Reconstruction Corporation of India (IRCI). Its main objective is to function as the principal credit and reconstruction agency for the revival of sick industries. Another important objective is to bring coordination among various agencies working for the revival of such units. Its management is vested in the hands of Board of Directors with one Chairman and Managing Director and 12 directors. All of them are appointed by Government of India. Its authorised capital was Rs. 200 crore, while it’s paid up capital was Rs. 98 crore as on June 1988. It has the privilege to receive interest free loans from Central Government to the tune of Rs. 80 crore every year. It can also raise foreign loans guaranteed by Government of India.

The following are the functions of IRBI:It can take over the management of sick industrial units, lease them out, sell them as running concerns or prepare •schemes for reconstruction by scaling down the liabilities.It can also assist and promote industrial development by granting loans and advances and also by subscription •and underwriting of shares and debentures.Its range of activities also includes services like provision of infrastructure facilities, consultancy, managerial •and merchant banking activities.

PerformanceIt sanctioned Rs. 208.7 crore during 1988-89 as against its disbursements of Rs. 116.5 crore. As shown in Table 6.4, till June, 1988 it assisted 535 units with Rs. 522 crore. If we take industry-wise, cotton textiles (14.8%) received a major share of funds, followed by paper and paper products (6.1%) and Steel (5.6%). West Bengal (Rs. 219 crore) stoodfirstinreceivingfinancialassistancedisbursedfromIRBI,followedbyMaharashtra(Rs.55crore)andGujarat(Rs, 50 crore) by June, 1988.

By June 1988, of the total 535 units assisted by IRBI, production of 257 units accounted for Rs. 6,362 crore and sales Rs. 6,450 crore. Thus, it has rendered a lot in remaining the sick units.

(Rs. in crores)

Year Sanctions Disbursements

1986-87 148.9 94.61987-88 186.5 101.91988-89 208.8 116.5Cumulative TotalTill 31.3.1989 912.2 624.1

Table 6.4 Loan sanctions and disbursements of IRBI(Source: IDBI, Report on Development Banking in India, 1988-89)

In spite of its contributions, IRBI is also being criticised because of the following reasons:It was alleged that the assistance is given only to a set of selected industries like engineering and textiles. Nearly •two-thirds of IRBI’s assistance was taken away by these industries.There was a wide gap between sanctions and disbursements. On average, only 55% of the loans sanctioned •were being disbursed.It is considering only a fraction of the total applications. Hence many applications are pending unsettled.•

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6.6.2 Small Industries Development Bank of India (SIDBI)Small Industries Development Bank of India (SIDBI) was set up as a wholly-owned subsidiary of IDBI under the SmallIndustriesDevelopmentBankofIndiaAct,1990.ItistheprincipalfinancialinstitutionTorpromotion,financingand development of small-scale industries. It is also expected to co-ordinate the functions of existing institutions engaged in similar activities. SIDBI commenced its operations on April 2. 1990 and has taken over from IDBI the responsibility of administering the Small Industries Development Fund and the National Equity Fund.

6.7 Evaluation of Development Banks in IndiaAllIndiafinancialinstitutions(AIFIs)viz.,IDBI,IFCI,ICICI,LIC,GICandUTIhavemaderapidprogressintheiroperations in recent years. Over the years, AIFIs have emerged as major catalysts for channelising development financetoindustryandrelatedsectors.Newandinnovativeschemeshavebeendevised.

ThedatarelatingtosanctionsanddisbursementsmadebyallfinancialinstitutionsinIndiaispresentedinTable6.5.It can be seen from the table that the aggregate sanctions and disbursements of loans by development banks had witnessed a steady increase over the years. During the period 1948-64, aggregate assistance sanctioned by them was to the order of’ Rs. 458 crore. Assistance sanctioned increased from Rs. 118 crore in 1964-65 to Ks. 177 crore during 1969-70. Particularly there was a spectacular growth in their sanctions and disbursements during the 1980s. Thus, loans sanctioned had touched Rs. 13.722 crore during 1988-89. Their cumulative sanctions till March 1989 accounted for Rs. 59,104 crore. Same trend is noticed in respect of their disbursements also. Thus, their disbursements which stood at Rs. 91 crore in 1964-65, shot up to Rs. 8,375 crore during 1988-89. Their cumulative disbursements till March 1989 were to the order of Rs. 42.1 12 crore.

(Rs. in crores)Year Sanctions Growth rate % Disbursements Growth rate %1980-81 2293.5 - 1599.6 -1981-82 2367.1 3.2 1826.2 14.21982-83 2907.2 22.8 2152.2 17.91983-84 3721.4 28.0 2687.3 24.91984-85 5031.9 35.2 3180.1 18.31985-86 5942.9 18.1 4552.9 43.21986-87 7237.6 21.8 5204.0 14.31987-88 8579.3 18.5 6233.5 19.81988-89 13722.8 60.0 8375.3 34.4

Cumulative Up to March 1989 59103.8 - 421125.5 -

Table 6.5 Assistance sanctioned and disbursed by AIFIs(Source: IDBI, Report on Development Banking in. India, 1988-89)

6.8 Critical AppraisalAllIndiafinancialinstitutionssufferfromthefollowingweaknesses:

Proceduraldelays:Duetocomplicatedproceduresinvolvedfromthestageofapplicationtillthefinalstageof•disbursement of loans, inordinate delays are taking place. Costs of the projects are tilting away by the time the loanreceived.Asaresult,thebeneficiaryunitsaredrasticallyaffected.Urbanandeliteculture:Sinceailtheoffices(headoffices,regionalofficesandbranchoffices)ofalldevelopment•banks are located at metropolitan cities and state capitals, their staff have no access to rural and backward areas. They had no opportunity to understand the problems of those areas. On the other hand, they develop some sort of urban and elite culture, which defeats the very purpose for which they are started in a country like India.

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Bias towards developed states: Almost all development banks extended assistance to forward states like •Maharashtra, Gujarat, Tamil Nadu and West Bengal instead of assisting backward states like Assam, Orissa, Meghalaya, Arunachal Pradesh, Tripura, Mizoram, Sikkim and Nagaland. This is perhaps due to absence of infrastructuralfacilities.Butitistobenotedthataslongasfinancialassistanceisnotprovidedforindustrialunits, there is very little scope to develop infrastructural facilities.Overdues: Overdues of development banks are increasing day by day and they have reached an alarming stage. •Of the amounts given as loans, nearly one-third are standing as overdues inspite of several legal measures.Paucity of funds: Yet another problem of development banks is paucity of funds. Obligations are many but •resources are limited. Further, Governments are unable to extend their helping hand due to obvious reasons. Asaresultofgrowinginflationandincreasingindustrialactivity,theirlimitedresourcescouldnotmeetthegrowing demands.Coordination: In spite of IDBI’s efforts, they lack coordination in the course of their activities with each other. •As a result, duplication of work, contradictions in procedures, etc., are taking place.

6.9 Need for State Level Term-Lending InstitutionsIndustrialFinanceCorporationofIndia(IFCI)wasestablishedin1948atallIndialeveltoprovidefinanceexclusivelyto large scale industrial units. Financial needs of medium and small size industries were not covered by IFCI. The government, therefore, felt the need for starting development hanks at the regional level to provide assistance to small scale industries. Consequently, State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs) were established in all the states. State level development banks were established with the following objectives:

ToprovidefinancialassistancetoindustrialunitsparticularlysmallscaleunitsintheState.•For establishing and managing the industrial estates.•To concentrate on the development of less developed parts of the States, through provision of infrastructure •facilities like roads, electricity, drainage and water supplyTo establish institutes to provide training to the middle and high level technicians.•To decentralise the development banking activities and take them to semi-urban areas in the State.•To provide better access to the borrowers and clientele.•To have thorough knowledge about the local conditions and problems.•To overcome the problem of language and communication.•

However, it is important to know the functions, types of assistance provided and the working of the two important term- lending institutions at State level namely State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs) along with Technical Consultancy Organisations (TCOs).

6.10 State Financial Corporation (SFC)State Financial Corporations Act, 195 1 was brought into force LO enable all State Governments (except Jammu andKashmir)tosetupStateFinancialCorporationsasregionaldevelopmentbanks.TheyaretomeetthefinancialrequirementsofsmallandmediumsizeindustrialunitsintherespectiveStates.ThefirstStateFinancialCorporationwas established in Punjab in 1953. Subsequently Andhra Pradesh and Bihar State Governments took the lead to set up SFCs in 1960 followed by Uttar Pradesh, Karnataka, Gujarat, Maharashtra and Orissa. At present, there are 18 SFCs operating in different States and Union Territories in the country.

Financial ResourcesCapital structure of an SFC is determined by the concerned State Government with a minimum of Rs. 50 lakhs and maximum of Rs. 5 crore. They are also authorised to raise funds by issue of share capital, and issue of bonds and debentures guaranteed by State Governments. They can also accept medium and long-term deposits from public. Inaddition,theycanborrowfromotherfinancialinstitutions.

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ManagementEvery SFC is managed by a 12 member Board of Directors. The State Government concerned appoints the-Chairman and the Managing Director, and nominates three directors. IFCI and IDBI nominate one director each. Three directors areelectedbyfinancialinstitutions.Therestwillbechosenonthebasisofoneeachfromschedulebanks,co-operativebanksandotherfinancialinstitutions.Onedirectoriselectedbynon-institutionalshareholders.

Types of AssistanceSFCs provide the following types of assistance:

Granting of long-term loans to industries for the purchase of land, buildings and machinery.•Guaranteeing payment on behalf of the entrepreneur for purchasing machinery on deferred payments from •suppliers within India.Underwriting issue of shares, bonds and debentures of industrial concerns.•Guaranteeing loans raised by industrial concerns for a period not exceeding 20 years.•Guaranteeing loans raisedby industries fromcommercial banksor co-operative banks for acquiringfixed•assets.Subscribing to debentures of industrial units.•Provision of foreign exchange loans to industries under the World Bank line of credit.•Special capital assistance up to Rs. 2 lakhs.•LoanstoindustriesincollaborationwiththecentralfinancialinstitutionsliketheIDBI,theIFCIandtheICICI,•andjointfinancingofprojectsalongwiththeSIDCsandthecommercialbanks.ActingasanagentoftheStateorCentralGovernmentoranyotherfinancialinstitutionsnotifiedonthisbehalf•by the Central Government.

EligibilityIndustrial concerns under any form of ownership viz., a proprietary concern, joint Hindu Family, registered co-operative society, private or public limited company engaged in or proposed to engage in one or more of the following activitiesareeligibleforfinancialassistance.

Manufacture of goods•Preservation of goods•Processing of goods•Mining•Hotel industry•Development of industrial estates•Generation and distribution of electricity or any other form of power•Transport industry•Assembling, repairing or packing any article with the aid of machinery and power•Fishingorprovidingshorefacilitiesforfishingormaintenancethereof•Providing special or technical knowledge or other services for the promotion of industrial growth•

Performance of SFCsOperationsofSFCswereonmoderatescaleduringthefiftiesandsixties.Buttherewasarapidincreaseintheiractivities during seventies. It was due to the emphasis laid by Government on promotion of small scale industries, new entrepreneurs and development of backward areas. By March 1989, their cumulative sanctions and disbursements stood at Rs. 8,651 crore and Rs. 6,356 crore respectively. In 1988-89 alone, sanctions and disbursements accounted for Rs. 1,405 crore and Ks. 1,053 crore respectively.

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SFCsareplayinganimportantroleinfinancingsmallandmediumscaleconcernsintheirrespectiveStates.They,however, are being criticised on the following grounds:

Recovery of Dues: Recovery of dues is not satisfactory. For example, their arrears had trebled from Rs. 215 crore •in 1979-80 to Rs. 623 crore in 1984-85. In case of many SFCs, overdues exceed their disbursements. Another disturbing trend is that the percentage of overdues to outstanding loans was increasing. The mounting arrears are severely affecting resource position of SFCs.Assistance to Tiny Industries: Financial assistance of SFCs to small industries sector is declining. Share of •units which received assistance up to Rs, 50,000 is declining both in terms of number and amount. Contrary to this, share of units which were sanctioned assistance above Rs. 10 lakhs is continuously increasing in terms of number as well as amount. Further 6.2% of the units sanctioned loans above Rs. 10 lakhs accounted for about 50% of total assistance of SFCs during 1984-85. As against this, small units which accounted for 42% of the total units received only 3.5% of the total sanctions given by SFCs.InadequateResources:ManySFCsdonothavesufficientfundstomeetgrowingdemandsfortheirfinancial•existence. In the recent past, the State Governments are found to concentrate more on welfare programmes. Hence,theSFCsarefindingitdifficulttoarrangefundstomeettheirneeds.Increasing Sickness: Many of the assisted units are becoming sick resulting in an increase in the burden of •debts.Too many Formalities: The SFCs follow the same old process of scrutiny and processing of loan applications. •Consequently,bythetimealoanisfinallysanctionedanddisbursed,businessscenemayhaveundergonesomuch change, that the project is no longer an attractive proposition.

6.11 State Industrial Development Corporations (SIDCs)Since 1960, many States and Union Territories started State Industrial Development Corporations (SIDCs) for accelerating industrial development in their respective States. In certain States these are called State Industrial InvestmentCorporations.AndhraPradeshandBiharwerethefirsttosetupsuchcorporationsin1960followedbyUttar Pradesh and Kerala in 1961 and Maharashtra, Gujarat and Orissa in 1962. By the year 1988 there were 26 SIDCs spread all over the country.

Financial resourcesBesides paid-up capital and loans from State Governments, SIDCs also borrow funds from market by way of bonds anddebenturesandrefinancefromIDBI.OfthetotalresourcesaggregatingRs.1,113croremobilisedbySIDCsduring 1988-89, break-up of contributions from different sources was as follows:

Increase in paid-up capital: 10.1%•Borrowings by way of bonds: 2.8%•Repayments by borrowers: 14.8%•Institutional borrowings: 33.5%•Others: 38.8%•

ManagementThe SIDCs function under the guidance of respective State governments. Except for one nominee of the IDBI, all other members of their Boards of Directors are nominated by State governments. The boards constitute special committees as and when they feel necessary. Those committees advise the board on various issues relating to the business. Managing Director is the Chief Executive of an SIDC. He looks after3its day-to-bay management.

FunctionsThe following are the functions of State Industrial Development Corporations:

Promoting industrial activities such as project identification, preparation of feasibility reports, identifying•entrepreneurs and assisting them in project implementation.Setting up of medium and large scale industrial projects either in joint sector or as wholly-owned •subsidiaries.

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Provision of infrastructural facilities and market intelligence services.•Grantingoffinancialassistancebywayoftermloans/bridgeloansandunderwritingorsubscriptionofequity•and preference shares.Acting as agent of State and Central Governments in respect of granting subsidies, incentives, etc.•

Performance of SIDCsSIDCsarecontributingalottothestructuraltransformationofindustry.Infactthree-fifthsoftheirtotalsanctionswere in respect of units in non-traditional industries like chemicals, basic metals and metal products, machinery, etc. Their assistance for accelerating industrial development in backward regions is increasing substantially. For instance, by March, 1989, industrial units in backward areas accounted for 62.9% of the cumulative sanctions of SIDCs.

Seed capital assistanceSIDCs have been playing an important role in widening the entrepreneurial base by operating the seed capital scheme on behalf of Small Industries Development Bank of India. But IDCs also suffer from the following problems and drawbacks:

Manyofthemarefacingtheproblemoffunds.Thepresentavailabilityoffundsistsufficientforgrowingneeds•of industrial units.Overheads are becoming a big problem for almost all SIDCs.•Political interference in activities of SIDCs has been increasing.•

6.12 Technical Consultancy OrganisationsInadditiontotheavailabilityoffinance,technicalconsultancyservicesplayaveryimportantroleintheindustrialgrowth of the country. The large scale industries can afford to maintain and equip separate technical consultancy departments or else they can spend good amount of money and can take the assistance from wel1established consultancy organisations. But the small scale units cannot afford the cost of services of private consultancy units operating purely on commercial considerations. It is in this context: that the technical consultancy organisations (TCOs)weresetupintheearlyseventies.TheIDBI,IFCIandICICI,incollaborationwithState-levelfinancial/development institutions and commercial banks, established a network of TCOs. At present, there are 17 TCOs in the country, some of them covering more than one State.

TCOs have been set up to provide a package of total consultancy services covering all stages in the project cycle undersingleroof.TCOsalsoprovideconsultancyservicestoStateGovernments,State-leveldevelopmentfinancinginstitutions and banks. The major thrust of operations of TCOs is in the area of preparation of project reports and feasibilitystudies.Havinggainedexperienceovertheyears,TCOshavediversifiedintothefieldsofidentificationofpotential entrepreneurs and their training, project implementation, rehabilitation, management consultancy, detailed design engineering, and turn-key services, besides energy audit and conservation.

During the year 1988-89, TCOs completed a total of 3.550 assignments, as against 3,082 during the previous year. The assignments included:

2,983feasibilitystudies/projectreports/profiles•31 project appraisals•170 industrial potential/ market / area development and other surveys•9 functional industrial complexes/ turn-key assignments•219 modernisation/rehabilitation/ diagnostic studies•138 other assignments1 special studies•

TCOs also prepared techno-economic feasibility reports involving investment of Rs. 503 crore and employment potential for 31,438 persons. Besides, they conducted 178 Entrepreneurship Development Programmes (EDPs) where 3,316 entrepreneurs wire trained. TCOs also conducted 54 Entrepreneurship awareness camps and 12 training programmes under the Self-Employment Scheme for Educated Unemployed Youth (SEEUY).

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SummaryDevelopmentbanksarespecialfinancialinstitutionsestablishedforthesupplyofthreebasicingredientsof•development: capital, knowledge and entrepreneurship to the industry.According to William Diamond “a development bank is a hybrid institution which combines in itself the functions •ofafinancecorporationanddevelopmentcorporation”.The post-Depression period witnessed the second phase of development banks during which the need to cater •for small-scale industries was recognisedIndustrialFinanceCorporationofIndia(IFCI)isthefirstdevelopmentBankestablishedinIndia.•Industrial Finance Corporation of India (IFCI) is managed by a Board of Directors, which consists of partly •elected and partly nominated directors.Industrial Finance Corporation of India had completed 42 years by June, 1990.•IndustrialCreditandInvestmentCorporationofIndia(ICICI)wasthesecondall-Indialevelfinancialinstitution•to be established in India. It was established in January 1952.Industrial Development Bank of India had come into existence on July 1964 by an Act of Parliament.•Besides IFCI, ICICI and IDBI, there are some other development banking institutions at national level.•AllIndiafinancialinstitutions(AIFIs)viz.,IDBI,1FC1,lCIC1,LIC,GICandUTIhavemaderapidprogress•in their operations in recent years.Since 1960, many States and Union Territories started State Industrial Development Corporations (SIDCs) for •accelerating industrial development in their respective States.Inadditiontotheavailabilityoffinance,technicalconsultancyservicesplayaveryimportantroleintheindustrial•growth of the country.TCOs have been set up to provide a package of total consultancy services covering all stages in the project •cycle under single roof.

ReferencesGupta, S. B., 1982. • Monetary Economics. S. Chand & Co., New Delhi.Mishra, S. K., 1990. • Money, Income and Financial Institutions. Pragathi Publications, Delhi.Financial Infrastructure: banking, Capital Markets and Co-operatives. • [Pdf] Available at: <http://www.isec.ac.in/Chapter%207.pdf> [Accessed 25 September 2013].LESSON-19 INSTITUTIONAL FRAMEWORK: FOR SMALL SCALE INDUSTRIES. • [Pdf] Available at: <http://www.du.ac.in/fileadmin/DU/Academics/course_material/EP_19.pdf>[Accessed25September2013].Term Lending Financial Institutions All India Level. • [Video online] Available at: <http://www.youtube.com/watch?v=_XzD4JBuHJ0> [Accessed 25 September 2013].Banks and Financial Institutions. • [Video online] Available at: <http://www.youtube.com/watch?v=ZLDpTsOrmDA> [Accessed 25 September 2013].

Recommended ReadingMithani, D. M., 1990. • Money Banking International Trade and Public Finance. Himalaya Publishing House, Delhi.Sundaram, K. P. M., 1989. • Money, Income and Financial Institutions. Sultan Chand & Sons, New Delhi.Crawford, G and Sen, B., 1996. • Derivatives and Decision Makers: Understanding and Managing Risk. John Wiley & Sons Ltd.

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Self AssessmentDevelopmentbanksarespecialfinancialinstitutionsestablishedforthesupplyof__________basicingredients1. of development

foura. threeb. fivec. twod.

The post-Depression period witnessed the second phase of development banks during which the need to cater 2. for ____________industries was recognised

medium-scalea. small-scaleb. large-scalec. major-scaled.

Which of the following statement is false?3. Certain development banks grant loans in foreign currencies also.a. Guarantee of loans also provide guarantees for loans raised by business concerns from other sources.b. Another important function of development banks is to underwrite the issue of industrial concerns.c. In the recent past some development banks have established subsidiary companies, for undertaking various d. merchant banking activities.

WhenwasthefirstdevelopmentBankestablishedinIndia?4. Industrial Credit and Investment Corporation of India (ICICI)a. Industrial Finance Corporation of India (IFCI)b. Industrial Development Bank of India (IDBI)c. Industrial Reconstruction Bank of India (IRBI)d.

Match the following5.

1. Industrial Finance Corporation of India (IFCI) A. It had come into existence on July 1964 by an Act of Parliament.

2. Industrial Credit and Investment Corporation of India (ICICI)

B.ItisthefirstdevelopmentBankestablishedinIndia.

3. Industrial Development Bank of India (IDBI) C. It was established as a statutory corporation on 20th March, 1985.

4. Industrial Reconstruction Bank of India (IRBI) D.Itwasthesecondall-Indialevelfinancialinstitution to be established in India.

1-B, 2-D, 3-A, 4-Ca. 1-A, 2-B, 3-C, 4-Db. 1-C, 2-A, 3-D, 4-Bc. 1-D, 2-C, 3-B, 4-Ad.

___________and management of ICICI is vested in the hands of a Board of Directors consisting 12 directors.6. Titlea. Ownershipb. Organisationc. Administrationd.

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The ____________of the IDBI is vested in a Board of Directors consisting of 22 directors including a full-time 7. Chairman-cum-Managing Director appointed by the Central Government.

ownershipa. administrationb. managementc. organisationd.

Which of the following statement is true?8. ICICI is the only corporation which specialises in securing assistance for industrial securities from a. abroad.The principal objective of setting up the IDBI was to make a coordinated effort to achieve minimum industrial b. growth.The Industrial Development Bank of India is the secondary development bank of India.c. ThecentralofficeoftheIDBIbankislocatedinJaipur.d.

All India ________institutions viz., IDBI, IFCI, ICICI, LIC, GIC and UTI have made rapid progress in their 9. operations in recent years.

fiscala. foreignb. financialc. freed.

ThefirstStateFinancialCorporationwasestablishedin___________in1953.10. Punjaba. Delhib. Mumbaic. Calcuttad.

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Chapter VII

Investment Institutions in India

Aim

The aim of this chapter is to:

introduce the purpose of investments•

explain LIC of India•

explicate IRDA and GIC of India•

Objectives

The objectives of this chapter are to:

enlist the various investment strategies•

elucidate general insurance business•

explain mutual funds•

Learning outcome

At the end of this chapter, you will be able to:

identify types of Mutual Funds•

understand the crisis of US 64•

defineinvestmentrestrictions•

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7.1 IntroductionFinancial institutions facilitate the process of capital accumulation by transferring resources from savers to investors. Investment institutions have occupied important place in thewell-integrated structure offinancial institution.These institutions are: Life Insurance Corporation of India (LIC), Unit Trust of India (UTI), and General Insurance Corporation of India (GIC). Though, the insurance companies are primarily engaged in providing the cover of insurance to the people, they mobilise huge sums by way of insurance premia, which they have to invest on a long-term basis. Thus, insurance institutions emerge as important investment institutions. In India, the Life Insurance CorporationofIndiahasbeenthesinglelifeinsuranceinstitutionforoverfivedecades.Ithasbuiltupinvestmentportfolioofsignificantmagnitude.Similarly,inthefieldofGeneralInsurance,theGeneralInsuranceCorporationof India and its four subsidiaries have been actively building up their insurance business and investing their funds. Recently, the insurance sector-both life and non-life (general) - has been opened to the private sector and a single authority - ‘Insurance Regulatory and Development Authority’ (IRDA) regulates the entire insurance industry.

Mutual Funds have also emerged in India as an intermediary in mobilising people’s savings and employing them in money market and capital market securities. Their activities including investment of funds are regulated by the Regulations issued by the Securities and Exchange Board of India (SEBI).

7.2 Life Insurance Corporation of IndiaIn 1956, the life insurance business was nationalised and a single monolithic organisation - the Life Insurance Corporation (LIC) was established under the Life Insurance Corporation of India Act, 1956. It is wholly owned by the Government of India and undertakes the business of life insurance by offering a variety of insurance policies to various segments of the society. In course of undertaking life insurance business, LIC mobilises savings of the masses and employs them in various types of securities and advances. Thus, with a view to safeguard the interests of the policyholders as well as the national interest, the fund at the disposal of LIC are subject to Government regulations. As per the guidelines issued under section 27A of the Insurance Act, 1938, the accretions to the “controlled funds” of LIC were to be invested as follows:

S. No. Investment Avenue Quantum of investment

(a) Central Government Marketable Securities Not less than 20%

(b) Loan to national Housing Bank including (a) above Not less than 25%

(c) Central Govt. & State Govt. Securities including Govt. Guaranteed securities including at (b) above Not less than 50%

(d) Socially-oriented sectors including Public sector, co-operative sector, and (c) above Not less than 75%

Table 7.1 Controlled funds of LIC

In respect of the balance 25 % of the accretion to the controlled funds, the Government had stipulated that the quantum of investment should be as follows:

Investment avenue Quantum of Investment

Loans against policies within surrender values 8%

Immovable properties 2%

Investment in Private Sector 10%

Surplus Cash balance 5%

Table 7.2 Revised investment avenue of LIC

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In1997,theabovesub-classificationofutilisationoffundswasremovedandLICwaspermittedtoinvesttheentireamount under the ceiling of 25 % on the basis of commercial judgement but subject to prudential norms.

[A] Investments in India Rs. crore1 Loans

State Electricity Boards / Power Corporations• 7075State Government for Housing• 2705National Housing Bank• 1002Apex Co-operative Housing Finance Society• 6371Municipalities / Zilla Parishad / Water Supply Sewage Boards• 2000State Road Transport Corporations• 375Companies and Co-operative Societies• 2830Power Generation• 111On Mortgage Property under Mortgage Schemes of LIC• 1152On Insurance Policies• 5020Others• 285

Total 289262 Stock exchange Securities

Govt. of India Securities• 70533State Government Securities• 11925Other Government Guaranteed Marketable Securities• 3556Power Generation (Private Sectors) • 1368Shares• 11482Debentures & Bonds• 15079Others• 90

Total 1140333 Special Deposits with Central Government 20424 Other Investments 906

Total (in India) 145907[B] Investments out of India 458

Grand Total 146365

Table 7.3 Investments policies of LIC

It is to be noted from the above table that the major portion of LIC’s funds are invested in Stock Exchange Securities pre-dominantly in Government guaranteed securities. Corporate securities are accountable for a small proportion oftotalinvestment.Amongstloansalso,bulkoftheassistancehasgonetofinancinghousing,electricitygenerationandwatersupply.CorporateSectorgotaninsignificantportion.Thus,attheendofMarch2000,thesector-wisebreak up of investment was as follows:

Public Sector: 84.2 %•Co-operative Sector: 1.53%•Private Sector: 14.27%•Thus, the total comes to 100.00%

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7.3 General Insurance Corporation of IndiaGeneral Insurance Corporation of India (GIC) was formed in 1973 after the nationalisation of a large number of general insurance companies. GIC has 4 subsidiary companies - National Insurance Company Limited, New India Insurance Company Limited, Oriental Fire and General Insurance Company Limited and the United India Insurance Company Limited. Thus, GIC along with its four subsidiaries provide a wide range of policies aimed at meeting the varied need of the customers in the area of general insurance. These insurance companies earn their income by way of insurance premia and invest the funds in various types of securities and provide loans to the corporate sector. The investment policy of GIC is governed by the Insurance Act, 1938 and the guidelines issued by the Central Government in this regard. In accordance with the regulations enforced from April 1, 1995 the GIC invested the funds in the following types of securities:

S. No. Investment Avenue Quantum of Investment

(a) Central Government Securities Not less than 20%

(b) State Government Securities & other Government Guaranteed Securities including (a) above Not less than 30%

(c) Housing Loans Not less than 15%

(d) Market Sector Not more than 55%

Table 7.4 Investment scheme of GIC

Thus, GIC was allowed to invest 45 % in socially oriented sector, and the balance 55 % in the market sector.

7.4 Insurance Regulatory and Development Authority (IRDA)Government of India has recently opened the Insurance Sector to the private sector. After the enactment of Insurance Regulatory and Development Authority Act, 1999, IRDA was set up on April 19, 2000, to:

Protect the interest of the policy holders.•Regulate, promote and ensure orderly growth of the insurance business.•

ReserveBankofIndiahasissuedguidelinestopermitthebanksandnon-bankfinancecompaniesbusiness,whichhave:

Net worth of not less than Rs. 500 crore in the insurance sector.•Capital Risk Adjusted Assets Ratio (CRAR) not less than 10%.•Reasonable level of non-performing assets.•Continuouslynetprofitforthelastthreeyears.•A satisfactory track record of the performance of the subsidiaries.•

Such institutions are permitted to set-up joint venture companies for insurance business with risk participation. It hasgrantedcertificatesofregistrationto10lifeinsurancecompaniesand6generalinsurancecompanies.Twelvecompanies have already commenced business. The IRDA has issued Investment Regulations for both Life Insurance and General Insurance Companies in 2001.

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The main points of these guidelines are as follows:Life Insurance BusinessFunds relating to pension, general annuity business and unit linked life insurance business are to be kept separate from the controlled funds of the insurance company. The controlled funds shall be invested in the following manner:

Government Securities 25%

Government Securities or other approved securities including above, not less than 50%

Approved InvestmentsInfrastructure and Social Sector, not less than•Other (to be governed by exposure norms) not exceeding•

15%35%

Table 7.5 Investment of controlled funds

InfrastructureandSocialSectoraredefinedintheseparateregulationsframedbyIRDA.Otherinvestmentshallbegoverned by Exposure Norms. Investment in other than approved investments can, in no case, exceed 15% of the fund. Detailed exposure norms for investments in equity, debentures, terms loans, etc. have been prescribed. It is to be noted from the above regulations, that while investment in Government and other approved securities continue to constitute 50% of the controlled funds, the remaining 50% will be distributed over:

Infrastructure sector•Social sector including Rural sector•Investment in securities of all India Financial Institutions•Deposits with banks•Commercial paper•Treasury bills•Approved investments under Section 27 A•

Thus, in the new regulations, emphasis is laid on insurer’s obligation towards rural and social sectors. Investments in the private sector companies, though permitted, will be subject to exposure limits.

General insurance businessGeneral insurers will keep invested their total assets in the following manner:

Central Government Securities: Not less than 20%•State Government securities and other Government guaranteed securities including above: Not less than 30%•HousingLoanstoStateGovernmentforhousingandfirefightingequipment:Notlessthan5%•Investment in approved investments•

Infrastructure and Social Sector: Not less than 10 % �Others (to be governed by exposure norms): Not less than 55 % �

7.5 Mutual FundsMutualFundisaninvestmentvehicle,whichcollectsthesavingsfromthesurplusunitsbyfloatingvariousunitschemes, and invests the amount so collected in the securities of industrial enterprises. Thus, a Mutual Fund collects the savings of investors who are not able to directly invest their savings into industrial securities and then invests the aggregate funds into securities, which have been thoroughly researched. Mutual Funds, therefore, provides the advantageofprofessionalmanagementforthesavingsofthesmallinvestorsbesidesdiversificationofrisksasthefunds collected are invested into large number of securities and other instruments.

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7.5.1 Schemes of Mutual FundsMutualFundsarepermitted tofloatdifferentUnitSchemeswithdifferentobjectives.Forexample,oneof theobjectives of the schemes may be to provide regular income or utmost liquidity or capital appreciation, etc. Mutual Funds in India have introduced a large number of Unit Schemes. At the end of March, 2001, there were 65 Unit Schemesfloatedbypublicsectormutualfunds(excludingUTI),while158schemeswerefloatedbyprivatesectormutualfunds.Theseschemesarebroadlyclassifiedintotwocategoriesasfollows:

Closed-end SchemesTheschemeswhichareopenforpublicsubscriptionforadefiniteperiod,say2or3monthsarecalledclosed-endschemes. Whatever funds are collected by the schemes during that period constitute the corpus of the scheme, which remainsthesame.Such,schemeshavedefinitematurityperiod,say5or7years,afterwhichtheystandterminated.Mutual Funds redeem the units at the prevailing NAV by liquidating the securities in which they had invested the funds of the scheme. The units of the closed-end schemes are transacted at the stock exchanges.

Open-end SchemesOpen-end Schemes are those, the subscription for which from the investors is solicited on continuing basis. The investors can join the schemes at any time they like. The corpus of the scheme varies over time due to ongoing purchases and redemptions. There is no time for maturity of the scheme.

In case of open-end schemes, the Mutual Fund provides liquidity to the investors by re-purchasing the units at a price linked with NAV. Sometimes, the closed-end schemes are either extended or rolled over i.e. continued for another period; some of them have been later on converted in open-end schemes. The open-end schemes can be wound up if the total numbers of units outstanding (after repurchases) fall below 50% of the original number of investors.

7.5.2 Types of SchemesSomeimportanttypesofUnit-SchemesfloatedinIndiaareasfollows:

Income fund: Its objective is to earn optimum return and maintain a balance of safety, yield and liquidity. The •investmentsaremadelargelyinfixedincomesecurities.Growth fund: Its objective is to generate long-term capital appreciation from a portfolio which is invested in •equity and equity related instruments.Balanced fund: Its objective is to generate capital appreciation along with current income. The investments are •made in combined portfolio of equity and equity related and equity related instruments and debt and money market instruments.Liquid fund: It provides income consistent with a high-level of liquidity. Portfolio comprises of money market •and debt instruments.Gilt fund: Its objective is to generate credit risk-free returns by investing in Central Government and/or State •Government securities.Tax saving plan: It provides tax relief to the investors. Its objective is to generate long-term capital appreciation. •It invests in equity and equity related instruments. There is a lock-in period for the units under this plan i.e. the units cannot be sold till the completion of the lock-in period, say 2 or 3 years.Indexfund:Thisisalsoagrowthfundbutitislinkedtoaspecificindexofshareprices.Itmeansthatthefunds•are invested principally in the securities of companies whose securities are included in the index concerned. Thus, the performance of the funds is linked to the growth in the concerned index, for e.g. NIFTY.Sector fund: It is also a variant of Growth Fund. Under it, funds are invested in equity or equity related instruments •of a selected sector, e.g. technology, pharmaceuticals, etc.

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7.6 Unit Trust of IndiaUnitTrustofIndia(UTI)wasthefirstMutualFundsetupIndiawaybackin1964,undertheUnitTrustofIndiaAct, 1963. It has been given a special status as it has been set up under a separate Law of Parliament and not as a company. Its initial capital Rs. 5 crore was contributed by IDBI, LIC, SBI and its subsidiaries and other Scheduled banks. UTI is managed and controlled by a Board of Trustees. Its chairman is appointed by the Government of India, while four trustees and the Executive Trustee are appointed by IDBI. Other contributors to the initial capital appoint the remaining trustees.

Unit Scheme, 1964 is the oldest and biggest Unit Scheme of the UTI. It is an open-end scheme. Its provisions are incorporated in the UTI Act itself. Besides this scheme, the UTI has introduced a large number of Unit Schemes- both open end and closed end - to mobilise the savings of different classes of investors. These schemes have different investment objectives. As on June 30th, 1998, 79 Unit Schemes were in operation consisting of 28 open-end schemes and 51 closed end schemes. Thus, Unit Trust of India has mobilised the largest amount from unit holders among the Mutual Funds and is the biggest Mutual Fund in India.

7.6.1 Unit Scheme, 1964The UTI sells units under this scheme throughout the year except in the month of June at a price determined by it. It also repurchases these Units from the unit holders at a re-purchase price, also determined by it. In July, every year UTI announces concessional sale and repurchase prices, which are increased continuously during the subsequent months. The UTI Act lays down the formula for determining these prices, which have not been exactly Net Asset Value(NAV)basedtillrecently.Thus,UTIhasbeenauthorisedtofixthesepricesdeviatingfromthebasicprincipleofNAVbasedpricing.Sinceitsinception,theUTIcommandedutmostpublicconfidence.Itgraduallyraisedtherate of dividend on US 64 from 6.10% in 1964-65 to 26% in 1991-92 to 1994-95.

Crisis in US 64Towards the end of September 1998, US 64 faced a serious crisis, when it was reported that US 64’s balance sheet carried negative reserves of Rs. 1098 crores as on June 30th 1998. Thus, it was realised that the net asset value of the Units was below par, while it was selling new units at Rs. 14 per unit. This led to heavy risk for redemption of units by the unit holders and at the same time also resulted in panic selling of equity shares, as large-scale off-loading shares by UTI was expected. Sensex declined by 220 points in a few days. UTI, however, faced the situation with thefinancialassistancefromtheReserveBankofIndia.

Causes of US-64 CrisisA Committee under the Chairmanship of Shri Deepak Parekh investigated the causes of the crisis, which are stated below:

The proportion of equity in the investment portfolio of US-64 increased considerably from 21% in 1986 to •63% in 1998. The share of interest income in the total income of UTI, therefore, fell considerably. Hence, UTI hadtosellgoodqualitysharestobookprofitsinordertomeetdividendobligation.Consequently,thequalityof the residual equity with the UTI deteriorated considerably. Moreover, it invested in many low quality equity issues.As already noted, the sale and repurchase prices were set by UTI without any regard to the Net Asset Values of •underlyingsecurities.Thus,wheneverthesharepricesfluctuated,theunitpricesremainedunaffected,primarilytoretaininvestor’sconfidence.UTI followed the policy of distributing dividends at gradually increasing rates since inception. During 1995-97, •UTI preferred to draw on reserves to maintain dividends rather than to reduce the dividend rate.

By implementing the major recommendations of the Deepak Parekh Committee Report, the UTI felt some improvementinitsfinancialpositionanditdeclaredadividendof13.5%)in1998-99,whichwasmainlythroughbookingprofitsbysellingequities.NAVoftheUS64alsoimproved.ButinJuly2001,US64sufferedanothermajor crisis. The Unit Trust of India slashed the rate of dividend to 10% from 13.5% in the previous year and suspended the sale and repurchase of units for six months till December 2001. Trading in US 64 units was allowed at the National Stock Exchange only.

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ThedeteriorationinthefinancialhealthofUS64schemeswasduetoseveralfactors,namely:Equity market suffered set back from the beginning of 2001, share prices went down by 25%.•UTI faced heavy redemption of Units in April and May, 2001 at the prevailing repurchase price, while the NAV •was much lower.With the decline in share price, capital gains could not be attained, to the desirable extent, to distribute •dividend.Reserves of US 64 consequently turned negative.•

A bailout package for small investors was announced in July, 2001. Unit holders with holding of up to 3000 units were allowed the repurchase facility at Rs. 10 per unit from August 1st, 2001. This repurchase price was increased by 10 paisa per unit every month till it reaches Rs. 12 in May 2003. Later on, this special repurchase facility was permitted for holders of up to 5000 units. From January 2002, US 64 has been made NAV linked scheme. Investors up to 5000 units are permitted to sell either at the above-mentioned assured repurchase price or at NAV linked price, whichever is higher. But units above 5000 are to be sold at NAV linked price from January 2002. NAV of US 64 has remained below par. These units were transacted at National Stock Exchange at Rs. 8.25 per unit on July 24, 2001. This price increased to Rs. 9.30 per unit on August 8th, 2001. The NAV has fallen considerably to approximately Rs. 6.50 recently.

ThepresentfinancialpositionofUTIisfarfrombeingsatisfactory.Forthefirsttimeinits38yearoldhistory,ithasdeclared no dividend for the year 2001-02. The Government has been providing budgetary support to unit holders to the extent of the gap between NAV and the assured repurchase price as announced on July 15, 2001. If dividend was declared, it would have increased the gap between the NAV and the special repurchase price and consequently the budgetary commitment of the Government.

UTI is also experiencing short-fall in the monthly income plans maturity in June and August 2002. It has tied up with State Bank of India for a line of credit of Rs. 1000 crore, with a guarantee from the Central Government. The short-fall would be met through the UTI’s Development Reserve Fund.

The UTI is, thus, surviving on Government support and bank borrowings. The pioneering investment institution isinsuchadeplorablestateofaffairs.Howfaritwillfulfilitscommitmentsandobligation,onlythefuturewillreveal. At present, the UTI has over 58 NAV-linked schemes. Apart from US 64 scheme, all other schemes are SEBI compliant through a voluntary agreement. Even US 64 has become SEBI compliant to the extent that it has been NAV linked since January 1st, 2002. The Government intends to restructure UTI by repealing the Act and bringing the UTI directly under the purview of SEBI Act.

7.7 Other Mutual FundsUTI enjoyed the monopoly position until 1987 when mutual funds were allowed to be set-up in the public sector. Leading public sector banks - State Bank of India and Canara Bank set up their mutual funds, followed by other nationalised banks such as Punjab National Bank, Bank of India and Indian Bank, Life Insurance Corporation and General Insurance Corporation also set up their mutual funds. In 1993, Mutual funds were permitted to be set up in the private sector also. This liberalisation induced a large number of private companies including foreign mutual fundstofloatmutualfundsinIndia.

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7.8 Governance of Mutual FundsMutual Funds are governed by SEBI (Mutual Fund) Regulation Act, 1996. The Securities and Exchange Board of India has issued guidelines for the all-round development and regulation of Mutual Fund Industry. The salient features of these regulations are as follows:

RegistrationoftheMutualFund:AMutualFundcanbesetuponlyafteraCertificateofRegistrationhasbeen•obtained from SEBI on an application made by its sponsor.Sponsor: Sponsor is an entity that establishes mutual fund. The sponsor is required to have a sound track record •andgeneralreputationoffairnessandintegrity.Thesponsorshouldbecarryingonbusinessinfinancialservicesforaperiodofnotlessthanfiveyears;itsnetworthispositiveinalltheimmediatelyprecedingfiveyearsandhasearnedprofitsinthreeoutoftheimmediatelyprecedingfiveyearsincludingthe5th year.Trustees: A Mutual Fund shall be constituted as a Trust Investment Institutions and the Trust Deed should •be registered under the Indian Registration Act, 1908. A person eligible for appointment as a trustee should be a person of ability, integrity and standing. At least 50% (now 2/3d) of the trustees should be independent trustees not associated with sponsors. The role of trustees is to supervise and monitor the activities of the Assets Management Company. The trustees and the Asset Management Company should enter into Investment Management Agreement.Asset Management Company: An Asset Management Company (AMC) should be appointed by the Sponsor or the •Trust, if so authorised by the Trust Deed. The Board of Directors of the Asset Management Company should have at least 50% of the Directors who are independent of the Sponsors or the Trust. The Asset Management Company cannot undertake any other business activity except in the nature of management and advisory services.Custodian: The Mutual Fund should appoint a custodian to carry out the custodial services for the schemes of •the fund.Offer Period: Any scheme of a Mutual Fund should remain open for subscription for a maximum period of 45 •days. The AMC should specify the minimum subscription amount; it seeks to rise under the schemes and the extent of oversubscription it intends to retain, in case of over-subscription.Pricing of Units: The Mutual Fund should calculate the net asset value of each scheme and publish the sale and •repurchase price of the units at least once a week, in case of open ended funds. The Mutual Funds also ensure that the repurchase price is not lower than 93% of the Net asset value and the sale price is not more than 107% of the Net asset value. In case of close-ended schemes, the repurchase price should not be less than 95% of the Net asset value.AcopyoftheofferdocumentforanyschemeoftheMutualFundhastobefiledwithSEBI,whichcansuggest•modificationsintheschemesintheinterestofinvestors.The advertisement in respect of each scheme shall be in conformity with the advertisement code prescribed by •SEBI.Mutual funds are required to invest their funds in transferable securities in the money market or in the capital •market or in privately placed debentures or securitized debts. Investments should be made subject to the investmentrestrictionsspecifiedintheRegulations.Mutual funds are permitted to borrow to meet temporary liquidity needs for the purpose of re-purchase, redemption •of units or payment of interest or dividend to the unit-holders. Such borrowings shall not exceed 20% of the net assets of the scheme and the duration of borrowing shall not exceed 6 months.SEBIhasspecifiedthevaluationnormsaccordingtowhicheveryMutualFundshallcarrybutvaluationofits•investments and publish the same.SEBI is authorised to undertake inspection of the books of accounts, records, infrastructure, systems, etc. and •to investigate the affairs of a Mutual Fund, the trustees and Asset Management Company. SEBI may appoint an auditor also for these purposes.SEBIisauthorisedtosuspendacertificategrantedtoaMutualFundifitcontravenesanyoftheprovisionsof•the SEBI Act and the Regulations or otherwise fails/defaults in meeting its obligations.

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SEBIcanalsocanceltheCertificateofRegistrationgrantedtoaMutualFund,iftheMutualFund:•is guilty of fraud, or has been convicted of an economic offence �has been guilty of repeated defaults �the Mutual Fund, Asset Management Company (AMC), Trustee of the Mutual Fund indulges in price �manipulation or price rigging or cornering activities affecting the securities market and the investor interestfinancialpositionoftheMutualFunddeterioratessothatitscontinuanceisnotintheinterestofunitholders �and other mutual funds

SEBI is also empowered to take action for suspension or cancellation of registration of an intermediary holding •aCertificateofRegistration,who fails to exerciseduediligenceor complywith theobligationsunder theRegulations.

7.9 Investment RestrictionsMutual Funds invest the funds mobilised from the investors Mutual Funds invest the funds mobilised from the investors in Capital Market and Money Market securities. The selection of the securities depends up on the investment objectives of respective Unit Schemes. For example, the growth schemes largely aim at capital appreciation, along with reasonable income. Thus, funds under such schemes are largely invested in equities.

Securities and Exchange Board of India (SEBI) has prescribed the following investment restrictions for Mutual Fund:

All the investments of the Mutual Funds will be in transferable securities (whether in the Capital Market or •Money Market) or bank deposits or in money call or in privately placed debentures and securitized debt.No loans for any purpose can be granted.•Under all its schemes, a Mutual Fund will not own more than 10% of any company’s paid up capital carrying •voting rights.Each scheme shall not invest more than 15% of its Net Asset Value (NAV) in debt instruments issued by a single •issuer, which are rated not below investment grade by a credit rating agency. Such investment may be extended to 20% of the NAV of the scheme with the prior approval of the Trustees and the Board of the AMC. Such limit will not apply to investments in Government securities and money market instruments.Investments within the above limit can be made in mortgage backed’ securitized debts, which are rated not •below investment grade by a credit rating agency.Each scheme shall not invest more than 10% of its NAV in unrated debt instruments issued by a single issuer. •Total investment in such instruments shall not exceed 25% of the NAV of the scheme.Till the funds are deployed as per the investment objective of the scheme, moneys under the scheme may be •invested in short-term deposits of scheduled commercial banks.No scheme of the Mutual Fund shall make any investment in:•

any unlisted security of an associate or group company of the sponsor �any security issued by way of private placement by an associate or group company of the sponsor �the listed securities of group companies of the sponsor which is in excess of 25% of the net assets �

No scheme of the Mutual Fund shall invest more than 10% of its NAV in the equity shares or equity related •instruments of any company.Each scheme shall not invest more than 5% of its NAV in the unlisted equity shares or equity related •instruments.Transfer of investments from one scheme to another scheme in the same Mutual Fund shall be allowed if:•

Such transfers are made at the prevailing market price for quoted securities on short basis. �The securities so transferred shall be in conformity with the investment objective of the schemes to which �such transfer has been made.

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The fund may buy or sell securities on the basis of deliveries and shall not make any short sales or engage in •carryforwardtransactionoffinance.Derivativestransactioninarecognisedstockexchangeispermittedforthe purpose of hedging and portfolio balancing.

7.10 Performance of Mutual Funds in India Till 1993, there were 7 Mutual Funds, all in the public sector, which had launched 116 schemes mobilising Rs. 8,011 crores from the market. Since then the number of Mutual Funds operating in India has grown up to 27, with Mutual Funds being allowed to be set up by private sector companies including foreign companies. The total number of schemesfloatedbythesefundsincreasedto196andthefundsmobilisedtoRs.13,890crorestill1995-96.

The cumulative resources mobilised by Mutual Funds in India till 1995-96 are shown in the following table:

Year (upto) Public Sector Private Sector Sub Total UTI Total

1986-87 - - - 4563.68 4563.68

1987-88 - - - 6738.81 6738.81

1988-89 1621.00 - 1621.00 11834.65 13455.65

1989-90 1460.00 - 1460.00 21376.48 19110.92

1990-91 1683.97 - 1683.00 31805.69 23060.45

1991-92 5476.51 - 5674.51 38976.81 37480.20

1992-93 8011.21 - 8011.21 51978.00 46988.02

1993-94 8407.21 916.00 9323.21 61500.00 61301.21

1994-95 10550.21 3000.00 13550.21 61500.00 75050.21

1995-96 10667.00 3223.00 13890.00 66700.00 80590.00

Table 7.6 Cumulative resources mobilised by Mutual Funds

7.11 Risk FactorsInvestment in the Units of the Mutual Funds is not without inherent risks. Mutual Funds invest in transferable securities at current market prices, which may vary over a period of time. This results in the variation in the Net Asset Value (NAV) of the units. NAV of the Units of the schemes is computed as follows:

NAV (Rs.)Market or fair value of securities investments+ current assets - current liabilities and provisions = No. of outstanding units under the scheme.

TheFundvaluesitsinvestmentsaccordingtothevaluationnorms,asspecifiedinSEBIregulations.NAViscalculatedatthecloseofeverybusinessday.NAVissignificanttotheinvestorsbecauseredemption(orrepurchase)oftheunits by the Fund depends upon the NAV. Sometimes, an exit load is also charged on redemptions. Sometimes, an exit load means that a small amount ½ say or 1 per cent is deducted from the NAV while making repayment to the investors.

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The following risks are involved in investing in Mutual Funds:Mutual Funds and securities investments are subject to market risks. There is no assurance or guarantee that •the scheme’s objectives (e.g. capital appreciation or regular return) will be achieved.The Net Asset Value of units may go up or go down depending on various factors and forces affecting the capital •markets. Thus, the redemption value of the units will also change accordingly.Past performance of the Mutual Fund does not indicate future performance.•The sponsor is not \responsible or liable for any loss or shortfall resulting from the operations of the scheme, •except up to the initial contribution towards the setting up of the Mutual Fund.Investors in the schemes are not being offered any guarantee or assured return.•

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SummaryFinancial institutions facilitate the process of capital accumulation by transferring resources from savers to •investors.Investmentinstitutionshaveoccupiedimportantplaceinthewell-integratedstructureoffinancialinstitution.•InIndia,theLifeInsuranceCorporationofIndiahadbeenthesinglelifeinsuranceinstitutionforoverfive•decades.Mutual Funds have also emerged in India as an intermediary in mobilising people’s savings and employing •them in money market and capital market securities.The activities including investment of funds are regulated by the Regulations issued by the Securities and •Exchange Board of India (SEBI).General Insurance Corporation of India (GIC) was formed in 1973 after the nationalisation of a large number •of general insurance companies.GIC has 4 subsidiary companies - National Insurance Company Limited, New India Insurance Company Limited, •Oriental Fire and General Insurance Company Limited and the United India Insurance Company Limited.The investment policy of GIC is governed by the Insurance Act, 1938 and the guidelines issued by the Central •Government in this regard.The IRDA has issued Investment Regulations for both Life Insurance and General Insurance Companies in •2001.MutualFundisaninvestmentvehicle,whichcollectsthesavingsfromthesurplusunitsbyfloatingvariousunit•schemes, and invests the amount so collected in the securities of industrial enterprises.MutualFundsarepermittedtofloatdifferentUnitSchemeswithdifferentobjectives.•Theschemeswhichareopenforpublicsubscriptionforadefiniteperiod,say2or3monthsarecalledclosed-•end schemes.Open-end Schemes are those, the subscription for which from the investors is solicited on continuing basis.•Liquid Fund Portfolio comprises of money market and debt instruments.•UnitTrustofIndia(UTI)wasthefirstMutualFundsetupIndiawaybackin1964,undertheUnitTrustof•India Act, 1963.A Committee under the Chairmanship of Shri Deepak Parekh investigated the causes of the US 64 crisis.•Mutual Funds are governed by SEBI (Mutual Fund) Regulation Act, 1996.•AMutualFund canbe set uponly after aCertificate ofRegistration has beenobtained fromSEBIon an•application made by its sponsor.Sponsor is an entity that establishes mutual fund.•A Mutual Fund shall be constituted as a Trust Investment Institutions and the Trust Deed should be registered •under the Indian Registration Act, 1908.An Asset Management Company (AMC) should be appointed by the Sponsor or the Trust, if so authorised by •the Trust Deed.

ReferencesPathak, B. V., 2011. • The Indian Financial System: Markets, Institutions and Services. Dorling Kindersley, New Delhi.Machiraju, H. R., 1998• . Indian Financial System.Vikas Publishing House, Delhi.Foreign Institutional Investors: Investment Preferences in India. • [Pdf] Available at: <http://joaag.com/uploads/4_PrasannaFinal3_2_.pdf> [Accessed 25 September 2013].Determinants of Foreign Institutional: Investors’ Investment in India. • [Pdf] Available at: <http://ejbe.org/EJBE2010Vol03No06p57KAUR-DHILLON.pdf> [Accessed 25 September 2013].

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All India Financial Institutions. • [Video online] Available at: <http://www.youtube.com/watch?v=gJxJ24JQHMQ> [Accessed 25 September 2013].Inside India’s Best Known Companies - ICICI -- Chanda Kochhar -- Reviving Investment. • [Video online] Available at: <http://www.youtube.com/watch?v=Z8JGhhPpqm0> [Accessed 25 September 2013].

Recommended ReadingBuckly, A., 1998. • Multinational Finance. 3rd ed., Prentice-Hall of India Private Limited, New Delhi.Apte, P. G., 1998. • International Finance. 3rd ed., Prentice-Hall of India Private Limited, New Delhi.Giddy, I. H., 1997.• Global Financial Markets, AITBS Publishers & Distributors, New Delhi.

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Self AssessmentInIndia,theLifeInsuranceCorporationofIndiahadbeenthesingle______insuranceinstitutionforoverfive1. decades.

propertya. houseb. life c. card.

Which body issues regulations that regulates the activities including the investments of the funds?2. The Securities and Exchange Board of India.a. Exchange Bank of Indiab. Reserve Bank of Indiac. Securities and Employment Board Of Indiad.

The investment policy of GIC is governed by the Insurance Act, 1938 and the guidelines issued by the _________ 3. Government in this regard.

Locala. Stateb. Centralc. Districtd.

Theschemeswhichareopenforpublicsubscriptionforadefiniteperiod,say2or3monthsarecalled_______4. schemes.

open-enda. closed-endb. dual-endc. multi-endd.

Which of the following statement is false?5. AMutualFundcanbesetuponlyafteraCertificateofRegistrationhasbeenobtainedfromSEBIonana. application made by its sponsor.Open-end Schemes are those, the subscription for which from the investors is solicited on continuing b. basis.Financial institutions impede the process of capital accumulation by transferring resources from hoarder c. tofinancier.Mutual Funds are governed by SEBI (Mutual Fund) Regulation Act, 1996.d.

A Committee under the Chairmanship of Shri _____________ investigated the causes of the US 64 crisis.6. Deepak Parekha. Dilip Parekhb. David Parekhc. Dhanush Parekhd.

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Which is an entity that establishes mutual fund?7. Investora. Traderb. Regulatorc. Sponsord.

Which of the following statement is true?8. The Trust Deed should not register under the Indian Registration Act, 1908.a. The Trust Company should manage the Indian Registration Act, 1908.b. The Trust Deed should be registered under the Indian Registration Act, 1908.c. The Trust Pact is not like the Indian Registration Act, 1908.d.

An _______________ should be appointed by the Sponsor or the Trust, if so authorised by the Trust Deed.9. Operative Banking Companya. Asset Management Company b. State Banking Companyc. International Banking Management Companyd.

WhichwasthefirstMutualFundsetupinIndiain1964?10. Unit Trust of Indiaa. Union of India b. Unit Trustworthy of Indiac. Trust and Unit of Indiad.

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Chapter VIII

India and the Global Financial System

Aim

The aim of this chapter is to:

introduce International Monetary Fund•

explain Euromarkets•

explicate Non- residents Indians deposits•

Objectives

The objectives of this chapter are to:

explain European monetary system•

elucidate Asian development bank•

explicateInternationalfinancecorporation•

Learning outcome

At the end of this chapter, you will be able to:

identify direct and portfolio investments•

understand external commercial borrowings•

describe exchange rate•

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8.1 IntroductionInthisageofglobalisation,nocountrycouldremaininisolation.Similaristhecasewiththefinancialsystemofa country. In developing countries like India, there is a greater need for foreign investment depending on foreign sourcesoffinance.Wehavedifferentsourcestoobtainthesame.Thereareinternationalfinancialinstitutions,whichlendforspecificpurposesindeservingcases.Besides,therearevariousotheravenuesoftapingforeigncurrencyresources by Indian corporates both in the form of equity and debt obligations.

DuringrecentyearstherehadbeengrowinginflowoffundsthroughthesechannelsintoIndia.ItisessentialtostudyaboutthesesourcesofexternalfinanceavailabletoIndia.

8.2 International Financial InstitutionsThe various International Financial Institutions are explained in the section below.

8.2.1 International Monetary FundThe International Monetary Fund (IMF) came into existence at the Bretton Woods conference held in July 1944 with 44 countries as its members. Currently, most of the countries, with the exception of Cuba, are its members. IMF is the central institution of the international monetary system. The major objective of IMF is to help its member countries in correcting the balance of payment imbalances. This improvement is brought about through changes in macroeconomic policies. Keeping this in view, IMF conducts studies and recommends changes in the areas of monetary, tariff and exchange rate policies. IMF, in recent times, has taken active role in longer-term efforts to solve the third-world debt problem.

ObjectivesThe objectives of the IMF, as set out in its Articles of Agreement, are as follows:

To promote international monetary co-operation through a permanent institution that provides the machinery •for consultation and collaboration on international monetary problems.To facilitate the expansion and balanced growth of international trade and thereby to contribute the promotion •and maintenance of high levels of employment and real incomes and to the development of the productive resources of all members as primary objectives of economic policy.To promote exchange stability so as to maintain orderly exchange arrangements among members, and avoid •competitive exchange depreciation.To assist in the establishment of a multilateral system of payments in respect of current transactions between •members and in the elimination of foreign exchange restrictions that hamper the growth of world trade.TogenerateconfidenceamongitsmembersbymakingthegeneralresourcesoftheFundtemporarilyavailable•to them. This provides them the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive to national or international prosperity.In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the balance of •payments of its member countries.

Thus, in addition to monitor the proper conduct of the international monetary system, IMF also provides assistance to countries facing temporary balance of payments crisis.

Organisational structureThe IMF is an autonomous organisation with 181 countries as its members. The highest policy-making body is the Board of Governors in which each member-country is represented by a Governor and an alternate Governor. The administrative responsibilities are vested in the Board of Executive Directors.

Exchange ratesAs stated, one of the objectives of IMF is to promote exchange stability. To achieve this, initially each member country was required to establish the par value of its currency in terms of gold or US dollars and to undertake to maintain the same within 1% of the declared par value. The par value was permitted to be changed with the

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prior approval of the IMF. Such a change was permitted if the member country was suffering from a fundamental disequilibrium in its balance of payments. The system came to be known as ‘adjustable peg system’ as it provided for the adjustment of exchange rates.

The above arrangement continued till early seventies of the previous century. After a series of evaluation of the USdollars,thesystemcalledtheBrettonWoodsSystem,finallycollapsedinMarch1973,when14majornationsdecidedtofloattheircurrencies.Currently,about1/3rdoftheIMFmembercountrieshavefloatedtheircurrencies.SomehavefixedparityoftheircurrencywithUSdollars,somehavefixedwithFrenchFrancs,whileothershavefixedwithSDRs.

ResourcesThe main resource of the IMF is the subscription made by the member-countries to its capital. Contribution by each member country is called the Quota, which is based on various factors such as country’s national income, reserves, exports variability and ratio of exports to national income. Initially, member countries were required to subscribe to the quota in the form of gold or US dollars to the extent of 25% and the balance, in the form of country’s own currency. Presently, however, the contribution in gold may be made in the form of Special Drawing Rights (SDRs) orotherforeigncurrencies.Quotasarereviewedatintervalsofnotmorethanfiveyears.In1994,thecapitaloftheIMF was SDR 144.6 billion.

Besides the subscriptions against the quotas received from the member countries, the IMF also has the power to borrow under the “General Agreement to Borrow”. Under this agreement, the ten industrialised countries agreed to lend to the IMF their own currencies up to a limit agreed upon. Originally, IMF could borrow these funds, under this arrangement, only when the participant countries need the funds. However, now the IMF can also have access to thesefundstofinancedrawingsbyothercountries,providedtheborrowingcountriesagreetoeconomicadjustmentprogramme approved by the IMF.

Special Drawing Rights (SDRs)The monetary system propounded at the Bretton Woods played a positive role in the rapid expansion of the world trade. However, one of its major shortcomings was that there was no provision for expanding the supply of international reserves necessary to support expanding trade. This eventually led to increase in holdings of national currencies, and in particular it strengthened the position of US dollars as the international reserve currency. The US dollars became the reserve asset of the new monetary system. But with the world trade growing, the’ need for international liquiditygrew.Tomeetthisneedforinternationalcurrency,continuingdeficitinUSbalanceofpayment,itwasessential to put dollars into the system. This shortage of international liquidity reached its height in late 1960s. The IMF countered this problem by the creation of a new international reserve asset called the ‘Special Drawing Rights (SDRs)’, in 1969.

Originally,theSDRwasequivalenttoafixednumberofdollars.Now,itisabasketofvariouscurrenciessuchasUS dollars, German Deutschmarks, Japanese Yen, French Francs and British Pound Sterling. These SDRs were allocated to the member countries in 1969 just as bonus shares are issued to the shareholders of a company.

Financing schemesOneoftheobjectivesoftheIMFistoprovidefinancialsupporttomembercountries,whicharefacingbalanceofpaymentdeficits.ThemostimportantwindowoffinancingistheDrawingfromtheIMF.Underthisscheme,wheneveramembercountryrequiresforeigncurrencytotideoveritsshort-termdeficitsinthebalanceofpaymentsposition,it tenders its own currency to the IMF and gets the required foreign exchange. This is called as “drawings” from the IMF. Once the balance of payments position of the borrower country improves, it “repurchases” its currency and pays back the foreign currency. Ordinarily, a member can draw not more than 25% of its quota during 12 months period. The aggregate drawing by a member can go up to a level where the IMF 7s holding of the concerned member country’s currency reaches 200% of the quota. For example, if country “A” has a quota of SDR 100, of which 75% has to be contributed in its own currency i.e. country ‘A’ contributed equivalent of SDR 75 in its own currency. Country A can borrow up to a maximum of SDR 125 so that the total holding of the country A’s currency would reach SDR 200 which is 200% of the country’s quota. This condition can, however, be .waived in special circumstances.

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The process of a member country to draw from the IMF is divided into stages or “Tranches”. The borrowing which takes the IMF’s holding of the borrowers’ own currency to 100% of the country’s quota is called the “Reserve Tranche”. Any borrowing beyond the reserve tranche is divided into four equal tranches called the “Credit Tranches”. A country can freely draw upon the reserve tranche but drawings from the credit tranches are subject to scrutiny by the IMF.

TheIMFalsohasotherschemesoffinancialassistance.Someoftheschemesareasfollows:Standby Arrangements: Under this arrangement, a member is allowed to draw upon the resources of the IMF •uptoaspecificlimitandwithinaspecifictimeframe.SuchfacilityistobenegotiatedbetweentheIMFandthe member country. It is similar to the overdraft facility offered by commercial bank.StructuralAdjustmentFacility:Thisschemeisaimedatprovidingfinancialassistancetomembercountriesfacing•prolonged balance of payment problems and as remedial measures follow the medium term macroeconomic structural adjustment programme (SAP). SAP in such countries aims at fostering growth and strengthening the balance of payments position. Loans provided under SAP are in proportion to the member country’s quota. These loans are normally disbursed over a period of three years during which the borrower country has to draw up three-year comprehensive strategy for ensuring structural adjustment.Enhanced Structural Adjustment Facility: This scheme is similar to the Structural Adjustment Facility but is •meantspecifically for thepoorestmember-countrieswhen theyareundertakingastrong threeyearmacro-economic and structural programme.Extended Fund Facility: The Extended Fund Facility has been formulated to assist the member countries in •meetingtheirbalanceofpaymentdeficitsforlongerperiodsandinlargeramountsthanavailableunderthenormal drawings programme. This facility is for countries suffering from serious balance of payments problems due to structural maladjustment in production, trade and prices.

8.2.2 International Bank for Reconstruction and Development (IBRD)International Bank for Reconstruction and Development (IBRD) more popularly known, as World Bank, is also the creator of the Bretton Woods Conference held in 1944. The Institutions in India main function of the World Bank is toprovidelong-termfinancialassistancetoitsmembercountriesfortheirreconstructionanddevelopment.Initially,the World Bank concentrated its efforts on the war-ravaged economies of Europe but later shifted its focus to the development of backward countries.

FunctionsThe main functions of the World Bank are:

To assist in reconstruction and development of its member countries by facilitating investment of capital for •productive purposes.To promote foreign private investment by guaranteeing of or through participation in loans and other investments •of, capital for productive purposes.To make loans for productive purposes out of its own resources or out of the funds borrowed by it where private •capital is not available on reasonable terms.To promote the long-term growth of international trade and the maintenance of equilibrium in the balance of •payments of members by encouraging international investment for the development of the productive resources of members.

Thus, the World Bank provides funds for productive projects, which lead to economic development in its member countries.

Organisational structureThe management of the World Bank consists of a Board of Governors, Executive Directors and a President. Of the 22 Executive Directors, 5 are nominated by the 5 biggest shareholders-USA, UK, Germany, Japan and France. The President acts as the Chairman of the Board of Executive Directors. The voting rights of the Governors and the Executive Directors are proportionate to the share-capital of the member country they represent. Hence, the policies oftheWorldBanktendtobeinfluencedbythelargeshareholdercountries.

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ResourcesThe resources of the World Bank consist of the capital contributions from its member countries besides the borrowings from the international capital markets. Initially, the capital of the World Bank was $ 10,000 million, which was contributed in Gold or US dollars (2%); members own currency (18%) and the balance 80% was kept as reserve, to be contributed whenever called upon. Thus, only 20% of each member-country’s contribution to the capital was available to the Bank for lending purposes, while the balance 80% served as guarantee resource to back the Bank’s borrowings in the international markets. The capital has been enhanced periodically and at present stands at $ 170 billion.

Financial schemesTheWorldBankprovidesfinancialassistancemostlyintheformofdirectloansorguarantees.Theassistanceisprovided for productive purposes such as agriculture and rural development, power, industry and transport projects. The World Bank grants loans having a repayment period of 10 to 35 years. These loans are made to the Governments of member countries or are guaranteed by the Government concerned. The rate of interest charged by the Bank is the estimated cost to the Bank, of borrowed money of comparable maturity period from the market. Besides this, the Bank charges commission @ 1% for the purpose of creating a special reserve against loss and 0.5% for covering the administrative expenses.

Besides the lending activities, the Bank also provides technical assistance in undertaking a full-scale economic survey of the developmental potential of member country and provides technical advice on the assisted projects. IndiahasbeenthesinglelargestborroweroffinancefromtheWorldBank.

8.2.3 International Finance Corporation (IFC)TheInternationalFinanceCorporation(IFC)isanaffiliateoftheWorldBank.OnlythemembersoftheWorldBank can become its members. As the World Bank can provide only loan funds and is not allowed to participate in the equity of a project, IFC was established in 1956 with the mandate to provide equity funds also to the private enterprises.

FunctionsIFC encourages development of the private sector in the member-countries. Its main functions are:

To invest in the private sector of the member countries, in association with private investors and without •Governmentguarantee,incasewheresufficientprivatecapitalisnotavailableonreasonableterms.To provide investment opportunities-both foreign and domestic, and experienced management.•Tostimulateconditionsconducivetotheflowofprivatecapital-bothforeignanddomestic, intoproductive•investments in member countries.

Organisational structureBeinganaffiliateoftheWorldBank,theBoardofGovernorsoftheWorldBankisalsotheBoardofGovernorsof the IFC. Further, the Executive Directors of the World Bank constitute the Board of Directors of IFC, which is responsible for the operations of IFC. The day-to-day operations are conducted under the superintendence of the Executive Vice-President.

ResourcesThe resources of the IFC consist of the capital contributed by the members and the accumulated reserves. It can also borrow resources from the World Bank up to four times of its net worth.

Financing schemesIFC provides long-term loans or invests in the equity capital of a wide variety of productive private enterprises in thedevelopingcountries.Theprojectassistedshouldbeeconomicallyviableandbeneficialtotheeconomyofthemembercountry.TheminimumquantumoffinancialassistanceprovidedbyIFCisUS$1millionandthemaximumis US $ 100 million. Further, IFC’s assistance usually does not exceed 50% of the total investment in a project.

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Besides,directlendingandequityinvestment,IFCalsoprovidesdevelopmentalservicessuchas: identificationandpromotionofprojects,promotionandestablishmentofprivatelyowneddevelopmentalfinancecompanies,encouragement of the growth of capital markets and advisory/technical counsel on measures that will create a climate conducive for the growth of private sector.

8.2.4 International Development Association (IDA)InternationalDevelopmentAssociation(IDA)isanotheraffiliateoftheWorldBankandisalsoreferredtoasthe“soft loan window” of the World Bank. It provides “soft loans” for economically sound projects of social importance to the member countries. The projects funded by IDA typically include projects like construction of roads, bridges, slum dwellings, etc. Such projects fall under the category of “high development priority” due to the impact of their benefitonthedevelopmentoftheareaconcerned,butthereturnsfromtheprojectsarenotsufficienttopaythehighrates of interest on borrowings. The IDA provides loans for such projects free of interest. These loans have longer maturity periods.

Functions and financial assistanceIDAextendsfinancial assistance to highpriority projects in themember countries.Thefinancemaybemadeavailable to the member Governments or to the private enterprises. Advances to private enterprises may be made without government guarantees. IDA also co-operates with other international institutions and member countries inprovidingfinancialand technicalassistance to the lessdevelopedcountries.Salient featuresof thefinancialassistance provided by IDA are as follows:

ThefinancialassistanceprovidedbyIDAisinterestfree.IDAchargesasmallservicecharge@0.75%p.a.on•the amount withdrawn, so as to cover the administrative expenses.Repayment period is usually over 50 years with an initial moratorium of 10 years.•IDAfinancesnotonlytheforeignexchangecomponentbutalsothedomesticcost.•The assistance can also be repaid in the local currency of the borrowing country.•

Organisational StructureAll member countries of the World Bank are eligible to become the member of the IDA. As in the case of IFC, the Board of Governors and Executive Directors of the World Bank are also the Board of Governors and Executive Directors of the IDA.

8.2.5 Asian Development Bank (ADB)Asian Development Bank (ADB) was started in 1966 under the aegis of the United Nations Economic Commission for Asia and Far East (ECAFE). Its membership consists of countries of the Asian region and other regions as well. Thereare47membersoutofwhich32countriesarefromtheAsia-Pacificregionwhile15countriesarefromEuropeand North America.

FunctionsThe main objectives and functions of ADB are:

To promote-investment in the ECAFE region of public and private capital for development purposes.•Toutilisetheavailableresourcesforfinancingdevelopment,givingprioritytothoseregionalandsub-regional•as well as national projects and programmes which will contribute most effectively to the harmonious economic growth of the region as a whole, and having special regard to the needs of the smaller or less developed member countries in the region.To meet the requests of members in the region to assist them in co-ordination of their development policies and •plans so as to achieve better utilisations of their resources making their economies more complementary and promoting the orderly expansion of their foreign trade, in particular, intra regional trade.Toprovidetechnicalassistanceforpreparation,financingandexecutionofdevelopmentprojectsandprogrammes,•includingtheformulationofspecificproposals.

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To co-operate with the United Nations, its organs and subsidiary bodies, in particular ECAFE and with public •international organisations and other international institutions as well as national entities whether public or private and to interest such institutions and entities in new opportunities, for investment and assistance.To undertake such other activities and to provide such other services as may advance its purposes.•

Organisational structureADB’s highest policy-making body is the Board of Governors. The Board of Governors consists of 12 Directors out of which 8 represents regional countries and 4 represent non-regional countries. The President of the Bank is elected by the Board of Governors and is also the Chairman of the Board of Governors.

Resources and financial assistanceThefinancialresourcesoftheBankconsistofequitycapitalcomprisingofsubscribedcapitalandreserves.Besidesequity funds, ADB also has access to funds raised through borrowings and Special Funds comprising of contributions from member countries and amounts previously set aside from the paid-up capital. ADB provides loans out of the equity funds generally to the member countries, which have attained a somewhat higher level of economic development. Loans from the Special Funds are disbursed exclusively to the poorest borrowing countries at highly concessional rates of interests.

8.3 European Monetary SystemAsafirststeptowardstheeconomicunificationofEurope,atreatywassignedin1951,underwhichtheEuropeanCoal and Steel Community (ECSC) was formed. In 1957, the Treaty of Rome was signed and the European Economic Community (EEC) came into existence. The main objective of the EEC was to facilitate an unfettered movement of goods, capital and manpower. As more countries joined, it was decided to establish a European Monetary System. Finally, with the signing of the Maastricht Treaty in 1992, the EEC was renamed as the European Union (EU) and the way was opened for setting up of institutions leading to the establishment of the European Monetary Union (EMU).

Objectives of EMSThe primary objective of the EMS is to provide and enhance monetary stability in the European Community. Its objectives include working towards the improvement in general and economic situation of the countries of the EU in terms of growth, full employment, standard of living, and reduction in regional disparities. It also aims at brining about a stabilising effect on international economic and monetary relations.

The key feature of the EMS is the Exchange-Rate Mechanism (ERM), which links the currencies to one another. EMS’slong-termgoalismonetaryunificationleadingtoasinglecurrencycalledtheEuropeanCurrencyUnit(ECU).TheEMSisoneofthefacetstowardstheeconomicunificationinEurope.Variousstepshavebeentakentoachievethisend.Asafirststep,bordercontrols,whichareusedtoenforcenationalquantitativerestrictionsthatrestrainimports from the rest of the world, have been ended. The intention is to convert these restrictions into Community-wide restrictions. The second step is the elimination of technical barriers to trade by mutual recognition of most barriers and harmonisation of others such as health, safety, and environmental regulations. The principle of mutual recognition implies that products legally marketed in one Member State can circulate freely throughout the EC. The third step is the opening up of the public procurement in four areas not already covered by existing international trade agreements-telecommunications, transportations, energy and water supply.

European Currency Unit (ECU)The European Currency Unit (ECU) is central to the EMS. It is a basket of various currencies of the EU weighted according to the economic strength of each one of them. The quantities of each currency in ECU stay the same while exchangeratefluctuates,asaresultofthesefluctuations,thevaluesand,therefore,theweightageofthevariouscurrencies may change. However, reconstitution or revision of the basket of currencies takes place, usually after everyfiveyears.

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8.4 Euro Market During the 1950s, the erstwhile USSR was earning dollars from the sale of gold and other commodities, which was to be used to purchase grains and other items from the West. USSR did not want to keep the sale proceeds in the USbanks,asitfearedthattheUSgovernmentmightfreezethedeposits,incasethecoldwarintensified.Hence,they approached banks in UK and France who accepted these dollar deposits and invested them partly in the US. Thus, the concept of “Eurodollars” originated.

Thus, a US dollar deposit with a bank in Paris is a Euro dollar deposit as is a Deutschmark deposit by a US company with the Geneva subsidiary of a US bank will still be called a Eurodollar deposit. The real impetus in the growth of Euro dollar market came from the US itself in the form of Regulation Q of the Federal Reserve Act, which put a ceiling on the interest rates that could be paid on bank deposits. Under the regulation, no interest was payable on bank deposits of less than 30 days’ tenure, while interest rates for longer tenure were governed by strict ceilings. Thus, on one hand, the interest rates payable on dollar deposits in the US were restricted. On the other hand, there was no such restriction on deposits outside the US. The banks, outside the US, were able to attract substantial dollar funds by offering higher interest rates than prevailing in the US. Further Regulation of the Federal Reserve Act, encouragedtheflowofdollardepositsfromtheUS.Underthisregulation,bankswererequiredtomaintaincertainpercentage as reserves against the dollar deposits. This regulation was not applicable to the deposits held by the European branches of the US banks. This made the cost of funds of the US branches higher as compared to the outside’ branches, which were able to pass on their saving in lower funds cost to their customers. All these factors encouragedtheflowoffundsfromtheUStobranchesoutsidetheUS.

Euro-currency market is a highly competitive market with free access for new institutions in the market. Consequently, the margin between the rate of interest on the deposits and the advances has narrowed down considerably. The transactions in the market involve large sums of money, which, has led to syndication of loans where a number ofbanksparticipateinalendingprogramme.AspecialfeatureoftheEuro-currencymarketisthe“floatingratesof interest” under which the rates are linked to a base rate such as the London Inter-Bank Offered Rate (LIBOR). The interest rates on the deposits or advances are reviewed periodically in accordance with the LIBOR. The Euro currency market can broadly be divided into 4 segments as follow:

Euro-credit market where the international banks lend funds on a long term medium-term basis.•Euro-bond market where the banks raise funds on behalf of international borrowers.•Euro-currency deposit/market where banks accept deposits usually on short-term basis.•Euro notes market where large corporations borrow funds.•

8.5 India and Foreign CurrencyIndian corporates regularly import capital equipment8 and critical raw materials. To make the payment for the same, they need foreign currencies. Indian industries have been largely dependent on the All-India Financial Institutions fortheirrequirementsofforeigncurrencies.Thesefinancialinstitutionsprovideforeigncurrencyloansnotonlyformeeting the cost of plant and machinery, but also the foreign technical know-how fees as well.

Thesefinancialinstitutions,inturn,raiseresourcesintheinternationalfinancialmarketsandfrommulti-lateralfinancialinstitutions.Apartfromtheabove,thereareothersourcesofraisinglong/mediumtermforeigncurrencyfinanceforIndiancompanieswhicharediscussedbelow:

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8.5.1 External Commercial Borrowings (ECBs)TheGovernmentofIndianowpermitsIndiancompaniestoraisefinanceforexpansionofexistingcapacityandfresh investments through External Commercial Borrowings. As per the guidelines issued by the Government of India, companies are free to raise ECBs from any internationally recognised source such as banks, export credit agencies, suppliers of equipments, foreign collaborators, and international capital markets. The salient features of the ECB guidelines as revised from time to time are as follows:

Average Maturity Period: For ECBs less than USD 20 million equivalents, the minimum average maturity is •threeyears.ForECBsofmorethanUSD20millionequivalents,theminimumaverageperiodisfiveyears.However, 100% Export Oriented Units, are permitted to raise ECBs with minimum average maturity of three years for any amount.QuantumofECBs:AllinfrastructureandGreenfieldprojectsarepermittedtoraiseECBstotheextentof35%of•thetotalprojectcost.Incaseofpowerprojects,moreflexibilityisallowedbasedonthemeritsofeachcase.Rate of Interest: ECBs can be raised at interest rate up to 1 or 2% points over LIBOR depending upon the credit •worthiness of the borrower.End-use of ECBs: ECBs are to be utilised for meeting the foreign exchange costs of capital goods and services. In •case of Infrastructure projects such as Power, Telecom, Roads, Ports, Industrial Parks and Urban Infrastructure, proceeds of ECBs can be used for meeting the project related rupee expenditure. ECBs by corporate borrowers can be used to acquire ships/vessels from Indian shipyards. However, under no circumstances, ECB proceeds can be utilised for investments in real estate and speculation in stock market. Security: The choice of security to be given to the lender is, to be decided by the borrower company. However, •in case the security is in the form of guarantee from an Indian Financial Institution or Bank, no counter guarantee orconfirmationoftheguaranteebyaForeignBank/FinancialInstitutionispermitted.

TheaimoftheGovernmentpolicyregardingExternalCommercialborrowingsistoprovideflexibilityinborrowingsby Indian Corporates and public sector undertakings. At the same time, a safe limit for total external borrowings consistent with provident debt management is to be maintained. The guiding principles for ECB policy are:

To keep maturities long•Low cost•Encourageinfrastructureandexportsectorfinancing.•

EveryyearanECBcapisfixedkeepinginviewtherequirementsofdifferentsectorsandmedium-termbalanceofpayment projections. The debt service ratio is kept within limit. Approvals given for External Commercial Borrowing during the last 3 years have been as follows:

1998-99: US $ million 5,200•1999-00: US $ million 3,398•2000-01: US $ million 2,837•

Gross disbursement of external commercial borrowings (excluding funds raised through India Millennium Deposits of US $ 5.51 billion) amounted to US $ 3.81 billion in 2000-01. The increase over the previous year was mainly on accountofre-financingofpre-paymentofmoreexpensiveloanswithrelativelysofterterms.

8.5.2 Euro-issuesConsequent to the economic liberalisation programme initiated since the 1990s, Indian corporates have been frequently accessing the international capital markets through the issue of bonds and euro-equities collectively called the “Euro-issues”. There are principally two mechanisms- Depository Receipts, which represents the indirect equity investments and the Euro-convertible Bond, which are debt instruments with an option to convert into equity.

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In the Depository Receipts mechanism, the shares issued by the company are held by a depository, which in turn, issues claims against these shares. These claims are called the Depository Receipts. Each receipt has a claim on aspecifiednumberofshares.Theunderlyingsharesarecalledthedepositoryshares.Thedepositoryreceiptsaredenominated in a convertible currency, usually dollars and are generally listed and traded on major stock exchanges. The Issuer Company pays dividends to the depository in the home currency, which is converted into dollars by the depository and distributed, to the depository receipt holders.

Through the mechanism of the Depository receipts, the Issuer Company is able to avoid the payment of listing fees and also the disclosure and reporting requirements of the international stock exchanges. Such depository receipts when issued to investors in the US are called the American Depository Receipts (ADRs). However, there has been emergence of European Depository Receipts (EDRs) and the Global Depository Receipts (GDRs).

The Government of India permitted Indian Companies to issue GDR’s in 1992 and issued guidelines as follows:AnIndiancompanyplanningtoraisefundsthroughtheGDRshasfirsttoobtainpermissionfromtheForeign•Investment Promotion Board (FIPB) Department of Economic Affairs, Govt. of India.End-use restriction: GDR issues are permitted only for the following end-use to be incurred within one-year •from the date of issue :

Financing import of capital goods �Financing domestic purchase/installation of plant, equipment and building �Pre-payment or scheduled payment of earlier external borrowings �Making investments abroad where these have been approved by competent authorities �Equity investment in Joint Ventures and Wholly owned subsidiaries in India �Corporate restructuring, up to a maximum of 25% of the issues proceeds. �

Eligibility:Onlycompanieshavingconsistenttrackrecordofgoodperformance(financialandotherwise)for•a minimum period of three years are allowed to issue GDRs. However, in case of infrastructure projects, this condition is relaxed.Banks, Financial Institutions and Non-banking Finance Companies (NBFCs) registered with RBI are exempted •from the end-use restriction provided that they do not invest the proceeds of the issue in real-estate and stock markets.All India Financial Institutions are also exempted from the end-use restrictions considering the multiplier effect •andbeneficialimpactonthesmall-scaleandmediumindustries,sincetheycannotaccessthesemarketsontheirown.Thereisnorestrictiononthenumberof issues,whichacompanyoragroupofcompaniesmayfloat, ina•financialyear.The company shall be required to specify the proposed end uses of the issue proceeds at the time of making •their application, and will be required to submit quarterly statement of utilisation of funds for the approved end-uses,dulycertifiedbytheirauditors.

8.5.3 Foreign Direct InvestmentsSincetheGovernmentofIndiapermittedtheflowofforeigninvestmentsinIndiain1992,therehasbeenarisingtrendintheinflowofsuchinvestments.Foreigninvestmentsfallintwobroadcategories:

Direct Investment•Portfolio Investment•

Foreign Direct Investments may be held by a person resident outside India (except Bangladesh, Pakistan or Sri Lanka). It can be by way of equity preferences/convertible preferences shares and convertible debentures issued by an Indian Company within prescribed limits. According to the Government’s policy direct foreign investments are permitted in certain sectors through automatic route (i.e. no permission is required). In some other sectors, there are sectoral limits prescribed. In the remaining cases, prior approval of Secretariat for Industrial Assistance (SIA) or

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of Foreign Investment Promotion Board (FIPB) of the Government of India is required. The terms and conditions prescribed by these authorities are to be complied with. Foreign Investments are allowed up to 100% in certain deserving sectors, e.g. exports.

8.5.4 Portfolio InvestmentsUnder the Portfolio Investment Scheme, foreign institutional investors (FII) registered with Securities and Exchange Board of India are permitted by the Reserve Bank of India to purchase shares and convertible debentures of Indian companies through registered brokers at recognised Stock Exchanges in India. These institutions are permitted to invest in India within certain limits only, e.g. each FII can invest up to 10% of total paid up capital of the Indian company or 10% of the paid up value of each convertible debentures issues by an Indian company. Total holding of all FIIs together shall not exceed 24% of the paid up equity capital or paid up value of each series of convertible debentures. The aggregate limit of all FIIs may be increased to 49% with the approval of the general body of shareholders. Purchase through private placement or arrangement is also permitted, subject to the above ceilings. Recently, FIIs have also been permitted portfolio investment through Secondary market up to the applicable sectoral levels of the issued and paid up capital of the company.

Portfolio investment is also permitted for Non-Resident Indians and Overseas Corporate Bodies on a recognised Stock Exchange in India on repatriation or non-repatriation basis, through a registered broker. But each NRI is permitted to hold such shares up to 5% of the paid up value of shares issued by the Indian Company/paid up value of each series of convertible debentures. Aggregate paid up value of shares of all NRIs/OCBs should not exceed 10% of the paid-up value of equity shares/each series of debentures. This limit may be raised to 24% by a special resolution at the General Body Meeting.

8.5.5 Non-Resident Indians DepositsAnothersourceofforeigncurrencyfinanceisthedepositsmadeinIndianBanksbyNon-ResidentIndians.ReserveBank of India has permitted the banks to open mainly three types of deposit accounts in the names of non-resident Indians. These accounts are held in Indian rupees as well as in four major foreign currencies. Under the Foreign Currency Non-Resident (Banks) scheme {FCNR (B)}, deposits are accepted in dollars, pounds, yen and Euro and they are repatriable in the foreign currency also. Under Non-resident External Rupee Accounts (NRERA), accounts are accepted in rupee, which are repatriable in foreign currency but at the prevailing rate of exchange. Non-resident (Non Repatriable) Rupee Deposits Scheme (NRNRRD) does not provide for repatriation of the deposits made in rupees.

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SummaryIn developing countries like India, there is a greater need for foreign investment depending on foreign sources •offinance.The International Monetary Fund (IMF) came into existence at the Bretton Woods conference held in July 1944 •with 44 countries as its members.IMF conducts studies and recommends changes in the areas of monetary, tariff and exchange rate policies.•The IMF countered the problem of international liquidity by the creation of a new international reserve asset •called the ‘Special Drawing Rights (SDRs)’, in 1969.SDRs were allocated to the member countries in 1969 just as bonus shares are issued to the shareholders of a •company. The process of a member country to draw from the IMF is divided into stages or “Tranches”.•The Extended Fund Facility has been formulated to assist the member countries in meeting their balance of payment •deficitsforlongerperiodsandinlargeramountsthanavailableunderthenormaldrawingsprogramme.International Bank for Reconstruction and Development (IBRD) more popularly known, as World Bank, is also •the creator of the Bretton Woods Conference held in 1944.The World Bank provides funds for productive projects, which lead to economic development in its member •countries.The management of the World Bank consists of a Board of Governors, Executive Directors and a President.•The resources of the World Bank consist of the capital contributions from its member countries besides the •borrowings from the international capital markets.The World Bank grants loans having a repayment period of 10 to 35 years.•InternationalDevelopmentAssociation(IDA)isanotheraffiliateoftheWorldBankandisalsoreferredtoas•the “soft loan window” of the World Bank.Asian Development Bank (ADB) was started in 1966 under the aegis of the United Nations Economic Commission •for Asia and Far East (ECAFE).AsafirststeptowardstheeconomicunificationofEurope,atreatywassignedin1951,underwhichtheEuropean•Coal and Steel Community (ECSC) was formed.The key feature of the EMS is the Exchange-Rate Mechanism (ERM), which links the currencies to one •another.

ReferencesRoy, C. S. and Walter, I., 1997. • Global Bankers. Oxford University Press, New York.Solomon, R., 1999. • Money on the Move: The Revolution in International Finance since 1980. Princeton University Press, New Jersey.India: Financial System Stability Assessment Update. • [Pdf] Available at: <http://www.imf.org/external/pubs/ft/scr/2013/cr1308.pdf> [Accessed 25 September 2013].India and the Global Financial Crisis: What Have We Learnt? • [Pdf] Available at: <http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/ICG230611FS.pdf> [Accessed 25 September 2013].Economic Collapse 2014 - US & World. • [Video online] Available at: <http://www.youtube.com/watch?v=v93r5SqUOOE> [Accessed 25 September 2013].India and the Global Economic challenge. • [Video online] Available at: <http://www.youtube.com/watch?v=jcUTozPVe1E> [Accessed 25 September 2013].

Recommended ReadingBuckly, A., 1998. • Multinational Finance. 3 rd ed., Prentice-Hall of India Private Limited, New Delhi.Arora, K. K., 1992. • Development Banking in India. Atlantic Publishers & Dist.Varshney, P. N., 1999. • Indian Financial System and Commercial Banking. Sultan Chand & Sons, Delhi.

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Self AssessmentThe International Monetary Fund came into existence at a conference held in July 1944 with ___ countries as 1. its members.

44a. 14b. 444c. 41d.

Which of the following statement is false?2. The monetary system propounded at the Bretton Woods played a negative role in the rapid expansion of a. the world trade.The IMF countered the problem of international liquidity by the creation of a new international reserve asset b. called the ‘Special Drawing Rights (SDRs)’, in 1969.SDRs were allocated to the member countries in 1969 just as bonus shares are issued to the shareholders c. of a company. The process of a member country to draw from the IMF is divided into stages or “Tranches”d.

AfteraseriesofevaluationoftheUSdollars,thesystemcalledthe______________,finallycollapsedinMarch3. 1973,when14majornationsdecidedtofloattheircurrencies.

Branda Woods Systema. Bretton Woods Systemb. Brittle Woods Systemc. Bretton Work Systemd.

What is the full form of ECSC?4. Entire Coal and Steel Community (ECSC)a. European Class and Steel Community (ECSC)b. European Coal and Steel Community (ECSC)c. European Coal and Ship Community (ECSC)d.

The World Bank provides funds for productive projects, which lead to ___________ development in its member 5. countries.

unstablea. non-stableb. economicc. non-economicd.

Into which broad category does the Foreign investments fall into?6. Direct and Indirect Investmentsa. Rational and Irrational Investmentsb. Portfolio and Ratio Investmentsc. Direct and Portfolio Investmentsd.

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The management of the World Bank consists of a Board of Governors, Executive Directors and a _________.7. Citizena. Residentb. Principalc. Presidentd.

Match the following8.

1. SDRs A. International Bank for Reconstruction and Development

2. IBRD B. Asian Development Bank

3. ECAFE C. Special Drawing Rights

4. ADB D. United Nations Economic Commission for Asia and Far East

1-B, 2-D, 3-A, 4-Ca. 1-A, 2-B, 3-C, 4-Db. 1-C, 2-A, 3-D, 4-Bc. 1-D, 2-C, 3-B, 4-Ad.

InternationalDevelopmentAssociation(IDA)isanotheraffiliateoftheWorldBankandisalsoreferredtoas9. the “_______________” of the World Bank.

soft loan windowa. hard loan windowb. soft loan shutterc. hard loan shutterd.

Which of the following statement is true?10. BeinganaffiliateoftheWorldBank,theBoardofsenateoftheWorldBankisalsotheBoardofGovernorsa. of the IFC.Beingan affiliateof theWorldBank, theBoardofGovernorsof theWorldBank is also theBoardofb. Governors of the IFC.BeinganaffiliateoftheWorldBank,theBoardofcounciloftheWorldBankisalsotheBoardofGovernorsc. of the IFC.BeinganaffiliateoftheWorldBank,theBoardofauthorityoftheWorldBankisalsotheBoardofGovernorsd. of the IFC.

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Case Study I

State Bank of India

BackgroundThe State Bank of India is the oldest and largest bank in India, with more than $250 billion (USD) in assets. It is the second-largest bank in the world in number of branches; it opened its 10,000th branch in 2008. The bank has 84 international branches located in 32 countries and approximately 8,500 ATMs. Additionally, SBI has controlling orcompleteinterestinanumberofaffiliatebanks,resultingintheavailabilityofbankingservicesatmorethan14,600 branches and nearly 10,000 ATMs.SBI traces its heritage to the 1806 formation of the Bank of Calcutta. The bank was renamed the Bank of Bengal in 1809 and operated as one of the three premier “presidency” banks (the presidency banks had the exclusive rights to manage and circulate currency and were provided capital to establish branch networks). In 1921, the government consolidated the three presidency banks into the Imperial Bank of India. The Imperial Bank of India continued until 1955, when India’s central bank, the Reserve Bank of India, acquired the majority interest in the bank and changed its name to the State Bank of India (SBI).In 1959, the Indian government passedtheStateBankofIndiaAct,resultingintheacquisition(majorityshareholding)ofeightstate-affiliatedbanksand the creation of the State Bank of India Group (SBI Group). The SBI itself is now majority owned by the Indian government,whichpurchasedthesharesheldbytheReserveBankofIndia.TheStateBankofIndiaanditsaffiliatebanksareprofiledinthetablebelow.

ProfileoftheStateBankofIndiaandAssociateBanks(May2008)

Bank Name Headquarters Branches ATMs

State Bank of India Mumbai, Maharashtra 10000 8500

State Bank of Bikaner and Jaipur Jaipur, Rajasthan 833 336

State Bank of Hyderabad Hyderabad, Audhra Pradesh 965 450

State Bank of Indore Indore Madhya Pradesh 965 450

State Bank of Mysore Bangalore Karnataka 654 247

State Bank of Patiala Patiala Punjab 766 353

State Bank of Saurashtra Bhavnagar, Gujarat 452 190

State Bank of Travancore Trivandrum, Kerala 706 331

Source: State Bank of India group

Note: The State Bank of Saurashtra has been consolidated into the State Bank of IndiaUnlikeprivate-sectorbanks,SBIhasadualroleofearningaprofitandexpandingbankingservicestothepopulationthroughout India. Therefore, the bank built an extensive branch network in India that included many branches in low-incomeruralareasthatwereunprofitabletothebank.Nonetheless,thebranchesintheseruralareasboughtbankingservicestotensofmillionsofIndianswhootherwisewouldhavelackedaccesstofinancialservices.Thistradition of “banking inclusion” recently led India’s Finance Minister P. Chidambaram to comment, “The State Bank of India is owned by the people of India.”

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A lack of reliable communications and power (particularly in rural areas) hindered the implementation of computerisation at Indian banks throughout the 1970s and 1980s. During this period, account information was typically maintained at the local branches with either semi automated or manual ledger card processing. During the 1990s, the Indian economy began a period of rapid growth as the country’s low labour costs, intellectual capital, and improving telecommunications technology allowed India to offer its commercial services on a global basis.This growth was also aided by the government’s decision to allow the creation of private-sector banks (they had been nationalised in the 1960s). The private-sector banks, such as ICICI Bank and HDFC Bank, altered the banking landscape in India. They implemented modern centralised core banking systems and electronic delivery channels that allowed them to introduce new products and provide greater convenience to customers. As a result, the private-sector banks attracted middle and upper-class customers at the expense of the public-sector banks. Additionally, foreign banks such as Standard Chartered Bank and Citigroup used their advanced automation capabilities to gain market share in the corporate and high-net-worth markets.

State Bank of India Core Systems ModernisationDrivers for a New Core SystemSBI had undertaken a massive computerisation effort in the 1990s to automate all of its branches, implementing a highly customised version of Kindle Banking Systems’ Bankmaster core banking system (now owned by Misys). However, because of the bank’s historic use of local processing and the lack of reliable telecommunications in some areas, it deployed a distributed system with operations located at each branch. Although the computerisation improvedtheefficiencyandaccuracyofthebranches,thelocalimplementationrestrictedcustomers’usetotheirlocal branches and inhibited the introduction of new banking products and centralisation of operations functions. The local implementation prevented the bank from easily gaining a single view of corporate accounts, and management lacked readily available information needed for decision making and strategic planning. The advantages in products andefficiencyoftheprivate-sectorbanksbecameincreasingevidentinthelate1990sasSBI(andIndia’sotherpublic-sector banks) lost existing customers and could not attract the rapidly growing middle market in India. In fact, this technology-savvy market segment viewed the public-sector banks as technology laggards that could not meet their banking needs. As a result, the Indian government sought to have the public-sector banks modernise their core banking systems. In response to the competitive threats and entreaties from the government, SBI engaged KPMG Peat Marwick (KPMG) in 2000 to develop a technology strategy and a modernisation road map for the bank. In 2002, bank management approved the KPMG-recommended strategy for a new IT environment that included the implementation of a new centralised core banking system. This effort would encompass the largest 3,300 branches of the bank that were located in city and suburban areas.

The State Bank of India’s objectives for its project to modernise core systems included:The delivery of new product capabilities to all customers, including those in rural areas.•Theunificationofprocessesacrossthebanktorealiseoperationalefficienciesandimprovecustomerservice.•Provision of a single customer view of all accounts.•TheabilitytomergetheaffiliatebanksintoSBI.•Support for all SBI existing products.•Reduced customer wait times in branches.•Reversal of the customer attrition trend.•

Challenges for the BankThe bank faced several extraordinary challenges in implementing a centralised core processing system. These challengesincludedfindinganewcoresystemthatcouldprocessapproximately75millionaccountsdaily-anumbergreater than any bank in the world was processing on a centralised basis. Moreover, the bank lacked experience in implementing centralised systems, and its large employee base took great pride in executing complex transactions on local in-branch.

(Source: Hunt, R., 2009. State Bank of India, World’s Largest Centralized Core Processing Implementation. [Pdf] Available at: <http://www.tcs.com/sitecollectiondocuments/case%20studies/bancs_case_sbi.pdf> [Accessed 7 October 2013]).

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QuestionsExplain the background of State Bank of India (SBI) in brief?1. AnswerThe State Bank of India is the oldest and largest bank in India. It now has more than $250 billion (USD) in assets. State Bank of India traces its heritage to the 1806 formation of the Bank of Calcutta. The bank was renamed the Bank of Bengal in 1809 and operated as one of the three premier “presidency” banks (the presidency banks had the exclusive rights to manage and circulate currency and were provided capital to establish branch networks). In 1921, the government consolidated the three presidency banks into the Imperial Bank of India. The Imperial Bank of India continued until 1955, when India’s central bank, the Reserve Bank of India, acquired the majority interest in the bank and changed its name to the State Bank of India (SBI).In 1959, the Indian government passed theStateBankofIndiaAct,resultingintheacquisition(majorityshareholding)ofeightstate-affiliatedbanksand the creation of the State Bank of India Group (SBI Group).

State the State Bank of India’s objectives for its project to modernise core systems?2. AnswerThe State Bank of India’s objectives for its project to modernise core systems included:

The delivery of new product capabilities to all customers, including those in rural areas•Theunification of processes across the bank to realise operational efficiencies and improve customer•serviceProvision of a single customer view of all accounts.•TheabilitytomergetheaffiliatebanksintoSBI.•Support for all SBI existing products.•Reduced customer wait times in branches.•Reversal of the customer attrition trend.•

What are the challenges faced by State Bank of India in processing centralised core?3. AnswerThe bank faced several extraordinary challenges in implementing a centralised core processing system. These challengesincludedfindinganewcoresystemthatcouldprocessapproximately75millionaccountsdaily-anumber greater than any bank in the world was processing on a centralised basis. Moreover, the bank lacked experience in implementing centralised systems, and its large employee base took great pride in executing complex transactions on local in-branch.

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Case Study II

The Internet Banking Boom

In 2001, a Reserve Bank of India survey revealed that of 46 major banks operating in India, around 50% were either offering Internet banking services at various levels or planned to in the near future. According to a research report, while in 2001, India’s Internet user base was an estimated 9 Lakhs; it was expected to reach 90 Lakhs by 2003. Also, while only 1% of these Internet users utilised the Internet Banking services in 1998, the Internet banking user base increased to 16.7% by mid-2000.

Many of the major banks like ICICI, HDFC, IndusInd, IDBI, Citibank, Global Trust Bank (GTB), Bank of Punjab and UTI were offering Internet banking services. Based on the above statistics and the analysts’ comments that India had a high growth potential for Internet banking, the players focused on increasing and improving their Internet banking services.

As a part of this, the banks began to collaborate with various utility companies to enable the customers to perform variousfunctionsonline.ICICI’s‘Infinity,’whichwasalreadyaleaderintheIndianInternetbankingarena,beganto allow its customers to pay their online real time shopping bills. HDFC, through its ‘payment gateway’ feature, allowed its Internet banking customers to make online and real time payments for their purchases.

HDFC also entered into tie-ups with various portals to provide these business-to-customer (B2C) e-commerce transactions. Centurion bank acquired an equity stake in the teauction.com portal to bring together buyers, sellers, suppliers, registered brokers and associations in the tea market and eliminate the need for their physical presence at various auctions. As more banks entered Internet banking arena, the competition between the banks also increased. This compelled the banks to focus on capturing new markets and customers and adopting advanced technology on the Internet. In the light of these developments, industry watchers remarked that Internet banking had arrived in a big way. Though it had a long way to go compared to the global standards, it was beginning to be seen as a replacement for the traditional banking set up in the future.

About Internet BankingGlobally, the banking business has always been in the forefront of harnessing technology to improve its services andefficiency.Bankshavebeenquicktoadoptrapidlyevolvingelectronicandtelecommunicationtechnologiestodeliver an extensive line of value added products and services to their customers. By the early 1990s, direct dial-up connections, personal computers, tele-banking and Automated Teller Machines (ATMs) became common in most developed nations. Internet banking evolved in the mid-1990s when Internet and the World Wide Web began to catch on. Soon, many major banks in the US and Europe began to use the Internet to provide banking services.

Internet banking is a web-based service that enables the bank’s authorised customers to access their account information.Itallowsthecustomerstologontothebank’swebsitewiththehelpofabank-issuedidentificationandaPersonalIdentificationNumber(PIN).

Thebankingsystemverifies theuserandprovidesaccess to therequestedservices.Therangeofproductsandservices offered by each bank on the Internet differs widely in their content. Most banks offer Internet banking as a value-added service. Internet banking has also led to the emergence of new banks, which operate only through the Internet and do not exist physically. Such banks are called ‘Virtual’ banks or ‘Internet only’ banks.

The products and services offered by the banks on the Internet can be divided into three types:Information Kiosks: It includes providing information regarding various products and services offered by the •bank to its customers and others in general. The bank’s site receives and answers queries of customers through e-mails.Basic Internet Banking: It includes enabling customers to open new accounts, check account balance and pay •utility bills.

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E-commerce Banking: Banks function as electronic market places (e-market place) enabling customers to use •their accounts for money transfers, bills payment, purchase and sale of securities and online real time purchases and payments.

(Source: THE INDIAN INTERNET BANKING JOURNEY. [Online] Available at: <http://www.scribd.com/doc/18643180/The-Indian-Internet-Banking-Journey-Globally-The-Banking-Business-Has> [Accessed 7 October 2013]).

QuestionsExplain Internet Banking in brief.1. What are the products and services offered by the Banks on the internet?2. Explain the Internet Banking boom.3.

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Case Study III

Banking Policy in Rural India (1969-present)

The banking policy in rural India has changed over the years. It can be summed up in four stages.

The First PhaseThefirstphasewasrightafterthenationalisationofIndia’s14majorcommercialbanksin1969.Theobjectiveofthe nationalisation of banks was for the state to gain access to new liquidity, particularly among the rich farmers, in the countryside. New objectives for rural banking were declared and were termed as “social and development banking”. These objectives are listed below

To provide banking services in previously unbanked or under-banked rural areas.•Toprovidesubstantialcredittospecificactivities,includingagricultureandcottageindustries.•To provide credit to certain disadvantaged groups such as, for example, Dalits and scheduled tribe •households.

It was only after 1969 that a multi-institutional approach to credit provision in the countryside became policy, with commercial banks, RRBs and Co-operative Institutions establishing wide geographical and functional reach in the IndiancountrysideRBIissuedspecificdirectiveswithrespecttosocialanddevelopmentbanking

Setting targets for the expansion of rural branches•Imposing ceilings on interest rates•Setting guidelines for the sectoral allocation of credit•

Atargetof40percentofadvancesforthe“prioritysectors”,namelyagricultureandalliedactivities,andsmall-•scale and cottage industries, was set for commercial banks. Advances to the countryside increased substantially, althoughtheywere,aswastheGreenRevolutionitself,biasedinrespectofregions,cropsandclasses.Thebenefitswere concentrated among the richer classes of cultivators from the north-west and south of India.

The Second Phase (late 1970 and early 1980)Thiswasaperiodwhentherhetoricoflandreformwasfinallydiscardedbytherulingclassesthemselves,andthemajorinstrumentsofofficialanti-povertypolicywerelaunchedforthecreationofemployment.Twostrategiesforemployment generation were as follows

Employment through state-sponsored rural employment schemes•Self-employment generation by means of loans-cum-subsidy schemes targeted at the rural poor•

Thus, began a period of directed credit, during which credit was directed towards the weaker sections. In 1975, theGovernmentestablishedanewnetworkofruralfinancialinstitutionscalledtheRegionalRuralBanks(RRBs),which were promoted by the Government of India State governments and commercial banks. The number of such banks expanded rapidly, and covered 476 districts by 1987. IRDP (1978-79) aimed the creation of productive income-bearing assets among the poor through the allocation of subsidised credit. The IRDP was extended to all rural blocks of the country in 1980. But this programme failed due to the following reasons:

The absence of agrarian reform and decentralised institutions of democratic government•The inadequacy of public infrastructure and public provisioning of support services•The persistence of employment-insecurity and poverty in rural society•

Third PhaseThis phase, which began in 1991, is that of liberalisation. It was recommended that interest rates be deregulated, and capital adequacy norms should be changed to “compete with banks globally”.

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Final PhaseThecurrentfinancingpolicieswereintroducedbyRBItooutreachortopenetratethroughvastsectionofpopulation.In November 2005, policies to include all segments of market were incubated.

QuestionsWhy was there a need for new banking policies for the rural areas?1. Were the policy changes introduced in the second phase good enough? Explain.2. What was the effect of the deregulation of interest rates on rural banking?3.

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Crawford, G and Sen, B., 1996. • Derivatives and Decision Makers: Understanding and Managing Risk. John Wiley & Sons Ltd.Giddy, I. H., 1997. Global Financial Markets, AITBS Publishers & Distributors, New Delhi.•Gomez, C., 2013• . Banking and Finance: Theory, Law and Practice.PHI Learning Private Limited.Guruswamy, S., 2009. Indian Financial System. 2nd ed., Tata Mc-Graw Hill, New Delhi.•Heffernan, S., 2005• . Modern Banking. 1st ed., Wiley.Jain, T.R., Trehan, M. and Trehan, R., • Indian Economy and Business Environment. VK Publications, New Delhi.Kaptan, S. S., 2001. New Instruments of Finance in India. Sarup & Sons, New Delhi. •Machiraju, H. R., 1998. • Indian Financial System. Vikas Publishing House, Delhi.Mishra, S. K., 1990. • Money, Income and Financial Institutions. Pragathi Publications, Delhi.Mithani, D. M., 1990. • Money Banking International Trade and Public Finance. Himalaya Publishing House, Delhi.Prasad, K.N., 2001.• Development of India’s Financial System. Sarup & Sons, New Delhi.Sundaram, K. P. M. and Varshney, P. N., 2000. • Banking and Financial System. Sultan Chand and Sons, Delhi.Sundaram, K. P. M., 1989. • Money, Income and Financial Institutions. Sultan Chand & Sons, New Delhi.Varshney, P. N. and Mittal, D. K., 2002. • Indian Financial System. Sultan Chand & Sons, Delhi.Varshney, P. N., 1999. • Indian Financial System and Commercial Banking. Sultan Chand & Sons, Delhi.

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Self Assessment Answers

Chapter Ia1. a2. c3. d4. a5. a6. c7. b8. a9. c10.

Chapter IIb1. a2. b3. b4. c5. a6. c7. d8. a9. b10.

Chapter IIIa1. d2. b3. c4. c5. b6. d7. c8. d9. a10.

Chapter IVb1. c2. a3. d4. a5. d6. b7. a8. b9. d10.

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Chapter Vb1. b2. c3. c4. b5. a6. c7. b8. a9. b10.

Chapter VIb1. b2. c3. b4. a5. b6. c7. a8. c9. a10.

Chapter VIIc1. a2. c3. b4. c5. a6. d7. c8. b9. a10.

Chapter VIIIa1. a2. b3. c4. c5. d6. d7. c8. a9. b10.