Indian Financial System

Financial System

An institutional framework existing in a country to enable financial transactions

Three main parts Financial assets (loans, deposits, bonds,

equities, etc.) Financial institutions (banks, mutual funds,

insurance companies, etc.) Financial markets (money market, capital

market, forex market, etc.) Regulation is another aspect of the financial

system (RBI, SEBI, IRDA,)

FUNCTIONS OF FINANCIAL SYSTEM

The financial system transfer resources across time, sectors, and regions.

The financial system manages risks for the economy-(Fire Insurance)

The financial system pools and subdivides funds depending upon the need of the individual saver or investor.

Performs an important clearinghouse function, which facilitates transactions between payers and payees.

Financial Assets/Instruments

Enable channelising funds from surplus units to deficit units

There are instruments for savers such as deposits, equities, mutual fund units, etc.

There are instruments for borrowers such as loans, overdrafts, etc.

Like businesses, governments too raise funds through issuing of bonds, Treasury bills, etc.

Instruments like PPF, KVP, etc. are available to savers who wish to lend money to the government

Major Financial Instruments

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

Savers

Financial marketsFinancial markets

Savers

Financial Intermediaries

Investors

Financial flows in the economy

Mutual funds buys diversified portfolio of stocks

Purchase of Govt. Bonds

Save salary

Business borrows

Bonds, IPO

Financial Institutions

Includes institutions and mechanisms which Affect generation of savings by the community Mobilisation of savings Effective distribution of savings

Institutions are banks, insurance companies, mutual funds- promote/mobilise savings

Individual investors, industrial and trading companies- borrowers

Financial Markets

Money Market- for short-term funds (less than a year) Organised (Banks) Unorganised (money lenders, chit funds, etc.)

Capital Market- for long-term funds Primary Issues Market Stock Market Bond Market

Organised Money Market

Call money market Bill Market

Treasury bills Commercial bills

Bank loans (short-term) Organised money market comprises RBI,

banks (commercial and co-operative)

Purpose of the money market

Banks borrow in the money market to: Fill the gaps or temporary mismatch of funds To meet the CRR and SLR mandatory

requirements as stipulated by the central bank To meet sudden demand for funds arising out of

large outflows (like advance tax payments)

Call money market serves the role of equilibrating the short-term liquidity position of the banks

Call money market (1)

Is an integral part of the Indian money market where day-to-day surplus funds (mostly of banks) are traded.

The loans are of short-term duration (1 to 14 days). Money lent for one day is called ‘call money’; if it exceeds 1 day but is less than 15 days it is called ‘notice money’. Money lent for more than 15 days is ‘term money’

The borrowing is exclusively limited to banks, who are temporarily short of funds.

Call money market (2)

Call loans are generally made on a clean basis- i.e. no collateral is required

The main function of the call money market is to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary deficit of funds

The call market helps banks economise their cash and yet improve their liquidity

It is a highly competitive and sensitive market It acts as a good indicator of the liquidity position

Call Money Market Participants

Those who can both borrow and lend in the market – RBI , banks and primary dealers

Once upon a time, select financial institutions viz., IDBI, UTI, Mutual funds were allowed in the call money market only on the lender’s side

These were phased out and call money market is now a pure inter-bank market (since August 2005)

Developments in Money Market

Prior to mid-1980s participants depended heavily on the call money market

The volatile nature of the call money market led to the activation of the Treasury Bills market to reduce dependence on call money

Emergence of market repo and collateralised borrowing and lending obligation (CBLO) instruments

Turnover in the call money market declined from Rs. 35,144 crore in 2001-02 to Rs. 14,170 crore in 2004-05 before rising to Rs. 21,725 crore in 2006-07

Bill Market Treasury Bill market- Also called the T-Bill market

These bills are short-term liabilities (91-day, 182-day, 364-day) of the Government of India

It is an IOU of the government, a promise to pay the stated amount after expiry of the stated period from the date of issue

They are issued at discount to the face value and at the end of maturity the face value is paid

The rate of discount and the corresponding issue price are determined at each auction

RBI auctions 91-day T-Bills on a weekly basis, 182-day T-Bills and 364-day T-Bills on a fortnightly basis on behalf of the central government

Money Market Instruments (1)

Money market instruments are those which have maturity period of less than one year.

The most active part of the money market is the market for overnight call and term money between banks and institutions and repo transactions

Call money/repo are very short-term money market products

Money Market Instruments(2)

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

Certificates of Deposit CDs are short-term borrowings issued by all scheduled

banks and are freely transferable by endorsement and delivery.

Introduced in 1989 Maturity of not less than 7 days and maximum up to a

year. FIs are allowed to issue CDs for a period between 1 year and up to 3 years

Subject to payment of stamp duty under the Indian Stamp Act, 1899

Issued to individuals, corporations, trusts, funds and associations

They are issued at a discount rate freely determined by the market/investors

Commercial Papers

Short-term borrowings by corporates, financial institutions, primary dealers from the money market

Can be issued in the physical form (Usance Promissory Note) or demat form

Introduced in 1990 When issued in physical form are negotiable by endorsement

and delivery and hence, highly flexible Issued subject to minimum of Rs. 5 lacs and in the multiple of

Rs. 5 lacs after that Maturity is 7 days to 1 year Unsecured and backed by credit rating of the issuing

company Issued at discount to the face value

Market Repos

Repo (repurchase agreement) instruments enable collateralised short-term borrowing through the selling of debt instruments

A security is sold with an agreement to repurchase it at a pre-determined date and rate

Reverse repo is a mirror image of repo and reflects the acquisition of a security with a simultaneous commitment to resell

Average daily turnover of repo transactions (other than the Reserve Bank) increased from Rs.11,311 crore during April 2001 to Rs. 42,252 crore in June 2006

Collateralised Borrowing and Lending Obligation (CBLO)

Operationalised as money market instruments by the CCIL in 2003

Follows an anonymous, order-driven and online trading system

On the lenders side main participants are mutual funds, insurance companies.

Major borrowers are nationalised banks, PDs and non-financial companies

The average daily turnover in the CBLO segment increased from Rs. 515 crore (2003-04) to Rs. 32, 390 crore (2006-07)

Evolution of banking services in India

British brought the modern concept of Banking to India But the concept of ‘banking’– was known to us Banking was used in synonymous with money lending Vedic literature records the details of banking

transactions Manusmrithi speaks about – deposits, pledge, loans

and interest rates etc., Sons ‘pious obligation’ – to discharge the loan of the

father

Indian ‘modern banking’

Alexander & Company a leading agency house started managing the Bank of Hindustan in 1770’s.

The Bank of Calcutta was established by the East India Company in 1806

Commercial Bank – in 1819

The concept of limited liability was not known – hence, till 1860 banks had to either obtain a special charter from the crown or had to operate under ‘unlimited liability’

1921 – three Presidency Banks at Calcutta, Bombay and Madras were merged into the Imperial Bank (vide Imperial Bank of India Act, 1920)

Reserve Bank of India was established in 1934

It was given the right of note issue;

Was also to act as ‘bankers bank’;

However, Imperial Bank was allowed to operate as the

agent of RBI, especially in those places where RBI had

no branches.

The RBI was initially a shareholder’s bank –but was

nationalized in 1948 [vide Reserve Bank (Amendment)

Act, 1948] State Bank of India Act, 1955

Imperial Bank was taken over by SBI

• Nationalization was perceived as a major step

in achieving the socialistic pattern of society July 19, 1969 –14 major banks were

nationalized 1980 – 6 more banks were nationalized A detailed scheme of objectives, regulations,

management etc., was drawn-up for these

banks

Bank Nationalization – an important milestone

“the branch network which was 8262 in June 1969

expanded to 60000 by1992 with major expansion (80%) in rural areas. The average number of people served by a branch came down from 60000 to 11000.

the development of credit is more widely spread all over the country as against only in advanced states. In 1969 deposits amounted to 13% of GDP and advances to 10%. By 1990 deposits grew to 30% and advances to 25% of the GDP…Deposits grew from a figure of Rs.4669 crores in July 1969 to Rs.2,75,000 crores on

31.3.1993. More than 45% of the total credit was

directed to the priority sector. More than 45% of the

total deposits were used by the government to fund its

five year plans…”

Types of banking services in India

CENTRAL BANK NON-BANKING FI’’S INSTITUTIONAL BANKS COMMERCIAL BANK SPECIALIZED BANKS

Commercial banking service include – (i) Receiving various types of deposits;

(ii) Giving various types of loans

(iii) Extending some non-banking facilities (i) Locker; (ii) Electricity bill; (iii) Payment of insurance premium etc.,

Examples:SBI AND ASSOCIATE BANKS

NATIONALIZED BANKS

PRIVATE BANKS

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

Special banking Special banking institutions are established

for definite specialized banking services The types of banks accept all types of

deposits but mobilize the amount in its specially focused area

SPECIALIZED BANKS

LAND MORTGAGE

RURAL CREDIT

IND.. DEVELOPMENT

CO-OPERATIVE

HOUSING FINANCE

EXPORT IMPORT

INSTITUTIONAL BANKS

IFCI SFC’’S IDBI ICICI NABARD HDFC

The Narasimham Committee 1990s India had traumatic moments Banks were

burdened with large percentage of non-performing loans .

Customer service had suffered and out-moded practices were in vogue .

Overall re-hauling was needed for entire financial systems in general and banking sector in particular

The Narasimham Committee was set up to recommend changes in financial system

Committee recommends

Overall emphasis upon ‘de-regulation’ No further nationalization to be adhered to No distinction between ‘public’ and ‘private’ sector banks Control of banking sector to be centralized (and not to be

divided between RBI and Dept. of Banking) SLR and CRR should be reduced to prudent levels Concessional lending to be phased out The capital base of banks should meet international

standards the appointment of Chief Executive of the banks to be de-

politicized

Role of a ‘commercial’ and ‘central bank’ -Commercial bank

There is no specific definition (although Banking Regulation Act – defines banking)

The ‘banker’ is one who deals in ‘money’

Two essential functions of banking 1. Borrowing (accepting of deposits) of money; & 2. Lending of money for needy purposes

Besides these essential function a banking company also performs

Other agency and

General utility functions

“a commercial bank mobilizes the savings of the society.This money is then provided to those who are in need of it by granting overdrafts or fixed loans or by

discounting bills of exchange or promissory notes. In short, the primary function of a commercial bank is that of a broker and a dealer in money. By discharging this function efficiently and effectively, a commercial bank renders a very valuable service to the community by increasing the productive capacity of the country and thereby accelerating the pace of economic development. It gathers the small savings of the people, thus reducing to the lowest limits the quantity of idle money…”

“…the banker should always bear in mind that it is the guardian of a very delicate mechanism

which paves the way for failure of economic

development and which, if disturbed, will

create monetary disequilibrium with all the evil

effects incidental thereto…

Indian Banking System

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

Scheduled (Second Schedule of RBI Act, 1934) - 218 Non-Scheduled - 4

Scheduled banks can be classified as: Public Sector Banks (28) Private Sector Banks (Old and New) (27) Foreign Banks (31) Regional Rural Banks (133)

Indigenous bankers

Individual bankers like Shroffs, Seths, Sahukars, Mahajans, etc. combine trading and other business with money lending.

Vary in size from petty lenders to substantial shroffs Act as money changers and finance internal trade

through hundis (internal bills of exchange) Indigenous banking is usually family owned

business employing own working capital At one point it was estimated that IBs met about

90% of the financial requirements of rural India

RBI and indigenous bankers (1)

Methods employed by the indigenous bankers are traditional with vernacular system of accounting.

RBI suggested that bankers give up their trading and commission business and switch over to the western system of accounting.

It also suggested that these bankers should develop the deposit side of their business

Ambiguous character of the hundi should stop Some of them should play the role of discount

houses (buy and sell bills of exchange)

RBI and indigenous bankers (2)

IB should have their accounts audited by certified chartered accountants

Submit their accounts to RBI periodically As against these obligations the RBI promised to

provide them with privileges offered to commercial banks including Being entitled to borrow from and rediscount bills with RBI

The IBs declined to accept the restrictions as well as compensation from the RBI

Therefore, the IBs remain out of RBI’s purview

Development Oriented Banking

Historically, close association between banks and some traditional industries- cotton textiles in the west, jute textiles in the east

Banking has not been mere acceptance of deposits and lending money; included development banking

Lead Bank Scheme- opening bank offices in all important localities

Providing credit for development of the district Mobilising savings in the district. ‘Service area

approach’

Progress of banking in India (1)

Nationalisation of banks in 1969: 14 banks were nationalised

Branch expansion: Increased from 8260 in 1969 to 71177 in 2006

Population served per branch has come down from 64000 to 16000

A rural branch office serves 15 to 25 villages within a radius of 16 kms

However, at present only 32,180 villages out of 5 lakh have been covered

Progress of banking in India (2)

Deposit mobilisation: 1951-1971 (20 years)- 700% or 7 times 1971-1991 (20 years)- 3260% or 32.6 times 1991- 2006 (11 years)- 1100% or 11 times

Expansion of bank credit: Growing at 20-30% p.a. thanks to rapid growth in industrial and agricultural output

Development oriented banking: priority sector lending

Progress of banking in India (3)

Diversification in banking: Banking has moved from deposit and lending to Merchant banking and underwriting Mutual funds Retail banking ATMs Internet banking Venture capital funds Factoring

Profitability of Banks(1)

Reforms have shifted the focus of banks from being development oriented to being commercially viable

Prior to reforms banks were not profitable and in fact made losses for the following reasons: Declining interest income Increasing cost of operations

Profitability of banks (2)

Declining interest income was for the following reasons: High proportion of deposits impounded for CRR

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

Rising costs of operations for banks was because of several reasons: economic and political

Profitability of Banks (3)

As per the Narasimham Committee (1991) the reasons for rising costs of banks were: Uneconomic branch expansion Heavy recruitment of employees Growing indiscipline and inefficiency of staff due to trade

union activities Low productivity

Declining interest income and rising cost of operations of banks led to low profitability in the 90s

Bank profitability: Suggestions

Some suggestions made by Narasimham Committee are: Set up an Asset Reconstruction Fund to take over

doubtful debts SLR to be reduced to 25% of total deposits CRR to be reduced to 3 to 5% of total deposits Banks to get more freedom to set minimum

lending rates Share of priority sector credit be reduced to 10%

from 40%

Suggestions (cont’d)

All concessional rates of interest should be removed Banks should go for new sources of funds such as

Certificates of Deposits Branch expansion should be carried out strictly on

commercial principles Diversification of banking activities Almost all suggestions of the Narasimham

Committee have been accepted and implemented in a phased manner since the onset of Reforms

NPA Management

The Narasimham Committee recommendations were made, among other things, to reduce the Non-Performing Assets (NPAs) of banks

To tackle this the government enacted the Securitization and Reconstruction of Financial Assets and Enforcement of Security Act (SARFAESI) Act, 2002

Enabled banks to realise their dues without intervention of courts

SARFAESI Act Enables setting up of Asset Management Companies to

acquire NPAs of any bank or FI (SASF, ARCIL are examples)

NPAs are acquired by issuing debentures, bonds or any other security

As a second creditor can serve notice to the defaulting borrower to discharge his/her liabilities in 60 days

Failing which the company can take possession of assets, takeover the management of assets and appoint any person to manage the secured assets

Borrowers have the right to appeal to the Debts Tribunal after depositing 75% of the amount claimed by the second creditor

The Indian Capital Market (1)

Market for long-term capital. Demand comes from the industrial, service sector and government

Supply comes from individuals, corporates, banks, financial institutions, etc.

Can be classified into: Gilt-edged market Industrial securities market (new issues and stock

market)

The Indian Capital Market (2)

Development Financial Institutions Industrial Finance Corporation of India (IFCI) State Finance Corporations (SFCs) Industrial Development Finance Corporation (IDFC)

Financial Intermediaries Merchant Banks Mutual Funds Leasing Companies Venture Capital Companies

Industrial Securities Market

Refers to the market for shares and debentures of old and new companies

New Issues Market- also known as the primary market- refers to raising of new capital in the form of shares and debentures

Stock Market- also known as the secondary market. Deals with securities already issued by companies

Financial Intermediaries (1)

Mutual Funds- Promote savings and mobilise funds which are invested in the stock market and bond market

Indirect source of finance to companies Pool funds of savers and invest in the stock

market/bond market Their instruments at saver’s end are called units Offer many types of schemes: growth fund, income

fund, balanced fund Regulated by SEBI

Financial Intermediaries (2)

Merchant banking- manage and underwrite new issues, undertake syndication of credit, advise corporate clients on fund raising

Subject to regulation by SEBI and RBI SEBI regulates them on issue activity and portfolio

management of their business. RBI supervises those merchant banks which are

subsidiaries or affiliates of commercial banks Have to adopt stipulated capital adequacy norms

and abide by a code of conduct

There are other financial intermediaries such as NBFCs, Venture Capital Funds, Hire and Leasing Companies, etc.

India’s financial system is quite huge and caters to every kind of demand for funds

Banks are at the core of our financial system and therefore, there is greater expectation from them in terms of reaching out to the vast populace as well as being competitive.