(Indian Financial System)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
The figures in the margin indicate full marks for the questions
1. (a) Fill up the gaps: 1x4=4
a) Under Section 22 of the RBI Act, the RBI issues notes.
b) The bill which does not require any acceptance is called Promissory Note.
c) The company which sets up a mutual fund is called Sponsor.
d) Sponsoring commercial bank contributes 35% of the total share capital of the Regional Rural Bank. (Govt. of India=50%, Sponsor banks=35% and State govt=15%)
(b) Write True or False: 1x4=4
a) Bank deposit is a non-marketable security. True
b) Government bond is a long-term security. True
c) Certificate of deposit can be issued only by commercial bank. False, can also be issued by FIs
d) Credit card is a prepaid card. False
2. Write short notes on (any four): 4x4=16
a) Liquidity management: Liquidity Management: Banks are often evaluated on their liquidity, or their ability to meet cash and collateral obligations without incurring substantial losses. In either case, liquidity management describes the effort of investors or managers to reduce liquidity risk exposure. Liquidity management is significant for any bank because of the following reasons:
1) To honor Cheque: Honoring the cheque in exchange of deposit is the key factor of maintaining public confidence. Although in regulation, the bank has to refund all the deposit at once only in the case of current deposit but in practice the customer has the capacity to refund their deposit whenever they need it. This is so because in saving account the customer is provided the facility to withdraw all the amount after fulfilling certain conditions. Similarly banks provide the facility of loan in the security of fixed deposit certificate upto 95% of total fixed deposits.
2) To maintain cash reserve ratio: The bank hast o maintain sufficient amount of cash reserve to meet statutory obligation and to maintain minimum safety.
3) To meet loan demand: A profitable loan is always an opportunity for the bank. A loan with high potentiality of easy recovering with long duration is regarded as profitable loan for the bank. So bank can wait for the opportunity of investment but the opportunity of profitable investment may not wait for bank. Therefore, to make such profitable investment, bank should have sufficient cash balance.
4) To meet administrative expenses: Bank has to pay administrative expenses in various sectors like payment of salary, rent, electricity charge, telephone billing etc. In a bank other business organization may open the account and can make payment through such bank. But in case of banks they have to pay such expenses from their own cash balance.
5) To pay bills of exchange: The use of credit instruments has been substantially increasing when globalization and trade liberalization have increased the volume of trade substantially. Although in overall credit instruments do not increase the volume of liquidity necessary in the bank, it requires some fraction of bank's liquidity to use for such transaction.
6) To resolve economic fluctuation: Banks are such organizations which are highly dependent upon the current economic situation. Currently banks are facing more volatile environment than ever before. For the banks to continue their business and to win the public confidence, they have to save themselves from the severe effect of the environment. The external factors are prevailing interest rate, demand and supply of loan, saving and investment situation, growth and slacking position of financial market. Similarly the internal factors consist of lending policy of bank, the management capacity and strategy, profit planning and funds flow situation etc. If the management has the capacity to mange the difficult situation and the managers are willing to bear risk, they may lower the liquidity in the bank. So bank has to maintain adequate amount of liquidity to solve the problem created by economic fluctuation.
b) E-banking: E- Banking: The banking services that are provided by a bank through network of computers or internet service to the customers for performing banking transactions in a better way is known as E-Banking. It is the fast, efficient and easy way of banking. It helps the customers to perform banking services easily. It is available to a customer all the time. There are no barriers to it. It has no geographical boundary. It enables the customer to operate his account of a bank from any where in the world. The different types of E-Banking are as follows:
Ø Home Banking: Home banking is a type of E-Banking where the bank’s customer can avail banking services all the time without visiting the bank personally. It is also known as Home-banking. It is of two types - Corporate Banking and Personal Banking.
Ø Tele-Banking: The type of E-Banking in which a customer interfaces with the bank through telephones is known as Tele-Banking. In this banking, a customer has to dial a service number, listen to the voice and follow the directed steps to avail banking services.
Ø Mobile Banking: The service provided by bank through which a customer can avail banking and financial services through mobile telecommunication devices is known as Mobile Banking or M-Banking or SMS Banking. It is based on Internet service.
Ø Card Based Banking: The type of Banking in which a customer undertakes banking services through electromagnetic cards is known as Card Based Banking. The cards that facilitate banking are Debit Cards, Credit Cards, Visa Cards, Smart Cards, etc.
Ø Internet Banking: The type of Banking is which is performed with the help of network of computers or Internet services are known as Internet Banking.
c) Merchant bank: Merchant bankers are body corporate who engaged in issue of securities. It acts as manager or advisor or consultant to issuing company. A merchant banker requires compulsory registration under the regulation 3 of SEBI (Merchant Bankers) Regulations, 1992. These activities mainly includes determining the composition of capital structure, compliance with procedural formalities , appointment of registration , listing of securities, arrangement of underwriting , selection of brokers and bankers, publicity and advertisement agent , private placement of securities, advisory services, etc.
The merchant bankers are responsible to make all efforts to protect the interest of investors. The merchant bankers has to exercise due diligence, high standards of integrity, dignity. The merchant bankers are also responsible in providing adequate information without misleading about the applicable regulations and guidelines. It is now mandatory for all public issue s to be managed by merchant bankers functioning as the lead managers.
Services provided by Merchant Bankers: Following other services are provided by merchant bankers.
1. Corporate counseling: Corporate counseling covers entire field of merchant banking viz project counseling, capital restructuring, project management, loan syndication, working capital, lease financing, portfolio management, underwriting etc. Such counseling is provided to corporate and client units to solve their problems.
2. Project Counseling: Which includes preparing project reports, finance for cost of project, appraising projects from the angle of technical, commercial and financial viability, Getting approval of project from bank/Govt and other agencies & Planning for public issue.
3. Loan Syndication: Arranging loan for big projects not only from one bank or financial institution but from more than one bank or financial institution as amount of loan is very large.
d) Source of funds of commercial banks: Primary Sources of Banks are given below
Ø Deposits: The major source of funds for commercial banks is saving. Deposits are gathered in local markets and typical have lower interest rate. They are relatively stable. Deposits can be classified as demand deposit (current deposits), etc. In case of demand deposits, the sources of funds are simply checking account that do not pay interest and permit unlimited check writing.
Ø Liabilities Management: The another important source of fund for commercial bank is liabilities management. They have to manage it very carefully to minimize risk and achieve goal. The various items included in the liabilities of commercial banks are equity, reserves, borrowings, deposits, new account, money market liabilities, deposit account, wholesale and retail certificate of deposits, negotiable instructs, brokered deposits, interest paying liabilities, short term loan, bills payable and other outstanding expenses.
Ø Repurchase agreement: This represents the temporary borrowing in money market, mainly from excess required reserves loaned to it by other banks or the bank has borrowed fund collateralize by some of its own securities from other bank or a large corporate customer.
Ø Mortgage loans: Long term loans taken generally for constructing building and building under construction serves as collateral are mortgage loans. The principal source of long term borrowing include real estate mortgage and this type of loan may have maturity upto thirty years.
Ø Capital funds: It refers to the long term funds contributed to a bank primarily by its owners. It represents the owner's equity interest in the bank. From the regulator point view, bank capital is divided into two groups - tier 1 and tier 2 capital. Tier 1 capital is known as core or primary capital and tier 2 capital is known as supplementary capital. Under this fund includes common stocks, suppliers, retained earnings and undivided profit.
e) Lead Banking: According to the recommendation of D.R Gadgil study group the RBI introduced Lead Bank Scheme on December 12, 1969. The study group also recommended an area approach to the development of banking and credit structure in the Indian Economy. Under the Lead Banking scheme formulated by the Reserve Bank, districts have been demarcated as lead districts and all the nationalized banks have been charged with the responsibility of lead role in the districts. The concept of a lead bank was formulated in order to involve commercial banks in rural development. It has two fold objectives, namely mobilization of deposits on one hand and providing increased credit to rural development on the other. The objectives of Lead Bank Scheme are:
a) Opening of bank branches in the allotted district.
b) Mobilization of savings of the allotted district.
c) Extending financial assistance/credit facilities for the development of allotted district.
d) To act as leader to bring co-ordination among co-operative bank, commercial bank, and other financial institutions in their respective district.
e) To involve commercial banks in rural development.
Benefits of Lead Bank Scheme are as follows:
a) Branch expansion: There was found more effectiveness in branch expansion, supervision and guidance after introducing the Lead Bank Scheme.
b) Co-operation: There was found more co-operation among commercial bank, Co-operative bank, other financial institution and government authorities after introducing the Lead Bank Scheme.
c) Identification: Identification of unbanked area within district was possible through Lead Bank Scheme.
f) Clearing function of the RBI: A clearing house may be defined as an organization of banks constituted for the purpose of settling inter-bank liabilities due to transfer of deposits by a customer of a particular bank to that of another bank. In India, the RBI acts as the clearing house for settlement of banking transactions. Since all banks have their accounts with the RBI, the RBI can easily settle the claims of various banks against each other with least use of cash. The RBI carries out the function through a cell known as National Clearing Cell and the entire clearing house operations are computerized.
3. (a) Give an overview of the Indian financial system. 14
Ans: Meaning and definition of financial system:
The financial system is possibly the most important institutional and functional vehicle for economic transformation. Finance is a bridge between the present and the future and whether the mobilization of savings or their efficient, effective and equitable allocation for investment, it the access with which the financial system performs its functions that sets the pace for the achievement of broader national objectives.
According to Christy, the objective of the financial system is to “supply funds to various sectors and activities of the economy in ways that promote the fullest possible utilization of resources without the destabilizing consequence of price level changes or unnecessary interference with individual desires.”
According to Robinson, the primary function of the system is “to provide a link between savings and investment for the creation of new wealth and to permit portfolio adjustment in the composition of the existing wealth.
A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the deficit. It is a composition of various institutions, markets, regulations and laws, practices, money manager analyst, transactions and claims and liabilities.
Features of financial system
The features of a financial system are as follows
1. Financial system provides an ideal linkage between depositors and investors, thus encouraging both savings and investments.
2. Financial system facilitates expansion of financial markets over space and time.
3. Financial system promotes efficient allocation of financial resources for socially desirable and economically productive purposes.
4. Financial system influences both the quality and the pace of economic development.
Elements or Structure of Indian Financial System
Role and Importance of Financial System in Economic Development
1. It links the savers and investors. It helps in mobilizing and allocating the savings efficiently and effectively. It plays a crucial role in economic development through saving-investment process. This savings – investment process is called capital formation.
2. It helps to monitor corporate performance.
3. It provides a mechanism for managing uncertainty and controlling risk.
4. It provides a mechanism for the transfer of resources across geographical boundaries.
5. It offers portfolio adjustment facilities (provided by financial markets and financial intermediaries).
6. It helps in lowering the transaction costs and increase returns. This will motivate people to save more.
7. It promotes the process of capital formation.
8. It helps in promoting the process of financial deepening and broadening. Financial deepening means increasing financial assets as a percentage of GDP and financial broadening means building an increasing number and variety of participants and instruments.
In short, a financial system contributes to the acceleration of economic development. It contributes to growth through technical progress.
Weaknesses of Indian Financial System
Even though Indian financial system is more developed today, it suffers from certain weaknesses. These may be briefly stated below:
1. Lack of co-ordination among financial institutions: There are a large number of financial intermediaries. Most of the financial institutions are owned by the government. At the same time, the government is also the controlling authority of these institutions. As there is multiplicity of institutions in the Indian financial system, there is lack of co-ordination in the working of these institutions.
2. Dominance of development banks in industrial finance: The industrial financing in India today is largely through the financial institutions set up by the government. They get most of their funds from their sponsors. They act as distributive agencies only. Hence, they fail to mobilise the savings of the public. This stands in the way of growth of an efficient financial system in the country.
3. Inactive and erratic capital market: In India, the corporate customers are able to raise finance through development banks. So, they need not go to capital market. Moreover, they do not resort to capital market because it is erratic and inactive. Investors too prefer investments in physical assets to investments in financial assets.
4. Unhealthy financial practices: The dominance of development banks has developed unhealthy financial practices among corporate customers. The development banks provide most of the funds in the form of term loans. So there is a predominance of debt in the financial structure of corporate enterprises. This predominance of debt capital has made the capital structure of the borrowing enterprises uneven and lopsided. When these enterprises face financial crisis, the financial institutions permit a greater use of debt than is warranted. This will make matters worse.
5. Monopolistic market structures: In India some financial institutions are so large that they have created a monopolistic market structures in the financial system. For instance, the entire life insurance business is in the hands of LIC. The weakness of this large structure is that it could lead to inefficiency in their working or mismanagement. Ultimately, it would retard the development of the financial system of the country itself.
6. Other factors: Apart from the above, there are some other factors which put obstacles to the growth of Indian financial system. Examples are:
a. Banks and Financial Institutions have high level of NPA.
b. Government burdened with high level of domestic debt.
c. Cooperative banks are labelled with scams.
d. Investors confidence reduced in the public sector undertaking etc.,
e. Financial illiteracy.
(b) Discuss about the major reforms undertaken in the Indian financial system during post-liberalization period. 14
Ans: Economic Reforms in Indian Financial System since 1991
The Indian Government has introduced many Economic Reforms in India since 1991. In 1990-91 India had to face grave economic problem. India was facing serious deficiency in her foreign trade balance and it was increasing. Since 1987-88 till 1990-91 it was increasing in such a rapid scale that by the end of 1990-91 the amount of this deficit balance became 10,644 crores of rupees.
At the same time the foreign exchange stock was also decreasing. In 1990 and 1991 the government of India had to take huge amount of loan from the IMF as compensatory financial facility. Even by mortgaging 46 tons of gold it had taken short term foreign loan from the Bank of England.
At the same time, India was also suffering from inflation, the rate of which was 12% by 1991. The reasons of that inflation were the increase in the procurement price of the agricultural products for distribution, the increase in the amount of monetized deficit in the budget, increase of import cost and decrease in the rate of currency exchange and Administered price like. Thus she was facing trade deficit as well as Fiscal Deficit.
To get relief from such a grave problem the government of India had only two ways before it to take foreign debt and to create favorable conditions within the country for increasing the flow of foreign exchange and also to increase the volume of export. The other was to establish fiscal discipline within the country and to make structural adjustment for the purpose.
Hence the government of India had to introduce a package of reforms which included:
a) To liberalize the industrial policy of the government and to invite foreign investment by privatization of industries and abolishing the license system as a part of that liberalization.
b) To make the import-export policy of the country more liberal and so that the export of Indian goods may become more easy and the necessary raw materials and instruments for both industrial development and production of exportable commodities may be imported and also to facilitate free trade by reducing the import duty.
c) To decrease the value of money in terms of dollar
d) To take huge amount of foreign debt from the IMF and the world Bank for rejuvenating the economic condition of the country and to introduce the structural adjustment in the economic condition of the country as a pre-condition of that debt,
e) To reform the banking system and the tax structure of the country and
f) To establish market economy by withdrawing and restricting government interference on investment.
The main objectives of the new fiscal policy are, however, to establish economic structural adjustment at the first stage and then to establish market economy by removing all controls and restrictions on it. There are two phases in the structural adjustment phase, the stabilization phase where all government expenditures are reduced and the banks are restricted on creating debt. The second phase is the structural adjustment phase where the production of exportable good and the alternative of import goods are increased and at the same time reducing governmental interference in industry, the management skill and productive capacity of the industries are increased through privatization.
Thus the new fiscal policy has introduced three significant things Deregulation, Privatization and Exit Policy. Excepting 15 important industries all other industries have been made free from license system. To encourage foreign investment its highest limit has been increased up to 51%. 38 industries have been made open for foreign investment like the Metal industry, Food Processing industry, Hotel and tourism industry etc. Exit Policy has been introduced in the industries which are running at a loss with surplus staff and the sick industries are scheduled to be closed.
The Economic liberalization have helped India to grow at faster pace. India is now considered one of the major economy of Asia. The Foreign investments in India have increased over the years. Many multinational companies have set-up their offices in India. The per-capita GDP of India have increased, which is a sign of growth and development.
India has emerged as a leading exporter of services, software and information-technology products. Many companies such as Wipro, TCS, HCL Technologies, Tech Mahindra have got worldwide fame. Thus the new economic policy is taking India towards liberal economy or market economy. It has relieved India much of her hardship that she faced in 1990-91.
4. (a) Discuss the recent development that have taken place in the activities of commercial banks. What challenges do they face from the private sector banks? 8+6=14
Ans: The role of banks in India has changed a lot since economic reforms of 1991. These changes came due to LPG, i.e. liberalization, privatization and globalization policy being followed by GOI. Since then most traditional and outdated concepts, practices, procedures and methods of banking have changed significantly. Today, banks in India have become more customer-focused and service-oriented than they were before 1991. They now also give a lot of importance to their rural customers. They are even willing ready to help them and serve regularly the banking needs of country-side India. The changing activities of commercial banks are depicted below:
1. Better Customer Service: Before 1991, the overall service of banks in India was very poor. There were very long queues (lines) to receive payment for cheques and to deposit money. In those days, some bank staffs were very rude to their customers. However, all this changed remarkably after Indian economic reforms of 1991.
Banks in India have now become very customer and service focus. Their service has become quick, efficient and customer-friendly. This positive change is mostly due to rising competition from new private banks and initiation of Ombudsman Scheme by RBI.
2. Foreign Currency Exchange: Banks deal with foreign currencies. As the requirement of customers, banks exchange foreign currencies with local currencies, which is essential to settle down the dues in the international trade.
3. Consultancy: Modern commercial banks are large organizations. They can expand their function to consultancy business. In this function, banks hire financial, legal and market experts who provide advice to customers in regarding investment, industry, trade, income, tax etc.
4. Bank Guarantee: Customers are provided the facility of bank guarantee by modern commercial banks. When customers have to deposit certain fund in governmental offices or courts for a specific purpose, a bank can present itself as the guarantee for the customer, instead of depositing fund by customers.
6. Credit cards: A credit card is cards that allow their holders to make purchases of goods and services in exchange for the credit card’s provider immediately paying for the goods or service, and the card holder promising to pay back the amount of the purchase to the card provider over a period of time, and with interest.
7. ATMs Services: ATMs replace human bank tellers in performing basic banking functions such as deposits, withdrawals, account inquiries. Key advantages of ATMs include:
Ø 24-hour availability
Ø Elimination of labor cost
Ø Convenience of location
8. Debit cards: Debit cards are used to electronically withdraw funds directly from the cardholders’ accounts. Most debit cards require a Personal Identification Number (PIN) to be used to verify the transaction.
9. Home banking: Home banking is the process of completing the financial transaction from one’s own home as opposed to utilizing a branch of a bank. It includes actions such as making account inquiries, transferring money, paying bills, applying for loans, directing deposits.
10. Online banking: Online banking is a service offered by banks that allows account holders to access their account data via the internet. Online banking is also known as “Internet banking” or “Web banking.”
Online banking through traditional banks enable customers to perform all routine transactions, such as account transfers, balance inquiries, bill payments, and stop-payment requests, and some even offer online loan and credit card applications. Account information can be accessed anytime, day or night, and can be done from anywhere.
11. Mobile Banking: Mobile banking (also known as M-Banking) is a term used for performing balance checks, account transactions, payments, credit applications and other banking transactions through a mobile device such as a mobile phone or Personal Digital Assistant (PDA),
12. Accepting Deposit: Accepting deposit from savers or account holders is the primary function of a bank. Banks accept deposit from those who can save money but cannot utilize in profitable sectors. People prefer to deposit their savings in a bank because by doing so, they earn interest.
13. Priority banking: Priority banking can include a number of various services, but some of the popular ones include free checking, online bill pay, financial consultation, and information.
14. Private banking: Personalized financial and banking services that are traditionally offered to a bank’s rich, high net worth individuals (HNWIs). For wealth management purposes,
HNWIs have accrued far more wealth than the average person, and therefore have the means to access a larger variety of conventional and alternative investments. Private Banks aim to match such individuals with the most appropriate options.
Challenges to public sector banks from private sector banks
The world has changed profoundly while public sector banks haven’t adapted adequately. The staggering amount of bad loans is merely the tip of the iceberg. The bigger worry is the rapid loss of market share to private sector competitors. In the past year, private banks accounted for a whopping 68% share of new loans; as a result the market share of public sector banks is expected to decline to 60% or even less within the decade.
The fundamental reason for this is the lack of competitiveness and differentiation. One respected deputy governor of the Reserve Bank of India recently admitted that there is little to differentiate one bank from another besides the signboard. He also stated that the publics sector banks are now lagging behind private sector banks in respect of facilities.
Navigating and surviving a perfect storm requires clarity and decisiveness. The contours of the solution to this wicked problem are fairly well understood. The P.J. Nayak Committee laid out the problem, the diagnosis and remedies with admirable candour. This led to Mission Indradhanush, which has the essential ingredients to help the banking sector get well again. In his final speech to FICCI and IBA, departing RBI governor Raghuram Rajan summarized what needs to be done with clarity and frankness.
The key to transformation lies in a massive upgradation of talent and culture of these organizations—the software more than the hardware. Like every business, banking has become a knowledge and technology intensive enterprise. Banking now requires incredible depth in areas such as risk management, project evaluation, treasury, credit evaluation, fraud detection, real-time monitoring of millions of streams of data, and deep analytics.
(b) Discuss about the organization and management of RBI.
Ans: RESERVE BANK OF INDIA: The Reserve Bank of India is the Central Bank of our country. The Reserve Bank of India is the apex financial institution of the country’s financial system entrusted with the task of control, supervision, promotion, development and planning. Reserve Bank of India came into existence on 1st April, 1935 as per the Reserve Bank of India act 1935. But the bank was nationalised by the government after Independence. It became the public sector bank from 1st January, 1949. Thus, Reserve Bank of India was established as per the Act 1935 and empowerment took place in Banking Regulation Act 1949.
The Reserve Bank of India influences the management of commercial banks through its various policies, directions and regulations. Its role in bank management is quite unique. In fact, the Reserve Bank of India performs the four basic functions of management, viz., planning, organising, directing and controlling in laying a strong foundation for the functioning of commercial banks. Reserve Bank of India has 4 local boards basically in North, South, East and West – Delhi, Chennai, Calcutta, and Mumbai.
ORGANISATION STRUCTURE AND MANAGEMENT OF THE RESERVE BANK OF INDIA
The Reserve Bank was set up as corporate body. The organizational structure of the Reserve Bank is provided by the Reserve Bank of India Act, 1934. It comprises of the – (a) Central Board and (b) Local Boards.
a) Central Board: The Central Board of Directors is the supreme governing body of the Bank. It consists of 20 members. The members include the following:
1) A Governor and not more than four Deputy Governors to be appointed by the Central Government.
2) Four Directors to be nominated by the Central Government, one each from the four local boards.
3) Ten Directors to be nominated by the Central Government. They are experts from the fields of business, industry, finance and co-operation.
4) One Government Official (Secretary, Ministry of Finance) to be nominated by the Central Government.
The power of the Board vests with the Governor who is the Chief Executive Officer of the Bank. The Governor has the responsibility of directing the affairs and business of the Bank. The Governor and Deputy Governors hold office for a period of 5years and are eligible for the reappointment. The Governor in his work is assisted by four Deputy Governors and four Executive Directors. The executive directors are not the members of the Central Board but attend Board meetings by invitation. They are subordinate to Deputy Governors.
b) Local Boards: Apart from Central Board of Directors, four Local Boards are constituted representing each area specified in the first schedule to the Act. There is a Local Board in Eastern, Western, Northern and Southern regions of the country with headquarters at Kolkata, Mumbai, New-Delhi and Chennai.
Local Board consists of five members, each appointed by the Central Government. They represent territorial and economic interest in their respective areas. In each Local Board, a Chairman is elected from amongst the members. The members of the Local Board hold office for a period of four years and are eligible for reappointment.
The Local Board carry out the functions of advising the Central Board on such matters of local importance as may be generally or specifically referred to it or perform such functions as may be delegated to it from time to time. Generally a Local Board deals with the management of regional commercial transactions.
5. (a) Define money market. Explain the different sub-markets of money market. 4+10=14
Ans: Meaning of Money Market: The money market is not a well-defined place where the business is transacted as in the case of capital markets where all business is transacted at a formal place, i.e. stock exchange. The money market is basically a telephone market and all the transactions are done through oral communication and are subsequently confirmed by written communication and exchange of relative instruments.
According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is a place where short term surplus investible funds at the disposal of financial and other institutions and individuals are bid by borrowers, again comprising institutions and individuals and also by the government.
From the above definition, it is clear that the money market consist of many sub-market such as the inter-bank call money, bill discounting, treasury bills, Certificate of deposits (CDs), Commercial paper (CPs), Repurchase Options/Ready Forward (REPO or RF), Inter-Bank participation certificates (IBPCs), Securitized Debts, Options, Financial Futures, Forward Rate Agreement (FRAs), etc. which collectively constitute the money market.
MONEY MARKET INSTRUMENTS (Constituents) or Structure of Indian money Market
The entire money market can be divided into two parts. They are
a) Organised money market
b) Unorganized money market.
Organised money markets are also known as authorised money market and unorganized money markets are known as unauthorized money market. Both of these components comprises off several components which are illustrated below with the help of a chart:
After studying above organizational chart of the Indian money market it is necessary to understand various components or sub markets within it. They are explained below.
1. Call Money: Call/Notice money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and up to 14 days it is called 'Notice money' otherwise the amount is known as Call money'. Intervening holidays and/or Sundays are excluded for this purpose. No collateral security is required to cover these transactions
Features of Call Money:
i. The call market enables the banks and institutions to even out their day-to-day deficits and surpluses of money.
ii. Commercial banks, Co-operative Banks and primary dealers are allowed to borrow and lend in this market for adjusting their cash reserve requirements.
iii. Specified All-India Financial Institutions, Mutual Funds and certain specified entities are allowed to access Call/Notice money only as lenders.
iv. It is a completely inter-bank market hence non-bank entities are not allowed access to this market.
v. Interest rates in the call and notice money market are market determined.
2. TREASURY BILLS MARKET: In the short term, the lowest risk category instruments are the treasury bills. RBI issues these at a prefixed day and a fixed amount. These are four types of treasury bills.
i. 14-day Tbill- maturity is in 14 days. Its auction is on every Friday of every week. The notified amount for this auction is Rs. 100 crores.
ii. 91-day Tbill- maturity is in 91 days. Its auction is on every Friday of every week. The notified amount for this auction is Rs. 100 crores.
iii. 182-day Tbill- maturity is in 182 days. Its auction is on every alternate Wednesday (which is not a reporting week). The notified amount for this auction is Rs. 100 crores.
iv. 364-Day Tbill- maturity is in 364 days. Its auction is on every alternate Wednesday (which is a reporting week). The notified amount for this auction is Rs. 500 crores.
A considerable part of the government's borrowings happen through Tbills of various maturities. Based on the bids received at the auctions, RBI decides the cut off yield and accepts all bids below this yield.
3. INTER-BANK TERM MONEY: Interbank market for deposits of maturity beyond 14 days and up to three months is referred to as the term money market. The specified entities are not allowed to lend beyond 14 days. The development of the term money market is inevitable due to the following reasons
i. Declining spread in lending operations
ii. Volatility in the call money market
iii. Growing desire for fixed interest rates borrowing by Corporates
iv. Move towards fuller integration between forex and money market
v. Stringent guidelines by regulators/management of the institutions
4. CERTIFICATE OF DEPOSITS: After treasury bills, the next lowest risk category investment option is the certificate of deposit (CD) issued by banks and FIs. CDs are issued by banks and FIs mainly to augment funds by attracting deposits from Corporates, high net worth individuals, trusts, etc. the issue of CDs reached a high in the last two years as banks faced with reducing deposit base secured funds by these means. The foreign and private banks, especially, which do not have large branch networks and hence lower deposit base use this instrument to raise funds.
The rates on these deposits are determined by various factors. Low call rates would mean higher liquidity in the market. Also the interest rate on one-year bank deposits acts as a lower barrier for the rates in the market.
5. INTER-CORPORATES DEPOSITS MARKET: Apart from CPs, Corporates also have access to another market called the inter- Corporates deposits (ICD) market. An ICD is an unsecured loan extended by one Corporates to another. Existing mainly as a refuge for low rated Corporates, this market allows funds surplus Corporates to lend to other Corporates. Also the better-rated Corporates can borrow from the banking system and lend in this market. As the cost of funds for a Corporates in much higher than a bank, the rates in this market are higher than those in the other markets. ICDs are unsecured, and hence the risk inherent in high. The ICD market is not well organised with very little information available publicly about transaction details.
6. COMMERCIAL PAPER MARKET (CP): CPs is negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold on discount basis. Companies can issue CPs either directly to the investors or through banks / merchant banks (called dealers). These are basically instruments evidencing the liability of the issuer to pay the holder in due course a fixed amount (face value of the instrument) on the specified due date. These are issued for a fixed period of time at a discount to the face value and mature at par.
7. READY FORWARD CONTRACT: It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds.
(b) What is secondary market? Distinguish between primary market and secondary market. 5+9=14
Ans: Secondary market or Stock exchange is a specific place, where trading of the securities, is arranged in an organized method. In simple words, it is a place where shares, debentures and bonds (securities) are purchased and sold. The term securities include equity shares, preference shares, debentures, government bonds, etc. including mutual funds.
According to the Securities Contracts (Regulation) Act 1956, the term 'stock exchange' is defined as ''An association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling of business in buying, selling and dealing in securities."
Husband and Dockerary have defined stock exchange as: "Stock exchanges are privately organized market which are used to facilitate trading in securities."
In simple Words, a stock exchange provides a platform or mechanism to, the investors - individuals or institutions to purchase or sell the securities of the companies, Government or semi Government institutions. It is like a commodity market where securities are bought and sold. It is an important constituent of capital market.
From the above discussion, we get the following important features of a stock exchange:
Ø Stock exchange is a place where buyers and sellers meet and decide on a price.
Ø Stock exchange is a place where stocks or all types of securities are traded.
Ø Stock exchange is at physical location, where transactions are carried out on a trading floor.
Ø The purpose of a stock exchange or market is to facilitate the exchange of securities between buyers and sellers, thus reducing the risk.
Differences between primary and secondary market
It deals in new securities which are issue for the first time.
It deals in already issued securities.
For Primary market, no organizational set up required.
But for a secondary market, a proper organizational set up is required.
Life of primary market is limited to point of issue of securities.
But Secondary Market has perpetual life.
It provides funds to the issuers for a particular purpose.
Funds from sell of shares can be utilised in any manner.
Individual issues are managed individually.
Manage and controlled by a central authority.
No fixed place for market.
Located at known fixed places.
6. (a) Explain the different types of mutual fund schemes in India. 14
Ans: Types of Mutual Fund: Types of Funds
1. Open-Ended Funds, Close-Ended Funds and Interval Funds:
a) Open-ended funds are open for investors to enter or exit at any time, even after the NFO.
b) Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO.
c) Interval funds combine features of both open-ended and close ended schemes. They are largely close-ended, but become openended at pre-specified intervals.
2. Actively Managed Funds and Passive Funds
a) Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher.
b) Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs.
3. Debt, Equity and Hybrid Funds
a) A scheme might have an investment objective to invest largely in equity shares and equity-related investments like convertible debentures. Such schemes are called equity schemes.
b) Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.
c) Hybrid funds have an investment charter that provides for a reasonable level of investment in both debt and equity.
Types of Debt Funds
a. Gilt funds invest in only treasury bills and government securities, which do not have a credit risk.
b. Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities.
c. Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality.
d. Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme.
e. Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market.
f. Liquid schemes or money market schemes are a variant of debt schemes that invest only in debt securities where the moneys will be repaid within 91-days.
Types of Equity Funds
a. Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors.
b. Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.
c. Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc.
d. Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investor is expected to retain the Units for at least 3 years.
e. Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and therefore, dividend represents a larger proportion of the returns on those shares.
f. Arbitrage Funds take contrary positions in different markets / securities, such that the risk is neutralized, but a return is earned.
Types of Hybrid Funds
a. Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities.
b. Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market.
4. Gold Funds: These funds invest in gold and gold-related securities. They can be structured in either of the following formats:
5. Gold Exchange Traded Fund, which is like an index fund that invests in gold. The structure of exchange traded funds is discussed later in this unit. The NAV of such funds moves in line with gold prices in the market.
6. Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies.
7. Real Estate Funds: They take exposure to real estate. Such funds make it possible for small investors to take exposure to real estate as an asset class. Although permitted by law, real estate mutual funds are yet to hit the market in India.
8. Commodity Funds: The investment objective of commodity funds would specify which of these commodities it proposes to invest in.
9. International Funds: These are funds that invest outside the country. For instance, a mutual fund may offer a scheme to investors in India, with an investment objective to invest abroad.
10. Fund of Funds: Such funds invests in another fund. Similarly, funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds.
11. Exchange Traded Funds: Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock exchange.
(b) How does SEBI protect the interest of investors? Explain. 14
Ans: SECURITIES AND EXCHANGE BOARD OF INDIA
With the growth in the dealings of stock markets, lot of malpractices also started in stock markets such as price rigging, ‘unofficial premium on new issue, and delay in delivery of shares, violation of rules and regulations of stock exchange and listing requirements. Due to these malpractices the customers started losing confidence and faith in the stock exchange. So government of India decided to set up an agency or regulatory body known as Securities Exchange Board of India (SEBI).
Securities Exchange Board of India (SEBI) was set up in 1988 to regulate the functions of securities market. SEBI promotes orderly and healthy development in the stock market but initially SEBI was not able to exercise complete control over the stock market transactions.
It was left as a watch dog to observe the activities but was found ineffective in regulating and controlling them. As a result in May 1992, SEBI was granted legal status. SEBI is a body corporate having a separate legal existence and perpetual succession.
Purpose and Role of SEBI: SEBI was set up with the main purpose of keeping a check on malpractices and protect the interest of investors. It was set up to meet the needs of three groups.
Objectives of SEBI: The overall objectives of SEBI are to protect the interest of investors and to promote the development of stock exchange and to regulate the activities of stock market. The objectives of SEBI are:
1. To regulate the activities of stock exchange.
2. To protect the rights of investors and ensuring safety to their investment.
3. To prevent fraudulent and malpractices by having balance between self regulation of business and its statutory regulations.
4. To regulate and develop a code of conduct for intermediaries such as brokers, underwriters, etc.
Functions of SEBI: The SEBI performs functions to meet its objectives. To meet three objectives SEBI has three important functions. These are:
i. Protective functions
ii. Developmental functions
iii. Regulatory functions.
Protective Functions: These functions are performed by SEBI to protect the interest of investor and provide safety of investment.
(a) SEBI has issued guidelines to protect the interest of debenture-holders wherein companies cannot change terms in midterm.
(b) SEBI is empowered to investigate cases of insider trading and has provisions for stiff fine and imprisonment.
(c) SEBI has stopped the practice of making preferential allotment of shares unrelated to market prices.