Indian financial system

Financial System
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An institutional framework existing in a country to
enable financial transactions
Three main parts
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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, FMC)

Financial assets/instruments
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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

Financial Institutions
 Includes
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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)
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Organised (Banks)
Unorganised (money lenders, chit funds, etc.)

 Capital
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Market- for long-term funds

Primary Issues Market
Stock Market
Bond Market

Organised Money Market
 Call

money market
 Bill Market
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Treasury bills
Commercial bills

 Bank

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

Purpose of the money market
 Banks
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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)
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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 (through LAF), 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
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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
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Treasury Bill market- Also called the T-Bill market
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These bills are short-term liabilities (91-day, 182-day, 364day) 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 TBills 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)
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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
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CDs are short-term borrowings in the form of UPN 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
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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
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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)
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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)

Indian Banking System
Central Bank (Reserve Bank of India)
 Commercial banks (222)
 Co-operative banks
Banks can be classified as:
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Scheduled (Second Schedule of RBI Act, 1934) - 218
Non-Scheduled - 4

Scheduled banks can be classified as:
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Public Sector Banks (28)
Private Sector Banks (Old and New) (27)
Foreign Banks (29)
Regional Rural Banks (133)

Indigenous bankers
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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)
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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)
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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
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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
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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)
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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
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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 2030% 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
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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:
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Declining interest income
Increasing cost of operations

Profitability of banks (2)
 Declining

interest income was for the following

reasons:
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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)
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As per the Narasimham Committee (1991) the
reasons for rising costs of banks were:
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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:
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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)
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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
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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:
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Gilt-edged market
Industrial securities market (new issues and stock
market)

The Indian Capital Market (2)
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Development Financial Institutions
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Industrial Finance Corporation of India (IFCI)
State Finance Corporations (SFCs)
Industrial Development Finance Corporation (IDFC)

Financial Intermediaries
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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)
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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)
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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

Conclusion
 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.

Indian financial system

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