Indian financial system

Principles & Practices of
Banking

Module A

Indian Financial System
K Chockalingam
IIBF

Financial System
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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.)

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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 issue of bonds, Treasury bills, etc.
Instruments like PPF, KVP, etc. are available to
savers who wish to lend money to the
government

Money Market Instruments
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Call money- money borrowed/lent for a day. No
collateral is required.
Inter-bank term money- Borrowings among
banks for a period of more than 7 days
Treasury Bills- short term instruments issued by
the Union Govt. to raise money. Issued at a
discount to the face value
Certificates of Deposit- Issued by banks to raise
money. Minimum value is Rs. 1 lakh, tradable in
the market
CDs can be issued by banks/FIs

Money Market Instruments (2)
 Commercial Paper (CPs) are issued by

corporates to raise short term money
 Issued in multiple of Rs.25 lakhs, can be
issued by companies with a net worth of at
least Rs. 5 crores
 CP is an unsecured promissory note
privately placed with investors at a
discount rate to face value. The maturity of
CP is between 3 and 6 months

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 fundspromote/mobilise savings
 Individual investors, industrial and trading
companies- borrowers

Financial Markets
 Money Market- for short-term funds (less

than a year)

 Organized (Banks)
 Unorganized (money lenders, chit funds, etc.)

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

Organized Money Market
 Call money market
 Bill Market
 Treasury bills
 Commercial bills

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

banks (commercial and co-operative)

Call money market (1)
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It deals with one-day loans (overnight, to be
precise) called call loans or call money
Participants are mostly banks. Also called interbank call money market.
The borrowing is exclusively limited to banks,
who are temporarily short of funds.
On the lending side, besides banks with excess
cash and as special cases few FIs like LIC, UTI
All others have to keep their funds in term
deposits with banks to earn interest

Call money market (2)
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Call loans are generally made on a clean basisi.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 earn interest and
yet improve their liquidity
It is a highly competitive and sensitive market
It acts as a good indicator of the liquidity position

Bill Market
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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

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Commercial Bill market- Not as developed in
India as the T-Bill market

Indian Banking System
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Central Bank (Reserve Bank of India)
Commercial banks
Co-operative banks
Banks can be classified as:

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

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Scheduled banks can be classified as:
 Public Sector Banks
 Private Sector Banks (Old and New)
 Foreign Banks
 Regional Rural Banks

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 IB 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
– Being entitled to borrow from and rediscount bills with
RBI

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The IB declined to accept the restrictions as well
as compensation from the RBI
Therefore, the IB 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 to include
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 68500 in 2005
Population served per branch has come down
from 64000 to 15000
A rural branch office serves 15 to 25 villages
within a radius of 16 kms
Still only 32,180 villages out of 5 lakh have been
covered

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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

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Expansion of bank credit: Growing at 20-30%
thanks to rapid growth in industrial and
agricultural output
Development oriented banking: priority sector
lending

 Diversification in banking: Banking has

moved from deposit and lending to

 Merchant banking and underwriting
 Mutual funds
 Retail banking
 ATMs
 Anywhere banking
 Internet banking
 Venture capital funds
 Factoring-

Profitability of Banks(1)
 Reforms has 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)
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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)
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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 NonPerforming 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 50% 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)
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Development Financial Institutions
 Industrial Finance Corporation of India (IFCI)
 State Finance Corporations (SFCs)
 Industrial Development Finance Corporation (IDFC)

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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
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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.

hank

ou

K Chockalingam
TEL : 9322295394
e.mail: chockalingam_2000@yahoo.com
chockalingam@iibf.org.in

Indian financial system

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