BCC 504 Financial Market-1

Financial Markets Unit 1

Sikkim Manipal University Page No. 1

Unit 1 Financial System

Structure:

1.1 Introduction

Objectives

1.2 Constituent entities forming Financial System

1.3 Regulatory Authorities

1.4 Commercial Banks

1.5 Financial Markets

1.6 Summary

1.7 Glossary

1.8 Terminal Questions

1.9 Answers

1.1 Introduction

When you speak of Financial System we mean the set of arrangements that

cover movement of money from the savers to banks, from banks to

borrowers, and from borrowers to real assets, which in turn create savings,

which go back into the same circle.

Let us assume, you are an earning member. Out of your salary you save

10%. This finds its way to a Bank. The Bank will not just keep this. It may

give a part of this as a loan to someone who has a business. Say the

business is registered as a ‘Company’ which has floated shares. Your

friends are shareholders of the company. (you are already familiar with

different forms of business and how companies are registered etc.) Now

your friends want to sell their shares. They would need a stock exchange to

sell these shares. One of your friends, who has sold the shares and

received the money, decides to visit a foreign country. He converts the

Indian Rupees into dollars through a bank which is authorized to do so. This

authorization is given by the ‘central bank of our country’ which is the

Reserve Bank of India.

The set comprises entire assembly of commercial banks, financial

institutions and financial markets, each being assigned a distinct role, but all

roles complementing one another. The unified objective of the system is to

maintain liquidity in the financial market and to increase the wealth of the

country in terms of the total value of its entire goods and services.



You can now look at figure 1.1 and visualize the interplay among savers,

Financial Sector, Real Sector and back to Savers.

Fig. 1.1: Interplay among savers

The system commences with the funds flowing from savers, who place them

with banks and institutions as deposits to earn interest. Banks and

institutions employ these funds as loans advanced to producers of goods

and services. The producers apply these loans as resources to create

assets in the form of plant, machinery, and industrial establishments. The

revenues resulting from utilisation of these assets create savings once

again. The cycle continues endlessly in a stable economy.

Objectives:

After studying this Unit, you should be able to:

Define the Financial System

Describe the purpose of Financial System

Construct a model of the System

Briefly explain the role of each player

Real Sector Financial Sector



1.2 Constituent entities forming Financial System

The financial system works under the overall governance of the Ministry of

Finance, Government of India. The constituent parts of the system may be

classified as:

1. The Regulatory authorities who take care of compliance of procedures

and guidelines on the part of each player in the course of its operations:

they are – Reserve Bank of India (RBI), Insurance Regulatory and

Development Authority (IRDA) and Securities Exchanges Board of India

(SEBI)

2. Commercial Banks who take care of the flow of money from the savers

to the producers of goods and services in the system: They are: - Public

Sector Banks, Private Sector Banks, Foreign Banks, Regional Rural

Banks, and Co-operative Banks

3. Development Financial Institutions which take care of balanced

distribution of capital for producers of goods and services to invest in

productive assets. They are: - Industrial Finance Corporation of India

(IFCI) – National Bank for Agricultural and Rural Development

(NABARD) – National Housing bank (NHB) – EXIM Bank

Discount and Finance house of India (DFHI) – Securities Trading

Corporation of India (STCI) – State Industrial and Investment

Development Corporation (SIIDC) – State Financial Corporation (SFC) –

State Small Industries Development Corporation (SSIDC)

4. Non-Banking Financial Companies which provide capital to producers of

goods and services as supplementary source and help trading volumes

in capital market and money market remain buoyant. They are: Unit

Trust of India (UTI), Mutual Funds, Leasing and Hire Purchase

Companies, Loan companies, Chit funds, Insurance companies

5. Financial Markets which take care of raising public debt for meeting the

short term and long term needs of the Government, regulate the inflow

and outflow of foreign currencies in the country and help banks comply

with the liquidity and reserve norms of Reserve Bank of India as

stipulated from time to time. They are: Money Market, Foreign Exchange

Market, Capital market, Derivative Market and Debt market.



Each of the constituent elements is briefly explained below to provide an

initial understanding. The subsequent Units will deal in extensively with

them to provide greater insight into the entire system.

The constituents of the system may be seen diagrammatically as

under:

Figure 1.2: The Constituents of the System

Self-Assessment Questions

1. The purpose of financial system is to eradicate poverty (True/False)?

2. Financial system is a means to convert savings into _________

__________________.

3. Assets formed out of investments create ____________________

Sector.

4. Trading in securities in financial markets provides _____________

___________.

5. The ratio between the value of financial assets and the value of real

assets measures ______________________.



1.3 Regulatory Authorities

Regulatory authorities in the Indian Financial System comprise Reserve

Bank of India (RBI), Insurance Regulatory and Development Authority

(IRDA) and Securities Exchanges Board of India (SEBI). Each Regulator is

constituted under a relevant Act of Parliament and charged with the

responsibility of controlling and developing the financial institutions assigned

to it.

Reserve Bank of India

Reserve Bank of India (RBI) is the central banking institution of the country.

It was established on April 1, 1935 under the Reserve Bank of India Act,

1934 which vested in it the role of regulating the financial system of the

country. Although it was a privately owned body during the British rule, since

its nationalization in 1949 the Bank is fully owned by the Government of

India. The RBI is the Banker of all banks in India.

The roles of the Bank as a regulator comprise:

Issuing currency notes and coins

Managing Balance of Payment position

Regulating money supply in the economy

Managing the external value of Indian Rupee

Raising resources for the Government

Regulating and supervising the operations of commercial banks and

Institutions

Banking Ombudsman Scheme

Evolving monetary and credit policies at periodic intervals

Issuing currency notes and coins

The Bank is the custodian of currency notes and coins that are in circulation

at any point of time. It decides the volume of currency and coins to be

circulated in the system. It is the sole authority to print the notes at the

Government press and manufacture coins in Government mints in specified

denominations from time to time. You can see the signature of the RBI

governor in the currency notes.

Managing Balance of Payment position

Balance of Payment (BOP) refers to India’s external obligations The Bank

regulates foreign trade in order to be able to discharge foreign debt without

default. In case the BOP shows large debts or borrowings and shows high



imports as against exports, the RBI could restrict imports and also take

measures to correct the imbalance to some extent.

Regulating money supply in the economy

Volume of money in the economy at a given time determines to an extent,

the rate of inflation in the country. In simple terms if larger supply of money

chases lesser supply of goods and services, it could lead to inflation. As

regulator of country’s overall economy, RBI controls the volume of money

supply by asking banks to withhold a percentage of their deposits from

lending. The ratio between the cash to be withheld as against the deposit

with the bank is called Cash Reserve Ratio (CRR). RBI modifies CRR

according as the volume of money appears too large or too small.

Managing the external value of Indian Rupee

RBI closely regulates the supply and demand positions of foreign exchange

in the market by suitably controlling imports and exports. The Bank may also

directly enter the forex market by either buying up or selling foreign currency

to rebalance supply and demand; the Bank thereby keeps the rate of

exchange between the Rupee and foreign currency in check.

Raising resources for the Government

As custodian of Government money, RBI raises funds from the public on

behalf of the Government either for short term or for long term. The short

term loans are intended to meet the temporary mismatches in cash flows,

that is, timing difference between revenue receipts (taxes) and revenue

payments (salaries, rent, and recurring costs, called non-plan expenditure).

RBI may raise such loans by way of selling Treasury Bills of short duration

up to 364 days to banks, corporates or other investors, or by itself providing

short term accommodation termed Ways and Means Advances to the

Government.

RBI may issue long term bonds to finance Government projects under the 5-

year plans. These are called dated securities and would have maturities

longer than one year. Banks, Institutions, Mutual Funds, Insurance

Companies, Corporates and Foreign institutional investors are the players to

whom the RBI sells the bonds through auctions.



Regulating and supervising the operations of commercial banks and

Institutions

Scope of regulation, supervision and guidelines of RBI over commercial

banks extend to the following areas:

Compliance of Cash Reserve Ratio and Statutory Liquidity Ratio

requirements

Interest rates charged on certain types of advances

Compliance with Managing Non-performing Assets and Capital

Adequacy norms

→ Banks are required to identify loans and advances where borrowers

have defaulted in payment of either interest or instalment or both.

These are to be reported as Non-performing Assets. Each bank is

required to make a provision for the expected loss arising out of

them before reporting profits. Appointment of Directors on the Board

→ RBI supervises banks’ compliance with Corporate Governance

norms. Thenorms extend to Composition of Board of directors, Code

of Conduct of Directors, the performance of Audit Committee,

conduct of Annual Meetings of shareholders, and other areas of

concern for good governance of the bank.

Compliance of ‘Know Your Customer’

→ Banks are required not to open accounts for strangers or undesirable

persons.

Quality and security of loans

→ Quality of appraisal, determination of loan amount, obtaining of

adequate and marketable security, and documents from the

borrower are subjected to periodic inspection of each branch of the

bank by RBI.

Rectification of irregularities reported by Inspectors

→ RBI scrutinizes the reports of statutory auditors and its own

inspectors on the branches of the banks to see whether irregularities

mentioned therein are rectified.

Banking Ombudsman Scheme

Banking ombudsman (BO) is a quasi-judicial authority created by RBI to

resolve complaints of bank customers relating to certain services rendered

by banks. The Scheme provides for (i) an expeditious and(ii) inexpensive



forum to bank customers to seek redressal of their grievances relating to

certain services rendered by the Banks.

Evolving monetary and credit policies at periodic intervals

RBI announces its Monetary Policy every year and a half-yearly review of it,

if needed. The policy scans the economic situation and proposes the steps

that the Bank would adopt to strengthen the economy and its sustainable

growth. Broadly, the steps would aim at achieving a self-imposed target for

rates of industrial growth and growth in Gross Domestic Product.

As a corollary to its monetary policy, RBI enunciates its Credit Policy

periodically. Credit policy primarily covers review of CRR and SLR, RBI’s

interest rate for lending and borrowing to and from commercial banks,

restrictions or relaxation for banks in lending to traders for procuring and

holding essential commodities, regulating or deregulating interest rates

charged by banks on their lending or the rates they may offer to depositors.


6. Balance of Payment statement is drawn up by Ministry of Finance,

Government of India (True/False)

7. Money supply in the economy is regulated by

(a) Ministry of finance

(b) Ministry of Revenue

(c) Reserve Bank of India

(d) Commercial Banks

8. Cash Reserve Ratio is a tool to regulate money supply in the economy

(True/False)

9. Loan to Deposit ratio measures _________ of a bank

10. ‘Ways and Means Advance’ is money loaned by RBI to the Government to help meet___________

11. Capital Adequacy Ratio of banks helps RBI regulates their profitability

(True/False)

Insurance Regulatory Development Authority of India

Insurance Regulatory Development Authority of India (IRDA) was

constituted under the IRDA Act, 1999. It is the regulator of all insurance

companies both in public and private sectors. Companies that offer any

insurance product – life insurance, general insurance or medical insurance –



are governed by IRDA. Besides administering the provisions of the Act, the

objective of IRDA is to ensure that insurance companies do not default in

meeting genuine claim settlements of the persons insured or their

successors.

With this objective, the Act requires that every insurance company should

maintain a deposit with RBI a stipulated percentage of its total gross

premium written in India in any financial year. Besides, every insurer should

maintain a minimum paid up share capital of Rs.100 crores; the promoter’s

quote not exceeding 26 per cent thereof.

Securities Exchanges Board of India

Securities Exchanges Board of India (SEBI) was established by the

Government under an Act of Parliament, the SEBI ACT, 1992. The Board is

charged with the duty to protect the interests of the investors in securities

and to regulate, maintain and develop the securities market operations.

As a regulator, the Board is required to perform the following

functions:

Regulate the transactions that take place in the stock exchanges

Admit and Register stock brokers and regulate their working

Regulate the working of sub-brokers, share transfer agents, bankers to a

public issue, Debenture trustees, registrars, merchant bankers,

underwriters, portfolio managers, and any other intermediary associated

with a public issue of shares or debentures

Registering and regulating the working of depositories and depository

participants

Regulate all public issues of shares and debentures by companies in

terms of the size of the issue and the purpose of issue, by vetting the

company’s application made to it, the advertisement placed in the

newspapers and the offer letter addressed to the public

Promoting investor’s education and training of intermediaries

Conduct of inspection and dealing with fraudulent or unfair trade

practices

The Board conducts inspection of stock exchanges and mutual funds

regularly to ensure compliance of its regulation and guidelines. Also, the

Board has the same powers as are vested in a civil court while trying a legal

suit. It has accordingly the powers to call for any information from the



exchanges or banks or companies while conducting an investigation into

any complaint or allegation. The Board has the power also to inspect and

investigate the brokers, sub-brokers and other intermediaries on a complaint

by an investor.

The Board is empowered to take any measure that it thinks right in the

interest of the investors. Such measures may include suspend trading in any

security in any exchange, order delisting of shares of the errant company,

suspend brokers and intermediaries from trading, suspend and file a legal

suit against any office bearer of an exchange, and impound and retain the

proceeds of a trade which is under investigation by it.

1.4 Commercial Banks

Commercial banks are banking companies registered under Banking

Regulation Act, 1949 and categorized as Schedule Banks and non-

Schedule banks. Schedule banks are those that are listed in Schedule VI of

the said Act. Banks are further distinguished based on their ownership.

Accordingly, they are either (i) Public sector banks or (ii) private sector

banks. Public sector banks are those in which the Government is a major

shareholder, while no shares are held by the Government in Private sector

banks. Among Private sector banks, are also included foreign banks

operating in India.

A sub-category among commercial banks is Authorised Dealers (ADs). Only

those commercial banks can conduct foreign exchange business, which

have been designated as Authorised dealers (AD) by RBI. RBI grants AD

status to a bank based on, among other things, the bank’s capital adequacy

measured by Capital to Risk Adjusted Asset Ratio, Risk management policy

being in place and availability of qualified staff.

Classification of Commercial Banks is shown in figure 1.3



Fig. 1.3: Classification of commercial banks

Public sector banks

Public sector banks are distinguished as State Bank Group and Nationalised

banks. State Bank Group comprises State Bank of India and its subsidiaries,

namely,

State Bank of Mysore

State Bank of Hyderabad

State Bank of Travancore

State Bank of Indore and

State Bank of Patiala.

The subsidiaries were the erstwhile banks of the princely states and were

established as State Banks carrying the names of the respective states

when the princes of those states were divested of their status after

independence.

Nationalized banks were private banks which were taken over by the

Government in two stages after 1968 by an Act of parliament. Currently,

they are 28 in number.



Private sector banks

Private sector banks are privately owned. Banks that came into existence

following economic liberalisation and market reforms in 1992 are referred as

‘new private sector banks’. Some of them are, ICICI Bank, HDFC Bank, UTI

Bank, Kotak Mahindra Bank, and Yes Bank. Their shares are listed in the

exchange and are widely traded. Currently, there are 24 banks in private

sector.

Foreign banks

Over a long time, foreign banks have been operating in India. Historically,

their presence was in port cities of Kolkata, Mumbai, and Chennai, as their

main business was financing imports and exports. Citibank, HSBC bank and

Standard Chartered Bank are currently the majors operating in India.

Foreign banks function mainly in metropolitan centres and are not into mass

banking or retail lending. They focus on services, such as, issuing letter of

credit and guarantees which do not imply fund outlay. These banks do

contribute, however, to the Indian banking, as they bring in new products

and technology, introducing an element of competitiveness for domestic

banks.

Foreign banks are also regulated by RBI and are subject to CRR and SLR

compliances with regard to their Indian operations.

Regional Rural Banks

With a view to extend financial inclusiveness of the rural population,

Regional Rural Banks (RRBs) were set up by the Government of India

under an Act of Parliament. These banks have a blend of a cooperative

society and a commercial bank, as their objective is not profit while doing

banking business. Each RRB is sponsored by a nationalised bank or a State

Bank group member in an area specified to it. The capital of RRB is

contributed by the Central Government, the Government of the state in

which it functions, and the sponsor bank in the proportion of 50:15:35. RBI

regulates RRBs, while NABARD supervises its operations, as their lending

operations are mainly for agriculture.

Cooperative Banks

Cooperative Banks (CBs) are set up under the Cooperative Societies Act

prevailing in the State in which it operates. CBs can accept deposits from



the public at large but can lend only to their members holding their shares.

Some CBs are permitted to operate in States other than where they are

registered. Non-schedule CBs cannot participate in clearing house except

through a designated commercial bank, while schedule CBs can be

members of the clearing house.

CBs can conduct foreign exchange business, if granted the status of

Authorised Dealer by RBI.

CBs may be registered as State cooperative banks or District or Urban

cooperative banks, the latter operating mainly within a specified district of

the State. All CBs are regulated by RBI and subject to CRR and SLR

compliance although RBI may stipulate diluted ratios for them. CBs are

supervised by the Registrar of Cooperative Societies of the State.

Development Financial Institutions

Development Financial Institutions (DFIs) are term lending institutions set up

under respective Acts of Parliament for the purpose of developing specific

sectors of industry. They are established both at national level and in the

States. With the difference in the functioning of commercial banks and DFIs

virtually disappearing, we have now only IFCI as a DFI at the centre doing

direct lending. State DFIs however continue to operate alongside

commercial banks. RBI is the regulator of DFIs.

Non-banking Finance Companies

Non-banking Finance Companies (NBFCs) are those which provide services

of financial nature but are not registered as commercial banks. They do not

conduct banking business, such as, opening current and saving accounts,

collecting cheques, issuing drafts and similar. However, they may accept

public deposits under various schemes of their own. The services offered by

them include Equipment leasing, Hire-purchase financing, mutual funds,

Chit funds, among others. NBFCs are required to be registered with RBI,

which is also their regulator.

Among NBFCs may be grouped Insurance Companies and Mutual

Funds. Insurance companies are classified as Life insurers (Life insurance

Corporation of India, SBI Life, ICICI Prudential are leaders in this sector)

and General insurers (National Insurance Corporation Ltd., United India

Insurance Corporation Ltd., and ICICI Lombard Ltd., are the leaders). All



insurance companies are regulated by Insurance Regulatory and

Development Authority (IRDA).

A Mutual Fund is established as a Public Trust which has (i) a sponsor

(ii) trustees (iii) an Asset Management Company (AMC) and a (iv) a

Custodian. Sponsor is the promoter who establishes the trust. The trustees

hold the trust property for the benefit of the general public who subscribe to

the fund by way of units. AMC manages the funds of the unit holders by

investing their money in securities and trading in them on their behalf to

raise maximum gain. AMC formulates various investment schemes to best

advantage. The Custodian holds the securities of the fund in its custody.

Units earn dividends for the holders who may not have been able to

construct and manage their own portfolio, owing to lack of expertise and the

smallness of size of investment. The holders may also sell back their units

to the fund at the net asset value ruling from time to time.Net asset value is

the market value of the securities held by the fund at a given point in time

less liabilities, divided by the number of outstanding units. SEBI is the

regulator of mutual funds, regardless of the nature of the securities in which

they invest.


12. Regional Rural Banks are regulated by RBI (True/False)

13. State Cooperative banks are regulated by respective State

Government, while urban cooperative banks are regulated by RBI

(True/False)

14. Mutual funds investing in Treasury Bills are regulated by RBI as they

are money market instruments (True/False)

15. Trading in securities for mutual funds is the function of

(a) Sponsor

(b) Custodian

(c) Asset Management Company

(d) Trustees

1.5 Financial markets

A financial market is not a physical place as one where you buy and sell a

commodity, but a virtual medium for transferring ownership or claim over



securities between two parties. Trading in money, shares, bonds or

contracts are done at prices chosen between a buyer and a seller under the

supervision of an intermediary called Exchange. The role of the exchange is

to ensure that the seller delivers security and the buyer makes the payment

at settlement, without default.

The classification of Financial Markets is shown in figure 1.4

Fig. 1.4: Classifications of Financial Markets

Money market

Money market is the medium through which (i) money is borrowed and lent

and (ii) short duration debt instruments are traded. The main players are

banks, insurance companies, provident funds, and mutual funds. Banks

borrow from money market when they need money for complying with SLR

and CRR requirements. Insurance companies, mutual funds and others can

only lend money and are not permitted to borrow. Their duration of such

borrowing can vary from one day to 364 days. Money borrowed for one day

is called Overnight money, upto two days is called Call Money, and upto

14 days is called Notice Money. Money borrowed for periods ranging from

15 days to 364 days is called Term Money. Interest rates are market driven

and not administered.



The second constituent of money market is trading in Debt Instruments.

They comprise promissory notes of maximum maturities of one year which

generate short term funds for the issuer. The instruments are:

Treasury Bills issued by RBI on behalf of government

Commercial Paper issued by corporates and

Certificates of Deposit issued by banks and financial institutions.

These instruments are issued at a price lower than the face value, and carry

no interest for the period. They are called Zero coupon bonds, the difference

between the face value and the discounted price becoming the return for the

buyer.

RBI is the regulator of money market. It does not directly administer the

interest rates in the market, but effectively intervenes when interest rates

appear to move widely from a stable position. Intervention implies that RBI

infuses money into the market by lending large amounts when interest rates

appear high and sucks out money when interest rates appear to be sinking

low. This activity is called Open Market Operation of RBI.

Capital Market

This is the medium available for corporates for raising long term funds

through issuing shares and bonds to the public. Investments raised by

public issue forms the primary market leg of the capital market. After

allotment of shares and bonds, they are listed on the stock exchange.

Listing means that those shares and bonds can be traded through the

members (brokers) of the exchange.

Trading in shares and bonds so listed forms the secondary market leg of the

capital market. Buyers and sellers of these securities operate through their

respective brokers. The exchange acts as a clearing house and ensures

that the buyers duly make the payment and that sellers duly deliver the

securities on the settlement date.

Derivative Market

A second constituent of capital markets is the Derivative Market. A

Derivative is a financial instrument whose value springs from the market

price of an asset that lies under it. The underlying asset may be a share, a

bond, a foreign currency, a commodity, or even a virtual asset such as a

sensitivity index of an exchange.



Derivative instruments are tradable over the Exchange. Typically,

derivatives are:

Swaps which are contracts between two parties exchanging interest

rates or currencies

Option which is a contract with option retained by one party to buy or sell

an asset on a future date at an predetermined price

Futures, which is a standardised forward contract to buy or sell an asset

on a future date at a predetermined price

Warrant, which is an instrument attached to a bond representing a

stated number of shares of the issuing company

The regulator of both capital and derivative markets is SEBI.

Debt Market

Debt market is the medium through which RBI can arrange funds for

Government projects by raising long term loans from the public. RBI issues

bonds (also called debentures) referred as Gilt securities or G-secs or Dated

Securities. They are tradable in the secondary market. Debt market is

regulated by RBI.

In the primary market, the Government issues bonds by holding auctions on

dates previously announced. The bidders at the auctions could be banks,

institutions, insurance companies, provident funds, corporates or Primary

Dealers (PDs). PDs are intermediaries who buy securities in large

quantities at auctions and sell them in retail to individual investors.

In addition to Treasury Bills and Dated Securities, the government also

issues from time to time special securities to entities like Oil marketing

companies, Fertiliser companies, The food Corporation of India, and others,

as compensation in lieu of cash subsidies.

Government securities are traded heavily in the secondary market since like

any other financial instrument, the price of a government security keeps

fluctuating in the secondary market. Their prices are influenced by the

changes in interest rates in the economy, specifically in money market,

besides macro-economic changes, such as, expected inflation rate and

liquidity in the market.



Foreign Exchange Market

If there was a single international currency, there would be no need for a

foreign exchange market (Forex market). That being not so, in any

international transaction, at least one party is dealing in a foreign currency.

The purpose of the foreign exchange market is to permit transfers of

purchasing power denominated in one currency to another, that is, to

exchange one currency for another.

More currency transactions are channeled through the worldwide interbank

market − the wholesale market in which major banks exchange different

currencies of the world with one another. This market is referred as the

foreign exchange market. The market is not located in any single country

but is dispersed over the major financial centres of the world. Trading is

generally done through telephone or on electronic trading platforms.

The major traders in forex are the banks, although large corporates may

also play. Exchange of currencies implies buying and selling of one currency

for the equivalent price of another currency.

A major reason for the banks to trade in forex markets is their need to sell

away excess currencies that they may be holding at the end of each day in

order to avoid overnight fall in their market price. For similar reason, banks

buy up currencies if they had sold more currency than they had bought

during the day in order to avoid a rise in market price overnight. Banks are

thus required to buy or sell currencies each day to square up their currency

balances to make them come as near to zero as possible.

As banks trade currencies wholesale among themselves, forex market is

also called interbank market, or simply, the Interbank. Exchange rate

between each pair of currencies evolves by sheer forces of demand and

supply of those currencies on a daily basis. Interbank quotations are

available continuously as bid and ask rates, meaning market is willing to buy

currency at one rate and sell currency at another rate. The rates are quoted

together and are therefore called two-way quotes. Obviously, market’s bid

rate is always lower than market’s asking rate. Bid/Ask rates are available

as Spot and Forward. Spot rate stands valid for settlement on the third

working day after the transaction day and Forward rate is fixed for applying

on a future date as agreed in a contract made between the trader and the

bank.



Forex market does not have an exchange, as each transaction is done

directly between the traders over the counter. Also, there is no statutory

regulator, but RBI may intervene as a big player to influence the exchange

rates.


16. Mention three instruments that are traded in money market

17. When RBI desires to reduce money supply does it make a Repo or a

Reverse Repo?

18. In money market, Notice money is money borrowed for

(a) One day

(b) 15 days

(c) Period from 15 days to 365 days

(d) Period from 3 days to 14 days

19. Open Market operation means

(a) Traders permitted to transact freely

(b) RBI directly entering the market to stabilize it

(c) Trading by foreign entities

(d) None of the above

20. Secondary Market is a stand-by market when primary market in

operable (True/False)

21. Depository is a trustee who sells securities of traders at fair prices

(True/False)

22. Instruments that are traded in derivative market are….......

23. Debt market is regulated by …………

24. Primary Dealer is a trader who buys securities in bulk and sell them in

retail (True/False)

25. Primary reason for banks to trade in Forex market is ………

26. Regulator of Forex market is

(a) RBI

(b) Government of India

(c) SEBI

(d) No one



1.6 Summary

Financial System is the set of banks, financial institutions and financial

markets, each playing a distinct role, all roles complementing one another.

The unified objective of the system is to maintain and develop the health of

the country’s economy.

The constituents of the financial system convert savings into investible

funds. Banks mobilise money from the savers and lend to producers of

goods and services. Producers generate assets which contribute to the

national capital, also termed Gross Domestic product.

Banks are classified as commercial banks and cooperative banks.

Commercial banks are registered under Banking Regulation Act, while

Cooperative banks are registered under the respective Cooperative

societies Act. Commercial banks are permitted to do all banking operations,

while commercial banks are restricted in their operations. Both categories

further fall into two parts – schedule banks and non-schedule banks,

depending on their net worth and size of business.

Commercial banks are classified as public sector banks and private sector

banks depending on their pattern of their ownership. Some commercial

banks are required to be sponsors of Regional Rural Banks which are

established to operate in rural parts to promote financial inclusiveness.

All banks are regulated by Reserve Bank of India. As regulator, RBI controls

the volume of money supply in the economy through regulating the extent of

bank lending. RBI also supervises the liquidity of banks for economic health

of the country.

Financial markets comprise (i) money market where banks and institutions

lend and borrow wholesale, (ii) capital market where corporates issue

shares and bonds and investors trade in them and (iii) debt market where

the Government borrows from banks and institutions by floating long dated

bonds and (iii) forex market where banks buy and sell different currencies of

the world to facilitate imports and exports.

All markets are inter-dependent as the volume of trade in one market

distantly or proximately impacts on others.



1.7 Glossary

Financial Asset: Money invested in securities and deposited in banks

Balance of Trade: Excess or deficit between imports and exports

Cash Reserve Ratio: The specified percentage of its time and demand

deposits that a bank is required to keep with RBI

Call money: Money borrowed by a bank in money market upto 2 days

Open market operation: The process of RBI entering a market as a

trader in his own right

Gilt securities: Bonds issued by RBI on behalf of Government

Treasury bill: Short term paper floated in money market to bridge

temporary mismatches of cash flow of the Government

Credit policy: Program of RBI relating to bank lending enunciated

periodically to regulate economy

Bid/Ask quotes: Rates at which a bank is willing to buy/sell foreign

currency

Interbank: Market comprising banks willing to trade in foreign currency

among themselves

Forward contract: A contract between a bank and customer locking

exchange rate of a currency for settlement on an agreed future date

1.8 Terminal Questions

1. “Financial System is a set of arrangements that cover borrowing and

lending of funds and transfer of ownership of financial claims”. Explain

the implications by outlining the role of each constituent in the system.

2. Distinguish the functioning of Capital market and Debt market.

3. Outline the features offered by Forex market. Why does RBI intervene

becoming a major trader?

1.9 Answers


1. False

2. Investments

3. Real



4. Liquidity

5. Contribution of financial system to national capital

6. False

7. Reserve Bank of India

8. True

9. Liquidity

10. Temporary mismatch of cash flows

11. False

12. True

13. False

14. False

15. (c)

16. TB, CP and CD

17. Reverse Repo

18. (d)

19. (b)

20. False

21. False

22. Swaps, Options, Futures, Warrants

23. RBI

24. True

25. To off load their closing stock of foreign currency to avoid exchange

risk

26. (d)

Terminal Questions

1. Refer section 1.2

2. Refer sections 1.4.2 and 1.4.4

3. Refer section 1.4.5

Recommended reading

1. Indian Financial System, Bharathi Pathak (2011) (Thompson)

2. Financial Institutions and Markets, L.M. Bhole (2010) Tata Mcraw-Hill

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BCC 504 Financial Market-1

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