4.1 An understanding of the organisational structure of markets for financial assets is vital for knowing the limitations and prospects in relation to efficiency, integration and stability. Financial markets in India comprise in the main, the credit market, the money market, the foreign exchange market, the debt market and the capital market 1 . Recently, the derivatives market - OTC and exchange traded - has also emerged. With banks having already been allowed to undertake insurance business, bancassurance market is also likely to emerge in a big way. Most of the financial markets were characterised till the early ’nineties by controls over the pricing of financial assets, restrictions on flows or transactions, barriers to entry, low liquidity and high transaction costs. These characteristics came in the way of developments of the markets and allocative efficiency of resources channelled through them. The initiation of financial sector reforms in the early ’nineties was essentially to bring about a transformation in the structure, efficiency and stability of financial markets, as also an integration of the markets. Some of the important structural changes enabled by financial sector reforms relate to introduction of free pricing of financial assets in almost all segments, relaxation of quantitative restrictions, removal of barriers to entry, new methods of floatation/issuance of securities, increase in the number of instruments and enlarged participation, improvement in trading, clearing and settlement practices, improvement in the informational flows, transparency and disclosure practices, to name a few. In this Chapter, an attempt is made to provide an account of the market structures and instruments of the financial sector, viz., the credit market, the money market, the foreign exchange market, the debt market, the capital market, the insurance market, and the recently established derivatives market and banc- assurance. Credit Market Structure 4.2 In the context of relatively underdeveloped capital market and with little internal resources, firms or economic entities depend largely on financial intermediaries for their fund requirements. In terms of sources of credit, they could be broadly categorised as institutional and non-institutional. The major institutional purveyors of credit in India are banks and non- banking financial institutions, i.e., development financial institutions (DFIs) and other financial institutions (FIs) and non-banking financial companies (NBFCs) including housing finance companies (HFCs). The non-institutional or unorganised sources of credit include money- lenders, indigenous bankers and sellers for trade credit. However, information about unorganised sector is limited and not readily available. The credit market is the predominant source of finance. An important aspect of the credit market is its term structure, viz., (i) short-term credit, (ii) medium-term credit, and (iii) long-term credit. While banks and NBFCs predominantly cater to short-term needs, FIs provide mostly medium and long-term funds. However, the actual time-length of the credit availed would depend, inter alia, on the production-sale cycle. Banks 2 4.3 Banks in India can be broadly classified as commercial banks and co-operative banks. In terms of ownership and function, commercial banks can be grouped into three categories–public sector banks, regional rural banks and private sector banks (both domestic and foreign). These banks have over 67,000 branches spread wide IV FINANCIAL MARKET STRUCTURE 1 One could, in fact, refer also to household finance market, NBFC market, and insurance market, as holding considerable promise in the years to come. These markets are not yet as developed and regulated as the credit/foreign exchange/money/capital/gilt-edged markets. Besides, there is very little of good time-series data of these markets that could be regarded as subjected to competitive forces. It is for these reasons, the focus on these markets had to be limited in this Report. 2 Details of data about the working and progress of banks in India are not included, since these are covered extensively in the Bank’s annual reports on Trend and Progress of Banking in India. Here the main focus would be on the structural aspects that have a bearing on financial integration and development.
Transcript
4.1 An understanding of the organisationalstructure of markets for financial assets is vitalfor knowing the l imitat ions and prospects inrelation to efficiency, integration and stability.Financial markets in India comprise in the main,the credit market, the money market, the foreignexchange market, the debt market and the capitalmarket1 . Recently, the derivatives market - OTCand exchange traded - has also emerged. Withbanks having already been allowed to undertakeinsurance business, bancassurance market is alsolikely to emerge in a big way. Most of the financialmarkets were characterised till the early ’ninetiesby controls over the pricing of financial assets,restrictions on flows or transactions, barriers toentry, low liquidity and high transaction costs.These characterist ics came in the way ofdevelopments of the markets and al locat iveefficiency of resources channelled through them.The initiation of financial sector reforms in theearly ’nineties was essentially to bring about atransformation in the structure, efficiency andstability of financial markets, as also an integrationof the markets. Some of the important structuralchanges enabled by financial sector reforms relateto introduction of free pricing of financial assetsin almost all segments, relaxation of quantitativerestrictions, removal of barriers to entry, newmethods of f loatation/issuance of securit ies,increase in the number of instruments andenlarged participation, improvement in trading,clearing and settlement practices, improvement inthe informational f lows, transparency anddisclosure practices, to name a few. In thisChapter, an attempt is made to provide an accountof the market structures and instruments of thefinancial sector, viz., the credit market, the moneymarket, the foreign exchange market, the debt
market, the capital market, the insurance market,and the recently established derivatives marketand banc- assurance.
Credit Market Structure
4.2 In the context of relatively underdevelopedcapital market and with little internal resources,firms or economic entit ies depend largely onf inancial intermediar ies for their fundrequirements. In terms of sources of credit, theycould be broadly categorised as institutional andnon-inst i tut ional. The major inst i tut ionalpurveyors of credit in India are banks and non-banking financial institutions, i.e., developmentfinancial institutions (DFIs) and other financialinst i tut ions (FIs) and non-banking f inancialcompanies (NBFCs) including housing financecompanies (HFCs). The non-inst i tut ional orunorganised sources of credit include money-lenders, indigenous bankers and sellers for tradecredit. However, information about unorganisedsector is limited and not readily available. Thecredit market is the predominant source offinance. An important aspect of the credit marketis its term structure, viz., (i) short-term credit,(ii) medium-term credit, and (iii) long-term credit.While banks and NBFCs predominantly cater toshort-term needs, FIs provide mostly medium andlong-term funds. However, the actual time-lengthof the credit availed would depend, inter alia, onthe production-sale cycle.
Banks2
4.3 Banks in India can be broadly classifiedas commercial banks and co-operative banks. Interms of ownership and function, commercialbanks can be grouped into three categories–publicsector banks, regional rural banks and privatesector banks (both domestic and foreign). Thesebanks have over 67,000 branches spread wide
I V FINANCIAL MARKETSTRUCTURE
1 One could, in fact, refer also to household financemarket, NBFC market, and insurance market, asholding considerable promise in the years to come.These markets are not yet as developed and regulatedas the credit/foreign exchange/money/capital/gilt-edgedmarkets. Besides, there is very little of good time-seriesdata of these markets that could be regarded assubjected to competitive forces. It is for these reasons,the focus on these markets had to be limited in thisReport.
2 Details of data about the working and progress of banksin India are not included, since these are coveredextensively in the Bank’s annual reports on Trend andProgress of Banking in India. Here the main focus wouldbe on the structural aspects that have a bearing onfinancial integration and development.
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across the country. After initiation of financialsector reforms, competition in the banking sectorhas increased. Porter (1985) crystal l isescompetition as a composite of five forces, viz.,rivalry amongst existing firms, potential entry ofnew competi tors, potent ial development ofsubstitute products, bargaining power of suppliersand bargaining power of consumers3. In thecontext of banking, all these are relevant exceptperhaps the bargaining power of suppliers. Thethreat of new entrants and substitute products aswell as the rivalry amongst existing banks arebecoming increasingly apparent in the Indianbanking industry.
4.4 Competition among commercial banks hasincreased with the entry of new private sectorbanks and the permission to foreign banks toincrease their number of branches in the ’nineties.After the guidelines issued in January 1993, 8 newprivate sector banks are presently in operation.These banks use state-of-the-art technology.Further, following India’s commitment to the WTOagreement in respect of the services sector, foreignbanks, including both new and the existing ones,have been permitted to open up to 12 branches ayear with effect from 1998-99 as against the earlierst ipulat ion of 8 branches. Also, competi t ionamong public sector banks has increased withrelaxat ion of many guidel ines, al lowing forport fo l io shi f ts for opt imising the ul t imateobjectives. With the amendment to the BankingCompanies Acts 1970/1980, public sector banksare now allowed to access the capital market toraise funds. This has diluted the shareholding ofthe Government, although it is stil l the majorshareholder with a minimum 51 per cent of totalequity. Local Area Banks (LABs) are also beingset up to induce competition in urban, semi-urbanand rural areas.
4.5 The competition in the banking sector hasso evolved in the recent years that the marketstructure of the banking sector has tended to beol igopol ist ic. Whi le the number of banks isreasonably large, the dominance of public sectorbanks, and especial ly of a few large bankscontinues. Such banks accounting for large shareof deposits and advances as market leaders areable to influence decisions about liquidity and ratevariables in the system. But, even such banks mayface challenges in the future and face tougher
competition, given the gradual upgradation ofskills and technologies in competing banks andthe restructuring and re-engineering processesbeing attempted by both foreign and private sectorbanks.
4.6 Since bank nationalisation in 1969, therehas been significant growth in the geographicalcoverage of banks and the amount of resourcesmobilised by banks. The spectacular increase indeposits as percentage of national income to 48.7per cent in 1999 as against 15.5 per cent in 1969test i f ies to the favourable impact of branchexpansion. There has also been a sharp increasein credit to agriculture, small-scale industries,trade and other activities which had little accessto bank finance before 1969.
4.7 Prior to f inancial sector reforms,commercial banks funct ioned in a regulatedenvironment, with administered interest ratestructure, quantitative restrictions on credit flows,fairly high reserve requirements and pre-emptionof significant proportion of lendable resources forthe priority and the government sectors. While thequantitative restrictions led to the credit rationingfor the private sector, interest rate controls led tosub-opt imal use of credit and low levels ofinvestment and growth. At the same time, flexibilityof monetary policy in influencing the volume andcost of credit was constrained by considerationsrelating to domestic debt management and theneed to f inance the resource needs of thegovernment sector. The resultant ‘ f inancialrepression’ led to decline in productivity andeff ic iency and erosion of prof i tabi l i ty of thebanking sector in general.
4.8 It is in the background of thesecircumstances that the development of soundcommercial banking system was worked outmainly with the help of the recommendations ofthe Committee on the Financial System(Chairman: Shri M. Narasimham), 1991. Theconsequential financial sector reforms envisagedinterest rate flexibility for banks and reductionin reserve requirements, besides a number ofstructural measures. Interest rates, as aconsequence, have emerged as a major signallingdevice for resource allocation. This apart, creditmarket reforms included introduction of newinstruments of credit , changes in the creditdelivery system and integration of functional rolesof diverse players, such as, banks, f inancialinstitutions and non-banking financial companies(NBFCs). The gradual introduction of a loan
3 Porter, Michel E., (1985), Competit ive Advantage:Creating and Sustaining Superior Performance, TheFree Press, New York.
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system in the place of a cash credit system hasfacil itated banks in planning their cash flowsbetter, and in reducing the costs of uncertainty. Atthe same time, there has been greater competitionwith the introduction of new private sector banksand the permission given to foreign banks to openbranches, as also with progressive improvementin the role of the non-banking sector. Restrictionson project financing by banks have been removed.With the result , the share of term loans aspercentage of total bank loans went up to 34.9per cent as at the end of March 1999 from 26.1per cent as at end-March 1995.
4.9 The implementation of prudential normscharacterised the initial phase of the financialreforms. Once the framework of improvedsoundness of f inancial intermediar ies wasprovided, attention was bestowed on deregulationof the credit market. The gradual scaling down ofcash reserve and statutory liquidity requirementshas afforded flexibility to banks to manage theirasset portfolios. The average CRR has beenprogressively brought down to 8.5 per cent inAugust 2000 from its peak at 15 per cent duringJuly 1989 to April 1993. The SLR, which was ata peak of 38.5 per cent during September 1990to December 1992, had been reduced to thestatutory minimum of 25 per cent by October1997. Besides, the coverage of priority sector hasalso been appropriately enlarged to includesoftware and agro-processing industries andventure capital, while the existing priority sectorcategories have been broadened, giving the bankslarger access in meeting the priority sector targets.Selective credit controls were eliminated overtime. In addition, credit restrictions have beengradual ly removed/relaxed for purchases ofconsumer durables, and loans to individualsagainst shares and debentures/bonds.
Subsidiaries of Banks
4.10 An important development in the financialsector in the recent years has been thediversi f icat ion and growth of para-bankingactivities. In India, following the erstwhile UKmodel, wherein diverse financial activities can beundertaken only through separate affiliates, bankswere allowed to undertake non-traditional activity,i.e., leasing through separate subsidiaries in 1983by amending the Banking Regulation Act, 1949.From 1986-87 and onwards, banks were allowedto set up subsidiaries to undertake other non-traditional activities, such as, mutual funds, hire
purchase, factoring, etc. A number of banks havesponsored mutual funds (for example, State Bankof India, Canara Bank and Indian Bank). In 1994,banks were also al lowed to undertakedepartmentally para banking activities, such as,leasing, hire purchase, factoring, etc. Presently,banks can undertake para banking activities eitherthrough subsidiaries or in-house or both.
4.11 The reasons for banks entering para-banking activities include the need for diversifyingearnings, maximising economies of scale andscope, making profits, and also the desire to haveleading market positions in financial services.
4.12 Merchant banking is an important areawhere subsidiaries of banks have made theirpresence felt. Merchant banking includes services,such as, pre-issue, management of public issue,etc., and as such is dependent on the conditionsin the stock market. Prior to 1983, banks usedto undertake merchant banking activites in-house.In 1983, they were allowed to set up separatesubsidiaries for undertaking merchant bankingactivities and the first banking subsidiary in thefield of merchant banking was the SBI CapitalMarket, which started functioning in 1987 whenthe capital market was buoyant. There are now anumber of bank subsidiaries involved in themerchant banking activities, such as, PNB CapitalServices, BOI Finance, Indbank Merchant BankingServices, etc.
4.13 The dealing in government securities isanother area where banks have been fairly active.Banks also set up subsidiaries for acting asprimary dealers for government securities whichinclude SBI Gilts, PNB Gilts, Gilts Securit iesTrading Corporation (set up by Canara Bank andBank of Baroda).
4.14 Banks, through their subsidiaries, alsoprovide services, such as, factoring (SBI Factors,Canbank Factors, etc), securitisation of loans andreceivables into debt securities (Citi Bank), stockbroking (SBI Securities, PNB Securities, etc.),financial guarantee for infrastructure projects,etc. Venture capital is a new area where bankshave entered. The main players include CanbankVenture Capital Fund. SBI, Andhra Bank, UnionBank of India have contributed towards equity ofventure capital funds f loated by TechnologyDevelopment and Investment Corporation of India(TDICI), Gujarat Investment Corporation, etc.Many banking subsidiaries, such as, SBI HomeFinance, BOB Housing Finance, and PNB Housing
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Finance, are also quite active in the field ofhousing finance. Banking subsidiaries are alsooperating in the credit card business, e.g., SBICards and Payment Services Ltd.
4.15 There is a shared responsibility betweenthe Reserve Bank and SEBI in the regulation ofpara banking activi t ies of banks. In India, aprudent ia l regulatory f ramework based oncapital adequacy is in place in the case of para-banking subsidiaries as well. It is also importantto adopt an arms-length approach between abank and its subsidiary since involvement ofbanking subsid iar ies in any act iv i ty that issubject to ‘bubbles’ and i rregular i t ies couldimpose financial burden on parent banks. But,as the problems of subsid iar ies are hardlyquickly noticed, public sector banks have beenrequired to provide a consolidated balance sheetincluding position of their subsidiaries from theyear ended March 31, 2000 to correctly reflecttheir financial strengths and weaknesses as isthe case in the US. Such a transparent practicewill help individual investors to make informedchoices better.
Financial Institutions
4.16 A large variety of financial institutions hascome into existence over the years to perform avariety of financial activities. While some of themoperate at all-India level, others are state levelinst i tu t ions. Al l - Ind ia f inancia l inst i tu t ions(AIFIs) consist of all-India development banks,special ised f inancial inst i tut ions, investmentinstitutions and refinance institutions. The statelevel institutions, on the other hand, comprise18 State Financial Corporations (SFCs) and 26State Industr ia l Development Corporat ions(SIDCs).
4.17 All-India development banks (IDBI, IFCI,ICICI, SIDBI and I IBI) occupy an importantposit ion in the f inancial system as the mainsource of medium and long-term project financeto industry. Among them, the IFCI (1948), IDBI(1964) and IRBI (present ly I IBI-1984) wereestablished under various Acts of the Parliament.The ICICI (1955) was set up as a public limitedcompany under the Companies Act. The SIDBI(1990), a wholly owned subsidiary of IDBI, wasset up for promotion, financing and developmentof industry in the small-scale, tiny and cottagesector. It acts as the chief refinancing institutionin this sector. Besides, special ised f inancial
institutions are also operating in the areas ofexport-import (EXIM Bank-1982), infrastructure(IDFC-1997), tourism (TFCI-1989) and venturecapital (IVCF, ICICI Venture). Investmentinstitutions in the business of mutual fund (UTI-1964) and insurance activity (LIC-1956, GIC andits subsidiaries-1972) have also played significantroles in the mobilisation of household sectorsavings and their deployment in the credit and thecapital markets. In the agriculture and rural sectorand the housing sector, the NABARD (1982) andNHB (1988) respectively, are acting as the chiefrefinancing institutions. Both of them are alsovested with certain supervisory functions.
4.18 Besides providing direct loans (includingrupee loans, foreign currency loans), financialinstitutions also extend financial assistance by wayof underwriting and direct subscription and byissuing guarantees. Recently, some developmentfinancial institutions (DFIs) have started extendingshort term/working capital finance, although term-lending continues to be their primary activity.Amongst them, the five all-India development banksaccounted for 83.9 per cent of the total financialassistance sanctioned during 1998-99. The overallimportance of these financial institutions could bejudged from the fact that their combined assetsestimated at Rs.4,88,516 crore formed about 55.1per cent of the assets of the banking sector as atend-March 2000.
4.19 Historically, the Reserve Bank and theCentral Government have played a major role infinancing these institutions by subscribing to theshare capital, by allowing them to issue Governmentguaranteed bonds and by extending long-term loansat concessional terms. However, with the financialsector reforms in the ’nineties, concessional lendingby the Reserve Bank and the Government wasphased out, leaving the financial institutions to relyfor financing their needs on the equity capital andthe debt markets. Expansion of their equity basethrough public offers and public issues of long-termbonds has become an important element of theirmarket-based financing. In order to provideflexibility, the Reserve Bank has also allowed FIsto raise resources by way of term deposits, CDsand borrowings from the term money market withinthe umbrella limit fixed in terms of net ownedfunds. In order to expand their scope of business,a large number of them have been entering variousbusinesses - venture capital, mutual funds, banking(through subsidiaries) and insurance.
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Non-Banking Financial Companies (NBFCs)
4.20 Non-banking financial companies (NBFCs)are financial intermediaries engaged primarily inthe business of accepting deposits and makingloans and advances, investments, leasing, hirepurchase, etc. NBFCs are a heterogeneous lot.NBFC sector is characterised by a large numberof privately owned, decentralised and relativelysmall-sized financial intermediaries. NBFCs areof various types, such as, loan companies (LCs),investment companies (ICs), hire purchasefinance companies (HPFCs), equipment leasingcompanies (ELCs), mutual benef i t f inancialcompanies (MBFCs) also known as Nidhis,miscellaneous non-banking companies (MNBCs)also known as Chit Funds and residuary non-banking companies (RNBCs). Loan companies,investment companies, hire purchase financecompanies and equipment leasing companies aredefined on the basis of the principal activity of theirbusiness. Although NBFCs in India have existedfor a long time, they shot into prominence in thesecond half of the ’eighties and in the first-half ofthe ’nineties, as deposits raised by them grewrapidly. Total assets/liabilities of NBFCs grew atan average annual rate of 36.7 per cent during the’nineties (1991-98) as compared with 20.9 per centduring the ’eighties (1981-91). Customerorientation, concentration in the main financialcentres and attractive rates of return offered bythem are some of the reasons for their rapidgrowth. Primarily engaged in the area of retailbanking, they face competition from banks andfinancial institutions.
4.21 An attempt to regulate NBFCs started inthe ’sixt ies when the Reserve Bank issueddirections relating to the maximum amount ofdeposits, the period of deposits and rate of interestthey could offer on the deposits accepted by them.To safeguard depositors’ interest, norms were laiddown from time to t ime, inter alia, regardingmaintenance of certain percentage of liquid assets,creation of reserve funds and transfer thereto everyyear a certain percentage of profit, etc. Thesedirections were amended from time to time, andin 1977 the Reserve Bank issued two separate setsof guidelines, viz., NBFC Acceptance of DepositsDirections, 1977 for NBFCs and MNBC Directions,1977 for MNBCs.
4.22 Traditionally, the regulation of NBFCs wasconfined to deposit-taking activities of NBFCs.Although some attempt was made to regulate the
asset side of NBFCs in 1994 in pursuance of theShah Committee recommendations, the absenceof adequate regulatory powers remained a majorconstraint. In 1997, however, the RBI Act wasamended and it was given comprehensive powersto regulate NBFCs. The amended Act made itmandatory for every NBFC to have minimum netowned funds (NOF) of Rs.25 lakhs (subsequentlyincreased to Rs.2 crore for the new companies)and obtain a certificate of registration from theReserve Bank for commencing or carrying onbusiness. The provisions relating to certificate ofregistration and minimum NOF were put in placeto ensure that only companies with a healthybackground and adequate capital were allowed tocarry on the business. This was also to reduce thenumber of NBFCs to a manageable universe forpurposes of effective regulation and supervision.As on June 30, 2000, out of the 37,274 companiesseeking registrat ion, 679 were approved forregistration with permission to accept publicdeposits, while 8,451 were approved forregistrat ion without authorisat ion to acceptdeposits. Ceilings were prescribed for acceptanceof deposits based on the principal business, capitaladequacy, credit rating and NOF. The amended Actalso empowered the Reserve Bank to regulate theasset side of NBFCs. Accordingly, in January 1998,the Reserve Bank laid down norms relating tocapital adequacy, income recognit ion, assetclassification, credit rating, exposure norms, etc.The Reserve Bank has also developed acomprehensive system to supervise NBFCsaccepting/holding public deposits. This involves:( i) on-si te inspection; ( i i ) off-si te monitor ingthrough periodic control returns from NBFCs; (iii)use of market intelligence; and (iv) submission ofreports by auditors of NBFCs.
4.23 Public deposits held by NBFCs (includingRNBCs) as at end-March 1999 at Rs.20,429 croreconstituted approximately 2.6 per cent of aggregatedeposits mobil ised by scheduled commercialbanks (excluding regional rural banks).Significantly, RNBCs (numbering only nine) held52.1 per cent of the total deposits held by allNBFCs. Public deposits of large NBFCs (i.e.,holding public deposits of Rs.20 crore and above)accounted for about 45 per cent of the totalliabilities of the NBFC sector as a whole. Depositsof large size (Rs.10,000 and above) constituted74.5 per cent of the total deposits of NBFCs.Increased competition in the financial sector, onthe one hand, and strengthening of the regulatory
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requirements, on the other, have resulted in amajor consolidation in the NBFCs sector in therecent period.
Housing Finance Companies (HFCs)
4.24 In India, investment in housing is mainlyfinanced by own sources or from informal creditmarket. The formal housing finance institutionscontr ibute only 15-20 per cent of housinginvestments in the country (NSS, 44 th Round,1988-89). However, within the formal housingf inance sector, the convent ional sources ofhousing finance in India have been the publicsector institutions. Over the years, they werefound to be grossly inadequate to meet therequirements of the new investments andmaintenance of housing and habitat systems.Accordingly, since the mid-eighties, efforts havebeen directed at the development of housingfinance institutions to meet the large resourcegap that exists for housing finance in the country.A policy shift to encourage private and co-operative sectors in housing could be discernedand the necessary legal and regulatory changesare being effected in this regard.
4.25 The formal segment of housing financeincludes funding provided by the Central andState Governments and funds from financialinstitutions like GIC, LIC, commercial banks andspecialised housing finance institutions and co-operative banks. HUDCO was set up in April1970 as an apex techno-finance organisation inorder to provide loans and technical support tostate and city level organisations. The StateGovernments are responsible for implementingsocial housing schemes. Almost all the Stateshave set up Housing Boards in order to facilitatethe implementat ion of the socia l housingschemes. Co-operative banks have been financinghousing schemes. Co-operative banks cater toeconomically weaker sections, low and middleincome groups as well as co-operative or grouphousing societ ies. The f i rs t comprehensiveguidelines in respect of these banks (other thanUrban Co-operative Banks) were issued by theReserve Bank in December 1984.
4.26 The second formal tier of the housingf inance consists of insurance corporat ions,commercia l banks and housing f inancecompanies. In 1976, the Reserve Bank issuedits f irst set of housing f inance guidel ines toscheduled commercial banks for the benefit of
weaker sections of the society. At present, banksare required to extend for housing finance 3 percent of incremental deposits in a financial year.This apart , the f inancial market for housingincludes housing f inance companies, whichprovide the bulk of housing finance. Althoughthere are around 400 HFCs in operation, themarket is dominated by a few big players. Morethan 95 per cent of disbursements are accountedfor by only 29 leading HFCs having refinancefacility from the National Housing Bank (NHB).
4.27 In recognition of the need for developing anetwork of special ised housing f inanceinstitutions in the country, the National HousingBank was set up in July, 1988 as a wholly ownedsubsidiary of the Reserve Bank under the NationalHousing Bank Act, 1987, to function as an apexbank for the housing finance. NHB regulates HFCs,refinances their operations and expands thespread of housing finance to different incomegroups all over the country, while functioningwithin the overall framework of the housing policy.I t has also helped in divert ing increasingproport ions of annual provident fundaccumulat ions for housing f inance throughhousing linked savings schemes for providentfund subscribers.
4.28 The second major policy in this directionwas introduced in 1994 in the form of the NationalHousing Policy (NHP) that envisaged a major shiftin the Government’s role from a provider to afaci l i tator. The pol icy framework deals withtechnological, financial and institutional aspects.The market for housing finance really startedgrowing after the NHP was framed. Among theHFCs, while HUDCO dominated in terms of size(paid up capital), HDFC and to an extent LICperformed better in terms of profits and totaldisbursements. The NHP also recognised the needto strengthen HUDCO through augmenting itsresources for meeting the requirements for shelterprovisions for lower income groups in a largermeasure in rural and urban areas including theshelters and the slum dwellers and for expandinginfrastructure facilities in the urban areas.
4.29 The NHB, as part of i ts regulatorymeasures, announced introduction of majorprovisions in September 1997 to strengthen theregulatory framework for HFCs. The regulations,inter alia, included compulsory registration ofhousing finance companies with minimum net-owned fund of Rs.25 lakhs, mandatory transfer
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of 20 per cent of net profits to a reserve fund,maintenance of 5 per cent of SLR in bank depositsand another 5 per cent in approved securities. TheUnion Budget for 2000-01 envisaged a 20 per centtax rebate under section 88 of the Income Tax Actfor repayment of housing loans up to Rs.20,000per year as against Rs.10,000 earlier.
4.30 The interest rate structure across HFCshas been similar due to the similarity in theirliability structure resulting in similar cost of funds.For the year 1996-97, 55 per cent of the depositsreceived from the public were collected at ratesabove 14 per cent.
Money Market Structure
4.31 Money markets perform the crucial role ofproviding a conduit for equilibrating short-termdemand for and supply of funds, therebyfacilitating the conduct of monetary policy. Themoney market instruments mainly comprise:( i ) cal l money, ( i i ) cert i f icates of deposit ,( i i i ) t reasury bi l ls , ( iv) other short-termgovernment securit ies transactions, such as,repos, (v) bankers’ acceptances/commercial bills,(vi) commercial paper, and (vii) inter-corporatefunds. Whi le inter-bank money markets andcentral bank lending via repo operations ordiscounting provide liquidity for banks, privatenon-bank money market instruments, such as,commercial bills and commercial paper providel iquidi ty to the commercial sector. Unl ike indeveloped economies where money markets arepromoted by f inancial intermediar ies out ofefficiency considerations, in India, as in manyother developing countries, the evolution of themoney market and i ts structure has beenintegrated into the overall deregulation processof the financial sector.
4.32 In 1985, the Chakravarty Committee firstunderlined the need to develop money marketinstruments in India, while in 1987 the WorkingGroup on the Money Market (Chairman: Shri N.Vaghul) laid the blueprint for the institution ofmoney markets. The Reserve Bank has graduallydeveloped money markets through a five-prongedeffort. First, interest rate ceilings on inter-bankcall/notice money (10.0 per cent), inter-bank termmoney (10.5-11.5 per cent), rediscounting ofcommercial bills (12.5 per cent) and inter-bankparticipation without risk (12.5 per cent) werewithdrawn effective May 1, 1989. Secondly, several
financial innovations in terms of money marketinstruments, such as, auctions of Treasury Bills(beginning with the introduction of 182-dayTreasury Bi l ls effect ive November 1986),certificates of deposit (June 1989), commercialpaper (January 1990) and RBI repos (December1992) were introduced. Thirdly, barriers to entrywere gradually eased by (i) increasing the numberof players (beginning with the Discount andFinance House of India (DFHI) in April 1988followed by primary and satellite dealers andmoney market mutual funds), (ii) relaxing bothissuance restrictions and subscription norms inrespect of money market instruments and allowingdetermination of yields based on demand andsupply of such paper, and (iii) enabling marketevaluation of associated risks, by withdrawingregulatory restrictions, such as, bank guaranteesin respect of CPs. Fourthly, the development ofmarkets for short- term funds at marketdetermined interest rates has been fostered by agradual switch from a cash credit system to aloan-based system, shifting the onus of cashmanagement from banks to borrowers andphasing out the 4.6 per cent 91-day tap Treasurybills, which in the past provided an avenue forinvesting short-term funds. Finally, institutionaldevelopment has been carried out to facilitateinter-linkages between the money market and theforeign exchange market, especial ly af ter amarket-based exchange rate system was put inplace in March 1993.
4.33 The changes in the money marketstructure need to be seen in the context of agradual shi f t f rom a regime of administeredinterest rates to a market-based pricing of assetsand liabilities. The development of money marketsin India in the last 3-4 years has been facilitatedby three major factors. First, the l imiting ofalmost automatic funding of the government,largely realised with the replacement of ad hocTreasury bills (which bore a fixed coupon rate of4.6 per cent per annum from July 1974, implyinga negative real interest rate for most part of theperiod) by ways and means advances (WMA) atinterest rates linked to the Bank Rate and thedevelopment of the government securities market,discussed later in the chapter, permitt ing agradual de-emphasis on cash reserve ratio as amonetary pol icy instrument. Secondly, thedevelopment of an array of instruments of indirectmonetary control , such as, the Bank Rate
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(re-act ivated in Apri l 1997), the strategy ofcombining auct ions, pr ivate placements andopen market operations in government paper(put in p lace in 1998-99) and the l iqu id i tyadjustment faci l i ty (LAF) ( inst i tuted in June2000) . Th i rd ly , the enabl ing ins t i tu t iona lf ramework was introduced in the form ofprimary and satellite dealers and money marketmutual funds. The monetary author i ty usesmoney markets to adjust primary l iquidity inthe domestic economy and monetary policy isoften, in turn, shaped by developments in themoney and the foreign exchange markets.
Call/Notice Money Market
4.34 The overn ight in ter -bank ca l l moneymarket , in which banks t rade pos i t ions tomaintain cash reserves, is the key segment ofthe money market in India. It is basically an‘over the counter’ (OTC) market without theintermediat ion of brokers. Part ic ipat ion hasbeen gradual ly w idened to inc lude o therfinancial institutions, primary/satellite dealers,mutual funds and other participants in the billsrediscounting market and corporates (throughprimary dealers) besides banks, LIC and UTI.While banks and primary dealers are allowedtwo-way operations, other non-bank entities canonly par t ic ipate as lenders . As per theannounced po l ic ies , once the repo marketdevelops, the call money market would be madein to a pure in ter -bank market , inc lud ingprimary dealers.
4.35 The call money market is influenced byliquidity conditions (mainly governed by depositmobi l isat ion, capi ta l f lows and the ReserveBank’s operat ions af fect ing banks ’ reserverequi rements on the supply s ide and taxoutf lows, government borrowing programme,non- food cred i t o f f - take and seasonalfluctuations, such as, large currency drawalsduring the festival season on the demand side).At times of easy liquidity, call rates tend to hoveraround the Reserve Bank’s repo rate, whichprovides a ready avenue for parking short-termsurplus funds. During periods of tight liquidity,call rates tend to move up towards the Bank Rateand more recently the Reserve Bank’s reverserepo ra te (and somet imes beyond) as theReserve Bank modulates liquidity in pursuit ofmonetary stability (Chart IV.1). Besides, thereare other influences, such as, (i) the reserverequirement prescr ipt ions (and st ipulat ions
regarding average reserve maintenance), (ii) theinvestment policy of non-bank participants in thecall market which are among the large suppliersof funds in the ca l l market , and ( i i i ) theasymmetries of the call money market, with fewlenders and chronic borrowers.
4.36 The annual turnover in the call moneymarket at Mumbai which amounted toRs.16,44,790 crore in 1991-92 and Rs.15,45,160crore in 1996-97 moved up in more recent years.For example, the daily turnover increased toRs.33,882 crore dur ing 1999-2000 fromRs.25,956 crore during 1998-99. The averageinterest in the call money market during last fouryears tended to move up from 7.8 per cent in1996-97 to 9.0 per cent dur ing 1999-2000.However, volatility tended to move downwards(Table 4.1 and Chart IV.1).
Term Money Market
4.37 The term money market in India is stillnot developed, with the daily turnover amountingto Rs.951 crore - Rs.1,489 crore during March2000, up from Rs.23 crore - Rs.967 crore duringMarch 1999. Select financial institutions (IDBI,ICICI, IFCI, IIBI, SIDBI, EXIM Bank, NABARD,IDFC and NHB) are permitted to borrow fromthe term money market for 3-6 months maturity,wi th in s t ipu lated l imi ts for each inst i tu t ion.Banks were exempted from the maintenance ofCRR and SLR on inter-bank liabilities to facilitatethe development of the term money market inApril 1997, subject to the condition that effectiveCRR and SLR on total demand and t ime
FINANCIAL MARKET STRUCTURE
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liabilities would not be less than 3 per cent and25 per cent, respectively.
Repos
4.38 Repo is a money market instrument, whichenables collateralised short-term borrowing andlending through sale/purchase operations in debtinstruments. Under a repo transacion, a holderof securities sells them to an investor with anagreement to repurchase at a pre-determined dateand rate. In the case of a repo, the forward cleanprice of the bonds is set in advance at a level whichis different from the spot clean price by adjustingthe difference between repo interest and couponearned on the security. Repo is also called a readyforward transaction as it is a means of fundingby selling a security held on a spot (ready) basisand repurchasing the same on a forward basis.Reverse repo is a mirror image of repo as in thecase of former, securities are acquired with asimultaneous commitment to resell.
4.39 Subsequent to the irregularit ies insecurities transactions, repos were initially allowedin the Central Government Treasury bills and datedsecurities created by converting some of theTreasury bills. In order to activate the repos marketessentially to be an equilibrating force between themoney market and the Government securitiesmarket, the Reserve Bank gradually extended reposfacility to all Central Government dated securitiesand Treasury bills of all maturities. Recently, whilethe State Government securities were made eligiblefor repos, the Reserve Bank also allowed all non-banking entities, maintaining SGL and currentaccount with its Mumbai office, to undertake repos(including reverse repos). Furthermore, it has beendecided to make PSU bonds and private corporatesecurities eligible for repos to broaden the reposmarket.
4.40 The Reserve Bank also undertakes repo/reverse repo operations with PDs and scheduled
commercial banks, as part of its open marketoperations. It also provides liquidity support to SDsand 100 per cent gilt mutual funds through reverserepos. There is no limit on the tenor of repos. TheReserve Bank initially conducted repo operationsfor a period of 14 days. Since November, 1996, theReserve Bank has been conducting 3-4 day repoauctions, synchronizing with working day and week-end liquidity conditions, in order to modulate short-term liquidity. With the introduction of LiquidityAdjustment Facility (LAF) from June 5, 2000, theReserve Bank has been injecting liquidity into thesystem through reverse repos and absorbingliquidity from the system through repos on a dailybasis. These operations are conducted on all workingdays except on Saturdays, through uniform priceauctions and are restricted to scheduled commercialbanks and PDs. This is apart from the liquiditysupport extended by the Reserve Bank to PDsthrough refinance/reverse repo facility at a fixedprice.
4.41 Repos help to manage liquidity conditionsat the short-end of the market spectrum. Reposhave often been used to provide banks an avenueto park funds generated by capital inflows toprovide a floor to the call money market. Duringtimes of foreign exchange market volatility, reposhave been used to prevent speculative activity asthe funds tend to flow from the money market tothe foreign exchange market. For instance, a fixedrate repo auct ion system was inst i tuted inNovember 1997 with a view to ensuring aneffective floor for the short-term interest rates inorder to ward off the spread of contagion duringthe South-East Asian crisis. The repo rates werereduced with the return of capital flows, whichimparted stability to the foreign exchange market.
Commercial Paper
4.42 Commercial Paper (CP) is issued by non-banking companies and al l - India Financial
# : Of monthly weighted averages.Source : Handbook of Statistics on Indian Economy, 2000, RBI.
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Institutions (AIFIs) as an unsecured promissorynote or in a demateriaslied form at a rate ofdiscount not tied to any transaction. It is privatelyplaced with investors through the agency of banks.Banks act as both principals ( i .e., as counterparties in purchases and sales) and agents indealership and placement. Banks are not allowedto either underwrite or co-accept issue of CP.
4.43 Conditions relating to issuing of CPs havebeen relaxed gradually with a view to broad-basingthe market. For instance, the maturity period hasbeen changed from 91 days - 6 months earlier to15 days - 1 year. The minimum size of CPs hasalso been reduced from Rs.1 crore to Rs. 5 lakh.The issuer base has been widened by allowingPDs, SDs and AIFIs, apart from corporates, toissue CPs to access short-term funds.
4.44 The limit for issuance of CP, which wasinitially carved out of the maximum permissiblebank finance (MPBF), was later linked to the cashcredit component of MPBF. With the cash creditcomponent gradually shrinking and, thereby,restricting the development of CP, the issuancelimit was delinked from the cash credit limit inOctober 1997. Initially, banks were required torestore the cash credit limit on the maturity ofthe paper, guaranteeing the issuer funds at thepoint of redemption. This “stand-by” facility waswithdrawn in October 1994 to impart a measureof independence to CP as a money marketinstrument. Banks could be approached for arestoration of the original cash credit limit at alater date, the sanction of which was left to theirdiscretion. The credit rating requirement, initiallyan enabling condition for issuing CP, graduallyturned to signal the issuer’s posit ion in themarket. The Reserve Bank converted CP into astand-alone product effective October 2000, witha view to enabling the issuers in the services sectorto meet short-term working capital requirementsand, at the same time, according banks and FIsthe flexibility to fix working capital limits aftertaking into account the resource pattern ofcompanies’ finances including CPs. Trading in thedematerial ised form, which was introducedrecently, is likely to reduce transactions costs.
4.45 The pricing of CP usually lies between thescheduled commercial banks’ lending rate (sincecorporates do not otherwise have the incentive toissue CP) and some representative money marketrate (which represents the opportunity cost ofbank funds). The Indian CP market is driven bythe demand for CP by scheduled commercial
banks, which, in turn, is governed by bankliquidity. Banks’ investments in CP, despite apositive interest rate differential between the bankloan rate and the CP rate, may be explained bytwo factors, viz., (i) the higher transactions costsof bank loans, and (ii) the relative profitability ofCP as an attractive short-term instrument to parkfunds during times of high liquidity. As inter-bankcall rates are typically lower than the CP rates,some banks also fund CP by borrowing from thecall money market and, thus, book profit througharbitrage between the two money markets. Mostof the CPs seem to have been issued by themanufacturing companies for a maturity periodof approximately three months or less, mainly dueto the fact that investors do not wish to lock fundsfor long periods of time. In most internationalmarkets, CP is issued on a short-term basis witha roll-over facility; this facility, however, is notallowed in the Indian CP market.
4.46 The secondary activity is subdued in mostCP markets on account of the investors’preference to hold the instrument due to higherrisk-adjusted return relative to those of otherinstruments. However, mutual funds find thesecondary market relatively remunerative, sincestamp duty for the issuer will be higher in casethe buyer is a mutual fund rather than a bank.Hence, there is a tendency to route a CP throughan institution (usually a bank), which attractslower stamp duty in the primary market, to amutual fund in the secondary market.
Certificates of Deposit
4.47 Certificates of Deposit (CD), introduced inJune 1989, are essentially securitised short-termtime deposits issued by banks during periods oftight liquidity, at relatively high interest rates (incomparison with term deposits). But thetransaction cost of CDs is often lower as comparedwith that of retail deposits. When credit picks up,placing pressure on banks’ liquidity, banks try tomeet their liquidity gap by issuing CDs, often at apremium. The required amounts are mobilisedin larger amounts through CD, often for shortper iods in order to avoid interest l iabi l i tyoverhang in the subsequent months when creditdemand slackens. As banks offer higher interestrates on CDs, subscribers find it profitable to holdCDs ti l l maturity. As a result, the secondarymarket for CDs has been slow to develop.
4.48 The Reserve Bank init ial ly l imited theissuance of CDs at a certain percentage of the
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fortnightly average of the outstanding aggregatedeposits of 1989-90. Over-time, bank-wise limitswere raised and subsequently abolished, effectiveOctober 16, 1993, enabling the CD to emerge asa market determined instrument. The reductionin the minimum maturity of time deposits andthe permission to allow banks to pay differentinterest rates based on deposit size, reduced therelative attractiveness of CDs. With a view tobroadening the CD market, the minimumissuance size was gradually scaled down to Rs.5lakh and the minimum maturity reduced to 15days in April 2000. Again, in order to provideflexibility and depth to the secondary market, therestr ict ion on transferabi l i ty per iod for CDsissued by both banks and financial institutionswas withdrawn effective October 10, 2000.
4.49 The issuance of CDs and subscription toCPs by scheduled commercial banks and theinterest rate on the two instruments broadlyreflected the liquidity conditions of banks (Table4.2 and Chart IV.2). The outstanding amount ofCP increased to Rs.3,264 crore as at end-March1994 from Rs.577 crore as at end-March 1993,while CDs decl ined to Rs.5,571 crore fromRs.9,803 crore. As liquidity conditions tightenedwith the increased demand for bank credit andcapital outflows, the outstanding amount of CDsincreased steadily to scale a peak of Rs.16,316crore as at end-March 1996, while CP issuesdwindled to Rs.76 crore. As liquidity conditionseased, the outstanding amount of CDs declinedto Rs.12,134 crore as at end-March 1997 butincreased to Rs.14,296 crore as at end-March1998 following the Reserve Bank’s monetary
tightening measures on January 16, 1998. CDsdeclined to Rs.3,717 crore at end-March 1999 asa result of slackening of credit demand and capitalinflows and remained limited to an average ofaround Rs.1,500 crore during 1999-2000. Theoutstanding amount of CP picked up, after thelimits were enlarged in October 1997, to Rs.4,770crore as at end-March 1999 and further toRs.5,663 crore as at end-March 2000.
Commercial Bills Market
4.50 The commercial bill market in India is verylimited, as evidenced by the fact that commercialbi l ls rediscounted by commercial banks withf inancial inst i tut ions stay often wel l belowRs.1,000 crore. The commercial bills market wasconstricted by the cash credit system of creditdelivery where the onus of cash managementrested with banks. The Reserve Bank withdrewthe interest rate cei l ing of 12.5 per cent onrediscounting of commercial bills, effective May1, 1989. The success of the bills discountingscheme is contingent upon financial discipline onthe part of borrowers. As such discipline did notexist, the Reserve Bank, in July 1992, restrictedthe banks to finance bills to the extent of workingcapital needs based on credit norms. However,in order to encourage the ‘bi l ls ’ culture, theReserve Bank advised banks in October 1997 thatat least 25 per cent of inland credit purchases ofborrowers should be through bills. The WorkingGroup on Bills Discounting by Banks (Chairman:Shri U.R. Ramamoorthy) has recently submittedits report to the Reserve Bank.
Table 4.2: Certificates of Deposit andCommercial Paper: Summary Statistics
4.51 In Apri l 1992, scheduled commercialbanks and publ ic f inancial inst i tut ions wereallowed to set up MMMFs, subject to certain termsand conditions. The prescribed restrictions wererelaxed subsequently between November 1995and July 1996 in order to impart more flexibility,liquidity and depth to the market. MMMFs areallowed to invest in rated corporate bonds anddebentures with a residual maturity of one year.The minimum lock-in period for units of MMMFswas relaxed from 30 days to 15 days in May 1998.In 1999-2000, MMMFs were allowed to offer‘cheque writing facility’ in a tie-up with banks toprovide more liquidity to unit holders. MMMFs,which were regulated under the guidelines issuedby the Reserve Bank, have been brought underthe purview of the SEBI regulations since March7, 2000. Banks are now allowed to set up MMMFsonly as a separate entity in the form of a trust.Current ly, there are only three MMMFs inoperation.
Foreign Exchange Market Structure
4.52 The foreign exchange market in Indiacomprises customers, authorised dealers (ADs)and the Reserve Bank. With the transition to amarket determined exchange rate system in March1993 and the subsequent gradual but significantliberalisation of restrictions on various externaltransact ions, the forex market in India hasacquired more depth.
4.53 The growing depth of the Indianforex market in the ’nineties reflects essentiallythe result of the implementation of a numberof recommendations of three importantcommittees, viz., the High Level Committee onBalance of Payments (Chairman: Dr. C.Rangarajan), the Report of the Expert Group onForeign Exchange Markets in India (Chairman:Shri O.P. Sodhani) and the Committee on CapitalAccount Convert ibi l i ty (Chairman: Shri S.S.Tarapore).
4.54 Since the unification of the exchange ratein March 1993, several measures have beenintroduced to widen and deepen the forex market.First, banks have been given the freedom to (i) fixnet overnight position limits and gap limits (withthe Reserve Bank formally approving the limits),(i i) ini t iate trading posit ion in the overseasmarkets, (iii) determine the interest rates of NRIdeposits (Linked to LIBOR in the case of FCNR(B)
deposits) and maturity period [minimum maturityof one year in the case of FCNR(B) deposits].Secondly, inter-bank borrowings have beenexempted from statutory pre-emptions. Thirdly,banks have been permitted the use of derivativeproducts for asset-liability management. Fourthly,in order to facilitate integration of domestic andoverseas money markets, ADs have been allowedto borrow abroad. However, as a prudentialmeasure, their external borrowings have beenrelated to their capital base. At present, ADs areallowed to avail of loans, overdrafts and othertypes of fund based credit facilities from theiroverseas branches and correspondents up to 15per cent of their unimpaired Tier I capital or US $10 million or its equivalent, whichever is higher.The funds are allowed to be used for any purpose- other than lending in foreign currencies. ADshave been provided the flexibility to cross theselimits solely for replenishing their rupee resourcesin India for normal business operations and notfor deployment in the call money or other markets.In such instances, a report on each borrowing hasto be immediately forwarded to the Reserve Bankand its prior permission is needed for repaymentof such loans. Such permission would be given onlyif the AD has no borrowings outstanding from theReserve Bank or other bank/financial institutionin India and the concerned AD is clear of all moneymarket borrowings for a period of at least fourweeks before the repayment. Fifthly, corporateshave been provided significant freedom in managingtheir foreign exchange exposures. They arepermitted to hedge anticipated exposures, thoughthis facility has also been temporarily suspendedafter the Asian crisis. Exchange Earners’ ForeignCurrency (EEFC) account entitlement has also beenrationalised. Risk management strategies likefreedom to cancel and rebook forward contractshave been allowed to corporates, although currentlydue to Asian crisis, freedom to rebook cancelledcontracts is suspended. However, corporates areallowed to roll over the contracts. Other riskmanagement tools like cross-currency options onback-to-back basis, lower cost option strategies likerange forwards and ratio range forwards andhedging of external commercial borrowing (ECB)exposures have been allowed subject to prudentialrequirements.
4.55 The customer segment of the spot marketin India essential ly ref lects the transactionsreported in the balance of payments. Although aspercentage of GDP, gross inflows and outflowshave not increased significantly, in absolute value
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terms, there has been a two-fold increase in themerchant transactions in the ’nineties (Chart IV.3).Current transactions, however, continue todominate the capital transactions. The merchantsegment of the market continues to be dominatedby select public sector units, in particular, theIndian Oil Corporation (IOC), and the Governmentof India. In the post-1993 period, the foreigninstitutional investors (FIIs) have also emergedas major players in the foreign exchange marketwith some evidence of links between the FII flowsand the behaviour of the exchange rate (ChartIV.4). During the four major phases of net FIIoutf lows (as shown by * in Chart IV.4), theexchange rate of the rupee seemed to depreciate.While earlier the debt service requirements of theGovernment and IOC were being routed throughthe Reserve Bank, since 1996 such demands havealso been routed through the market. As the forexdemand on account of public sector units and theGovernment tends to be lumpy and uneven,resultant demand-supply mismatches entai loccasional pressures in the forex market,warranting market interventions by the ReserveBank.
4.56 There has been a considerableimprovement in the forex market turnover in therecent years, particularly during the post-reformperiod. The total turnover, i.e., merchant andinter-bank taken together, in the forex marketincreased by 6-fold between the period 1987-88to 1999-00. The average monthly turnoverincreased from about US $ 17 billion in 1987-88to US $ 50 billion in 1993-94 and further to US $109 billion in 1998-99. Reflecting restrictions on
re-booking of cancelled forward contracts forimports and splitting of forward and spot legs ofa commitment, the monthly turnover declined toUS $ 95 bi l l ion in 1999-00. The inter-bankturnover constitutes the predominant part of totalturnover. The proportion of inter-bank turnoverin total turnover increased from 82 per cent in1987-88 to 91 per cent by 1991-92 but declinedto less than four-fifths by 1999-00. As regardsthe classification by way of spot and forwardtransactions, available data for the recent periodindicate that the merchant segment is dominatedby spot transactions, while the inter-bank segmentis dominated by forward transactions. During1999-00, spot transactions accounted for about55 per cent of total merchant turnover, while theforward transactions formed 40 per cent of totalinter-bank turnover.
4.57 In the Indian forex market, which isessential ly transactions driven, interbanktransactions in the spot segment mostly facilitatemarket making. At times, however, inter-banktransactions also reflect the “day trading” pattern.With restrictions on overnight overbought andoversold positions, day trading allows one tobenef i t f rom the intra-day exchange ratemovements without violating the close of the dayposition limits. During normal market conditions,the rat io between inter-bank and merchanttransactions should be somewhat stable. In theface of disorderly conditions, tendency for daytrading may increase and, as a result, the ratiomay increase. This is evidenced from Chart IV.5.Whenever the Indian rupee was under pressure(particularly corresponding to the three points
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shown by * in Chart IV.5), the ratio of inter-bankspot transact ions to merchant transact ionstended to exceed the average, suggesting that daytrading activities increase during volatile marketconditions.
4.58 In the forward/swap segment of the market,importers and corporates generally tend to rush forcover when the spot market turns disorderly andprefer to keep their positions open during stablemarket conditions. This creates occasional largemismatches in the forward segment of the market.This is evidenced from Chart IV.6. If merchant salein the forward segment is used as a proxy forforward demand by importers and merchantpurchase in the forward segment is used as a proxyfor supplies by exporters in the forward market,then the ratios of monthly forward demand tomonthly imports and monthly forward supply tomonthly exports could explain the sensitivity ofexporters and importers to forward market in India.Chart IV.6 shows that the ratio of demand forforward cover to imports remained below oneduring stable market conditions, but got close toone or exceeded one whenever the spot exchangerate came under pressure. Two-way movement inthe exchange rate is essential to increase thesensitivity of exporters and corporates to theforward market.
4.59 Initiation of longer maturity contracts upto one year represents a healthy development inthe forex market. According to the BIS Survey onGlobal Foreign Exchange markets, the maturitybreakdown of outright forward transactions indifferent markets shows that while for the globalmarket as a whole the share of one year contracts
was about 4 per cent, in India it was close to 3per cent. Forward contracts up to seven days,however, represented 51 per cent of total outrightforward transactions in the world as against 22per cent in India. This could be on account of therestrictions in the Indian market that without anunderlying transaction, an agent cannot enter intoa forward contract.
4.60 The Reserve Bank’s presence in themarket essentially reflects its policy of ensuringorderly market conditions. Reflecting its stance,net intervention sales of the Reserve Bankgenerally coincided with conditions of excessdemand in the market, while net interventionpurchases coincided with surplus marketconditions and contributed to reserve build-up(Chart IV.7).
Structure of Debt Market
4.61 The domestic debt market comprises twomain segments, viz., the Government securitiesand other (mainly corporate) securi t iescomprising private corporate debt, PSU bondsand DFIs bonds. The government securi t iesmarket is pre-dominant, while the other segmentis not very deep and liquid.
Government Securities Market
4.62 The size of the Government securitiesmarket is large and is growing. This is evidentfrom the fact that secondary market transactionsin Government securi t ies increased to Rs.5,39,255 crore in 1999-2000 as against Rs.1,27,179 crore in 1995-96.
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securi t ies in June 1992, marking a move tomarket related rates on the Governmentsecurities. The important objective to be achievedthrough the auction system was the process ofprice discovery. At present, the sale of Governmentsecurities in India is done both through auctionmethod as well as pre-determined coupon/tapissues. Auctions are of the discriminatory/multipleprice, sealed bid type. The multiple price auctionis the mostly used selling technique. The sale ofTreasury bills is conducted through the auctionmethod. Apart f rom the al lotment throughauct ion, the pract ice of entertaining non-competi t ive bids in Treasury bi l ls to StateGovernments, non-government provident fundsand other central banks at the weighted averageprice determined in auctions also exists. Non-competitive bids are, however, accepted outsidethe notified amount. This is done to encourageparticipants who do not have sufficient expertisein such bidding. The Reserve Bank alsopart ic ipates on a non-competi t ive basis inTreasury bills and dated securities to primarilytake up some part of the issues in case of under-subscription. In the recent years, with a view tomoderat ing the market impact of the largeborrowing programme on interest rates, theReserve Bank has accepted private placement ofgovernment stocks and released them to themarket when the interest rate expectations turnedout to be favourable.
4.66 With a view to eliminating the problem of“winner’s curse”, associated with the multipleprice auction, and broadening the marketparticipation, the uniform price auction methodwas introduced in respect of 91-day Treasury bill.Since 1999-2000 most of the current primaryissues of dated securities are through re-issuesand price-based auctions, instead of yield-basedauctions, to enable consolidation of securities.Such consolidation is necessary for ensuringsufficient volumes and liquidity in any one issueand to facilitate the emergence of bench-marksand development of Separately Traded RegisteredInterest and Principal of Securities (STRIPS).
4.67 While there exists a fixed calendar forauctions of all types of treasury bills, auctions/issues of dated securities are not based on anyfixed calendar (Table 4.3). However, the auction/issue of Treasury bi l l and dated securi ty isannounced in advance through a publ icnot i f icat ion. Whi le the 14-day and 91-dayTreasury bills are auctioned on a weekly basis,
4.63 The Government securi t ies marketwitnessed signif icant transformation in the’nineties. Its development was constrained mainlyby lack of def in i te l imi ts on the automaticmonetisation of the Central Government budgetdeficits and by relatively low coupon rates offeredon the Government securities. The artificially lowyield on Government securities had an impact onthe entire yield structure of financial assets in thesystem. Both these factors were corrected duringthe ’nineties. As regards the secondary market,there was not much activity which was hinderedby low bond yields and predominence of captiveinvestors. The secondary market act iv i tyincreased following the introduction of auctionbased yields. The activity in the secondary marketcould further pick up once bond yields are betteraligned and investors, other than institutions(banks and insurance companies) start activelytransacting in the market.
Type of Instruments
4.64 As a part of developing money marketinstruments, a variety of Treasury bi l ls, viz.,14-day, 91-day, 182-day, 364-day maturities havebeen introduced. Innovations have also beenintroduced with respect to long-term bonds, whichinclude zero coupon bonds, floating rate bondsand capital indexed bonds.
Selling Techniques
4.65 An event of significance to the gilt marketwas the introduction of auction system for dated
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the auctions of 182-day and 364-day Treasurybills are held on a fortnightly basis. The treasurybills/bonds are issued to successful bidders inthe form of stock certificates or by credit to theirSubsidiary General Ledger Account.
Types of Traders/Market Participants
4.68 The main investors in the Governmentsecurities market in India are commercial banks,co-operative banks, insurance companies,provident funds, financial institutions (includingterm-lending institutions), mutual funds especiallythe gilt funds, primary dealers, satellite dealers,non-bank finance companies and corporateentities. The Reserve Bank also absorbs primaryissuance of Government securities, either throughprivate placement or devolvement. Though bankshave traditionally been the dominant investors inthe Government securities due mainly to SLRrequirements, they have, in recent years, found itadvantageous to invest in the Governmentsecurities beyond the statutory requirements partlybecause of the better risk-return characteristic ofsuch securities in the context of adherence tocapital adequacy requirements and partly becauseof relatively sluggish demand for commercialcredit. The share of commercial bank holdingscontinued to rise during the ’eighties and the early’nineties. It reached a peak of 72.5 per cent as atend-March 1994 before declining to 59.5 per centas at end-March 1999 (Table 4.4).
4.69 A large part ic ipant base reduces theborrowing cost for the Government, reducesmarket volatility and imparts competition in themarket. A market with adequate depth and
l iquidi ty for part ic ipants with di f ferentperceptions and liquidity requirements shouldemerge; this is also essent ial to avoidunidirectional movements in the market. Thepresent structure of the Government securitiesmarket is pre-dominantly institutional, while thehousehold participation is negligible or nearlyabsent. Foreign Institutional Investors (FIIs) arealso permitted to invest in the dated Governmentsecurities and Treasury bills, both in the primaryand secondary markets, within the overall debtceilings. While FIIs are allowed to invest in thedebt up to a maximum of 30 per cent of their totalinvestments, there is no such limit for dedicateddebt funds.
4.70 In order to promote the retai l marketsegment and provide greater liquidity to retailinvestors, the Reserve Bank allowed banks tofreely buy and sell Government securities on anoutr ight basis at prevai l ing market pr ices,removing restriction on the period between saleand purchase. Furthermore, the interest incomeon government securities was exempted from theprovision of Tax Deduction at Source (TDS) witheffect from June 1997, facilitating quotations at‘clean prices’ and genuine trading in the secondarymarket.
Market Supporting Structures/Institutions
4.71 A crucial issue in the development of theGovernment securities market is the need for awell functioning secondary market, which requires(i) a transparent system of trading; (ii) a securesystem of sett lement of transactions; ( i i i) aninstitutional structure whereby the market players
Table 4.3 : Features of TreasuryBills Auction
Type of Periodicity Notified Day of Day ofTreasury Amount Auction Payment
bi l l (Rupeescrore)
1 2 3 4 5
14-day Weekly 100 Every Friday FollowingMonday
91-day Weekly 100 Every Friday FollowingMonday
182-day Fortnightly 100 Wednesday Followingpreceding the Thursdaynon-reportingFridays
364-day Fortnightly 500-750 Wednesday Followingpreceding the ThursdayreportingFridays
Table 4.4: Pattern of Investment inCentral and State Government Dated
Securities - By Investor Category(Per cent)
End of March Reserve Commercial LIC OthersBank Banks
1 2 3 4 5
1981 20.6 45.6 12.0 21.8
1986 25.2 48.1 10.6 16.1
1991 20.3 59.4 12.3 8.0
1996 7.3 64.9 16.8 11.0
1997 2.8 63.0 18.7 15.5
1998 10.7 58.9 18.0 12.4
1999 9.1 59.5 17.9 13.5
FINANCIAL MARKET STRUCTURE
IV - 17
have divergent perceptions about liquidity andinterest rates; and (iv) a liquid market with amatured system of price determination.
4.72 To develop the secondary market for theGovernment securities, the following measureswere initiated.
Secondary Market Window
4.73 The central banks often play the role ofmarket makers providing two-way quotes throughtheir sales window to infuse l iquidi ty in thesecondary market for the Government securities.General ly, two approaches are adopted foroperating the secondary market window by thecentral banks: (i) fixing buying and selling pricesand announcing them to the market, and (ii) usinga dynamic approach whereby the secondarymarket window pricing is continuously adjustedin response to the market dynamics. During theinitial stages of market development, the ReserveBank used to announce the sale and purchaseprices of securities. In the recent period, however,the Reserve Bank has offered a select list ofsecurities for sale, depending upon supply anddemand conditions. A few securities are alsoincluded in the purchase l ist, with a view toimproving liquidity through select securities. Thesale/purchase prices and the securities offered onsale are frequently revised.
Discount House Arrangements
4.74 The DFHI was originally set up in April1988 for developing the money market. It was alsoallowed to participate in Treasury bills and datedsecurities. Further, for developing an efficientinstitutional infrastructure for an active secondarymarket in Government securi t ies and publ icsector bonds, the Securities Trading Corporationof India (STCI) was set up in May 1994. BothDFHI and STCI later transformed themselvesinto PDs.
Primary Dealer System
4.75 The primary dealer system was evolvedand made functional in 1996 with the objectiveof strengthening the securi t ies marketinfrastructure and bringing about improvementin the secondary market trading, liquidity andturnover in Government securi t ies as alsoencouraging their voluntary holding amongst awider investor base. PDs have ensured maximum
part ic ipat ion in the auct ions of Governmentsecurities. In the secondary market, they act asmarket makers by providing continuous two-wayquotes thereby ensuring liquidity and support tothe success of primary market operations. Thesystem also creates appropriate conditions foropen market operations of the Reserve Bank andfacilitates the transfer of market making activitiesfrom the Reserve Bank to the market agents.
4.76 As on March 31, 2000, there were 15approved PDs in the gilts market. The ReserveBank guidel ines specify that the inst i tut ionswilling to register as PDs should have sufficientand continuous presence in the Governmentsecuri t ies market and a certain minimumfinancial capacity (minimum net owned funds ofRs.50 crore). A PD commits bids in the auctionfor a minimum amount in the Central Governmentdated securities and Treasury bills, maintains aminimum level of success ratio, underwrites pre-determined parts by which subscriptions/acceptedbids fall short of the notified amounts, offerstwo-way quotes for Government securities andachieves an annual turnover of not less than fivetimes in Government dated securities and tentimes in Treasury bil ls, within which outrighttransactions should be three and six t imes,respectively. In return to such obligations, theReserve Bank extends to them facil i t ies l ikecurrent account/SGL account, liquidity supportlinked to bidding commitments, freedom to dealin money market instruments and favoured accessto open market operations. The primary marketpurchases of PDs in Government securities andTreasury bills rose from Rs.20,835 crore in 1996-97 to Rs.53,797 crore in 1999-2000. Thesecondary market turnover (outright plus repos)of PDs also recorded significant growth fromRs.90,453 crore to Rs.3,34,471 crore during thesame period.
Satellite Dealers
4.77 With a view to broadening the market witha second tier of dealer system in trading anddistribution and imparting greater momentum interms of increased l iquidi ty and turnover, asystem of SDs was put in place in December 1996.The Reserve Bank had granted registration to 9entities as SDs in the Government securitiesmarket. The network of satellite dealers providesretai l out lets thereby encouraging voluntaryholding of Government securities among a wideinvestor base. The SDs are also given limited
REPORT ON CURRENCY AND FINANCE
IV - 18
liquidity support from the Reserve Bank. It maybe noted that some of the SDs have become PDs.At present 4 SDs are in operation. The schemefor approval of both PDs and SDs has been madean ongoing process. However, the response to thescheme of SDs has been limited so far.
Gilt Funds
4.78 The Reserve Bank also encouraged settingup of mutual funds dealing exclusively in gilts,cal led gi l t funds with a view to encouragingschemes of mutual funds dedicated toGovernment securi t ies and creating a widerinvestor base for them. Mutual funds dedicatedexclusively to investment in Governmentsecurities are also provided liquidity support bythe Reserve Bank by way of reverse repos inCentral Government securities outstanding at theend of the previous calendar month. The liquiditysupport provided by the Reserve Bank would beto the extent of 20 per cent of the investment inGovernment dated securities.
Trading and Settlements/Clearing Systems
4.79 Under market microstructure theory, themarket efficiency is significantly influenced by thetransaction costs or costs of trading (Box IV.1).The transaction costs are, in turn, determined bythe type of trading, clearing and settlement systemexisting in a market. A well developed market inGovernment securi t ies requires a system oftransparent pricing and allotment, which, in aspecial sense, refers to information needs. Inturn, such a system would imply active marketmaking activity and broad-based participation.The National Stock Exchange (NSE) introduced
a transparent screen-based trading system in thewholesale debt market, including Governmentsecurities in June 1994. The trading systemknown as National Exchange for AutomatedTrading (NEAT) is a fully automated screen-basedtrading system. The Over the Counter Exchangeof India (OTCEI) also started trading inGovernment securities in July 1997. However, amajor part of government securities transactionin the secondary market is operated through over-the-counter negotiated deals. The brokers, whoare members of the NSE and OTCEI can transactbusiness on behalf of commercial banks. TheOTCEI and NSE markets complement each other.As announced in the Mid-term Review of Monetaryand Credit Policy for 2000-01, the Reserve Bankhas taken an in-principle decision to move overin due course to order-driven screen-basedtrading in Government securities on the stockexchanges. The screen based trading systemwould be applicable to all stock exchanges onwhich banks and FIs can operate.
Clearing system
4.80 The presence of a fast, transparent andefficient clearing system constitutes the basicfoundation of a well-developed secondary marketin Government securities. In India, a major stepin this direction was the establishment of the DvPsystem. The Reserve Bank presently operates aGovernment securit ies settlement system forthose having Subsidiary General Ledger (SGL)Accounts in its Public Debt Offices through DvPSystem. The DvP system ensures settlement bysynchronising the transfer of securities with thecash payment. This reduces settlement risk in
The last two decades have seen a tremendous interest in themarket microstructure. Market microstructure theory, whichis still in the process of evolution, analyses as to how specifictrading mechanisms affect the price formation process. Theinterest in the role of trading mechanisms has been spurredafter the market crash in 1987. In contrast to traditionalmodels of f inance that assumed perfect markets andequil ibrium condit ions, security market microstructureconcerns with market imperfections, such as, cost of tradingand asymmetries in information, etc.
The concerns about trading mechanism in the pricing processwere raised by many, but the most direct analysis was that ofDemsetz (1968) who examined the importance of tradingmechanism in the determination of prices in securitiesmarkets. Although his focus was on the nature of transaction
Box IV.1
Market Microstructure - A Theoretical Perspective
costs, his analysis of how the time dimension of supply anddemand affected market prices set the stage for the formalstudy of market microstructure. He brought into focus thetime dimension of trading, i.e., if the number of traderswishing to sell immediately did not equal the number whowished to buy immediately, imbalance of trade would make itimpossible to find a market-clearing price at a given time.The immediate execution of trading involves the implicit costs,which are referred to as the price of immediacy. Thus, Demsetzargued that the lack of equilibrium could be overcome bypaying a price for immediacy. His analysis also brought intofocus the implication that the specific structure of the marketcould affect the trading price. Since the size of the priceconcession needed to trade immediately (i.e., the spread)depended on the numbers of traders, factors, such as, volume
(Contd...)
FINANCIAL MARKET STRUCTURE
IV - 19
secur i t ies t ransact ions and also preventsdiversion of funds through SGL transactions.
4.81 Under the current system, banks,financial institutions, insurance companies andnow PDs are allowed to hold SGL Accounts forsecurities and Current Accounts for cash. Forthese participants, the settlement takes throughthe DvP system. Other par t ic ipants l ikecorporates, mutual funds, provident funds, co-operative banks and societies and individuals arenot allowed to hold direct SGL Accounts with theReserve Bank. However, the SGL account holdersare provided the facility to maintain a second SGLAccount called Constituents’ SGL Account withthe Reserve Bank to enable them to holdGovernment secur i t ies on behal f o f the i rconstituents.
Trading Volumes in Subsidiary General LedgerAccount
4.82 The secondary market transactions inGovernment securities (through SGL Accounts),
as publ ished f rom September 1994, havewitnessed significant growth with an averageannual growth rate working out to 91 per centduring the period 1994-95 to 1999-2000. Thisreflects the increased depth of the Governmentsecurities market (Table 4.5). The average annualtransactions increased by 10-fold between 1994-95 and 1999-2000. The composi t ion oftransactions reveals that the share of outrighttransactions consistently rose from 42.1 per centin 1994-95 to 84.7 per cent in 1999-2000. Thesteady growth in outr ight transact ions is anevidence of the emergence of a more liquid andmatured Government securities market.
Competitive Pricing of Securities
4.83 Auct ions have contr ibuted to thedevelopment of bidding skills among banks andinst i tut ions. Banks, in part icular, have beenpaying special attention to treasury operationsas they could become centres of profit. An elasticband of interest responsiveness f rom theinvestors as par t o f act ive investment
could affect the cost of immediacy and, thus, the market price.Demsetz’s work clearly suggested that the behaviour ofmarkets, much like the behaviour of firms, could only beunderstood by examining their structure and organisation.
If the role of trading mechanism is important as analysed inDemsetz model, the interactions between the marketmechanism and trader behavior is not less important. If thetrading mechanism matters in setting prices, it also willmatter in affecting traders’ order decisions. Therefore, thequestion of how prices are set is a far more complex processthan assumed under Walrasian framework.
The initial theoretical microstructure literature concernedwith the policies of market makers and explained their bid-ask spread through the use of two approaches. The initialapproach emphasised the role of transaction costs indetermining the bid-ask spread. The inventory approachbeginning with Garman (1976) highlighted the importanceof transaction costs in determining the bid-ask spread asthe specialist or market maker faces complex balancingproblem in that he must moderate random deviations ininflows and outflows. Inventory models provide an addedrationale for the reliance on market maker. Just as physicalmarketplaces bring buyers and sellers together in space, themarket maker can bring buyers and sellers together in timethrough the use of inventory. A buyer need not wait for aseller to arrive but simply buy from the dealer who depleteshis inventory.
In 1971, a new theory, beginning with Bagehot (1971),emerged to explain market prices that did not rely ontransaction costs, but rather on an important role forinformation. In the information-based market
microstructure models, new information gets reflected intoprices as a result of the trading behavior of informed anduninformed traders. The information-based models usedinsights from the theory of adverse selection to demonstratehow, even in competit ive markets without explicittransaction costs, spreads would exist. Adverse selectionarises when the market maker is dealing with an informedtrader. That the spread of a market maker reflects balancingof losses with the informed trader with gains from theuninformed trader represented a fundamental insight intomarket making.
W hile inventory and transaction costs are important factors,the notion that information costs also affect prices provideda new and important direction for market structure research.Underlying much of the research of information-basedmodels is the focus on the information implicit in marketdata and on the learning process that translates thisinformation into prices.
References
1. Bagehot, W., (1971), “The Only Game in Town”, FinancialAnalysts Journal, 27, pp. 12-14, 22.
2. Demsetz, H., (1968), “The Cost of Transacting”, QuarterlyJournal of Economics, 82, pp. 33-53.
3. Garman, M., (1976), “Market Microstructure”, Journalof Financial Economics, 3, pp. 257-275.
4. Madhavan, Ananth, (2000), “Market Microstructure: ASurvey”, Marshall School of Business, Working PaperSeries.
management to a range of matur i t ies is animportant step in the process of competit ivepr ic ing of secur i t ies in the pr imary andsecondary markets. The interest rates onGovernment securities are now within the rangeof substitutability where rate movements evokea response from investors leading to a possibleconfluence of interest rates in the system.
Improvement in Market Absorption
4.84 Since the switchover to the marketmechanism for issuing securities, the primaryissues of the Central Government have reflecteda more than ten-fold increase. However, with theemergence of an active Government securitiesmarket, the Reserve Bank’s absorption of primaryissues came down drastically from 45.9 per centin 1992-93 to 1.45 per cent in 1993-94 and tobarely 0.74 per cent in 1994-95, partly reflectingthe rise in market absorption. However, in recentyears, the primary subscription by the ReserveBank has remained high (29.4 per cent in 1999-2000), ref lect ing the unfavourable marketconditions at the time of issuances. The monetaryimpact of the Government borrowings wascontained by offloading these securities in themarket at a favourable time through an openmarket operation of the Reserve Bank. Thus, anactive use of open market operations to ensurethe success of the borrowing programme and thelesser reliance on the Reserve Bank is a reflectionof the depth acquired by the Governmentsecurities market. Market orientation to issues
of Government securities paved the way for theReserve Bank to activate open market operationsas a tool of market intervention.
Other Debt Markets
4.85 The corporate debt market still constitutesa small segment of the debt market despite policyinitiatives taken during the ’nineties. The interestrate cei l ing on corporate debentures wasabolished in 1991 paving the way for marketbased pricing of corporate debt issues. In orderto improve the quality of debt issues, all publiclyissued debt instruments, irrespective of theirmaturity, are presently required to be rated. Therole of trustees in case of bond and debentureissues has also been strengthened over the years.
4.86 A large proportion of corporate debenturesin India is of hybrid variety combining features ofboth debt and equity. The corporate sector hasbeen issuing debt instruments of longer maturity,incorporating features of liquidity and often atfloating rates of interest. Besides the public issueof debt instruments, the private placement routehas also emerged as an important mode offloatation of new corporate debt issues during the’nineties. During 1999-2000, the private sectordebt issues in the private placement marketamounted to Rs.18,122 crore, as against Rs.2,401crore by way of public and rights issues. Someprivately placed debt- instruments aresubsequently l isted on stock exchanges fortrading.
4.87 DFI bonds have emerged as an importantsegment of the debt market. During the last 8years or so, DFIs made large issues of bonds invarying maturity ranging from 1 year to as longas 20 years. Some of the bond issues of DFIsoffered innovative features including call and putopt ions at various points of t ime during thecurrency of the bonds. DFIs have issued bondsby way of public issues as well as on a privateplacement basis.
4.88 Since the middle of the ’eighties, long-termbond issues (maturity 5-10 years) by public sectorundertakings (PSUs) imparted a new dimensionto the debt market. Resource mobi l isat ionthrough PSU bonds, which included both tax freeand taxable bonds, increased sharply to touchRs.5,663 crore in 1990-91, of which 44.9 per centwas accounted for by tax-free bonds. The ’nineties,however, witnessed a steady decline in the issueof tax-free PSU bonds, accounting for only 4.6 per
Table 4.5: Secondary Market Transactionsin Government Securities
(Rupees crore)
Year (Apri l -March) O u t r i g h t R e p o Tota l
N o t e : Figures in brackets are percentages to tota lt r a n s a c t i o n s .
FINANCIAL MARKET STRUCTURE
IV - 21
cent of PSU bonds (Rs.8,622 crore) during 1999-2000. While traditionally most of the PSU bondswere floated in the public issues market, in therecent years, most of such bond issues wereprivately placed. This is one reason why secondarymarket activity in PSU bonds has been limited.
4.89 The secondary market activity in the debt-segment, in general, however, remains low andsubdued both at BSE and the Wholesale DebtMarket Segment of the NSE, partly due to of lackof sufficient number of securities and partly dueto lack of interest by retail investors. In order toimprove the secondary market activity in thissegment, the Union Budget for 1999-2000abolished stamp duty on transfer ofdematerialised debt instruments.
Capital Market Structure
4.90 Capital market structure has evolved overtime with the market practices and conditionsgenerally reflecting the policies put in place. Tillthe onset of reforms in the early ’nineties, raisingof resources in the primary segment of the marketwas subject to several controls, disallowing thepricing to be determined by market conditions.Trading in the secondary market was subject toopaque practices. The trading and settlementsystem was outdated and out of tune withinternationally followed practices. The volumes,however, increased and securities continued toexist in the physical form. Physical securities alsocreated uncertainties for investors and increasedthe transaction cost. Besides, long and uncertainsettlement cycles created serious problems forclearing houses. Informational f lows to themarket participants were also deficient. As theprocess of price formation has to be efficient forthe growth and stability of the market, it wasconsidered necessary to orient the Securities andExchange Board of India (SEBI) to undertake thetasks of regulation and supervision. The SEBIwas, for this purpose, given statutory powersthrough a separate legislation in 1992.
New Capital Issues - Free Pricing Introduced
4.91 Raising of capital f rom the securi t iesmarket before 1992 was regulated. Under theCapital Issues (Control) Act, 1947, firms wererequired to obtain approval from the Controllerof Capital Issues (CCI) for raising resources inthe market. New companies were allowed to issueshares only at par. Only the existing companies
with substantial reserves could issue shares at apremium, which was based on some prescribedformula. In 1992, the Capital Issues (Control)Act, 1947 was repealed and with this ended allcontrols relating to raising of resources from themarket. Since then the issuers of securities couldraise the capital f rom the market withoutrequiring any consent from any authority eitherfor making the issue or for pricing it. Restrictionson r ights and bonus issues have also beenremoved. New as well as established companiesare now able to price their issues according totheir assessment of market conditions. However,issuers of capital are required to meet theguidelines of SEBI on disclosure and investorprotect ion. Companies issuing capital arerequired to make sufficient disclosures, includingjustification of the issue price and also materialdisclosure about the ‘risk factors’ in their offeringprospectus. These guidelines have served as animportant measure for protecting investor interestand promoting the development of the primarymarket along sound lines.
New Capital Issues - Issuing Mechanism
4.92 After the CCI regime was discontinued, themechanics of determining offer price assumedimportance. Initially, only fixed price mechanismof floating new capital issues was followed. Thismethod of floatation, however, suffered from adrawback in that it was not easy to determine theprice at which the market would clear the issueand, thus, could lead to either underpricing oroverpricing of an issue. The empirical evidencein many countries suggests that new capital issuesare normally underpriced. This results in transferof wealth from the issuer to the investor, entailing,in the process, a cost to the issuer. As the methodof offering shares at a fixed price by the issuerhas proved to be not efficient, an alternativemechanism of book building has become popularin many countries. Book building mechanism isa method through which an offer price of an InitialPublic Offering (IPO) is based on investors’demand. The book building mechanism whichwas introduced in 1995 gave the issuer the choiceto raise resources either through this or the fixedprice mechanism. Although the book buildingguidelines were prescribed in 1995, no issue wasfloated due to certain restrictive guidelines, whichwere modified in 1999. In terms of the extantguidelines issued by the SEBI, an issuer has beengiven the option to book build either 90 per cent
REPORT ON CURRENCY AND FINANCE
IV - 22
of the net offer to the public or 75 per cent of netoffer to the public. The balance issue is offered tothe public at the fixed price determined throughthe book building exercise. In the 75 per cent bookbuilding scheme, the allotment in the book builtportion is required to be only in the dematerialisedform. The book building mechanism of floating newcapital issues has been devised in such a way thatsmall investors are also able to subscribe tosecurities at a price arrived at through a transparentprocess.
4.93 As the book building process is both timeand cost-effective, it is becoming quite popular. Thiscan be gauged from the fact that during 2000-2001(April-October), 12 issues for an aggregate amountof Rs.1,256 crore (constituting 40.2 per cent ofthe total resources raised from the public issuemarket) were floated using book buildingmechanism as against 4 issues aggregating Rs.516crore (constituting 6.7 per cent of the totalresources raised) during the entire year of1999-2000.
4.94 Both BSE and NSE offer their infrastructurefor conducting on-line IPOs through book building.A related development has been the efforts tomarket IPOs through the existing secondary marketinfrastructure (trading terminals of stockexchanges, brokers, etc.). The SEBI has alreadyapproved a proposal of marketing of IPOs throughstock exchanges and the guidelines to this effectare expected to be issued shortly. Once implemented,the system would help to overcome the inherentdisadvantages faced by issuers and investors in theform of reduction of load on the banking and postalsystem and saving of time and cost associated withthe process of new capital issues.
Secondary Market - Trading Mechanism
4.95 The efficiency of automated vis-à-vis floor-based trading system in the secondary segment ofthe market is widely debated, although the evidencearound the world suggests that markets are movingaway from the floor-based trading system. Overtime, floor-based trading is likely to disappear,going by the trends noticed so far. Transparencyis the major factor in debates over floor-basedsystem versus electronic system and proponentsof the automated system contend that floor-basedtrading is inefficient and less transparent. Manymajor international stock markets, such as,London, Paris, Toronto, Frankfurt and Sydney,conduct electronic trading.
4.96 Till recently, trading on the Indian stockexchanges took place through open outcry systembarring NSE and OTCEI, which adopted screen-based trading system from the beginning (i.e.,1994 and 1992, respectively). At present all otherstock exchanges have adopted on-line screen-based electronic trading, replacing the open outcrysystem. Of the two large stock exchanges, theBSE provides a combination of order and quotedriven trading system, while NSE has only anorder driven system. In an order driven system,orders from all over India are entered into theelectronic system and matched directly on acontinuous basis without the involvement of ajobber or market maker. In a quote driven system,the market makers offer two way quotes and areready to buy and sell any quantity. With theintroduction of computerised trading, memberscould enter their orders/quotes on work stationsinstalled in their offices instead of assembling inthe trading ring. All stock exchanges operating inIndia have over 8000 terminals spread wideacross the country. In pursuance of theannouncement made in the Union Budget 1999-2000, the SEBI issued guidelines for opening andmaintaining the trading terminals abroad. Whileno trading terminal could be opened abroad dueto high cost of connectivity, the permission ofinternet trading provides an alternative as theinvestor in any location could route the orderthrough the internet for execution on the Indianstock exchanges. For ensuring greater markettransparency, the SEBI has recently bannednegotiated and cross deals (where both the sellerand the buyer operate through the same broker).In September 1999, all private off-market dealsin both shares as well as listed corporate debtswere banned. All such deals are now routed onlythrough the trading screens.
4.97 There are three main advantages ofelectronic trading over floor-based trading asobserved in India, viz., transparency, moreeff ic ient pr ice discovery, and reduct ion intransaction costs. Transparency ensures thatstock prices fully reflect available information andlowers the trading costs by enabling the investorto assess overall supply and demand. Owing tocomputer-based trading, the speed with whichnew information gets reflected in prices hasincreased tremendously. The quantity and qualityof information provided to market participantsduring the trading process (pre-trading and post-trading) having significant bearing on the price
FINANCIAL MARKET STRUCTURE
IV - 23
formation has also improved. Besides, the screen-based trading has the advantage of integratingdifferent trading centres all over the country intoa single trading platform. It may be noted thatprior to screen-based trading, the very presenceof stock markets in different regions impliedsegmentat ion of markets affect ing the pr icediscovery process. Investors in other locationswere, under such conditions, unable to participatein the price formation process at the major stockexchange, namely the BSE. However, with screen-based trading spread across various locations, theprocess of price discovery has improved in theIndian stock markets. Screen-based trading hasalso led to significant reduction in the transactioncost since it enabled the elimination of a chain ofbrokers for execution of orders from variouslocations at BSE and NSE.
Instruments and Market Participants
4.98 The capital market has widened anddeepened considerably in the recent years withenlargement of participants and emergence of newinstruments. In the Indian capital market,traditionally mainly two instruments were traded,i.e., debt and equity. However, starting from themid-’eighties and especially during the first-halfof the ’nineties, a wide range of innovative/hybridinstruments combining both the features of debtand equity were introduced to suit varied needsof investors and issuers/borrowers. Besides DFIs,PSUs also issued many debt instruments withinnovative features.
4.99 Markets have also widened with theincrease in the number of players, such as, mutualfunds and foreign institutional investors. Thereare now 34 mutual funds operating in the countrywith total asset base of over Rs. one lakh crore.At the end of November 2000, there were about551 FIIs registered with the SEBI. They madeinvestment to the extent of about US $ 11.5 billionin equity. With large investment base and activetrading operations, FIIs now significantly impactthe Indian stock markets.
Trading, Clearing and Settlement Systems
4.100 The trading, clearing and settlementsystems, which had suffered from severalbottlenecks, have been considerably improved withmeasures taken to shorten the settlement cyclethrough the introduction of rolling settlement systemin select scrips and acceleration of the process ofelectronic book entry transfer through depository.
Trading Regulations
4.101 Trading by member brokers is subject tosome restrictions. These relate to marginingsystem, intra-day trading limit and exposure limit.Each broker is subject to margins and to thetrading limit, Various types of margins, such as,daily margins, mark to market margin, ad hocmargin and volatility margins to contain pricevolatility, are in place. There is also an intra-daytrading limit, which is the limit to volume. Eachbroker’s trading volume during a day is notallowed to exceed the intra-day trading limit. Incase a broker wishes to exceed this limit, he orshe has to deposit additional capital with theexchange. Thus, brokers are now required to haveadequate capital in relation to their positions.With a view to enhancing market safety, the upperlimit for gross exposure of the member-broker ofthe stock exchange has been fixed at 20 times ofhis capital. These restrictions have an impact ondaily transaction volume and daily volatility.
Gradual Switch Over to the Rolling Settlement
4.102 The Indian stock market has, historically,adopted an account period settlement systemwhereby positions of brokers are accumulated tillthe end of a specified period and only the nettedout positions with respect to every security aresettled. The accumulation of position during thesettlement cycle has given scope for speculativeactivities and, thus, increasing the possibility ofdefault by participants. By combining the featuresof both cash and futures markets, the accountperiod sett lement also impeded the pr icediscovery process. Further, the end of thesettlement period, in the absence of significantborrowing and lending facility, has often witnessederratic price movements. Although the accountperiod sett lement system through increasedvolume of trade, has tended to add to the liquidityin the system, there have been concerns over itsill-effects. As a partial remedy, the period oftrading cycle was reduced from a fortnight to oneweek uniformly across all stock exchanges. Thelong-term solution to the trading system, however,rests with the al ternat ive system of rol l ingsettlement (RS), which is accepted and is beingadopted in a phased manner. Under the RSsystem, any transaction made on a particular daynecessarily results in delivery after a fixed numberof days. The rolling settlement on a T+5 basis wasintroduced in select scrips numbering 10 in all inJanuary 2000. Subsequently as on May 8, 2000,
REPORT ON CURRENCY AND FINANCE
IV - 24
153 more scrips were brought under the rollingsettlement system. The introduction of roll ingsettlement, however, demands quicker movementof funds and securities. This, in turn, requiresadequate developments in dematerialisation andelectronic funds transfer (EFT) facility. While theprocess of dematerial isat ion is taking placesatisfactorily through the existing depositories,efforts are afoot to improve and expand theexisting EFT facility.
Increased Dematerialisation
4.103 Safe and quick transfer of securities is animportant element for smooth and eff icientfunctioning of the securities market. Apart fromthe problems involved in the movement of physicalsecurity certificates, bad deliveries due to faultypaper work, theft, forgery etc. added to thetransaction cost and restricted l iquidity. Toovercome these difficulties, legislative changes werecarried out for maintaining ownership records inan electronic book-entry form. Under this mode,securities are transferred in a speedy and safemanner without interposition of issuers in theprocess, except in few circumstances. In order tocatalyse the process of dematerial isation ofsecurities and dematerialised trading, an elementof compulsion was introduced by requiring theindividual and institutional investors to settletrades compulsorily in dematerialised form inshares of select companies. At end-October 2000,there were 1415 scrips in which all investors -institutional and retail - were required to settletrades in dematerialised form. As at end-May2000, 93 per cent of securit ies delivered forsettlement by value at BSE and NSE combinedtogether were in the dematerialised form. Withprogressive expansion of the list of securities inthe compulsory dematerialised form, it is expectedthat more than 98 per cent of scrips traded on allexchanges would be in compulsory dematerialisedform by end-March 2001.
Near Elimination of Counter-party Risk
4.104 One of the shortcomings of the clearingand sett lement process of the Indian stockmarkets was the absence of a system to reducecounter-party risk. Managing this risk is essentialfor promoting a safe and efficient market. Toprovide the necessary funds and ensure timelycompletion of settlements in cases of failure ofmember brokers to ful f i l their sett lement
obligations, major stock exchanges have set upSettlement Guarantee Funds. The aggregatecorpus of the Fund at the stock exchanges ispresently over Rs.1,000 crore. The NSE has setup a clearing corporat ion which guaranteessettlement of all trades. The clearing corporation,thus, assumes the counter party risk involved inall the transactions.
4.105 All stock exchanges in the country haveestablished clearing houses. Consequently, alltransactions are settled through the clearinghouses. In the past, while some transactions weresettled through the clearing houses, others weresettled directly between the members. Routingof transactions through clearing houses hassubstant ial ly reduced the credit r isk in thesettlement system.
Circuit Breakers/ Price Bands
4.106 Circuit breakers were first introduced in1987 in the U.S. in the wake of sharp fall in theshare prices. To contain abnormal pricevariations, scrip-wise specific daily price bandsor circuit breakers in India were introduced in1995 whereby the trading automatical ly gotsuspended if the prices varied either side beyond8 per cent; further trading was allowed only upto the price band. Price bands, which wereoriginally fixed at 8 per cent, were relaxed inJanuary 2000, whereby a further variation of 4per cent in the scrip beyond 8 per cent, after acooling off period of 30 minutes, was allowed.This was made applicable in the case of 100scrips. In June 2000, for al l scrips undercompulsory rolling settlement, the price band wasrelaxed by 8 per cent (from 4 per cent earlier)with half an hour cooling period after the scriphad hit the initial price band of 8 per cent.
4.107 While recent experiences in somecountries,, such as, Brazil, Taiwan and Thailand,showed that circuit f i l ters were successful inslowing down the market momentum, there hasbeen some controversy over the effectiveness ofcircuit filters over the medium to long-term. Theopponents of circuit filters also cite their adverseeffects on the process of price formation. In therecent Asian crisis, there were many instanceswhen the price discovery process was impededin the cash markets, spilling over subsequentlyto the futures markets as well. However, circuitfilters are favoured mainly on the ground that they
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are the best available tool for containing volatility.This is based on the belief that containing ofexcess volat i l i ty helps to maintain investorconfidence in the market.
Structure of Informational Flows
4.108 Market microstructure is concerned withinformation and disclosures. There is a broadagreement that transparency affects theinformation and price discovery. A companyoffering securities in the Indian capital market isrequired to make a publ ic disclosure of al lrelevant information through its offer documents,as indicated earlier. After a security is issued tothe public and subsequently listed on a stockexchange, the stock exchange requires the issuingcompany to make continuing disclosures underthe l ist ing agreement. In India, al l l is tedcompanies are now required to furnish to thestock exchanges and also publish mandatedunaudited financial results on a quarterly basis.India is one of the few countries in the world tohave a system of quarterly disclosures and it hasserved a useful purpose in that price-sensitiveinformation on earnings and revenues is nowavailable at greater frequency. The publication ofhalf-yearly corporate results on the basis oflimited review by its auditors has also been mademandatory for listed companies. The disclosuresof material information, which would have abearing on the performance/operations of thecompany, are now required to be made availableto the public immediately. Recently, a decision hasbeen taken that the companies would be requiredto make decisions regarding dividend, bonus andrights announcements or any material eventwithin 15 minutes of the conclusion of the boardmeeting where the decisions are taken. Followingthe international practices, companies in India arealso required to provide shareholders with cashflow statements in the prescribed format alongwith the complete balance-sheet and profit andloss statement. Companies are also required tofurnish to the stock exchanges on a quarterlybasis, a statement on the actual utilisation offunds and actual profitability, as against projectedutilisation of funds and projected profitability. Aspart of better corporate governance practices,disclosures about segment reporting, related partytransactions and consolidated balance sheet arealso expected to be introduced.
Emphasis on Fair Trading Practices
4.109 The SEBI has been mandated under itsAct to prohibit insider trading in securities. In1992, the SEBI formulated the Insider TradingRegulations prohibiting insider trading and madeit a criminal offence punishable in accordancewith the provisions under the SEBI Act, 1992.The Regulations define an insider as a person whohas access to price-sensit ive non-publicinformation with regard to a company. Such aperson is prohibited from trading in the securitiesof such a company under the regulations. Theviolat ion of the regulat ions can resul t inprosecution of the person guilty of such violation.During 1999-2000, of the 56 cases investigatedby SEBI, 47 related to pr ice r igging andmanipulation. There are now separate regulationsin place governing substantial acquisit ion ofshares and takeovers of companies. Theregulations are aimed at making the takeoverprocess more transparent and to protect theinterests of minority shareholders.
Increasing Integration of Various Segments ofSecurities Markets
4.110 In India, different stock exchanges haveso far followed their own practices relating tosettlement procedures creating segmentation ofthe market. While stock exchanges continue tofollow different systems, certain developmentshave resulted in better integration of the varioussegments of the Indian securities market. The twomajor stock exchanges, viz., BSE and NSE, haveexpanded their operations in different locations,thus, providing investors across the country withthe facility to trade in the stocks listed/permittedin these stock exchanges. The Inter-connectedStock Exchange of India Ltd. (ICSI) has been setup as an inter-connected market system andprovides its trading members a facility to tradeon the national market in addition to the tradingfacility at the regional stock exchanges. This hasintegrated the various regional stock exchanges,although the trading activity in the ICSI has notbeen very signi f icant. Many regional stockexchanges have also become members of BSE andNSE, which further strengthened the integrationprocess of various stock exchanges in the country.Equity market is also increasingly integrating withthe Government securities and private corporate
REPORT ON CURRENCY AND FINANCE
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sector debt market. The interest rate structure ofGovernment securities and securities issued bythe corporate entities is better aligned at presentthan in the past.
The Impact of the Changing Structure
4.111 The changing structure of capital markethas had some positive impact on the volatility,liquidity and transaction cost.
Volatility
4.112 Volatility plays a key role in assessing therisk/return trade-offs and forms an importantinput in asset allocation decisions. It is widelyaccepted that large fluctuations in market returnscarry important negative effects on risk-averseinvestors. Besides, they have important economicimplications, especially for the overall domesticinvestment, and for the flow of funds from abroad.Volatility is caused by a number of factors rangingfrom technical or short-term to fundamentals.These, inter alia, include trading practices likethe length of the settlement period, the facility forcarry-forward of transaction, announcements ofcorporate results, measures announced in theGovernment budgets, industrial production, theoverall economic condition including the policystance, and the extent of openness of the economy.Several macroeconomic variables like inflation,money supply, interest rates, etc. also affect themovements in share prices directly or indirectly.The market microstructure too wields influenceon volatility.
4.113 An analysis of the volatility of the Indianstock markets as measured in terms of co-efficientof variation (CV) in the BSE Sensex suggests thatalthough stock markets continue to be highlyvolatile, the volatility has tended to decline in therecent years. Co-efficient of variation at 25.93 percent during the period from April 1991 to March2000 was lower as compared with 33.43 per centduring the 6-year period from April 1985 to March1991. The CV declined further to 17.51 per centduring the period from April 1995 to March 2000.Volatility in recent years has been affected by thetrends in the NASDAQ market.4
Liquidity
4.114 The condition of market liquidity can beconsidered as one of the factors affecting the pricediscovery function and market efficiency. A liquid
market is defined as a market where a largevolume of trades can be accommodated withoutany significant effects on price. Liquidity on theIndian stock exchanges has improved significantlydue to sharp increase in trading volumes, whichgrew at an average annual rate of 75.8 per centduring the latter half of the ’nineties (Table 4.6).The growth of liquidity is also evident from thetwo ratios, viz., traded value ratio and turnoverratio, which are commonly used to measure theliquidity.
4.115 The traded value ratio is measured as thetotal value traded divided by GDP. The turnoverratio is measured by the value of total sharestraded divided by market capitalisation. Whereasthe traded value ratio captures trading in relationto the size of the economy, the turnover ratiocaptures trading in relation to the size of the stockmarket.
4.116 An analysis of these two ratios in theIndian stock market suggests that liquidity hasincreased in the recent years. The traded valueratio, which was 23.2 per cent during 1993-94,declined to 15.7 per cent during 1994-95, butincreased sharply thereafter to 58.1 per cent by1998-99. A sharp improvement has also takenplace in the turnover ratio. The ratio, which was50.9 per cent during 1993-94, declined to 34.4per cent in the following year, but increasedgradually thereafter to as high as 215.1 per centduring 1999-2000 (Table 4.7).
Transaction Costs
4.117 Transaction costs have a signif icantbearing on returns as they can substantially affectthe notional gains from investments. Transactioncosts also impact volumes and volat i l i ty asreduction in trading cost could induce the investorto trade more frequently leading to increasedvolumes. The empirical evidence suggests thatincreased trading volumes by increasing liquidityresult in reduction in volatility. Transaction costs,apart from including expl ic i t cost, such as,brokerage fees, etc. also include some implicitcomponents, such as, market impact cost (costof degradation in price suffered due to executionof large orders), clearing and settlement costarising due to counter party risk, paper work costand bad delivery, etc. In addition, in a trading
4 Volatility has been covered in detail in Chapter V.
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mechanism which involves market makers,trading cost also includes bid and ask spread.
4.118 Despite the growing popularity of stockmarkets during the ’eighties and the first half ofthe ’nineties, the transaction costs were high dueto physical movement of papers, bad deliveriesdue to existence of securities in physical form,less transparent method of trading, involvementof a chain of brokers for executing transactionsin the largest stock exchange, etc. Changes in themarket microstructure, such as, automatedtrading, dematerialisation, increased liquidity,guarantee of trades and increased competition inthe supply of brokerage services and resultantreduction in brokerage fees have brought about asignif icant reduction in the transaction cost.According to the estimates, there has been adecline in average transaction cost for all investors
in the past few years. The transaction cost onIndia’s equity market declined to 0.6 per cent ofselling/buying price in 1999 from 4.75 per centin 1994. The transact ion cost in India nowcompares well with that in the best markets ofthe world (Table 4.8). The reduction in thetransaction cost is an excel lent signal ofimprovement in the overall market efficiency andmarket growth.
Insurance Market Structure
4.119 In an increasingly competitive economy,the need for insuring against r isks is wellrecognised. In India, the insurance industry isbroadly classified into life insurance and non-lifeinsurance business. The life insurance businesshas so far been undertaken by the Life InsuranceCorporat ion of India (LIC) and the non-l i feinsurance by the General insurance Corporation(GIC) and its four subsidiaries. The share ofinsurance in the financial savings of the householdsector grew up from 7.6 per cent in 1980-81 to11.4 per cent in 1999-2000. Despite the statemonopoly, the insurance business in rural areasremains underdeveloped. In terms of sum assuredfor life insurance by LIC, 47.0 per cent of the newbusiness originated from the rural areas during1998-99. By contrast, only 5.2 per cent ofinsurance premium of GIC and its subsidiarieswas from rural areas during the same year.
4.120 Insurance penetration - measured as theratio of insurance premium to GDP - at 2.6 percent in 1998 has remained quite low as comparedwith the world average of 7.4 per cent. Theinsurance industry in India, so far organised asstate monopoly, while contributing substantially
Table 4.7: Indicators of Liquidity(Per cent)
Year Traded Value Turnover(April - March) Ratio Ratio
1 2 3
1993-94 23.2 50.9
1994-95 15.7 34.4
1995-96 18.7 39.7
1996-97 45.8 132.3
1997-98 58.1 154.1
1998-99 58.1 178.3
1999-00 - 215.1
- Not available.
Table 4.6: Turnover at Stock Markets(Rupees crore)
- Not available.Note : Figures in brackets indicate percentage variation
over the previous year.Source : BSE, NSE and SEBI.
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in terms of mobilisation of long-term financialsavings, has not been able to cover more than 18per cent of the population. This was due mainlyto the absence of competitive pressure resultingin inadequate development of insurance products.While the Government securities dominate theinvestment portfolio of LIC, market instruments,such as, shares and debentures are importantinvestment avenues for GIC and its subsidiaries.
4.121 In the wake of f inancial l iberal isat ionduring the early ’nineties, the Committee onReform of the Insurance Sector (Chairman: ShriR. N. Malhotra) recommended in 1994 theopening up of the insurance sector to privateparticipation and the institution of a separateregulatory and development authori ty.Accordingly, the Insurance Regulatory andDevelopment Authority (IRDA) Act was enactedin 1999, and a separate Insurance Regulatory andDevelopment Authority was set up. The insurancesector was also thrown open to the private sector.This has opened up the possibility of developingIndia’s insurance industry on a competitive basisto meet the insurance demand of a socially andeconomical ly mobi le society and a rapidlychanging industrial sector.
4.122 With the dismant l ing of the statemonopoly, the emerging structure of the insurancebusiness remains uncertain. However, the natureof the evolving insurance business would certainlyinf luence the market posi t ion of var iousparticipants. Init ially, insurance is seen as acomplex product of a high advice and servicecomponent in which face-to-face interaction is
important. As the products become simpler andawareness increases, they become off-the-shelfcommodities, which can be sold through retailcounters (e.g., banks), telephones or Internet.However, such transition is a slow process andthe importance of the exist ing distr ibut ionchannels, part icular ly in India, would notdiminish. Nevertheless, banks, f inancialinstitutions and NBFCs may be willing to utilisetheir existing customer-depositor base for thepurpose. While there would be a tendency for thenew entrants to eat into the market share of theLIC and GIC in the exist ing segments, themaximum growth in business is expected to bethrough bui lding up of niches around newproducts. Examples of potential niches of newentrants may be (i) offering creditors’ insuranceschemes to financial sector players, (ii) providinggeneral insurance cover for service sector, whichremains under-serviced at present, (iii) greatercoverage in personal insurance including health,shopkeepers, accident and professional indemnitycovers, and (iv) providing index-linked returns onlife insurance policies.
4.123 An evolving insurance sector needs highdegree of regulation to ensure solvency of insurersand also the protect ion of interests ofpolicyholders. The IRDA Act 1999, while allowingprivate part icipation including foreign equityparticipation up to 26 per cent of the paid-upcapital, has simultaneously stipulated prudentialnorms for investments and service obligations inthe less-lucrative rural sector.
4.124 Both banks and NBFCs satisfying theprescribed criteria have already been permittedto enter the insurance business with priorapproval of the Reserve Bank. All banks and theirsubsidiaries are permitted to undertake fee-basedinsurance business without risk participation. Forrisk participation, banks would be required toform a joint-venture company with a normal equityparticipation of 50 per cent. The Reserve Bankwil l give permission to banks and registeredNBFCs, desirous of entering the insurancebusiness on a case-by-case basis subject to thesatisfaction with the laid down criteria. When aforeign partner contributes 26 per cent of theequity with the prior approval of IRDA/ FIPB, morethan one bank may be permitted to participate inthe equity of the insurance joint venture. NBFCsare also allowed to participate in the insurancebusiness subject to the satisfaction of laid downcriteria relating to net owned fund (not less than
Source : SEBI and Indian Securities Market - A Review,NSE, September 2000.
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IV - 29
Rs.500 crore), CRAR, net NPAs, net profits, etc.Banks and NBFCs entering the insurancebusiness have been directed to ensure that ‘armslength’ distance is maintained between the bank/FI/NBFC and the insurance entity, so that the risksin the insurance business are not transferred tothe parent entity.
Emerging Markets
4.125 Apart from traditional financial markets,two more markets are emerging, namely, thederivatives market, which has come into beingrecently and the bancassurance market, which islikely to emerge in an important way once banksstart undertaking insurance business.
Derivatives Market Structure
4.126 Financial der ivat ives in the Indianfinancial markets are of recent origin barringtrade related forward contracts in the forexmarket5 . Recently, over-the-counter (OTC) as wellas exchange traded derivat ives have beenintroduced, marking an important developmentin the structure of financial markets in India.Forward contracts in the forex market have alsobeen liberalised. Exchange traded derivativestend to be more standardised and offer greaterliquidity than OTC contracts, which are negotiatedbetween counterparties and tailored to meet theneeds of the parties to the contract. Exchangetraded derivatives also offer centralised limits onindividual positions and have formal rules for riskand burden sharing.
4.127 In India, OTC derivatives, viz., InterestRate Swaps (IRS) and Forward Rate Agreements(FRAs) were introduced in July 1999, while oneexchange traded derivative, viz., Stock IndexFutures was introduced by the two largeststock exchanges in June 2000. The FRA is anoff-balance sheet contract between two partiesunder which one party agrees on the start date(or trade date) that on a specified future date (thesettlement date) that party, viz., the party thatagrees, would lodge a notional deposit with theother for a specified sum of money for a specifiedperiod of time (the FRA period) at a specified rateof interest (the contract rate). The party that hasagreed to make the notional deposit has, thus,sold the FRA to the other party who has boughtit. The IRS is a contract between two counter-
parties for exchanging interest payment for aspecified period based on a notional principalamount. The not ional pr incipal is used tocalculate interest payments but is not exchanged.Only interest payments are exchanged. The IRSand FRA were introduced with a view to deepeningthe money market as also to enable banks,Primary Dealers and f inancial inst i tut ions tohedge interest rate risks. The IRS has emergedas the more popular of the two instruments inthe Indian market, accounting for nearly all of the928 outstanding deals, amounting to Rs.12,620crore of notional principal as on November 17,2000. The overnight call money rates and theforex forward rates have emerged as the mostpopular benchmark rates.
4.128 A resident of India who has borrowedforeign exchange in accordance with the FEMA,may enter into an interest rate swap or currencyswap or coupon swap or foreign currency optionor interest rate cap/col lar or Forward RateAgreement (FRA) contract with an authoriseddealer (AD) in India or with a branch outside Indiaof an authorised dealer for hedging his loanexposure and unwinding from such hedgesprovided that (i) the contract does not involverupee, (ii) foreign currency borrowing has beenduly approved, (iii) the notional principal amountof the hedge does not exceed the outstandingamount of the loan, and (iv) the maturity of thehedge does not exceed the un-expired maturity ofthe underlying loan. ADs in India may remitforeign exchange related to such foreign exchangederivative contracts. No resident in India canenter legally into a foreign exchange derivativecontract without the prior permission of theReserve Bank. Among the non-residents, whileFIIs may enter into a forward contract with rupeeas one of the currencies with an AD in India, non-resident Indians and Overseas Corporate Bodiescould take forward cover with an AD to hedge (i)dividend due on shares held in India, (ii) balancesin FCNR(B) and NR(E)A, and (iii) the amount ofinvestment made under portfolio scheme. TheReserve Bank may also consider al lowingresidents to hedge their commodity price risk(including gold but excluding oil and petroleumproducts) subject to certain conditions.
4.129 A beginning with equity derivatives hasbeen made with the introduction of stock indexfutures by BSE and NSE. Stock Index Futurescontract allows for the buying and selling of theparticular stock index for a specified price at a
5 Futures markets in the commodity segment, however,have existed for a long time.
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IV - 30
specified future date. Stock Index Futures, interal ia , help in overcoming the problem ofasymmetr ies in informat ion. Informat ionasymmetry is mainly a problem in individualstocks as it is unlikely that a trader has market-wide private information. As such, the asymmetricinformation component is not likely to be presentin a basket of stocks. This provides anotherrationale for trading in Stock Index Futures. Also,t rading in index der ivat ives involves lowtransaction cost in comparison with trading inunderly ing individual stocks comprising theindex. While the BSE introduced stock indexfutures for BSE Sensex comprising 30 scrips, theNSE introduced Stock Index Futures for S&P CNXNifty comprising 50 scrips. Stock Index Futuresin India are available with one month, two monthand three month maturities. Till November 8,2000, both the stock exchanges had recorded acumulative combined turnover of Rs.1,210 crore.To effect ively manage r isk in the derivat ivesegment, adequate risk containing measures havebeen put in place. They include specify ingminimum net worth requirement of brokers andits composition, margining system based on 99per cent Value at Risk (VaR) model, position limitfor var ious part ic ipants and guidel ines forcollection and enforcement of margins. Anotherequity derivative product in the equity market, viz.,stock index options is likely to be introducedshortly. The SEBI has set January 2001 as thetarget date for introducing options trading in theIndian market.
4.130 Forward contracts market has emerged asan important segment of the forex market in Indiain the recent years. It comprises customers, suchas, corporates, exporters, importers, andindividuals, Authorised Dealers (ADs) and theReserve Bank. Of late, FIIs have emerged as majorparticipants in this segment. The market operatesfrom major centres with Mumbai accounting forbulk of the transactions. Til l February 1992,forward contracts were permitted only againsttrade related exposures and these contracts couldnot be cancelled except where the underlyingtransactions failed to materialise. In March 1992,in order to provide operat ional f reedom tocorporate ent i t ies, unrestr icted booking andcancellation of forward contracts for all genuineexposures, whether trade related or not, werepermitted. At present, the forward contractsmarket is active up to six months where two-wayquotes are available. The maturity profile has
recently elongated with quotes available up to oneyear. With the gradual opening up of the capitalaccount, forward premium is now increasinglygetting aligned with the interest rate differential.Importers and exporters also inf luence theforward market in many ways. Besides, banksare allowed to grant foreign currency loans out ofFCNR (B) l iabi l i t ies and this too faci l i tatedintegration of the forex and the money markets,affecting the forward premium.
Bancassurance
4.131 In developing countries, one importantcharacter of insurance business and of long-termlife insurance, in particular, is that insurancepol ic ies are general ly a combinat ion of r iskcoverage and savings. The savings component inthe insurance policies is seen as a possible sourceof competition for the banking industry, as theinsurance industry develops on a competitivebasis. There are, however, other considerations,that point to the possible complementarities andsynergies between the insurance and bankingbusiness.
4.132 The most important source ofcomplementarity arises due to the critical role thatbanks could play in distributing and marketingof insurance products. So far, direct branchnetwork of LIC, GIC and its subsidiaries togetherwith their agents have been instrumental inmarketing of insurance products in India. Withfurther simpl i f icat ion of insurance products,however, the vast branch network and thedepositor base of commercial banks are expectedto play an important role in marketing insuranceproducts over the counter. The eagerness on thepart of several banks and NBFCs to enter intoinsurance business following the opening up ofthe industry to private participation reflects thisemerging process.
4.133 The present interest of banks to enter intoinsurance business also mirrors the global trend.In Europe the synergy between banking andinsurance has given r ise to the concept of‘bancassurance’ - a package of financial servicesthat can fulfill both banking and insurance needs.In France, for example, over half of the insuranceproducts are sold through banks. In the US,banks lease space to insurers and retail productsof multiple insurers, in the way the shops sellproducts. The inst i tut ional f ramework withinwhich this functional overlaps are taking place
FINANCIAL MARKET STRUCTURE
IV - 31
has been varied - floatation of separate insurancecompanies by banks, banks’ buying stakes inexisting insurance companies, and swap of sharesand mergers. Insurance companies have alsosought to acquire stakes in some banks.
4.134 In India, the Reserve Bank, in recognitionof the symbiotic relationship between bankingand the insurance industries, has identified threeroutes of banks’ participation in the insurancebusiness, viz., (i) providing fee-based insuranceservices without risk participation, (ii) investingin an insurance company for prov id inginfrastructure and services support and ( i i i )setting up of a separate joint-venture insurancecompany with risk participation. The third route,due to its risk aspects, involves compliance tostringent entry norms. Further, the bank has tomaintain an ‘arms length’ relationship between
its banking business and its insurance outfit. Forbanks entering into insurance business with riskpar t ic ipat ion, the prescr ibed ent i ty (viz. ,separate joint-venture company) also enables toavoid possible regulatory overlaps between theReserve Bank and the Government/IRDA. Thejo int-venture insurance company would besubjected ent i re ly to the IRDA/Governmentregulations.
4.135 Besides commercial banks, rural co-operative credit institutions are also envisaged asan important vehicle for distributing insuranceproducts in under-served rural areas. The TaskForce to Study the Co-operative Credit System andSuggest Measures for i ts Strengthening(Chairman: Shri J. Capoor) noted that this couldhave the at tendant benef i t of port fo l iodiversification for these institutions.
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