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PROJECT
ON
The Role of Financial Institutions in
Long Run Economic Growth
Sri Shared Institute of Indian Management-Research
7, Institutional Area, Phase-II, Vasant Kunj, New Delhi -110070
Website : www.srisiim.org
( 2010-2012 )
Submitted To: Submittedby:
Prof. DevRaj Deepak Singh(108)
H.R.Praveen(111)
Sanjeev Roy(145)
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DECLARATION
We,Deepak Singh, H.R. Praveen and Sanjeev Roy student of PGDM (2010-12) hereby declare
that we have completed this project on The Role of Financial Institutions in Long Run
Economic Growth The information submitted is true to the best of our knowledge.
Deepak Singh
H.R.Praveen
Sanjeev Roy
(PGDM 2010-12)
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THE ROLE OF FINANCIAL INSTITUTIONS IN
LONG RUN ECONOMIC GROWTH
INTRODUCTION
The recent economic difficulties in Southeast Asian economies are often linked to
the financial sector in these countries. The business and popular press around the
world are replete with stories connecting the economic crisis with difficulties in the
financial sectors in these economies. The connection between the troubled
banking sector and the economic slowdown is especially stressed. Asian
economies that have been less impacted by the economic crisis, for example
Taiwan, are often characterized as having more stable financial institutions then
their neighbors. Yet this is not the first time financial difficulties have been
linked with poor macroeconomic performance. Many today believe the Great
Depression of the 1930s was made much more sever by problems in the banking
sector specifically and financial markets inefficiencies in general. More recently
the dramatic economic slowdown in the 1980s in the state of Texas in the United
States are often linked to the banking and savings and loan crisis that gripped the
state at the same time. This raises the question, what is the link between financial
institutions and the macroeconomic performance of an economy?
Economists hold dramatically different views regarding this question. From a
much earlier time, Bagehot (1873), and Schumpeter (1911) argued that an efficient
financial system greatly helped a nations economy to grow. As Ross Levine has
pointed out it was Schumpeters contention that well-functioning banks spurred
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area. The implications, however, are clear; the poor do save but not in financial
institutions. These low savings in turn makes it difficult for entrepreneurs in the
economy to borrow funds in economically disadvantaged areas. Due to this
difficulty in borrowing experienced by entrepreneurs the economy will experience
a low level of investment. Thus, even though savings is taking place in the
economy, the savings is not being used efficiently since it is not making its way
into the hands of deficit units. If the savings could make their way to the
entrepreneur the resulting investment would have positive spillover effects for the
entire economy. The positive spillover effects from investment to economic growth
are well known. If investment in physical capital creates new knowledge, then as
Romer (1986, 1987) has shown there will be a spillover from each persons
investments to knowledge that is useful for all the other agents in the economy.
Economies that already have high capital will have the highest returns for new
investment.
Higher levels of investment led to positive spillovers increasing the returns to and
incentives for higher levels of investment. However, in economically
disadvantaged areas with a lack of financial institutions a low level of investment
results due to the lack of incentive for investment. This low level of investment
results in slower or no economic growth thus retarding the growth of financial
institutions in the economy. This relationship can be shown using Figure 1 below.
An economy that begins with a lack of financial institutions will thus suffer from alow savings rate. This low savings rate will lead to a low level of investment.
Finally, this low level investment will result in slow or no economic growth,
further retarding the growth of financial institutions. Then the pattern repeats its
self.
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Lack of Financial Institutions
Low Savings Slow or No Growth
Low Business Investment
Figure 1
There also may be other poverty traps stemming for the lack of financial
institutions. Consider the role of information costs. With a lack of financial
institutions, the information costs for savers and borrows are extremely high.
Thus, these high information costs may also be reducing the level of business
investment and furthering slowing economic growth. Figure 2 shows this
compounding effect from suffering from a lack of financial institutions. The lack
of financial institutions result in a low savings rate, but also in increased
information costs. Both the low savings and high information costs reduce overall
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levels of business investment. This lower level of investment slows any economic
growth that the economically disadvantaged economy may be experiencing. As in
figure 1 the slower economic growth retards expansion of financial institutions and
thus the cycle starts over.
Lack of Financial Institutions Higher information costs
Low Savings Slow or No Growth
Low Business Investment
Figure 2
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ROLE OF BANKS AND FINANCIAL INSTITUTIONS IN
ECONOMY
Money lending in one form or the other has evolved along with the history of the
mankind. Even in the ancient times there are references to the moneylenders.Shakespeare also referred to Shylocks who made unreasonable demands in casethe loans were not repaid in time along with interest. Indian history is also replete
with the instances referring to indigenous money lenders, Sahukars and Zamindars
involved in the business of money lending by mortgaging the landed property of
the borrowers.
Towards the beginning of the twentieth century, with the onset of modern industry
in the country, the need for government regulated banking system was felt. The
British government began to pay attention towards the need for an organizedbanking sector in the country and Reserve Bank of India was set up to regulate the
formal banking sector in the country. But the growth of modern banking remained
slow mainly due to lack of surplus capital in the Indian economic system at that
point of time. Modern banking institutions came up only in big cities and industrial
centres. The rural areas, representing vast majority of Indian society, remained
dependent on the indigenous money lenders for their credit needs.
Independence of the country heralded a new era in the growth of modern banking.
Many new commercial banks came up in various parts of the country. As the
modern banking network grew, the government began to realize that the bankingsector was catering only to the needs of the well-to-do and the capitalists. The
interests of the poorer sections as well as those of the common man were being
ignored.
In 1969, Indian government took a historic decision to nationalize 14 biggest
private commercial banks. A few more were nationalized after a couple of years.
This resulted in transferring the ownership of these banks to the State and the
Reserve Bank of India could then issue directions to these banks to fund the
national programmers, the rural sector, the plan priorities and the priority sector atdifferential rate of interest. This resulted in providing fillip the banking facilities
to the rural areas, to the under-privileged and the downtrodden. It also resulted in
financial inclusion of all categories of people in almost all the regions of the
country.
However, after almost two decades of bank nationalization some new issues
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operate his bank account without actually visiting the bank premises. The facility
of ATMs and the credit/debit cards has revolutionized the choices available with
the customers. The banks also serve as alternative gateways for making payments
on account of income tax and online payment of various bills like the telephone,
electricity and tax. The bank customers can also invest their funds in various stocks
or mutual funds straight from their bank accounts. In the modern day economy,
where people have no time to make these payments by standing in queue, the
service provided by the banks is commendable.
While the commercial banks cater to the banking needs of the people in the cities
and towns, there is another category of banks that looks after the credit and
banking needs of the people living in the rural areas, particularly the farmers.
Regional Rural Banks (RRBs) have been sponsored by many commercial banks in
several States. These banks, along with the cooperative banks, take care of the
farmer-specific needs of credit and other banking facilities.
FutureTill a few years ago, the government largely patronized the small savings schemes
in which not only the interest rates were higher, but the income tax rebates and
incentives were also in plenty. The bank deposits, on the other hand, did not entail
such benefits. As a result, the small savings were the first choice of the investors.
But for the last few years the trend has been reversed. The small savings, the bank
deposits and the mutual funds have been brought at par for the purpose of
incentives under the income tax. Moreover, the interest rates in the small savingsschemes are no longer higher than those offered by the banks.
Banks today are free to determine their interest rates within the given limits
prescribed by the RBI. It is now easier for the banks to open new branches. But the
banking sector reforms are still not complete. A lot more is required to be done to
revamp the public sector banks. Mergers and amalgamation is the next measure on
the agenda of the government. The government is also preparing to disinvest some
of its equity from the PSU banks. The option of allowing foreign direct investment
beyond 50 per cent in the Indian banking sector has also been under consideration.
Banks and financial intuitions have played major role in the economic
development of the country and most of the credit- related schemes of the
government to uplift the poorer and the under-privileged sections have been
implemented through the banking sector. The role of the banks has been important,
but it is going to be even more important in the future
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Role of Specialised Financial Institutions
SFI
Need for and importance of Specialized Financial Institutions (SFIs)
SFIs are institutions set up mainly by the government for providing medium and
long-term financial assistance to industry. As these institutions provide
developmental finance, that is, finance for investment in fixed assets,they are also
known as development banks or development financial institutions. These
institutions receive funds for their financing operations primarily from the
government or other public institutions. These institutions also raise funds from the
capital market.
Need for SFIs
The need for establishing SFIs arose mainly because of the following reasons:-
1. It was difficult for industry in general to procure sufficient long term funds in
the capital markets. There were no other institutions to supply long-term finance to
industry. Traditionally, only short term finance could be availed from commercial
banks. SFIs were established to ensure that industry get sufficient long-term funds
and in the desired sectors in accordance with planned priorities.
2. Certain particular sections of the industry faced greater difficulties than others in
procuring long-term finance. These included
(a) Small and medium sized concerns,
(b) new concerns set up by new entrepreneurial groups,
(c) specific industries, such as cotton and jute, which required funds for
modernization,
(d) concerns involved in innovation and new technological developments,
(e) concerns requiring extra-ordinarily large amounts of finance with a long
gestation period,
(f) concerns in backward regions.
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7. These institutions have been helpful in the establishment of concerns which
required extra-ordinarily large amounts of finance for their projects with a long
gestation period.
20.4 Types of Specialized Financial Institutions
Specialized financial institutions may be divided into the following types:
(a) All India Development Banks
1. Industrial Development Bank of India (IDBI)58 :: Business Studies
2. Small Industries Development Bank of India (SIDBI)
3. Industrial Finance Corporation of India (IFCI)
4. Industrial credit and Investment corporation of India (ICICI)
5. National Bank for Agriculture and Rural Development
(NABARD)
6. Industrial Investment Bank of India Ltd. (previously, Industrial Reconstruction
Bank of India)
(b) State-level Institutions
1. State Financial Corporations (SFCs)
2. State Industrial Development Corporations (SIDC)
3. State Industrial Investment Corporations (SIIC)
( c ) Investment institutions
1. Unit Trust of India (UTI)
2. Life Insurance Corporation of India (LIC)
3. General Insurance Corporation (GIC)
20.5 Objectives and Functions of Industrial Finance
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Industrial Development Bank of India (IDBI)
These institutions along with ICICI (discussed in the next section) met the
financial needs of different sectors of industry, showed a steady growth in their
operations and contributed substantially to the industrial development of theeconomy. However need was felt for a central coordinating agency to be ultimately
concerned with all problems relating to long and medium term financing of
industry and to act as an apex industrial financing and developmental agency.
The Industrial Development Bank of India was set up in July 1964 as wholly
owned subsidiary of the Reserve Bank of India. The purpose waste enable the new
institution to benefit from the financial support and experience of RBI. After a
decade of its working, it was delinked forbid in 1976, when its ownership was
transferred to the Government of India. The purpose was to allow RBI to
concentrate on its central banking function and allow IDBI to grow into a
developmental agency. After the public issue of equity shares and sale of a part of
Governments shareholding in July 1995, Governments shareholding in IDBI has
been reduced to 72.14%.
IDBI is now the principal financial institution for co-coordinating the working of
institutions engaged in financing, promoting or developing industry, assisting the
development of such institutions and providing credit and other facilities for the
development of industry. Thus the role of IDBI may be stated as under:
( 1 ) As an apex financial institution, it coordinates the working of otherfinancial
institutions.
( 2 ) It assists in the development of other financial institutions.
( 3 ) It provides credit to large industrial concerns directly.
( 4 ) It undertakes other activities for the development of industry.
Objectives
The main objectives of IDBI is to serve as the apex institution for termfinance for
industry in India. Its objectives include-64 :: Business Studies
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( 1 ) Co-ordination, regulation and supervision of the working of other financial
institutions such as IFCI , ICICI, UTI, LIC, Commercial Banks and SFCs.
( 2 ) Supplementing the resources of other financial institutions and thereby
widening the scope of their assistance.
( 3 ) Planning, promotion and development of key industries and diversifications of
industrial growth.
( 4 ) Devising and enforcing a system of industrial growth that conforms to
national priorities.
Function
The IDBI has been established to perform the following functions-
( 1 ) To grant loans and advances to IFCI, SFCs or any other financial institution
by way of refinancing of loans granted by such institutions which are repayable
within 25 year.
( 2 ) To grant loans and advances to scheduled banks or state co-operative banks by
way of refinancing of loans granted by such institutions which are repayable in 15
years.
( 3 ) To grant loans and advances to IFCI, SFCs, other institutions, scheduledbanks, state co-operative banks by way of refinancing of loans granted by such
institution to industrial concerns for exports.
( 4 ) To discount or rediscount bills of industrial concerns.
( 5 ) To underwrite or to subscribe to shares or debentures of industrial concerns.
( 6 ) To subscribe to or purchase stock, shares, bonds and debentures of other
financial institutions.
( 7 ) To grant line of credit or loans and advances to other financial institutions
such as IFCI, SFCs, etc.
( 8 ) To grant loans to any industrial concern.
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( c ) The income of the trust is divided among the unit holders or shareholders of
the trust after meeting management expenses.
( 2 ) Closed-end Investment Trusts
The distinguishing characteristics are as under -
(a) These Trusts do not continuously sell their shares or units;
(b) They also do not buy back their shares or units;
( c ) The shares or units of the trust are listed on stock exchanges and can be
bought and sold like shares of any other company;
(d) The market value of shares or units of these trusts depends upon the market
forces of demand and supply;
( e ) Such institutions can also raise loans to make investments;
( f ) They may plough back a part of their profits.
20.9 Unit Trust of India (U.T.I)
The Unit Trust of India is a statutory public sector investment institution
Established under the Unit Trust of India Act, 1963. It began functioning
on Ist July, 1964. It commenced its operations with an initial capital of
Rs.5 crores contributed as follows -
Reserve Bank of India ............... Rs.2.5 crore
Life Insurance Corporation............ Rs.75 Lakhs
State Bank of India.................. Rs.75 Lakhs68:: Business Studies
Scheduled Banks and other financial institutions............. Rs. 1 crore
With the amendment of the Public Financial Institutions Laws, the contribution
made by RBI to the initial capital and the control exercised by it are vested in the
IDBI with effect from 16th Feb.1976.
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UNIT TRUST OF INDIA ( UTI)
The Unit Trust of India is an investment trust. It mobilizes the savings of people
through sale of units. The savings as collected are invested in the shares and
debentures of profit-making companies. The income received by the trust by wayof interest and dividend is passed on to the unit holders by way of dividend after
meeting management expenses of the trust.
The small savers get benefit by participating in the investment schemes of UTI
and thus in the industrial prosperity of the country. Investment through UTI results
in lower risk of loss and higher return on investments due to professional
management by U.T.I.
What are units?
The total investment made by UTI in industrial securities (shares, debentures and
bonds) is divided into smaller parts called units. The Unit Trust of India sell units
under different schemes and also buys back its own units at the purchase price
fixed by it from time to time. Units have a face value of Rs.10 each.
Objectives
The main objectives of UTI are as under -
( i ) To encourage savings of people belonging to middle and low income
Groups;
(ii) To mobilize savings from the small savers;
(iii) To channelize savings to industrial growth;
(iv) To allow investors to participate in the prosperity of the industries.
Functions
The main functions of UTI are as follows -Role of specialized Financial
Institutions::
( i ) To mobilize the savings of the community through sale of units;
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(ii) To invest the savings so mobilized in corporate securities such as
Shares and debentures, etc;
(iii) To serve unit holders along the length and breadth of the country;
(iv) To underwrite the issue of shares and debentures.
Intext
Industrial Credit and Investment Corporation ofIndia
(ICICI)
Industrial Credit and Investment Corporation of India was established as a joint
stock company in the private sector in 1955. Its share capital was contributed by
banks, insurance companies and foreign institutions including the World Bank. Its
major shareholders now are Unit Trust of India, Life Insurance Corporation of
India and General Insurance Corporation and its subsidiaries. They together hold
approximately 50%of the paid up share capital of ICICI.70 ::
Objectives
The ICICI has been established to achieve the following objectives:
(I) To assist in the formation, expansion and modernization of industrial units in
the private sector;
(ii) To stimulate and promote the participation of private capital (both Indian and
foreign) in such industrial units;
(iii) To furnish technical and managerial aid so as to increase production and
expand employment opportunities;
(iv) To assist in the development of the capital market through its underwriting
activities.
Functions
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ICICI has promoted the following institutions in recent years, showingwidening
scope of activities of ICICI:
1. ICICI Securities and Finance Co. Ltd.
2. ICICI Asset Management Co. Ltd.
3. ICICI Investors Services Ltd.
4. ICICI Banking Corporations Ltd.
5. Credit Rating Information Services of India Ltd. (CRISIL)
6. Technology Development and Information Company of India Ltd.
(TDICI)
7. Programmed for the Advancement of Commercial Technology.
8. Programme for Acceleration of Commercial Energy Research
Financial Institutions :
The IFCI which was established in 1948, provides financial assistance to industrial
concerns for a period not exceeding 25 years. It also guarantees loans raised by
industrial concerns in the open market and underwrites issues of shares and
debentures. It grants financial assistance to industrial concerns in the corporate and
cooperative sectors. State Financial Corporation (SFCs) have been established by
State governments under State Financial Corporation Act, 1951. There are at
present 18 SFCs. These corporations grant assistance to industrial concerns for a
maximum period of 20 years. Financial assistance can be granted to industrial
concerns in corporate or co-operative sectors as well as sole proprietary or
partnership concern. Financial assistance is granted to medium and small sizeconcerns. Most of the financial assistance is in the form of term loans. Maximum
financial assistance that may normally be granted to a single industrial concern is
Rs. 60lakhs. The paid up share capital and free reserves of the industrial concern
seeking financial assistance should not exceed Rs 3 crore.
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The IDBI was established in 1964, to regulate, supervise and coordinate
the activities of other financial institutions. It supplements the financial Role of
specialized Financial Institutions :: 73resources of other financial institutions. It
also provides loan directly to industrial concerns. It guarantees loans and deferredpayments. It discounts and rediscounts bills of industrial concerns, refinances loans
granted bother financial institution, promotes industries and provides merchant
banking services.
The UTI was established in 1964 to stimulate and pool together the savings of
people by selling its units to investors in different parts of the country. It invests its
funds in shares and debentures of other industrial concerns and pays dividends to
the holders of its units.
The ICICI was formed in 1955 to provide assistance to industrial units in the
private sector. However the activities of ICICI have widened no-win scope. Joint
sector, public sector as well as co-operative sector industrial units are eligible for
financial assistance from ICICI. It is empowered to provide any amount of
financial assistance to business units. But normally, it provides such assistance in
the range of Rs. 5lakhs and Rs. 1 crore.
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