Financial Institutions & Markets - HP University

1

Lesson 1-10

Written by: Prof. Vijay Kaushal

Revised by: Dr. Suresh Sharma

Financial Institutions

& Markets

International Centre for Distance Education and Open Learning

Himachal Pradesh University, Gyan Path

Summer Hill, Shimla - 171005

M.COM. II SEMESTER

COURSE- MC 2.5

2

CONTENTS

SR. NO. TOPIC PAGE NO.

Contents 1

Syllabus 2

Chapter-1. Indian Financial System 3

Chapter-2. Money and Capital Markets 14

Chapter-3. Money Market Instruments 22

Chapter-4. Government Securities Market 30

Chapter-5. Industrial Securities Market 37

Chapter-6. National Depository Securities in India 49

Chapter-7. Commercial Banking 57

Chapter-8. Merchant Banking 70

Chapter-9. Reserve Banking of India: Central Banking 82

Chapter-10. Mutual Fund in India – An Overview 90

Chapter-11. Financial Regulations and Reforms 104

‘Assignments’ 124

3

MC 2.5: FINANCIAL INSTITUTIONS & MARKETS

Max Marks: 80

Internal Assessment: 20

Note: There will be nine (9) questions in all. The first question is compulsory and consists of ten

(10) short-questions having two (2) marks each. The candidate will be required to attempt one question from each unit and each question carries fifteen (15) marks.

COURSE CONTENTS

Unit I

INTRODUCTORY: Nature and role of financial system - Financial System and financial markets. An

economic analysis of financial system in India. Indian financial system - A critical analysis.

FINANCIAL MARKETS: Money and capital markets. Money market Instruments: Call money, treasury

bills, certificates of deposits, commercial bills, trade bills, etc. Capital market: Government securities market, Industrial security market, Role of SEBI - and overview; Recent developments National Depository Securities Ltd. (NDSL). Market- Makers.

Unit II

MONEY MARKET INSTITUTIONS: Central bank: Functions and its role in money creation,

Commercial banks; Present structure. Introduction to International and Multinational banking.

NON- BANKING INSTITUTIONS: Concept, role of financial institutions, sources of funds, Functions

and types of non-banking financial institutions.

Unit III

MUTUAL FUNDS: The evaluation of mutual funds, regulation of mutual funds (with special reference to

SEBI guidelines), Performance evaluation, Design and marketing of mutual funds scheme; Latest mutual fund schemes in India - An overview. Evaluating of mutual funds.

MERCHANT BANKING: Concept, function, growth, government policy regarding Merchant banking

business and Future of merchant banking in India.

Unit IV

Changing Role of Financial Institutions : Role of banking, financial sector reforms, financial and

promotional role of financial institutions, universal banking; concept and consequences.

References:

Auerbach, Robert D, Money, Banking and Financial Markets; Macmillan Publishing Co; New York and Collier MacMillan Publisher; London.

Avadbani, V.A., Investment and Securities Market in India; Himalaya Publishing House; Bombay..

Khan, M.Y., Indian Financial System -Theory and Practice; Vikas Publishing House; New Delhi.

Mishkin, Frederics, S., The Economics of Money Banking and Financial Markets ; Harper Collins Publisher; New York.

4

Lesson-1

Indian Financial System

STRUCTURE

1.0 Learning Objectives

1.1 Introduction

1.2 Paradigm Shift in Financial Markets

1.3 Indian Financial System

1.4 Functions of the Financial System

1.5 Financial Institutions

1.6 Financial Markets

1.7 Corporate Securities Market

1.8 Problem Areas in the Financial System

1.9 Financial Markets: Emerging Trends

1.10 Rational of Financial Market Reforms

1.11 Indian Financial System: An Economic Analysis

1.12 self Assessment Exercise

1.13 Summary

1.14 Glossary

1.15 Answers to Self Check Exercise

1.16 Terminal Questions

1.17 Answers to Terminal Questions

1.18 Suggested Readings

1.0 LEARNING OBJECTIVES

After studying this chapter you should be able to:

1. Understand the financial systems and its functions.

2. Explain the perfect capital market.

3. Know the different markets to be found in the financial system.

1.1 INTRODUCTION

The rapid economic growth and globalization of financial markets is perhaps one of the most significant developments at the international level. The past two decades have witnessed a process of accelerating changes in the global financial markets. Driven by an interacting process of liberalization and innovation, controls and regulations have been removed, new financial products have emerged and old boundaries between financial intermediaries have blurred. Financial innovations have brought many advantages. A large number of financial assets and liabilities are not available to end-users. The

5

costs of financial intermediation have fallen. Risk management tools have become increasingly sophisticated. Global economics have found new ways to mobilize domestic and international savings.

In comparison with newly industrializing countries and ASEAN countries, India’s economic growth may not measure up to the potential. Nonetheless, the liberalization policies have definitely helped the country in recording better performance. However, the significant policy pronouncement that has been made since the middle of 1991 had certainly improved the growth and performance of the economy during the last few years.

With the objective of bringing about a highly competitive system and promoting efficiency in the real sectors of the Indian economy, recently economic reforms in the areas of trade, industry, and the exchange rate system have been undertaken to correct economic imbalances and bring about structural adjustments. The liberalization and supportive policies of the Government have gained momentum on the last few years with major plan of diversification, expansion and modernization of the industrial sector in the country. This has led to an increased demand for funds and encouraged authorities to find out alternative source of finance for industry. Since the conventional budgetary support cannot be of any positive help to the public section, and at the same time the private help of the public sector, and at the same time the private corporate sector which used to depend heavily on banks and financial institutions in the past, now collects funds from the capital markets.

The Indian financial markets play a crucial role in economic development through the saving-investment process, also known as capital formation. A vibrant and competitive financial market is a necessary concomitant to gain the benefits of liberalization policies and to sustain the ongoing reforms. Many financial reforms were undertaken to improve the efficiency and stability of the financial system.

The process of liberalization initiated by the Government has not been new but prior piecemeal efforts were not stable and widespread. The structural reforms initiated during the period 1991-95 years have had a 'positive impact on the investment climate of the country. The new economic policies aimed to liberalization and globalizations are all embracing consistent and appear to be irreversible. The country has pursued conservative, inward looking policies for almost four decades. The positive effects of these policies may be there, but they are outweighed by their negative impact of inefficiency, corruption, delays and the non-competitive nature of the industrial/economic environment. May mightily socialists economics have crumbled under their own weight and India could very well imagine what is in store for it, if it did not change its course.

In its bid to open up the country’s economy, the Government of the India has geared up the financial sector to meet the Global challenges. As such, Indian financial markets are undergoing a process of rapid change, which has transformed the entire complexion of the financial system. The Government of India during the last several years announced a number of measures to make the Indian financial markets more potent and. capable of raining vast resources from the .domestic market and abroad.

1.2 PARADIGM SHIFT IN FINANCIAL MARKETS

Financial markets play a vital role in mobilization and collection of savings in the economy that provides useful inputs for formulation, implementation of policies and thus facilitate liquidity management, which is consistent with the macro-economic policy objectives. In Indian context, Government of India, Reserve Bank of India, Securities and Exchange Board of India are the major regulators of the financial market, which play crucial role both pro-actively and recovery in the development of financial market. Financial sector reforms viz., localization, liberalization and deregulation along with technological advancement has integrated international markets which has facilitated the scope for uninterrupted mobility of funds in various financial markets of the world.

Financial services are in a process of acquiring new meanings and dimensions. In this context, the law of survival of the fittest would apply and thus only those who respond to the changes in the environment and suitably modify their Structure, organization, procedures and process can think of growth and

6

survival. As it is well known that Indian financial system was tailored keeping in view the requirements of the mixed economy. But the domestic as Well as global contexts have dramatically changed during nineties. Therefore, it would be relevant to have a look at the status and future of financial sector and thus accordingly the changing role of market regulator. The challenges before various intermediaries of financial sector and also the regulators arise because something has happened which tells us that things cannot go as they used to go in the past.

1.3 INDIAN FINANCIAL SYSTEM

The financial system consists of a variety of institutions, markets and instruments. It provides the principal means by which savings arc transformed into investments. Given its role in the allocation of resources, the efficient functioning of the financial system is of critical importance to a modem economy. The Figure. 1 presents atypical structure of financial system in any economy.

1.4 FUNCTIONS OF THE FINANCIAL SYSTEM

In modem economy, the financial system performs the following functions.

a) It provides a payment system for the exchange of goods and services.

7

b) It enables the pooling of funds for undertaking large scale enterprises.

c) It provides a mechanism for spatial and temporal transfer of resources.

d) It provides a way for managing uncertainty and controlling risk.

e) It generates information that helps in coordinating decentralized decision-making.

f) It helps in dealing with the problems of informational asymmetry.

A well-developed financial system offers a variety of instruments that enable economic agents to pool price and exchange risk. It provides opportunities for risk pooling and risk sharing for both household and business firms. As Robert Merton says:

“It facilitates efficient life-cycle risk bearing by households, and it allows for the separation of the providers of working capital for real investments (i.e., personnel, plant and equipment) from the providers of risk capital who bear the financial risk of those investments.”

Mainly, financial instruments, financial institutions, and financial markets constitute the financial system. Financial instruments range from the common (coins, currency notes, demand deposits, corporate debentures, gilt-edged securities, equity shares, units, agro-bonds) to the more exotic (future-and options). Financial instruments may be viewed as financial assets and financial liabilities.

Financial assets represent claims against the future income and wealth of others. Financial liabilities, the counterparts of financial assets, represent promise to pay some portion of prospective income and wealth to others. Financial assets and liabilities emanate from the basic process of financing. They distribute the returns and risks of economic activities to a variety of participants.

The important financial assets and liabilities, claims and promises, in India are as follow:-

a) Money

b) Demand Deposit

c) Short-term Debt.

d) Intermediate-term Debt

e) Long term Dept

f) Equity Stock

g) Futures and options

h) Financial derivatives

i) Bonds

1.5 FINANCIAL INSTITUTIONS

The primary role of a financial institution is to serve as an intermediary between lenders and borrowers. Financial institutions in the organized sector come under the regulatory purview of RBI/Securities and Exchange Board of India. In India there are till India Financial Institution like IDBI, ICICI, IFCI etc. and the State level Financial Corporation set up under State Financial Corporation Act. 1993.

1.6 FINANCIAL MARKETS

A real transaction that involves exchanges of money for real goods or services, whereas a financial transaction involves creation or transfer of a financial asset. Financial transactions includes issue of equity stock by a company purchased of bonds in the secondary market, deposit of money in a bank account, transfer of funds from a current account to a saving account. The financial transactions are very pervasive throughout the economic system.

Hence financial markets, which exist where ever financial transactions occur, are equally pervasive. There are two broad segments, of the financial market, viz. the money market and the capital market. The money market deals with short-term debt, whereas the capital market deals with long-term debt

8

and stock (equity and preference). Further, each of these markets has a primary segment and a secondary segment. New financial assets are issued in the primary market, whereas outstanding financial assets are traded in the secondary segment.

9

1.7 CORPORATE SECURITIES MARKET

The capital market is the market of financial assets that have long or indefinite maturity. The Figure 2 depicts the components of India Corporate Securities Market. When a company wishes to raise capital by issuing securities or other entity intends to raise funds through units, debt instruments, bonds, etc., it goes to the primary market which is the segment of the capital market where issuers exchange financial securities for long-term funds. The primary market facilities the formation of capital.

There are three ways in which a company may raise capital in the primary viz., market-public issue, right issue, and private placement. Public issue, which involves sale of securities to members of the public, is the most important mode of raising long-term funds. Rights issue is the method of raising further capital from existing shareholder by offering additional securities to them on a pre-emptive basis. Private placement is a way of selling securities privately to a small group of investors.

The secondary market of India, where outstanding securities are traded, consists of the stock exchanges which are self-regulatory bothes under the overall regulatory purview of the government/SEBI. Recently, SEBI has proposed the trading in futures and options (capital market derivatives): Accordingly, the definition of securities under SCRA will have to be amended.

The government has accorded powers to the Securities and Exchange Board of India (SEBI), as an autonomous body, to oversee the functioning of the securities market and the operations of intermediaries like mutual funds and merchant bankers, underwriter’s portfolio managers, debenture trustee, hankers to an issue, sub brokers. FIIs (Foreign Institutional Investors), plantation companies schemes including rating agencies and also to prohibit insider trading.

1.8 PROBLEM AREAS IN THE FINANCIAL SYSTEM

One of the basic problem with the financial system is that “it continues to the fragmented by artificial barriers hindering smooth flow of resources making it inefficient (although the present economy has taken the initiatives in the trisection of taking away these barriers and to make financial markets/systems smooth and progressing) and expensive. Although, the financial sector reforms seeks to address the problem of a fragmented system yet there is a scone for further improvement in the system.

Hence to conclude Financial Markets. Services and institution in India are taking shape for. turbulent times and various intermediaries, market participants and institutions are gearing themselves to meet the challenges of change.

1.9 FINANCIAL MARKETS: EMERGING TRENDS

The rapid growth and globalization of financial markets is perhaps one of the most significant developments in the world economy. This development has far reaching consequences, not only for financial markets per se but the growth and direction of world business. No other development has contributed so much to |the growth of inter-dependence among the nations. Total volume of funds made available through these markets for exceed the flows of the un sponsored international financial institutions.

In its bid to open up the country’s money, the Government of India has geared up the financial sector to meet the challenges, which economy is likely to face. As such Indian financial market is undergoing a process of rapid change which as transformed the entire complexion of financial system. The Government of India during last few years have announced a number of measures to make the Indian financial markets more potent and capable of raising vast resources from the domestic market and abroad. This chapter discusses some of these aspects emerging from structural changes in financial markets.

10

Financial deregulation and innovations have changed the whole structure and functioning of financial markets of many industrialized countries since the beginning of 1970s.

This trend also influenced the growth of financial systems of several countries in the Asia Pacific region during 1980s and 1990s. The developments relating to globalization of financial markets, market oriented financial structure, evolution of regional trading blocks like EEC. Asia-Pacific, North America, etc. growth of investment banking, narrowing of functional differentiation between banking etc. are in general the results of the above changes.

In comparison with Newly Industrializing Countries and ASIAN countries, out-economic growth may not measure up to the potential nonetheless the liberalization policies have definitely helped the country in recording better performance in the 1980s. However the significant policy pronouncements since the middle of 1991 onwards certainly improved the growth of economy during the first subsequent years of reform process.

1.10 RATIONALE OF FINANCIAL MARKET REFORMS

With the objective of bringing about a highly competitive system and promoting efficiency in the real sectors of the Indian economy, recent economic reforms in the areas of trade, industry and exchange rate system have been undertaken to coned the macro-economic imbalances and to bring about the structural adjustments. The liberalization and supportive policies of the Government have gained momentum in the last few years with major plans of diversification, expansion and modernization of industrial sector in the country. This has led to an increased demand for funds and encouraged authorities to find out alternative sources of finance for the industry. Since the conventional budgetary support cannot he of any positive help to the public sector and the private corporate sector which used to depend heavily on banks and financial institutions in the past, now collects funds from the capital markets.

The Indian financial markets play a crucial role in economic development through, saving investment process, also known as capital formation. A vibrant and competitive financial market is necessary concomitant of trade and industrial policy liberalization to sustain the ongoing reform in the structural aspects of the real economy. Many financial sector reforms were undertaken to improve the efficiency and stability of the financial system and internal and external development which made it increasingly difficult to maintain a rightly regulated financial system.

The process of liberalization initiated by the Government has not been new but prior piecemeal efforts were not stable and widespread. The structural reforms initiated during since 1991 have had a positive impact on the investment climate of the country. The new economic policies aimed at liberalization and globalizations are all embracing, consistent and appear to be irreversible. The country has pursued conservative, inward looking policies for almost four decades. The positive effect of these policies may be many but they are out weighed by their negative impact of inefficiency, corruption, delays and non competitive nature of industrial / economic environment. Many mighty socialist economies have crumbled under their dead weight and India could very well imagine what is in store for it, if it does not change the course. The whole nation is in a mood for change at the beginning of the new' century and liberalization process is getting a fair trial in spite of scams and corruption charges.

Capita] market which is concerned with the supply of long-term funds in response to gradual liberalization of economic and industrial policies since the beginning of eighties resulted in a virtual capital market revolution. In its bid to open up the country’s economy, the Government of India has geared up the financial sector to meet the challenges, which economy is likely to face. As such Indian financial markets are undergoing a process of rapid change which has transformed the entire complexion of financial system. The Government of India during last few years have announced a number of measures to make the Indian financial markets more potent and capable of raising vast resources from the domestic market and abroad.

11

The purpose of this chapter is to examine the developments in the Indian financial markets, as a result of liberalized policy of the government The objective is to review the policy changes initiated to tap the international resources for the development of the economy.

1.11 INDIAN FINANCIAL SYSTEM: AN ECONOMIC ANALYSIS

The role of money and finance in economic activities is a much discussed topic among economists. The issue has been looked at differently in various branches of Economics. Is it possible to influence the level of economic activities, that is the level of national income, employment, and so on, through variations in the supply and volume of money and credit? How far can economic fluctuations or business cycles be controlled by manipulating the period of production on the one hand and the monetary factors on the other? How far is development a matter of financing capital formation?

Although money and finance by themselves cannot bring about economic development, it is now agreed that they do play a significant role in bringing, about economic development. Given the real resources and suitable attitudes, a well-developed financial system can contribute materially to the acceleration of economic development.

Thus, the role of financial system is to accelerate the rate of economic development, and thereby

improve the general standard of living, and increase the social welfare. This is achieved through the

mobilization and increase of savings and investment, i.e. by stimulating the accumulation of capital and

by allocating capital efficiently for socially desirable and productive purposes. This, in turn, is achieved

by financial markets by performing a number of important and useful proximate functions or by

providing a number of services such as (i) enabling economic units to exercise their time preference,

(ii) separation, distribution, diversification, and reduction of risk, (iii) efficient operation of payment

mechanism, (iv) transmutation or transformation of financial claims so as to suit preferences of the

savers and borrowers, (v) enhancing liquidity of financial claims through securities trading, and

(vi) portfolio management. Let us briefly describe the process through which the financial system

contributes to economic development.

Economic development is to a very great extent dependent on the rate of investment or capital

formation which, in turn, depends on whether finance is made available in time, and the quantity of it,

and the terms on which it is made available. In any economy, in a given period of time, there are some

people whose current expenditures are less than their current incomes, while there are others whose

current expenditures exceed ‘their current incomes. In current terminology, the former are called the

ultimate savers or surplus-spending- units, and the latter are called the ultimate investors or the deficit-

spending-units.

Modern economies are characterized (a) by the ever-expanding nature of business organizations such

as joint-stock companies or corporations; (b) by the ever-increasing scale of production; (c) by the

separation of savers and investors; and (d) by the differences in the attitudes of savers (cautious,

conservative, arid usually averse to taking risks) and investors (dynamic and risk-takers). In these

conditions of what Samuelson calls the dichotomy of saving and investment, it is necessary to connect

the savers with the investors. Otherwise, savings would be wasted (hoarded) for want of investment

opportunities, and investment plans will have to be abandoned for want of savings. The function of a

financial system is to establish a bridge between the savers and the investors and thereby help the

mobilization of savings and thus enable the fructification of investment ideas into realities. Figure.3

reflects such a role of the financial system in economic development.

A financial system also directly helps to increase the volume and rate of savings by supplying

diversified portfolio of financial instruments, offering investment inducements and choices which are in

12

keeping with the array of savers’ preferences. It becomes possible for the deficit-spending units to

undertake more investment expenditures because the financial system enabled them to command

more capital. As Schumpeter has said, without the transfer of purchasing power to him, an

entrepreneur cannot become the entrepreneur.

A financial system not only encourages investment, it also efficiently allocates resources in different

investment channels. It helps to sort out and rank investment projects by sponsoring, encouraging, and

selective supporting of business units or borrowers through project appraisal, feasibility stuthes,

monitoring, and generally keeping a watch over the execution and management of projects.

Fig.3 Relationship between financial system and economic development

The contribution of a financial system to the development process goes beyond merely increasing prior saving based investment.

It plays a positive and catalytic role by providing finance or credit through creation of credit in anticipation of savings. This, to a certain extent, ensures the independence of investment from saving in a given period of time. According to Schumpeter, Keynes, and Kalecky, the investment financed through created credit generates the appropriate level of income which, in turn leads to an amount of savings which are equal to the investment already undertaken. The First Five Year Plan in India echoed this view when it stated that the judicious credit creation in production and availability of genuine savings has also a part to play in the process of economic development. It is however, to be noted that

13

this role assumes that investment out of created credit is not faulty and that it results in prompt income generation. If this assumption is not fulfilled, the initial credit creation results in sustained inflation rather than sustained growth.

Another contribution of a well-developed financial system is to facilitate the normal production-process and exchange of goods, and to enlarge markets over space and time. In other words, financial system enhances the efficiency of the function of medium of exchange and thereby helps in economic development.

The relationship between economic development and financial development is symbiotic or mutually reinforcing. While financial markets accelerate development, they, in turn, grow with economic development. In the words of Schumpeter, “the money market is always... the head quarters of the capitalist system, from which orders go out to its individual divisions, and that which is debated and decided there is always in essence the settlement of plans for further development. All kinds of credit requirements come to this market; all kinds of economic project are first brought into relation with each other and contend for their realization in it; all kinds of purchasing power flows to it to be sold. This gives rise to a number of arbitrage operations and intermediate manoeuvres which may easily veil the fundamental thing.... Thus, the main function of the money or capital market is trading in credit for the purpose of financial development. Development creates and nourishes this market. In the course of development, it becomes the market for sources of income themselves.

1.12 SELF CHECK EXERCISE:-

1. Define ‘Financial Market’.

2. What is ‘Financial System’?

3. What is ‘Security Market’?

4. What is ‘Financial Structure’?

1.13 SUMMARY

Indian financial markets are sub-divided broadly into money markets (that deal in short-term funds) and capital markets (that deal in long-term funds). Structurally, money market comprises both organised and unorganised sectors. Unorganised sector is normally made up of indigenous money lenders and bankers who do not follow formal lines of business. Their businesses are informal and thus independent of the Reserve Bank of India or banks for any fund support. This sector is shrinking but, during the period of economic reforms launched after 1991, the activities of these institutions have become a matter of serious concern and anxiety. The organised component of money market consists of the RBI, commercial banks and cooperative banks. The RBI is the head of the financial institutions as well as the monetary authority of the country. In the diagram, we have not shown anything about the RBI.

1.14 GLOSSARY

Bank: Bank is a financial institution where customers can save or borrow money. Banks also invest money to build up their reserve of money. Banks may give loans to customers under an agreement to pay the money back to the bank at a later time, with interest.

Finance: Finance is a broad term that describes activities associated with banking, leverage or debt,

credit, capital markets, money, and investments. Finance also encompasses the oversight, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems.

Financial Institution: Financial Institution is a company engaged in the business of dealing with

financial and monetary transactions such as deposits, loans, investments, and currency exchange.

14

Financial System: Financial system is a system that allows the exchange of funds between

lenders, investors, and borrowers. Financial systems allow funds to be allocated, invested, or

moved between economic sectors. They enable individuals and companies to share the associated

risks.

Monetary System: Monetary system is something related to money or currency. The system

wherein people pay with dollar bills and other paper money is an example of the monetary system.

1.15 ANSWERS TO SELF CHECK EXERCISE

1. Refer to Section 1.2




1.16 TERMINAL QUESTIONS

1. What do you understand by financial system?

2. Discuss the functions of the financial system?

3. Discuss the functions of financial market?

4. Discuss the different markets to be found in the financial system?

1.17 ANSWERS TO TERMINAL QUESTIONS

1. Refer to Section 1.1, 1.2 & 1.3


3. Refer to Section 1.6 & 1.7


1.18 SUGGESTED READINGS

1. Pathak Bharati (2018). Indian Financial System. Pearson Education; Fifth edition.

2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice Hall of

India,

3. Meir Kohn (2013). Financial Institutions and Markets. Oxford University Press

4. Rajesh Kothari (2012). Financial Services in India: Concept and Application, Sage

publications, New Delhi.

5. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain Book

Agency, Mumbai.

---///---

15

Chapter-2

Money and Capital Market

STRUCTURE


2.1 Introduction

2.2 Financial Markets

2.3 Money Market

2.4 Characteristics of the Money Market

2.5 Need for a Money market

2.6 Goals of the Money market investor

2.7 Capital Market

2.8 Nature and Constituents

2.9 Growth of Capital Market

2.10 Components of the Capital Market

2.11 Self Check Exercise

2.12 Summary

2.13 Glossary







1. Explain the classification of the financial markets.

2. Describe the functions of the money market.

3. Know the components and growth of the capital market.

2.1 INTRODUCTION

Each and every business unit must operate within the financial environment. The financial system consists of a number of organizations, institutions and market. They secure the needs of the consumers, firms and governments. If a firm invests the idle funds temporarily in marketable securities, then it has to approach the financial market. Most of the firms use the financial markets to finance their investments in assets Financial markets can be defined as “All Institutions and procedures for bringing buyers and sellers of the financial instruments together”. They provide better facilities for buying and selling of all the financial claims and services. All the participants trade in the financial products in the markets either directly or through the brokers. Financial institutions, agents, brokers, dealers, borrowers, lenders and savers participate both on demand and supply sides of the financial markets. The demand for capital will be influenced by the business expectations regarding the future state of the economy. The demand for goods is highly influenced by the prices, government policies, profitability, availability of internal funds, cost of funds and technology changes. On the other hand, the

16

supply of funds depends on its level of savings by the household sector, business sector and government sector in a given economy. The savings of the participants in the market are determined by a number of factors. The factors will depend on the level of current and expected income, distribution of income in the economy, degree of certainty in income, wealth, inflation provision for old age, family members, rate of interest, availability of savings media with required investment characteristics. The development banks and financial institutions can also influence the supply of funds. The government will determine the volume of supply of funds, allocation of funds, cost of funds and other factors.

2.2 FINANCIAL MARKETS

The financial markets are characterized by many imperfections, restrictive practices, existence of transaction costs, lack of information, limited number of operators, direct and indirect intervention by the authorities and soon.

The financial markets may be categorized as the primary and secondary markets. The Primary market is also known as the Direct Market. The Secondary market is also known as the indirect market Further the Direct market is called as the “New Issue Market”. The NIM deals with the new securities offered by the newly established concerns or the existing enterprises. On the other hand the Secondary market deals with securities that are already issued by the Companies. The primary market creates the capital formation in the country. It channelises the savings in a productive way. The secondary markets do not contribute directly to the supply of the additional capital. But it will provide liquidity to the primary market. Therefore the NIM and secondary markets have impact on each other.

The financial markets are also classified as:

(a) Organized and Unorganized.

(b) Formal and Informal.

(c) Official and Parallel.

(d) Domestic and Foreign.

The financial transactions which arise in a systematic manner in an organized system are called as “Organized Markets”. The financial transactions which take place outside the well-established exchange constitute the “Unorganised Markets”. The Unorganized markets refer to the markets in rural areas. The “Informal markets” constitute the financial transactions which arise between the individuals and small families.

The financial markets are further classified as:

A. Money market, and

B. Capital market.

There is no difference between these two markets. Both of them perform the same functions in the transferring of the financial assets. They provide a mechanism to sell the financial assets.

2.3 MONEY MARKET

The Money market is a market for the short-term funds. It provides funds for less than a period of one year. It is dominated by the Central Bank. The RBI is the watch-dog of the monetary system. It provides a channel for the exchange of the financial assets for money. The money market is of very great help in the financing industry and commerce for their working capital requirements. The money market includes money, capital and bill markets. Markets consists of both money and capital markets. In the money market, the fund is being sold and purchased at a certain price. It is like the commodity market. It refers to lending and borrowing activities of banking, financial institutions and individuals.

The Money market is defined by A. Crowther as “the money market is the collective name given to various firms and institutions that deal with various grades of near money.” It deals with the trade bills, promissory notes, and treasury bills for a short period. The RBI defined the money market as “the

17

money market is a market for short-term financial assets that are close substitutes for money, facilitates the exchange of money for the new financial claims in the primary market and also for the financial claims, already issued in the secondary market.”

The Central Bank Act as a promotional and development banker in the money market. The money market can be organized as the organized sector and unorganized sector. The unorganized sector consists of indigenous bankers and village moneylenders. The organized sector consists of the RBI, SBI, Mutual Funds, Companies, Cooperative Societies and Financial Institutions. Geographically, the money market may be located or associated with a particular place like Indian Money Market, New York Money Market, Bombay Money Market etc. In the Bombay Money Market, the short-term loanable fund is available for the whole India. The London Money Market, on the other hand is a market of international importance. It is known as the International Money Market. It attracts the short-term funds from all over the world for redistribution among the borrowers. The demand for the short period comes primarily from the Government, Business concerns and Private individuals. The Government has become probably the biggest borrower; everywhere money is being required to meet the current deficits. Individual and Commercial concerns borrow funds for working capital needs. Sometimes they borrow to enable to carry additional inventories. The other important private borrowers include the stock exchange brokers, dealers in the government and other security merchants, manufactures, fanners. Banks themselves may require additional funds and may borrow from the Central Bank or from each other. The supply of loanable funds in the money market comes mostly from the Central Bank of the country, the Commercial Banks and other finance companies. The Central Bank is the source of credit to the Commercial Banks while the latter constitute the most important source of the short-term credit to the individual houses, business houses and the brokers.

2.4 CHARACTERISTICS OF THE MONEY MARKET

The following are the characteristics of the money market:

1. It involves in the arrangement of the short-term funds.

2. It is a tool for the preparation of the monetary policy and fiscal management.

3. It deals with the high liquid instruments.

4. The players in this market are the RBI, Commercial Banks and Companies.

5. It is subjected to the RBI regulations.

6. It tells about the trends in the liquidity and interest rates.

7. It provides funds at low transaction cost.

8. It suits the requirements of the borrowers for the short-term funds.

9. It encourages the open market operations.

Different sub-markets of a developed money market help in the proper functioning of the Central Bank. The money market and the short-term rates of interest serve as a good barometer for monetary and banking conditions in the country. Thus they provide a valuable guide in determining the Central Banking Policy, the developed money market being a highly integrated structure enables the Central Bank to deal with the most sensitive sub-markets also.

The main borrowers of the short-term funds in the money market are:

1. Commercial Banks.

2. Central Government

3. State Government.

4. Corporate Sector.

18

5. Local Bothes.

The money market is unable to meet the long-term requirements of the industries. It consists of Central Banks, Commercial Banks, Cooperative Banks, Savings Banks, Discount Houses, Acceptance Houses, bill market, bullion market etc. The existence of a well-developed money market ensures that the market instruments can be converted into money without incurring much loss.

2.5 NEED FOR A MONEY MARKET

1. It is a coordinator between borrowers and lenders of the short-term funds.

2. It provides the transmission of funds from surplus concerns to the shortage funds concerns.

3. It is a device of the Government to balance its cash inflows and outflows.

4. It is a weapon of the business firms to meet their short-term funds.

5. Money Market creates the minimum rate of return on the idle fund lying at the disposal of the Corporate and Banking Sectors.

6. It is tool to the finance managers in more utilization of the funds to enhance the share-holder’s wealth.

The following chart shows the structure of the Indian Money Market:

19

2.6 GOALS OF THE MONEY MARKET INVESTOR

1. The main objective of the investors in the money market is about the safety and liquidity of the principal amount. They also think about some gains along with their amount.

2. The Money market is a parking place of an idle fund.

3. The Investor wisely escapes from the long-term market risks.

4. Money market instruments generally offer more protection against the political risk and inflation risk.

5. In money market, the investor never faces default risk.

On overall evaluation of the money market, we can find that it is entirely dominated by the RBI. All the policy matters of the sector will be finalized by the India’s Central Bank. The SEBI and the other statutory organizations have been playing an important role in the smooth functioning of the Money Market. It is a powerful weapon in the hands of the Central Government. It is handled skillfully by the Ministry of Finance. Crores of rupees are available in the market at the disposal of various large organizations within few hours. Therefore the development of the Money Market can boost the wealth of a nation. It also encourages the capital market.

2.7 CAPITAL MARKET

Capital Market is the market for long-term funds. It deals long-term and medium term funds. Capital market consists of shares, stocks, debentures and bonds. Securities dealt in capital market are long-term securities. The funds which flows into the capital market comes from the savers. It provides a market mechanism for those who have savings and to those who need funds for productive investments. It diverts resources from wasteful and unproductive channels to productive investments. Since 1951, the Indian Capital Market has been broadening slowly. There is a steady improvement in the volume of savings and investment. Many types of encouragement and tax relief exists in the country to promote savings. Many steps have been taken to protect the interests of the investors. The growth of capital market indicates the growth of Joint Stock Companies and corporate enterprises. In 1951, there were 28,500 companies with a paid up capital of nearly Rs. 7.5 crores and as on 31-3-1998, there were more than 2,00,000 companies with a paid up capital of nearly Rs. 1,37,959 crores. The growth of investment has been quite phenomenal in recent years in accordance with the accelerated tempo of development.

Capital Market can be defined as “the market for relatively long-term financial instruments.”

According to Arun K. Datta the capital market may be defined as “the capital market is a complex of institutions investment and practices with established links between the demand for and supply of different types of capital gains.”

Further F. Livingston defined the capital market as “In a developing economy, it is the business of the capital market to facilitate the main stream of command over capital to the point of the highest yield. By doing so, it enables, control over resources to pass into the hands of those who can employ them must effectively thereby increasing production capacity and spelling the national dividend.”

Capital market consists of gilt edged market and fire industrial securities market. The gilt edged market refers to the market for government and semi-government securities backed by the RBI. The securities traded in this market are stable in value and are much sought after by the banker and other institutions. The Industrial securities market refers to the market for equities and debentures of old and new companies. The industrial securities market is further divided by the new issue market and further capital issue market. The new issue market refers to the raising of capital by the new companies in the form of shares and debentures. While further old issue capital deals with securities already issued by the existing companies. The two markets are equally important. But the NIM is much more important for

20

the capital formation in the country. However, the functioning of NIM will be facilitated only when there are facilities for the transfer of the existing securities. Considerable deregulation of financial markets whose taken place in India favouring the unbridled growth of financial services companies. The reforms have been increased competitiveness within the financial sector by means of, interest rates, allowing new financial institutions and instruments. As a consequence, the scope and activities of the banks, and non-banking finance companies have expanded rapidly due to the liberalization drive, more particularly since 1991, the non-banking finance companies have been competing and complementing the services of the Commercial Banks. It has been observed that the growth of non-banking finance companies are more pronounced than banking companies.

2.8 NATURE AND CONSTITUENTS

The capital markets consists of a number of individuals and institutions. The Government is also an important player in the capital market. The players in the capital market canalize the supply and demand for the long term capital. The constituents of the capital markets are the stock exchange, commercial banks, co-operative, banks, savings banks, development banks, insurance companies, investment trusts and companies etc.

2.9 GROWTH OF THE CAPITAL MARKET

The Indian financial system is both developed and integrated today. Integration has been through a participatory approach in granting loans as well as in saving schemes. The expansion in size and number of institutions has led to a considerable degree of diversification and increase in the types of financial instruments in the financial sector which are wholly owned by the government

The development banks in the Indian financial system have witnessed vast changes in the planning periods. Now the development banks constitute the backbone of the Indian capital market. The relevant of the development banks in the industrial financial system is not merely qualitative, but they have overwhelming qualitative dimensions in terms of their promotional and innovational functions. The growth of the capital market is determined by the following factor:

• Economic development.

• Rapid industrialization.

• Level of savings and investment of the household sector.

• Technological advances.

• Corporate performance.

• Regulatory framework.

• Participation of foreign institutional investors in the capital market.

• Development of financial services.

• Liquidity factors.

• Political stability.

• Globalization.

• Financial innovation.

• Economic and financial sector reforms.

• International developments.

• Agency costs.

• Emergence of financial intermediaries.

21

• Specialization among investment managers.

• Incentives.

• Speed in acquiring, processing and acting upon information.

• NRIs investment

2.10 COMPONENTS OF THE CAPITAL MARKET

In a capital market, banks and financial institutions are the important components. They act as catalysts in the economic development of any country. These institutions mobilize financial savings from household, corporate and other sector of the economy and channelise them into productive investments. They act as a Reservoir of resources and form the backbone of the economic and financial system. The banking industry has undergone a sea change during the last three decades. After the modernization of banks, they not only lend for the social and economic causes but also participated in the development programmes of the central government and state government. The main components of the capital market in India are:

New-Issue Market (NIM)

Secondary Market (Stock market)

2.11 SELF CHECK EXERCISE

1. What is ‘Money Market’?

2. Define ‘Capital Market’?

3. Define ‘Financial Market’?

4. What is ‘New Issue Market’?

2.12 SUMMARY

Money market basically refers to a section of the financial market where financial instruments with high liquidity and short-term maturities are traded. The Money market has become a component of the financial market for buying and selling of securities of short-term maturities, of one year or less, such as treasury bills and commercial papers. Over-the-counter trading is done in the money market and it is a wholesale process. It is used by the participants as a way of borrowing and lending for the short term. Money market consists of negotiable instruments such as treasury bills, commercial papers and certificates of deposit. It is used by many participants, including companies, to raise funds by selling commercial papers in the market. Money market is considered a safe place to invest due to the high liquidity of securities. The money market is an unregulated and informal market and not structured like the capital markets, where things are organised in a formal way. Money market gives lesser return to investors who invest in it but provides a variety of products.

2.13 GLOSSARY

Bill Market: Is a market where short-term papers or bills are traded. These bills include bills of

exchange and treasury bills.

Call/Notice Money Market: Is a market where the day-to-day surplus funds, mostly of banks are

traded.

Commercial Bill: It is an instrument used in the Indian money market to finance the movement and

storage of agricultural and industrial goods in domestic and foreign trade.

Commercial Paper: It enable highly rated corporate borrowers to diversify their sources of short-term

borrowing and also to provide an additional instrument to investors.

22

Derivative Promissory Notes: Under this instrument, banks were permitted to issue derivative usance

promissory note for a period not exceeding 90 days under the strength of underlying bills.

Discount Houses: It performs the function of discounting/rediscounting the commercial bills and

T-Bills.

Money Market: Is a market for short-term funds and covers money and financial assets that are close

substitutes for money.

Repo: It refers to a transaction in which a participant acquires fund immediately by selling securities

and simultaneously agreeing for repurchase of the same or similar securities after specified period of time at a given price.







1. Describe the characteristics of a money market.

2. What is the need for a money market?

3. Explain the growth and components of the capital market.







2. Gomez Clifford (2008). Financial Markets, Institutions and Financial Services. Prentice

Hall of India,


4. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage


5. Madhu Vij & Swati Dhawan (2000). Merchant Banking and Financial Services. Jain

Book Agency, Mumbai.

---///---

23

Lesson-3

Money Market Instruments

STRUCTURE


3.1 Introduction

3.2 Features of Money Market

3.3 Money Market Instruments

3.3.1 Call Money Market

3.3.2 Term Money Market

3.3.3 Treasury Bills

3.3.4 Certificates of Deposits (CDs)

3.3.5 Commercial Paper


3.5 Summary

3.6 Glossary






After studying this lesson you should know:

1. The features of the money market.

2. The various money market instruments.

3.1 INTRODUCTION

Money market is a very important segment of the Indian financial system. It is the market for dealing in

monetary assets of short-term nature. Short-term funds up to one year and for financial assets that are

close substitutes for money are dealt in the money market. Money .market instruments have the

characteristics of liquidity (quick conversion into money), minimum transaction cost and no loss in

value. Excess funds are deployed in the money market which in turn are availed of to meet temporary

shortages of cash and other obligations. Money market provides access to providers (financial and

other institutions and individuals) and users (comprising institutions and government and individuals) of

short-term funds to fulfill their borrowings and investment requirements at an efficient market clearing

price. The rates struck between borrowers and lenders represent an array of money market rates. The

inter-bank overnight money rate is referred to as the call rate. There are also a number of other rates

such as yields on treasury bills of varied maturities, commercial paper rate and rates offered on

certificates of deposit Money market performs the crucial role of providing an equilibrating mechanism

24

to even out short-term liquidity and in the process, facilitating the conduct of monetary policy. Short-

term surpluses and deficits are evened out. The money market is the major mechanism through which

the Reserve Bank influences liquidity and the general level of interest rates. The Bank’s interventions to

influence liquidity serve as a signaling-device for other segments of the financial system.

The Indian money market was segmented and highly regulated and lacked depth till the late eighties. It

was characterized by a limited number of participants, regulation of entry and limited availability of

instruments. The instruments were limited to call (overnight) and short notice (up to 14 days) money,

inter-bank deposits and loans and commercial bills. Interest rates on market instruments were

regulated. Sustained efforts for developing and deepening the money market were made only after the

initiation of financial sector reforms in early nineties.

3.2 FEATURES OF MONEY MARKET

The money market is a wholesale market. The volumes are very large and generally transactions are

settled on a daily basis. Trading in the money market is conducted over the telephone, followed by

written confirmation from both the borrowers and lenders.

There are a large number of participants in the money market: commercial banks, mutual funds,

investment institutions, financial institutions and finally the Reserve Bank of India. The bank’s

operations ensure that the liquidity and short-term interest rates are maintained at levels consistent with

the objective of maintaining price and exchange rate stability. The central bank occupies a strategic

position in the money market. The money market can obtain funds from the central bank either by

borrowing or through sale of securities. The bank influences liquidity and interest rates by open market

operations, REPO transactions changes in Bank Rate, Cash Reserve Requirements and by regulating

access to its accommodation. A well-developed money market contributes to an effective

implementation of the monetary policy.

3.3 MONEY MARKET INSTRUMENTS

The money market instruments comprise of call money (which is overnight and short notice up to

14 days), term money (1,3 and 6 months), certificates of deposits (CD), participation certificates,

commercial paper (CP), money market mutual funds, commercial bills, treasury bills and inter-corporate

funds and Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS). Of these instruments, call

money and short notice money market and treasury bills form the most important segment of the Indian

money market. The major players in this market are banks, financial institutions and primary dealers.

3.3.1 CALL MONEY MARKET

The call/notice money market was predominantly an inter-bank market until 1987, except for UTI and

LIC which were allowed to operate as lenders since 1971. Call rates were freed from the ceiling rate in

May, 1991 enabling price discovery. The Discount and Finance House of India was set up on 1988, in

order to provide reasonable access to users of short-term money by promoting secondary market in

money market instruments; and Securities Trading Corporation of India (STCI) was set up in 1994 to

provide an active secondary market in government securities and public sector bonds. ‘Inter-bank

liabilities were freed from reserve requirements in April, 1997 to generate a smooth yield curve and

reduce volatility in call rates. The Bank has widened the market in 1996-97 by increasing the number of

participants. Apart from banks who traditionally formed the core, the bank permitted Primary Dealers to

participate in the call/notice money market as both borrowers and lenders. Eleven mutual funds set up

in the private sector and approved by the SEBI were also allowed to participate as lenders. The other

participants were the QIC, IDBI, NABARD, DFHI (1988) and STCI (1994) and corporate. Entities that

could provide evidence of surplus funds have been permitted to route their landings through PDs. The

minimum size of each transaction is Rs. 3 crore and the lender has to give an undertaking that no

outstanding loans exist from the banking sector and money market mutual funds.

25

The market practice is that borrowers/ lenders inform the DFHI about the funds required by them or available with them at the negotiated interest rate. After DFHI and the lender/borrower confirm the transaction, these indications are converted into firm commitments. In case of borrowing by DFHI, a call-deposit-receipt is issued to the lender against a cheque drawn on the Reserve Bank of India, representing the amount lent. When DFHI lends, it issues the RBI cheque representing the amount lent to the borrower against the call- deposit-receipt. The minimum size of operation per transaction is Rs.

10 crore.

The transaction is reversed the next day when the lender surrenders the deposit-receipt duly discharged, against which the DFHl issues the RBI a cheque representing the principal amount together with interest thereof. In the case of borrowing, a cheque drawn on the RBI in favour of the DFHI is issued by the borrower representing the interest and principal, in receipt of which the DFHI surrenders the deposit-receipt duly discharged. Lenders who wish to renew, inform the DFHI early in

the day or the next day or after the expiry, of the fixed deposit. In case DFHI needs funds, it can confiim the extension of the transaction on the, deposit-receipt by recording the date of renewal and the rate of

interest. Renewals are allowed up to 14 days after which the transaction has to be reversed. Funds lent on notice or term basis are reversed on the due dates. Cooperative banks also participate.

Measures were initiated in April, 1999 to enable non-bank participants to deploy their short-term resources to develop and widen the repos market with proper regulatory safeguards such as delivery versus payment and uniform accounting. Non-bank participants were also allowed to access short-term money market through repos on par with banks and PDs to facilitate their cash management. The move is expected to facilitate nonbank participants to move out of the call money market. A pure inter-bank call/notice/term money market is likely to emerge where there would be no restriction on the maximum period for which repos can be undertaken. During 1999-2000, the daily peak call rates averaged 9.51%, whereas the daily low rates averaged 8.39%. The average daily call rates were 9.09%. The introduction of Liquidity Adjustment Facility (LAF) on 5.6.2000 in which rate of interest and amount are varied to respond to day-to-day liquidity conditions in the system is likely to impart a greater degree of stability to the short-term money market rates and facilitate the emergence of a short-term rupee yield curve. The refinance rate (export credit and credit to PDs) would also influence the call rates.

Various reform measures since May, 2001 have rendered the call money market into a pure inter-bank market closing access of other participants, PDs, mutual funds. Corporate through primary dealers,

financial institutions and non-bank finance companies. To moderate short-term liquidity, Liquidity Adjustment Facility was introduced in June, 2000. It has emerged as an effective instrument to provide a corridor for the overnight call rate movement. This has resulted in stability and orderly market conditions through clear signaling.

A few banks tended to be overly exposed to the call/notice money market imparting high volatility to call loans. They carried out banking operations and long-term asset creation with the help of call money market. The CBSR recommended that there must be clearly defined prudent limits beyond which banks should not be allowed to rely on call money market and that access to this market should essentially be for meeting unforeseen mismatches and not as regular means of financing banks lending operation. After asset-liability management system was put in place, the mismatches in cash flows in the 1—28 days bucket were kept under check. Participants operate now within limits on both lending and borrowing operations. The call money market is now an inter-bank market with ALM discipline for participants and prudential limits for borrowing and lending.

In 2003-04, volatility in the call money market declined along with turnover (Rs. 9,809 crore in February, 2004 and Rs. 23,998 crore in October, 2003). The call money rates were in the range of 4.33%-1.91%. A part of the activity migrated to the repo market (outside LAF) and Collateralized Borrowing and Lending Obligation (CBLO) segment on account of cheaper availability of funds vis-a-vis call money

market.

26

3.3.2 TERM MONEY MARKET

The term money market in India has been dormant. The factors that have inhibited the development of term money market are statutory preemptions on inter-bank liabilities, regulated interest rate structure, high degree volatility in the call money rates, availability of sector specific refinance, cash credit system of financing, absence of Asset Liability management practices among banks and inadequate development of money market instruments. RBI has gradually removed most of the constraints in the past decade. Recent money market reforms encompassing development of the repo market, introduction of exposure limits for banks in the call money market have infused vibrancy in the various segments. The average daily turnover in the term money market rose by 52% to Rs. 519 crore in 2003-04 from Rs. 341 crore in 2002-03. The volume of transactions has picked up in response to policy measures to develop the market segments.

3.3.3 TREASURY BILLS

Treasury Bills of the Central Government have been issued since the inception of the bank. They offer

short-term investment opportunity financial institutions, banks under the normal borrowing programme

of the central government and market stabilization scheme (MSS). They were issued for 91 days. The

sales were occasionally suspended. Treasury Bills are claims, against the government. They are

negotiable securities and since they can be rediscounted with the Bank, they are highly liquid. Their

other features are absence of default risk, easy availability, assured .yield, low transaction cost,

eligibility for inclusion in the securities for SLR purposes and negligible capital depreciation. There are

14-day, 91-day, 182-day and 364-day treasury bills in vogue in 2005-06. They are not issued in scrip

form. The purchases and sales are affected through the Subsidiary General Ledger Account.

14-day intermediate Treasury Bills: They are issued for deployment of short-term cash surpluses by

state government. The outstanding amount was Rs. 7,253 crore in 2005-06.

91-day Treasury Bills: There are two types of 91-day Treasury Bills, ordinary and ad-hoc. Ordinary

Treasury Bills are issued to the public and the RBI for enabling the Central Government to meet the

temporary requirement for funds.

Treasury Bills were sold on tap, since 1965, throughout the week to commercial banks and the public at

a fixed rate. Under tap sale, bills can be purchased on any day of the week and the actual rate of

discount is not subject to fluctuations as a result of weekly auctions.

Treasury Bills are repaid at par on maturity. The difference between the amount paid by the tenderer at

the time of purchase (which is less than the face value) and the amount received on maturity

represents the interest on the Treasury Bills and is known as the discount.

In the 1992-93 auctions, a scheme was introduced for the issue of 91-day Treasury Bills with a

predetermined amount but with Reserve Bank participation. The notified amount of each auction is Rs.

100 crore. The cut-off yields were significantly higher than the fixed discount rate of 4.6 per cent per

anoum on such bills sold on tap. The notified amount for weekly auction of 91-day treasury bills was

raised to Rs. 500 crore during 2003-04.

182-Day Treasury Bills: These bills were reintroduced from the year 1999-2000 to enable the

development of a market for government securities. They are not rediscountable with RBI. They are

offered for sale on an auction basis. After discontinuing them they were reintroduced with notified amount of Rs, 500 crore for fortnightly auction in 2005-06. 364-Day Treasury Bills Anew instrument in

the form of 364 days Treasury Bills was introduced at the end of April, 1992. They are a part of market

loans. The auction of these bills on a fortnightly basis has since then become a regular feature. On

account of its relative attractiveness and since it constituted a safe avenue for investors, the auction of

27

these bills evoked good response. These bills offer short-term investment opportunity to financial

institutions like banks and other parties. These bills are not rediscountable with the Reserve Bank of

India. They are offered periodically for sale on an auction basis by the Reserve Bank of India in

Bombay. The notified amount was Rs. 1,000 crore per auction since 2002- 03. The outstanding amount

is placed at Rs. 12,996 crore.

Primary Dealers: Primary dealer system was introduced in 1996 with the objective of strengthening the

securities market infrastructure and improvement in the secondary market trading, liquidity and turnover

in government securities and also for encouraging voluntary holding amongst a wider investor base.

The obligations of PDs include

• participating in the primary market in a substantial and consistent manner;

• serving as a market maker in the secondary market by providing two way quotes; and

• providing market related information to the public debt manager.

There are 18 PDs and their bidding commitment for auctions other than those under MSS for 2004-05

for dated securities was fixed at Rs. 1,20,300 crore (96.5%) of the issue amount to be raised.

3.3.4 CERTIFICATES OF DEPOSITS (CDS)

CDs in eurodollar market: CDs are similar to the traditional term deposits but are negotiable and can

be traded in the secondary market. It is often a bearer security and there is a single payment, principal

and an interest, at the end of the maturity period. The bulk of the deposits have a very short duration of

1, 3 or 6 months. For long-term CDs, there is a fixed coupon or a floating rate coupon. For CDs with

floating rate coupons, the life of CD is subdivided into sub-periods of usually 6 months. Interest is fixed

at the beginning of each period and is based on LIBOR or US Treasury Bill rate or prime rate.

In India Certificates of Deposits are being issued since 1989, by banks, either directly to the investors

or through the dealers. CDs are documents of title to time deposits with banks. They are interest

bearing, maturity dated obligations of banks and are technically a part of bank deposits. They represent

bank deposit accounts which are transferable. CDs are marketable or negotiable short-term

instruments in bearer form and are known as Negotiable Certificates of Deposit. They represent

securitized and tradeable term deposits. CDs are a high cost liability and are issued only when deposit

growth is sluggish but credit demand is high. The minimum issue of CDs to a single investor is.Rs.10

lakh (April 15, 1994) and additional amount in multiples of Rs. 5 lakh each. CDs are in bearer form and

can be traded in the secondary market. Since they are not homogeneous in terms-of issuer, maturity,

interest rate and other features, secondary market has not developed.

There has been a spurt in the growth of CDs on account of issue of guidelines by RBI on investment by

banks in non-SLR debt securities, reduction in stamp duty on CDs effective March 1, 2004 and greater

opportunity for secondary market trading’.

CDs are issued at face value for periods varying between 2 weeks to 5 years. They are commonly

issued for 90 days. Banks tailor the maturity to suit corporate customers. The outstanding amount of

CDs varied in the range of Rs. 1,485, Rs. 4,656 crore in 2003-04 in the range of 5% in 2003-04. Total

CDs outstanding constituted 5.1% of the aggregate deposits of issuing banks.

3.3.5 COMMERCIAL PAPER

Commercial paper was introduced in January, 1990, to enable highly-rated corporate borrowers to

diversify their sources of short-term borrowings and also to provide an additional instrument to the

investor.’ The guidelines issued by the RBI regulating the issue of commercial paper applies to all non-

banking financial arid non-financial companies. PDs have also been permitted to issue CPs to access

short-term funds.

28

Issue of commercial paper Commercial paper can be issued by a company whose, (i) tangible net

worth (paid up capital plus free reserve) is not less than Rs. 5 crore; (ii) fund-based working capital

limits are not less than Rs. 4 crore; (iii) shares are listed on a stock exchange; (iv) specified credit rating

of P2 is obtained from Credit Rating Information Services of India Ltd. (CRISILJ-and A2 in the case of

Investment Information and Credit Rating Agency of India Limited (ICRA);

(v) borrower account is classified under health code No. 1; and

(vi) current ratio is 1.33 :1.

Usance Commercial paper should be issued for a minimum period of 7-days and a maximum of one

year. No grace period is allowed for payment and if the maturity date falls on a holiday it should be paid

on the previous working day. Every issue of commercial paper is treated as a fresh issue.

Denomination Commercial paper is issued in the denomination of Rs. 5 lakh. But the minimum lot or

investment is Rs. 25 lakh (face value) per investor. The secondary market transactions can be Rs. 5

lakh or multiplies thereof. Total amount proposed to be issued should be taised within two weeks from

the date on which the proposal is taken on record by the bank. The paper may be issued in a single day

or in parts on different dates in which case each paper should have the same maturity date.

Ceiling The aggregate amount that can be raised by commercial paper by corporate is 100% of the

working capital credit limit (November, 1996).

Mode of issue and discount rate Commercial paper should be in the form of usance promissory note

negotiable by endorsement and delivery. It can be issued at such discount to face value as may be decided by the issuing company. Issue expenses Issue expense consisting of dealer’s fees, rating

agency fee and other relevant expenses should be borne by the company.

Investors Commercial paper may be issued to any person, banks, companies and other registered (in

India) corporate bothes and unincorporated bothes. Issue to NRIs can only be on a non-repatriable

basis and is non- transferable. The paper issued to the NRI should state that it is non-repatriable and

non-endorsable.

Procedure for issue Commercial paper is issued only through the bankers who have sanctioned

working capital limits to the company. It is counted as a part of working capital. Unlike public deposits,

commercial paper really cannot augment working capital resources. There is no increase in the overall

short-term borrowing facilities.

Every company proposing to issue commercial paper should submit the proposal in the form prescribed

by the RBI to the bank which provides working capital along with credit rating of the company. The bank

scrutinizes the application and on being satisfied that the eligibility criteria are met and conditions

stipulated are complied with, takes the proposal on record. The issue has to be privately placed within

two weeks by the company or through the good offices of a merchant banker. The initial investor pays

the discounted value of the paper to the account of the issuing company with the bank in writing. The

company has to advise the RBI through the bank, of the amount of commercial paper issued within

3 days.

Commercial paper proved popular as a money market instrument during periods of down swing of

credit growth when corporate are able to access the CP market at rates lower than the PLRs of banks.

The share of manufacturing companies in the amount of CPs declined over time to 31% in 2004-05; the

share of leasing/ finance companies increased to 56%; and FIS, 13%. Manufacturing companies

enjoyed larger internal accruals and introduction of sub PLR lending banks saving on stamp duty, costs

of demat and fees for issuing and paying agents. The outstanding amount of CPs was Rs. 9,131 crore

as on March 31, 2004. The weighted average discount rate was 5.11% at the end of March, 2004.

29

Commercial bill market Trade bills are drawn by the seller (drawer) on the buyer (drawee) for the value of goods delivered to him. Commercial banks as a part of the working capital limits grant a component for discounting such bills. Normally, 20 per cent margin, is kept and the trade bill when presented by the constituent proceeds to his account. These bills can be for 30 days, 60 days or 90 days depending on the credit extended in the industry to which the constituent belongs. Interest is charged for the time it takes to collect the bill.

Bill discounting is a part of money market and the bill as an instrument provides short-term liquidity to banks in need of funds by getting them discounted by financial institutions such as Banks, LIC, UTI, GIC, ICICI, IRBI and ECGC. Although the cost of bill rediscounting is lower than the cost of inter-bank

deposits and loans of 60/90 days, the trade bill has hot become popular. Bills rediscounted by commercial banks with FIs amounted to Rs. 735 crore at the end of February, 2000. The proportion of bills Rs. 37,066 crore to total bank credit of (bills plus cash credit), Rs. 2,40,144 crore on March 31,1999 was 15.3 per cent. There is hardly any secondary market.


1. What is ‘Call Money Market’?

2. Define ‘Term Money Market’?

3. What are ‘Teasing Bills’?

4. What are “Certificate of Deposits”?

3.5 SUMMARY

The Capital market is referred to as a place where saving and investments are done between capital suppliers and those who are in need of capital. It is, therefore, a place where various entities, trade different financial instruments. The primary market is a new issue market; it solely deals with the issues of new securities. A place where trading of securities is done for the first time. The main objective is capital formation for government, institutions, companies, etc. also known as Initial Public Offer (IPO). The secondary market is a place where trading takes place for existing securities. It is known as a stock exchange or stock market. Here the securities are bought and sold by the investors. The main point of difference between the primary and the secondary market is that in the primary market only new securities were issued, whereas in the secondary market the trading is for already existing securities. There is no fresh issue in the secondary market. The securities are traded in a highly regularised and legalized market within strict rules and regulations. This ensures that the investors can trade without the fear of being cheated. In the last decade or so due to the advancement of technology, the secondary capital market in India has seen a great boom.

3.6 GLOSSARY

Capital: Capital is a large sum of money which you use to start a business, or which you invest in order to make more money. Capital is the part of an amount of money borrowed or invested which does not include interest.

Capital Market: Capital Market deals in financial instruments and commodities that are long-term securities. The funds will be used for productive purposes and create wealth in the economy in the long term.

Initial public offering (IPO): IPO or stock market launch is a type of public offering. Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise money for expansion and to become publicly traded enterprises.

Stock Exchange: Stock Exchange share market or bourse is a place where people meet to buy and

sell shares of company stock. Some stock exchanges are real places (like the New York Stock Exchange), others are virtual places (like the NASDAQ).

30

Stock Market: Stock Market is a place where shares of pubic listed companies are traded. The primary market is where companies float shares to the general public in an initial public offering (IPO) to raise capital.

Stock Market Works: Stock market works like an auction where investors who buy and sell shares of

stocks. These are a small piece of ownership of a public corporation.


1. Refer to Section 3.3.1





1. Define money market and specify the instruments.

2. Who can issue commercial paper?

3. Discuss the different types of Treasury Bills.








India.


---///---

31

Lesson-4

Government Securities Market

STRUCTURE


4.1 Introduction

4.2 Nature of Government Securities Market

4.3 Salient Features


4.5 Summary

4.6 Glossary






By the end of this chapter, you should be able to know:

1. The composition of the stock market in India.

2. The significance of the market in government securities.

3. The nature of the government securities market.

4.1 INTRODUCTION

This chapter and the next are devoted to describing and analyzing working of stock market. The stock market is composed of the new issue market which is a primary market for raising fresh capital, and the stock exchange which forms the secondary market for securities. Each of these markets deals in two important groups of securities: (a) Government and semi government securities, and (b) industrial securities. Although the stock market is associated in the minds of most people with a market for industrial securities, in fact these’ constitute a relatively small part of the stock market. Fresh funds mobilized through the issue of government and semi government securities and the private corporate securities accounted for 93 to 97 per cent and 3 to 7 per cent, respectively, of the total amount of fresh funds mobilized through the issue of all securities on the stock market during 1971-72 to 1977-78. The share of government securities in the total capital raised varied between 94.1 and 79.44 per cent during 1986-87 to 1988-89.

Thus the market in government securities happens to be an overwhelmingly significant part of the stock market in India. In the UK also, as in India, the market in government securities is much larger than that in industrial securities. In the USA, however, it is the other way round. In this chapter we will discuss various aspects of the working of the market in government securities in India.

4.2 NATURE OF GOVERNMENT SECURITIES MARKET

(i) The supply of government securities stems from the issue of government’s marketable debt. These securities are issued by the Central government, State governments, and semi-government authorities

32

which include local government authorities like city corporations and municipalities, autonomous institutions like port trusts, improvement trusts, state electricity boards, metropolitan authorities, public sector corporations, and other government agencies such as IDBI, IFCI, SFCs, SIDCs, NABARD, LDBs, housing boards, and the like. The Central Government issues bonds, treasury bills, and special rupee securities in payment of India’s subscriptions to IMF, IBRD, ADB, IDA, and so on. The special rupee securities are treated as a part of internal floating debt of the government. They are non-negotiable and non-interest bearing claims. The market for treasury bills has already been discussed. The State governments and semi-government agencies issue bonds or debentures. Certain government agencies like IDBI are established to implement Government’s various lending operations and they issue bonds to finance their activities. Originally, most of them were financed by the Treasury, but there has been a trend towards their self-financing through the issuing of debentures. This segment of the government securities market is, therefore, an expanding one.

(ii) Government securities are a unique and important financial instrument in the financial markets of any country. Unlike other instruments (except TBs), it is also held by the central bank of the country, and the working of two of the major techniques of monetary control of the central bank—open market operations and statutory liquidity ratio—are closely connected with the dynamics of the market for this instrument. Again, unlike other instruments, its issues are helpful in implementing the fiscal policy of the Government. Financial institutions like commercial banks are required to maintain their secondary reserve requirements in the form of these securities. It is also easier to obtain loans against the collateral of these securities. Commercial banks in India can obtain accommodation from the RBI against the collateral of these securities. As the RBI can issue currency notes against the backing, apart from gold and foreign exchange, of the Central Government bonds, they constitute the ultimate source of liquidity in the economy. As government security is a claim on the Government, it is an absolutely secure financial instrument which guarantees the certainty of both income and capital. It is, therefore, called a “gilt-edged” security or stock. It is true that many alternative instruments like industrial debentures, and stocks of local “authorities are also quite secure, but the Central Government securities are the safest of all such claims.

(iii) These securities are normally issued in the denomination of Rs. 100 or Rs. 1000. The face value which used to be 100 till the middle of the 1980s was raised to 1000 in the recent past. The rate of interest on these securities is relatively lower because of their being liquid and safe. In addition, it has been deliberately maintained at a low level by the government in order to minimize the cost of servicing public debt. Yet, the market for these securities has expanded every year because of the regulations, statutory or otherwise, under which financial institutions are required to invest a certain proportion of their investible funds in these, securities. At the rates of interest that can be earned on these securities, any other borrower but government or government-backed organizations would have been unable to raise funds on any significant scale, let alone on an increasing scale.

(iv) The interest on government securities is payable half yearly. Interest in respect of Central and State government securities, along with income in the form of interest or dividends on other approved investments, is exempt from income-tax subject to a limit The value of investments in these securities and other investments specified in the Wealth Tax Act 1957 is exempt from wealth tax up to a limit. As individuals do not normally invest in these securities, saving in tax liability does not seem to be an important motivation behind investment in them. Unlike in the USA, interest on the securities of local authorities is not exempt from tax in India.

(v) Although it is true that government securities are liquid and safe, securities of different authorities differ in respect of the extent to which they possess these attributes. The marketability of securities of State governments, and semi-governments is relatively restricted; therefore, they are less liquid than Central government securities. There is no active market, particularly in semi-government securities. There is no need for the underwriting or guaranteeing the sale of Central and State government securities. The fact that the RBI is always ready to buy the unsubscribed (by public) part of any loan

33

issued amounts to underwriting of these issues. Around the 1950s, issues of State government securities used to be underwritten, but, thereafter, such a need has not arisen. The securities of semi-government agencies, however, may need to be underwritten. They are also guaranteed by the Central or State government for repayment of principal and the payment of interest.

(vi) There are three forms of Central and State government securities: (a) inscribed stock or stock certificate (SC); (b) promissory note (PN); (c) bearer bond. While these days, bearer bonds are not usually issued in India, stock certificates are not very popular with investors. Consequently, most government securities currently are in the form of promissory notes. Promissory notes of any loan can be converted into stock certificates of any other loan or vice versa. In order to popularize the holding of stock certificates, governments specially advertise the following advantages to distinguish them from promissory notes: (a) they are safer than PN as the name of the holder is registered in the books of the Public Debt Office (PDO); (b) the stock certificate relating to the application tendered at any branch of the SBI or its subsidiary is sent to the applicant directly by the registered post by the PDO; (c) the. half-yearly interest is remitted to the holder directly by an interest warrant drawn at par on any Treasury or SBI as stipulated by the holder or is remitted by M.O. if so desired; (d) the holder, can sell it by signing

the transfer form on the reverse of the certificate. On the other hand, interest on PN is payable only on the presentation of the note at the office at which it is enfaced. The major reason why SC is not popular in spite of these advantages is its lack of quick transferability and negotiability. It is not transferable by endorsement; the procedure for effecting its transfer is much more complex. In the case of PN, the title is transferable by endorsement and delivery and it is a negotiable financial instrument. This suggests that investors-who need to borrow often against the collateral of government securities prefer, PN to SC. In a relative sense, if SCs are often bought by investors like L1C, PF, etc., PNs are in demand by banks.

(vii) Government securities are issued through the PDO of the RBI. The method of selling them differs from that of selling TBs. Instead of selling them through auction, the issues are notified a few days before they become open for subscription and they are kept open for subscription for 2—3 days, but, they may be closed for subscription earlier if the subscriptions approximate the amount of issue. The budgeted amount of issues in a given year is raised in a number of tranches in that year. This is obviously to avoid flooding the market with securities at a given time. However, as the issues are mostly bought by institutional investors, there can be a small number of large issues. After the announcement of new issue, the RBI suspends the sale of existing loans till the Closure of subscriptions to new loans. The Government reserves the right to retain subscriptions up to a specified percentage, say 10 per cent in excess of notified amounts. Applications for loans are received at the offices of the RBI and at the branches of the SBI. In the case of issues of State government securities, over-subscription to loans of one government is transferable to the other government whose loan is still open for subscription, at the option of the subscriber. Due to the seasonal character of the money market, issues are mostly concentrated dining the slack seasons.

Because of the size of debt and the continuous need for raising fresh capital, the effective issue and redemption on single dates as happens in the case of industrial securities has become impossible. The old method of issue of blocks of securities and their redemption on single maturity dates continues in form, but, when the issue of bonds is announced, a part is taken over by the RBI which sells the amount gradually through the stock exchanges in the ensuing period. Similarly, “grooming” and “switching” implies that the RBI buys the bonds gradually through the stock exchange until usually only a small proportion remains to be paid off on the formal maturity date. Thus, in practice, the process of issue and redemption have become continuous. This also means that securities are available on “tap”, and the securities thus obtained may be called “tap stocks”,

(viii) The role of brokers and dealers in the process of marketing of government securities in India is much more limited than in other countries. The RBI does have, it’s approved brokers and the major part of the turnover in the market takes place through these brokers. But the scope for participation in the

34

market by other brokers is limited. A recent step taken by the RBI has also reduced the volume of business available to official brokers. With effect from June 1978, the RBI has discontinued the practice of charging differential interest rates for the purchase and sale of the Central government securities to enable banks to approach it directly instead of through brokers. As regards the dealers, it may be stated that the agency of dealer-banks is more active than that of individual dealers. There are some half-a-dozen active firms of security dealers in Bombay, but their number elsewhere is limited. They are in daily contact with the RBI as well as banks, LJC, and other institutional investors. They also keep in touch with each other and as a result of their activities gilt-edged securities enjoyed the benefit of extremely fine quotations. These dealers act mainly as jobbers. The gilt-edged market is an “over-the-counter” market and each sale and purchase has to be separately negotiated. Orders received locally by members of the stock exchange are passed on to the security brokers and dealers who then try various sources, among which are banks. The brokers and dealers explore the possibilities of business among themselves and with their upcountry correspondents, but such business is limited and the market is confined mainly to institutional investors.

The scope for individual dealer activity in the Government securities market in India is limited perhaps because the volume of floating stock is limited. Most of the investors who purchase government securities usually hold them till maturity. Commercial banks can buy as much as they want, but they cannot sell securities beyond a limit due to the SLR requirements. All such factors have restricted the growth of the secondary market which, in turn, has restricted the scope for dealer activity. Commercial banks deal in securities as they supply securities to the market. They also take up state loans and corporation bonds when they are first floated, and sell them gradually when the market can absorb them. The RBI acts as the biggest dealer through its OMOs. In other countries, the central bank confines its dealings mainly to treasury bills as a part of OMOs; this has created a need for the services of dealers in government securities in those countries. In India, on the other hand, continuous participation by the RBI in the government securities market has resulted in the lack of growth of the institution of dealers. Further, dealers need funds for their operations. Usually such funds are obtained from the commercial banks in other countries. But the high cost of borrowing funds from banks compared with the low yield on government securities has also inhibited the growth of dealers in this market. With the tremendous growth of Government stocks however, there is a Scope for the growth of dealers in the government securities market.

(ix) In any given year, both the Central and State governments need to raise funds through public borrowings. The normal practice has been to sell their securities separately; but in 1954-55 and 1963-64 only consolidated loans were issued. The method of issuing consolidated loans has, it was found, certain important disadvantages. First, it is difficult to decide the share of various State is in a consolidated loan. Second, the centralized method does not offer space for trapping local rsources.

The issue of securities may be undertaken for refunding, i.e, conversion or refinancing of maturing securities; advance refunding of securities that have not yet matured (in India this is known as reissue of loans) and cash financing. Refunding itself can be carried out either by selling new securities for cash settlements and using the proceeds to retire old issues, or by offering holders of the maturing securities the right to exchange (convert) old securities for new issues. The objectives of conversion and reissue of loans is to lengthen the maturity structure of Government debt, and to reduce the volume of cash repayment of loans. It may be relevant here to mention two other operations usually carried out by the RBI in the government securities market to achieve the objectives just mentioned and to facilitate the new issues of securities. They are “grooming” of the market and “switches” in the market. While “grooming” may be defined as “acquiring securities nearing maturity to facilitate redemption and making available on tap a variety of loans to broaden the gilt-edged market”, switches are “purchases of one security against the sale of another security as distinct from outright purchase or sale of security.” These operations are part of the OMOs of the Central Bank and might be said to differ technically from “refunding” and “reissue” in that they are undertaken in the secondary market, while the latter are undertaken in the primary market for government securities.

35

(x) The RBI occupies a pivotal position in this market it is continuously in the market selling Government securities and buying them mostly in switch operations and rarely for cash. It purchases these securities out of the surplus funds of IDBI, EXIM Bank, and NABARD under special arrangements. Switch operations are useful to banks and financial institutions to improve their yields on their investments in Government securities. Sometimes, there are triangular switch transactions in which one investor’s sale or purchase is matched by the purchase or sale transactions of another investor, the RBI being the middle party. The RBI fixes annual quota, based on the size of the bank, for switch transactions for each bank from time to time with a view to prevent banks from exclusive sales of low-yielding securities to the RBI. It maintains separate lists of securities for purchase and sale transactions. Different scrip’s are included in the two lists having regard to the stock of securities and dates of their maturities. One of file unique features of trading in this market is the “voucher trading” or “voucher benefit”. The banks and financial institutions whose earnings are taxed purchase the securities around the interest due date and unload them in the market after availing themselves of the voucher for the full year. This practice has activated trading in these securities, particularly around interest due date. But this active trading is not a genuine trading. Therefore, Chakravarty Committee has ‘asked the RBI to fix quotas for switch transactions, and to, suspend trading in a particular scrip for one month before interest due date.

4.3 SALIENT FEATURES

Certain salient features of the market in government securities that emerge from the foregoing discussion may be summarized below:

(1) In “terms of size, it is much bigger than the industrial securities market. Due to the growing requirement of funds by the government for developmental and non-developmental needs, this market has been rapidly expanding. This is similar to the situation obtaining in the UK, but not in the USA, where the market for industrial securities is bigger than the market in government securities. This is so because of the difference in the share of the public sector in investment in physical and financial assets.

(2) The ownership pattern of government securities also differs from that of industrial securities. Although indirect ownership has increased with regard to both, the participation by individuals is much greater in the industrial securities market. On the other hand, government securities play a special role in the asset management of many financial institutions. As far as individual ownership is concerned, the situation in India is largely similar to that in the UK, but it differs somewhat from the USA where government securities are owned by individuals to a greater extent.

(3) The average maturity of government debt at first decreased till 1965, then it increased substantially. Thus, since the early 1970s, the risk of monetization of government securities and the threat from that side to monetary policy have diminished.

(4) Unlike in the UK and the USA, the secondary market in government securities in India is narrow and less active. Only commercial banks participate in this market on any significant scale. In the UK and USA, the secondary market in government securities is quite active and sophisticated, because of which the holders of government securities, particularly large ones, can earn dealing profits by a policy of switching from one stock to another as temporary price differences appear. The institution, of dealers is well-established in those countries and institutional developments like securities repurchase agreements between dealers and corporations have emerged in a country like America. In India, there is no worthwhile connection between the call money market and the government securities market.

(5) Interest rates in the government securities market are not aligned well with rates in other financial markets, although the gap between rates in these markets has been significantly narrowed during the 1980s. In the UK, movements in the yield on-government bonds affect the entire structure of interest rates.

(6) The intervention of authorities in the government securities market in India has been mainly for

supporting the market and for minimizing the cost of servicing public debt. The growing national debt

36

has also made it necessary for governments in the UK and the USA to intervene in this market mainly

for the same purpose.


1. What is ‘Stock Market’?

2. Define ‘Government Securities’?

4.5 SUMMARY

Government securities are the instruments issued by central government, state governments, semi-

government bothes, public sector corporations and financial institutions such as IDBI, IFCI, State

Financial Corporation’s (SFCs) etc. in the form of marketable debt. Government securities form an

important part of the stock market in India. Today, funds mobilised through the issue of government

securities account for more than 80% of the total amount of funds mobilised on the stock exchanges of

India through the issue of all securities including government and corporate). Funds mobilised are tired

to meet the short-term and long-term needs of the government. Central government securities are

considered to be the safest amongst all type of securities as regard to the payment of interest and

repayment of principal amount. They are free of default-risk or credit risk. They are considered to be

more liquid assets and ensure certainty of capital value not only at maturity but also before maturity.

Since the date of maturity as mentioned in the securities, these are also known as dated government

securities.

4.6 GLOSSARY

Government securities: government securities are the instruments issued by Central Government

State governments and is government bothes public sector corporations and Financial Institutions such

as IDBI IFSC state financial corporations etc.

Primary dealers (PD): primary dealers are introduced by Reserve Bank of India for strengthen the

infrastructure in the GSM so as to make it more vibrant liquid and broad-based.

Satellite dealers (SD): Reserve Bank of India introduced the concept of satellite dealers in order to

provide supporting infrastructure in the Government Security market. Satellite dealers help in trading

and distribution of government securities. 4.7 ANSWERS TO SELF CHECK EXERCISE

1. Refer to 4.1

2. Refer to 4.2


1. Describe the working of stock market.

2. Discuss the nature of government securities.

3. Explain the salient features of the market in government securities.

4.9 ANSWERS TO TERMINAL QUESTIONS:

1. Refere to Section 4.1 & 4.2



37




Hall of India,






---///---

38

Lesson-5

Industrial Securities Market

STRUCTURE


5.1 Introduction

5.2 Organization of the stock market

5.3 Industrial Securities

5.3.1 Ordinary Shares

5.3.2 Preference Shares

5.3.3 Debentures or Bonds

5.4 Salient Feature of Industrial Securities


5.6 Summary

5.7 Glossary






After studying this lesson you should be able to:

1. Know the significance of the industrial securities.

2. Explain the Organization of the stock market

3. Describe the different types of industrial securities premising in India.

5.1 INTRODUCTION

Having discussed the market in government securities in the previous chapter, we will now take up the market in industrial securities.

5.2 ORGANIZATION OF THE STOCK MARKET

At the end of June 1989, there were eighteen recognized stock exchanges in India. Four of these—in Bombay, Delhi, Calcutta, and Ahmadabad— accounted for about 90 per cent of the overall business, and Bombay alone accounts for about 70 per cent of the total trading business on all the stock exchanges put together. It accounts for 40 per cent of the total listed issues, 67 per cent of paid-up capital, and 76 per cent of market value of issues listed in India. The stock exchange at Bombay is distinguished not only by its size, but it is also the oldest market and has been recognized permanently, while the recognition for other markets is renewed every five years. Stock markets are organized either as voluntary, non-profit-making associations (Bombay, Ahmadabad, Indore), or public limited companies (Calcutta, Delhi, Bangalore) or company limited by guarantee (Madras, Hyderabad). Thus,

39

unlike in the UK, there are in India separate, independent exchanges with diversity of organizational structures, and there is neither the National Exchange nor provincial exchanges in our country. In the UK there has been a move to create a unitary organization of stock exchanges. In 1965, 22 separate provincial stock exchanges were merged into three regional stock exchanges, and in 1973 these, in turn, were combined to form the National Stock Exchange under the title of the Stock Exchange which has trading, floors in many former provincial centre. In view of the large size of the country, to adopt such a policy for India is not advisable.

The size of the industrial securities market in India is relatively much smaller than that in other industrialized countries. This is so because of the industrial structure, investment habits, and the level of education of investors in India. During the planning period, the role of public sector companies has much increased in the business activity of the country; today, in terms of paid-up capital, government companies are much more important than companies in the private sector. The shares of government joint stock companies are not yet quoted on stock markets, although there is .a move to offer a part of capital (say, 25 per cent) of selected government companies for subscription to the public. Industrial securities are not a major source of funds even for private sector industrial units. Nor are they a very popular mode of savings for individuals. Savings in the form of industrial securities were hardly one per cent of total financial assets of the household sector till the end of 1960s. Subsequently, this share was about 3 per cent till 1984-85, and 4 to 6 per cent thereafter. In short, the volume of industrial securities in relation to government securities, their role in financing the private sector, and their significance as a savings medium, indicate that the industrial securities market can hardly be regarded as a barometer of economic activity in India.

Movements in equity prices do not reflect the state of Indian economy. The market in equities in India is dominated by speculators; it thrives on scarcities and inflation. The interest of stock market centres around the performance of a few industrial units whose shares are valued by speculators. Hardly 30 to 40 scrips (2 per cent of listed stock) in the cleared as well as non-cleared list account for the bulk of activity on the Bombay Stock Exchange. In 1981, 17 leading scrips accounted for over 90 per cent of business in cleared securities. In 1988, 25 scrips accounted for 75 per cent of overall trading business.

We will not discuss here the details of membership rules, listing regulations, and trading rules concerning stock market. Only a few important points may be noted here. Such securities only are traded on the stock market as are “listed”. They (listed stock) are also known as quoted securities. With effect from 13 February 1989, any company can list, duelist and realist its securities by paying a stipulated fee, provided its equity capital is at least Rs. 3 crores and at least Rs. 1.8 crores, i.e. 60 per cent of this capital, is offered for public A subscription. Earlier, minimum equity capital limit was Rs. 1 crore. Of this amount, a maximum of 11 per cent may be reserved for the Government, their development agencies, and financial institutions. The principal objective behind the listing-requirement is to ensure proper supervision and control of dealings in securities, and to protect the interests of share-holders and the general investing public. Another objective is to avoid the concentration of economic power, to give promoters an opportunity to invest sufficiently in the company for their own benefit, and to require promoters to have a reasonable stake in the company.

Listed securities are classified as “cleared” or “specified” or “Group A” securities and “non-cleared” or “unspecified” or “Group B” or “cash” securities. Cleared securities on a given exchange are those that are included in the cleared list by the governing body of that exchange after the securities have satisfied the following conditions: they are folly paid-up equity shares; they must not be shares of banking companies; they must have been admitted to dealings for at least three years on the given exchange; they must not appear on the cleared list of any other stock exchange; the companies whose shares they are should be of public importance; the subscribed capital of these companies must be at least Rs. 25 lakhs: their aggregate value at the ruling market price should be at least Rs. 1 crore; and at least 49 per cent of the capital of the companies must be held by the public. At present, there are about 120 shares in the specified group in Bombay, Delhi, Calcutta and Ahmadabad exchanges; out of these

40

scrips, 70 are listed on the Bombay Stock Exchange alone. As far as Bombay is concerned, the average monthly turnover of “A Group” securities was Rs. 600 crores whereas for “Group B” it was Rs. 120 crores in 1987.

As the conditions laid down for inclusion in the cleared list are difficult to meet, cleared securities are few in number and form only a small proportion of the total corporate securities. But because of their characteristics, they are more actively traded in, and in terms of the number of shares traded, business in them accounts for a major portion of the total business on the stock exchanges in India.

Transactions on stock exchanges are carried out on either cash basis or carry over basis, i.e. through “clearing”. Exchanges at Bombay, Calcutta, Madras and Ahmedabad have their own clearing houses. The business in Group A securities is settled through clearing houses in addition to other methods of settlement. The stock exchange year is divided into periods called “accounts”. An account normally runs into a fortnight, but sometimes it may be for longer durations of 3 to 4 weeks. All transactions made during one account are to be settled by payment for purchases and by delivery of share certificates in the case of sales on notified days of the clearing programme of a given stock exchange. Transactions in non-specified securities have to be settled compulsorily by delivery; carryover is permitted only in respect of Group A securities. At the end of a settlement period, the investor in specified shares has three options: (a) he can terminate his contract of sale or purchase by a cross contract, i.e. by squaring up transaction; (b) he can complete the contract by delivery or payment as the case may be; and (c) he can carry over the contract to the next settlement. For example, if the investor who has purchased shares has no money to pay for his purchases, he can arrange with his broker to carry forward his business to the next settlement account. His broker would then find out someone who would receive the shares on behalf of the said investor and pay for them on the due date, i.e. on pay-in-day. The financier who advances the required funds will charge interest on the money loaned by him, and this is known as “contango” or “badla” for the fortnight till the next pay-in-day. Sometimes the seller may also have to pay the charge to the buyer when the shares are oversold and the buyers are in a demanding position; this is known as “backwardation charge” or “undha badla”. The “badla” system plays a crucial role in the carry forward transactions. The badla charges have the-approval of the stock exchange authorities who may even fix badla charges under exceptional circumstances. Usually, special sessions are held by the stock market at the end of each settlement period to determine the badla charges of individual shares in the specified list in actual biddings.

The types of transactions on cash basis according to arrangement for delivery (delivery-wise) are: (a) spot delivery, the delivery and payment are made on the same day as the day of contract or on the next day; (b) hand deliver, the delivery and payment are made when stipulated or within 14 days whichever is shorter; (c) special delivery, the delivery and payments are made beyond 14 days if permitted by the stock exchange authority.

The marketing of old or new securities on the stock markets can be done only through members of the stock exchanges. These members are either individuals or partnership firms. There are more individual members than partnership firms. In the UK the authorities have allowed the entry of joint-stock companies as brokers or dealers, for they can mobilize large amounts of funds. In India also, in order to rid stock exchanges of the stranglehold of a few and powerful groups of brokers, and with a view to broadening the base of the management of stock exchanges, moves have been initiated to allow banks, mutual funds, and other financial institutions to become members of the stock exchanges. It is also expected that individuals, partnerships, and family concerns of brokers would organize themselves into corporate bothes. The stock exchange members act in One or more capacity as: (a) commission broker, (b), floor broker, (c) Tarvaniwala, (d) jobber or dealer, (e) odd lot dealer, (f) budliwala or financier, and (g) arbitrageur. With regard to new issues, brokers do all that which is performed by specialized issuing houses in the UK-’The practice of some commercial batiks managing issues through their merchant banking divisions is also known to the market. The brokers advise promoters on the composition of capital structure and the form in which the new issue is to be made; they draft

41

prospectus and application forms; they explore the possibilities of securing loans from financial institutions; they arrange for underwriting, sub-underwriting, and placing of new issues; they organize the preliminary distribution of securities; and they procure direct subscription from investors. The commission rates of brokers are fixed by the stock exchanges. The official brokerage for both types of issues is fixed at 1.5 per cent. It is found that some brokers offer commission as high as 4 to 5 per cent to their sub-brokers to sell weak issues as attractive ones. This has detrimental effect on the interests of investors.

A part of the transactions on the stock exchanges is riot covered by any of the four methods of setting transactions mentioned earlier. This part is known as forward trading. In its wider sense, forward trading includes not only dealings in forward markets, but also all orders given in advance and all long-term contracts. Similarly, forward trading is done not only in shares but also in commodities, foreign exchange, and so on. It refers to entering into contracts today (i.e. in advance) to buy or sell (i.e. demand and supply) certain goods at some particular date in the future, the date being beyond a certain minimum period of time fixed for settling spot transactions. In a market economy, forward trading is a device to coordinate the price expectations and plans to buy arid sell by different individuals. It is the uncertainty about the future and the desire to keep one’s hands free to meet that uncertainty and profit from it which gives rise to forward trading. Forward markets are usually made of hedgers, i.e. those who enter into forward Contracts in order to reduce the risk arising out of uncertainty in regard to their desire to buy or sell in a future period, and speculators, i.e. those who seek a profit out of a discrepancy between the future price and the spot price they expect to rule on the corresponding date. As opposed to the hedger, the speculator puts himself in a more risky position as a result of his forward trading. The forward market in shares is dominated by speculators rather than by hedgers. Forward trading is said to be indispensable for ensuring price continuity, liquidity, free negotiability of capital, and fair evaluation of securities. If this is so, a ban on forward trading should adversely affect the activity connected with new issues. But in India, this has not actually happened.

Transactions on forward markets are determined by the relationship between the current spot price, currently fixed future price, and the expected spot price at a particular date in the future. There is said to be a Backwardation” if the future price is below the current spot price, a “contango” in the reverse case. If the spot price is expected to be about the same at some future date as it is today, the future

price for delivery at that date would be below the spot price now ruling. On the other hand, contango can arise only when spot prices are expected to rise sharply in the future; this usually means that current spot prices are abnormally low.

With regard to the organization of the stock market, it is necessary to remember that the entire working of the new issue market in India is governed by the Controller of Capital Issues (CCI) who exercises his powers in terms of the Capital Issues (Control) Act, 1947. The timing of the new issues by private sector companies, the composition of securities to be issued, interest (dividend) rates which can be offered on debentures and preference shares, .the timings and frequency of bonus issues, the price of right issues, the amount of prior allotment to promoters, floatation costs, premium to be charged on securities are all subject to the regulation of the CGI. Over time, the CCI has liberalized the rules and regulations. Effective from 1966, Private Ltd. Cos. and Government Companies not making public issues, and banking and insurance companies have been exempted from the prior consent of the CCI. Even in the case of non-financial non-government companies, so long as they conform to certain prescribed norms pertaining to debt-equity ratio, public participation, and premium size, they now merely need to inform the authorities of their intention to raise capital for which a no objection certificate is issued by the CCI.

The extent of growth of listed stock can be gauged from Table 5.1. The number of companies whose securities are listed on any one of the stock exchanges is very small, but in terms of paid-up capital, listed companies constitute a major portion of the non-government corporate sector. It can also be observed that in terms of various indicators, the growth of listed stock has occurred at a faster rate

42

during the period after 1961. In fact, the proportion of listed paid-up capital to the total paid-up capital in the private sector declined during 1946-61, picked up again and exceeded its original level subsequently.

Table

Growth of Listed Stock in India, 1946-88

Item/Year 1946 1961 1977 1988

1. Number of listed companies 1125 1203 1996 5841

2. 1 as percentage of non-government companies 7 5 5 4

3. 1 as percentage of non-government public limited companies

11 18 26 32

4. No. of stock issues of listed companies 1506 2111 3462 7694

5. No. of share units issued by listed companies (lakhs)

1565 4264 18910 ---

6. Paid-up capital of listed companies (Rs. Crores) 270 675 2538 21465

7. 6 as percentage of paid-up capital of non-government companies

65 53 75 ---

8. 6 as percentage of paid-up capital of non-government public limited companies

88 71 90 ---

9. Market value of 6 (Rs. Crores) 971 1216 3276 51379

10. 9 as percentage of 6 359.63 180.15 129.08 239.36

Source: Bombay Stock Exchange, Stock Exchange Directory.

Another way to gauge the growth of stock market activity is to know the volume of turnover on stock exchanges. Table 5.2.presents the annual turnover on all stock exchanges in India and on Bombay stock exchange. It shows that the turnover has tripled during the decade

Table 5.2 Annual Turnover on Stock Exchanges in India, 1979-88 (Rs. Crores)

Year All-India Bombay

1979 3159 2211

1960 3095 2166

1981 8279 5795

1962 6794 4756

1983 3430 2401

1954 6364 4455

1955 8763 6134

1986 19423 13596

1987 12486 8740

1988 8695 6087

SOURCE: Bombay Stock Exchange.

43

1979-88; that the volume of turnover is subject to fluctuations; that the peak in turnover was reached in 1986; and that Bombay stock exchange accounts for about 70 per cent of total turnover in India.

5.3 INDUSTRIAL SECURITIES

Business concerns raise capital through three major types of security. They are: (a) ordinary shares or variable dividend securities or common stock, (b) preference shares, and (c) debentures or bonds. Ordinary shares and preference shares are also known as “equities.” Unlike bank deposits and units, these securities are the major primary securities in the financial markets of any country. They differ in their investment characteristics and as such satisfy different preferences of various investors and enjoy differing degrees of popularity. It is necessary to note the major characteristics and the variants of these security types as they prevail in India.

5.3.1 ORDINARY SHARES

Ordinary shares are ownership securities which have certain advantages in favour of the issuing companies and investors depending on their attitude to risk-taking. Investment in this financial instrument is permanent but not illiquid. Due to the existence of a fairly active secondary market in shares, investors can turn their share holdings into cash fairly quickly. Because of the high risk which he bears, the investor can participate in the earnings and wealth of the company without limit. In a period of inflation since the value of holdings increases, ordinary shares are expected to be a hedge against inflation. From the point of view of the company, it is advantageous because dividend payments on ordinary shares are not mandatory and there is no need to refinance the capital raised through the issue of ordinary shares. As in other countries, this instrument is quite .popular with individual investors. The face value of ordinary shares in India varies from Rs. 1 to Rs. 1000 but the most common and popular denomination of shares is Rs. 100.

A special type of ordinary, share, called “deferred share”, was in vogue in India till the 1960s. The existence of this novel financial instrument was a result of the managing agency system peculiar to India. Managing agency firms issued shares with a low denomination, but, with disproportionate rights in respect of voting, dividend, and distribution of assets on winding-up of the company. Invariably these deferred shares were allotted to the managing agents and their associates. The practice of issuing “deferred shares” has now been discontinued.

5.3.2 PREFERENCE SHARES

A preference share is a complex financial instrument with a number of modifications to its general characteristics. Strictly speaking, it is an ownership security like an ordinary share, but carries a fixed rate of return (dividend) like a debenture. The holders of preference shares are entitled to income after the claims of creditors of the company have been met, but before ordinary shareholders receive any income. Because of these modifications, one comes across the following types of preference shares in the market; (a) cumulative and non-cumulative, (b) convertible and non-convertible, (c) redeemable and non-redeemable, (d) participating and non-participating. On cumulative preference shares, if dividend is

skipped in any period/periods, it has to be paid subsequently. Convertible preference shares can be converted into ordinary shares on terms and conditions fixed at the time of issue of such shares. A redeemable preference share matures in a fixed period of time and for all practical purposes it is regarded as a debt security like a debenture. Participating preference shareholders can earn a higher dividend than the fixed one if the company makes good profits.

Most preference shares in India are fixed rate dividend shares with cumulative rights. Both redeemable and non-redeemable shares are in vogue in India, but many redeemable shares are so, only at the discretion of the companies. Over a period of time, there has been a trend towards increasing the proportion of redeemable shares to total preference shares. The maturity period of redeemable shares is usually between 12 to 15 years. The practice of issuing preference shares with participation and conversion rights is not common. A study of 189 issues of preference shares during 1966-70 by the RBI

44

indicated that only two of them were convertible into equity. Preference shareholders have voting rights only on those issues which vitally affect the rights attached to their shares or when dividend has not been paid for a long period of time. The rate of dividend on these shares is subject to a ceiling fixed by the Controller of Capital Issues. The denomination of preference shares is known to vary between Rs. 1 and Rs. 1000, but the most common and popular one has been Rs. 100.

In theory, a preference share offers a perfect certainty of income and, as such, is less risky. But “In fact our analysis of relative frequencies of dividend skipping on preference and equity shares indicates that the degree of risk attached to preference shares was only a shade less than that attached to equity shares.” Apart from this uncertainty of return, the marketability and liquidity of preference shares are low in practice because the market for them is narrow and less active. The importance of preference share as a medium of investment for individuals has declined and now they are mostly held by institutional investors. Their relative importance as a method of financing for companies has also declined. However, in the case of new companies, they still play a relatively greater role than in the case of older companies.

5.3.3 DEBENTURES OR BONDS

Unlike the two securities that have been considered, debenture or bond is a creditor-ship security with a fixed rate of return, fixed maturity period, perfect income certainty, and low capital uncertainty. In the USA, while bonds are secured by tangible physical assets of the company, debentures are secured only by the general credit-worthiness of the company. No such distinction prevails in the UK and India where industrial debenture might be secured or unsecured. There are different kinds of debentures: (a) registered, (b) bearer, (c) redeemable, (d) perpetual, (e) convertible, (f) right, (g) nonconvertible, and (h) partially convertible. Almost all the debentures which are listed on Indian stock exchanges are mortgage registered debentures. Their face value varies from Rs. 5 to Rs. 5000, but, the most common denomination is Rs. 100. The maturity period is up to 12 years, and the coupon rate is subject to the ceding fixed by the Controller of Capital Issues (CCI). The CCl use to fix two rates, one for debentures up to 7-year maturity and the other for debentures with 7 to 12 year maturity. Of late, the most common maturity period of debentures in India has been 7 years and the ceiling rate is being fixed for these debentures only.

An important development which has occurred in the field of bond financing during the 1970s is the emergence of the practice of issuing convertible debentures and rights debentures. Convertible debenture is one that can be converted at the option of the holder into ordinary shares of the same company under specified terms and conditions. In the UK and USA, convertible debentures form a significant portion of the total amount of debt securities. In India, although the issues of convertible debentures were not unknown till 1970, there were very few of them. It is only after 1970 that a greater possibility for issuing convertible debentures has been noticed. The nature of this security can be understood with the help of a case of convertible debentures issued by Reliance Textiles in the second half of 1.979. These debentures were issued for cash at par for public subscription in units of Rs. 500 each. An amount of Rs. 250 per debenture was payable on application and the’ ba lance of Rs. 250 on allotment. Interest at the rate of 11 per cent per annum was payable on the debentures at equal half -yearly installments. They were, if not converted, redeemable at par in five equal annual installments on the expiry of the 8th, 9th, 10th, 11th and 12th year from ; the date of allotment. The debenture-holders were entitled to convert 20 per cent of the face value of each debenture into four equity shares of Rs. 10 each credited as fully paid-up at a premium of Rs. 15 per share. The option for conversion was to be exercised during the two months from 1 October to 30 November 1980 by giving notice to the company to that effect. The total value of debentures to be thus issued was Rs. 7 crores. The practice of issuing convertible debentures has increased in India during the 1970s and 1980s,

Another innovation introduced on the stock market a few years back was the issue of right debentures. This was thought of as a solution to the problem of restrictions on acceptance of deposits by companies

45

from the public and from, their shareholders. The following characteristics bring out the nature of this new financial instrument: (a) right debentures can be issued by public limited companies to raise finance for long-term working capital requirements; (b) they are not issued to the public, but are issued on a right basis to the existing shareholders of the issuing j company in a certain ratio to the ordinary shares held by them. These j rights are transferable and renounceable. The issues of right debentures, however, do not supplant the issues of conventional debentures to the public; (c) their maturity period is up to 12 years; (d) their face value is Rs. 100; (e) they are listed on the stock exchanges; they are

secured mortgage debentures, (f) the amount of capital a company can raise through the issue of these debentures cannot exceed 20 per cent of its current assets, loans advanced minus the long-term fund available for financing working capital, or 20 per cent of the company’s paid-up share capital, including preference capital and free reserves, whichever is lower subject to a maximum of Rs. 2.50 crores; (g) the debt/equity ratio, including proposed debenture issue, should not exceed 1:1; (h) they can be

issued only by a listed company and only if its equity shares were quoted at or above the par value during the six months prior to the date of the application for the issue of debentures; (t) debentures can be actually allotted only after a minimum subscription of 75 per cent of the amount of debentures issued has been secured; (/) although these debentures are mostly non-convertible, there have been cases of companies who have combined “convertibility” and “right” features in issuing their debentures. Rights debentures have been subscribed mainly by financial institutions and charitable and other trusts where these debentures have been declared as “public securities” by the respective State governments. They have not been able to attract genuine small investors. Of late, even financial institutions have developed a reluctance to subscribe to these debentures because of their low interest rates and lack of liquidity. The lack of liquidity is due to the absence of any good secondary market for debentures. Financial institutions would like the ceiling rate of interest on these debentures to be raised. Most of these debentures are quoted at a discount. The amount of capital issued through these debentures has been quite small.

Whatever the actual trends on the new issue market, it is not desirable to rely significantly on right debentures as a source of funds. The issue of right debentures, the conversion of a part of loans from financial institutions into equity, and the practice of encouraging share-holders by offering higher interest rates to keep deposits with their own companies have tended to make nonsense of the debt/equity ratio officially prescribed for the corporate sector. They have tended to lower the security available to the holders of creditor-ship securities. It is a sound principle of capital structure that an increase in debt capital is required to be backed by an increase in equity capital. The norms with regard to debt/equity ratio are prescribed in order to accord protection to the creditors. Now, when the same investor is induced to provide both borrowed capital and equity capital in the same company, he is required as the owner of the company to protect his own capital as a creditor. In other words, in such a situation, although the balance between equity and debt capital may be maintained, there is no real protection available to the creditors.

So far we have described the principal types of industrial securities/Let us now see what important innovations have occurred in India during the 1980s in respect of these securities.

The instrument of ordinary debenture or Non-convertible Debenture (NCD) has now been made extremely flexible as a result of the guidelines issued by the Government. Pursuant to the recommendations made in 1981 by the N.N. Pai Working Group to develop primary and secondary markets in debentures, the Government of India revised the guidelines about issuing -debentures, as a result of which NCDs have become quite attractive, both to the investors and the issuing companies, in respect of return, maturity, liquidity, tax status, and so on. The face value of NCDs is mostly Rs. 100 and their maturity period 7 years. There was a ceiling rate of interest on them of 15 per cent between 1982 to 1986 which was reduced to 14 per cent in 1987-88. These debentures have a buy-back facility after a lock-in period of one year. They are in most cases redeemed at 105 per cent of the face value. They are fully secured; interest is paid quarterly or six-monthly; and the interest income from them up to

46

Rs. 2500 is not taxed at source. The companies are allowed to retain 50 per cent of oversubscribed amount, to convert NCDs into equity shares, and to issue them not only for meeting expansion, diversification, and long-term working capital needs but also to meet almost every conceivable need for funds. The companies are mostly ready to review interest rate on these debentures upwards, in case of an upward movement in interest rates in the economy. It means that these debentures are variable or floating rate debentures. .

A few companies have issued linked NCDs”, i.e. they have issued ordinary share with NCDs; in this case the applicant has to apply both for shares and NCDs in the specified proportion. When such linked issues of NCDs are made, the interest rate offered on NCDs is lower than the i usual interest rate on them.

There have been cases of issuing “zero bonds” i.e. zero interest convertible bonds. One company recently issued such bonds at par on right basis to employees arid shareholders in the ratio of one debenture for 100 equity shares held. The debentures would be fully convertible into equity shares at the end of 3 years from allotment at a premium to be decided by CCI which will not be more than Rs. 30 per share. The face value of the debenture is Rs. 1000.

The Government approved in January 1989 a new instrument, namely, Partly Convertible Debenture (PCD). It has a shorter maturity period of 5 years and the issuing company provides buy-back facility relating to the residual non-convertible portion at the option of the investors.

In addition to the private corporate sector debentures and Government bonds, the market has become familiar since 1985 with the Public Sector Bonds (PSBs). According to the guidelines issued by the Government in September 1985, the existing and new public sector undertakings or Government corporate bothes can issue these bonds which have a face value of Rs. 500 or Rs. 1000. Normally, these bonds will not be redeemable before the expiry of 7 years; their maximum maturity is 10 years. The interest rate on these bonds is fixed by the Union Finance Ministry; the maximum interest rate on them at present is either 13 per cent or 9 per cent per annum; the interest can be cumulative or non-cumulative. There is no deduction of tax at source on interest income, while 9 per cent .10-year bonds are completely tax-free without limit, 13 per cent 7 to 10 year bonds are entitled to deduction under SOL of Income Tax Act. Both categories of bonds are exempt from wealth-tax without limit. These bonds are transferable by endorsement and delivery and they also enjoy buyback facility. The SBI buys and sells these bonds at a small price difference across the counter. These bonds are guaranteed by the Government; they are traded on stock exchanges; the holders up to Rs. 40000 enjoy the buy-back facility provided they hold these bonds for at least 3 years. The “railway bonds” issued in the early part of 1991 by the Indian Railway Finance Corporation are the latest example of public sector bonds.”

The public financial institutions have been issuing “capital gains bonds or debentures.” NHB, IDBI, and HUDCO are some of the examples of institutions issuing these bonds. They carry the interest rate of 9 per cent per annum; they are available throughout the year at a number of outlets. They are meant for investment of capital gains’ for the purpose of exemption from capital gains tax to the extent of 100 per cent. Interest on them is payable in advance or on a six monthly basis. Capital gains from the sale of long-term assets such as land, buildings, shares, securities, jewellery can be invested in these bonds. There is no deduction of tax at source on interest earned. Interest income is exempted under SOL of Income Tax Act, and bonds enjoy wealth tax benefits. The maturity period of bonds is 3 years. There is an option to receive an advance payment of interest for the period of full 3 years on a discounted basis; in the case of NHB, this can be done at the rate of Rs. 240 per Rs. 1000 invested and payable 3 months from the date of investment.

The bond market has also witnessed the issue of “NRI Bonds”. These are US dollar denominated bank

instruments in the form of promissory notes offered by the SBI to NRIs. They serve the purpose of

remitting to India dollar denominated funds of the NRIs. The first series of these bonds was issued in

1988 which had collected $92 million from NRIs in more than 70 countries. The second series of these

47

bonds, which is more attractive, has been issued in December 1990. No interest is payable if the bonds

are encased before the expiry of one year. These bonds carry an interest rate of 11 per cent per annum

(11.5 per cent in the case of first series). The interest is payable on a cumulative or non-cumulative

basis; while in the case of the former, the interest is compounded half-y early in. US dollars and paid

along with the principal amount on maturity, in the case of the latter, the interest is paid non-repatriable

in Indian rupees. The maturity period of bonds of both the series has been 7 years. The bonds are

easily transferable among NRIs by endorsement and delivery. The first series bonds could be encased

after a minimum lock-in period of three years; there is no such lock-in period in the case of second

series bonds. While the first series bonds could be gifted to lineal descendants, the second series

bonds can be gifted to any Indian resident. The interest on bonds is free from income tax, wealth tax,

and gift tax, but these tax concessions are not available in the case of premature encashment. The

denominations of bonds are, $500, $ 1000, $5000, and $10000, and .the minimum investment is $500.

It is feared that these bonds might be used to convert black money into white money.

In the equities market, the Government introduced Cumulative Convertible Preference Shares (CCPs)

in August 1985. According to the Government guidelines, Indian public limited companies can issue

CCPs for the purposes of setting up new projects, expanding and diversifying existing projects, and

raising funds for normal capital expenditure and working capital needs. CCPs are fully convertible into

equity shares between the 3rd and 5th years of their issue and are deemed equity for purposes of debt-

equity ratio. The rate of dividend, payable on the CCPs is fixed at 10 per cent per year. The guideline

regarding the ratio of 1: 3 as between other preference shares and equity shares is not applicable to

the CCPs, the amount of issue of CCPs can be to the extent of equity shares offered by the company to

the public. The CCPs are compulsorily converted into equity at the end of five years and no CCP is

redeemable at any stage.

5.4 SALIENT FEATURES OF INDUSTRIAL SECURITIES

Certain features of the market in industrial securities may be summarized below:

(a) Industrial securities market comprises the new issue (Primary) market and stock exchange

(Secondary market).

(b) There are 18 stock exchanges in India at present; the Bombay Stock Market among them accounts

for about 70 percent of the total trading business of all stock exchanges put together.

(c) The small volume of industrial securities in relation to Government securities, their minor role in

financing the private sector, and their marginal significance as a saving medium indicate that industrial

securities market in not really a barometer of economic activity in India.

(d) Only the “listed” securities can be traded on stock exchanges and the marketing of old as well as

new securities can be done only through the members of stock exchanges.

(e) The entire working of the new issue market in India is controlled by controller of capital issue.

(f) During 1946 to 1988, the number of listed companies on stock markets has increased from 1125 to

5841 and their paid up capital has gone up from about Rs. 270 crores to about Rs. 21465 crores.

(g) The annual turnover on all stock exchanges has tripled from Rs. 3159 crores in 1979 to Rs. 8695

crores in 1988.

(h) Business concerns reuse capital through three major types of security Ordinary shares, preference

shares, and debentures. The subtypes of these securities are: cumulative, non-cumulative, convertible,

non-convertible, participating, non-participating, redeemable, non-redeemable, cumulative convertible

preference shares; convertible, non-convertible, partially convertible, rights, linked non-convertible,

zero, public sector units, capital gains, and NRI-bonds or debentures.

48


1. What is ‘Stock Market’?

2. What are ‘Industrial Securities’?

5.6 SUMMARY

Stock, market represents the secondary market where existing securities (shares and debentures) are

traded, Stock exchange provides an organised mechanism for purchase and sale of existing securities.

By now, we have 24 approved stock exchange in our country.

The investors want liquidity for their investments. The securities which they hold should easily be sold

when they need cash. Similarly there are others who want to invest in new securities. There should be

a place where the securities may be purchased and sold. Stock exchanges provide such a place where

securities of different companies can be purchased and sold. Stock exchange is a body of persons,

whether incorporated or not, formed with, view to helping, regulating and controlling the business of

buying and seam of securities.

5.7 GLOSSARY

Stock Exchange: stock exchanges are market places where securities that have been listed on May

be bought and sold for either investment of speculation.

Listing of securities: listing of security means permission to court shares and debentures officially on

the trading floor of the stock exchange.

Jobbers: Job Bazar security merchants dealing in shares and debentures as independent operators.

They buy and sell securities on their own behalf and try to earn through price changes.


1. Refers to 5.1

2. Refers to 5.3


1. Describe the organization of the stock market.

2. Discuss the followings:

(a) Ordinary shares

(b) Preference Shares

(c) Debentures

3. Explain the salient features of industrial securities.


1. Refers to Section 5.1 & 5.2

2. (a) Refers to 5.3.1

(b) Refers to 5.3.2

(c) Refers to 5.3.3

3. Refers to 5.4

49




Hall of India,






---///---

50

Lesson-6

NATIONAL DEPOSITORY SECURITIES IN INDIA

STRUCTURE


6.1 The Depository System

6.2 Benefits of A Depository System

6.3 The Depository Process

6.4 The National Securities Depository Limited


6.6 Summary

6.7 Glossary






After studying this chapter you should be to:

1. Describe the benefits of depository system

2. Explain the depository system in India

3. Discuss the national securities depository limited

6.1 THE DEPOSITORY SYSTEM

Technology has changed the face of the Indian stock markets in the post-liberalization era. Competition amongst the stock exchanges, increase in the number of players, and changes in the trading system have led to a tremendous increase in the volume of activity. The traditional settlement and clearing system have proved to be inadequate due to operational inefficiencies. Hence, there has emerged a need to replace this traditional system with a new system called the ‘depository system'.

Depository, in very simple terms, means a place where something is deposited for safekeeping. A depository is an organization which holds securities of a shareholder in an electronic form and facilitates the transfer of ownership of securities on the settlement dates. According to Section 2(e) of the Depositories Act, 1996, ‘Depository means a company formed and registered under the Companies Act, 1956 and which has been granted a certificate of registration under Section 12(1 A) of the Securities and Exchange Board of India Act, 1992.'

The depository system revolves around the concept of paperless or scripless trading because the shares in a depository are held in the form of electronic accounts, that is, in dematerialized form. This system is similar to the opening of an account in a bank wherein a bank will hold money on behalf of the investor and the investor has to open an account with the bank to utilize its services. Cash deposits and withdrawals are made in a bank, in lieu of which a receipt and bank passbook are given, while in

51

depositories, scrips are debited and credited and an account statement is issued to the investor from time to time. An investor in a bank deals directly with the bank while an investor deals through a depository participant in a depository. A depository also acts as a securities bank, where dematerialized physical securities are held in custody.

An effective and fully developed depository system is essential for maintaining and enhancing market efficiency, which is one of the core characteristics of a mature capital market.

Need for Setting-up a Depository in India

This need was realized in the 1990s due to various reasons as outlined below:

Large-scale irregularities in the securities scam of 1992 exposed the limitations of the prevailing settlement system.

A lot of time was consumed in the process of allotment and transfer of shares, impeding the healthy growth of the capital market.

With the opening up of the Indian economy, there was a widespread equity cult which resulted in an increased volume of transactions.

Mounting fiscal deficit made the government realize that foreign investment was essential for the growth of the economy and that was being stricted due to non-availability of depositories.

There were various problems associated with dealing ii physical shares, such as

problems of theft, fake and/or forged transfers,

share transfer delays particularly due to signature mismatches; and

paper work involved in buying, selling, and transfer leading to costs of handling, storage, transportation, and other back office costs.

To overcome these problems, the Government of India, in 1996, enacted the Depositories Act, 1996 to start depository services in India.

Depository can be in two forms—dematerialized or immobilized. In dematerialization, paper certificates are totally eliminated after verification by the custodians. In immobilization, initial paper certificates are preserved in safe vaults by custodians and further movement of papers are frozen.

The depository system provides a wide range of services.

Primary market services by acting as a link between the issuers and the prospective shareholders.

Secondary market services, by acting as a link between the investors and the clearing house of the exchange to facilitate the settlement of security transactions through book-keeping entries.

Ancillary services, by providing services such as collecting dividends and interests, reporting corporate information, and crediting bonus, rights, shares.

These services lead to a reduction in both time and cost which ultimately benefits the investors, issuers, intermediaries, and the nation as a whole.

Difference Between a Demat Share and a Physical Share

A demat share is held by the depository on behalf of the investor whereas a physical share is held by the investor himself. The holding and handling of a demat share is done electronically, whereas a physical share is in the form of a paper. The demat share can be converted into a physical share on request. This is referred to as the rematerialization of the share. The interface between the depository and the investor is provided by a market intermediary called the depository participant (DP) with whom

52

an investor has to open an account and give all instructions. The demat share does not have a folio number, distinctive number, or certificate number like a physical share. Demant shares are fungible, that is, all the holdings of a particular security will be identical and interchangeable. Though there is no stamp duty on the transfer of demat shares from one account to another, the depository participant charges a transaction fee and levies asset holding charges.

There is, however, no difference between demat shares and physical shares as far as the beneficial interests of ownership of securities are concerned. The owner is entitled to exactly the same benefits of ownership of a security no matter in what form it is maintained.

6.2 Benefits of a Depository System

A depository system enables immediate allotment, transfer, and registration of securities, thereby increasing the liquidity of stocks. It eliminates all problems related with the holding of shares in physical form, thereby increasing investor confidence. An investor saves in terms of costs like stamp duty, postage, and brokerage charges (Table 18.1). Pledging of shares and portfolio shuffling become convenient for an investor. This system enables trading of even a single share, thereby eliminating the problem of odd-lot shares. Shares get credited into the demat holder's account in a couple of days, unlike the physical mode where it took an average of a month to transfer the shares.

Further, loans against the pledged demat shares come at interest rates that are lower by 0.25 per cent to 1.5 per cent in comparison to pledged physical shares. The limit of loan against dematerialized

security as collateral is double (at `20 lakh) of that against collateralized physical security (`10 lakh).

The Reserve Bank of India has also reduced the minimum margin to 25 per cent for loans against dematerialized securities as against 50 per cent for loan against physical securities. Many brokerage firms have brought down their brokerage to the extent of 0.5 per cent as the risk associated with bad delivery has reduced.

This system has facilitated the introduction of the rolling settlement system which, in turn, has led to shorter settlement cycles and a decrease in settlement risks and frauds. Lastly, this system helps in integrating the domestic capital market with international capital markets.

Depository System in India

The move on to a depository system in India was initiated by the Stock Holding Corporation of India Limited (SHCIL) in July 1992 when it prepared a concept paper on ‘National Clearance and Depository System’ in collaboration with Price Waterhouse under a programme sponsored by the US Agency for International Development. Thereafter, the government of India constituted a technical group under the chairmanship of R. Chandrasekaran, Managing Director, SHCIL, which submitted its report in 1993.

Subsequently, the Securities and Exchange Board of India (SEBI) constituted a seven-member squad to discuss the various structural and operational parameters of the depository system. The Government of India promulgated the Depositories Ordinance in September 1995, thus paving the way for setting up of depositories in the country.

Some features of the Depositories Ordinance are as follows:

The depository is a registered owner of the share while the shareholder is the beneficial owner retaining all the economic and voting rights arising out of share ownership.

Shares in the depository will be fungible.

Transfers pertaining to sale and purchase will be effected automatically.

Any loss or damage caused to the participant will be indemnified by the depository.

If trades are routed through depository, there is no need to pay stamp duty.

53

The Depositories Act was passed by the Parliament in August 1996. It lays down the legislative frame-work for facilitating dematerialization and book entry transfer of securities in a depository. The act pro-vides that a depository is required to be a company under the Companies Act, 1956 and depository participants (DPs) need to be registered with the SEBI. The investors have the option to hold securities in physical or dematerialized form or to rematerialize securities previously held in dematerialized form.

The SEBI issued a consultative paper No. X on the draft regulations for depositories and participants in October 1995 for wide consultation and notified the regulations in May 1996. The SEBI has allowed multiple depositories to ensure competition and transparency.

The Depositories Related Laws (Amendment) Ordinance, 1997, issued in January of that year enabled units of mutual funds and UTI, securities of statutory corporations and public corporations to be dealt through depositories. The Dhanuka Panel in its draft Depository Act (Amendment) Bill, 1998 recommended empowering the SEBI to make trading in demat shares mandatory. The SEBI laid down an elaborate time schedule envisaging that beginning January 4, 1999, till March 26, 2001, 3,145 listed scrips or 40 per cent of the total listed securities would be traded compulsorily in the demat form. Besides equity, new debt issues will also be in demat form. The minimum networth stipulated by the

SEBI for a depository is `100 crore.

It is mandatory for all listed companies to have their securities admitted for dematerialization with both the depositories, viz, NSDL and CDSL. Securities include shares, debentures, bonds, commercial paper, certificate of deposits, pass through certificates, government securities and mutual fund units.

SEBI (Depositories and Participants) (Amendment) Regulations 2008 were notified on March 17, 2008, which provided for the shareholding such as

1. sponsor should at all times hold at least 51 per cent shares in the depository;

2. no person, either singly or together with persons acting in concert, can hold more than 5 per cent of the equity share capital in the depository;

3. the combined holding of all persons resident outside India in the equity share capital of the depository will not exceed, at m\ time. 40 per cent of its total equity share capital, subject further to the following:

a. the combined holdings of such persons acquired through the foreign direct investment route’ are not more than 26 per cent of the total equity share capital, at any time;

b. the combined holdings of foreign institutional investors are not more than 23 per cent of the total equal) share capital, at any time;

c. no foreign institutional investor acquires shares of the depository otherwise than through the secondary market.

6.3 The Depository Process

There are four parties in a demat transaction: the customer, the depository participant (DP), the deposi-tory and the share registrar and transfer agent (R&T).

Opening an Account An investor who wants to avail of the services will have to open an account with

the depository through a DP. who could either be a custodian, a bank, a broker, cr individual with a

minimum net worth of `1 crore. The investor has to enter into an agreement with the DP after

which he is issued a client account number or client ID number. PAN Card is now mandatory to

operate a demat account. The holder of a demat account is called 'beneficial owner’ (BO). He can open more than one account with the same or multiple DPs.

54

Dematerialization To convert his physical holdings of securities into the dematerialized form, the investor: make an application to the DP in a dematerialization request form (DRF). Within seven days, the DP forwards the form, along with the security certificates, to me issuer or its registrar and transfer agent after electronically registering the request with the depository.

The depository electronically forwards the demat request lo the respective issuer or its registrar and transfer agent, who verifies the validity of the security certificates as well as the fact that the DRF has been made by a person recorded as a member in its register of members.

After verification, the issuer or its registrar and transfer agent authorises an electronic credit for the security in favour of the client. Thereafter, the depository causes the credit entries to be made in the account of the client.

Rematerialization To withdraw his security balance with the depository, the investor makes an application to the depository through its DP. He requests for the withdrawal of balance in his account in a rematerialization request form (RRF). On receipt of the RRF, the participant checks whether sufficient free relevant security balance is available in the client’s account. If there is, the participant accepts the RRF and blocks the balance of the client to the extent of the rematerialization quantity and electronically forwards the request to the depository.

On receipt of the request, the depository blocks the balance of the participant to the extent of the rematerialization quantity in the depository system. The depository electronically forwards the accepted rematerialization application to the issuer or its registrar agent, which is done on a daily-basis.

The registrar and transfer agent confirm electronically to the depository that the RRF has been accepted. Thereafter, the issuer or registrar and transfer agent despatches the share certificates arising out of the rematerialization request within 30 days.

Distributing Dividend A company (issuer or its registrar and transfer agent shall make known the

depositor) of the Corporate actions such as dates for book closures, redemption or maturity of security, conversion of warrant’s, and call money from time to time. The depository will then electronically provide a list of the holdings of the clients-as on the cut-off date. The company can then distribute dividend, interest, and other monetary benefits directly to the client on the basis of the list. If the benefits are in the form of securities, the company or its registrar and transfer agent may distribute these, provided the newly created security is an eligible security and the client has consented to receive the benefits through depositor).

Closing an Account A client wanting to close an account shall make an application in the format

specified to that elfect to the participant. The client may close his account if no balances are outstanding to his credit in the account. If any balance exists, the account may be dosed in the fallowing manner: (i) By rematerialization of all its existing balances in his account and/or (ii) By transferring his security balances to his other account held either with the same participant or with a different participant.

The participant shall ensure that all pending transactions have been adjusted before dosing such an account. After ensuring that there are no balances in the client’s account, the participant shall execute the request for closure of the client’s account.

Trading/Settlement of Demat Securities

The procedure for buying and selling dematerialized securities is similar to the one for physical securities. In case of purchase of securities, the broker will receive his securities in his account on the payout day and give instruction to its DP to debit his account and credit investors account. Investor can either give receipt instruction or standing instruction to OP for receiving credit by filling appropriate form. In case of sale of securities, the investor will give delivery instruction to DP to debit his account

55

and credit the broker's account. Such instruction should reach the DP’s office at least 24 hours before the pay-in.

6.4 THE NATIONAL SECURITIES DEPOSITORY LIMITED

The Indian capital market took a major step in its rapid modernization when the National Securities Depository Limited (NSDL) was set up as the first depository in India. The NSDL, promoted by the Industrial Development Bank of India, the Unit Trust of India (UTI), the National Stock Exchange of India Limited (NSE), and the State Bank of India (SBI) was registered on June 7, 1996, with the SEBI and commenced operations in November 1996. The NSDL is a public limited company formed under

the Companies Act. 1956 with a paid-up capital of `105 crore.

The NSDL interacts with investors and clearing members through market intermediaries called depository participants (DPs). The NSDL performs a wide range of securities-related functions through the DPs. These services are as follows:

1. Core services

a. Maintenance of individual investors ‘beneficial holdings in an electronic form,

b. Trade settlement.

2. Special services

a. Automatic delivery of securities to the clearing corporation.

b. Dematerialization and rematerialization of securities.

c. Account transfer for settlement of trades in electronic shares.

d. Allotments in the electronic form in case of initial public offerings.

e. Distribution of non-cash corporate actions (bonus rights, etc).

f. Facility for freezing/locking of investor accounts.

g. Facility for pledge and hypothecation of securities.

h. Demat of National Savings Certificates (NSC) Kisan Vikas Patra (KVP).

i. Internet based services such as SPEED-e and IDeAS.

Business Partners of the NSDL

An important link between the NSDL and an investor is a DP. A DP could be a public financial institution, a bank, a custodian, or a stock broker. Corporate entities are not allowed to become DPs nor can they set up depositories. A DP acts as an agent of the NSDL and functions like a securities bank' as an investor has to open an account with the DP. The SHCIL was the first depository participant registered with the SEBI. The number of DPs operational as on March end 2010 stood at 287 as against 24 in the end of March 1997 including ail custodians providing services to local and foreign institutions.

At present, the competition among DPs has increased and, in a bid to attract and retain customers, DPs are exploring new avenues including latest technology for increasing their efficiency. For instance, many DPs have launched interactive voice response (IVR) units. They have also slashed their service charges and many of them are rendering free-market and off-market buy services to them corporate clients.

Besides DPs, other business partners of the NSDL include issuing companies/their share transfer agents, clearing corporations/houses, and clearing members. The NSDL facilitates the settlement of trades carried out in the book entry segment of stock exchanges. The actual settlement function is performed by the clearing corporation/houses of the stock exchanges. The NSDL has its by-laws

56

regarding the powers and functions of board of directors, executive committee, rules of business, participants, nomination of persons of eminence, safeguards for clients, participants, and accounts by book entry. Trading in dematerialized securities commenced on December 26, 1996, in the NSE.

The NSDL has achieved paperless trading in perhaps the shortest time in the world—a little over three years. Today 99.9 per cent of all equity is traded in demat form. The NSDL has more than 1.58 crore (Box 18.1) investor accounts and 268 DPs. making it the second largest depository in the world.

The NSDLs computer system handles around eight to nine million messages (to debit and credit indi-vidual investor accounts) per day on an online basis, it links three types of data bases—a central NSDL one those of 281 DPs as well as those of 8.338 companies. Moreover, it has the ability to monitor everything that is happening in the computers of its DPs.

The NSDL has undertaken a pilot project to dematerialize securities like National Savings Certificates and Kisan Vikas Patra at select post offices. In addition, it also manages a countrywide tax information network for the ministry of finance. It has also been appointed as central Record keeping agency for the New Pension System of the Government of India.

The NSDL has created three pioneering systems: SPEED-e, STeADY and IDeAS. SPEED-e allows users to execute delivery instructions using the Internet. STeADY (Securities Trading—Information Easy Access and Delivery) was launched by the NSDL or November 30, 2002 and it constitutes an internet-based infrastructure few facilitating straight-through processing. It is a means of transmitting digitally signed trade information with encryption across market participants electronically, through the Internet. This facility enables brokers to deliver contract notes to custodians and or fund managers electronically. ‘IDeAS’ (Internet-based Denial Account Statement) enables its account-holders including clearing members to view their account balances and transactions of the last five days. These systems reflect the continual process or sophistication of depository services being undertaken by the NSDL.


1. Define Depositary System.

2. Define “National Securities Depositary System”.

6.6 SUMMARY

One of the biggest problem faced by the Indian capital market has been the manual and paper based settlement system. Under this system, the clearing and settlement of transactions take place only with the use of paper work. The system of physical delivery of scrips poses many problems for the purchaser as well as the seller in the form of delayed settlements, long settlement periods, high level of failed trade, high cost of transactions, bad deliveries etc. In many cases transfer process takes much longer time than two months as stipulated in section 113 of the Companies Act, 1956 or section 22 A of the Securities Contracts (Regulations) Act, 1956. Moreover, a large number of transactions end up as bad deliveries due to faulty compliance of paper work, mismatch of signatures on transfer deeds with specimen record of the issuer or other procedural reasons. Besides, theft, forgery, mutilation of certificates and other irregularities have also become rampant.

6.7 GLOSSARY

Depository participant: DP is an agent of the depository. If an investor wants to avail the services

offered by the depository, the investor has to open an account with DP.

Beneficial owner: beneficial owner means a person whose name is recorded as such with the

depository. Beneficial owner is the real owner of the securities who has lost his securities with the depository in the form of book entry.

Depository: a depository is a form where in the securities of an investor are held in electronic form in

the same way as Bank holds money.

57

National securities depository Limited (NSDL): NSDL was the first depository organisation promoted by IDBI UTI and National Stock Exchange. NSDL was set up to provide electronic depository facilities for securities being traded in capital market.

Rematerialisation of shares : rematerialisation is the process of conversion of electronic holding of

securities into physical certificate form. For rematerialisation of scripts the investor has to fill up a Re mat request form and submit it to the Depository Participant.


1. Refers to 6.1

2. Refers to 6.4


1. What do you understand by depositary system in India?

2. Discuss the benefits of depositary system.

3. Explain the national depositary securities limited.



2. Refers to Section 6.2





Hall of India,






---///---

58

Lesson-7

Commercial Banking

STRUCTURE


7.1 Introduction

7.2 Theoretical Basis of Banking Operations

7.3 Present Structure of Banking

7.4 Role of Foreign Banks

7.4.1 Advantages and Disadvantages of Foreign Banks

7.5 Road Map for Foreign Banks in India


7.7 Summary

7.8 Glossary






After studying this lesson you should be able to

1. Describe the evolution of commercial banking

2. Explain the present structure of banking

3. Discuss the role of foreign banks in India

7.1 INTRODUCTION

Commercial banks are the oldest, biggest, and fastest growing financial intermediaries in India. They are also the most important depositories of public saving and the most important disbursers of finance. Commercial banking in India is a unique system, the like of which exists nowhere in the world. The truth of this statement becomes clear as one stuthes the philosophy and approaches that have contributed to the evolution of the banking policy, programmes and operations in India. This however is too big a subject to be discussed here in detail. We will therefore confine ourselves to presenting an outline of this philosophy and approaches.

The banking system in India works under the constraints that go with social control and public ownership. The public ownership of banks has been achieved in three stages: 1955, July 1969, and

59

April 1980. Not only the public sector banks but also the private sector and foreign banks are required to meet targets in respect of sectoral deployment of credit, regional distribution of branches, and regional credit-deposit ratios. The operations of banks have been determined by Lead Bank Scheme, Differential Rate of Interest Scheme, Credit Authorization Scheme, inventory norms and lending systems prescribed by the authorities, the formulation of the credit plans, and Service Area Approach.

The focus of this chapter is on discussing the actual working of banks and not on the philosophy and approaches behind that working.

7.2 THEORETICAL BASIS OF BANKING OPERATIONS

Commercial banks ordinarily are simple business or commercial concerns which provide various types of financial services to customers in return for payments in one form or another, such as interest, discounts, fees, commission, and so on. Their objective is to make profits. However, what distinguishes them from other business concerns (financial as well as manufacturing) is the degree to which they have to balance the principle of profit maximization with certain other principles. In India specially, banks are required to modify their performance in profit-making if that clashes with their obligations in such areas as social welfare, social justice, and promotion of regional balance in development. In any case, compared to other business concerns, banks in general have to pay much more attention to balancing profitability with liquidity. It is true that all business concerns face liquidity constraint in various areas of their decision making and, therefore, they have to devote considerable attention to liquidity management. But with banks, the need for maintenance of liquidity is much greater because of the nature of their liabilities. Banks deal in other people’s money, a substantial part of which is repayable on demand. That is why for banks, unlike other business concerns, liquidity management is as important as profitability management.

This is ‘reflected in the management and control of reserves of commercial banks. They are expected to hold voluntarily a part of their deposits in the form of ready cash which is known as cash reserves; and the ratio of cash reserves to deposits is known as the (cash) reserve ratio. As banks are likely to be tempted not to hold adequate amounts of reserves if they are left to guide themselves on this point, and since the temptation may have extremely destabilizing effect on the economy in general, the central bank in every country is empowered to prescribe the reserve ratio that all banks must maintain. The central bank also undertakes, as the lender of last resort, to supply reserves to banks in times of genuine difficulties. It should be clear that the function of the legal reserve requirements is two fold to make deposits safe and liquid, and to enable the central Bank to control the amount of checking deposits or bank money which the banks can create. Since the reserve banks are required to maintain a fraction of their deposit liabilities, the modem banking system is also known as the “fractional reserve banking”.

Another distinguishing feature of banks is that while they can create as well as transfer money (funds), other financial institutions can only transfer funds. In other words, unlike other financial institutions, banks are not merely financial intermediaries. This aspect of bank operations has been variously expressed. Banks are said to create deposits or credit or money, or it is said that every loan given by banks creates a deposit. This has given rise to the important concept of deposit multiplier or credit multiplier or money multiplier. The import of this is that banks add to the money supply in the economy, and since money supply is an important determinant of prices, nominal national income, and other macro-economic variables, banks become responsible in a major way for changes in economic activity. Further, as indicated in chapter one, since banks can create credit, they can encourage investment for some time without prior increase in saving.

Let us briefly discuss the basis and process of the creation of money by banks. In modem economies, almost all exchanges are effected with money. Money is said to be a medium of exchange, a store of value, an unit of account. There is much controversy as to what, in practice in a given year, is the measure of supply of money in any economy. We do not need to go into that controversy here. Suffice

60

it to say that everyone agrees that currency and demand deposits with banks are definitely to be included in any measure of money supply. Thus, apart from the currency issued by the Government and central bank, the demand or current or checkable deposits with banks are accepted by the public as money. Therefore, since the loan operations of banks lead to the creation of checkable deposits, they add to the supply of money in the economy. To recapitulate, ,the money creating power of banks stems from the facts that modem banking is a fractional reserve banking, and that certain liabilities of banks are accepted (used) by the public as money.

The process of money creation works as follows: Assume that the legally required reserve ratio is 10 per cent and that banks are maintaining just that ratio. Assume further that a bank in the economy receives a brand new input of Rs. 1000 of reserves either as a deposit or as proceeds of a sale of Government bond to the central bank or as some other form. There is thus a creation of Rs. 1000 of bank money, but there is yet no multiple expansion of money. If banks were required to keep 100 per cent cash reserve balances, no bank would be in a position to create any extra money out of a new deposit of Rs. 1000 with it.

But since a bank is required to hold only 10 per cent of its deposits as cash reserves, it now has Rs. 900 as excess reserves which it can utilize to invest or to give loan. Assume that the bank gives a loan of Rs. 900, and the borrower who takes the loan in cash or cheque deposits it either with the same bank or with some other bank. Either way, there has been a creation of money and the total amount of bank money created at this stage is Rs. 1000+900 = Rs. 1900. This process of creation can continue till no bank anywhere in the system has reserves in excess of the required 10 per cent reserve, and the total money supply created in the economy is Rs. 10,000. The ratio of new deposits to the original increase in reserves is called the money multiplier or credit multiplier or deposit multiplier. This multiplier will be equal to the reciprocal of the required reserve ratio.

The process of the creation of bank money does not work in practice to the full capacity or the full potential as has been described. Banks may have a reserve ratio which is higher than the required reserve ratio. There may also be leakages in the form of cash holding when the banks make Joans. The process moves rather slowly and with jerks, and not as promptly and smoothly as implied. Subject to such qualifications, there is no doubt that modem banks can create money in the process of their working.”

With this theoretical background one should be in a position to understand the actual working of commercial banks in India.

7.3 PRESENT STRUCTURE OF BANKING

Tables 7.1 to 7.4 and Figures 7.1 and 7.2 present the growth and structure of Indian banking system with varying details and for different spans of time. Together they should enable the reader to assess all the possible dimensions of the structure and growth of banks in India. For lack of space, only the salient features of these aspects have been touched upon.

Table 7.1. Growth of Commercial Banks in India During Post-Nationalization Period

Variables 1969 1989

1. Total Deposits (Rs. Crores) 4667 145684

2. Deposits/National Income (%) 15.5 49

3. Number of Deposit Accounts (Million) 18 247

4. Deposits per office (Rs. lakhs) 57 252

61

5. Rural Deposits/Total Deposits 3 15

6. Total Credit (Rs. Crores) 3602 90185

7. Number of Credit Accounts (Million) 1.1 25.6

8. Credit per office (Rs. lakhs) 44 156

9. Credit to Priority Sectors (Rs. crores) 504 36238

10. Priority sector credit/Total Credit (%) 14 40

11. Number of total branches (offices) 8187 57611

12. Number of Rural offices 1443 32873

13. Rural Offices/Total offices 18 57

14. Population served per office 65000 12000

SOURCE: RBI Bulletin, March 1990. pp. 198-99, and October 1990. p.766.

Table 7.2 Annual Average Rates of Growth of Commercial Banks in India 1951-1986 (Percentages)

SURCE: Based on Table 7.3.

In September 1990,296 scheduled banks had 59388 offices, Rs, 1,87,469 crores of deposits, and

Rs. 1,12,212 crores of credit. The corresponding figs, for 1951 were 93 banks, 2847 offices, Rs. 856

crores of deposits, and Rs. 459 crores of credit. In other words, compared to 1951, the banking

business in 1990 was 22 times in terms of offices, 219 times in terms of deposits, and 244 times in

terms of credit. Fig. 7.1.which is drawn with the ratio scale, and Table 7.3 (column 5) reflect this

phenomenal growth of Indian banking during a period of 40 years. According to the latest available

information, as on 22 March, 1991, the aggregate bank deposits and bank credit were Rs. 1,91,189

crores and Rs. 1,16,184 crores, respectively.

Table.7.-1.concentrates on the growth of banking only during the post-nationalization period but with

many core indicators. The growth of banking has been far more rapid after the nationalization than

before it. Further the overall growth in business has been accompanied by a significant increase in the

share of rural and priority sectors in the toted business. While the bank deposits to national income

ratio has increased from just 15 per cent in 1969 to as high as 50 per cent in 1989, the population

Period Number of offices Deposits Credit

1951-61 2.7 12.98 11.45

1961-69 9.96 19.33 22.92

1969-78 23.16 49.90 44.64

1978-86 5.9 37.92 33.06

1951-86 25.30 367.47 314,81

62

served per office has drastically- declined from 65000 to 12000 during the same period. However,

within the post-nationalization period, the annual rate of growth appears to have slowed down in the

1980s compared to the 1970s. Table 7.2 shows the extent and time pattern of this growth.

2. Number of Offices in India

1951 — — 2647 1504 4151 +-

(63.76) (36.23) (100)

1961 4319 71 4390 622 5012 —

(86.17) (1.41) (87.58) (12.41) (100)

1969 8696 131 8826 181 9007 —

(96.54) (1.44) (97.94) (2.09) (100)

1978 27596 129 27725 ' 57 27782 1722

(99.33) (0.46) (99.79) (0.20) (100)

1986 40725 136 40861 42 40903 12846

(99.56) (0.33) (99.89) (0.1) (100)

3. Total Deposits

(Rs. crores)

1951, — — — ' — 909 —

1961 1792 257 2749 40 2089 —

(85.78) (12.30) (98.08) (1.91) (100) i '

1969 4808 487 5295 24 5319 —

(90.39) (9.15) (99.54) (0.45) (100)

1978 28084 1112 291% 10 29206 75

Table7.3. Structure and Growth of Commercial Banks in India. 1951 to 1986

Category of Banks

Variables

Indian Schedule

Banks

Foreign Schedule

Banks

Total Schedule

Banks

Non Schedule Banks

Total

(3+4)

Regional Rural Banks

(1) (2) (3) (4) (5) (6)

1. Number of Reporting Banks

1951 — — 92 474 566 —

(16.25)82 (83.74)210 (100)

1961 67 15 82 210 292 —

(22.94) (5.13) (28.08) (71.91) (100)

1969 58 13 71 14 85 —

(68.23) . (15.2,9) (83.5) (16.47) (100)

1978 61 12 73 4 77 48

(79.22) (15.58) (94,80) (5.19) (100)

1986 58 21 79 3 82 194

(70.73) (25.6) (96.34) (3.65) (100)

63

(96.15) (3,80) (99.96) (0.04) (100)

1986 114066 3725 117791 29 117820 1786

(96.81) (3.16) (99.97) (0.03) (100) '" -

4. Total Bank Credit

(Rs. crores)

1951 — — 681 46 727 —

(92.66) (7.33) (100)

1961 1090 230 1321 25 1345 '—

(81.15) (17.10) (98.21) (1.85) (100)

1969 3396 403 3799 12 3811 —

(89.11) (10.57) (99.8) (0.31) (100)

1978 18322 7% 19118 6 19124 91

(95.80) (4-16) (99.96) (0.04) (100)

1986 67013 2681 6%94 19 69713 1792

(96.13) (3.84) (99.97) (0.03) (100)

N.B.: (i) Figures in brackets are percentages to the totals.

(ii) Regional Rural Banks are also scheduled banks. They have been shown separately because of their special position: Figures in columns 1,3,5 are exclusive of figures in column 6.

SOURCE: RBI, Statistical Tables Relating to Banks in India, various Issues

Years

· Deposits Rs. Crores ı Credit

* Inv. in Secu. • No of Offices

Fig. 7.1. The growth of scheduled banks in India (Source: RBI, RCF, various issues)

Note: The figures in brackets are % to total scheduled banks.

Source: RBI Statistical Tables Relating to Banks in India, various issued.

Figure 7.2.portrays the types of banks which constitute the Indian banking system and Tables 7.3 and

7.4 show the relative shares of these different types of banks in the total banking business in terms of

four indicators, namely the number of reporting banks and bank offices, and the volume of deposits and

64

credit. One observes that the scheduled commercial banks presently account for virtually the entire

banking business. During early 1950s, there were many non-scheduled banks and each of such banks

had many offices, but they have since become quite unimportant in every respect.

65

66

Among the scheduled banks, ‘the Indian scheduled banks’, excluding Regional Rural Banks (RRBs), belonging to both the public mid private sectors have increased their share in the total banking business during 1951 -90, and now they account for more than 95 per cent of this business.

On the other hand, over the years the number of foreign (scheduled) banks has increased, but their share in the total business has-declined. They now account for 3 to 4 per cent of the total bank deposits (credit) compared to 10 to 17 per cent till 1969.

The share in the total banking business of the scheduled banks in the public sector including RRBs has increased, while that of the private sector banks has declined. This share of the public sector banks is now more than 90 per cent, and that of the private sector banks is between 4 to, 5 per cent. At present there are about 100 private sector banks, most of which have just one or two branches. Of these, only 24 banks are large enough and 3 of them account for about 70 per cent of the total business of private sector banks.

Among the public sector banks, the State Bank of India (SBI) alone accounted for about 14 per cent of the total number of bank offices, 21 per cent of the total bank deposits, and 24 per cent of the total bank credit in 1986. If the subsidiaries of the SBI were included, the corresponding figures for the SBI group were 20 per cent, 27 per cent, and 30 per cent, respectively it that year. As on 14 December, 1990 also, the SBI and the SBI group had shares in banking business very much similar to those that have been discussed. The twenty nationalized banks other than the SBI and its subsidiaries now account for 50 to 60 per cent of the total banking business.

A beginning to set up the RRBs was made in the latter half of 1975 in accordance with the recommendations of the Banking Commission. It was intended that the RRBs would operate exclusively in rural areas and would provide credit and other facilities to small and marginal farmers, agricultural labourers, artisans, and small entrepreneurs. They now carry all types of banking business generally within one to five districts. The RRBs can be set up provided any public sector bank sponsors them. The ownership' capital of these banks is held by the Central Government (50 per cent), concerned State Government (15 per cent), and the sponsor bank (35 per cent). They are, in effect, owned by the Government, and there is little local participation in the ownership and administration of

67

these banks also. Further, they have a large number of branches. In March 1990,196 RRBs were operating in 369 districts with 14079 offices, Rs. 3119 crores of deposits, and Rs. 2919 crores of credit The RRBs make an important part of the banking structure, in terms of the number of banks and offices, but not in terms of deposits and credit. They accounted for 71 per cent of the number of banks, 24 per cent of the total number of bank offices, about 1.5 per cent of total deposits, and about 2.5 per cent of total bank credit in 1986. There has been little change in this position since then.

The banking systems in India is thus characterized by excessive concentration of business in a small number of scheduled public sector banks. The banking in India, as in the UK, is entirely of the type called branch banking. If we exclude RRBs, just twenty-one banks (with seven subsidiaries) are now

operating a vast network of about 45000 branches over a vast geographical area: This concentration of banking business has been brought about through the policy of mergers and consolidation of banks, and their Government ownership. The number of major operating banks has been reduced from 566 in 1951 to about 75 exclusive of RRBs 'and to 270 inclusive of them in 1990. The phenomenon of branch banking has aggravated the problem of organizational and operational inefficiency in the banking sector. There is a need to decide on the optimum size of a bank in Indian conditions. Some of the banks in India appear to have become too big to function efficiently. The branch banking has accentuated another problem, namely, the drain of resources from the rural to urban areas so much so that the authorities had to set different targets of credit/deposit ratio for different geographical areas.

In view of the vastness of the country coupled with regional disparities in the structure and level of economic development, and in order to avoid the drain of resources from the rural areas, it would perhaps have been a wiser policy if the small local banks were strengthened through suitable policy measures instead of liquidating them or merging them with other banks. The policy of promoting and nurturing unit banking system would perhaps have yielded better results. The working of many private sector banks today support this viewpoint These banks are found to be compact in size which has

facilitated cutting of red tape, promoting good rapport between the staff and management, motivating staff, and giving better service to the customers and community.

7.4 ROLE OF FOREIGN BANKS

It is now widely believed that for financial institutions to operate efficiently there is a need to maintain competitive conditions. The empirical and theoretical literature in banking also suggests that a competitive banking system is more efficient. It has therefore, been the endeavour of the Government and the Reserve Bank to enhance competition through entry of new private sector banks, increased presence of foreign banks and provision of operational flexibility to public sector banks. To diversify ownership, public sector banks were allowed to raise funds from the capital markets, subject to the Government shareholding being retained at 51 percent. Various other restrictions hindering the competitive process have also been, by and large, phased out.

In recognition of the emergence of foreign banks as key vehicles in the international integration of the financial systems, a liberalized policy towards foreign banks’ entry has become a high priority in policymakers agenda in various countries in recent years. Liberalization of financial services by allowing foreign financial institutions to participate in the domestic market improves competition, thereby facilitating better and cheaper financial intermediation. Apart from increasing competition and efficiency through infusion of technology and skill management, some of the other benefits of foreign banks’ entry are said to include introduction of superior risk management practices and stronger capital base, which is also less sensitive to host Country’s business cycle.

India also liberalized the entry of foreign banks in the post-reform period. In the roadmap by the Reserve Bank released in February 2005, the opening up of the domestic banking sector to foreign banks was envisioned in two phases. The first phase envisaged that foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100 per cent wholly owned subsidiary (WOS) following the one-mode presence criterion. In the second

68

phase (April 2009 onwards), the policy on foreign banks is to be taken up for a review. At that stage, various issues associated with the increased presence of foreign banks such as impact on the domestic

banks, supervisory and regulatory challenges in view of their sophisticated operations and their involvement in complex and sophisticated products, financial inclusion, credit to agriculture and SMEs, and public policy on credit delivery, cost and allocation would need to be weighed. The issues relating to co-ordination between home and host countries regulators would also pose a challenge.

7.4.1 ADVANTAGES AND DISADVANTAGES OF FOREIGN BANKS

The following are the commonly highlighted benefits of foreign bank entry. First, it heightens competition and promotes efficiency leading to decline in costs or increase in productivity. When a foreign bank enters through green field investment and sets up a de novo institution, the increase in the

number of banks in the host country directly enhances competition. Entry through merger and acquisition, which infuses more skilled management and upgrade governance through introducing more advanced systems and risk management, may force other banks in the host country to improve their efficiency in order to protect their market shares. Second, entry of foreign banks improves credit allocation, as in making credit decisions, they apply formal credit standards and risk-adjusted pricing and are not influenced by other considerations.

Third, foreign banks help in the development of local financial markets since they have both the incentives and the expertise to develop certain segments of local market, such as funding, derivatives and securities markets. Foreign banks that lack a branch network to guarantee deposit financing of their activities are more likely to turn to the inter-bank market. Foreign banks can also contribute by bringing professional expertise to the local foreign currency markets. They often try to create markets or gain market share through product innovation, especially by offering a variety of new financial services to corporate clients, including structured products.

Fourth, the overall soundness of domestic financial system is enhanced by introducing the risk management practices of the foreign parent banks. Based on tighter credit review policies and practices, they adopt more aggressive measures to address asset quality deterioration and limit the build-up of non-performing assets in the financial system.

Fifth, foreign banks may exert a stabilizing influence in times of financial distress, as stronger capitalization and the possibility of an injection of additional funds by the parent, if needed, reduces the probability of failure. For the same, foreign banks are less sensitive to both home and host country business cycles, and consequently, lending to local residents in the local market is likely to be more stable in times of stress than either cross- border lending or the lending of indigenous banks in the markets. Further, when the foreign banks continue to operate in a crisis, the probability of the system as a whole remaining functional increases.

Sixth, there could be long-term benefits from lower cost structures in the banking system. Foreign banks, in general, are found to operate with lower administrative costs as has been found in Latin America and most of other developing countries. However, in some countries such as India, operating cost of foreign banks was found to be higher than that of domestic banks.

Seventh, foreign ownership usually involves the transfer of human capital at both the managerial and the operational level. Complementary to this is the transfer of soft infrastructure such as back office

routines or credit control systems. Such transfers have gained importance to reap economies of scale through standardization of processes.

There could also be several costs associated with the entry of foreign banks.

First, entry of foreign banks could also lead to concentration and loss of competition. In many countries, foreign banks entered the system mainly by acquiring existing domestic banks, while in some countries domestic banks consolidation and concentration occurred in response to foreign competition.

69

Second, though foreign banks entry may lower interest margins and potentially foster the process of financial intermediation, the impact would depend on the form it takes and may not benefit all borrowers. The benefits would depend on whether the lower spread is the result of a more aggressive pricing strategy across the board or the banks choosing to lend only to the most transparent segments where there is more competition or at least greater market contestability.

Third, the growing presence of foreign banks can increase the complexity of the tasks facing supervisory authorities and thus lead to regulatory conflicts. This could be a particular concern in countries where foreign commercial banks expand their operations rapidly in the area of lion-bank financial services such as insurance, portfolio management, and investment banking. Given the complex structure of many internationally active banks, Integral issues within foreign banks are increasingly being shown to be of potential systemic significance. Fourth, foreign banks expose the country to some downside risks/ challenges attached with their entry. More strikingly, domestic banks in emerging markets generally incur costs since they have to compete with large international banks with better reputation, particularly in developing world.

Fifth, there is a general concern that as foreign banks have historically followed home-country customers or specialized in servicing corporate customers, their entry would lead to neglect of rural customers and small and medium sized firms. Another concern is that with foreign banks using the inter-bank market for much of their funding, local banks could divert their funds from domestic loans to the inter-bank market, thereby channeling fund to large corporate at the expense of small companies.

Sixth, it is also argued that the presence of foreign banks may not necessarily yield a more stable source of credit to domestic borrowers because foreign banks can, at times, shift funds abruptly from one market to another for risk management purposes. Literature also suggests that foreign banks will be more likely to shift their funds to more attractive markets during a crisis if their parent banks are weak.

7.5 ROAD MAP FOR FOREIGN BANKS IN INDIA

With a view to delineate the direction and pace of reform process in this area and to operationally the extant guidelines of March 4, 2004 in a phased manner, the RBI, on February 28,2005, released the road map for presence of foreign banks in India. The roadmap was divided into two phases.

Phase I: March 2005 to March 2009: During the first phase, foreign banks were permitted to establish

presence by way of setting up a wholly owned banking subsidiary (WOS) or conversion of the existing branches into a WOS. The guidelines covered, inter alia, the eligibility criteria of the applicant foreign banks such as ownership pattern, financial soundness, supervisory rating and the international ranking. The WOS was required to have a minimum capital requirement of Rs. 300 crore and maintain a capital adequacy ratio of 10 percent or as was prescribed from time to time on a continuous basis, from the commencement of its operations. The WOS was treated on par with the existing branches of foreign banks for branch expansion with .flexibility to go beyond the existing WTO commitments of 12 branches in a year and preference for branch expansion in under-banked areas. During this phase, permission for acquisition of share holding in Indian private sector banks by eligible foreign banks was limited to banks identified by the RBI for restructuring. The RBI—if it was satisfied that such investment by the foreign bank concerned was in the long-term interest of all the stakeholders in the invested bank—permitted such acquisition. Where such acquisition was by a foreign bank having presence in India, a maximum period of 6 months was given for conforming to the one form of presence concept.

Phase II: April 2009 onward: Phase II commenced in April 2009 after a review of the experience

gained and after due consultation with all the stakeholders in the banking sector. The review examined issues concerning extension of national ‘treatment to WOS, dilution of stake and permitting mergers/acquisitions of any private sector banks in India by a foreign bank in Phase II.

70

The parent foreign bank will continue to hold 100 percent equity in the Indian subsidiary for a minimum prescribed period of operation. The composition of the-Board of directors should, inter alia, meet the following requirements: (a) not less than 50 percent of the directors should be Indian nationals resident in India and (b) not less than 50 percent of the directors should be non-executive directors.


1. What is ‘Bank’?

2. What are ‘Commercial Banks’?

3. Define ‘Ferries’ Banks’?

7.7 SUMMARY

The importance of Commercial banks and their contribution are discussed. An attempt is made is to provide the effect of RBI banking regulations, demand supply theory of money, interest and profitability of banks are explained. The risk management practices observed by banks are discussed. The management of primary and secondary reserves, loan policy formulation and issues involved are discussed. There is also discussion on the financial institutions, which offer a variety of specialized to traditional services to the business and act as mediators and agents of transfer of funds to create wealth to the society at some charge for the service, which would be their source of revenue. They have the obligation of creating a qualitative Financial System and should cooperate with the regulatory bothes engaged with various measures to discipline the economic system.

7.8 GLOSSARY

Credit or loan: Credit or loan refers to sum of money along with interest payable. Finance: Finance is

monetary resources comprising debt and ownership funds of the state, company or person.

Financial Institutions: Financial Institutions are business organizations that act as mobilizes and

depositories of savings and as purveyors of credit or finance. They also provide various financial services to the society.

Financial System: Financial System is concerned about money, credit and finance.

Money: Money refers to the current medium of exchange or means of payment.


1. Refers to 7.1

2. Refers to 7.2

3. Refers to 7.4


1. What is commercial Banking?

2. Discuss the growth and structure of Banking.

3. Describe the role of foreign Banks.


1. Refers to 7.1 & 7.2

2. Refers to 7.3

3. Refers to 7.4 & 7.5

71



India.


3. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage publications,

New Delhi.


Agency, Mumbai.

---///---

72

Lesson-8

Merchant Banking

STRUCTURE


8.1 Introduction

8.2 Origin of the Merchant Bankers

8.3 Objectives of the Merchant Banking Company

8.4 Obligations and Responsibilities

8.5 Code of Conduct

8.6 Merchant Banking in India

8.7 Services Rendered by the Merchant Banks

8.8 Regulations for Merchant Banking

8.8.1 Guidelines of the SEBI

8.8.2 Guidelines of the ministry of finance

8.8.3 Companies Act. 1956

8.8.4 Securities contract (Regulation) Act. 1956

8.8.5 Listing Guidelines of Stock exchange


8.10 Summary

8.11 Glossary






After studying this chapter you should be able to

1. Describe merchant bank and its activities

2. State the general obligations and responsibilities of a merchant banker

3. Explain the regulations for merchant banking

8.1 INTRODUCTION

Funds are tapped from the capital market to finance various mega industrial projects. In attracting the public savings, the Merchant bankers play a vital role as specialized agencies. The primary business of a merchant banker is the resource raising function. The primary market hold the key of rapid capital formation, growth in industrial production, and exports. There has to be

73

accountability to the end use of the funds raised from the market. The trends in the primary market in India suggest that merchant bankers have been playing a very significant role in the corporate sector’s drive for mobilizing the funds from the public. If the number of issues and amount increases the number of the merchant brokers also increase. Therefore, the field becomes a highly competitive market where it requires a special skill in handling the situation. The financial assets that are sold to the public should represent the genuine claims on future cash flows and viable assets. The Merchant banks have a social responsibility in building the industrial structure in India.

Merchant banking is an essential part of financial sector when a developing economy widens its industrial base. Originally, the merchant banking business was established in Italy and France in the metheval period. A merchant banker in those days was a trader-cum-entrepreneur who added banking business with trading. In the U.K., merchant bankers came into existence by the end of the 18th century. In the U.S.A., a kind of merchant banking activity emerged through investment bankers in the early twentieth century.

In the Indian context, the Ministry of Finance defined merchant banker as “any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager, consultant advisor or rendering corporate advisory service in relation to such issue management.” There is a thin distinction between merchant banking and investment banking. The former is purely fee-based. The later is both fees as well as fund-based.

8.2 ORIGIN OF THE MERCHANT BANKERS

In the 19th century, a British merchant used to send an agent out to little known parts of the world. The agent took with the manufactured goods that were produced in the home country to sell and at the same time he would buy the products of that country and ship them home. For this trade, money had to be remitted from one country to another, the bill of exchange which was the instrument in usage throughout the Europe since a long time came to be used more and more. The bill of exchange of London became the means of financing the trade practically in the whole world. The well-established merchant agreed to do for commission; and gradually the practice of accepting the bills to finance the hade of others took the shape of accepting the bills to finance their own trade. These firms in London are styled as the Merchant Banks. The oldest merchant bankers in London were the Barring Brothers. It was very prominent in Europe in the 19th century. The Industrial revolution made England into a powerful trading nation. Rich merchant houses which made their fortunes in the colonial trade had diversified into Banking. They themselves involved in the acceptance of the Commercial bills pertaining to domestic as well as international trade.

They became as “Acceptance Houses, Discount Houses and Issue Houses”. The Merchant banker was primarily a merchant than a banker. The merchant banker was entrusted with the funds by his customers.

8.3 OBJECTIVES OF THE MERCHANT BANKING COMPANY

The Merchant Bankers render their specialized assistance in achieving the main objectives. They are

presented below:

1. To carry on the business of the merchant banking, assist in the capital formation, manage advice,

underwrite, provide stand by assistance, securities and all kinds of investments issued, to be issued or

guaranteed by any company corporation, society, firm, trust, person, government, municipality, civic of

body, public authority established in India.

2. The main objective of the merchant banker is to create a secondary market for bills and discount

or rediscount bills and acts as an acceptance house.

3. Merchant bankers involve in assistance and promotion of economic endeavour, identification of

projects, promoters, preparation of project reports, project feasibility stuthes, market research, pre-

74

investment stuthes and investigation of industries at micro and macro level.

4. They also provide services to the finance housing schemes for the Construction of houses and buying of land.

5. They render the services like foreign exchange dealer, money exchanges, authorized dealer and to buy and sell foreign exchange in all lawful ways in compliance with the relevant laws in India.

6. They also involve in acquiring and holding one or more membership in stock exchange/National Stock Exchange, trade associations, commodity exchange, clearing houses, or associations in India or any part of the world.

7. They help to promote or procure in corporation formation or setting up to concerns and undertakings as a company, body corporate, partnership or any other association or person for engaging in any other association or persons in any industrial, commercial or business activities.

8. Their objective is to perform financial services including factoring and syndication of both the loans i.e. short-term and long-term with financial institutions, bank and others to manage mutual funds and to provide financial software programme.

9. The objective of the merchant banking is to carry on the business of financing the industrial enterprises.

10. They invest in buying and selling of transfers, hypothecate, and deal with the disposal of shares, stocks, debentures, securities and properties of any other company.

8.4 OBLIGATIONS AND RESPONSIBILITIES

Merchant bankers has the following obligations and responsibilities:

1. Merchant banker should maintain proper books of accounts, records and submit half yearly/annual financial statements to the SEBI within the stipulated period of time.

2. No Merchant banker should associate with another merchant banker who does not register with the SEBI.

3. Merchant bankers should not enter into any transactions on the basis of unpublished information available to them in course of their professional assignment.

4. Every Merchant banker must submit himself to the inspection by the SEBI when required for and submit all the records.

5. Every Merchant banker must disclose information to the SEBI when it requires any information from him

6. All Merchant bankers must abide by the code of conduct prescribed for them.

7. Every Merchant banker who acts as the lead manager must enter into an agreement with the issuer settling out mutual rights, liabilities, obligations relating to such issues with particular references to disclosers, allotment, refund etc.

8.5 CODE OF CONDUCT

According to the 13 Regulation of the SEBI Regulations 1992 (Merchant bankers), every merchant banker should comply with the following code of conduct. They are:

(a) The Merchant banker must observe high standard of integrity and fairness in all his dealings.

(b) He should raider at all times high standard of services, exercise due diligence and independent professional judgement

(c) If necessary, he must disclose to his clients the possible sources of conflict of duties and interests.

75

(d) He should not indulge in unfair practice or competition with other merchant bankers.

(e) He should not make any exaggerated statement about his capacity or achievement

(f) He should always endeavour to give the best possible advice and prompt, effective and cost effective service.

(g) He should maintain the secrecy of all confidential information received during the course of service to his clients.

(h) He should not engage in the creation of a false market or price rigging or manipulation.

8.6 MERCHANT BANKING IN INDIA

After the termination of the managing agency System in India, there was a strong need of legal and financial services to the corporate sector which required an alternative agency. On such situation, Merchant banking emerged. The Merchant Banking system in India was introduced by Grindlays Bank in 1967. It was the first bank which received licence from the RBI. It started with the management of capital issues rendering the services according to the needs of the emerging new class entrepreneurs for diverse financial services ranging from production to marketing research. It also provided services to the large and medium range companies. The CITI bank established its Merchant banking wing in 1970. Later on the Banking Commission which was established in 1972 fell the need for the establishment of the merchant bank institutions to offer services like syndication or financing, promotion of projects, investment management, advisory services to the corporate sector. The SBI was the first commercial bank of India to launch its merchant banking division in 1972 on the recommendation of the banking commission in 1972. Later other commercial banks and financial institutions like Indian Bank, Punjab National Bank, Indian Overseas Bank, Bank of Baroda, Syndicate Bank, Chartered Bank, LIC, GIC, UTI etc. also started the merchant banking divisions. Some brokerage houses were diversified into this area like J.M. Financial and Investment Consultancy Services Pvt. Ltd., Tata Consultancy Services Ltd., etc. Among the development banks, the ICICI started the merchant banking activities in 1973. It was followed by the IFCI in 1986 and the IDBI in 1991.

8.7 SERVICES RENDERED BY THE MERCHANT BANKS

Merchant banks have been rendering diverse services and functions as organizing and extending finance for the investments in projects, raising of EURO dollar loans, equipment leasing, mergers and acquisitions, valuation of assets, investment management, and promotion of investment trusts. All these services are not offered by all the merchant bankers. But different merchant bankers are specialized in different services. The Merchant bank is a multi-service oriented agency. Merchant banking is a creative activity. In India, the merchant banks have been engaging in the following activities:

(a) Corporate Finance Services (management of public issues, credit syndication).

(b) Advisory Services (project counseling, financing, capital restructuring).

(c) Services to the NRls. (evaluation of investment portfolio, promotion of industries).

(d) Leasing (equipment, machinery etc,)

8.8 REGULATIONS FOR MERCHANT BANKING

Merchant banking activities are regulated in India by:

(a) Guidelines of the SEBI.

(b) Guidelines of the Ministry of Finance.

(c) Companies Act, 1956.

76

(d) Securities Contract (Regulation) Act, 1956.

(e) Listing guidelines of the Stock Exchange.

8.8.1 GUIDELINES OF THE SEBI

After the abolition of the CCI, its place was occupied by a legal organ called ‘Securities and Exchange Board of India’. The issue of capital and the pricing of issues by the companies has become free from prior approval. The SEBI has issued guidelines for the issue of capital by the companies. The guidelines broadly cover the requirement of the first issue by a new company or the first issue of a new company set up by the existing company. The SEBI is the most powerful organization to control and lead the primary and secondary markets. According to the SEBI guidelines, if any company approaches the public, by the issue of share capital through the public issues, must be kept open for three working days mid it should be mentioned in the prospectus. In the case of right issue, the subscription time should not be kept more than 60 days. The gap between the rights and public issues should not exceed 30 days. The issued capital must he fully paid up within 12 months of the date of issue. The minimum amount of subscription by the investors in the public issue either at par or premium has been fixed at Rs. 5000. The amount of the issue should not exceed the amount specified in the prospectus.

Over subscription amount retention by the company is not permitted under any circumstances.

The SEBI has announced the new guidelines for the disclosures by the companies leading to the investor protection. They are presented below:-

(a) If any company’s other income exceeds 10 per cent of the total income the details should be disclosed.

(b) The company should disclose any adverse situation that affects the operations of the company and that occurs within one year prior to the date of filling the offer document with the registrar of the companies of the stock exchange.

(c) The company should disclose the information regarding the utilization of the plant for the last 3 years.

(d) The promoters of the company must maintain their holding at least at 20 per cent of the expanded capital.

(e) The minimum application money payable should not be less than 25 per cent of the issue price.

(f) The company should disclose the time taken for the disposal of various types of investor’s grievances.

(g) The company can make firm allotments in the public issues as follows:

1. Indian Mutual Funds (20%).

2. FIIs (24%).

3. Regular employees of the company (10%).

4. Financial Institutions (20%).

(h) The company should disclose the safety net scheme or buy back arrangements of the shares proposed in the public issue. This scheme is applicable to a limited number of 500 shares per allotted and the offer should be valid for a period of at least 6 months from the date of dispatch of the securities.

(i) According to the guidelines, in case of the public issues at least 30 mandatory collection centres should be established.

(j) According to the SEBI guidelines, regarding the rights issue, the company should give advertisements at least in 2 newspapers about the dispatch of letters of offer. No preferential allotment

77

may be made along with any rights issue.

(k) The company should disclose about the fee agreed between the lead managers and the company in the memorandum of understanding.

The guidelines will apply to all the issues to be made after the promulgation of the ordinance by which the Capital Issues Act has been repealed. Further the SEBI issued guidelines for the “disclosure and investor protection” as presented below (issued by the SEBI vide GL/IP No. 1/SEBI/PMD 92-93, dated 11-6-92).

(a) First Issue of the New Companies.

(b) First Issue of the existing private/closely held companies.

(c) Public Issue by the Existing Listed Companies.

(d) Underwriting.

(e) Issue of PCD/FCD/NCD.

(f) New Financial testaments.

(g) Reservation in Issues.

(h) Deployment of Issue Proceeds.

(i) Employee Stock Option Scheme.

(j) Promoter’s Contribution and lock-in period.

(k) Bonus issues’.

(l) Guidelines for the protection of the interest of the debenture holders,

(m) General.

(a) First Issue of New Companies

According to the guidelines, a new company is defined as: “one which has not completed 12 months of commercial operations and its audited operative results are not available, where it is set up by the entrepreneurs without a track record.” They will be permitted to issue the capital to the public only at par. If a new company is being set up by the existing companies with a 5 years track record of consistent profitability. It will be free to price its issue provided the participation of the promoting companies would investors uniformly provided that the prospectus or offer documents would contain the justification for the issue price.

A draft prospectus that contains the disclosures will be vetted by the SEBI, before a public issue is made. No private placement of the promoter’s share should be made by the solicitation of the share contribution from unrelated investors through any kind of market intermediaries. The shares of the above companies can be listed on either the O.T.C. or any other stock exchange.

(b) First Issue by the Existing Private/Closely held Companies

According to the guidelines, the first issue by the existing private companies with 3 years track record of consistent profitability should be permitted to freely price the issue and list their securities on the stock exchanges. The pricing would be determined by the issuer and the lead managers to the issue and would be on justification for the issue price.

(c) Public Issue by the Existing Limited Companies

The SEBI permitted these companies to raise the fresh capital by freely pricing their further issues; The Issue price will be determined by the issuer in consultation with the lead managers. The draft prospectus will be vetted by the SEBI to ensure the adequacy of disclosures. The prospectus should

78

contain the net asset value of the company and a justification for the price of the issue. It should also disclose high and low of the shares for the last 2 years.

(d) Underwriting

According to the SEBI guidelines underwriting is mandatory for the full issue and a minimum requirement of 90 per cent subscription is also mandatory for each issue of capital to the public. The number of underwriters would be decided by the issuing company. If the company does not receive 90 per cent of the issued amount from the public subscription plus accepted development from the underwriters, within 120 days from the date of opening of the issue, then the company should refund the amount of subscription. The lead managers must satisfy themselves about the net worth of the underwriters and the outstanding commitments should disclose the same to the SEBI. The underwriting agreements may be filed with the stock exchanges.

(e) Issue of FCD/PCD/NCD

The SEBI issued guidelines on the convertible and non-convertible debentures are as follows:

In case of the issue of fully convertible debentures, the debentures may be converted after 36 months and the conversion is made optional with the put and call option. The crediting should be made if the conversion period is after 18 months. In the prospectus, the premium time of conversion stages should be indicated. The interest rate for the debentures will be freely determined by the issuing company.

In case of the issue of debentures with the maturity of 18 months or less are exempted from the requirement of appointment of the Debenture Trustee. The trust deed should be executed within 6 months of the closure of the issues. The debenture holders are free in case of conversion, if it takes place at or after 18 months from the date of allotment, but before 36 months. The rating is compulsory in case of NCD/PCD if maturity period exceeds 18 months. The prospectus should inform all the information regarding premium amount, conversion period, rate of interest and all other particulars. The SEBI may prescribe additional disclosure requirement from time to time after the due notice.

(f) New Financial Instruments

The Issue of Capital should made adequate disclosures regarding the terms and conditions,

redemption, security conversion, and any other relevant features of the instruments such as deep

discount bonds, debentures with warrants, secured premium notes etc. Therefore, the investor can be

made reasonable determination of the risks, returns, safety and liquidity of the instalments. This

disclosures should be vetted by the SEBI in this regard.

(g) Reservation in Issues

The reservation can be made by the company with the consent of the SEBI in the following manner.

In case of the issue of capital by the new companies, reservations to the employees, promoting

companies, associate companies, working directors on a suitable percentage is permitted to the share-

holders of the group companies. In case of the existing companies, it can be offered on a preferential

basis. The shareholders of the promoters companies should also be eligible for the preferential

allotment. Reservations to the NRIs should be made according to the schemes prescribed by the RBI

from time to time.

(h) Deployment of the Issue Proceeds

After closing the issue, the company should report to the SEBI regarding the collection of money. If the

application money and the allotment amount together exceed Rs. 250 crores, the company would

voluntarily disclose and make arrangements for the use of the proceedings of the issue as per. the

disclosure to be monitored by one of the financial institutions. In issue of the above size and beyond,

the amount to be called upon the application allotment and on various calls should not exceed 35 per

cent of the total quantum of issue.

79

(i) Employee Stock Option Scheme

The employee stock option is a voluntary scheme to motivate the employees to have a higher participation in the company. A suitable percentage of reservation can be made by the issue company for its employees. However the reservation amount should not exceed 5 per cent of the issue. Equal distribution of shares among the employees will contribute to the smooth working of the scheme. The company may like to have the non-transferability of shares at its discretion in the new issues. The allotted shares to employees cannot be transferable for a period of 3 years.

(j) Promoter’s Contribution

The promoter has the choice to contribute the share capital which is offered to the public. The promoters, directors, his friends, his relatives and associates can contribute up to 25 per cent of the total issue of the equity capital and up to Rs. 100 crores and 20 per cent for issuing the above 100 crores. In case of the fully convertible, 1/3rd of the issue amount should be contributed by the prompters, directors, friends and associates in the form of equity before the issue is made. In case of the PCDs, 1/3rd of the convertible portion should be brought in as the contribution of promoter before the issue is made. The minimum subscription by each of his friends/relatives and associates, should not be less than Rs. 1.00 lakh. The promoter must bring his full subscription to the issue in advance before the public issue. The promoter’s contribution should not be diluted for a lock in period of 5 years from the date of commencement of the production or date of allotment.

Further, all the firm allotments, preferential allotments to collaborators, share-holders of the promoters companies whether corporate or individual should not be transferable for 3 years from the date of commencement of production or date of allotment. The share certificates issued to the promoter and his associates should carry the inspection “not transferable” for a period of 3-5 years as may be applicable from the date of commencement of production or date of allotment.

(k) Bonus Issue

The SEBI issued guidelines in case of the bonus issue. The company should ensure the following while issuing the bonus shares:

1. The bonus issue is made out of free reserves or share premium collected in cash.

2. The reserves created by the revaluation of the fixed asset should not be capitalized.

3. The investment allowance reserve is considered as free reserve for the calculation of the residual reserves.

4. All contingent liabilities would be taken into account in the calculation of the residual reserves.

5. The residual reserves after the proposed capitalization should be at least 40 per cent of the increased paid capital.

6. The declaration of the bonus issue in lieu of the dividend is not made.

7. The bonus issue should be made only after the full payment of the share capital.

8. There should be a provision in the articles of association for capitalizing the reserves.

9. The company should get a resolution passed in its general body meeting for the bonus issue.

10. Before the bonus issue, the company should not default in the payment of interest and the dues to employees.

11. The Company should implement the bonus issue within 6 months after the approval of the board

(l) Protection of the Debenture Holders

The SEBI issued guidelines to protect the interest of the debenture holders in two aspects. They are:

80

1. Servicing of the Debentures

As per the SEB1 guidelines, a debenture redemption reserve should be created by all the companies raising debentures on the following basis:

(a) The company may redeem the debentures in greater number of instalments.

(ii) The company may distribute dividends out of general resources in certain years.

(iii) A moratorium up to the date of the commercial production can be provided for the creation of the DRR (Debenture Redemption Reserve).

(iv) The Company should create the DRR equivalent to 50 per cent of the amount of the debenture issue before the redemption commences.

(v) Drawal from the DRR impermissible only after 10 per cent of the debenture liabilities has been actually redeemed by the companies.

(vi) The DRR may be created either in equal instalments or higher amounts if profit permits.

(vii) In case of the PCDs, the DRR should be created.

(viii) In case of the convertible issues by the new companies, the creation of the DRR should earn profits from the year for the remaining life of debentures.

2. Protection of the Debenture Holders Interest

(i) The debentures are issued by the companies for the purpose of avoiding the shares acquisition in other countries.

(ii) The debenture-holders have the right to appoint a nominee director on the board.

(iii) The lead bank of the company will monitor the debentures raised for working the capital funds.

(iv) Institutional debenture holders should obtain a certificate from the Company’s auditor.

(m) General

1. The subscription list should be kept open for at least 3 days to the public issues and up to 60 days to rights issue.

2. The quantum of the issue should not exceed the amount specified in the prospectus.

3. No retention of over-subscription is permitted under any circumstances.

4. After closing the issue, the company should submit a compliance report from the Chartered Accountant and forward it to the SEBI by the lead managers to the issue within 45 days.

5. The SEBI will have the full rights to prescribe further guidelines to bring transparency in the primary market.

6. Any violation of the guidelines by the issuers/intermediaries will be punishable through the prosecution by the SEBI under the Act.

7. The provisions of the Companies Act, 1956 and other applicable laws should be compiled in connection with issue of shares and debentures.

8. The SEBI should have the right to issue necessary clarifications to these guidelines to remove any difficulty in its implementation.

9. According to the RBI guidelines, the stock invest would now be restricted to the individual investors

and the Mutual funds only. (RBI, Press release. Dated 6-9-94).

The Merchant bankers, irrespective of the form in which they are organized are governed by the

81

Merchant Bank rules issued by the SEBI and the Ministry of Finance.

8.8.2 GUIDELINES OF THE MINISTRY OF FINANCE

The Ministry of Finance, Department of Economic Affairs has issued guidelines in April 1990. According

to the guidelines, any person or body proposing to engage in the business of merchant banking would

need authorization from SEBI. The guidelines indicated the following activities to be performed by the

merchant bankers:

(a) Issue management

(b) Corporate advisory services

(c) Underwriting

(d) Portfolio management

(e) Managers to the issue

(f) Consultants to the issue

(g) Advisers to the issue.

The guidelines also provided relating to authorization criteria, terms of authorization etc. The authorized

merchant bankers are required to observe the guidelines, follow the code of conduct and work as per

the requirements of SEBI: The certificate of registration has been made to be valid for the period of 3

years from the date of issue of the certificate. If merchant bankers were already carrying on activities as

registrars, share transfer agents, bankers to the issue, debenture trustees. They were required

separate application to be submitted for each of such activity. The government issued orders to the

Registrar of Companies for verification of prospectus, whether the prospectus has been drafted by the

authorized merchant bankers or not: Hence the merchant bankers in India should follow the guidelines

issued by the SEBI.

8.8.3 COMPANIES ACT, 1956

Companies raising funds from the market shall fulfil the regulatory compliances as per the rules and

regulations. The merchant banker should select the suitable form of organization like sole

proprietorship or partnership firm or Hindu Undivided family or a corporate enterprise. The corporate

form of enterprise is preferred by professionals who have the managerial expertise and skills. The scale

of operations, borrowing facilities, better resources position are the best advantages of the corporate

sector. Hence such enterprise may be incorporated under the Companies Act, 1956. A company can

be a private limited, public limited or a government company. It can appropriately render category

merchant banking services. A detailed project report should be prepared before establishing the

company. For forming a public company at least 07 persons and for forming a private company at least

02 persons are required as promoters. Sec. 12 of the Companies Act deals with the registration

formalities of the form of company. The members should subscribe their names to the memorandum of

association and comply with the Companies Act. The promoters should take a approval from the

Registrar of Companies. The Memorandum of association, Articles of association and prospectus

should submit to the ROC to get the approval. A certificate of incorporation will be issued by the

Registrar, after fulfilment of all legal formalities. The Registrar will issue a commencement of business

certificate for public companies. A private company is prohibited from inviting public to subscribe to its

share capital.

8.8.4 SECURITIES CONTRACT (REGULATION) ACT, 1956

Merchant bankers play a vital role in the capital market. They work as sponsors of the capital issues. They render valuable services to the issuing company. They involve in determining the composition of

82

the capital structure of the issuing company. They involve in public issues right from drafting of prospectus and application forms, compliance with legal formalities, appointment of registrars, underwriters, bankers to issue, listing of securities, selection of brokers, publicity and advertising agents and printers. Hence the merchant banker is a guiding force behind the company for making success of a public issue. He has to work under many regulations of the various Acts. The Securities Contract Act provides the broad framework of the functioning of stock exchanges in India. The objectives of the Act is to prevent malpractice insecurities transactions by regulating the business. Hence the merchant banker should fulfill all the conditions of the Securities Contract Act. 1956.

8.8.5 LISTING GUIDELINES OF THE STOCK EXCHANGE

The Sees. 21-22A of Security Contract Regulation Act deal with the process of listing a share with recognized stock exchange. Listing means, an admission of a scrip to trade on stock exchange officially. Sec. 73 of the Companies Act reveals that listing of security is compulsory, if a company makes public issue. The legal serviced to issuing company.

(a) The prospectus shall contain only the facts.

(b) The prospectus should be advertised in tire media 10 days before the issue.

(c) Publicity material should be fifed with stock exchange.

(d) The company should abide by the advertisement code.

(e) The prospectus shall indicate about the mode of payment.

(f) The merchant bankers should take all precautions in printing of forms.

(g) The application must provide space for “PAN”.

(h) The MB shall make arrangements for the acceptance of forms through the bankers.

(i) The MB shall also made arrangements for sending allotment letters.

(j) The MB shall send the share certificates within 2 months or 10 weeks of closing of issue.

(k) The MB shall produce a certificate from the auditor regarding allotment of shares.

(l) The merchant bankers shall inform to the stock exchange about the date of completion, posting of refund orders, allotment letters, certificate of shares.


1. Define “Merchant Banking”.

2. What is “Code of Conduct”?

8.10 SUMMARY

The origin of merchant banking can be traced back to 13th century when a few family owned and managed firms engaged in sale and purchase of commodities were also found to be engaged in banking activity. These firms not only acted as bankers to the kings of European States, financed coastal trade but also borne exchange risk. In order to earn profits, they invested their funds where they expected higher returns despite high degree of risk involved. They charged very high rates of interest for financing highly risky projects. In turn, they suffered heavy losses and had to close down. Some of them restarted the same activity after gaining financial strength. Thus merchant Banking survived and continued during the 13th century.

Later, merchant bankers were known as “commission agents” who handled the coastal trade on commission basis and provided finance to the owners or supplier of goods. They made investments in goods manufactured by sellers and made huge profits. They also financed continental wars. The sole

83

objective of these merchant bankers was profit maximisation by making investments in risky projects.

8.11 GLOSSARY

Merchant banking: merchant banking has been so widely used that sometime it is lied to banks who

are not merchants sometimes two merchants who are not banks and sometimes to those intermediaries who are neither merchants nor Bank.

Investment banking: investment banking channelization savings of individuals into the investments in

the securities issued by business Enterprises.

Corporate counselling: this service is usually provided free of charge to a corporate unit.

Corporate counselling: this service is usually provided free of charge to a corporate unit merchant

bankers Randers advised to corporate enterprise from time to time in order to improve performance and build better image among investors.

Portfolio management: portfolio management is bus service provided by merchant banker not only

two companies issuing the securities but also to the investors.

Stock Exchange: Stock exchanges are market places where securities that have been listed on

May be bought and sold for either investment of speculation.


1. Refers to 8.1

2. Refers to 8.5


1. Discuss the objectives of the merchant banking.

2. Describe the concept and functions of the merchant banking in India.

3. Discuss the government policy and regulations for merchant banking in India.


1. Refers to Section 8.2. & 8.3

2. Refers to Section 8.6. & 8.7

3. Refers to Sections 8.8




Hall of India,






---///---

84

Lesson- 9

Reserve Bank of India: Central Banking

STRUCTURE


9.1 Introduction

9.2 Central Banking

9.3 Organization and Management

9.4 The Role and Functions

9.4.1 Note Issuing Authority

9.4.2 Government Banker

9.4.3 Banker’s Bank

9.4.4 Supervising Authority

9.4.5 Exchange Control Authority

9.4.6 Promoter of the Financial System

9.4.7 Regulator of Money and Credit

9.5 Self Assessment Exercise

9.6 Summary

9.7 Glossary

9.8 Answers to Self Assessment Exercise






1. Explain the pattern of Central Banking

2. Analysis the monetary policy of the Reserve Bank of India.

3. Describe the functions of a Central Bank.

9.1 INTRODUCTION

A study of financial institutions in India should appropriately begin with a brief discussion of the functions, role, working, and policy of the Reserve Bank of India (RBI or Bank). The RBI, as the central bank of the country, is the nerve centre of the Indian monetary system. As the apex institution, the RBI has been guiding, monitoring, regulating, controlling, and promoting the destiny of the IFS since its inception. The purpose of this chapter is to help the reader to understand the functioning of the RBI by highlighting the major aspects of its working.

85

9.2 CENTRAL BANKING

The pattern of central banking in India was based on the Bank of England. England had a highly developed banking system in which the functioning of the central bank as a banker’s bank and their regulation of money supply set the pattern. The central bank’s function as ‘a lender of last resort was on the condition that the banks maintain stable cash ratios as prescribed from time to time. The effective functioning of the British model depends on an active securities market where open market operations can be conducted at the discount rate. The effectiveness of open market operations however depends on the member banks’ dependence on the central bank and the influence it wields on in terest rates. Later models, especially those in developing countries showed that central banks play an advisory role and render technical services in the field of foreign exchange, foster the growth of a sound financial system and act as a banker to government.

9.3 ORGANIZATION AND MANAGEMENT

The RBI is quite young compared with such central banks as the Bank of England, Riksbank of Sweden, and the Federal Reserve Board of the USA. However, it is perhaps the oldest among the central banks in the developing countries. It started functioning from 1 April 1935 in terms of the Reserve Bank of India Act, 1934.1twasaprivate shareholders’ institution till January 1949. After which it became a state-owned institution undo* the Reserve Bank (Transfer to Public Ownership) of India Act, 1948. This Act empowers the Central Government, in consultation with the Governor of the Bank, to issue such directions to it as they might consider necessary in the public interest Further, the Governor and all the Deputy Governors of the Bank are appointed by the Central Government

The Bank is managed by the Central Board of Directors, four Local Boards of Directors, and the Committee of the Central Board of Directors. The functions of the Local Boards are to advise the Central Board on such matters as are referred to them; they are also required to perform such duties as are delegated to them. The final control of the Bank vests in the Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors nominated by the Central Government. The Committee of the Central Board consists of the Governor, the Deputy Governors, and such other Directors as may be present at a given meeting.

The internal organizational set-up of the Bank has been modified and expanded from time to time in order to cope with the increasing volume and range of the Bank’s activities. The underlying principle of the internal organization is the functional specialization with adequate coordination. In order to perform its various functions, the Bank has been divided and sub-divided into a large number of Departments. Apart from the Banking and Issue Departments, there are at present twenty Departments and three training establishments at the Central Office of the Bank.

9.4 THE ROLE AND FUNCTIONS

The RBI functions within the framework of mixed economic planning. The legal, economic, and institutional factors in India have rendered the issue of the independence of the central bank almost irrelevant. With regard to framing various policies, it is necessary to maintain close and continuous collaboration between the Government and the RBI. In the event of a difference of opinion or conflict, the Government view or position can always be expected to prevail. Given this environment or setting, the Bank performs a number of functions which are discussed in the following sections.

9.4.1 NOTE ISSUING AUTHORITY

The RBI has, since its inception, the sole right or Authority or monopoly of issuing currency notes other than one rupee notes and coins, and coins of smaller denominations. The issue of currency notes is one of its basic functions. Although one rupee coins and notes, and coins of smaller denominations are issued by the Government of India, they are put into circulation only through the RBI. The currency notes issued by the Bank are legal tender everywhere in India without any limit. At present, the Bank

86

issues notes in the following denominations: Rs. 2,5,10,20,50,100, and 500. The responsibility of the Bank is not only to put currency into, or withdraw it from, the circulation but also to exchange notes and coins of one denomination into those of other denominations as demanded by the public. All affairs of the Bank relating to note issue are conducted through its Issue Department In order to discharge its currency functions, the Bank maintains (at present) 14 local offices and the currency chests in which the stock of new and reissuable notes, and rupee coins are stored. The total number of currency chests at the end of March 1990 was 3791. Of these, 17 chests were with the RBI, 2745 with the SBI and associate banks, 622 with nationalized banks, 402 with treasuries, and 5 with Jammu and Kashmir Bank.

As stated elsewhere, the currency even today forms the major part of the money supply in India. The currency as percentage of money supply (Mt = currency + demand deposits with banks) was 69.2% in 1950-51,71.1% in 1960-61,51.0% in 1975-76, and 59,0% in 1988-89. The composition of currency in 1987 was: small coins=Rs. 440 crores; rupee coins=Rs. 423 crores; rupee notes=Rs. 300 crores; and Bank notes=Rs. 28,743 crores. The volume of note issue (including one rupee notes) has increased from Rs. 1114 crores in 1952 to Rs. 29043 crores in 1987.

The Bank can issue notes against the security of gold coins and gold bullion, foreign securities, rupee coins, Government of India securities, and such bills of exchange and promissory notes as are eligible for purchase by’ the Bank. The RBI notes have a cent per cent backing or cover in these approved assets. Earlier, i.e. till 1956, not less than 40 per cent of these assets was to consist of gold coin and bullion and sterling/ foreign securities. In other words, (he proportional reserve system of note issue existed in India till 1956. Thereafter, this system was abandoned and a minimum value of gold coin and bullion and foreign securities as a part of total approved assets came to be adopted as a cover for the note issue.

9.4.2 GOVERNMENT BANKER

The RBI is the banker to the Central and State Governments. It provides to the Governments all banking services such as acceptance of deposits, withdrawal of funds by cheques, receipts and collection of payments on behalf of the Government, transfer of funds, making payments on Government behalf, and management of the public debt.

The Bank receives Government deposits flee of interest, and it is not entitled to any remuneration for the conduct of the ordinary banking business of the Government. The deficit or surplus in the Central Government account with the RBI is managed by the creation and cancellation of Treasury bills (known as ad hoc treasury bills).

As a banker to the Government, the Bank can make “ways and means advances” (i.e. temporary advances made in order to bridge the temporary gap between receipts and payments) to both the Central and State Governments. The maximum maturity period of these advances is three months. However, in practice, the gap between receipts and payments in respect of the Central Government is met by the issue of ad hoc treasury bills, while the one in respect of the State Governments is met by

the ways and means advances.

The ways and means advances to the State Governments are subject to some limits. These advances are of the following types: (a) Normal or clean advances i.e. advances without any collateral security; (b) Secured advances, i.e. those which are secured against the pledge of Central Government securities; and (c) Special advances, i.e. those granted by the Bank at its discretion. The interest rate charged by the Bank on these advances did not, till May 1976, exceed the Bank rate. Thereafter, the Bank has been operating a graduated scale of interest based on the duration of the advance. ‘

Apart from the ways and means advances, the State Governments have made heavy use of the overdrafts from the RBI. An overdraft refers to drawls of credit by the State Governments from the RBI in excess of the credit (ways and means advances) limits granted by the RBI. In other words, overdrafts

87

are unauthorized ways and means advances drawn by the State Governments on the RBI. At present, overdrafts up to arid inclusive of the seventh day are charged at the Bank rate and from .the eighth day onwards at 3 per cent above the Bank rate. The management of the States’ overdrafts has gradually become one of the major responsibilities of the RBI on account of the persistence of large proportions of those overdrafts.

The issue, management, and administration of the public (Central and State Governments) debt are among the major functions of the RBI as the banker to the Government. The Bank charges a commission from the Governments for rendering this service.

9.4.3 BANKERS’ BANK

The RBI, like all central banks, can be called a banker’s Bank because it has a very special relationship with commercial and co-operative banks, and the major part of its business is with these banks. The Bank controls the volume of reserves of commercial banks and thereby determines the deposits/credit creating ability of the banks. The banks hold a part or all of their reserves with the RBI. Similarly, in times of their needs, the banks borrow funds from the RBI. It is, therefore, called the bank of last resort or the lender of last resort. On the whole, the RBI is the ultimate source of money and credit in India.

9.4.4 SUPERVISING AUTHORITY

The RBI has vast powers to supervise and control commercial and cooperative banks with a view to developing an adequate and a sound banking system in the country. It has, in this field, the following powers: (a) to issue licenses for the establishment of new banks; (b) to issue licenses for the setting up of the bank branches; (c) to prescribe minimum requirements regarding paid-up capital and reserves, transfer to reserve fund, and maintenance of cash reserves and other liquid assets; (d) to inspect the working of banks in India as well as abroad in respect of their organizational set-up, branch expansion, mobilization of deposits, investments, and credit portfolio management, credit appraisal, region-wise performance, profit planning, manpower planning and training, and so on; (e) to conduct ad hoc

investigations from time to time into complaints, irregularities, and frauds in respect of banks; (f) to control methods of operations of banks so that they do not fritter away funds in improper investments and injudicious advances, (g) to control appointment, reappointment, termination of appointment of the Chairman and chief executive officers of the private sector banks; and (h) to approve or force amalgamations.

9.4.5 EXCHANGE CONTROL AUTHORITY

One of the essential functions of the RBI is to maintain the stability of the external value of the rupee. It pursues this objective through its domestic policies and the regulation of the foreign exchange market. As far as the external sector is concerned, the task of the RBI has the following dimensions: (a) to administer the foreign Exchange Control (b) to choose the exchange rate system and fix or manage the exchange rate between the rupee and other currencies; (c) to manage exchange reserves; and (d) to interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing Union, and other countries, and with international financial institutions such as the IMF, World Bank and Asian Development Bank.

The RBI administers the Exchange Control in terms of the Foreign Exchange Regulation Act (FERA),

1947 which has been replaced by a more comprehensive Foreign Exchange Regulation Act, 1973. The

objective of exchange control is primarily to regulate the demand for foreign exchange within the limits

set by the available supply. This is sought to be achieved by conserving foreign exchange, by using it in

accordance with the plan priorities, and by controlling flows of foreign capital. In India, during most of

the years since 19S7, foreign exchange earnings have been far less than the demand for foreign

exchange, with the result that the latter had to be rationed in order to maintain exchange stability. This

is done through Exchange control which is imposed both on receipts and payments of foreign exchange

88

on trade, invisible and capital accounts. The problem of foreign exchange shortage has been so

persistent and acute that the scope of exchange control in India has steadily widened and the

regulations have become progressively more elaborate over the years. The Bank administers the

control through authorized foreign exchange dealers.

FERA lays down that the exchange rates used for the conduct of foreign exchange business must be

those which are fixed by the RBI. The arrangements or the system under which exchange rate is fixed

by the RBI has undergone many changes over the years. Till about 1971 as a member of the IMF, India

had an exchange rate system of “managed flexibility.” This arrangement changed during 1970s as a

result of international monetary crisis in 1971. Since 1975, the exchange rate of the rupee has been

fixed in terms of the “basket of currencies”. The different exchange rate systems in India will be

discussed in detail in chapter 21 on foreign exchange market.

The RBI is the custodian of the country’s foreign exchange reserves, and it is vested with the

responsibility of managing the investment and utilization of the reserves in the most advantageous

manner. The RBI achieves this through buying and selling of foreign exchange from and to scheduled

banks which are the authorized dealers in the Indian foreign exchange market The Bank also manages

the investment of reserves in gold accounts abroad and the shares and securities issued by foreign

governments and international banks or financial institutions.

9.4.6 PROMOTER OF THE FINANCIAL SYSTEM

Apart from performing the functions already mentioned, the RBI has distinguished itself by rendering

“developmental” or “promotional” services which have strengthened the country’s banking and financial

structure. This has helped in the mobilization of savings and directing credit flows to desired channels,

thereby helping to achieve the objective of economic development with social justice. It has played a

major role in deepening and widening the financial system. As a part of its promotional role, the Bank

has been pre-empting credit for certain sectors at concessional rates.

In the money market, the RBI has continuously worked for the integration of its unorganized and

organized sectors by trying to bring indigenous bankers into the mainstream of the banking business. In

order to improve the quality of finance provided by the money market, it introduced two Bill Market

Schemes, one in 1952, and the other in 1970. With a view to increasing the strength and viability of the

banking system, it carried out a programme of amalgamations and mergers of weak banks with the

strong ones. When the Social Control of banks was introduced in 1968, it was the responsibility of the

RBI to administer the country for achieving the desired objectives. After the nationalization of banks, the

RBI’s responsibility to develop banking system on the desired lines has increased. It has been acting as

a leader in sponsoring and implementing the Lead Bank scheme. With the help of a statutory provision

for licensing the branch expansion of banks, the RBI has been trying to bring about an appropriate

geographical distribution of bank branches. In order to ensure the security of deposits with banks, the

RBI took the initiative in 1962 in creating the Deposits Insurance Corporation.

The RBI has rendered yeoman’s service in directing an increased flow of credit to the agricultural

sector. It has been entrusted with the task of providing agricultural credit in terms of the Reserve Bank

of India Act, 1934. The importance with which the RBI takes this function is reflected in the fact that

since 1955, it has appointed a separate Deputy Governor in charge of rural credit It has undertaken

systematic stuthes of the problem of rural credit and has generated basic data and information in this

area. This was first done in 1954 by conducting an All-India Rural Credit Survey. And that was followed

by the stuthes of the All-India Rural Credit Review Committee in 1968, the Committee to Review

Arrangements for Institutional Credit for Agriculture and Rural Development in 1978, and the

Agricultural Credit Review Committee in 1986.

89

As a part of its efforts to increase the supply of agricultural credit, the Bank has been striving to

strengthen the cooperative banking structure through provision of finance, supervision, and inspection.

It provides the co-operative banks (through the State Co-operative Banks) short term finance at a

concessional rate for seasonal agricultural operations and marketing of crops. It subscribes to the

debentures of Land Development Banks. It operates the National Agricultural Credit (Long-Team

Operations) Fund, and foe National Agricultural Credit (Stabilization) Fund, through which it provides

long-term and medium-term finance to cooperative institutions. It established the Agricultural Refinance

Cooperation (now known as NABARD) in July, 1963 for providing medium-term and long-term finance,

for agriculture. It also helped in establishing an Agricultural Finance Corporation.

The role of the Bank in diversifying the institutional structure for providing industrial finance has been

equally commendable. All the Special Development Institutions at the Central and State levels and

many other financial institutions were either created by the Bank on its own or it advised and rendered

help in setting up these institutions. The UTI, for example, was originally an associate institution of the

RBI. A number of institutions providing financial and other services such as guarantees, technical

consultancy, and so on have come into being on account of the efforts of the RBI.

Through these institutions, the RBI has been providing short-term and long-term funds to the

agricultural and rural sectors, to small scale industries, to medium and large industries, and to the

export sector. It has helped to develop guarantee services in respect of loans to agriculture, small

industry, exports, and sick units. It also co-ordinates the efforts of banks, financial institutions, and

Government agencies to rehabilitate sick units.

The Bank has evolved and put through practice the consortium, cooperative, and participatory

approach to lending among banks, and other financial institutions, and among other financial

institutions. By developing the culture of inter-institutional participation, of expertise pooling, and of

geographical presence, it has helped to upgrade credit delivery and service capability of the financial

system. By issuing appropriate guidelines in 1977 regarding the transfer of loan accounts by the

borrowers, it has evolved mutually acceptable system of lending, so that the banking business should

grow in a healthy manner and without cutthroat competition.

9.4.7 REGULATOR OF MONEY AND CREDIT

The function of formulating and conducting monetary policy is of paramount importance for any central

bank. Monetary policy refers to the use of techniques of monetary control at the disposal of the central

bank for achieving certain objectives.

9.5 SELF ASSESSMENT EXERCISE

1. Define ‘Central Bank’.

2. What is Note Issuing Authority?

3. What is ‘Bankers Bank’?

4. “Exchange Control Authority”?

9.6 SUMMARY

The Reserve Bank of India (RBI) is India’s central bank, also known as the banker’s bank. The

RBI controls monetary and other banking policies of the Indian government. The Reserve Bank of

India (RBI) was established on April 1, 1935, in accordance with The Reserve Bank of India Act,

1934. The Reserve Bank is permanently situated in Mumbai since 1937. The Reserve Bank is

fully owned and operated by the Government of India, he primary objectives of RBI are to

90

supervise and undertake initiatives for the financial sector consisting of commercial banks,

financial institutions and non-banking financial companies (NBFCs). The Preamble to the

Reserve Bank of India Act, 1934 (the Act), under which it was constituted, specifies its objective

as “to regulate the issue of Bank notes and the keeping of reserves with a view to securing

monetary stability in India and generally to operate the currency and credit system of the country

to its advantage”. While rising global integration has its advantages in terms of expanding the

scope and scale of growth of the Indian economy, it also exposes India to global shocks. Hence,

maintaining financial stability became an important mandate for the Reserve Bank.

9.7 GLOSSARY

Cash Reserve Ratio: Cash reserve ratio is the amount of funds that banks have to maintain with the

Reserve Bank of India (RBI) at all times. If the central bank decides to increase the CRR, the amount

available with the banks for disbursal comes down. The RBI uses the CRR to drain out excessive

money from the system.

Reserve Bank of India: RBI is the central bank of India, which was established on April 1935, under

the Reserve Bank of India Act. The Reserve Bank of India uses monetary policy to create financial

stability in India, and it is charged with regulating the country’s currency and credit systems.

Repo Rate: Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case

of India) lends money to commercial banks in the event of any shortfall of funds.

Reverse Repo Rate: Reverse Repo rate is the rate at which the Reserve Bank of India borrows funds

from the commercial banks in the country. In other words, it is the rate at which commercial banks in

India park their excess money with Reserve Bank of India usually for a short-term. Current Reverse

Repo Rate as of February 2020 is 4.90%.

SLR: SLR is used by bankers and indicates the minimum percentage of deposits that the bank has to

maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and

some other approved liability (deposits). It regulates the credit growth in India.

9.8 ANSWERS TO SELF ASSESSMENT EXERCISE



3. Refers to Section 9.4.3



1. What do you understand by central Banking?

2. Discuss the functions of a central bank.

3. What is the monetary policy of Reserve Bank of India?


1. Refers to Section 9.1 &9.2



91



India.


3. Rajesh Kothari (2012). Financial Services in India: Concept and Application. Sage publications,

New Delhi.


Agency, Mumbai.

---///---

92

Lesson-10

Mutual Fund in India- An Overview

STRUCTURE


10.1 Introduction

10.2 Mutual Funds in India

10.3 Resource Mobilization by Mutual Funds

10.4 Objectives of Mutual Funds

10.5 Benefits of Mutual Funds

10.6 Types of Mutual Funds

10.6.1 Closed-end Funds

10.6.2 Open-end funds

10.7 Types of Schemes

10.8 Offshore funds

10.9 GETFs

10.10 Recommendations of the Study Group

10.11 SEBIs Directives for Mutual Funds

10.11.1 SEBI’s Major Regulatory Provisions

10.12 Private Mutual Funds

10.12.1 Sponsor with Track Record

10.13 Asset Management Company (AMC)

10.14 Evaluation of Performance of Mutual Funds

10.14.1 Return per unit of Risk

10.14.2 Sharpens Index

10.14.3 Treynor’s Index

10.14.4 Differential Return (Alpha)

10.15 Problems of Mutual Funds

10.15.1 Competition with Government Schemes

10.15.2 Competition with Insurances

10.15.3 Volatility of Mutual Fund Performance

10.15.4 Tax System Encourages short-term objectives


10.17 Summary

93

10.18 Glossary






After studying the lesson you should be able to

1. Understand the objectives of Mutual Funds.

2. Analyze the different types of mutual funds.

3. State the guidelines that regulate mutual funds.

10.1 INTRODUCTION

Mutual funds are financial intermediaries which collect the savings of investors and invest them in a large and well diversified portfolio of securities such as money market instruments, corporate and Government bonds and equity shares of joint stock companies. A mutual fund is a pool of commingle funds invested by different investors, who have no contact with each other. Mutual funds are conceived as institutions for providing small investors with avenues of investment in the capital market. Since small investors generally do not have adequate time, knowledge, experience and resources for directly accessing the capital market, they have to rely cm an intermediary which undertakes informed investment decisions and provides the consequential benefits of professional expertise. The raison d’etre of mutual funds is their ability to bring down the transaction costs. The advantages for the

investors are reduction in risk, expert professional management, diversified portfolios, liquidity of investment and tax benefits. By pooling their assets through mutual funds, investors achieve economies of scale. The interests of the investors are protected by the SEBI which acts as a watchdog. Mutual funds are governed by the SEBI (Mutual Funds) Regulations, 1993.

10.2 MUTUAL FUNDS IN INDIA

The first mutual fund to be set up was the Unit Trust of India in 1964 under an Act of Parliament. During the years 1987-1992, seven new mutual funds were established in the public sector. In 1993, the government changed its policy to allow fee entry of private corporate and foreign institutional investors into the mutual fund segment. By fee end of March, 2005 there were 29 mutual funds, 8 in fee public sector and 21 in fee private sector.

The UTI dominated the mutual fund sector until 1994-95, accounting for 76.5 per cent of the total mobilization. But there were large purchases by UTI in 1995-96 and 1996-97 which resulted in reverse flow of funds. Meanwhile, fee number of mutual funds especially in fee private sector have grown along wife fee number of schemes matching fee preferences of investors. The year 1999-2000 was a watershed year in which mutual funds emerged as an important investment conduit for investors at large. Net resource mobilization by all mutual funds amounted to Rs. 21,972 crore. Growth was led mainly by private sector mutual funds which witnessed an inflow of fee order of Rs. 17,171.0 crore.

Fiscal incentives provided in fee Union Budget 1999-2000 exempted all income received by fee investors from UTI and other mutual funds from income tax. All open-ended equity oriented schemes along wife fee US 64 scheme were exempted from dividend tax for three years. Buoyant stock markets were also a contributory factor.

The outstanding net assets of all domestic schemes of mutual funds, stood at Rs. 1,49,601 crore at fee end of March, 2005. The share of UTI in outstanding assets was 13.9%, public sector mutual funds 7.6% and private sector mutual funds 78.5%.

94

10.3 RESOURCE MOBILIZATION BY MUTUAL FUNDS

(a) Mutual funds mobilized large resources in the eighties and in the first four years of nineties registering an annualized growth of more than forty per cent. The growth was aided mainly by the buoyant secondary market, setting up of new mutual funds in the second half of the eighties and tailor-made schemes introduced by them and UTI. Another contributory factor was the assured rate of return offered by some mutual funds. In 1995-96 and 1996-97 the subdued stock market conditions, along with a perceived lack, of transparency in the functioning of mutual funds, delayed refunds, poor accountability and lack of efficient service led to the poor performance of many mutual fund schemes resulting in low or, even in negative returns, thereby eroding the investors confidence. Consequently, the resource mobilization of mutual funds (other than UTI) during 199A96 and 1996-97 was poor. With respect to foe UTI, there were large reverse flows, in view of substantial repurchases. The mutual funds had to get their act together by revamping their operations, be responsive to the investors’ needs and infuse greater expertise and efficiency in their operations, in order to earn the investor’s confidence.

(b) After subdued performance in 1997-98 and 1998-99 a sharp turnaround was witnessed in 1999- 2000 when resource mobilization reached a peak of Rs. 21,972 crore mainly led by private sector funds which mobilized Rs. 17,171 crore through offer of more than 44 new schemes to match investor preferences.

The overall mobilization was aided by the tax benefits announced in the Union Budget for 1999-2000 particularly those relating to equity oriented Schemes. The bullish trends in the secondary market combined with attractive returns ort units of mutual funds had a favourable influence on the investors.

10.4 OBJECTIVES OF MUTUAL FUNDS

Mutual funds have specific investment Objectives, which are stated in their prospectus. The main objectives are growth, growth-income, balanced income, and industry specific funds. Growth funds strive for large capital gains, while growth-income funds seek both dividend income and capital gains from the common stock. The balanced fund generally holds at of diversified common stocks, preferred stocks and bonds with the hope of realizing capital gains, dividend and interest, income while at the same time, conserving the principal. Income funds concentrate heavily on high interest and high, dividend yielding securities. The industry specific mutual funds obviously specialize in selected industries such as chemicals, petroleum or power stocks. In general, growth funds seems to have the highest risk balanced funds, the lowest risk and income growth finds, intermediate risk.

10.5 BENEFITS OF MUTUAL FUNDS

Tax shelter is the most important advantage, the mutual funds industry enjoys in India. A mutual fund, set up by a public sector bank or a financial institution or one that is authorized by the SEBI is exemputed from tax, under Section 10 (23D) of IT act, provided it distributes 90 percent of its profits.

(c) The Union Budget for 1999-2000 granted tax exemption for a period of three years for US 64 scheme and for all open-ended equity oriented schemes of UTI and other mutual funds with more than 50 per cent investment in equity. It also announced the exemption from income tax of all income from UTI and other mutual funds received in the hands of investors. The Budget for2000-01 however, raised the tax rate on income distributed by debt-oriented mutual funds and UTI from 10% to 20%.

As compared to direct investment, mutual funds offer firstly, reduced risk and diversified investment. Mutual funds help small investor’s ill reducing risk by diversification, economies of scale in transaction cost and professional portfolio management Secondly, mutual funds offer revolving type of investments. Automatic reinvestment of dividends and capital gains provide tax relief to the members. Thirdly, selection and timing of investment are undertaken by mutual funds. The fund as an organization, supplies expertise in stock selection and timing purchase and sale of securities to investors on the invested funds to generate higher returns to them. Finally, mutual funds assure liquidity and investment

95

care. The units of mutual funds could be converted to cash without any loss of time, relieving investors from various rules and regulations, which they have to comply with indirect investments.

10.6 TYPES OF MUTUAL FUNDS

Two major fund categories of mutual funds are closed-end funds and the open-end funds. Open-end funds are commonly referred to as the mutual funds. Mutual funds can be further classified into equity funds, growth funds, income funds, real estate funds, offshore funds, leveraged funds and hedge funds. Such schemes are listed on the stock exchanges for dealings in the secondary market.

10.6.1 CLOSED-END FUNDS

Closed-end mutual funds have the following characteristics. Firstly, closed-end fund Investment Company cannot sell share units after its initial offering. Its growth in terms of the number of shares is limited. The shares are issued like the new issues of any other company, listed and quoted on a stock exchange.

Secondly, the shares of the closed-end hinds are not redeemable at their NAV as in the case of open-end funds. On the other hand, these shares are traded in the secondary market on a stock change, at market prices that may be above or below their Net Asset Value (NAV). Thirdly, the objectives of the closed-end funds may differ from that of the open-end funds. Fourthly, closed-end funds are canalized into the secondary market, for the acquisition of corporate securities. Finally, the prices of closed-end mutual funds’ shares are determined by demand and supply and not by NAV as in the case of open-end mutual fund shares. The minimum amount of the fund is Rs. 20 crore or 60% of targeted amount. Redemption is after a specified period (4 to 7 years). Morgan Stanley’s scheme is for 15 years.-Other examples are UTIs master share, SBls Magnum and Canbank’s can double. In all there were 129 close-ended schemes at the end of March 2006.

10.6.2 OPEN END FUNDS

The open-end mutual funds are characterized by the continual selling and redeeming of shares. In other words, mutual funds do not have a fixed capitalization. It sells its shares to the investing public, whenever it can, at their Net Asset Value per share (NAV) and stands ready to repurchase the same, directly from the investing public, at the net asset value per share. Minimum amount of the fund is Rs. 50 crore or 60% of targeted amount. Examples are UTIs Unit 64, Kothari/ Pioneer, Prima and LIC schemes. There were 463 open-ended schemes at end March 2006.

10.7 TYPES OF SCHEMES

Mutual funds offer growth, income, tax planning and miscellaneous schemes. The growth schemes are usually closed-ended and listed on ‘the stock ‘exchange. Benefits of capital appreciation and dividend exist. Examples are UTI’s Master share 86, Master gain 92 and SBIMF’s Magnum. Income schemes can be closed-ended of open-ended. Monthly income schemes are closed-ended. Regular dividends are paid since investment is primarily in debt instruments. Generally income schemes are not listed but Unit 64 is listed on OTCEI and NSE. Examples are UTIs’ Unit 64, SBIMFs’ Magnum, Bank of India MF s’ rising monthly scheme. Equity linked savings schemes called tax planning schemes are closed-ended. Investment up to Rs. 10,000 provides 20% tax rebate under section 99 of IT Act. They are growth oriented and provide capital appreciation. The schemes are not listed on stock exchange and before 3 years are not transferable. Redemption after 10 years on NAV with 20% deduction at source. Examples are Canbank’s Cahpep and SBIMFs tax gain. Finally, miscellaneous schemes have specific purpose and, are generally open-ended. Investment matures on the fulfillment of the purpose, like Children’s Gift Growth ‘plan and Senior Citizen’s plan. Specific purpose scheme units cannot be listed or pledged. Tax concessions admissible as specified in the scheme. Examples are Canbank’s Canpep and SBIMFs Tax Gain.

96

To avoid any distortion in the unit holding pattern and its impact, minimum number of 20 investors in a scheme has been prescribed. No single investor should hold more than 25% of the corpus of any scheme/ plan.

During 2005-06,592 schemes were in operation of which 463 schemes (78.2%) were open-ended schemes. In terms of investment objectives income (debt oriented) schemes were 251(18.9%), growth (equity oriented) schemes 231 (39.0%) and balanced (equity and debt) schemes 36 (6.0%).

10.8 OFFSHORE FUNDS

There were total of 12 offshore funds end-March, 2003. Of the 12 offshore funds, eight belong to the public sector and remaining four to the private sector. The net assets of public sector mutual funds were Rs. 552.55 crore (66.7% of total) arid private sector Rs. 276.89 crore (33.3%).

The funds (Rs. 796.55 crore) are mainly deployed in equity related instruments (96%) and debt/ money market instruments (3.97%).

10.9 GETFs

SEBI notified on January 12,2006 the introduction of Gold Exchange Traded Funds. Any household can buy and sell gold units for Rs 100. The assets of the scheme have to be kept in the custody of a bank which is registered as a custodian With SEBI. The wholesale intermediary sells/buys gold units to mutual funds. The funds of any such scheme should be invested only in gold or gold related instruments except to the extent necessary to meet the liquidity requirements for honouring redemptions or repurchases. Gold Exchange traded funds have only gold as the sole underlying asset. These spot instruments are freely transferable among the participants through stock exchange. Unit holders have no right on the underlying asset but are entitled to the accrued benefit on the scheme by way of dividend and market arbitrage. GETF units can be used as collateral for loans.

10.10 RECOMMENDATIONS OFTHE STUDY GROUP

In 1991, a 10-member study group headed by Dr. S.A. Dave. Chairman of the Unit Trust of India, was formed by the Government of India to study the functioning of mutual funds, with a view to permit mutual funds in the private joint sectors. The major recommendations’ of the study group are:

(i) Minimum amount to be raised in the closed end scheme should be Rs. 20 crore and that of the open-end scheme is Rs. 50 crore.

(ii) The private mutual funds should-enjoy tax benefits similar to the UTT.

(iii) No minimum return should be guaranteed.

(iv) Distribution of at least 80 per cent earnings.

(v) A limit of Rs. 200 crore should be set for borrowing over two years.

10.11 SEBI’S DIRECTIVES FOR MUTUAL FUNDS

The Government brought mutual funds in foe security market under the regulatory framework of the Securities and Exchange Board of India (SEW) in foe year 199J3. SEBI issued guideline^ in the year 1991 and a comprehensive set of regulations relating to the organization and management of mutual funds in 1993.

SEBI’s Major Regulatory Provisions

1. Mutual funds shall be authorized for business by the SEBI.

2. Mutual funds shall be sponsored by the registered companies with sound track, general reputation and fairness in all their business transactions.

97

3. Mutual funds shall be established in the form of trusts under Indians Trusts Act. The sponsoring institution will be free to work out the details regarding the Constitutions of the Trust.

4. The Trust shall be authorized to float one or several different schemes under which units shall be issued to the investors.

5. Mutual funds shall be operated by separately established Asset Management Companies (AMC) to be approved by the SEBI.

6. AMC cannot act as the Trustee of Unit Trusts.

7. AMC cannot undertake any other business activity than management of mutual funds and such other activities as financial services constantly, exchange of research and analysis on commercial basis as long as these are not in conflict with the management activity itself.

8. The mutual funds shall use the services of a custodian registered with the SEBI.

9. The custodian shall be totally de-linked from the AMC.

10. Each authorized mutual funds shall be allowed to float different schemes as long as the AMC concerned meets the required capital adequacy criteria.

11. Each scheme floated by a mutual fund shall have prior registration with SEBI.

12. Mutual funds can start and operate both closed-end and open-end schemes.

13. For each closed-end scheme, the mutual fund shall be required to raise at least Rs.20 crore and for each open-end scheme at least Rs.50 crore.

14. Mutual funds cannot keep closed-end schemes open for subscription for more than 45 days. For open-end schemes, the first 45 days of the subscription period should be considered for determining the target figure or minimum size.

15. Mutual funds shall provide continuous liquidity. Closed-end scheme shall have to be listed on exchanges.

For open-end schemes, mutual funds shall sell and repurchase, units at predetermined prices based on net asset value.

16. Mutual funds are allowed to invest only in transferable securities either in the money market or in the capital market, including any privately-placed debentures or securitized debt. Privately placed debentures, securitized debt and other unquoted debt instruments holdings shall not exceed 10% in case of growth funds, and 40% in case of income funds.

17. Mutual funds shall not be allowed to provide term loan s for any purpose.

18. No individual scheme of the mutual fund shall invest more than 5 per cent of its corpus in any-one company’s shares.

19. No mutual fund under all its schemes shall own more than 5 per cent of any company’s paid-up capital carrying voting rights.

20. No mutual fund under all its schemes taken together shall invest more than 10 per cent of its funds in the shares or debentures or other securities of a single company.

21. No mutual fund under all its schemes taken together shall invest more than 15 percent of its funds in the shares or debentures of any specific industry.

22. No scheme shall invest in or lend to another scheme under the same AMC.

23. The AMC may charge the mutual fund with investment management and advisory services which should have been disclosed fully in the prospectus subject to the following ceiling:

98

a) 1.25% of the weekly average net assets outstanding in the current year for the scheme concerned as long as the net assets do not exceed Rs. 100 wore, and

b) 1% of the excess amount over Rs. 100 crore, where net assets so calculated exceed Rs. 100 crore, and

c) All mutual funds must distribute a minimum of 90 per cent of their profits in any given year.

The SEBI has recently allowed the Mutual funds to invest 100% of funds raised in Money Market up to 6 months and thereafter 30% of funds for 6 months to one year and only 25% in Money Market and again 100% of funds in Money market, 6 months prior to repayment to investors.

24. Every scheme should have at least 20 investors and no single investor should hold more than 25 per cent of the fund’s assets.

25. Every mutual fund will have to furnish to SEBI at least the following periodic reports, in addition to any other SEBI may ask for:

(a) Copies of the duly audited annual statement of account including the balance sheet and the profit and loss account for the funds and for each scheme, once a year.

(b) Six-monthly un-audited accounts as above.

(c) A statement of movements in net assets for each of the schemes of the funds, every quarter.

(d) A portfolio statement, including changes from the previous periods, for each scheme, every quarter.

26. All mutual funds are required to adopt a written code of ethics designed to deal with the potential conflicts of interest that may arise from transition; by the affiliated persons or companies.

27. Every mutual fund shall have to copy with a common advertising code laid down by the SEBI. The fund is expected to submit to the SEBI the texts of tire marketing literature and advertisements issued to the investors.

Mutual funds shall have to disclose in their marketing and publicity brochures for each scheme, the investment objectives, the method and periodicity of valuation of investment, the exact method and periodicity of sales and purchases and other details considered by to SEBI to be essential for investors.

28. SEBI can, after due investigation, impose penalties on mutual funds for violating the guidelines as may be necessary. However, for cases of penalties of suspension or deauthorisation of mutual fund entities, prior concurrence of the RBI and the government is necessary.

The regulatory framework for mutual funds smacks of ineffective panning, clarity of thought and suffers from several shortcomings. There does not seem to be any justification for separate regulatory framework to govern the operations of the mutual funds the UTI Act with comprehensive guidelines already in existence. It would have been more logical to broaden the scope of the UTI Act to make it applicable to all the mutual funds. Some of the guidelines issued by the RBI and SEBI are contradictory. For instance, while the EBI prohibits bank sponsored mutual funds from investing in finance companies, SEBI has actually made reservations for mutual funds in public issues of finance companies. The existing rules and regulations are quite comprehensive to ensure greater ‘transparency about the operations of mutual funds. However, there is some scope of effectively curbing the malpractices, particularly in the field of distribution of mutual fund products by regulating the activities of intermediaries. Further, some of the rules and regulations, viz., restrictions on investment, requirements of underlying securities in the derivative market, individual investor’s communication and recording of all secondary transactions have been identified as very stringent. These have had an adverse impact, to some extent, on the performance of mutual funds.

99

SEBI rules regarding late trading and rapid trading are either ineffective or nonexistent Although SEBI has introduced a specific regulation against late trading since March, 2004, it has failed to check late trading. As a result, there is rampant late trading by mutual funds to the detriment of common investors. What is most disturbing to note is that there are still no regulations to deter rapid trading in mutual funds, even though the regulator is aware of how it can harm long-term investors. While late trading is nothing short of cooking the books, rapid trading is not a crime but need to be discouraged.

10.12 PRIVATE MUTUAL FUNDS

Another key development in the financial sector was the opening up of mutual funds to private sector in early 1992. Though quite a few industrial groups and financial majors evinced a keen interest in the setting up of mutual funds, it took nearly two years for the first private mutual fund to be launched. The first private sector mutual fund was launched by the Madras based H.C. Kothari group which, in collaboration with the Pioneer group of the US offered two schemes in 1994. This was followed by several mutual funds having foreign tie-ups with renowned asset management companies— 20th century has collaboration with Kemper Financial Services, the Tata with Kleinwort Bonson and ICICI with J.P. Morgan.

The competition becomes intense when investors switch over from one fund to another, based on their decisions on the performance of the funds. And that should begin sooner than later, with as many as 29 mutual funds in the field. The trend world over especially in the USA, U.K. and Japan is for investors to switch over from secondary markets to mutual funds. For the companies also, the retail route is quite an expensive method of raising funds. The trends in private funding of equity and bought out deals in our country, clearly indicate that individual households, in their own interest (since they lack stock picking drills and manage their own portfolios) should leave the job to professionals such as mutual funds.

10.12.1 SPONSOR WITH TRACK RECORD

A mutual fund in a private sector has to be sponsored by a limited company having a track record. The mutual fund has to be established as trust under the Indian Trust Act, 1882. The sponsoring company should have at least a 40 per cent stake in the paid up capital of the asset management company. Mutual funds are required to avail off the services of a custodian who has secured the necessary authorization from the SEBI.

10.13 ASSET MANAGEMENT COMPANY (AMC)

A mutual fund is managed by an Asset Management Company that is appointed by the sponsor company or by the trustees. The asset management company has to, be registered under the Companies Act and has to be approved by the SEBI. The AMD manages the affairs of the mutual funds and its schemes. AMCs are registered by the Registrar of Companies only after a draft memorandum and the articles of association are cleared by the SEBI.

10.14 EVALUATION OF PERFORMANCE OF MUTUAL FUNDS

The performance of a portfolio is measured by combining the risk and return levels into a single value. The differential return earned by a portfolio may be due to the difference in the exposure risk from that of, say the stock market index. There are three major methods of assessing a risk adjusted performance. Firstly the return per unit of risk, secondly, differential return, and thirdly, the components of investment performance.

10.14.1 RETURN PER UNIT OF RISK

‘The first measure determines the performance of a fund in terms of the return per unit of risk. The absolute level of return achieved is related to the level of risk exposure to develop a relative risk adjusted measure for ranking the fund performance. Funds that provide the highest return per unit of

100

risk would be judged as having performed well while those providing the lowest return per unit of risk would be judged as poor performers (see Fig. 10.1.).

The return per unit of risk is measured by Sharpe’s investment performance index and Treynor’s portfolio perform knee index.

Sharpe’s Index Sharpe’s investment performance index is a risk adjusted rate of return measure that is calculated by dividing the assets risk premiums E(r) — R, by their standard deviations of returns. This

index is used to rank the investment performance of different assets, Sharpe’s index considers both the average rates of return and the risk. It assigns the highest scores to the assets that have the best risk adjusted rate of return. Sharpe’s reward to visibility of return is simply, the ratio of the reward defined as the realized portfolio return (rs) in excess of foe risk-free rate (rf) to the variability of return, measured

by the standard deviation of return (op).

Sharpe’s ratio rp = f

p

p

rr

where, (rp) is the realized portfolio return or the assets’ average rate of return,

(rf) is the risk-free rate, and p is the assets’ SD of return.

In terms of the capital market theory, this portfolio performance measure uses the, total risk to compare portfolios with the Capital Market Line (CML) [see Fig. 10.1]. A higher Sharpe’s ratio value than the market portfolio would lie above the CML and would indicate superior risk adjusted performance.

Fig. 10.1: Differential Return for Funds A, M & Z

10.14.3 Treynor’s Index

An index of portfolio performance that is based on systematic risk, as measured by the portfolio’s beta coefficients rather than on total risk as done by Sharpe’s measure was put forward by Jack Treynor. It is used to rank the investment performance of different assets. It is a risk adjusted rate of return measure that is calculated by dividing the assets’ risk premium E(r) – R, by their beta coefficients. The index of systematic risk is a Characteristic of the Regression Line (CRL) and the beta coefficient. As with the individual assets, the beta coefficient from a portfolio’s characteristic line is an index of the portfolio’s systematic or undiversified risk. The systematic risk remains after the unsystematic variability of retains of the individual assets average turns out to be zero. In view of this Treynor suggested measuring a portfolio’s return, relative to its systematic risk rather than to its total risk, as is done in the Sharpe’s measure:

Treynor’s ratio p f

p

r r

101

A larger TR value indicates a higher slope and a better; portfolio for all the investors. Comparing a portfolio’s TR value to a similar measure for the market portfolio, indicates whether the portfolio would plot above the Security Market line (SML) [see Fig. 10.1]. Deviation from the characteristic line measures the relative volatility of the portfolio’s returns, in relation to the returns for the aggregate

market or the portfolios beta coefficient. m equals 1.0, the market’s beta, which indicates the slope of

the SML.

The TR value for the aggregate market is calculated as follows:

m f

m

m

R RT

where, MR =Returns from the market portfolio.

m = Systematic risk of the market. In this expression, b equals 1.0 and the markets’ beta

indicates the slope of the SML. Therefore; a portfolio with a higher TR value than foe market portfolio would lie above foe SML. This would indicate a superior risk adjusted performance. Comparison of Sharpe’s and Treynor’s Measures are similar in a way, since they both divide the risk premium by a numerical risk measure. However, foe Sharpe’s portfolio performance measure uses foe standard deviation of returns as the measure of risk, whereas Treynor’s performance measure employs beta coefficient as a denominator. Sharpe’s measure tanks the assets dominance m the CML’s risk return space while foe Treynor’s measure ranks the dominance in foe CAPM’s risk return space. Both measures assume that money can be freely borrowed and lent at R This assumption is required to generate linear investment opportunities that emerge from Rand allow funds in different risk classes to be compared and ranked. The standard deviation as a. measure of the total risk is appropriate when evaluating foe ride return relationship for well diversified portfolios. On the other hand; foe beta coefficient is foe relevant measure of risk when evaluating less than fully diversified portfolios or individual stocks. In spite of the risk measures they employ the Sharpe’s and Treynor’s portfolio performance measures yield very similar ranking of portfolios in most cases.

Table. 9.2. illustrates the calculation of return per unit of ride under the two methods using two hypothetical funds A and Z along with the market fond M, as a benchmark for comparison. The market fund provided 0.26 return per unit of standard deviation and exceeded the Sharpe’s ratio of 0.25 return provided for Z, but was below the Sharpe’s ratio of 0.3 for fond A According to the reward to volatility ratio, the market, fund provided a return per unit of beta of 4, which again exceeds the Treynor’s ratio of 3.7 for fund Z, but way below foe Treynor’s ratio of 4.4 derived for fond A (Fig. 9.1)

The ranking of funds was identical under either measures and A was the best, Z the worst while the markets fund M, an intermediate performer.

10.14.4 DIFFERENTIAL RETURN (ALPHA)

A second category of risk adjusted performance measure is the Jenson’s measure. This measure was developed by Michael Jenson and is sometimes referred to as the differential return. This measure involves the calculation of returns that should be expected for the fund, given the realized risk of the fund and compare that with the returns realized over the period. It is assumed that the investor has a passive or naive alternative of merely buying the market portfolio and adjusting for the appropriate level of risk, by borrowing or lending at a risk-free rate. Given the assumption, the most commonly used method of determining the return for a level of risk is by way of the alpha formulation:

N p f p m fr r

= -p p pr r N r

102

To evaluate the performance of the fund A we insert the appropriate variables in the formula:

N 3 0.67(7 3) 5.68%pr

6 5.68 0.32%

Fund A would have been expected to have earned 5.68% over the period. The fund actually earned 6.00% and thus provided a differential return of risk adjusted to 0.32% (Fig. vt). Jenson also provided a way of determining whether the differential return could have occurred by change, or whether it was significantly different from zero in statistical sense. It is possible to establish this, since Jenson’s measure is ordinarily derived by running a regression of the monthly or quarterly returns of the fund, being evaluated against the return of a market index, over the relevant performance period. The regression equation is:

The form of the regression equation is similar to that of the previous equation, except that an intercept term alpha and an error term (e) have been added. The error term enables in assessing how well the regression equation fits the date, a low error indicating a well-defined relationship and a high error indicating a poorly defined relationship. The intercept measures the performance of the fund with either a negative value that indicates a below average performance, or a positive value for above average performance.

p f p p m fr r r r e

X The form of the regression equation is similar to that of the previous equation, except that an intercept terms alpha and an error term (e) have been added. The error term enables in assessing how well the regression equation fits the data, a low error indicating a well-defined relationship and a high error indicating a poorly defined relationship. The intercept measures the performance of the fund with either a negative value that indicates a below average performance, or a positive value for above average performance.

Table 10.1 Calculation of Return Per Unit of Risk Ratios

Fund Return Rp R-Rr S.D SR B TR

A 6 3 3 10 0.30 0.67 4.4

M 7 3 4 15 0.26 1.00 4.0

Z 8 3 5 20 0.25 1.33 3.7

10.15 PROBLEMS OF MUTUAL FUNDS

India has a high household savings ratio. Indians, like most people anywhere, are conservative in their habits, and it would take many years to change this behaviour, particularly when it comes to the use of their savings. As in most countries, investment in physical assets (mainly housing and gold) accounts for the most important percentage of household assets. Owning a home is usually a first priority once a family has any disposable income at all.

10.15.1 COMPETITION WITH GOVERNMENT SCHEMES:

Mutual funds compete against a host of high yielding government-backed savings schemes such as Public Provident Fund (PPF), National Savings Scheme (NSS), RBI Bonds, and so on, as well as against life insurance products and, in the future, against the new pension schemes for the unorganized sector. [1] The political and social reasons for keeping yields higher than the market for small savers, particularly retired savers, is understandable. The market is distorted by such a policy. Government

103

should have the strategic aim of discontinuing over time or at least reducing the availability of the unrealistically high yielding avenues for small savings. The objective of widening and deepening ownership of mutual funds is unlikely to be met until this happens.

Fixed income and balanced mutual funds have offered a reasonably competitive rate of return but they are not guaranteed, a key attraction to Indian investors. The net result is that mutual funds fail to attract much money from retail investors, who prefer to invest in a no-risk, high return product, i.e. government saving schemes or provident funds or keep their money safely in the bank.

Government -sponsored instruments crowd out mutual funds since for the majority of Indians buying mutual funds, before they have their full complement of government-backed savings instruments, would be both wrong and foolish.

In most countries government guaranteed financial instruments offer returns that are likely to be significantly lower than private sector investments available from mutual funds or insurance companies. This is the penalty that investors are prepared to pay for little or no risk. However, Indian retail investors are not being asked to sacrifice any substantial amount of return in exchange for a government guarantee. Conversely, returns on government assured investments are often better than that available elsewhere. While conventional government bonds do give lower returns than equivalent private sector corporate bonds, the retail government assured products give higher returns for almost no risk. It is thus hardly surprising that an investor of modest means would choose to invest in, for instance, national savings certificates, since he can thus obtain a better return for a much lower risk. Any investor would be well advised to invest the maximum permitted in the various government assured schemes before considering other forms of investment.

The reasons why the government is prepared to pay above market rates of interest on certain financial products is understandable. At a time when interest rates have fallen substantially from their previous levels, savers who had counted on the interest on their savings to provide an income, particularly in retirement, are being subsidized. Given that pension arrangements, particularly in the unorganized sector, are not widespread, such an approach is reasonable and indeed most small savers are acting rationally when they choose the low risk option. However, this approach conflicts with a desire to widen and deepen participation in capital markets through mutual funds or other non-governmental savings products by the less well-off sectors of the population.

10.15.2 COMPETITION FROM INSURANCE:

The take up life assurance is growing rapidly and may be pre-empting some of the market that mutual funds could aim at. Life assurance is an easier product to sell, since in the mind of the investor the payment of a premium is often linked to a specific outcome, a lump sum payment on death or a guaranteed minimum sum on maturity. It also pays higher commissions to sales agents (typically the amount of the first 5 to 6 months premium). Thus a sales agent will usually prefer to sell a life policy since it will reward him better.

10.15.3 VOLATILITY OF MUTUAL FUND PERFORMANCE: There is a perception that mutual funds

have somehow let down their investors and given them poor returns. In July 2001 where UTI slashed down the dividend rates for the year 2000-01 and suspended sales and repurchases of US-64 for a period of 6 months from July 2001 to December 2001, it created a crisis of confidence among the investors with long-term effects.

10.15.4 TAX SYSTEMENCOURAGES SHORT-TERM OBJECTIVES:

Mutual funds are regarded in most countries as a diversified, professionally managed and well regulated vehicle for mobilizing household savings and are often accorded tax privileges specifically in pursuit of a government policy goal to encourage long-term savings, notably for retirement. [2] It is unusual for such tax privileges to impel mutual-funds towards short-term goals, which is what seems to

104

be the case in India True, Indian unit trusts are diversified, professionally managed and well-regulated, but they are certainly not serving long-term objectives.

The Mutual Fund Industry in India is quite sophisticated and successful. It is dominated by good and reputable institutions, both Indian and International. Nevertheless improvements are always possible and desirable in order to enhance file ability of the mutual fund industry to mobilized savings on a wider scale and to contribute to the further development of capital market.

Although reforms in the financial sector since 1991 have been successful in creating a competitive environment, the growth of mutual fund has solved down, partially due to the problems faced by UTI.


1. Define ‘Mutual Fund’

2. Define ‘Offshore Funds’.

3. What is ‘Asset Management Company’?

4. Define ‘GETF”.

10.17 SUMMARY

A mutual fund is a trust that pools the savings of a number of investors who share a common financial

goal. The money, thus, collected is then invested in capital market instruments such as shares,

debentures and other securities. The income earned through these investments and the capital

appreciation realised are shared by its unit holders in proportion to the number of units owned by them.

Thus, a mutual fund is the most suitable investment for the common man as it offers an opportunity to

invest in a diversified, professionally managed basket of securities at a relatively low cost. Mutual funds

have proved to be an attractive investment for many investors, the world over, since they provide them

a mixture of liquidity, return and safety in accordance with their performance. Further, the investor

obtains these benefits without having to directly a diversified portfolio, which is handled by specialists.

The interests of various investors are generally protected through mutual funds. As individual investors,

they may not hold much clout in companies whose shares they hold, but by being part of institutional

investors like mutual funds, their bargaining power is enhanced.

10.18 GLOSSARY

Mutual Fund: A mutual fund is a kind of investment that uses money from investors to invest in stocks,

bonds or other types of investment.

Close-ended Funds: These funds are fixed in size as regards the corpus of the fund and the number

of shares.

Growth-oriented Funds: These funds do not offer fixed, regular returns but provide substantial capital

appreciation in the long run. The pattern of investment in general is oriented towards shares of high

growth companies.

Income-oriented Funds: These funds offer a return much higher than the bank deposits but with less

capital appreciation.

NAV: NAV is the market value of the fund’s assets divided by the number of outstanding shares/units of

the fund.

Open-ended Funds: In open-ended funds, there is no limit to the size of the funds. Investors can

invest as and when they like. The purchase price is determined on the basis of Net Asset Value (NAV).

105

Specialised Funds or Industry Funds: These funds are invested in a particular industry like cement,

steel, jute, power or textile, etc.

Tax Relief Funds: These funds are raised for providing tax relief to those investors whose income

comes under taxable limits.

ULIPs: ULIPs are a category of goal-based financial solutions that combine the safety of insurance

protection with wealth creation opportunities.







1. Discuss the benefits and objectives of mutual funds in India.

2. State the different types of mutual funds prevailing in India?

3. Discuss the SEBI’s regulatory provisions for Mutual Funds.


1. Refers to Section 10.3, 10.4 & 10.5




1. Cohen, Jerome, B.: Zinbarg, Edward D., and Zeikel, Arthur (2006). Investment Analysis and

Portfolio Management. Homewood.

2. Cottle, C.C., and Whitman, W.T. (1953). Investment Timing: the formula plan approach. New

York, McGraw Hill.

3. Curley, Anthony J. and Bear, Robert M. (2003). Investment Analysis and Management. NY,

Harper & Row.

4. D. Ambrosio, Charles A. (1970). Guide to Successful Investing. Englewood Cliffs, NJ Prentice-

Hall.

---///---

106

Chapter-11

Financial Regulations and Reforms

STRUCTURE


11.1 Regulation of the Capital Market

11.2 The Securities and Exchange Board of India (SEBI)

11.3 Regulations and Guidelines Issued by the SEBI

11.4 Regulation of the Securities Market

11.5 Need the financial reforms

11.6 Major reforms after 1991


11.8 Summary

11.9 Glossary






After studying the chapter you should be able to:

1. Explain the regulation of the capital market.

2. Describe the need for financial reforms.

3. Discuss the major reforms after 1991.

11.1 REGULATION OF THE CAPITAL MARKET

The securities market is regulated by various agencies such as the Department of Economics Affairs (DEA), the Department of Company Affairs (DCA), the Reserve Bank of India (RBI), and the SEBI. The activities of these agencies are coordinated by a high level committee on capital and financial markets. The High Level Co-ordination Committee for Financial Markets (HLCCFM) discusses various policy level issues which require inter-regulatory coordination between the regulators in the financial market, viz., RBI, SEBI, Insurance Regulatory and Development Authority (IRDA), and Pension Fund Regulatory and Development Authority (PFRDA). The Committee is chaired by the Governor, RBI, Secretary-Ministry of Finance, Chairman—SEBI, Chairman—IRDA and Chairman—PFRDA are members of the committee.

The capital market, i.e., the market for equity and debt securities is regulated by the Securities and

Exchange Board of India (SEBI). The SEBI has full autonomy and authority to regulate and develop the capital market. The government has framed rules under the Securities Contracts (Regulation) Act (SCRA). The SEBI Act and the Depositories Act. The SEBI has framed regulations under the SEBI Act and the Depositories Act for registration and regulation of all market intermediaries, for prevention of

107

unfair trade practices, and insider trading. Under the acts, the Government and the SF.BI issue notifications, guidelines, and circulars which need to be complied with by market participants. All the rules and regulations are administered by the SEBI. The powers in respect of the contracts for sale and purchase of government securities, money market securities and ready forward contracts in debt securities are exercised concurrently by the RBI.

The four main legislations governing the capital market are as follows:

The SEBI Act, 1992 which establishes the SEBI with four-fold objectives of protection of the interests of investors in securities, development of the securities market, regulation of the securities market and matters connected therewith and incidental thereto.

The Companies Act, 1956 which deals with issue, allotment and transfer of securities, disclosures to be made in public issues^ underwriting, rights and bonus issues and payment of interest and dividends.

The Securities Contracts (Regulation) Act, 1956 which provides for regulations of .securities trading and the management of stock exchanges.

The Depositories Act 1996 which provides for establishment of depositories tor electronic maintenance and transfer of ownership of demat securities.

11.2 THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

With the announcement of the reforms package in 1991, the volume of business in both the primary and secondary segments of the capital market increased. A multicrore securities scam rocked the Indian financial system in 1992. The then existing regulatory framework was found .to be fragmented and inadequate and hence a need for an autonomous, statutory, and integrated organization to ensure the smooth functioning of capital market was felt. To fulfill this need, the Securities and Exchange Board of India (SEBI), which was already in existence since April 1988, was conferred statutory powers

to regulate the capital market.

Objectives of SEBI

Protect the interest of the investor in securities.

Promote the development of securities market.

Regulating the securities market

The SEBI got legal teeth through an ordnance issued on January 30, 1992. The ordinance conferred wide-ranging powers on the SEBI, including the authority to prohibit ‘insider trading’ and ‘regulate sub-stantial acquisition of shares’ and ‘take over of business’. With this, the Capital Issues (Control) Act was repealed and the office of the Controller of Capital Issues (CCl) was abolished in 1992. The SEBI Was set up with statutory powers on February 21, 1992. The objectives defined by the ordinance for the board were: (i) investor protection; and (ii) promotion and development of the capita! market while simultaneously regulating the functioning of the securities market. The function of market development includes containing risk, broad basing, maintaining market integrity and promoting long-term investment.

The ordinance was repealed by the SEBI Act on April 4, 1992. The Securities and Exchange Board of India Act, 1992, provides for the establishment of the board to: protect the interest of the investors in securities, promote the development of and regulate the securities market and matters connected therewith or incidental to Certain powers under certain sections of the Securities Contracts (Regulation) Act and the Companies Act were delegated to the SEBI. The regulatory powers of the SEBI were increased through the Securities Laws (Amendment) Ordinance of January 1995, which was subsequently replaced by an act or parliament. The SEBI works under the Ministry of Finance. It has

108

been given a status of an independent organization regulating each and every aspect of the securities market backed by a statute and accountable to the parliament

Management of the SEBI Under the SEBI Act, 1992

Section 4 of the act lays down the constitution of the management of the SEBI. The board of members of the SEBI shall consist of a chairman, two members from amongst the officials of the ministries of the central government dealing with finance and law; one member from amongst the officials of the RBI constituted under Section 3 of the RBI Act, 1934; two other members to be appointed by the central government, who shall be professionals and, inter alia, have experience or special knowledge relating to the securities market.

Figure 11.1 provides an overview of regulatory structure of financial institutions and markets.

Powers and Functions of the SEBI

Section 11 (1) of the act casts upon the SEBI the duty to protect the interests of investors in securities and to promote the development of and to regulate the securities market through appropriate measures. These measures provide for the following:

Regulating the business in stock exchanges and any other securities markets;

Commercial

Banks All India

Financial

Institutions:

IFCI, IIBI,

Exix Bank

TFCI,SIDBI,

NABARD.

and. NHB

Government

Securities

Market and

Money

Market

Urban Co-operative Banks

REGULATORS

State and

District

Central

Cooperative

Banks

Non-banking

Finance

Companies

Cooperative

Including

Primary

Dealers,

MFIs

Foreign Exchange Market

Urban Co-operative

Banks

Securities and

Exchange Board of

India

Rural

Co-operative

Banks

Regional

Rural Banks

State

Governments

SIDBI Insurance Regulatory

and Development

Authority

Reserve Bank

of India

NABRD

Capital Market,

Capital market

Intermediaries Mutual

Funds, Including UTI

II, Venture Capital

Fits, Corporate Bond

Market, Comedies

Market

State Financial

Corporations State

Industrial Development

Corporate

Insurance

Companies:

Public Sector

and Private

Sector Life and

Non-life

109

Registering and regulating the working of stock brokers, sub—brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner,

Registering and regulating the working of the depositories, participants, custodians of securities, foreign institutional investors, credit rating agencies and such other intermediaries as the Board may, by notification, specify in this behalf;

Registering and regulating the working of venture capital funds and collective investment schemes, including mutual funds:

Promoting and regulating self-regulatory organisations,

Prohibiting fraudulent and unfair trade practices relating to securities markets;

Promoting investors’ education and training of intermediaries of securities markets;

Prohibiting insider trading in securities;

Regulating substantial acquisition of shares and takeover of companies;

Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds, other persons .associated with the securities market, intermediaries and self-regulatory organisations in the securities market;

Calling for information and records from any person including any bank or any other authority or board or corporation established or constituted by or under any central, or state act

which, in the. opinion of the Board, shall be relevant to any investigation or inquiry by the Board in respect of any transaction-in securities; -

Calling for information from, or furnishing information to, other authorities, whether in India or outside India, having functions similar to those of the Board, in the matters relating to

the prevention or detection of violations in respect of securities laws, subject to the provisions of other laws for the time being in force in this regard.

Provided that the Board, for the purpose of furnishing any information to any authority outside India, may enter into an arrangement or agreement or understanding with such authority with the prior approval of the central government;

Performing such functions and exercising such powers under the provisions of the Securities Contracts ( Regulation) Act, 1956 (42 of 1956), as may be delegated to it by the

central government;

Levying fees or other charges for carrying out the purposes of this section;

Conducting research for the above purposes;

Calling from or furnishing to any such agencies, as may be specified by the Board, such information as may be considered necessary by it for the efficient discharge of its functions.

Performing such other functions as may be prescribed.

The SEBI exercises powers under Sections 11 and 11B of the SEBI Act, 1992, and 17 other regula-tions. The SEBI. with its powers, can carry out the following functions:

Ask any intermediary or market participant tor information.

Inspect books of depository participants, issuers or beneficiary owners.

110

Suspend or cancel a certificate of registration granted to a depository participant or issuer.

Request the RBI to inspect books of a banker to an issue. And suspend or cancel the registration of the banker to an issue.

Suspend or cancel certification issued to the custodian of securities.

Suspend or cancel registration issued to foreign institutional investors.

Investigate and inspect books of accounts and records of insiders.

Investigate an acquirer, a seller, or merchant banker for violating takeover rules.

Suspend or cancel the registration of a merchant banker.

Investigate the affairs of mutual funds, their trustees and asset management companies.

Investigate any person dealing in securities on complaint of contravention of trading regulation.

Suspend or cancel the registration of errant portfolio managers;

Cancel the certification of registrars and share transfer agents.

Cancel the certification of brokers who fail to furnish information of transactions in securities or' who furnish false information.

11.3 REGULATIONS AND GUIDELINES ISSUED BY THE SEBI

Regulations

SEBI (Stock Brokers and Sub Brokers) Regulations, 1992.

Guidance note to SEBI (Prohibition of Insider Trading) Regulations, 2015.

SEBI (Merchant Bankers) Regulations, 1992.

SEBI (Portfolio Managers) regulations, 1993.

SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993.

SEBI (Underwriters) Regulations, 1993.

SEBI (Debenture Trustees) Regulations, 1993.

SEBI (Bankers to an Issue) Regulations, 1994.

SEBI (Foreign Portfolio Investors) Regulations, 2014.

SEBI (Custodian of Securities) Regulations 1996.

SEBI (Depositories and Participants) Regulations, 1996.

SEBI (Mutual Foods) Regulations, 1996.

SEBI (Substantial Acquisition-of Shares and Takeovers) Regulations, 1997.

SEBI (Buyback of Securities) Regulations, 1998.

SEBI (Credit Rating Agencies) Regulations, 1999.

SEBI (Collective Investment Schemes) Regulations, 1999.

SEBI (Foreign Venture Capital Investors) Regulations, 2000.

SEBI (Procedure for Board Meeting) Regulations, 2001.

111

SEBI (Issue of Sweat Equity) regulations. 2002.

With a view to making markets more competitive and compliant, the SEBI brought in the following new regulations:

SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.

SEBI (Ombudsman) Regulations, 2003.

SEBI (Central Database for Market Participants) Regulations, 2003.

SEBI (Self Regulatory Organizations) Regulations, 2004.

SEBI (Issue and Listing of Debt Securities by Municipalities) Regulations, 2015.

SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.

SEBI (Procedure for Search and Seizure) Repeal Regulations, 2015.

SEBI (Infrastructure Investment Trusts) Regulations, 2014.

SEBI (Real Estate Investment Trusts) Regulations, 2014.

SEBI (Research Analysts) Regulations, 2014.

SEBI (Settlement of Administrative and Civil Proceedings) Regulations, 2014.

SEBI (Share Based Employee Benefits) Regulations. 2014.

SEBI (Investment Advisers) Regulations, 2013.

SEBI (Issue And Listing Of Non-Convertible Redeemable Preference Shares) Regulations, 2013,

SEBI (Alternative Investment Funds) Regulations, 2012.

Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012.

SEBI {KYC (Know Your Chent) Registration Agency} Regulations, 2011.

SEBI (Delisting of Equity Shares) Regulations, 2009.

SEBI (Investor Protection and Education Fund) Regulations, 2009.

SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.

*SEBI (Intermediaries) Regulations, 2008.

SEBI (Issue and Listing of Debt Securities) Regulations, 2008.

SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008.

SEBI (Certification of Associated Persons in the Securities Markets) Regulations, 2007.

SEBI (Regulator) Fee on Stock Exchanges) Regulations, 2006.

As a measure of regulatory productiveness, the existing regulations are frequently reviewed and amendments notified. Regulations are superior to guidelines as the former have a stronger legal force.

Regulations are passed by the SEBI, tabled in the Parliament and are subject to explicit penalties and remedial actions.

112

Guidelines

• Guidelines for opening of trading terminals abroad.

• Guidelines for Anti-money laundering measures.

• SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines 1999.

• Framework for recognition and supervision of stock exchanges/platforms of stock exchanges for small and medium enterprises.

• SEBI (Aid for Legal Proceedings) Guidelines, 2009.

• SEBI (International Financial Services Centres) Guidelines, 2015.

The orders of the SEBI under the securities laws are appealable before a securities appellate tribunal. (SAT) the body that hears appeals against the SEBI’s orders. The orders of the SAT are appealable before the high court or the Supreme Court.

An order passed by the SEBI against market participants such as brokers, custodians, depositories, or mutual funds can be challenged before the SAT. The market participants can move the high court or the Supreme Court if they are not happy with the SAT order. The entire process can take years before a case is finally resolved. There is a provision for out-of-court settlements in the SEBI guidelines. The out-of-court settlement system attempts to resolve administrative, civil, and criminal disputes with the consent of the involved parties and the SEBI. This system saves time, efforts and money of both the involved parties and the regulator as they do not have to go through long range of legal proceedings.

Under SEBI guidelines,-the proposal to settle a dispute is first placed before a high-powered advisory committee of the regulator. If the proposal gets the committee’s approval, the terms of settlement are drafted and orders are passed by a panel of tub whole-time directors of the SEBI after the cause and nature of violation is established. The panel normally imposes penalty on the offenders and can also temporarily suspend a market participant. If a case is pending before the SAT, the committee files the terms of settlement before the tribunal. It is mandatory for the accused to give an undertaking to the regulator dial it will refrain from taking any legal action against it. If the accused violates any condition of the settlement, the regulator can revive its legal action.

11.4 REGULATION OF THE SECURITIES MARKET

The SEBI has powers to register and regulate all market intermediaries. The SEBI has powers penalize

them in case of violations of the previsions of the act, rules and regulations made there under.

It can conduct enquiries, audits, and inspection of all market intermediaries and adjudicate offences under the SEBI Act, 1992.

The SEBI registers and regulates the intermediaries in the primary market. Some of the major inter-mediaries it regulates are merchant bankers, underwriters, bankers to an issue, registrars to an issue and share transfer agents and debenture trustees. The SEBI registers and regulates various. intermediaries in the secondary market such as brokers, subbrokers, stock exchanges, foreign institutional investors (FTIs) custodians, depositories, mutual funds, and venture capital funds.

11.5 NEED FOR FINANCIAL REFORMS

The need for financial reforms had arisen because the financial institutions and markets were in a bad shape. The banking sector suffered from lack of competition, low capital base, low productivity and high intermediation costs. The role of technology was minimal and the quality of service did not receive adequate attention. Proper risk management system was not followed and prudential norms were weak. All these resulted in poor assets quality. Development financial institutions operated in a over-protected environment with most of the funding coming from assured sources. There was little

113

competition in insurance and mutual funds industries. Financial markets were characterised by control over pricing of financial assets, barriers to entry and high transactions costs. The banks were running either at a loss or on very low profits and consequently were unable to provide adequately for loan defaults and build their capital. There had been organisational inadequacies the weakening of management and control functions, the growth of restrictive practices, the erosion of work culture and flaws in credit management. The strain on the performance of the banks had emanated party from the imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and directed credit programmes for the priority sector-all at below market or concessional or subsidised interest rates. This apart from affecting bank profitability adversely, had resulted in the low or repressed or depressed interest rates on deposits and in higher interest rates on loans to the larger borrowers from business and industry. The phenomenon of cross-subsidisation had got built into the system where concessional rates provided to some sectors were compensated by higher rates charged to non-concessional borrowers.

Further, the functioning of the financial system and the credit delivery as well as recovery process had decode profoinocised which damaged the quality of lending and the culture of repaying loans. The widespread or across the board write 0ffs of the loans had seriously jeopardised the viability of banks. As the closure of sick industrial units was discouraged by the government, banks had to continue to finance non-viable sick units. This further compromised their own viability. The legal system was not of much help in recovering loans. There was a lack of transparency in preparing statements of accounts by banks.

In order words, the reforms had become imperative on account of the facts that despite its impressive quantitative growth and achievements, the financial health, integrity, autonomy, flexibility and vibrancy in the financial sector had deteriorated over the past many years. The allocation of resources had become severely distorted the portfolio quality had deteriorated and productivity, efficiency and profitability had been eroded in the system. Customer service was poor, work technology remained outdated and transaction costs were high. The capital base of the system remained low, the accounting and disclosure practices were faulty, and the administrative expenses had greatly soared. The system suffered also from a lack of delegation of authority, inadequate internal controls and poor housekeeping.

It was felt by many that all this was the consequence of policy-induced rigidities of excessive degree of centralised administrative direction of investments, credit allocations and internal management of banks and financial institutions massive branch expansion, overstaffing and union pressures and excessive political intervention interference and pressures.

For a long time an alarming increase of sickness in the Indian financial system had required urgent remedial measures or reforms which were ultimately introduced in 1991.

The key words describing reforms have beers liberalisation, deregulation, marketisation, privatisation, and globalisation, all of which convey reforms objectives in a succinct manner. The basic proxies

underlying the reforms has been that the state ownership and regulation have harmed the financial system, particularly the banks and the investors, and that such regulation is no longer relevant and adequate. To use the well-known academic terminology, the objective of financial reforms has been to

correct and eliminate financial repression; and so transform a financially repressed system into a free system. At the same time, it has been held that the deregulation does not imply total absence of regulation; instead, it assumes sophisticated form of prudential, supervisory structure which would “protect the financial system without unnecessarily restraining it”. The reforms are said to be directed towards “stringent prudential regulation” in a “deregulated environment”.

Financial sector reforms are said to be grounded in the belief that the competitive efficiency in the real sectors of the economy cannot be realized so it’s full extent unless the locative efficiency of the private sector was improved. The main thrust of financial sector reforms was on the creation of efficient and

114

stable financial institutions and markets, the removal if structural bottlenecks, introduction of new player and instruments, introduction of free pricing of financial assets, relaxation of quantitative restrictions, improvement in trading, clearing, and settlement practices, promotion of institutional infrastructure, refinement of market micro-structure, creation of liquidity, depth, and the efficient price discovery process, and ensuring technological up gradation.

The approach or strategy of reforms has been such that they are being effected by adapting the old institutions in the new tasks and ethos. A careful attempt has been made at crisis-avoidance and at creating an environment' which promotes greater efficiency in the delivery of financial services. The financial sector reforms have been operating in conjunction with a larger set of goals relating to eco-nomic stability and growth. The reforms have been introduced at a gradual pace combined with effective and appropriate regulation and intervention policy. Efforts have also been made to fulfil (meet) the “commandments” (prerequisites) of financial sector reforms, namely, carrying out a macro-economic stabilisation programme, introducing supportive fiscal and external sector policies, and implementing wide-ranging reforms in oilier sectors simultaneously.

11.6 MAJOR REFORMS AFTER 1991

The reforms have had a broad sweep encompassing operational matters, banking, primary and secondary stock markets, government securities market, external sector policies, and the system as a whole. Some people have classified them into three areas: issues relating to creating a resilient banking system; development of institutions such as private sector banks and mutual funds; and monetary policy instruments such as interest rates, reserve ratios, and refinancing facilities. In other words, reforms relate to the issues of ownership and control, competition, and policy and regulation stance.

While presenting a list of reforms, it needs u» be pointed out that sometimes a distinction between normal policy changes which are specific to tune and economic conditions, and reforms proper is not maintained: the former are included in the latter, which makes the list of reforms unduly and unmanageably long. To reforms means to make (improve) or become better by the removal of faults or errors or abuses. It is primarily in this sense that the major reforms are listed below in terms of certain categories.

(i) Systemic Policy Reforms

Most of the interest rates in the economy deregulated; a beginning made to move towards market rates on government securities; the system of administered interest rates largely dismantled; and the structure of interest, rates greatly simplified.

The pre-emption of banks’ resources through SLR in favour of the government was brought down and the rate of return on SLR securities is maintained by and large at market rates. The SLR on incremental net domestic and time liabilities (NDTL) of banks reduced from 38.5 per cent in 1991-92 to 25 per cent now.

The incremental CRR of 10 per cent removed, and the average CRR reduced from !5 per cent in 1991-92 to !0 per cent in 1995-96. The CRR of FCNR (B) and NRNR deposit accounts removed. The CRR on NRE deposits outstanding as on 27.10.1995 reduced from 14 per cent to 10 per cent and the CRR on an increase in NRE deposits removed.

Capital adequacy norms for banks, financial institutions, and virtually all market intermediaries introduced. The Basie Committee framework for capital adequacy adopted.

A Board of Financial Supervision (BPS) with an advisory council and an independent department of supervision established in RBI. It would supervise, apart from banks, all-India financial institutions and non-banking financial companies from April-July 1995-A new

115

Supervisory Reporting System, introduced in February 1995, will focus attention on critical areas such as capital adequacy, assets quality, management, earnings, and liquidity.

Recovery of Debts Due to Banks and Financial Institutions Act, 1993 passed to set up Special Recovery Tribunals to facilitate quicker recovery of loan arrears.

In order to moderate or minimise the automatic monetisation of the budget deficit, the agreement to impose a ceiling on the issue of ad hoc Treasury' Bills (TBs) and to phase them out in due course signed by the Government of India (GOI) and RBI in September 1994. Sub-sequently, the system of ad hoc treasury bills abolished and replaced by the system of ways and means advances effective April 1, 1997.

The private sector allowed to set up banks, mutual funds, money market mutual funds, insurance companies, etc., public sector banks permitted diversified ownership by law subject to 51 per cent holding of government/RBI. SBI, IFCI and IRBI converted into public limited companies. The Industrial Development Bank of India Act, 1964 amended to allow IDBI to raise capital up to 49 per cent of its paid-up capital from the public and to induct private participation in its Board of Directors. The policy of permitting foreign banks to open branches liberalised.

Capital Issues (Control) Act, 1947 repealed and the office of Controller of Capital Issues abolished.

Securities and Exchange Board of India (SEBI) made a statutory body in February 1992 and armed with necessary authority and powers for regulation and reform of the capital market.

Convertibility clause is no longer obligatory in the case of assistance sanctioned by term lending institutions.

Floating interest rate on financial assistance (linked to interest rate on 364-day TBs) introduced by all-India development banks.

The Reserve Bank of India (Amendment) Act 1997 passed requiring all non-bank financial companies (NBFCs) with net-owned funds of Rs. 25 lakh and more to register with the RBL

Over the Counter Exchange of India (OTCEI) and the National Stock Exchange (NSE) with nationwide stock trading and electronic display, clearing and settlement facilities established and made operational.

Twin objectives of “maintaining price stability” and “ensuring availability of adequate credit to productive sectors of the economy to support growth” continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance.

Reflecting the increasing development or financial market and greater liberalisation, use of broad money as an intermediate target has been de-emphasised and a multiple indicator approach has been adopted.

Emphasis has been put on development of multiple instruments to transmit liquidity and interest rate signals in the short-term m a flexible and bi-directional manner.

Interlink age between various segments of the financial market including money, government security and force markets instruments has increased.

There has been a move from direct instruments (such as, administered interest rates, reserve requirements, selective credit control) to indirect instruments (such as, open market operations, purchase and repurchase of government securities) for the conduct of monetary policy.

116

Liquidity adjustment facility (LAF) has been introduced, which operates through repo and reverse repo auctions, effectively provide a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also as a signalling devise for interest rate in the overnight market.

Use of open market operations are used to deal with overall market liquidity situation especially those emanating from capital flows.

There has been introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal with enduring capital inflows without affecting short-term liquidity management role of LAF.

Automatic monetisation has been discontinued through an agreement between the government and the Reserve Bank.

Introduction of delivery versus payment system and deepening of inter-bank repo market.

Primary dealers are introduced in the government securities market to play the role of market maker. Securities Contracts Regulation Act (SCRA), has been amended to create the regulatory framework.

Government securities market has been deepened by making the interest rates on such securities market related.

Auction of government securities has been introduced.

A risk-free credible yield curve has been developed in the government securities market as a benchmark for related markets.

A pure inter-bank call money market has been developed.

Non-bank participants are allowed to participate in other money market instruments.

Automated screen-based trading in government securities has been introduced through negotiated dealing system (NDS).

Setting up of risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL).

There has been Phased introduction of real time gross settlement (RTGS) system.

Forex market has been deepened and autonomy of authorised dealers has increased.

Technical advisory committee on monetary policy with outside experts has been set up to review macroeconomic and monetary developments and advise the Reserve Bank on the Stance of Monetary Policy.

A separate financial market department within the RBI has been created.

(ii) Banking Reforms

Interest rates on deposits and advances of ail co-operative banks including urban co-operative banks deregulated. Similarly interest rates on commercial bank loans above Rs. 2 lakh, and or, domestic term deposits above two years, and Non Resident (External) Rupee Accounts [NRNR] deposits decontrolled. The number of administered interest rates on commercial bank advances reduced from more than 20 in 1989-90 to 2 in 1994-95. Banks allowed to set their own interest rate on post-shipment export credit in rupees for over 90 days.

The State Bank of India and other nationalised banks enabled to access the capital market for debt and equity.

117

Prudential norms for income recognition, classification of assets and provisioning for bad debts

for commercial banks, including regional rural banks and financial institutions introduced. They

are required to adopt uniform and sound accounting practices in respect of these matters, and

the valuation of investments. Banks are required to mark to market the securities held by them.

The Performance Obligations and Commitments (PQ & C) obtained by RBI from each bank;

they provide tor essential quantifiable performance parameters which lay emphasis on

increased but low-cost deposits, quality lending, generation of more income and profits,

compliance with priority ; sectors and export lending requirements, improvement in the quality of

investments, reduction in expenditure, and stepping up of staff productivity. The PO & C are

meant to ensure a high level of portfolio qualify so that problems such as heavy losses, low

profits, erosion of equity do not recur. The non-fulfilment of PO & C entail penalty in the form of

higher CRR/SLR, stoppage of RBI refinance facility, stoppage of further capital contribution by

the government, etc.

Banks required to make their balance sheets fully transparent and make full disclosures in

keeping with International Accounts Standards Committee.

Banks given greater freedom to open, shift, and swap branches as also to open extension

counters.

The perceived constraints on banks such as prior credit authorisation, inventory and receivables

norms, obligatory' consortium lending and curbs in respect of project finance relaxed.

The budgetary support extended for recapitalisation of weak public sector banks.

Banking Ombudsman Scheme 1995 introduced to appoint 15 ombudsmen (by RBI) to look into

Publand resolve customers' grievances in a quick and inexpensive manner. Most of the

recommendations of Goiporia Committee in connection with improving customer service by

banks implemented.

Banks set free to fix their own foreign exchange open position limit subject to RBI approval.

Loan system introduced for delivery of bank credit. Banks required to bifurcate the maximum

permissible bank finance into loan component (short-term working capital loan) and cash credit

component, and the policy of progressively increasing the share of the former introduced.

Operational autonomy has been granted to public sector banks.

Public ownership in public sector banks are reduced by allowing them to raise capital from

equity market up to 49 per cent of paid-up capital.

Transparent norms have been issued for entry of Indian private sector, foreign and joint-venture

banks and insurance companies, permission for foreign investment in the financial sector in the

form of foreign direct investment (FDI) as well as portfolio investment, permission to banks to

diversify product portfolio and business activities.

Roadmap has been developed for presence of foreign banks and guidelines an issued for

mergers and amalgamation of private sector banks and banks and NBFCs.

Guidelines on ownership and governance in private sector banks are developed.

Sharp reduction in pre-emption through reserve requirement, market determined pricing for gov-

118

ernment securities, disbanding of administered interest rates with a few exceptions and

enhanced transparency and disclosure norms to facilitate market discipline.

Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short

term liquidity management, facilitation of improved payments and settlement mechanism.

Significant advancement in dematerialisation and markets for securitised assets are being

developed.

Introduction and phased implementation of international best practices and norms on risk-

weighted capital adequacy requirement, accounting, income recognition, provisioning and

exposure.

Measures to strengthen risk management through recognition of different components of risk,

assignment of risk-weights to various asset classes, norms on connected lending, risk

concentration, application of marked-to-market principle for investment portfolio and limits on

deployment of hind in sensitive activities.

‘Know Your Customer’ and ‘Anti Money Laundering’ guidelines, roadmap Sat Basel II introduc-

tion of capital charge for market risk higher graded provisioning for NPAs, guidelines for owner-

ship and governance, securitisation and debt restructuring mechanisms norms etc.

Setting up of lok adalats (people’s courts), debt recovery tribunals, asset recommuction

companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for

quicker recovery/restructuring.

Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of

Securities Interest (SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor

rights.

Setting up of Credit Information Bureau of India Limited (CIBIL) for information sharing on

defaulters as also other borrowers.

Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for

facilitating payments and settlement system relating to fixed income securities and money

market instruments.

Establishment of the board for financial supervision as the apex supervisory authority for

commercial banks, financial institutions and non-banking financial companies.

Introduction of CAMELS supervisory rating system, move towards risk-based supervision, con-

solidated supervision of financial conglomerates, strengthening of offsite surveillance through

control returns.

Recasting of the role of statutory auditors, increased internal control through strengthening of

internal audit.

Strengthening corporate governance, enhanced due diligence on important shareholders, fit and

proper tests for directors.

Setting up of INFINET as the communication backbone for the financial sector, introduction of

negotiated dealing system (NDS) foe screen-based trading in government securities and real

time gross settlement (RTGS) system.

119

(iii) Primary and Secondary Stock Market Reforms

A norm of five shareholders for every Rs. 1 lakh of fresh issues of capital and to shareholders

for every Rs 1 lakh of offer for sale prescribed as an initial and continuing listing requirement.

The payment of any direct or indirect discounts or commissions to persons receiving firm

allotment prohibited.

Debt issues not accompanied by an equity component permitted to be sold entirely by the book-

building process.

Housing finance companies considered to be registered for issue purposes, provided they are

eligible for refinance from the National Housing Bank

Issuers allowed to list debt securities on stock exchanges without their equity being listed.

Mutual funds permitted to underwrite public issues.

The stock exchanges required to disclose, carry forward position scrip-wise and broker-wise at

the beginning of airy forward session.

A ceiling of Rs 10 crore imposed on stock market members doing business of financing carry

forward transactions.

Depositories Act, 1996 passed to provide a legal framework for the establishment of

depositories to record ownership details in book entry form, and to facilitate dematerialisation of

securities. The Depositories Related Laws (Amendment), 1997 issued through an Ordinance

will now allow banks, mutual funds and IDBI to dematerialise their scrips.

Stock lending scheme without attracting capital gains introduced. Under this scheme, short

sellers can borrow securities through an intermediary before making such sales.

Stock exchanges asked to modify listing agreements in order to provide for the payment of

interest by companies to investors from the 30th day of the closure of public issue

All stock exchanges required to institute the buy-in or auction process

Stock exchanges asked to collect 100 per cent daily margin ; cr. the notional loss of a broker for

every scrip, to restrict gross traded value to 33.33 times the broker’s base minimum capital, and

to impose quarterly margins on the basis of concentration ratios.

The stock exchanges are being modernised; many of them have introduced electronic trading

system; the Bombay Stock Exchange has started its on-line trading system, BOLT.

The Bombay Stock Exchange and other exchanges with screen-based trading system allowed

to expand their trading terminals to locations where no stock exchange exists, and to others

subject to an understanding with the local stock exchange.

Both short and long sales are required to be disclosed to the exchange at the end of each day,

and they are to be regulated through the imposition of margins.

There are many other stock market reforms which have been introduced during the past five to

six years. The important ones among them are listed in Chapter 7.

SEBI framed guidelines relating to disclosure of grading of the Initial public offer (IPO) by issuer

companies who may want to opt for grading of their IPOs by the rating agencies. If the issuer

120

companies opt for grading, then they are required to disclose the grades, including the

unaccepted ones, in the prospectus.

SEBI issued directions for the issuing companies, relating to qualified institutions’ placement, to

pave the path for a fast and cost-effective way of raising resources from Indian securities

market.

In order to further strengthen Know- Your Client (KYC) norms in the cash market and to

generate a reliable audit trail, PAN was made mandatory for all transactions in the cash market

with effect from January 01. 2007.

PAN was made mandatory for all demat accounts, opened after April 01, 2006, pertaining to all

categories including minors, trusts, foreign corporate bothes, banks, corporates. FIIs, and NRIs

For demat accounts that existed prior to April 01, 2006, time for furnishing and verification of

PAN card details was extended upto December 31. 2006.

Procedure for re-introduction of derivatives contracts and modified position limits were reviewed

by the Secondary Market Advisory Committee (SMAC). Further, based on a decision taken by

SEB1 board, Derivatives Market Review Committee was set up to carry out a comprehensive

review of developments and to suggest future directions for derivatives market in India.

The investment limit for Fills to government securities (including treasury bills) was raised from ,

USD 2 billion to USD 2.6 billion by RBI. Tire list of eligible investment categories of Fills was

enlarged to allow more participation in Indian securities market

SEBI Board approved the draft guidelines for real estate mutual funds (REMFs). REMF means

a scheme of a mutual fund which has investment, objectives to invest directly or indirectly in real

estate property and shall be governed by the provisions and guidelines under SEBI (Mutual

Funds) Regulations.

(iv) Government Securities Market Reforms

A 364-day treasury bill (TB) replaced the 182-day TB in 1992-93, and it is being sold by

fortnightly auction since April 1992.

Auction of 91-day TB commenced from January 1993.

Maturity period for new issues of Central government securities shortened from 20 to 10 years

and that for state government securities from 15 to 16 years.

Funding of Auction TBs into fixed coupon dated securities at the option of holders introduced

since April 19, 1993.

Six new instruments introduced: (a) zero coupon bonds on 18.1.94, (b) tap stock on 29.7.94,

(c) partly-paid government stock on 15.11.94, (d) an instrument combining the features of tap

and partly-paid stocks on 11-9-95, (e) floating rate bonds on 29.9.95, and (f) capital indexed

bonds in 1997.

State governments and provident funds allowed to participate in 9i-day TB auctions on a non-

competitive basis from August 1994.

A scheme for auction of government securities from RBI’s own portfolio as a part of its open

market operations announced to March 1995.

121

The institution of primary dealers to government securities market established and guidelines for

them issued in March 1995.

A system of Delivery vs. Payment (DVP) in Subsidiary General Ledger (SGL) transactions intro-

duced in Bombay in July 1995.

Reverse repo facility with RBI to government dated securities extended to Discount and Finance

House of India (DFHI) and Securities Trading Corporation of India (STCI).

Administered interest rates on government securities were replaced by an auction system far

price discovery.

Automatic monetisation of fiscal deficit through toe issue of ad hoc treasury bills was phased

out.

Primary dealers (PD) were introduced as market makers in the government securities market.

For ensuring transparency in the trading of government securities, delivery versus payment

(DvP) settlement system was introduced.

Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment.

Subsequently, the liquidity adjustment facility (LAF) was introduced. LAF operates through repo

and reverse repo auctions and provide a corridor for short-term interest rate. LAF has emerged

as the tool for both liquidity management and also signalling device for interest rates in the

overnight market. The Second LAF (SLAF) was introduced in November 2005.

Market stabilisation scheme (MSS) has been introduced, which has expanded the instruments

available to the Reserve Bank for managing the enduring surplus liquidity in the system.

Effective April 1, 2006, RBI has withdrawn from participating in primary market auctions of

government paper.

Banks have been permitted to undertake primary dealer business while primary dealers are

being allowed to diversify their business.

Short sales in government securities is being permitted in a calibrated manner while guidelines

for "when issued’ market have been issued recently.

91-day treasury bill was introduced for managing liquidity and benchmarking. Zero coupon

bonds, floating rate Bonds, capital indexed bonds were issued and exchange traded interest

rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced.

Outright sale of Central Government dated security that are not owned have been permitted.

subject to the same being covered by outright purchase from the secondary market within the

same trading day subject to certain conditions.

Repo status has been granted to State Government securities in order to improve secondary

market liquidity.

Foreign Institutional Investors (Fills) were allowed to invest in government securities subject to

certain limits.

Introduction of automated screen-based trading in government securities through negotiated

dealing system (NDS).

122

Setting up of risk-free payments and settlement system in government securities through

Clearing Corporation of India Limited (CCIL).

Phased introduction of real lime gross settlement system (RTGS).

Introduction of trading in government securities on stock exchanges for promoting, retailing in

such securities, permitting non-banks to participate in repo market.

Recent measures include introduction of NDS-OM and T+1 settlement norms.

(v) External Financial Market Reforms

Flexible exchange rate system introduced and exchange controls largely dismantled.

Foreign Institutional Investors (Fils) allowed access to Indian capital market on registration with

SEBI. Fils permitted to invest up to 10 per cent in equity of any company, to invest in unlisted

companies, to set up pure (100 per cent) debt funds, and to invest in government securities.

Foreign endowment funds, university funds, foundations and charitable trusts/societies are

allowed to register as Fils.

Indian companies permitted to access international capital markets through various instruments

including euro-equity issues.

The Union Budget 1997-98 proposed the replacement of Foreign Exchange Regulation Act

(FERAV 1972 by a Foreign Exchange Management Act (FEMA) to facilitate easy capital flows.

Rupee made convertible on current account and a considerable progress made in introducing

capital account convertibility.

The rate of long-term capital gains tax on portfolio investments by NRIs reduced from 20 per

cent to 10 per cent and brought on par with the rate for Fils.

NRIs, OCBs Fils permitted to invest up to 24 per cent in equities of Indian companies engaged

in all activities except those of agriculture and plantation.

In case of medium and long-term external commercial borrowings (ECBs), on lending or the

proceeds of development finance institutions to different borrowers at different immaturities

permuted. All corporates, institutions, railways, telecommunications permitted to utilise the

foreign currency proceeds upto US $3 million for incurring roper expenditure with a minimum

simple maturity of 3 years. Telecommunications and oil exploration; and development

(excluding refining companies permitted to raise ECBs at a minimum of 5 years average

maturity instead of 7 years even for borrowings exceeding US $15 million equivalent Exporters

permitted to raise ECB for wasting project-related rupee expenditure upto the equivalent of US

$15 million, or the average; annual exports of the previous three years, whichever is fewer. All

infrastructure and greenfield projects permitted to avail of ECBs to the extent of 35 precent of

project cost (50 per cent for telecommunication sector).

Companies permitted to retain euro-issue proceeds as foreign currency deposits with banks and

public financial institutions in India. Further, companies permitted to remit funds into India in

anticipation of the use of funds for general corporate restructuring and working capital needs.

Euro issues are now treated as direct foreign investment in the issuing companies. Restrictions

on the number of issues to be floated by a company or group of companies in a given year

moved. Banks, financial institutions, NBFCs registered with the RBI made eligible for GDR

issue, without reference to the end-use.

123

RBI made a single-window agency for receipt and disposal of proposals for overseas

investments by Indian companies.

The Foreign Investment Promotion Board (EIPB) reconstituted and Foreign Investment

Promotion Council (FIPC) set up to promote foreign direct investment in India.

Evolution of exchange rate regime from a single-currency change rate system to fixing the

value of rupee against a basket of currencies and further to market-determined floating

exchange rate regime.

Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII

of the Articles of Agreement of the IMF. De Facto full capital account convertibility for non

residents and calibrated liberalisation of transactions undertaken for capital account purposes in

the case of residents

Development of rupee-foreign currency swaps market.

Introduction of additional hedging instruments, such as, foreign currency-rupee options.

Authorised dealers permitted to use innovative products like cross-currency options; interest

rate swaps (IRS) and currency swaps, caps/coilars and forward rate agreements (FRAs) in the

international forex market.

Authorised dealers permitted to initiate trading positions, borrow and invest in overseas; market

subject to certain specifications and ratification by respective Banks’ Boards. Banks are also

permitted to fix interest rates on non-resident deposits. subject to certain specifications, use

derivative products for asset-liability management and fix overnight open position limits and gap

limits in the foreign exchange market, subject to ratification by RBI.

Permission to various participants in foe foreign exchange market, including exporters. Indians

investing abroad. Fils, to avail forward cover and enter into swap transactions without any limit

subject to genuine underlying exposure.

Fils and NRIs permitted to trade in exchange-traded derivative contracts subject to certain

conditions.

Foreign exchange earners permitted to maintain foreign currency accounts. Residents are

permitted to open such accounts within the general limit of US $ 25.000 per year.


1. What do you mean by ‘Capital Market’?

2. Define ‘SEBI’.

3. What is ‘Financial Reforms’?

11.8 SUMMARY

SEBI plays an important role in regulating all the players operating in the Indian capital markets. It

attempts to protect the interest of investors and aims at developing the capital markets by enforcing

various rules and regulations. SEBI is a statutory regulatory body established on the 12th of April, 1992.

124

It monitors and regulates the Indian capital and securities market while ensuring to protect the interests

of the investors formulating regulations and guidelines to be adhered to. The head office of SEBI is in

Bandra Kurla Complex, Mumbai. SEBI has a corporate framework comprising various departments

each managed by a department head. There are about 20+ departments under SEBI. Some of these

departments are corporation finance, economic and policy analysis, debt and hybrid securities,

enforcement, human resources, investment management, commodity derivatives market regulation,

legal affairs, and more.

11.9 GLOSSARY

Capital: Capital is a large sum of money which you use to start a business, or which you invest in order

to make more money. Capital is the part of an amount of money borrowed or invested which does not

include interest.

Debt security: Debt security refers to money borrowed that must be repaid that has a fixed amount, a

maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the

original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper.

Security: Security is any proof of ownership or debt that has been assigned a value and may be sold.

For the holder, a security represents an investment as an owner, creditor or rights to ownership on

which the person hopes to gain profit. Examples are stocks, bonds and options.

Securities Exchange Board of India (SEBI): Securities Exchange Board of India (SEBI) is a

regulatory authority, for the investment market in India. Its main objective is to protect the interests of

the investors in the new issue market and stock exchange and to regulate, develop and improve the

quality of the securities market in India.

Security Value: Security Value means the monetary value placed on security by a lender in

determining the extent to which it can make loans against such security.






1. What are the guidelines issued by securities exchange board of India with regard to the capital

market?

2. Discuss the need for financial reforms in India.

3. Describe the major reforms in financial sector after 1991.





125




Hall of India,






---///---

126

FINANCIAL INSTITUTION AND MARKET

Assignment:

Attempt 75% of the assignment

1. What do you understand by the financial system? Discuss its functions?

2. Explain the working of stock market in India.

3. What is commercial banking? Discuss the growth and structure of banking?

4. Discuss the SEBI's regulatory provisions for Mutual Funds.

127

Date post:	23-Apr-2023
Category:	Documents
Upload:	khangminh22
View:	0 times
Download:	0 times

Financial Institutions & Markets - HP University

Documents