EPGCFM -08

Session 1

Management of Financial
Institutions

Prof. Pankaj Baag

baagpankaj@iimk.ac.in
Ph 0495 2809121
Mob. 8943716269
Room 01/21
Ext 121

Evaluation Criteria
Group Project/Assignment/class
participation : 30%
Quiz:
20%
End term Exam:
50%

Your VC code
MFI0807

 On-line banking trends in India and abroad

Alliances in Financial Services Industry case study of one or two major ones
Case study of micro finance organization in India and comparison with banks
MF
Challenges in marketing of Mutual Funds
Trend in recent offerings of Credit cards
IT issues in transacting payments over internet
Evaluation of Debit cards in India
Banking services by NBFCs case study
Indian Post, Banking License and Financial inclusion
Health Insurance companies, policies transparency
Comparative study of promotional schemes for Housing Finance
Marketing strategies by private sector Life Insurance Companies
Recent regulatory moves relating to MFIs

INDIAN
FINANCI
AL
SYSTEM
6

Units in an economy ..
In an Economy there are three units :
Individual or Households : This is the unit which is
providing labour and services to other two units
against which it is receiving wages ;
Government : This is the unit which is availing the
service of the household and then producing goods
and services as well as policy measures for overall
improvement of a country ;
Business : This is the unit which is generating goods
and services by making investment and the same is
being used for consumption of other two units.

Flow of income,payments and production in the

economic system
Flow of Expenditure
For consumption and
taxes

Producing
Units
( Mainly
Business
Govt)

Flow of production
Of Goods and
Services

Flow of Productive
Services
Flow of Income

Consuming
Units
(Mainly
Households)

Entities in an Economy
Entity

Savings

Investments

Household

Current IncomeCurrent
Expenditure

Purchase of assets
( durable) goods

Business firm

Retained
Earning+Non Cash
Expenses

Purchase of Assets

Government

Current IncomeCurrent
Expenditure

Spending on
Building , Maintaining
of Public facilities

Evolution of Financial
Transaction
All financial transactions perform at least one
basic function- movement of scarce fund from
those who save and lend to those who wish to
borrow and invest.
However, the transfer of funds from savers to
borrowers can be accomplished in at least
three different ways .
We label these methods of fund transfer as
Direct Finance
Semi direct Finance
Indirect Finance

Direct Finance
In the direct finance, borrower and lender
meet each other and exchange funds in
return for financial assets
One such example is the borrowal of money
from one individual to another in exchange
of promissory notes ( signed by the
borrower) against money ( given by the
lender) .
The process is explained below with the help
of the following diagram:

Direct Finance
Flow of Fund

Lenders
(surplus budget
unit)

Borrowers
(deficit budget
unit)

Primary Security

Direct Finance- Limitations

Both borrower and lender must meet each other
to carry out the transaction.
So cost of searching/information is high.
Both borrower and lender must agree to
exchange exactly identical amount of money
that is difficult
Lender must have faith on the security issued by
the borrower, which is also difficult to achieve

Semi direct Finance

In this type of finance , some
individuals and business houses
become security brokers and dealers
whose essential function is to bring
surplus and deficit budget units
together.
The process reduces information
costs.

Semi Direct Finance

Primary Security

Primary Security

Security brokers,
dealers and
investment
bankers

Borrowers
(deficit budget
unit)

Flow of Funds

Lenders
(surplus
budget unit)

Flow of Funds

Semi Direct Finance-Improvement

over Direct Finance
Information cost for participants is
reduced to a great extent.
The requirement of exact amount of
money involved is eliminated as dealers
can split up securities and sale in smaller
lots.
Both dealers and brokers help in the
development of the secondary market.

Semi Direct FinanceLimitations

In this process also , the lender has
to accept the security offered by
the borrower as an acceptable
security.

Indirect Finance
The limitations of both direct and semi
direct finance can be removed in the
Indirect Finance .
In this form of finance, one financial
intermediary comes in between lenders
and borrowers.
The financial intermediaries performs
the following functions:

Indirect Finance
The financial intermediary accepts money from the
surplus budget unit in the form of deposits.
In return of the money deposited, the financial
intermediary issues secondary security.
Since most of the financial intermediaries are regulated
by financial regulations in terms of financial strength,
lenders are more willing to accept this secondary
security as gains the primary securities issued by the
borrower himself.
The financial intermediary finds out the deficit budget
units for giving loans and collects money from the
borrowing unit.
The information and searching cost are reduced.

Indirect Finance
Primary Security

Secondary Security

Financial
Intermediaries
(Banks,
Financial Institutions

Borrowers
(deficit budget
unit)

Flow of Funds

Lenders
(surplus
budget unit)

Flow of Funds

Functions of a financial system

The main function of a financial system is the

collection of savings and their distribution for
investment,
thereby
stimulating
capital
formation and, to that extent, accelerating the
process of economic growth.
The financial system is a link between the
savers (savings-surplus economic units) and
the investors (saving-deficit economic units).
It is made up of all those channels through
which
savings
become
available
for
investment.
21

Organization of the financial system

The organisation of the financial system

comprises of three inter-related components,
namely,
financial intermediaries,
financial markets and
financial assets/instruments (securities).

22

Financial Intermediaries
Financial intermediaries (FIs) represent a significant
change in the whole process of a transfer of choice of
investment from an individual saver to an institutional
agent.
They convert primary securities with a given set of
characteristics, into indirect securities with very different
features.
A primary security is a security issued by a non-financial
economic unit.
A security issued by a financial intermediary is an indirect
security.
23

The pooling of funds by an FI leads to a number of

indirect and derived benefits that add greatly to the
effectiveness and efficiency of the savings-investment
process.
The benefits/services associated with the tailoring of
financial assets according to the desires of the savers
and investors are:
(i)

(ii)
(iii)
(iv)

24

convenience in terms of denomination and

liquidity,
lower risk due to diversification of the portfolio,
expert management of the portfolio and
lower cost resulting from economies of scale.

A diversified structure of FIs in a matured and

sophisticated financial system consists of banks, NBFCs,
mutual funds, insurance organisations and so on.
With a variegated structure, these are able to mobilise
savings from the widest section of the investing public
and channelise them to a cross-section of
economic/industrial enterprises.

Financial Markets
Financial markets are a significant component of the
financial system.
They are not a source of funds, but they act as a
facilitating organisation and link the savers and investors,
both individual as well as institutional.
As facilitating organisations, financial markets provide a
wide variety of specialist institutional facilities.
Based on the nature of funds which are their stock-intrade, they are classified into:
(i)
money markets and
(ii)
capital/securities markets.
26

Money Markets
Money
market
is
a
market
for
dealing
in
monetary/financial assets of a short-term nature,
generally less than one year.
Its broad objectives are to provide
(i)

an equilibrating mechanism for evening out shortterm surpluses and deficiencies in the financial
system,

(ii)

a focal point of central bank (RBI) intervention for

influencing liquidity in the economy through a variety
of instruments, and

(iii)

a reasonable access to the users of short-term funds

27

The money market organisation comprises of a

number of interrelated sub-markets
such as
call market, T-bills market, commercial bills market, CP
market, CD market, repo market and so on.

28

Capital Markets
Capital/securities market is a market for longterm funds.
It has two segments: primary/new issue market
and secondary/stock exchange/market.
The primary market deals in new securities,
offered to the investors for the first time.
It performs a triple-service function, at the
different stages of the issue, namely, origination,
that is, investigation, analysis and processing of
new
issue
proposals;
underwriting;
and
29

The stock exchange is a market for existing

securities.
It discharges three vital functions:
i.

it acts as a nexus between savings and

investment,

ii.

it provides liquidity to investors by offering

a place for transaction in securities and

iii.

it helps in continuous price formation.

30

Financial Assets/Instruments
A financial asset/instrument/security is a claim
on a stream of income and/or assets of
another economic unit and is held as a store of
value and for the expected return.
There are three types of financial assets:
primary/direct,
indirect and
derivatives.

31

Primary Security

A primary security is a security issued by a

non-financial economic unit, such as ordinary/
preference shares, debentures/bonds and
innovative
debt
instruments
including
participating, convertibles, warrants and so on.

32

Indirect Security
An indirect security is a security issued by an
FI such as units of mutual funds.
It is based on an underlying primary security.
The pooling of funds by an FI and converting a
primary security into an indirect security is
associated with a number of benefits, namely,
convenience,
diversification,
expert
management and lower cost.

33

Derivative Instruments
A derivative instrument includes:
(i)

a security derived from a debt instrument, share,

secured or unsecured loan, risk instrument,
contract for differences or any other form of
security and

(ii)

a contract which derives its value from the

prices/index of prices of the underlying securities.

It is an instrument of risk management.

The most commonly used derivative contracts are
forwards, futures and options.
34

A forward contract is an agreement

exchange
an
asset
for
cash,
at
predetermined future date specified today.

to
a

At the end of the contract, one can enter into

an offsetting transaction by paying in the
difference in the price.
It is settled by the delivery of the asset on the
expiration date.

35

Future contracts are transferable specified

delivery forward contracts.
They
are
agreements
between
two
counterparties to fix forward the term of an
exchange/lock-in the price today, of an
exchange that will take place between them at
some fixed future date, ranging between 3 to
21 months.
Depending on the underlying asset, future
contracts could be stock futures or index
36
futures.

Options give the holder the right (but not the

obligation) to buy (call option) or sell (put option)
securities at a predetermined price (strike/exercise
price) within/at the end of a specified period.
In order to acquire the right of option, the buyer pays
to the seller, an option premium as the price for the
right.
He can lose no more than the option premium paid but
his possible gain is unlimited.
The sellers possible loss is unlimited but his
maximum gain is restricted to the option premium
charged by him.
37

Financial Disintermediation
In the process of financial disintermediation ,
the role of financial intermediary has been
eliminated and the borrowers can raise the
fund directly from the lender with the help of
either public issue or private placement of
securities.
This can be performed with the help of stock
exchanges.

Indian Financial System

FUNCTIONS

Collection of SAVINGS & Distribution for INDUSTRIAL

INVESTMENT.
Stimulating CAPITAL FORMATION & ACCELERATING THE
ECONNOMIC GROWTH

STRUCTURES
1. Regulatory Bodies (RBI/SEBI/IRDA/PFRDA)
2. Financial Intermediaries
3. Financial Markets
4. Financial Assets / Instruments

PHASES
* Up to 1951
Pvt. Sector
* 1951 to 1990
Public Sector
* Early Nineties
Privatization
* Present Status Globalization
39

Indian Financial System

Process of Capital Formation

Involves three distinct, although inter-related activities.

(i) Savings: The ability by which resources are set aside and become
available for other purpose.
(ii) Finance: The activity by which claims to resources are either
assembled from those released by domestic savings, obtained from
abroad, or specially created usually as bank deposits or notes and
then placed in the hands of the investor.
(iii) Investments: The activity by which resources are actually
committed to production.
The financial system is a link between the savers (savings
surplus economic units) and the investors (savings deficit
economic units). It is made up of all those channels through which
savings become available for investment.
The main function of financial system is the collection of savings and
their distribution for industrial investment, thereby stimulating the
capital formation.

40

Indian Financial System

Orderly mechanism & structure in
economy.
Mobilises the monetary resources/capital
from surplus sectors.
Distributes resources to needy sectors.
Transformation of savings into investment
& consumption.
Financial Markets Places where the
above activities take place.

41

Indian Financial System

ORGANISATION Financial System consists of
What they do

Who They Are

Financial Intermediaries
(a) Collect Savings
(b) Issue claim against themselves
Banks, NBFC,
(c) Use Funds, thus raised, to purchase
ownership or debt-claims
Notes: Characteristics of claims issued against
self & debt-claims are absolutely different.
(ii) Financial Markets

MF insurance
organizations etc.

(a) Not a Source of funds

Call Market
(b) Act as a facilitating organization and link
T-Bill Market
saver & investor
CP-Market
(c) Based on nature of work they are classified
Repo Market
as (1) Money Market (2) Capital/Security
Stock Exchange
Markets.

(iii) Financial Asset/Instrument/

(a) Financial Product innovation
Shares, Debt
Security
(b) Three broad categories
Instruments
(1) Direct/Primary e.g. Share, Debt.,
Debentures etc.
Pref. Share etc.
(2) Indirect MF, Security Receipts,
Securitized Debt Investment.
(3) Derivatives Forward, Future, Options.
42

43

INTRODUCTION
An efficient, articulate and developed financial system is
indispenabale for rapid economic growth.
The process of economic development is invariably
accompanied by a corresponding and parallel growth of
financial systems/ organisations.
However, their institutional structure, operational policies
and regulatory framework differ widely and are largely
influenced
by
the
prevailing
politico-economic
environment.
Planned economic development in India had greatly
influenced the course of financial development till the
early nineties.
In 44the post-1990s, the financial system has emerged in

Pre-1951 Organisation
The main features of the pre-1951 organisation of the
Indian financial system (IFS) were:
closed-circle character of industrial entrepreneurship;
a semi-organised and narrow industrial securities
market devoid of issuing institutions;
and the virtual absence of participation by
intermediary financial institutions in the long-term
finance of industry.
Such a system was naturally not responsive to
opportunities for industrial investment
45

Indian Financial System

1.
2.
3.
4.
5.
6.
7.
8.
9.

Pre 1951

Control of Money Lenders

No Laws / Total Private Sector
No Regulatory Bodies
Hardly any industrialization
Banks Traditional lenders for Trade and that too short
term
Main concentration on Traditional Agriculture
Narrow industrial securities market (i.e.
Gold/Bullion/Metal but largely linked to London Market)
Absence of intermediatory institutions in long-term
financing of industry
Industry had limited access to outside saving/resources

46

Indian Financial System

phase II- 1951 to 1990
Moneylenders ruled till 1951. No worth-while Banks at that
time. Industries depended upon their own money. 1951
onwards
5 years PLAN commenced.
PVT. SECTORS TO PUBLIC SECTOR MIXED ECONOMY
1st 5 year PLAN in 1951 Planned Economic Process. As part of
Alignment of Financial Systems Priorities laid down by Govt.
Policies.

47

Organisation Upto Mid-eighties

The organisation of the IFS during the post-1951 period

evolved in response to the imperatives of planned
economic development.
Planning signified the distribution of credit and finance in
conformity with the planning priorities, which, in turn,
implied Government control over the financial system.
The main elements of the IFS were:
i.
ii.
iii.
iv.

public/government ownership of financial institutions;

fortification of the institutional structure;
protection to investors; and
participation
of financial institutions (FIs) in corporate
48
management.

Public Ownership of FIs

Public ownership of FIs was brought about
partly through nationalisation of existing
institutions [e.g. State Bank of India (1956),
LIC (1956), Commercial banks (1969) and GIC
(1972)] but mainly through the creation in the
public sector, of new institutions, namely,
special-purpose
term-lending
institutions/development banks and UTI.

49

Fortification of Institutional
Structure

The fortification of the institutional structure of the

IFS was partly the result of modification in the
structure and policies of the existing FIs, but mainly
due to the addition of new institutions.
The banking policies and practices were moulded so
as to be in tune with the planning practices.
Banks were encouraged to reorient their operational
policies towards the financing of industry, as against
commerce and trade.
They were also encouraged to enter into new forms
of 50industrial financing, namely, underwriting and

The banks also enlarged their functional coverage

in terms of financing of small scale industries,
exports and agriculture.
To expand the coverage and credit remedy gaps
to the priority sector, a scheme of social control
was introduced, followed by nationalisation of the
banks to control the heights of the economy and
meet progressively and serve better the needs of
development of the economy in conformity with
national priorities and objectives.

51

The post-nationalisation period yielded significant

changes in operational policies and practices of
banks.
This resulted in an acceleration of credit
availability to the priority sector and consequent
decline in the share of large industry in the total
bank credit, due to regulation and credit rationing.
The backbone of the institutional structure of the
IFS during this phase was the variegated structure
of development banks, namely, IDBI, IFCI, ICICI,
SFCs, SIDCs, SIICs and so on.
52

They were conceived as instruments of the state

policy of directing capital into a chosen area of
industry, in conformity with the planning priorities,
and of generally securing the development of
private industry along the desired path, to
facilitate effective public control of private
enterprise.
They were also the agency through which specific
socio-economic objectives of state policy, such as
encouragement to new entrepreneurs and small
enterprises and the development of backward
regions in order to broadbase the growth of
industry, were being realised
53

The setting up of the LIC, as a result of an

amalgamation of 245 life insurance companies into
a single monolithic state-owned institution, was a
part of the deliberate and conscious attempt to
mould the IFS according to the requirements of
planned development.
It not only transferred an important saving
institution from private to public ownership, but also
brought about a massive concentration of long-term
funds in the hands of LIC, which emerged as the
largest reservoir of
long-term savings in the
country.
Similarly, the setting up of the UTI was the
54
culmination
of a long overdue need of the IFS to

Protection to Investors
Alongwith the measures being taken to strengthen and
diversify the institutional structure of the IFS, extensive
legal reforms were carried out to provide protection to
investors so as to restore their confidence in industrial
securities.
The main elements of the elaborate legislative code
adopted by the Government were:
Companies Act;
Capital Issues (Control) Act (now repealed and replaced
by the SEBI Act);
Securities Contracts (Regulation) Act;
MRTP Act (now replaced by Competition Act) and;
Foreign Exchange Regulation Act (now replaced by
Foreign
Exchange Management Act).
55

Participation in Corporate
significant Management
feature of the IFS was

A
the
participation by the FIs, in the management and
control of companies to which finance was
provided, in marked contrast to the timehonoured tradition of not getting involved in the
control and management of assisted companies.
This change in approach of the FIs could be
ascribed to three factors:
Government policy;
structure of the industrial securities itself; and
the deep involvement of the FIs in the fortune of
the companies through lending operations.
56

57

Lacking/Deficiency
A serious lacuna in the organisation of the IFS during
the pre-1990 period, related to its institutional
structure, which was dominated by the development
banks, which depended for resources on their
sponsors (RBI, Government).
The IFS did not have the ability to autonomously
mobilise savings and had degenerated into a
distributive mechanism.
It had also resulted in a lop-sided capital structure of
corporates with a heavy component of borrowed
capital.
58

Post-90s Organization
In the post-1991 period, with a decline in the role of
the Government in economic management and, as a
logical corollary, in the distribution of finance and
credit, the capital market has emerged as the main
agency for the allocation of resources for all the
sectors of the economy.
The
IFS
has
transformation.

naturally

undergone

The notable developments contributing to

transformation are:
privatisation of FIs;
reorganisation
of the institutional structure; and
59

major

this

Privatisation of FIs
Beginning with the conversion of the IFCI into a
company and the offer of equity shares to private
investors by the IDBI, steps were initiated to privatise
important financial institutions.
The private sector financial institutions that had
come into being are the new generation of banks
under the RBI guidelines; mutual funds under SEBI
regulations, sponsored by FIs, FIIs, banks and
insurance organisations; and insurance companies
sponsored by both domestic and foreign promoters,
under IRDA guidelines.
Pension
funds also have since opened for private
60

Reorganisation of the
institutionalStructure
structure of the IFS

The
has
undergone an outstanding transformation in
its evolution to reflect its capital marketorientation.
The
components
which
witnessed
the
transformation
are
the
development
banks/term-lending
FIs/public
financial
institutions, commercial banks, insurance
companies,
mutual
funds,
NBFCs
and
securities/capital market and money market.

61

With the impending reorganisation/liquidation

of the IFCI Ltd. and the IIBI Ltd. and the
conversion of the ICICI and the IDBI into banks,
the development banks which constituted the
backbone of the organisation of the IFS, have
virtually disappeared from the Indian financial
scene, the only surviving institution being the
SFCs

62

Banks
Indian
banking
is
characterised
by
prudential/viable banking. By the early nineties, a
geographically wide and functionally diverse
banking system had emerged, as reflected in the
phenomenal branch expansion, especially in the
rural and semi-urban and unbanked areas, the
phenomenal growth in deposits and the increase
in the share of priority sector in total bank
lending.
This impressive progress of Indian banking in
achieving social goals had indeed been a
major developmental input.
63

However, serious weaknesses developed in the

form of decline in the efficiency of the banking
system and consequently, a serious erosion of its
profitability, with adverse implications for its
viability itself.
The first generation of reforms, as a follow-up to
the Narsimham Committee I recommendations,
focused on arresting the qualitative deterioration
in the functioning of the banking system in terms
of
directed
investments;
directed
credit
programmes; the interest rate structure; capital
adequacy norms; income recognition, asset
classification and provisioning norms and so on.
64

The second generation of reforms, as a follow-up to the

Narsimham Committee II recommendations, addressed
the issue of making the banking system internationally
competitive.
The focus shifted to internal financial management of
banks, in contrast to the regulatory compliances until
then.
The major components of internal financial management
are:
(1) rigorous prudential norms relating to credit/investment
portfolio and capital adequacy;
(2) management
of non-performing assets (NPAs) to
ensure speedy/effective recovery in terms of DRTs,
corporate debt restructuring and securitisation of
financial assets and enforcement of security interest,
and

With the entry of private insurance companies,

the monopoly of the public sector LIC and GIC has
been dismantled.
Mutual funds have emerged as the most preferred
route
of
institutionalisation
of
security
investments for the relatively small investors.
NBFCs broaden the range of financial services,
both fund-based and fee-based.
They operate within the rigorous framework of
RBIs directions relating to acceptance of public
deposits, prudential norms and auditors, reports.
66

Capital Market
The securities/capital market has witnessed the
most profound transformation.
From being a marginal institution in the mideighties, it has come to occupy the centrestage in
the IFS.
The structure of both the primary and the
secondary market is characterised by significant
changes.

67

The reforms of the intermediaries as well as the pre

and post-issue procedure and activities, are indeed
thorough going, as a consequence of which the
primary market organisation has assumed, highly
developed character, capable of catering to the
requirements of the sophisticated and articulate
securities market.
The secondary market, which represented an
institutional mechanism that was inadequate, nontransparent, hardly regulated and rarely geared to
investor protection, has been truly transformed.
The notable developments relate to intermediaries,
reorganisation of stock exchanges, trading and so on.
68

Readings: Chapter 1, 2, 3
Notes:
Rural credit cooperatives in India
Note on the Mutual fund Industry in India
Basel III
Need for financial regulation with respect
to financial crisis

Write a short note on the evolution of financial

transaction
What is the function of a financial system?
What constitutes a financial system or how a
financial system is organized? What they do?
Who they are?
What are the main elements of financial
organization during the phase II of the Indian
financial system and discuss the deficiencies
Discuss the organization of the Indian financial
system post 1990s and till 1950