Indian Financial System

Financial System

An institutional framework existing in a country to enable financial transactions Three main parts

Financial assets (loans, deposits, bonds, equities, etc.) Financial institutions (banks, mutual funds, insurance companies, etc.) Financial markets (money market, capital market, forex market, etc.)

Regulation is another aspect of the financial system (RBI, SEBI, IRDA)

Financial assets/instruments

Enable channelising funds from surplus units to deficit units There are instruments for savers such as deposits, equities, mutual fund units, etc. There are instruments for borrowers such as loans, overdrafts, etc. Like businesses, governments too raise funds through issuing of bonds, Treasury bills, etc.

Financial Institutions

Includes institutions and mechanisms which

Affect generation of savings by the community Mobilisation of savings Effective distribution of savings

Institutions are banks, insurance companies, mutual funds- promote/mobilise savings Individual investors, industrial and trading companies- borrowers

Financial Markets

Money Market- for short-term funds (less than a year)

Organised (Banks) Unorganised (money lenders, chit funds, etc.)

Capital Market- for long-term funds

Primary Issues Market Stock Market Bond Market

Organised Money Market

Call money market Bill Market

Treasury bills Commercial bills

Bank loans (short-term) Organised money market comprises RBI, banks (commercial and co-operative)

Purpose of the money market

Banks borrow in the money market to:

Fill the gaps or temporary mismatch of funds To meet the CRR and SLR mandatory requirements as stipulated by the central bank To meet sudden demand for funds arising out of large outflows (like advance tax payments)

Call money market serves the role of equilibrating the short-term liquidity position of the banks

Call money market (1)

Is an integral part of the Indian money market where day-to-day surplus funds (mostly of banks) are traded. The loans are of short-term duration (1 to 14 days). Money lent for one day is called call money; if it exceeds 1 day but is less than 15 days it is called notice money. Money lent for more than 15 days is term money The borrowing is exclusively limited to banks, who are temporarily short of funds.

Call money market (2)

Call loans are generally made on a clean basis- i.e. no collateral is required The main function of the call money market is to redistribute the pool of day-to-day surplus funds of banks among other banks in temporary deficit of funds The call market helps banks economise their cash and yet improve their liquidity It is a highly competitive and sensitive market It acts as a good indicator of the liquidity position

Call Money Market Participants

Those who can both borrow and lend in the market RBI , banks and primary dealers Once upon a time, select financial institutions viz., IDBI, UTI, Mutual funds were allowed in the call money market only on the lenders side These were phased out and call money market is now a pure inter-bank market (since August 2005)

Developments in Money Market

Prior to mid-1980s participants depended heavily on the call money market The volatile nature of the call money market led to the activation of the Treasury Bills market to reduce dependence on call money Emergence of market repo and collateralised borrowing and lending obligation (CBLO) instruments Turnover in the call money market declined from Rs. 35,144 crore in 2001-02 to Rs. 14,170 crore in 2004-05 before rising to Rs. 21,725 crore in 2006-07

Bill Market

Treasury Bill market- Also called the T-Bill market

These bills are short-term liabilities (91-day, 182-day, 364day) of the Government of India It is an IOU of the government, a promise to pay the stated amount after expiry of the stated period from the date of issue They are issued at discount to the face value and at the end of maturity the face value is paid The rate of discount and the corresponding issue price are determined at each auction RBI auctions 91-day T-Bills on a weekly basis, 182-day TBills and 364-day T-Bills on a fortnightly basis on behalf of the central government

Money Market Instruments (1)

Money market instruments are those which have maturity period of less than one year. The most active part of the money market is the market for overnight call and term money between banks and institutions and repo transactions Call money/repo are very short-term money market products

Money Market Instruments(2)

Certificates of Deposit Commercial Paper Inter-bank participation certificates Inter-bank term money Treasury Bills Bill rediscounting Call/notice/term money CBLO Market Repo

Certificates of Deposit

CDs are short-term borrowings in the form of UPN issued by all scheduled banks and are freely transferable by endorsement and delivery. Introduced in 1989 Maturity of not less than 7 days and maximum up to a year. FIs are allowed to issue CDs for a period between 1 year and up to 3 years Subject to payment of stamp duty under the Indian Stamp Act, 1899 Issued to individuals, corporations, trusts, funds and associations They are issued at a discount rate freely determined by the market/investors

Commercial Papers

Short-term borrowings by corporates, financial institutions, primary dealers from the money market Can be issued in the physical form (Usance Promissory Note) or demat form Introduced in 1990 When issued in physical form are negotiable by endorsement and delivery and hence, highly flexible Issued subject to minimum of Rs. 5 lacs and in the multiple of Rs. 5 lacs after that Maturity is 7 days to 1 year Unsecured and backed by credit rating of the issuing company Issued at discount to the face value

Market Repos

Repo (repurchase agreement) instruments enable collateralised short-term borrowing through the selling of debt instruments A security is sold with an agreement to repurchase it at a pre-determined date and rate Reverse repo is a mirror image of repo and reflects the acquisition of a security with a simultaneous commitment to resell Average daily turnover of repo transactions (other than the Reserve Bank) increased from Rs.11,311 crore during April 2001 to Rs. 42,252 crore in June 2006

Collateralised Borrowing and Lending Obligation (CBLO)

Operationalised as money market instruments by the CCIL in 2003 Follows an anonymous, order-driven and online trading system On the lenders side main participants are mutual funds, insurance companies. Major borrowers are nationalized banks and nonfinancial companies The average daily turnover in the CBLO segment increased from Rs. 515 crore (2003-04) to Rs. 32, 390 crore (2006-07)

Indian Banking System

Central Bank (Reserve Bank of India) Commercial banks (222) Co-operative banks Banks can be classified as:

Scheduled (Second Schedule of RBI Act, 1934) - 218 Non-Scheduled - 4 Public Sector Banks (28) Private Sector Banks (Old and New) (27) Foreign Banks (29) Regional Rural Banks (133)

Scheduled banks can be classified as:

Indigenous bankers

Individual bankers like Shroffs, Seths, Sahukars, Mahajans, etc. combine trading and other business with money lending. Vary in size from petty lenders to substantial shroffs Act as money changers and finance internal trade through hundis (internal bills of exchange) Indigenous banking is usually family owned business employing own working capital At one point it was estimated that IBs met about 90% of the financial requirements of rural India

RBI and indigenous bankers (1)

Methods employed by the indigenous bankers are traditional with vernacular system of accounting. RBI suggested that bankers give up their trading and commission business and switch over to the western system of accounting. It also suggested that these bankers should develop the deposit side of their business Ambiguous character of the hundi should stop Some of them should play the role of discount houses (buy and sell bills of exchange)

RBI and indigenous bankers (2)

IB should have their accounts audited by certified chartered accountants Submit their accounts to RBI periodically As against these obligations the RBI promised to provide them with privileges offered to commercial banks including

Being entitled to borrow from and rediscount bills with RBI

The IBs declined to accept the restrictions as well as compensation from the RBI Therefore, the IBs remain out of RBIs purview

Development Oriented Banking

Historically, close association between banks and some traditional industries- cotton textiles in the west, jute textiles in the east Banking has not been mere acceptance of deposits and lending money; included development banking Lead Bank Scheme- opening bank offices in all important localities Providing credit for development of the district Mobilising savings in the district. Service area approach

Progress of banking in India (1)

Nationalisation of banks in 1969: 14 banks were nationalised Branch expansion: Increased from 8260 in 1969 to 71177 in 2006 Population served per branch has come down from 64000 to 16000 A rural branch office serves 15 to 25 villages within a radius of 16 kms However, at present only 32,180 villages out of 5 lakh have been covered

Progress of banking in India (2)

Deposit mobilisation:

1951-1971 (20 years)- 700% or 7 times 1971-1991 (20 years)- 3260% or 32.6 times 1991- 2006 (11 years)- 1100% or 11 times

Expansion of bank credit: Growing at 20-30% p.a. thanks to rapid growth in industrial and agricultural output Development oriented banking: priority sector lending

Progress of banking in India (3)

Diversification in banking: Banking has moved from deposit and lending to

Merchant banking and underwriting Mutual funds Retail banking ATMs Internet banking Venture capital funds

Profitability of Banks(1)

Reforms have shifted the focus of banks from being development oriented to being commercially viable Prior to reforms banks were not profitable and in fact made losses for the following reasons:

Declining interest income Increasing cost of operations

Profitability of banks (2)

Declining interest income was for the following reasons:

High proportion of deposits impounded for CRR and SLR, earning relatively low interest rates System of directed lending Political interference- leading to huge NPAs

Rising costs of operations for banks was because of several reasons: economic and political

Profitability of Banks (3)

As per the Narasimham Committee (1991) the reasons for rising costs of banks were:

Uneconomic branch expansion Heavy recruitment of employees Growing indiscipline and inefficiency of staff due to trade union activities Low productivity

Declining interest income and rising cost of operations of banks led to low profitability in the 90s

Bank profitability: Suggestions

Some suggestions made by Narasimham Committee are:

Set up an Asset Reconstruction Fund to take over doubtful debts SLR to be reduced to 25% of total deposits CRR to be reduced to 3 to 5% of total deposits Banks to get more freedom to set minimum lending rates Share of priority sector credit be reduced to 10% from 40%

Suggestions (contd)

All concessional rates of interest should be removed Banks should go for new sources of funds such as Certificates of Deposits Branch expansion should be carried out strictly on commercial principles Diversification of banking activities Almost all suggestions of the Narasimham Committee have been accepted and implemented in a phased manner since the onset of Reforms

NPA Management

The Narasimham Committee recommendations were made, among other things, to reduce the Non-Performing Assets (NPAs) of banks To tackle this the government enacted the Securitization and Reconstruction of Financial Assets and Enforcement of Security Act (SARFAESI) Act, 2002 Enabled banks to realise their dues without intervention of courts

SARFAESI Act

Enables setting up of Asset Management Companies to acquire NPAs of any bank or FI (SASF, ARCIL are examples) NPAs are acquired by issuing debentures, bonds or any other security As a second creditor can serve notice to the defaulting borrower to discharge his/her liabilities in 60 days Failing which the company can take possession of assets, takeover the management of assets and appoint any person to manage the secured assets Borrowers have the right to appeal to the Debts Tribunal after depositing 75% of the amount claimed by the second creditor

The Indian Capital Market (1)

Market for long-term capital. Demand comes from the industrial, service sector and government Supply comes from individuals, corporates, banks, financial institutions, etc. Can be classified into:

Gilt-edged market Industrial securities market (new issues and stock market)

The Indian Capital Market (2)

Development Financial Institutions

Industrial Finance Corporation of India (IFCI) State Finance Corporations (SFCs) Industrial Development Finance Corporation (IDFC) Merchant Banks Mutual Funds Leasing Companies Venture Capital Companies

Financial Intermediaries

Industrial Securities Market

Refers to the market for shares and debentures of old and new companies New Issues Market- also known as the primary market- refers to raising of new capital in the form of shares and debentures Stock Market- also known as the secondary market. Deals with securities already issued by companies

Financial Intermediaries (1)

Mutual Funds- Promote savings and mobilise funds which are invested in the stock market and bond market Indirect source of finance to companies Pool funds of savers and invest in the stock market/bond market Their instruments at savers end are called units Offer many types of schemes: growth fund, income fund, balanced fund Regulated by SEBI

Financial Intermediaries (2)

Merchant banking- manage and underwrite new issues, undertake syndication of credit, advise corporate clients on fund raising Subject to regulation by SEBI and RBI SEBI regulates them on issue activity and portfolio management of their business. RBI supervises those merchant banks which are subsidiaries or affiliates of commercial banks Have to adopt stipulated capital adequacy norms and abide by a code of conduct

Indian Financial Sector: different phases

Three distinct periods: 1947-68, 1969-91, 1991 onward 1947-68: relatively liberal environment - the role of RBI was to supervise and control the banks 1969-91: Bank nationalization and Financial repression banking policies re-oriented to meet social objectives such as the reduction in inequalities and the concentration of economic power interest rate controls and directed credit programs 1991 onward: financial sector liberalization

Indian Financial Sector: Pre-Nationalization

RBI Act: scheduled commercial banks are required to maintain a minimum cash reserve of 7% of their demand and time liabilities - SLR was 20% (cash, gold, govt. securities) LIC formed in 1959 by nationalizing the existing insurance companies 1962: RBI was empowered to vary the CRR between 3% and 15% - empowered to stipulate minimum lending rates and ceilings rates on various types of advances Problem of bank failures and compulsory merger of weak banks with relatively stronger ones (no. of banks fell from 566 in 1951 to 85 in 1969 due to mergers).

Indian Financial Sector: Pre-Nationalization

1962: Deposit insurance scheme with the establishment of the Deposit Insurance Corporation

1964: RBI directly regulated the interest on deposits (prior to this, interest rates were governed by a voluntary agreement among the important banks) Certain disquieting features: (i) banking business was largely confined to the urban areas (neglect of rural and semi-urban areas) (ii) agriculture sector got only a very small share of total bank credit (iii) within industry, the large borrowers got the greatest share of credit
The pattern of credit disbursement was inconsistent with the goal of achieving an equitable allocation of credit and the priorities set in the plans - bank nationalization in 1969

Indian Financial Sector: Bank nationalization

1969: 14 largest scheduled commercial banks nationalized; 22 largest banks accounting for 86% of deposits had become public sector banks; 6 more banks nationalized in 1980 bringing the share of public sector banks deposits to 92% Rural branch expansion to mobilize deposits and enhancement of agriculture credit Priority sector lending (agriculture, small scale industries, retail trade, transport operators etc); requirement was 33%, raised to 40% in 1979. UTI and IDBI, IFCI and ICICI were set up with specific objectives in mind

Indian Financial Sector: 1980s

Increasing reliance of the govt. on the banking sector for financing its own deficits The govt. used the banking sector as a captive source of funds by means of SLR (the proportion of net demand and time deposits that banks have to maintain in cash, gold, and approved securities) SLR originally intended as an instrument of monetary policy, but in effect served two other purposes: (i) allocate banks resources to the govt (ii) allocate cheap resources to development finance institutions Steady increase of SLR: 28% (in 1970-1) to 38.5% (in 198990) Increased monetization of the deficit (budget deficit to GDP ratio increased from 0.96% during the first half the 1970s to 2.09% during the second half of the 1980s)

Indian Financial Sector: 1980s

To neutralize the effects of deficit financing on monetary growth, CRR steadily increased from 7% (1973-4) to 15% (1989-90) Larger portion of the bank funds locked into non interest bearing bank reserves Suppressed the govt. securities market to keep the cost of borrowing low for the govt.; open market operations lost its effectiveness as a tool of monetary policy Problems:(i) heavy segmentation of markets, (ii) inefficient use of credit, (iii) poor bank profitability due to restrictions on the use funds, (iv) rigidity due to the imposition of branch licensing requirements (v) lack of competition and efficiency due to entry restrictions and public sector dominance

Indian Financial Sector: Reforms

Chakravarty Committee (1985): suggest measures for improving the effectiveness of monetary policy. Main recommendations: (i) develop treasury bills as a monetary instrument so that open market operations could gradually become the dominant instrument of monetary policy (ii) revise upwards the yield structure of govt. securities so as to increase the demand for them and limit the degree of monetization Money markets were underdeveloped till the mid 80s: Few large lenders (LIC and UTI) and large no. of borrowers (commercial banks) ceiling of 10% on the rate

Reforms in the money market

Vaghul Committee (1987): study the money market; recommendation to achieve a phased decontrol and development of money markets Introduction of the 182 days Treasury Bills; withdrawal of the ceilings on call money rates; new short term instruments (Commercial Paper and Certificates of deposits) Discount and Finance House of India (DFHI) was instituted by RBI in 1987 DFHI was allowed to participate as both lender and borrower; No. of lenders increased Instability in the rates and RBI intervention to stabilize Significant deregulation and development of money market by the late eighties little progress in the deregulation of credit and capital markets

Narasimham Committee Recommendations

Narasimham Committee (1991) to study the working of the financial system. (i) bring down SLR in a phased manner to 25% over five years (ii) use CRR as an instrument of monetary policy rather than using to neutralize the effect of monetization (iii) phase out directed credit programs and reduce the requirement to lend to the priority sectors down to 10% of aggregate credit (iv) bring the interest rate on govt. borrowing in line with other market determined interest rates and phase out concessional interest rates

Narasimham Committee Recommendations

(v) allow the more profitable public sector banks to issue fresh capital to the public through the capital market (vi) abolish branch licensing closing and opening of branches left to the judgment of individual banks

(vii) liberalize policies towards foreign banks

(viii) quasi-autonomous body under the aegis of the RBI to be set up to supervise banks and financial institutions (ix) phase out the privileged access of development finance institutions to concessional finance

Reforms in the credit market

Interest rate deregulation in a phased manner: total freedom to the banks to set their own lending rates (from 1994) Since 1991, term lending institutions can charge interest rates in accordance with perceived risks

Contraction of subsidized and captive source of funds to term lending institutions forced to borrow at market rate of interest Diversification of term lending institutions in to banking, MFs etc.
Some decline in the priority sector lending particularly agriculture credit

Reforms and changes in the capital market market

Upward revision of interest rates for govt. securities (T bills and dated securities) and significant growth in the primary market for T bills Use of open market operations by the RBI (by selling and buying the govt. securities) to absorb a part of the excess liquidity in the banking system caused by the surge in foreign capital inflows The proportion T bills outstanding with the RBI came down significantly from the earlier level of about 90% Dated Securities: alignment of the interest rate with other interest rates in the financial sector reduction in the maximum maturity from 20 to 10 years

Reforms and changes in the capital market market

Creation of the Securities and Trading Corporation of India (STCI) in 1993: the task is to develop an efficient secondary market in govt. securities and public sector bonds Stock Market: prior to 1992, the primary issues market was very closely regulated, which discouraged corporations from using new issues to raise funds Creation of SEBI (1992): regulatory authority for new issues of companies; companies are now free to approach the capital market after a clearance from SEBI Free entry of FII (pension funds, mutual funds, investment trusts, asset management companies) initial registration with SEBI

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