Financial system in India P1

Financial system in India-

• It is a set of complex and closely interconnected financial institutions, markets, instruments, services, practices and transactions

Financial Market and its various Dimensions-

Introduction to Financial Market-

Functions of Financial market in India

• Risk sharing between investors and the companies.

• Mobilisation of Savings and Channeling them into the most Productive Uses.

• Providing Liquidity to Financial Assets.

• The financial market helps provide every type of information to the traders without the requirement of spending any money by them.

Before starting ,lets have look on some of the basic terms-

Debits-

• A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account.

Credits-

• In accounting, a credit is a record that results in either an increase to a liability or equity account, or a decrease to an asset or expense account.

Share-

• A share is a unit(a part) of the capital of the company. hares are ownership capital, issued by a company to the public.

Debenture-

• A debenture is a debt instrument issued to raise a borrowed fund.Debentures are debt tools; issued by companies to raise funds as loans from the public.

• It is an acknowledgement from a corporate entity that it has taken a loan from you.

Promissory note-

• A promissory note is a written document that contains an unconditional promise, signed by the maker, to pay a specific amount of money only to a certain person or to the bearer of the note. It is not considered a bank note or currency note.

Division of Financial Market

Financial system in India is divided as follows-

• The Credit Market.

• The Debt Market.

• The Money Market.

• The Capital Market.

• The foreign exchange market.

• Other Types of Markets.

The Credit Market

• This market deals with enhancing the credit structure in India

It is further divide as follows-

1.Unorganized Credit Market

2.Organized Credit Market

1.Unorganized Credit Market

In this type of market, government does not have direct control

It includes-

Unregulated -

• Non-Banking Financial Intermediaries such as  chit funds, nidhis etc.

Indigenous Bankers-

• They receive deposits and lend money in the capacity of an individual or a private firms Ex- Chettiars,Gujarati Shroffs etc.

Money Lenders-

• They are individuals who lend money to different people at high interest rates.

2.Organized Credit Market-

This type of market id directly controlled by government

It is further divided into two parts-

A.Banks

B.Non banking financial institutions

A Banks-

The banking structure in India is Broadly classified as follows- 

(i)Commercial Banks-

• A commercial bank is a type of financial institution that provides various banking services to its customers, including deposit acceptance, checking account services, loan facilities, and financial products such as certificates of deposit and savings accounts. Commercial banks cater to the financial needs of both individuals and small businesses.

It is further divided as follows-

• Public sector banks.

• Regional rural banks ( Government owned scheduled commercial banks  that operate at regional level in different states of India).

• Private sector banks (both domestic and foreign).

The development of sound commercial banking system in India was worked out mainly with the help of the recommendations of the Committee on the Financial System (Chairman: Shri M. Narasimham), 1991

(ii)Co-operative Bank-

• A cooperative bank is a financial institution that is owned and operated by its members who are also its customers. These banks are typically smaller in size compared to commercial banks and focus on serving the needs of their members through various banking and financial services.

B.Non Banking Financial institutions /companies-

• A financial institution (FI) is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments etc.

All India Financial Institutions-

• The All India Financial Institutions (AIFI) is a collection of financial regulatory bodies that have a crucial role in the functioning of financial markets.

• Initially there were 5 AIFI I.e. IFCI (1948); ICICI (1955); IDBI (1964); SIDBI (1990) & IIBI (1997) but all of them are either merged or converted into banks

At present there are total 4 Such institutions-

(i)EXIM Bank-

• The Export-Import Bank of India Act of 1981 led to the establishment of the EXIM bank in 1982.

• The primary objective of EXIM Bank is to provide financial assistance to exporters and importers, as well as to act as the primary financial institution that coordinates the activities of entities involved in financing the import and export of goods and services, with the aim of promoting the international trade.

• The Export-Import Bank (EXIM Bank) provides financial assistance directly to exporters and importers, as well as indirectly through refinancing. This helps promote trade and supports the growth of businesses involved in international trade.

(ii)National Bank for Agriculture and Rural Development (NABARD) 

• The National Bank for Agriculture and Rural Development (NABARD) was founded on 12 July 1982, based on the suggestions of the B. Sivaraman Committee.

• The aim of the committee was to execute the National Bank for Agriculture and Rural Development Act of 1981.

• NABARD, which stands for National Bank for Agriculture and Rural Development, serves as the primary regulatory body for overseeing the operations of regional rural banks and apex cooperative banks throughout India.

• It provides credit to promote rural areas’ linked economic activities, including small-scale enterprises, cottage industries, handicrafts, and rural craft.

• NABARD oversees the functioning of State Cooperative Banks (StCBs), District Cooperative Central Banks (DCCBs), and Regional Rural Banks (RRBs).

(ii)Small Industries Development Bank of India (SIDBI)

• Small Industries Development Bank of India (SIDBI) is the apex regulatory body for overall licensing and regulation of micro, small and medium enterprise finance companies in India.

• The SIDBI was established on April 02, 1990 (under Small Industries Development of India Act 1989)as a wholly owned subsidiary of IDBI Bank .

• It was delinked from IDBI in 2000

(iv)National Housing Bank (NHB)

• It was founded in 1988 under National Housing Bank Act of 1987.

• The Finance Act, 2019 has amended the National Housing Bank Act, 1987.

• The amendment grants the Reserve Bank of India the authority to regulate Housing Finance Companies (HFCs), which are now fully owned by the government.

• It does not provide direct credit to individuals but it provide indirect financial help through refinancing.

Other institutions includes-

• State industrial development corporations-SIDC(In 1960, the first  (SIDC) were established in Bihar).

• Sate Finance Corporations (SFCs): First came up in Punjab (1955).

Non-Banking Financial Companies (NBFCs)-

• A Non-Banking Financial Company (NBFC) is a type of company that is registered under the Companies Act, 1956 and primarily engaged in providing loans and advances, as well as acquiring shares, securities, and other financial assets issued by the government or other companies.

Difference between banks & NBFCs?

• NBFC cannot accept demand deposits.

• Non-Banking Financial Companies (NBFCs) are not included in the payment and settlement system and are not authorized to issue cheques that are drawn on themselves.

• The Deposit Insurance and Credit Guarantee Corporation does not offer deposit insurance to depositors of NBFCs, which differs from the protection provided to depositors of banks.

It is divided as follows-

(i)Asset Finance Company (AFC) -

• An Asset Finance Company (AFC) is a financial institution that specializes in financing physical assets and makes it their primary business activity.

(ii)Investment Company (IC) -

• An Investment Company (IC) refers to a financial institution that primarily engages in the acquisition of securities as its core business.

(iii)Loan Company (LC)-

• An LC refers to a financial institution whose principal business is providing finance, whether by making loans, advances, or otherwise, for any activity other than its own. However, an LC does not include an Asset Finance Company.

(iv)Infrastructure Finance Company (IFC)-

• An Infrastructure Finance Company (IFC) is a type of non-banking financial company that specializes in financing infrastructure projects. As per RBI guidelines, an IFC must deploy at least 75% of its total assets in infrastructure loans.

(iv)Investment Company (CIC-ND-SI)-

• CIC-ND-SI is a non-banking financial company that specializes in acquiring shares and securities as a part of its business operations.

(v)Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC) -

• IDF-NBFC is a company registered as NBFC to facilitate the flow of long term debt into infrastructure projects.

(vi)Micro Finance Institution (NBFC-MFI)-

• NBFC-MFI is a non-deposit taking NBFC which provides loan for small financing activities

(vii)Non-Banking Financial Company – Factors (NBFC-Factors)-

• NBFC-Factors are non-deposit taking non-banking financial companies that specialize in the principal business of factoring.

(viii)Mortgage Guarantee Companies (MGC) -

• Mortgage Guarantee Companies (MGC) are financial institutions that primarily engage in mortgage guarantee business, with at least 90% of their business turnover or gross income derived from such activities. Additionally, MGCs are required to maintain a net owned fund of at least Rs 100 crore.

(ix)NBFC- Non-Operative Financial Holding Company (NOFHC)-

• It is financial institution through which promoter / promoter groups will be permitted to set up a new bank .

(x)Housing finance companies-

• It is an NBFC whose financial assets, in the business of providing finance for housing, constitute at least 60% of its total assets.

The Money Market

• The money market is a financial market where short-term, low-risk debt instruments are issued and traded on a daily basis.

• These instruments are unsecured and highly liquid, making them a popular choice for investors looking for safe, low-risk investments with quick returns.

• It has no physical location.

• The money market facilitates the borrowing and lending of short-term funds to address temporary cash shortages.

• The money market is made up of several key players, including the Reserve Bank of India (RBI), commercial banks, non-banking finance companies, state governments, large corporate houses, and mutual funds. Each of these participants plays a vital role in the functioning of the money market.

Components of Money Market

The money market instruments mainly comprise:

(i) call money and notice money

(ii) certificates of deposit

(iii) treasury bills

(iv) trade bills

(v) commercial bills

(vi) commercial paper

(vii) Money mutual market

(viii)Repos and Reverse repos

(i) call money and notice money

• Banks primarily use call money to meet their temporary cash requirements.

• They borrow and lend money from each other on a daily basis, with repayment on demand and maturity periods ranging from one day to a fortnight.

• The interest rate paid on call money loans is known as the call rate.

Notice money-

• Funds that are borrowed/raised for a maximum period upto 14 days

(ii) Certificates of deposit-

• Certificates of Deposit (CD) were introduced in June 1989 as short-term instruments.

• CDs are issued by commercial banks and special financial institutions (SFIs) and are freely transferable from one party to another.

• The maturity period for CDs ranges from 91 days to one year.

• CDs can be issued to individuals, co-operatives, and companies.

(iii) Treasury bills

• A Treasury bill is  an instrument of short-term borrowing by the Government of India maturing in less than one year.

• They are also known as Zero Coupon.

• Treasury bills are bonds issued by the Reserve Bank of India on behalf of the Central Government to fulfill short-term funding needs.

• These bills are issued in the form of a promissory note.

• They are sold at a price lower than their face value and are repaid at par upon maturity.

• Treasury bills are highly liquid and offer a guaranteed yield, while carrying a low risk of default.

Sub types of treasury bills-

(a) 14-day (Intermediate TBs)

(b) 14-day (Auctionable TBs)

(c) 91-day TBs (d) 182-day TBs

(e) 364-day TBs

(iv) Bill of exchange/trade bills

• Traders often purchase goods from manufacturers or wholesalers on credit.

• The seller typically receives payment at the end of the credit period.

• In cases where the seller requires immediate payment or does not want to wait for the end of the credit period, they can draw up a bill of exchange in the buyer's favor.

• If the buyer accepts the bill, it becomes a negotiable instrument known as a bill of exchange or trade bill.

(v) Commercial bills

• It is a short term financing mechanism used by All India Financial Institutions (AIFIs), Non-Banking Finance Companies (NBFCs), Scheduled Commercial Banks, Merchant Banks, Co-operative Banks and the Mutual Funds.

(vi) Commercial paper

• Commercial Paper (CP) is an unsecured financial instrument in the form of a promissory note.

• It was first introduced in 1990 as a way for corporate borrowers to raise short-term funds.

• CP is typically issued by companies with high credit ratings.

• The maturity period of CP is usually between 7 days to 1 year.

• The minimum investment in CP is usually around Rs. 5 lakh.

• The Securities and Exchange Board of India (SEBI) regulates the issuance of CP in India.

(vii)Money Market Mutual Funds (MMMFs)

• It was introduced/organised in 1992 to provide short-term investment opportunity to individuals.

• Since March 2000, MFs have been brought under the preview of SEBI, besides the RBI.

(viii)Repos and Reverse Repos-

• The repo system enables banks and other financial institutions to borrow funds from the Reserve Bank of India (RBI) in the short term by selling government securities to the RBI.

• The reverse repo system allows banks and financial institutions to purchase government securities from the RBI in exchange for funds.

The Debt Market

The domestic debt market comprises two main segments

The Government securities annd other like- Private corporate debt, PSU bonds and DFIs(The Discount and Finance House of India Limited (DFHI) bonds.

• The market for government securities is the most dominant, while the other segment lacks depth and liquidity.

• The main investors in the Government securities market in India are commercial banks, co-operative banks, insurance companies, provident funds, financial institutions , mutual funds , primary dealers, satellite dealers, non-bank finance companies and corporate entities.

• The Reserve Bank plays a role in absorbing primary issuance of government securities, which can happen through private placement or devolvement.

DFHI- The Discount and Finance House of India Limited (DFHI)

• The Development Financial Institutions (DFHI) was established in April 1988 with the aim of developing the money market.

• It was also allowed to participate in Treasury bills and dated securities.

• Initially it was formed by RBI along with other financial institution and in  2004, the RBI transferred its total holding in the DFHI to the State Bank of India arm SBI Gilts Limited.

The Capital Market

• The capital market involves institutions and arrangements for raising and investing long-term funds in both debt and equity.

• In 1992, the Securities and Exchange Board of India (SEBI) was given statutory powers to regulate the capital market.

• The market where securities are traded is known as the securities market.

Division of Capital Market

It consists of two different segments namely primary and secondary market

(i)Primary Market-

• The Primary Market is designed to help companies obtain long-term funding by issuing new shares and debentures.

• Investors in the primary market include banks, financial institutions, insurance companies, mutual funds, and individuals.

• Companies can use the primary market to raise capital through a variety of financial instruments, such as equity shares, preference shares, debentures, loans, and deposits.

Methods of raising-

Offer through Prospectus-

• A prospectus is a document that seeks to raise capital by making a direct appeal to investors through advertisements in newspapers and magazines.

• The securities offered in a prospectus may be underwritten and are required to be listed on at least one stock exchange.

Offer for Sale-

• Under this method securities are not issued directly to the public but are offered for sale through intermediaries like issuing houses or stock brokers.

Rights Issue- 

• A rights issue is a mechanism through which a company offers its existing shareholders the opportunity to purchase new shares, subject to the terms and conditions set by the company.

e-IPOs- 

• To issue capital to the public through the online system of the stock exchange, a company must enter into an agreement with the stock exchange.

• This process is known as an Initial Public Offer (IPO).

Private Placement-

• Private placement involves a company offering securities to institutional investors and a select group of individuals.

• This method of fundraising allows companies to raise capital more quickly than through a public issue.

• Private placements are typically offered to accredited investors, who are deemed to have the financial sophistication and means to invest in these securities.

• Unlike a public issue, private placements are not registered with regulatory authorities and are therefore subject to less regulatory scrutiny.

(ii)Secondary market-

• The secondary market is an organized market for trading shares and debentures with high levels of transparency and security.

• It is also referred to as the stock market or stock exchange.

• This market deals with the buying and selling of existing securities.

• A thriving secondary market is beneficial for the growth of the primary market, as investors in the primary market can count on a continuous market for liquidity of their holdings.

Difference Between Primary and Secondary market

Difference Between Money Market and Capital Market

Important One Liner Questions and answers on Financial system in India.

What is financial system in India?

A complex set of interconnected financial institutions, markets, instruments, services, practices and transactions.

What are the functions of financial market in India?

Risk sharing, mobilization of savings, providing liquidity, and providing information to traders.

What is a debit in accounting?

An entry that increases an asset or expense account, or decreases a liability or equity account.

What is a credit in accounting?

An entry that results in either an increase to a liability or equity account, or a decrease to an asset or expense account.

What is a share?

A unit of ownership capital issued by a company to the public.

What is a debenture?

A debt instrument issued by companies to raise funds as loans from the public.

What is a promissory note?

A written document containing an unconditional promise to pay a specific amount of money to a certain person or bearer of the note.

How is the financial system in India divided?

Into the credit market, debt market, money market, capital market, foreign exchange market, and other types of markets.

What is the unorganized credit market in India?

A type of credit market in which the government does not have direct control, and includes unregulated non-banking financial intermediaries, indigenous bankers, and money lenders.

What is the organized credit market in India?

A type of credit market that is directly controlled by the government and includes banks and non-banking financial institutions.

What are commercial banks?

Financial institutions that provide various banking services to customers, including deposit acceptance, checking account services, loan facilities, and financial products such as certificates of deposit and savings accounts.

What are regional rural banks?

Government-owned scheduled commercial banks that operate at a regional level in different states of India.

What are cooperative banks?

Financial institutions that are owned and operated by its members who are also its customers.

What are non-banking financial institutions?

Companies engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, etc.

What are All India Financial Institutions?

A collection of financial regulatory bodies that have a crucial role in the functioning of financial markets in India.

What is the Export-Import Bank of India?

A financial institution that provides financial assistance to exporters and importers, and coordinates the activities of entities involved in financing the import and export of goods and services to promote the nation's international trade.

What is the National Bank for Agriculture and Rural Development?

A regulatory body that oversees the operations of regional rural banks and apex cooperative banks throughout India, and provides credit to promote rural areas' linked economic activities.

What is the debt market in India?

A market for trading long-term debt instruments such as bonds, debentures, and notes.

What is the money market in India?

A market for short-term borrowing and lending, with maturity periods ranging from overnight to one year.

What is the capital market in India?

A market for trading long-term financial instruments such as stocks, bonds, and debentures, and for raising capital for companies.