JAIIB (Module A)

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, FMC)

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. Instruments like PPF, KVP, etc. are available to savers who wish to lend money to the government

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 (through LAF), 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 nationalised banks, PDs and non-financial 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 Factoring

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

Conclusion

There are other financial intermediaries such as NBFCs, Venture Capital Funds, Hire and Leasing Companies, etc. Indias financial system is quite huge and caters to every kind of demand for funds Banks are at the core of our financial system and therefore, there is greater expectation from them in terms of reaching out to the vast populace as well as being competitive.

Money

Money is any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another.

Types of money

Commodity money-is a good whose value serves as the value of money. Gold coin are example of it. Flat money- flat money is a good, the value of which is less than the value it represents as money, e.g. dollar bill. Bank money-consists of the book credit that bank extend to their depositors. Transactions made using cheques drawn on deposits held at banks involve the use of bank money.

Definition of money

Crowther stats that Anything that is generally accepted as a means of exchange and that at the same time acts as a measure and as a store value. This definition covers three major function of money that is exchange, measure of value and store of value.

Function of Money

Prof. Kenley has divided money in the following three heads: Primary functions

(1) Medium of Exchange- to facilitate transactions. With out money all transaction would be conducted by barter.

(2) Measure of value.

Money

Secondary functions

Standard for deferred payments- payment that have to be made at later stage. Store of value- in order to be a medium of exchange, money must hold its value over time; it must be a store of value. Transfer of value- it also use as a transfer of due from one place to other. Money as liquid assets. Money as guarantor of solvency- e.g. bank pay deposit to depositors.

Money

Money as a bearer of options Unit of accounts Contingent functions- beside other primary and secondary functions, money also play four contingent functions

Distributor of joint product Equalizer of marginal and productivity Basic of credit Give generic value to capital and wealth

Types of money

On the basic of Accountability

Legal tender-(1) limited legal tender eg. Coins (2) Unlimited legal tender Optional money-is a non legal tender eg. Like cheques, Bank OD, are option money. On the basic of material used-(A) Metallic Moneymainly Standard money or token money. (a) Standard money- also know as fully bodied money. It generally made through gold and silver. (b) Tokan Money-its face value is always higher than its intrinsic value and fully under control of GOI. One Rupee is example of it.

Paper money

(B) Paper money- it made of paper.

(1)Representative paper money-such type of money is fully backed by gold or silver and is redeemable at the option of the holder in gold, e.g. American gold and silver certification (1927). (2)Convertible paper money-this type of money is convertible into standard corns at any time at the option of holder. 100% of backup not require. (3) Non-convertible paper money-e.g. one rupee (4) Flat money- its another type of non-convertible paper money which is generally issued without any back of gold, silver or government securities. It is issued by GOI under extra circumstances. E.g. German mark issued after World War one.

4. Money and Near Money- the liquidity basic & 5. Credit money or Bank Money

(a) Liquid form of Money: Money has a qualify of general acceptability which makes it, most liquid of assets. E.g. coins, currency and bank money are the most liquid form of money or 100% liquid. (2) Near- Money: Certain assets not as liquid as money but can be easily convertible in to money, e.g. are NSD, FD, Share etc. this type of money can be call Near money Quasi-Money or Liquid Money. 5. Credit Money

Demand for Money

Transactions motive- most transaction demand money for exchange. Precautionary Motive- people of demand money as precaution against future. Speculative Motive- Money is like an assets. the demand for an assets depends on both its ROI and opportunity cost.

Importance of Money Capitalistic Economic

Capitalistic economic recognizes the right of individual property. It is free from all government control. All factors of production are owned, controlled & operated by private entrepreneurs. Profit motive is prime motive in capitalistic economic. Money is the blood of capitalistic economic.

Importance of Money Capitalistic Economic

Consumer can make a ration be choice of goods- price mechanism help in their decision. Production decisions are based on money. Money simplifies the distribution systemshare of remuneration. Decision regarding saving and spending. Price mechanism regulates the flow of investment. Money is the basis of credit which is soul of

Importance of money in socialistic economic

A socialist economic is one in which all economic activities are planned, controlled and guided by Government or its agencies. In this type of economic, there is no free market as no right of property to individual. Socialists believe that money is the root cause of exploitation of labour by capitalist. In this economic money would be abolished and goods would be exchanged for goods.

Importance of money in socialistic economic

Guide to economic activities. Allocation of resources. Distribution of Income

Importance of Money in a planned economic

It has a important role to play in a developing planned economic. It generally followed in underdeveloped countries.

Interest

In economics, interest is considered the price of credit.

Interest

Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements.

Interest

Interest can be thought of as "rent of money". When money is deposited in a bank, interest is typically paid to the depositor as a percentage of the amount deposited; when money is borrowed, interest is typically paid to the lender as a percentage of the amount owed.

Types of Interest

Simple interest Simple interest is calculated only on the principle amount, or on that portion of the principle amount that remains unpaid. For example, imagine that a credit card holder has an outstanding balance of Rs. 2500 and that the simple interest rate is 12.99% per annum. The interest added at the end of 3 months would be, and he would have to pay Rs. 2581.19 to pay off the balance at this point.

Compound interest

Compound interest is very similar to simple interest; however, with time, the difference becomes considerably larger. This difference is because unpaid interest is added to the balance due. Put another way, the borrower is charged interest on previous interest. Assuming that no part of the principal or subsequent interest has been paid, the debt is calculated by the following formulas:

Compound interest

For example, if the credit card holder above chose not to make any payments, the interest would accumulate So, at the end of 3 months the credit card holder's balance would be Rs. 2582.07 and he would now have to pay Rs. 82.07 to get it down to the initial balance.

Fixed and floating rates

Commercial loans generally use simple interest, but they may not always have a single interest rate over the life of the loan. Loans for which the interest rate does not change are referred to as fixed rate loans. Loans may also have a changeable rate over the life of the loan based on some reference rate (such as LIBOR and EURIBOR), usually plus (or minus) a fixed margin. These are known as floating rate, variable rate or adjustable rate loans.

Flat Rate Loans and the Rule of 78s:

Some consumer loans have been structured as flat rate loans, with the loan outstanding determined by allocating the total interest across the term of the loan by using the "Rule of 78s" or "Sum of digits" method. Seventy-eight is the sum of the numbers 1 through 12, inclusive. The practice enabled quick calculations of interest in the pre-computer days. In a loan with interest calculated per the Rule of 78s, the total interest over the life of the loan is calculated as either simple or compound interest and amounts to the same as either of the above methods.

Market interest rates

There are markets for investments (which include the money market, bond market, as well as retail financial institutions like banks) set interest rates. Each specific debt takes into account the following factors in determining its interest rate: Opportunity cost Inflation Default Default Interest Length of time

What is CRR, repo and reverse repo rate?

Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system. Commercial banks are required to maintain with the RBI an average cash balance, the amount of which shall not be less than 3% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis and the RBI is empowered to increase the rate of CRR to such higher rate not exceeding 20% of the NDTL.

What is Reverse Repo rate?

Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.

What is a Repo Rate?

The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the US.