FINANCIAL SYSTEM
Overview of Indian Financial System
Various players
 Banks
NBFCs- deposit taking and non deposit taking)
Insurance companies
Chit funds, CIS schemes etc
Capital market and money market players like
mutual funds
Financial intermediaries
Regulators-SEBI, RBI, IRDA,PFRDA
 Banking sector- most important players in the financial
system- consists of scheduled commercial banks, cooperative
banks (rural & urban)
 Scheduled commercial banks in turn consist of public sector,
private sector and foreign banks. There are 26 PSBs including
SBI & associates
 There are 146 scheduled commercial banks in India as on
date
 Total deposits in the banking system are Rs.80.5 lakh Cr
and gross advances are Rs.70 lakh crore. Y-o-y growth is
13.9% and 11.6% respectively.
 PSBs still command 75% of market share despite entry of
private sector and foreign banks
 Banks alos perform the important task of facilitating govt
borrowing by investing in government securities
• NBFCs like Muthoot Finance, Manappuram finance etc- they
cannot perform normal banking activities. There are deposit
taking and non deposit taking NBFCs.
• NBFCs also perform financial intermediation. For instance
lending against gold and reach those segments not served by
banking system. They however, charge higher rates of interest
and had higher solvency requirements till recently.
• Certain NBFCs are eager for a bank license.
• Banks in turn lend to NBFCs for on lending activities.
 Insurance companies- both life & non life insurance
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companies- LIC has the biggest market share and its market
cap is estimated to be close to INR 4 lakhs
In India insurance penetration is very low. Hence, this sector
is very important. Government intends to pass legislation to
bring 49% FDI to the sector which will bring Rs.50,000 Cr.
Health of the insurance industry is measured by means of
solvency ratio. They have to maintain sufficient solvency ratio
to process claims of customers.
Apart from life insurance, health and motor insurance are also
available. The most important indicator of insurance business
is new business premiums generated during the year. This is
defined as the amount of capital relative to premiums written
IRDA wants 150% minimum solvency ratio by end of 2014.
• Money market- refers to the market for short
term funds like 14 days and upto less than 1
year. Major money market instruments are
commercial papers, certificate of deposits etc.
• The interest rates charged on these instruments
determine the short term rates for various
instruments and serves as a sort of benchmark
• For instruments such as CPs and CDs ratings,
general liquidity conditions, demand for funds
etc determine the rates.
• Major players in MM are banks and mutual
funds.
• Capital market refers to the market for longer
term funds This comprises the stock market
and various players such as brokers, stock
exchanges etc regulated by SEBI.
• Indian capital market is in a developed state
with the NSE seeing active trading in the
derivative segment apart from the cash
segment. Daily trading in the F&O segment is
quite high.
• Corporates raise funds through Capital market
by means of FPOs, IPOs etc. They play an
important role in channelizing savings into
investments.
Monetary and fiscal policies
• Monetary and fiscal policy can influence the Gross National
product or national Income (Y) which is the sum of Consumption
(c), Investment (I), Government expenditure (G) and net exports
(X).
Y = C+I+G+X
• Fiscal and monetary policies are administered by Govt of India
and RBI respectively. The Govt and RBI make use of various
monetary policy tools to achieve growth and economic stability .
• Fiscal & monetary policies can make overall economc situation
brighter or check and unwarranted boom
• They encourage investment and production in certain priority
sectors and discourage them in non priority sectors
• They are capable of influencing technological choice and
investment and production patterns.
• Fiscal & monetary policies can determine aggreate demand and
associated levels of output, employment, wages, profits etc.
MONETARY POLICY
• Monetary policy refers to use of instruments within the control of central
banks to regulate aggregate demand and regulate credit flows by varying
the asset pattern of credit institutions, principally commercial banks.
• Monetary policies also affect the economy through influencing the cost of
credit . Since credit forms a vital function of economic activity, the cost
and availability of credit is of significance.
Measures of money stock
RBI employs 4 measures of money stock namely, M1, M2, M3 and M4
M1: This is the sum of notes in circulation ( currency notes, coins etc) and
deposits (demand deposits with banks and other deposits with RBI).
Demand deposits more than half of money supply
M2: M1 + Post office savings deposits
M3: M1 + Time deposits with banks. Usually referred as aggregate monetary
resources.
Reserve money: Currency in circulation + bankers’ deposits with RBI +
other deposits with RBI
• Monetary and fiscal policy can increase/decrease money supply. For
instance, if Govt wants to borrow more and run deficits, money
supply will increase.
Bank deposits: This is an important source of money supply.
Orginates in 2 ways
1. Active creation of deposits; when banks create deposits by
extending credit.
2. Passive creation; When accounts are opened against cash receipts or
through cheques.
In the first case, money supply in the system increases immediately
since it a part of it might be deposited either with itself or with
some other banks. In the second case, there is no immediate money
creation but only a transfer of savings. However, even in the second
case, it helps to augment credit at a later stage.
Monetary and fiswcal policies attempt to control credit by
impacting the credit creation capacity of banks.
Monetary policy instruments
1. General(Quantitative) methods and
2. Selective (qualitative) methods
The general methods Affect the total quantity of credit and impact
the economy generally while selective methods impact credit flow
by re directing credit to certain specific segments.
I. General Credit Controls
There are 3 major instruments namely; 1) the Bank rate 2) Open
Market Operations (OMO) and 3) Variable Reserve requirements
Bank Rate: This is the rate at which RBI lends banks or the rate at
which RBI discounts bank’s bills. In a broader sense it is the rate at
which RBI provides financial accommodation to commercial
banks. It affects cost of credit. However, this rates has lost
relevance now since bill discounting business is negligible. At
present it is 9%. Bank rate also impact money market rates.
Theoretically, bank rate changes can affect money supply and in
turn the demand and price levels.
Open market operatios (OMO). Usually refers to purchas and sale by
RBI of forex, gold, company shares, Government securities etc.
However, in index, OMO means purchase and sale of Government
securities. OMOs help to vary the money supply.
For instance, when the central bank purchases securities, equivalent
money is released and this increases commercial bank reserves. Credit
creation and money supply will also increase. Converse is true when
the central bank wish to curtail money supply.
This is also used to aid Government borrowing programme. Govt
manages fiscal deficits through borrowing. Borrowing programme for
FY 15 is Rs.6 lakh cr.
OMOs are conducted by RBI through auctions every fortnight
through securities worth Rs.15,000 Cr.
Also used to provide funds to banks during times of liquidity tightness
and busy seasons.
Variable reserve ratio: This refers to the amount of funds banks
keep as reserves with the central bank, generally as a percentage of
their deposits. This can be varied by the central bank at any time as
per its discretion. In India this is called cash Reserve Ratio (CRR)
and Statutory Liquidity Ratio (SLR) currently at 4% and 22%
respectively.
If CRR is cut, money supply increases and vice versa. It also
indirectly impacts money market rates through liquidity conditions.
Banks to maintain 95% of CRR on a daily basis.CRR calculated on
the basis of Net demand & Time Liabilities of banks.
Banks do not earn any interest on CRR balances kept with RBI.
Interest on CRR is a long standing demand.
Even small changes in CRR can lead to wide variations in money
supply and hence this is a potent tool to influecne money supply.
Statutory Liquidity Ratio (SLR): Amount of NDTL banks invest in
Government securities. Can be Central Govt securities and state
Govt securities.
At present, SLR requirement is 22% of NDTL. It was brought down
from 24% since April 2014.
SLR, by forcing banks to invest in Government securities, help in
meeting Govt borrowing programmes.
However, the move to induce banks to lend by cutting SLR ay not
have the desired impact since banks already hold excess SLR.
Moreover, since economy is barely turning the corner, credit demand
has not yet picked up.
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2.
3.
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5.
Selective credit controls: These are aimed at restricting the quality
of credit while general credit controls emphasized regulation of
quantity of credit. The RBI is empowered to give directions to
individual banks/group of banks to direct credit to certain segments.
Not lend to certain segments
The BR ACT empowers RBI to give direction to banks as to
The purposes for which advances may or may not be made
The margin to be made in respect of secured advances ( like LTV
for gold loans)
The maximum quantum of advances or financial accommodation
which may eb given to any one company firm, association etc(eg
proposal to cut group exposure limit from 40% to 25% of net worth)
Maximum amount upto which guarantees may be given by a
banking company on behalf of any firm, association individual etc.
Rate of inteerst and other terms and conditions.
The techniques of selective credit controls generally used are
1. Minimum margins for lending against certain securities
2. Ceilings on the amount of credit for certain purposes and
3. Discriminatory rates of interest on certain types of advances’
Moral suasion: Apart from general and selective credit control
mechanisms, RBI has been informally communicating with banks
the need to provide credit to certain segments through discussions,
letters etc. This combined with government influence over
commercial banks, has helped in directed lending in a big way.
Monetary policy during present times
The instruments of monetary policy has evolved over the years. Apart
from usual instruments of CRR, OMOs and SLR, repos are also
widely used to manage system liquidity. There are both overnight
repos and term repo facilities available which enable banks to borrow
funds for short term needs and manage liquidity.
A snapshot of liquidity and rates
Month
LAF borrowing Term repo
MSF
Weighted
call rate
Weighted
CBLO rate
Jan2014
34665
69007
70
8.09
8.06
Feb 2014
29057
89015
1435
7.97
7.82
March 2014
34751
100019
425
8.03
8.21
April 2014
21691
61005
95
8.65
8.72
May 2014
9857
1709
A61005
snapshot of
liquidity7.96
7.87
June 2014
18663
70130
8880
8.10
7.75
July 2014
20792
91508
0
7.90
8.09
61512
0
7.71
7.93
August 2014 8118
Definitions of some terms:
LAF: This is Liquidity Adjustment Facility and is the window
through which commercial bans borrow from RBI overnight
funds. The rate at which funds are borrowed is repo rate
currently at 8%. Capped at 0.75% of NDTL.
Term repo: Under this window, funds are not borrowed overnight
but for periods ranging from 7-28 days. This window has been
introduced to develop money markets and to have a term
money market structure.
Marginal Standing facility (MSF). To meet emergency fund
requirements. Usually 1% above the repo .Currently at 9%.
Repo, reverse repo and MSF rates move at repo rate + and – 1%
bands. Thus change in the repo rate automatically changes
other two rates.
Banks can borrow from repo and term repo window depending
on the extent of excess SLR
FISCAL POLICY
Fiscal policy is concerned with raising revenue through taxes and other
means and deciding on the pattern of expenditure
Fiscal policy operates through the Budget. Budget is an estimate of
Government expenditure and revenue for the ensuing financial year
presented to the Parliament. During an election year, there is a vote-on
account and not a full fledged budget.
An estimate of all anticipated revenue and expenditure of the Union
Government for the ensuing financial year is laid out during the last
working day of February and is called the Annual Financial Statement.
It also covers the transactions of Central Govt within and outside India
during the year as well as the ensuing year.
All receipts and disbursements are recorded under two separate headsthe Consolidated Fund of India and Public Account of India. All
revenue received, loan raised etc form part of Cosolidated Fund and
withdrawal from it require authoirty under an Act of Parliament unlike
that from Public Account funds.
Structure of the Budget:
Budget is divided vertically into revenue receipts and expenditure
and horizontally into revenue account and capital account.
All revenue and expenditure which are currently incurred/accrued
are revenue receipts/expenditure. For instance, taxes are a part of
revenue receipts while expenditure on Govt administration is
revenue expenditure.
All receipts/expenditure which are incurred/accrue over a period of
time are called capital receipts/expenditure. For eg repayment of loan
is a capital receipt while spendingh on defence equipment is a capital
expenditure.
The Budget estimates are given by the Controller general of
Accounts (CGA).
\
The gap between total expenditure and receipts is known as
fiscal deficit which is bridged through borrowings. The
borrowings equiv alent to deficits is managed by RBI on
behalf of the Govt . For this Govt securities are auctioned
to banks and SLR stipulates banks to maintain certain
minimum investments in Govt securities.
Govt borrowing programme for current financial year
(2014-15) is INR 6 lakh crore. 60% is completed during
first half year. The target is to achieve a fiscal deficit target
of 4.1% for FY 2015.
Revenue deficit is the gap between revenue expenditure
and revenue receipts.
Primary deficit is the gap between fiscal deficit and inteerst
payments on government borrowings.
The constitution of India has earmarked separate sources of revenue
for the Centre and States. Moroever, the Finance Commission is
constituted every Five Years to make recommendations as to the
devolution of finances between Centre and States.
The Finance commission provides recommendations As to
1. The distribution between the Union and states of net tax proceeds and
share of states in such taxes
2. The principles governing grants in aid of states in need of assistance.
3. Any other matter referred to the commission by the President of India
The 14th Finance Commission headed by Dr. Y.V.Reddy is in
operation now.
As part from the Finance Commission, the Planning Commission
prepares the Five Year Plans. Now there is a proposal to scrap the
Plan panel.
The importance of Budget is significant, especially in developing
economies. Central Govt expenditures alone account for almost a fifth
of GDP. In a developing country like Inia,. A Budget msut serve the
following objectives.
1. Accelerate the pace of development by resource mobilisation and
effective allocation
2. Facilitate improvement in productive capability of private enterprises
3. Effect improvement in income distribution
4. Promote exports and encourage import substitution
5. Achieve economic stabilisatyion
Apart from the above, various fiscal incentives and disincentives may
also be employed in the Budget.
MONEY A& CAPITAL MARKET
Money Market refers to the market for short term funds and capital
market is the market for longer term funds
Money Market: The major constituents of money markets are
commercial banks, mutual funds and a strong central bank. The
central bank is considered as the ‘presiding deity’ in the money
market.
In Inda there are both organized and unorganised versions of money
market- unorganized versions consist of money lenders indigenous
lenders. This segment is characterized lack of uniformity and is
outside RBI control.
As the RBI observes rightly, a developed money market is very
important for smooth conduct of monetary policy and it is through
this market than RBI comes in direct contact with market players.
Important functions of a money market are as follows:
1. Augmenting system liquidity
2. Efficient function helps to minimize volatility in money market
3. By imparting funds at lower cost, helps lower cost of funds
4. A developed money market ensures quick transfer of funds from one
place to another
5. By providing an avenue for short term surplus funds, helps financial
institutions to enhance profitability.
6. Enhances the amount of liquidity available to the entire country
7. Augments the supply of funds
CAPITAL MARKET
Capital market is usually referred to as the market for long term
funds. However, many a time, the same institutions receive and supply
long term and short term funds. To that extent, the distinction between
the two is blurred. Both the markets are inter dependent.
Commercial banks, cooperative banks, insurance companies etc are
constituents of capital market.
capital market has three main components- the lenders, borrowrs and
financial intermediaries.
Capital market comprises of not only initial fund raising (IPOs) but
also trading of shares in the secondary market.
developed countries have well developed money markets and capital
markets. In India, our money markets and capital market is fairly well
developed.
Importance of capital market
 Capital market determines the pace of economic development by
channelizing savings into capital formation. In India, rate of capital
formation is slow at present.
 A developed capital market provides number of investment
opportunities for small investors
 They help in augmenting resources by attracting and lending funds
on a global scale.
 An organized capital market can pool together even the scattered
savings and augment the availability of investible funds.
 A developed capital market provides investment opportunities for
small investors
Developments Indian capital market
 Open outcry system replaced by screen based trading system
 Framing of insider trading regulations
 FIIs allowed to invest in equities
 Development of Futures & Options segment