Indian Financial System


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Indian Financial System

E XECUTIVE S UMMARY In 1990s, the balance of payments position facing the country had become critical and foreign exchange reserves had depleted to dangerously low levels i.e. $585 million, which was sufficient for financing just one week of India's exports. Since the initiation of reforms in the early 1990s, the Indian economy has achieved high growth in an environment of macroeconomic and financial stability. The period has been marked by broad based economic reform that has touched every segment of the economy. of greater competition. The story of Indian reforms is by now well-documented, nevertheless, what is less appreciated is that India achieved this acceleration in growth while maintaining price and financial stability. As a result of the growing openness, India was not insulated from exogenous shocks since the second half of the 1990s. These shocks, global as well as domestic, included a series of financial crises in Asia, Brazil and Russia, 9/11 terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests, political uncertainties, changes in the Government, and the current oil shock. Nonetheless, stability could be maintained in financial markets. These reforms were designed essentially to promote greater efficiency in the economy through promotion


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Indian Financial System

Indeed, inflation has been contained since the mid-1990s to an average of around five per cent, distinctly lower than that of around eight per cent per annum over the previous four decades. Simultaneously, the health of the financial sector has recorded very significant improvement. India's path of reforms has been different from most other emerging market economies: it has been a measured, gradual, cautious, and steady process, devoid of many flourishes that could be observed in other countries. Reforms in these sectors have been well-sequenced, taking into account the state of the markets in the various segments. The main objective of the financial sector reforms in India initiated in the early 1990s was to create an efficient, competitive and stable financial sector that could then contribute in greater measure to stimulate growth. For efficient price discovery of interest rates and exchange rates in the overall functioning of financial markets, the corresponding development of the money market, Government securities market and the foreign exchange market became necessary. Reforms in the various segments, therefore, had to be coordinated. for. Till the early 1990s the Indian financial system was characterized by extensive regulations such as administered interest rates, directed credit programmes, weak banking structure, lack of proper accounting and risk
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In this process, growing integration of the Indian

economy with the rest of the world also had to be recognized and provided

Indian Financial System

management systems and lack of transparency in operations of major financial market participants. Such a system hindered efficient allocation of resources. Financial sector reforms initiated in the early 1990s have attempted to overcome these weaknesses in order to enhance efficiency of resource allocation in the economy. Simultaneously, the Reserve Bank took a keen interest in the development of financial markets, especially the money, government securities and forex markets in view of their critical role in the transmission mechanism of monetary policy. As for other central banks, the money market is the focal point for intervention by the Reserve Bank to equilibrate short-term liquidity flows on account of its linkages with the foreign exchange market. Similarly, the Government securities market is important for the entire debt market as it serves as a benchmark for pricing other debt market instruments, thereby aiding the monetary transmission process across the yield curve. The Reserve Bank had, in fact, been making efforts since 1986 to develop institutions and infrastructure for these markets to facilitate price discovery. These efforts by the Reserve Bank to develop efficient, stable and healthy financial markets accelerated after 1991. There has been close co-ordination between the Central Government and the Reserve Bank, as also between different regulators, which helped in orderly and smooth development of the financial markets in India.


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Indian Financial System


 Introduction
 Features of Financial System  Role of Financial System  Back Drop of Financial System  Indian Financial System from 1950 – 1980  Indian Financial System Post 1990’s


Thakur College Of Science & Commerce

Indian Financial System

The financial system or the financial sector of any country consists of:(a) specialized & non specialized financial institution (b) organized &unorganized financial markets and (c) Financial instruments & services which facilitate transfer of funds. Procedure & practices adopted in the markets, and financial inter relationships are also the parts of the system. These parts are not always mutually exclusive. For example, the financial institution operate in financial market and are, therefore a part of such market. The word system in the term financial system implies a set of complex and closely connected or inters mixed institution, agents practices, markets, transactions, claims, & liabilities in the economy. The financial system is concerned about money, credit, & finance – the terms intimately related yet some what different from each other. Money refers to the current medium of exchange or means of payment. Credit or Loan is a sum of money to be returned normally with Interest it refers to a debt of economic unit. Finance is a monetary resources comprising debt & ownership fund of the state, company or person.


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Indian Financial System

1. It provides an Ideal linkage between depositors savers and Investors Therefore it encourages savings and investment. 2. Financial system facilitates expansion of financial markets over a period of time. 3. Financial system should promote deficient allocation of financial resources of socially desirable and economically productive purpose. 4. Financial system influence both quality and the pace of economic development.

The role of the financial system is to promote savings & investments in the economy. It has a vital role to play in the productive process and in the mobilization of savings and their distribution among the various productive activities. Savings are the excess of current expenditure over income. The domestic savings has been categorized into three sectors, household, government & private sectors. The savings from household sector dominates the domestic savings component. The savings will be in the form of currency, bank deposits, non bank deposits, life insurance funds, provident funds, pension funds, shares, debentures, bonds, units & trade debts. All of these currency & deposits are voluntary transactions & precautionary measures. The


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Indian Financial System

savings in the household sector are mobilized directly in the form of units, premium, provident fund, and pension fund. These are the contractual forms of savings. Financial actively deals with the production, distribution & consumption of goods and services. The financial system will provide inputs to productive activity. Financial sector provides inputs in the form of cash credit & assets in financial for production activities. The function of a financial system is to establish a bridge between the savers and investors. It helps in mobilization of savings to materialize investment ideas into realities. It helps to increase the output towards the existing production frontier. The growth of the banking habit helps to activate saving and undertake fresh saving. The financial system encourages investment activity by reducing the cost of finance risk. It helps to make investment decisions regarding projects by sponsoring, encouraging, export project appraisal, feasibility studies, monitoring & execution of the projects.


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Indian Financial System

An overview of Financial System and Financial Markets in India

Financial Institutions




Insurance company

Mutual Fund

Venture Capital Fund

Capital Market

Commercial Banks


Money Market

LIC & Other

GIC & Other

Primary Market Development Banks Investment Banks Sectoral Banks State Level Financial Institution

Secondary Market

Stock Exchange

Government Security Market


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Indian Financial System


At the time of independence, India had a reasonably diversified financial system in terms of intermediaries but a somewhat narrow focus on terms of
Industry’s share in credit doubled, agriculture, rural areas, SSI, exports still neglected

RRBs setup






Neglected: long term, agricultural, and rural area credit Need for specialized FIs felt. DFIs, SFCs, UTI, Co-op Banks setup.

Nationalisation of Banks to ensure credit allocation as per plan priorities


Credit to Industry / Govt doubled Highly segmented financial market, highly restricted

intermediation, i.e., a lack of a long term capital market and the relative neglect of agriculture in particular and rural areas in general. As India embarked on a process of industrialization and growth, RBI set up Development Financial Institutions (DFI’s) and State Finance Corporations (SFC’s) as providers of long term capital. Agriculture’s need for credit was met by cooperative banks. UTI was set up to canalize resources from retail investors to the capital market. In essence, the understanding that requirement of financial needs for accelerated growth and development was best met by specialized financial


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Indian Financial System

intermediaries who performed specialized functions influenced financial market architecture. To ensure that these specializations were adhered to, financial intermediaries developed and promoted by the Reserve Bank of India had significant restrictions on both the asset and liabilities side of their balance sheets. In the 1950s and 1960s, despite an expansion of the commercial banking system in terms of both reach and mobilization of resources, agriculture still remained under funded and rural areas under banked. Whereas industry’s share in credit disbursed almost doubled between 1951 and 1968, from 34 to 67.5%, agriculture got barely 2% of available. Credit to exports and small scale industries were relatively neglected as well. In view of the above, it was decided to nationalize the banking sector so that credit allocation could take place in accordance in plan priorities. Nationalization took place in two phases, with a first round in 1969 followed by another in 1980. By the mid-seventies it was felt that commercialized banks did not have sufficient expertise in rural banking and hence in 1975 Regional Rural Banks (RRBs) were set up to help bring rural India into the ambit of the financial network. This effort was capped in 1980 with the formation of National Bank for Agriculture and Rural Development (NABARD), which was to function as an apex bank for all cooperative banks in the country, helping control and guide their activities. NABARD was also given the remit of regulating rural credit cooperatives.
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Indian Financial System

Following with the logic of specialization, the 1980s saw other DFIs with specific remits being set up – e.g. The EXIM Bank for export financing, the Small Industries Development Bank of India (SIDBI) for small scale industries and the National Housing Bank (NHB) for housing finance. Long term finance for the private sector came from DFIs and institutional investors or through the capital market. However both price and quantity of capital issues was regulated by the Controller of Capital Issues. At least one indicator of the fact that the strategy paid off in deepening financial intermediation is the near doubling of the M3/GDP (see Error: Reference source not found Error: Reference source not found For more details on various types of money supplies) ratio from 24.1% in 1970/71 to 48.5 in 1990/91. Over the same period, bank credit to the commercial sector as a proportion of GDP more than doubled from 14.3 to 30.2%. However net bank credit to government (including lending by the Reserve Bank) doubled as well, from 12 to 24.6%. Therefore the deepening of financial intermediation had occurred with an increase in the draft by both the commercial sector and the government on financial resources mobilized. At the end of the 1980s then the Indian financial system was characterized by segmented financial markets with significant restrictions on both the asset and liability side of the balance sheet of financial intermediaries as well as the price at which financial products could be offered.


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Indian Financial System

In the Indian context segmentation meant that competition was muted. In a scenario where price was determined from outside the system and targets were set in terms of quantities, there was no pressure for non-price competition as well. As a result the financial system had relatively high transaction costs and political economy factors meant that asset quality was not a prime concern. Therefore even though the Indian financial system at the end of 1980s had achieved substantial expansion in terms of access, this had come at the cost of asset quality. In addition, was the fact that the draft of the government on resources of the financial system had increased significantly. This in itself need necessarily was not a problem but over this period, i.e., the 1980s, the composition of government expenditure was changing as well, with shift towards current rather than capital expenditure. In addition, in the absence of a reasonably liquid market for government securities, an increase in net bank lending to the government meant that the asset side of banks’ balance sheets tended to become increasingly illiquid. The impetus for change came from one expected and one unexpected quarter - first, the importance of prudential capital adequacy ratios was underlined by the announcement of BaselI norms (see Error: Reference source not found Error: Reference source not found) That banks were expected to adhere to; second the macroeconomic crisis of 1990-91. The reform process that followed accelerated the process of liberalization already begun in the 1980s and began a series of measured and deliberate steps to integrate India into the global economy, including the global financial network.


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Briefly however, given the problems facing the financial system and keeping in mind the institutional changes necessary to help India financially integrate into the global economy, financial reform focused on the following: improving the asset quality on bank balance sheets in particular and operational efficiency in general; increasing competition by removing regulatory barriers to entry; increasing product competition by removing restrictions on asset and liability sides of financial intermediaries; allowing financial intermediaries freedom to set their prices; putting in place a market for government securities; and improving the functioning of the call money market. The government security market was particularly important not only because it was decided the RBI would no longer monetize the fiscal deficit, which would now be financed by directly borrowing from the market, but also monetary policy would be conducted through open market operations and a large liquid bond market would help the RBI sterilise, if necessary, foreign exchange movements.


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Indian Financial System

Indian Financial System During this period evolved in response to the objective of planned economic development. With the adoption of mixed economy as a pattern of industrial development, a complimentary role was conceived for public and private sector. There was a need to align financial system with government economic policies. At that time there was government control over distribution of credit and finance. The main elements of financial organization in planned economic development are as follows:1. Public ownership of financial institutions – The nationalization of RBI was in 1948, SBI was set up in 1956, LIC came in to existence in 1956 by merging 245 life insurance companies in 1969, 14 major private banks were brought under the direct control of Government of India. In 1972, GIC was set up and in 1980; six more commercial banks were brought under public ownership. Some institutions were also set up during this period like development banks, term lending institutions, UTI was set up in public sector in 1964, provident fund, pension fund was set up. In this way public sector occupied commanding position in Indian Financial System. 2. Fortification Of Institutional structure – Financial institutions should stimulate / encourage capital formation in the economy. The important feature of well developed financial system is


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Indian Financial System

strengthening of institutional structures. Development banks was set up with this objective like industrial finance corporation of India (IFCI) was set up in 1948, state financial corporation (SFCs) were set up in 1951, Industrial credit and Investment corporation of India Ltd (ICICI)was set up in 1955. It was pioneer in many respects like underwriting of issue of capital, channelisation of foreign currency loans from World Bank to private industry. In 1964, Industrial Development of India (IDBI). 3. Protection of Investors – Lot many acts were passed during this period for protection of investors in financial markets. The various acts Companies Act, 1956 ; Capital Issues Control Act, 1947 ; Securities Contract Regulation Act, 1956 ; Monopolies and Restrictive Trade Practices Act, 1970 ; Foreign Exchange Regulation Act, 1973 ; Securities & Exchange Board of India, 1988. 4. Participation in Corporate Management – As participation were made by large companies and financial instruments it leads to accumulation of voting power in hands of institutional investors in several big companies financial instruments particularly LIC and UTI were able to put considerable pressure on management by virtual of their voting power. The Indian Financial System between 1951 and mid80’s was broad based number of institutions came up. The system was characterized by diversifying organizations which used to perform number of functions. The Financial structure with considerable strength and capability of supplying industrial capital to various enterprises was gradually built up the whole financial system came under the ownership and control of public authorities in this manner public sector occupy a commanding position in the industrial
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Indian Financial System

enterprises. Such control was viewed as integral part of the strategy of planned economy development.

The organizations of Indian Financial system witnessed transformation after launching of new economic policy 1991. The development process shifted from controlled economy to free market for these changes were made in the economic policy. The role of government in business was reduced the measure trust of the government should be on development of infrastructure, public welfare and equity. The capital market an important role in allocation of resources. The major development during this phase are:-

1. Privatisation of Financial Institutions – At this time many institutions were converted in to public company and number of private players were allowed to enter in to various sectors: a) Industrial Finance Corporation on India (IFCI): The pioneer development finance institution was converted in to a public company.
b) Industrial

Development Bank of India & Industrial Finance

Corporation of India (IDBI & IFCI): IDBI & IFCI ltd offers their equity capital to private investors. c) Private Mutual Funds have been set up under the guidelines prescribed by SEBI.
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Indian Financial System

d) Number of private banks and foreign banks came up under the RBI guidelines. Private institution companies emerged and work under the guidelines of IRDA, 1999. e) In this manner government monopoly over financial institutions has been dismantled in phased manner. IT was done by converting public financial institutions in joint stock companies and permitting to sell equity capital to the government. 2. Reorganization of Institutional Structure – The importance of development financial institutions decline with shift to capital market for raising finance commercial banks were give more funds to investment in capital market for this. SLR and CRR were produced; SLR earlier @ 38.5% was reduced to 25% and CRR which used to be 25% is at present 5%. Permission was also given to banks to directly undertake leasing, hire-purchase and factoring business. There was trust on development of primary market, secondary market and money market. 3. Investors Protection – SEBI is given power to regulate financial markets and the various intermediaries in the financial markets.


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 Money Market  Call Money Market  Commercial Paper  Certificate of Deposit  Treasury Bill Market  Money Market Mutual Fund  Capital Market  International Capital Market


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Indian Financial System

Money market deal with short term monetary assets and claims, which are generally from one day to one year duration. Govt. securities on the other hand are also called dated securities to denote that they are generally long term in nature and are issued by state and central govt. under their borrowing programmes and duration of more than one year, generally of 5 years and above. These securities being long term in nature are also traded in govt. securities market between institution and banks also on the stock exchanges- debt segments.

One of the important function of a well developed money market is to channelize saving into short term productive investments like working capital. Call money market, treasury bills market and markets for commercial paper and certificate of deposit are some of the example of money market.

The call money markets form a part of the national money market, where day –to- day surplus funds, mostly of banks are traded . The call money loans are very short term in nature and the maturity period of this vary from 1 to 15 days. The money which is lent for one day in this market is known as
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“call money”, and if it exceeds one day (but less than 15 days), is referred as “notice money” in this market any amount could be lent or borrowed at a convenient interest rate . Which is acceptable to both borrower and lender .these loans are consider as highly liquid as they are repayable on demand at the option of ether the lender or borrower.

Call money is borrowed from the market to meet various requirements of commercial bill market and commercial banks. Commercial bill market borrower call money for short period to discount commercial bills. Banks borrower in call market to: 1:- Fill the temporary gaps, or mismatches that banks normally face. 2:- Meet the cash Reserve Ratio requirement. 3: - Meet sudden demand for fund, which may arise due to large payment and remittance. Banks usually borrow form the market to avoid the penal interest rate for not meeting CRR requirement and high cost of refinance from RBI. Call money helps the banks to maintain short term liquidity position at comfortable level.

In India call money markets are mainly located in commercial centers and big industrial centers and industrial center such as Mumbai, Calcutta, Chennai, Delhi and Ahmedabad. As BSE and NSE and head office of RBI


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and many other banks are situated in Mumbai; the volume of funds involved in call money market in Mumbai is far bigger than other cities.

Initially, only few large banks were operating in the bank market. however the market had expanded and now scheduled , non scheduled commercial banks foreign banks ,state , district, and urban cooperative banks , financial institution such as LIC,UTI,GIC, and its subsidiaries , IDBI, NABARD, IRBI, ECGC, EXIM Bank, IFCI, NHB , TFCI, and SIDBI, Mutual fund such as SBI Mutual fund . LIC Mutual funds. And RBI Intermediaries like DFHI and STCI are participants in local call money markets. However RBI has recently introduced restriction on some of the participants to phase them out of call money market in a time bound manner. Participant in call money market are split into two categories

1:- BORROWER AND LENDER:This comprises entities those who can both borrower and lend in this market, such as RBI, intermediaries like DFHI, and STCI and commercial banks.

2:- ONLY LENDER: This category comprises of entities those who can act only as lender, like financial institution and mutual funds.


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The interest paid on call loan is known as the call rates. Unlike in the case of other short and long rates. The call rate is expected to freely reflect the day to day availability and long rates. These rates vary highly from day to day. Often from hour to hour. While high rates indicate a tightness of liquidity position in market. The rate is largely subject to be influenced by sources of supply and demand for funds. The call money rate had fluctuated from time to time reflecting the seasonal variation in fund requirements. Call rates climbs high during busy seasons in relation to those in slack season. These seasonal variations were high due to a limited number of lender and many borrowers. The entry of financial institution and money market mutual funds into the call market has reduced the demand supply gap and these fluctuations gradually came down in recent years. Though the seasonal fluctuations were reduced to considerable extent, there are still variations in the call rates due to the following reason: 1:- large borrower by banks to meet the CRR requirements on certain dates cause a gate demand for call money. These rates usually go up during the first week to meet CRR requirements and decline afterwards. 2:- the sanction of loans by banks, in excess of their own resources compel the bank to rely on the call market. Banks use the call market as a source of funds for meeting dis-equilibrium of inflow and out flow of fund s.


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3:- the withdrawal of funds to pay advance tax by the corporate sector leads to steep increase in call money rates in the market.

Commercial paper are short term, unsecured promissory notes issued at a discount to face value by well- known companies that are financial strong and carry a high credit rating . They are sold directly by the issuers to investor, or else placed by borrowers through agents like merchant banks and security houses the flexible maturity at which they can be issued are one of the main attraction for borrower and investor since issues can be adapted to the needs of both. The CP market has the advantage of giving highly rated corporate borrowers cheaper fund than they could obtain from the banks while still providing institutional investors with higher interest earning than they could obtain form the banking system the issue of CP imparts a degree of financial stability to the systems as the issuing company has an incentive to remain financially strong.

1. They are negotiable by endorsement and delivery.

2. They are issued in multiple of Rs 5 lakhs.
3. The maturity varies between 15 days to a year. 4. No prior approval of RBI is needed for CP issued.

5. The tangible net worth issuing company should not be less than 4 lakhs 6. The company fund based working capital limit should not less than Rs 10 crore.


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7. The issuing company shall have P2 and A2 rating from CRISIL and ICRA.

Certificate of Deposits,. Instruments such as the Certificates of Deposit (CDs introduced in 1989), Commercial Paper (CP introduced in 1989), inter-bank participation certificates (with and without risk) were introduced to increase the range of instruments. Certificates of Deposit are basically negotiable money market instruments issued by banks and financial institutions during tight liquidity conditions. Smaller banks with relatively smaller branch networks generally mobilise CDs. As CDs are large size deposits, transaction costs on CDs are lower than retail deposits

1. All scheduled bank other than RRB and scheduled cooperative bank are eligible to issue CDs. 2. CDs can be issued to individuals, corporation, companies, trust, funds and associations. NRI can subscribe to CDs but only on a non- repatriation basis. 3. They are issued at a discount rate freely determined by the issuing bank and market. 4. They issued in the multiple of Rs 5 lakh subject to minimum size of each issue of Rs is 10 lakh.


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Indian Financial System

5. The bank can issue CDs ranging from 3 month t 1 year , whereas financial institution can issue CDs ranging from 1 year to 3 years.

TREASURY BILLS MARKET:Treasury bills are the main financial instruments of money market. These bills are issued by the government. The borrowings of the government are monitored & controlled by the central bank. The bills are issued by the RBI on behalf of the central government. The RBI is the agent of Union Government. They are issued by tender or tap. The bills were sold to the public by tender method up to 1965. These bills were put at weekly auctions. A treasury bill is a particular kind of finance bill. It is a promissory note issued by the government. Until 1950 these bills were also issued by the state government. After 1950 onwards the central government has the authority to issue such bills. These bills are greater liquidity than any other kind of bills. They are of two kinds: a) ad hoc, b) regular. Ad hoc treasury bills are issued to the state governments, semi government departments & foreign ventral banks. They are not marketable. The ad hoc bills are not sold to the banks & public. The regular treasury bills are sold to the general public & banks. They are freely marketable. These bills are sold by the RBI on behalf of the central government. The treasury bills can be categorized as follows:26 Thakur College Of Science & Commerce

Indian Financial System

1) 14 days treasury bills:The 14 day treasury bills has been introduced from 1996-97. These bills are non-transferable. They are issued only in book entry system they would be redeemed at par. Generally the participants in this market are state government, specific bodies & foreign central banks. The discount rate on this bill will be decided at the beginning of the year quarter.
2) 28 days treasury bills:-

These bills were introduced in 1998. The treasury bills in India issued on auction basis. The date of issue of these bills will be announced in advance to the market. The information regarding the notified amount is announced before each auction. The notified amount in respect of treasury bills auction is announced in advance for the whole year separately. A uniform calendar of treasury bills issuance is also announced.
3) 91 days treasury bills:-

The 91 days treasury bills were issued from July 1965. These were issued tap basis at a discount rate. The discount rates vary between 2.5 to 4.6% P.a. from July 1974 the discount rate of 4.6% remained uncharged the return on these bills were very low. However the RBI provides rediscounting facility freely for this bill.
4) 182 days treasury bills:-

The 182 days treasury bills was introduced in November 1986. The chakravarthy committee made recommendations regarding 182 day
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treasury bills instruments. There was a significant development in this market. These bills were sold through monthly auctions. These bills were issued without any specified amount. These bills are tailored to meet the requirements of the holders of short term liquid funds. These bills were issued at a discount. These instruments were eligible as securities for SLR purposes. These bills have rediscounting facilities.
5) 364 days treasury bills:-

The 364 treasury bills were introduced by the government in April 1992. These instruments are issued to stabilise the money market. These bills were sold on the basis of auction. The auctions for these instruments will be conducted for every fortnight. There will be no indication when they are putting auction. Therefore the RBI does not provide rediscounting facility to these bills. These instruments have been instrumental in reducing, the net RBI credit to the government. These bills have become very popular in India.

Money Market Mutual Funds (MMMFs)
The benefits of developments in the various in the money market like cell money loans. Treasury bills, commercial papers and certificate of deposits were available only to the few institutional participants in the market. The main reason for this was that huge amounts were required to be invested in these instruments, the minimum being Rs. 10 lack, which was beyond the means of individual money markets to small investors.


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MMMFs are mutual funds that invest primarily in money market instruments of very high quality and of very short maturities. MMMFs can be set up by very high quality and of very short maturities. MMMFs can be set up by commercial bank, RBI and public financial institution either directly or through their existing mutual fund subsidiaries. The guidelines with respect to mobilization of funds by MMMFs provide that only individuals are allowed to invest in such funds. Earlier these funds were regulated by the RBI. But RBI withdrew its guidelines, with effect form March 7, 2001 and now they are governed by SEBI. The schemes offered by MMMfs can either by open – ended or closeended. In case of open- ended schemer, the units are available for purchase on a continuous basis and the MMMFs would be willing to repurchase the units. A close –ended scheme is available for subscription for a limited period and is redeemed at maturity. The guidelines on the on MMMfs specify a minimum lock – in period of 15 days during which the investor cannot redeem his investment. The guidelines also stipulate the minimum size of the MMMF to be Rs. 50 crore and this should not exceed 2% of the aggregate deposits of the latest accounting year in the case of banks and 2% of the longterm domestic borrowings in the case of public financial institutions.


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Structure of capital market

Primary Market

Secondary Market



Practices of Settlements & Clearing

Method of Issue

Quantum of Issue

Costs of Issue

Public Issue

Right Issue

Bonus Issue

Private Placement




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Indian Financial System

Companies (Issuer)

Instruments Interest Rates

Intermediaries (Merchant Banks FIIs & Broker) Investor (Public)


Capital market is market for long term securities. It contains financial instruments of maturity period exceeding one year. It involves in long term nature of transactions. It is a growing element of the financial system in the India economy. It differs from the money market in terms of maturity period & liquidity. It is the financial pillar of industrialized economy. The development of a nation depends upon the functions & capabilities of the capital market. Capital market is the market for long term sources of finance. It refers to meet the long term requirements of the industry. Generally the business concerns need two kinds of finance:1. Short term funds for working capital requirements. 2. Long term funds for purchasing fixed assets. Therefore the requirements of working capital of the industry are met by the money market. The long term requirements of the funds to the corporate sector are supplied by the capital market. It refers to the institutional arrangements which facilitate the lending & borrowing of long term funds.

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Capital market deals with long term funds. These funds are subject to uncertainty & risk. Its supplies long term funds & medium term funds to the corporate sector. It provides the mechanism for facilitating capital fund transactions. It deals I ordinary shares, bond debentures & stocks & securities of the governments. In this market the funds flow will come from savers. It converts financial assets in to productive physical assets. It provides incentives to savers in the form of interest or dividend to the investors. It leads to the capital formation. The following factors play an important role in the growth of the capital market:• A strong & powerful central government. • Financial dynamics • Speedy industrialization • Attracting foreign investment • Investments from NRI’s • Speedy implementation of policies • Regulatory changes • Globalization • The level of savings & investments pattern of the household sectors • Development of financial theories • Sophisticated technological advances.

Capital market is a market for long term funds. It requires a well structured market to enhance the financial capability of the country. The market consist a number of players. They are categorized as:1. Companies
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2. Financial intermediaries 3. Investors.


Generally every company which is a public limited company can access the capital market. The companies which are in need of finance for their project can approach the market. The capital market provides funds from the savers of the community. The companies can mobilize the resources for their long term needs such as project cost, expansion & diversification of projects & other expenditure of India to raise the capital from the market. The SEBI is the most powerful organization to monitor, control & guidance the capital market. It classifies the companies for the issue of share capital as new companies, existing unlisted companies& existing listed companies. According to its guidelines a company is a new company if it satisfies all the following:a) operations. b) c) Its audited operative results are not available. The company may set up by entrepreneurs with or without The company shall not complete 12 months of commercial

track record. A company which can be treated as existing listed company, if its shares are listed in any recognized stock exchange in India. A company is said to be an existing unlisted company if it is a closely held or private company.




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Financial intermediaries are those who assist in the process of converting savings into capital formation in the country. A strong capital formation process is the oxygen to the corporate sector. Therefore the intermediaries occupy a dominant role in the capital formation which ultimately leads to the growth of prosperous to the community. Their role in this situation cannot be. The government should encourage these intermediaries to build a strong financial empire for the country. They are also being called as financial architectures of the India digital economy. Their financial capability cannot be measured. They take active role in the capital market. The major intermediaries in the capital market are:a) Brokers. b) Stock brokers & sub brokers c) Merchant bankers d) Underwriters e) Registrars f) Mutual funds g) Collecting agents h) Depositories i) Agents j) Advertising agencies


The capital market consists many numbers of investors. All types of investor’s basic objective is to get good returns on their investment. Investment means, just parking one’s idle fund in a


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right parking place for a stipulated period of time. Every parked vehicle shall be taken away by its owners from parking place after a specific period. The same process may be applicable to the investment. Every fund owner may desire to take away the fund after a specific period. Therefore safety is the most important factor while considering the investment proposal. The investors comprise the financial investment companies & the general public companies. Usually the individual savers are also treated as investors. Return is the reward to the investors. Risk is the punishment to the investors for being wrong selection of their investment decision. Return is always chased by the risk. An intelligent investor must always try to escape the risk & attract the return. All rational investors prefer return, but most investors are risk average. They attempt to get maximum capital gain. The return can be available to the investors in two types they are in the form of revenue or capital appreciation. Some investors will prefer for revenue receipt & others prefer capital appreciation. It depends upon their economic status & the effect of tax implications.

The structure of the capital market has undergone vast changes in recent years. The Indian capital market has transformed into a new appearance over the last four & a half decades. Now it comprises an impressive network of financial institutions & financial instruments. The market for already issued securities has become more sophisticated in response to the different needs of the investors. The specialized financial institutions were involved in


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providing long term credit to the corporate sector. Therefore the premier financial institutions such as ICICI, IDBI, UTI, and LIC & GIC constitute the largest segment. A number of new financial instruments & financial intermediaries have emerged in the capital market. Usually the capital markets are classified in two ways:A. On the basis of issuer B. On the basis of instruments On the basis of issuer the capital market can be classified again two types:a) b) two kinds:a) Equity market b) Debt market Recently there has been a substantial development of the India capital market. It comprises various submarkets. Equity market is more popular in India. It refers to the market for equity shares of existing & new companies. Every company shall approach the market for raising of funds. The equity market can be divided into two categories (a) primary market (b) secondary market. Debt market represents the market for long term financial instruments such as debentures, bonds, etc. Corporate securities market Governments securities market

On the basis of financial instruments the capital markets are classifieds into



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To meet the financial requirement of their project company raise their capital through issue of securities in the company market. Capital issue of the companies were controlled by the capital issue control act 1947. Pricing of issue was determined by the controller of capital issue the main purpose of control on capital issue was to prevent the diversion of investible resources to non- essential projects. Through the necessity of retaining some sort of control on issue of capital to meet the above purpose still exist . The CCI was abolished in 1992 as the practice of government control over the capital issue as well as the overlapping of issuing has lost its relevance in the changed circumstances.

It was set up in 1988 through administrative order it became statutory body in 1992. SEBI is under the control of Ministry of Finance. Head office is at Mumbai and regional offices are at Delhi, Calcutta and Chennai. The creation of SEBI is with the objective to replace multiple regulatory structures. It is governed by six member board of governors appointed by government of India and RBI.

1. To protect the interest of investors in securities. 2. To regulate securities market and the various intermediaries in the market. 3. To develop securities market over a period of time.
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POWERS AND FUNCTIONS OF SEBI: (1) ISSUE GUIDELINES TO COMPANIES:SEBI issues guidelines to the companies for disclosing information and to protect the interest of investor. The guidelines relates to issue of new shares, issue of convertible debentures, issue by new companies, etc. After abolition of capital issues control act, SEBI was given powers to control and regulate new issue market as well as stock exchanges.

(2) REGULATION OF PORTFOLIO MANAGEMENT SERVICES:Portfolio Management services were brought under SEBI regulations in January 1993. SEBI framed regulations for portfolio management keeping securities scams in mind. SEBI has been entrusted with a job to regulate the working of portfolio managers in order to give protections to investors.

(3) REGULATION OF MUTUAL FUNDS:The mutual funds were placed under the control of SEBI on January 1993. Mutual funds have been restricted from short selling or carrying forward transactions in securities. Permission has been granted to invest only in transferable securities in money market and capital market.

(4) CONTROL ON MERCHANT BANKING:38 Thakur College Of Science & Commerce

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Merchant bankers are to be authorized by SEBI, they have to follow code of conduct which makes them responsible towards the investors in respect of pricing, disclosure of/ in the prospectus and issue of securities, merchant bankers have high degree of accountability in relation to offer documents and issue of shares.

(5) ACTION FOR DELAY IN TRANSFER AND REFUNDS:SEBI has prosecuted many companies for delay in transfer of shares and refund of money to the applicants to whom the shares are not allotted. These also gives protection to investors and ensures timely payment in case of refunds.

(6) ISSUE GUIDELINES TO INTERMEDIARIES:SEBI controls unfair practices of intermediaries operating in capital market, such control helps in winning investors confidence and also gives protection to investors.

(7) GUIDELINES FOR TAKEOVERS AND MERGERS:SEBI makes guidelines for takeover and merger to ensure transparency in acquisitions of shares, fair disclosure through public announcement and also to avoid unfair practices in takeover and mergers.

(8) REGULATION OF STOCK EXCHANGES FUNCTIONING:39 Thakur College Of Science & Commerce

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SEBI is working for expanding the membership of stock exchanges to improve transparency, to shorten settlement period and to promote professionalism among brokers. All these steps are for the healthy growth of stock exchanges and to improve their functioning.

(9) REGULATION OF FOREIGN INSTITUTIONAL INVESTMENT (FIIS):SEBI has started registration of foreign institutional investment. It is for effective control on such investors who invest on a large scale in securities.

A company can raise its capital through issue of share and debenture by means of :-

PUBLIC ISSUE :Public issue is the most popular method of raising capital and involves raising capital and involve raising of fund direct from the public .

RIGHT ISSUE :Right issue is the method of raising additional finance from existing members by offering securities to them on pro rata basis. A company proposing to issue securities on right basis should send a letter of offer to the shareholders giving adequate discloser as to how the additional amount received by the issue is used by the company.


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BONUS ISSUE:Some companies distribute profits to existing shareholders by way of fully paid up bonus share in lieu of dividend. Bonus share are issued in the ratio of existing share held. The shareholder do not have to nay additional payment for these share .

PRIVATE PLACEMENT :private placement market financing is the direct sale by a public limited company or private limited company of private as well as public sector of its securities to a limited number of sophisticated investors like UTI , LIC , GIC state finance corporation and pension and insurance funds the intermediaries are credit rating agencies and trustees and financial advisors such as merchant bankers. And the maximum time – frame required for private placement market is only 2 to 3 months. Private placement can be made out of promoter quota but it cannot be made with unrelated investors.

The secondary market is that segment of the capital market where the outstanding securities are traded from the investors point of view the secondary market imparts liquidity to the long – term securities held by them by providing an auction market for these securities. The secondary market operates through the medium of stock exchange which regulates the trading activity in this market and ensures a measure of safety and fair dealing to the investors.


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India has a long tradition of trading in securities going back to nearly 200 years. The first India stock exchange established at Mumbai in 1875 is the oldest exchange in Asia. The main objective was to protect the character status and interest of the native share and stock broker.

Bombay Stock Exchange is the oldest stock exchange in Asia with a rich heritage, now spanning three centuries in its 133 years of existence. What is now popularly known as BSE was established as "The Native Share & Stock Brokers' Association" in 1875. BSE is the first stock exchange in the country which obtained permanent recognition (in 1956) from the Government of India under the Securities Contracts (Regulation) Act 1956. BSE's pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. It migrated from the open outcry system to an online screen-based order driven trading system in 1995. Earlier an Association of Persons (AOP), BSE is now a corporatised and demutualised entity incorporated under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). With demutualisation, BSE has two of world's best exchanges, Deutsche Börse and Singapore Exchange, as its strategic partners.

Over the past 133 years, BSE has facilitated the growth of the Indian
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corporate sector by providing it with an efficient access to resources. There is perhaps no major corporate in India which has not sourced BSE's services in raising resources from the capital market.

Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the world's 5th in transaction numbers. The market capitalization as on December 31, 2007 stood at USD 1.79 trillion . An investor can choose from more than 4,700 listed companies, which for easy reference, are classified into A, B, S, T and Z groups.

The BSE Index, SENSEX, is India's first stock market index that enjoys an iconic stature , and is tracked worldwide. It is an index of 30 stocks representing 12 major sectors. The SENSEX is constructed on a 'free-float' methodology, and is sensitive to market sentiments and market realities. Apart from the SENSEX, BSE offers 21 indices, including 12 sectoral indices. BSE has entered into an index cooperation agreement with Deutsche Börse. This agreement has made SENSEX and other BSE indices available to investors in Europe and America. Moreover, Barclays Global Investors (BGI), the global leader in ETFs through its iShares® brand, has created the 'iShares® BSE SENSEX India Tracker' which tracks the SENSEX. The ETF enables investors in Hong Kong to take an exposure to the Indian equity market. BSE has tied up with U.S. Futures Exchange (USFE) for U.S. dollardenominated futures trading of SENSEX in the U.S. The tie-up enables
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eligible U.S. investors to directly participate in India's equity markets for the first time, without requiring American Depository Receipt (ADR) authorization. The first Exchange Traded Fund (ETF) on SENSEX, called "SPIcE" is listed on BSE. It brings to the investors a trading tool that can be easily used for the purposes of investment, trading, hedging and arbitrage. SPIcE allows small investors to take a long-term view of the market.

BSE provides an efficient and transparent market for trading in equity, debt instruments and derivatives. It has a nation-wide reach with a presence in more than 450 cities and towns of India. BSE has always been at par with the international standards. The systems and processes are designed to safeguard market integrity and enhance transparency in operations. BSE is the first exchange in India and the second in the world to obtain an ISO 9001:2000 certification. It is also the first exchange in the country and second in the world to receive Information Security Management System Standard BS 7799-2-2002 certification for its BSE On-line Trading System (BOLT).

BSE continues to innovate. In recent times, it has become the first national level stock exchange to launch its website in Gujarati and Hindi to reach out to a larger number of investors. It has successfully launched a reporting platform for corporate bonds in India christened the ICDM or Indian Corporate Debt Market and a unique ticker-cum-screen aptly named 'BSE Broadcast' which enables information dissemination to the common man on the street.


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In 2006, BSE launched the Directors Database and ICERS (Indian Corporate Electronic Reporting System) to facilitate information flow and increase transparency in the Indian capital market. While the Directors Database provides a single-point access to information on the boards of directors of listed companies, the ICERS facilitates the corporates in sharing with BSE their corporate announcements.

BSE also has a wide range of services to empower investors and facilitate smooth transactions: Investor Services: The Department of Investor Services redresses grievances of investors. BSE was the first exchange in the country to provide an amount of Rs.1 million towards the investor protection fund; it is an amount higher than that of any exchange in the country. BSE launched a nationwide investor awareness programme- 'Safe Investing in the Stock Market' under which 264 programmes were held in more than 200 cities.

The BSE On-line Trading (BOLT): BSE On-line Trading (BOLT) facilitates on-line screen based trading in securities. BOLT is currently operating in 25,000 Trader Workstations located across over 450 cities in India. In February 2001, BSE introduced the world's first centralized exchange-based Internet trading system, This


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initiative enables investors anywhere in the world to trade on the BSE platform. Surveillance: BSE's On-Line Surveillance System (BOSS) monitors on a real-time basis the price movements, volume positions and members' positions and real-time measurement of default risk, market reconstruction and generation of cross market alerts.

BSE Training Institute: BTI imparts capital market training and certification, in collaboration with reputed management institutes and universities. It offers over 40 courses on various aspects of the capital market and financial sector. More than 20,000 people have attended the BTI programmes Awards

The World Council of Corporate Governance has awarded the Golden Peacock Global CSR Award for BSE's initiatives in Corporate Social Responsibility (CSR). The Annual Reports and Accounts of BSE for the year ended March 31, 2006 and March 31 2007 have been awarded the ICAI awards for excellence in financial reporting. The Human Resource Management at BSE has won the Asia - Pacific HRM awards for its efforts in employer branding through talent management at work, health management at work and excellence in HR through technology

Drawing from its rich past and its equally robust performance in the recent times, BSE will continue to remain an icon in the Indian capital market.
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The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country. On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000. NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of:

establishing a nation-wide trading facility for equities, debt instruments and hybrids,
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ensuring equal access to investors all over the country through an appropriate communication network, providing a fair, efficient and transparent securities market to investors using electronic trading systems, enabling shorter settlement cycles and book entry settlements systems, and Meeting the current international standards of securities markets.

The standards set by NSE in terms of market practices and technology have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It's that force which is guiding the industry towards new horizons and greater opportunities.

The logo of the NSE symbolises a single nationwide securities trading facility ensuring equal and fair access to investors, trading members and issuers all over the country. The initials of the Exchange viz., N, S and E have been etched on the logo and are distinctly visible. The logo symbolises use of state of the art information technology and satellite connectivity to bring about the change within the securities industry. The logo symbolises


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vibrancy and unleashing of creative energy to constantly bring about change through innovation.

NSE is one of the first de-mutualised stock exchanges in the country, where the ownership and management of the Exchange is completely divorced from the right to trade on it. Though the impetus for its establishment came from policy makers in the country, it has been set up as a public limited company, owned by the leading institutional investors in the country.

From day one, NSE has adopted the form of a demutualised exchange - the ownership, management and trading is in the hands of three different sets of people. NSE is owned by a set of leading financial institutions, banks, insurance companies and other financial intermediaries and is managed by professionals, who do not directly or indirectly trade on the Exchange. This has completely eliminated any conflict of interest and helped NSE in aggressively pursuing policies and practices within a public interest framework.

The NSE model however, does not preclude, but in fact accommodates involvement, support and contribution of trading members in a variety of ways. Its Board comprises of senior executives from promoter institutions, eminent professionals in the fields of law, economics, accountancy, finance, taxation, and etc, public representatives, nominees of SEBI and one full time executive of the Exchange.


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While the Board deals with broad policy issues, decisions relating to market operations are delegated by the Board to various committees constituted by it. Such committees includes representatives from trading members, professionals, the public and the management. The day-to-day management of the Exchange is delegated to the Managing Director who is supported by a team of professional staff.



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The genesis of the present international markets can be teased to 1960s, when there was a real demand for high quality dollar-denominated bonds form wealthy Europeans (and others) who wished to hold their assets their home countries or in currencies other then their own. These investors were driven by the twin concerns of avoiding taxes in their home country and protecting themselves against the falling value of domestic currencies. The bonds which were then available for investment were subjected to withholding tax. Further it is was also necessary to register to address these concerns. These were issued in bearer forms and so, there ownership and tax was withheld. Also, until 1970, the International Capital Market focused on debt financing and the equity finances were raised by the corporate entities primarily in the domestic markets. This was due to the restrictions on cross-border equity investments prevailing unit then in many countries. Investors too preferred to invest in domestic equity issued due to perceived risks implied in foreign equity issues either related to foreign currency exposure or related to apprehensions of restrictions on such investments by the regulator. Major changes have occurred since the ‘70s which have witnessed expanding and fluctuating trade volumes and patterns with various blocks experiencing extremes in fortunes in their exports/imports. This was the was the period which saw the removal of exchange controls by countries like the UK, franc and Japan which gave a further technology of markets have played an important role in channelizing the funds from surplus unit to deficit units across the globe. The international capital markets also become a major source of external finance for nations with low internal saving. The
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markets were classified into euro markets, American Markets and Other Foreign Markets.

THE PLAYERS Borrowers/Issuers, Lenders/ Investors and Intermediaries are the major players of the international market. The role of these players is discussed below. BORROWERS/ISSUERS These primarily are corporates, banks, financial institutions, government and quasi government bodies and supranational organizations, which need forex funds for various reasons. The important reasons for corporate borrowings are, need for foreign currencies for operation in markets abroad, dull/saturated domestic market and expansion of operations into other countries. Governments borrow in the global financial market to adjust the balance of payments mismatches, to gain net capital investments abroad and to keep a sufficient inventory of foreign currency reserves for contingencies like supporting the domestic currency against speculative pressures. LENDERS/INVESTORS In case of Euro-loans, the lenders are mainly banks who possess inherent confidence in the credibility of the borrowing corporate or any other entity mention above in case of GDR it is the institutional investor and high net


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worth individuals (referred as Belgian Dentists) who subscribe to the equity of the corporates. For an ADR it is the institutional investor or the individual investor through the Qualified Intuitional Buyer who put in the money in the instrument depending on the statutory status attributed to the ADR as per statutory requirements of the land.

INTERMEDIARIES LEAD MANGERS They undertake due diligence and preparation of offer circular, marketing the issues and arranger for road shows. UNDERWRITERS Underwriters of the issue bear interest rate/market risks moving against them before they place bonds or Depository Receipts. Usually, the lend managers and co-managers act as underwriters for the issue. CUSTODIAN On behalf of DRs, the custodian holds the underlying shares, and collects rupee dividends on the underlying shares and repatriates the same to the depository in US dollars/foreign equity. Apart from the above, Agents and Trustees, Listing Agents and Depository Banks also play a role in issuing the securities. THE INSTRUMENTS


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The early eighties witnessed liberalization of many domestic economies and globalization of the same. Issuers form developing countries, where issue of dollar/foreign currency denominated equity shares were not permitted, could access international equity markets through the issue of an intermediate instrument called ‘Depository Receipt’. A Depository Receipt (DR) is a negotiable certificate issued by a depository bank which represents the beneficial interest in shares issued by a company. These shares are deposited with the local ‘custodian’ appointed by the depository, which issues receipts against the deposit of shares. The various instruments used to raise funds abroad include: equity, straight debt or hybrid instruments. The following figure shows the classification of international capital markets based on instruments used and market(s) accessed.

EURO EQUITY GLOBAL DEPOSITORY RECEIPTS (GDR): A GDR is a negotiable instrument which represents publicly traded localcurrency equity share. GDR is any instrument in the from of a depository receipt or certificate created by the Overseas Depository Bank outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company. Usually, a typical GDR is denominated in US dollars whereas the underlying shares would be denominated in the local currency of the Issuer. GDRs may be – at


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the request of the investor – converted into equity shares by cancellation of GDRs through the intermediation of the depository and the sale of underlying shares in the domestic market through the local custodian. GDRs, per se, are considered as common equity of the issuing company and are entitled to dividends and voting rights since the date of its issuance. The company transactions. The voting rights of the shares are exercised by the Depository as per the understanding between the issuing Company and the GDR holders.

FOREIGN EQUTIY AMERICAN DEPOSITORY RECEIPTS (ADR): ADR is a dollar denominated negotiable certificate, it represents a non-US company’s publicly traded equity. It was devised in the last 1920s to help Americans invest in overseas securities and assist non-US companies wishing to have their stock traded in the American Markets. ADRs are divided into 3 levels based on the regulation and privilege of each company’s issue. I. ADR LEVEL – I: It is often step of an issuer into the US public equity market. The issuer can enlarge the market for existing shares and thus diversify to the investor base. In this instrument only minimum disclosure is required to the sec and issuer need not comply with


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the US GAAP (Generally Accepted Accounting Principles). This type of instrument is traded in the US OTC Market. The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges. II. ADR LEVEL – II: Through this level of ADR, the company can enlarge the investor base for existing shares to a greater extent. However, significant disclosures have to be made to the SEC. The company is allowed to List on the American Stock Exchange (AMEX) or New York Stock Exchange (NYSE) which implies that company must meet the listing requirements of the particular exchange. III. ADR LEVEL – III: This level of ADR is used for raising fresh capital through Public offering in the US Capital with the EC and comply with the listing requirements of AMEX/NYSE while following the USGAAP.



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EUROBONDS The process of lending money by investing in bonds originated during the 19th century when the merchant bankers began their operations in the international markets. Issuance of Eurobonds became easier with no exchange controls and no government restrictions on the transfer of funds in international markets. THE INSTRUMENTS EUROBONDS All Eurobonds, through their features can appeal to any class of issuer or investor. The characteristics which make them unique and flexible are: a) b) c) No withholding of taxes of any kind on interests payments They are in bearer form with interest coupon attached They are listed on one or more stock exchanges but issues are

generally traded in the over the counter market. Typically, a Eurobond is issued outside the country of the currency in which it is denominated. It is like any other Euro instrument and through international syndication and underwriting, the paper is sold without any limit of geographical boundaries. Eurobonds are generally listed on the world's stock exchanges, usually on the Luxembourg Stock Exchange.

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Straight debt bonds are fixed interest bearing securities which are redeemable at face value. The bonds issued in the Euro-market referred to as Euro-bonds, have interest rates fixed with reference to the creditworthiness of the issuer. The interest rates on dollar denominated bonds are set at a margin over the US treasury yields. The redemption of straights is done by bullet payment, where the repayment of debt will be in one lump sum at the end of the maturity period, and annual servicing. FLOATING RATE NOTES (FRNs):


FRNs can be described as a bond issue with a maturity period varying from 5-7 years having varying coupon rates - either pegged to another security or re-fixed at periodic intervals. Conventionally, the paper is referred to as notes and not as bonds. The spreads or margin on these notes will be above 6 months USOR for Eurodollar deposits.



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These are relatively lesser known bonds issued by foreign entities for raising medium to long-term financing from domestic money centers in their domestic currencies. A brief note on the various instruments in this category is given below: a) YANKEE BONDS: These are US dollar denominated issues by foreign borrowers (usually foreign governments or entities, supranational and highly rated corporate borrowers) in the US bond markets. A bond denominated in U.S. dollars and is publicly issued in the U.S. by foreign banks and corporations. According to the Securities Act of 1933, these bonds must first be registered with the Securities and Exchange Commission (SEC) before they can be sold. Yankee bonds are often issued in trenches and each offering can be as large as $1 billion. Due to the high level of stringent regulations and standards that must be adhered to, it may take up to 14 weeks (or 3.5 months) for a Yankee bond to be offered to the public. Part of the process involves having debt-rating agencies evaluate the creditworthiness of the Yankee bond's underlying issuer. Foreign issuers tend to prefer issuing Yankee bonds during times when the U.S. interest rates are low, because this enables the foreign issuer to pay out less money in interest payments.


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b) SAMURAI BONDS: A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations. Other types of yendenominated bonds are Euro/yens issued in countries other than Japan. Samurai bonds give issuers the ability to access investment capital available in Japan. The proceeds from the issuance of samurai bonds can be used by non-Japanese companies to break into the Japanese market, or it can be converted into the issuing company's local currency to be used on existing operations. Samurai bonds can also be used to hedge foreign exchange rate risks. These are bonds issued by non-Japanese borrowers in the domestic Japanese markets. c) BULLDOG BONDS: These are sterling denominated foreign bond which are raised in the UK domestic securities market. A sterling denominated bond that is issued in London by a company that is not British. These sterling bonds are referred to as bulldog bonds as the bulldog is a national symbol of England. d) SHIBOSAI BONDS:
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These are the privately placed bonds issued in the Japanese markets. EURONOTES Euronotes as a concept is different from syndicated bank credit and is different from Eurobonds in terms of its structure and maturity period. Euronotes command the price of a short-term instrument usually a few basic points over LIBOR and in many instances at sub – LIBOR levels. The documentation formalities are minimal (unlike in the case of syndicated credits or bond issues) and cost savings can be achieved on that score too. The funding instruments in the form of Euronotes possess flexibility and can be tailored to suit the specific requirements of different types of borrowers. There are numerous applications of basic concepts of Euronotes. These may be categorized under the following heads: a) COMMERCIAL PAPER:

These are short-term unsecured promissory notes which repay a fixed amount on a certain future date. These are normally issued at a discount to face value. b) NOTE ISSUANCE FACILITIES (NIFs):

The currency involved is mostly US dollars. A NIF is a mediumterm legally binding commitment under which a borrower can issue short-term paper, of up to one year. The underlying currency is mostly US dollar. Underwriting banks are committed either to


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purchase any notes which the borrower b unable to sell or to provide standing credit. These can be re-issued periodically. c) MEDIUM-TERM NOTES (MTNs):

MTNs are defined as sequentially issued fixed interest securities which have a maturity of over one year. A typical MTN program enables an issuer to issue Euronotes for different maturities. From over one year up to the desired level of maturity. These are essentially fixed rate funding arrangements as the price of each preferred maturity is determined and fixed up front at the time of launching. These are conceived as non-underwritten facilities, even though international markets have started offering underwriting support in specific instances. A Global MTN (G-MTN) is issued worldwide by tapping Euro as well as the- US markets under the same program. Under G-MTN programs, issuers of different credit ratings are able to raise finance by accessing retail as well as institutional investors. In view of flexible access, speed and efficiency, and enhanced investor base G-MTN programs afford numerous benefits to the issuers. Spreads paid on MTNs depend on credit ratings, treasury yield curve and the familiarity of the issuers among investors. Investors include Private Banks, Pension Funds, Mutual Funds and Insurance Companies.
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In today’s world no country is self sufficient, so there is a need for exchange of goods and services amongst the different countries. However, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency which is a legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.

In India, foreign exchange has been given a statutory definition. Section 2 (b) of Foreign Exchange Regulation Act, 1973 states: ‘Foreign exchange’ means foreign currency and includes: • All deposits, credits and balances payable in any foreign currency and any drafts, traveler’s cheques, letters of credit and bills of exchange , expressed or drawn in Indian currency but payable in any foreign currency, • Any instrument payable, at the option of drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other.


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For India we can conclude that foreign exchange refers to foreign money, which includes notes, cheques, bills of exchange, bank balances and deposits in foreign currencies.

Particularly for foreign exchange market there is no market place called the foreign exchange market. It is mechanism through which one country’s currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. The market comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. With the help of Reuters Money 2000-2, it is possible to access any trader in any corner of the world within a few seconds.







The main players in foreign exchange markets are as follows:

The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars as they have to pay in dollars for the goods/services they have imported.


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They are most active players in the forex market. Commercial banks dealing with international transactions offer services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. As every time the foreign exchange bought and sold may not be equal banks are left with the overbought or oversold position. The balance amount is sold or bought from the market. Nowadays, in international foreign exchange markets, the

international trade turnover accounts for a fraction of huge amounts dealt, i.e. bought and sold. The balance amount is accounted for either by financial transactions or speculation. Banks have enough financial strength and wide experience to speculate the market and banks does so. Which is popularly known as the trading in the forex market. Commercial banks have following objectives for being active in the foreign exchange markets. • They render better service by offering competitive rates to their customers engaged in international trade; • They are in a better position to manage risks arising out of exchange rate fluctuations; • Foreign exchange business is a profitable activity and thus such banks are in a position to generate more profits for themselves;


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• They can manage their integrated treasury in a more efficient manner. • In India Reserve Bank of India has given license to the commercial banks to deal in foreign exchange under section 6 Foreign Exchange Regulation Act, 1973, which are called the Authorized Dealers (ADs).



In all countries central banks have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank. Apart from this central banks deal in the foreign exchange market for the following purposes: 1) Exchange rate management: It is achieved by the intervention though sometimes banks have to maintain external rate of the domestic currency at a level or in a band so fixed. 2) Reserve management: Central bank of the country is mainly concerned with the investment of countries foreign exchange reserve in a stable proportions in range of currencies and in a range of assets in each currency. For this bank has to involve certain amount of switching between currencies.



Forex brokers play a very important role in the foreign exchange markets. However the extent to which services of forex brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India as per FEDAI guidelines the A Ds are free to deal directly among themselves without going through brokers.


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The forex brokers are not allowed to deal on their own account all over the world and also in India. .



Today the daily global turnover is guestimated to be more than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in world forex markets is constituted of financial transactions and speculation. As we know that the forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to Tokyo.

The risk on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics, the time frame can not be foretold with clock precision. Exporters and importers alike, can not be precise as to the time when the


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shipment will be made as sometimes space on the ship is not available, while at the other, there are delays on account of congestion of port etc. In international trade there is considerable time lag between entering in to a sales/purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency in to foreign currency, he may end up in loss. Consequently, buyers and sellers want to protect them against exchange rate risk. One of the methods by which they can protect themselves is entering in to a foreign exchange forward contract. We can see from the daily report of the Vadilal Industries Limited (Forex division) that the rupee fell down nearly 25 paise in a day. The date of this fluctuation is 25th May 2000. Now let suppose that the exporter has dealt

Forward exchange forward contract is a contract wherein two parties agree to deliver certain amount of foreign exchange at an agreed rate either at a fixed future date or during a fixed future period. If the merchants are sure about the remittance or the payment of the foreign exchange then they can choose the fix date forward exchange contract, in which they are bound by the date on which they have to meet their part of liability in the agreement. If the customers are not sure about the date of remittance or the payment of the foreign exchange they can enter in to the option period forward exchange contract. Both the types are explained below.


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If under the foreign exchange forward contract, foreign exchange is to be delivered at fixed date, the contract is known as fixed date foreign exchange forward contract.

If under the foreign exchange forward contract, foreign exchange is to be delivered in future, during a specified period, the contract is known as option foreign exchange forward contract. In this type of contract there is no option for taking/ delivery of foreign exchange. Such contracts provide for option as far as date of delivery of foreign exchange is concerned. While entering in to a option forward contract first date and the last date for exercising option for giving /taking delivery of foreign exchange is always fixed. In India, like developed countries, there are not many instruments available for hedging foreign exchange risk. As a result the merchants have to hedge their foreign exchange exposures through forward contracts only. For merchants this is the only tool available to minimize the risk due to adverse foreign exchange fluctuation .


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The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of riskaverse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices.

Introduction of derivatives in the Indian Capital market is the beginning of a new era, which is truly exciting. Index futures were introduced as the first exchange traded derivatives product in the Indian Capital Market in June 2000. With introduction of index options, individual stock futures and options, Indian derivatives market has turned multi-product derivatives market, at par with the global standards. Derivatives, worldwide are recognized as Risk Management products. These products have a long history in India in the unorganized sector, especially in currency and commodity markets. The availability of these products on organized exchanges has provided the market with broad-based risk management tools. Derivatives also facilitate the creation of new financial products in an economy. Today, financial markets around the world are undergoing a profound change in terms of the financial innovation. New financial
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products are being architected, on a day-to-day basis, to cater to the specific needs of both the issuers and investors. To keep pace with the global markets, Indian Securities Market also needs to develop new financial products in all the dimensions of the economy including commodities, securities, currency etc. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among individual investors, who are major users of index-linked derivatives. Even small investors find this useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for their growing use.

Derivative is a product whose value is derived from the value of one or more basic variables called bases (underling asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”.


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The most commonly used derivatives contracts are forwards, futures and options and since this project revolves around futures and options, it will be discussed in greater detail later on. For now we take a brief look at the various derivatives contracts that have come to be used.

A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s preagreed price.

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. In simpler words, futures are forward contracts quoted in an exchange.

Options are of two types: - Calls and Puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.


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Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated warrants are called warrants and are generally traded over the counter.

The acronym LEAPS mean Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.

Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.

Swaps are private agreements between two parties to exchange cash flows in the future according to prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

These entail swapping only the interest related cash flows between the parties in the same currency.

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These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is to pay fixed and receive floating.

A forward contract, as it occurs in both forward and futures markets, always involves a contract initiated at one time; performance in accordance with the terms of the contract occurs at a subsequent time. It is a simple derivative that involves an agreement to buy/ sell an asset on a certain future date at an agreed price. This is a contract between two parties, one of which takes a long position and agrees to buy the underlying asset on a specified future date for a certain specified price. The other party takes a short position, agreeing to sell the asset at the same date for the same price.


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For example, when one orders a car, which is not in stock, from a dealer, he is buying a forward contract for the delivery of a car. The price and description of the car are specified. The mutually agreed price in a forward contract is known as the delivery price. The delivery price is chosen in such a way that the value of the forward contract to both the parties is zero, so that it costs nothing to take either a long or a short position. On maturity, the contract is settled so that the holder of the short position delivers the asset to the holder of the long position, who in turn pays a cash amount equal to the delivery price. The value of a forward contract is determined, chiefly by the market price of the underlying asset. Forward contracts are being used in India on a large scale in the foreign exchange market to hedge the currency risk. Forward contracts, being negotiated by the parties on one to one basis, offer them tremendous flexibility to articulate the contract in terms of price, quantity, quality (in case of commodities), delivery time and place. From the simplicity of the contract and its obvious usefulness in resolving uncertainty about the future, it is not surprising that forward contracts have had a very long history.

The forward price of a contract is the delivery price, which would render a zero value to the contract. Since upon initiation of the contract, the delivery


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price is so chosen that the value of the contract is nil, it is obvious that when a forward contract is entered into, the delivery price and forward price are identical. As time passes the forward price could change but the delivery price would remain unchanged. Generally, the forward price at any given time varies with the maturity of the contract so that the forward price of a contract to buy or sell in one month would be typically different from that of a contract with time of three months or six months to maturity.

A futures contract is a type of forward contract with highly standardized and closely specified contract terms. As in all forward contracts, a futures contract calls for the exchange of some good at a future date for cash, with the payment for the good to occur at a future date. The purchaser of a futures contract undertakes to receive delivery of the good and pay for it, while the seller of a future promises to deliver the good and receive payment. The price of the good is determined at the initial time of contracting. In a crude sense, futures markets are an extension of forward markets. These markets, being organized/ standardized, are very liquid by their own nature. Therefore, liquidity problem, which persists in the forward market, does not exist in the futures market. In futures market, clearing corporation/ house becomes the counter-party to all the trades or provides the unconditional guarantee for their settlement i.e. assumes the financial integrity of the entire system. In other words, we may say that in futures market, the credit risk of


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the transactions is eliminated by the exchange through the clearing corporation/ house.

We now come to the next derivative product that is traded, namely Options. Options are fundamentally different from forward and future contracts. An option gives the holder of the option the right to do something. The holder need not exercise this right. In contrast, in a forward or futures contract, the two parties are committed and have to fulfill this commitment. Also it costs nothing (except margin requirement) to enter into a futures contract whereas the purchase of the option requires an upfront payment called the option premium.

A call option gives the buyer the right to purchase a specified number of shares of a particular company from the option writer (seller) at a specified price (called the exercise price) up to the expiry of the option. In other words the option buyer gets a right to call upon the option seller to deliver the contracted shares anytime up to the expiry of the option. The contract thus is only a one-way


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obligation, i.e. the seller is obliged to deliver the contracted shares while the buyer has the choice to exercise the option or let the contract lapse. The buyer is not obliged to perform.


Intrinsic value Lines


Premium b

Stock Price _


b Stock Price _ Intrinsic value Lines

(a) Buy A Call

(b) Write a Call

An option buyer starts with a loss equivalent to the premium paid. He has to carry on with the loss till the stock market price equals the exercise price as shown in (a). The intrinsic value of the option up to this price remains zero, and thus runs along the X-axis. As the stock price increases further, the loss starts reducing and gets wiped out as soon as the increase equals the


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premium, represented on the graph by point ‘b’, also called the break even point. The profitability line starts climbing up at an inclination of 45 degrees after crossing the X-axis at b and from thereon moves into the positive side of the graph. The inclined line beyond the point ‘ b’ indicates that the option acquires intrinsic value and is, thus referred to as the intrinsic value line.

The position graph (b) represents the profitability status of the writer who does not own the stock i.e. naked or an uncovered writer. The graph is logically the inverse of that for the option buyer.

A put option gives a buyer the right to sell a specified number of shares of a particular stock to the option of the writer at a specific price (called exercise price) any time during the currency of the option. The seller of a put option has the obligation to take delivery of underlying asset. When put position is opened, the buyer pays premium to the put seller. If the price of underlying asset rises above the strike price and stays there, the put will expire worthless. The seller of put will keep the premium as his profit and the put buyer will have a cost to purchase right.

Put buyers are bearish, they believe that the price of the underlying asset will fall and they may not be able to sell the asset at a higher price. Put sellers are bullish, as they believe that the price of the underlying asset will rise.

Position Graph:
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Intrinsic Value Line +

Stock Price _ Premium

Swap can be defined as a financial transaction in which two counter parties agree to exchange streams of payments, or cash flows, over time. Two types of swaps are generally seen i.e. interest rate swaps and currency swaps. Two more swaps being introduced are commodity swaps and the tax rate swaps, which are seen to be an extension of the conventional swaps. A swap results in reducing the borrowing cost of both parties.


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 Industrial Development Bank

 Industrial Finance Corporation of India  Industrial Investment Bank of India  Export Import Bank of India  State Financial Corporation  State Industrial Development Corporation INVESTMENT INSTITUTIONS  Life insurance Corporation  General Insurance Corporation  Unit trust of India  Mutual Funds BANKS
 Reserve Bank of India  Commercial Banks  Scheduled Banks 82 Thakur College Of Science & Commerce

Indian Financial System  Regional Rural Banks

 Investment Trust

 NIDHIS  Merchant Banks  Hire Purchases Finance Company  Lease Finance Company  Housing Finance Companies  National Housing Bank  Venture Capital Funding Companies

IDBI was established in 1964 as a subsidiary of the RBI by an act of the parliament and was made a wholly owned govt. of India undertaking in 1975. It was established with the main objective of serving as an apex financial institution to coordinate the functioning of all other financial institution. Planning ,promoting and developing functioning of all other financial institution .industries to fill the gaps in the industrial structure of the country providing technical administrative assistance for promoting or expansion of industry . undertaking market and investment research survey n connection with the development of industry and to provide finance keeping in view national priorities irrespective of the financial attractiveness of project are its other objective IDBI finance industries directly & also support state financial corporation and state industrial development corporations by providing refinance and through the bill rediscounting scale IDBI was transformed from finance institution to commercial bank in the year 2004.


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IFCI is the first financial institution to be established in India in 1948 by an act of parliament with objective of providing medium and long term finance to industrial concerns eligible for financing under the act. The sector for which the IFCI provides finance extend through the industrial spectrum of the country.

The IIBI first came into existence as a central government corporation with the name Industrial Reconstruction Corporation of India in 1971. Its basic objective was to finance the reconstruction and rehabilitation of sick and closed industrial unit. Its name was changed to Industrial reconstruction bank of India and it was made the principal credit and reconstruction agency in the country in 1985 through the RBI act 1984. The bank started coordinary similar work of the institutions and banks preparing schemes for reconstructions by reconstructing the liabilities appraising schemes of merger & amalgamation of sick company and providing financial assistance for modernization expansion, diversification and technological up gradation of sick units. In March 1987, in line with the ongoing policies of financial and economic reforms, IRBI was converted into a full-fledged development financial institution. It was renamed as Industrial Investment Bank of India ltd. And was incorporated as company under the companies act 1956. Its entire
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equity is finance for the establishment of new industrial project as well as for expansion diversification and modernization of existing industrial enterprises. It provides financial assistance in the form of term loans, subscription to debenture equity shares and deferred payment guarantees. IIBI is now also active ion merchant banking and its services includes inter alia, structuring suitable instrument for public rights issues preparation of prospective offer documents and working as a lead manager it also offers its services for debt syndication and package of services for merger and acquisition.

The EXIM Bank was set up in 1982 to coordinate the activity of the various institutional engaged in trade finance it helps Indian exporter in extending credit to their overseas customer by providing long term finance to them it also provides financial assistance to bank in extending credit for export and export linked imports it also provides advisory services and information to exports.

At the beginning of the fifties the govt. found that of achieving rapid industrialization separate institution should be set up that cater exclusively to the needs of the small medium sector therefore the SFC was act passed by the parliament in 1951 to enable the state govt. establish SFC the basic objective for which the SFC was set up was to provide financial assistance to small and medium scale industries estates. The SFC provides finance in the form of log term loan, by underwriting issue of share and debentures
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and standing guarantee for loans raised from other institution and form the general public.

The SIDCS have been set up to facilitate rapid industrial growth in the respective state. In addition to providing finance , the SIDC identify and sponsor project in the participation of private entrepreneurs.

The LIC was established in 1956 by amalgamation and nationalization of 245 private insurance companies by an enactment of parliament . the main business of LIC is to provide life insurance and it has almost a monopoly in this business. The LIC act permits it invest up to 10 percent of the investable funds in the private sector . it provides finance by participating in a consortium with other institution and does not undertake independent appraisal of projects.

GENERAL INSURANCE CORPORATION OF INDIA The GIC was establish in 1974 with the nationalization of general insurance business in country it can invest up to 30 % of the fresh accrual of funds in the private sector . like the LIC the GIC also provides finance by


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participating in consortium based on the appraisal made by other financial institutions but does not independently provide the finance.

The UTI was founded in 1964 under the UTI act 1963. Initially 50% of the capital of the trust was contributed by the RBI while the rest was brought in by the SBI and its associates, LIC ,GIC, and other financial institutions. In 1974 the holding of RBI was transferred to the IDBI making the UTI an associate of IDBI . the primary objective of UTI is to mobilize the savings in the countries and channelize them in to productive corporate investments. UTI provides assistance by underwriting debenture and share , subscription to public and right issue of share and debenture subscription to provide private placement and bridge finance. In January . 2003 UTI split in to two part UTI – 1 and UTI-2 . UTI-1 has given all the assured return scheme and unit scheme 64 and it is being administrated by central govt. UTI-2 entrusted with the task of managing NAV-based schemes. UTI -2 is being managed by SBI, PNB,BOB and LIC.

Mutual funds serves the purpose of mobilizing of funds from various categories of investors and channelizing them into productive investment. Apart form UTI. Mutual fund sponsored by various bank subsidiaries, insurance organizations private sector financial institutions DFI and FII have come up . these mutual fund work within the framework of SEBI regulation which prescribe the mechanism for setting up of a mutual fund , procedure of registration its constitution and the duties, functions and responsibility of the various parties involved.


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Indian Financial System

The Reserve Bank of India is the central bank of the country entrusted with monetary stability, the management of currency and the supervision of the financial as well as the payments system. Established in 1935, its functions and focus have evolved in response to the changing economic environment. Its history is not only intrinsically interwoven with the economic and financial history of the country, but also gives insights into the thought processes that have helped shape the country's economic policies. The Reserve Bank of India is the central bank of the country. Central banks are a relatively recent innovation and most central banks, as we know them today, were established around the early twentieth century. The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which commenced operations on April 1, 1935. The RBI has 22 regional offices, most of them in state capitals like Bhopal, Hyderabad, Jaipur, Nagpur, Kolkata etc.


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The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. The existing currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue Department. Offices of the Banking Department were established in Calcutta, Bombay, Madras, Delhi and Rangoon. Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to act as the Central Bank for Burma till Japanese Occupation of Burma and later up to April, 1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan up to June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was originally set up as a shareholder's bank, was nationalized in 1949. The RBI was established by legislation in 1934, through the RBI Act of 1934. The RBI started functioning from April 1st 1935. This represented the culmination of a long series of efforts to set up an institution of this kind in the country. The RBI was originally constituted as a Shareholders’ Bank with a share capital of Rs.5 Crore. In view of the need of close integration between its policies and those of the government, it was nationalized in 1949.


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With liberalization, the Bank's focus has shifted back to core central banking functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing the Payments System and onto developing the financial markets. The sequences of events leading to the formation of the RBI are summarized in the figure:

Presidency Bank Imperial Bank of India Central Banking Enquiry Committee, 1931 Reserve Bank of India Act, 1934 Constitution of RBI, April 1st 1935 Nationalization of the RBI. 1949

In India, the urgent need for a central banking institution was recognized when the 3 presidency banks – Bank of Madras, Bank of Bombay & Bank of Bengal were amalgamated in 1921 to form the Imperial Bank.


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In 1926, the Hilton-Young Commission recommended the establishment of a central bank. A bill was passed in the Central Legislature in January 1927 but was dropped. A fresh bill was introduced on September 8th, 1923 and was received. Thus the Reserve Bank of India was established by legislation in 1934 through the Reserve Bank of India Act 1934. The Act provides the statutory basis of functioning of the bank which commenced operations on April 1st, 1935.

The Reserve Bank's affairs are governed by a central board of directors. The Board is appointed by the Government of India in keeping with the Reserve Bank of India Act. The Board of Directors is comprised of: 1. A governor and not more that 4 deputy governors appointed by the Central Government. 2. Four Directors nominated by the Central Government, one from each of the 4 Local Boards. 3. Ten Directors nominated by the Central Government 4. One government official nominated by the Central Government. The Governor & Deputy Governor hold office for such periods not exceeding 4 years as may be fixed by the Central Government at the time of their appointment and are eligible for reappointment. The Government official holds office during the pleasure of the Central Government. The Governor, in his absence, appoints a deputy Governor to be the chairman on


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the Central Board. Meetings of the Central Board are required to be held not less than 6 times in each year & at least once in a quarter.

Central Board of RBI

4 Local Boards at Chennai, Kolkata, Mumbai & New Delhi 18 branches in major cities of the country.

Internal Organization & Management: This consists of about 25 departments training establishments & research institutions.

For each of the 4 regional areas of the country, there is a Local Board with headquarters in Kolkata, Chennai, and Mumbai & New Delhi. Local Boards consist of 5 members each, appointer by the Central Government for a term of 4 years. The Local Board members elect from amongst themselves the chairman of the Board. The Regional Directors of the bank offices in Kolkata, Chennai, and Mumbai & New Delhi are the ex-officio secretaries of the Local Boards at the Centers. The functions of Local Boards are reviewed by the Central Board from time to time.


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Its functions include advising the Central Board on local matters and representing territorial and economic interests of local cooperative and indigenous banks & to perform such other functions as delegated by Central Board from time to time.

The Governor is the Chief Executive Architect of the RBI. The Governor has the powers of general superintendence and direction of affairs and business of the Bank. The Executive General Managers are in between the Deputy Governors and Chief General Managers of central office departments. Formulating of policies concerning monetary management, regulation and supervision of banks, non banking institutions, financial institutions, and cooperative banks, extension of exchange resources and rendering of advice to the Government on economic and financial matters are also done by the RBI.

The Reserve Bank of India was constituted to: • Regulate the issue of banknotes • Maintain reserves with a view to securing monetary stability • Operate the credit and currency system of the country to its advantage


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• Promote financial and economic development jeopardizing monetary stability • Set up many financial institutes provide development of finance and foster financial markets.

Following are the core functions of the Reserve Bank of India: • Operating monetary policy for maintaining price stability and ensuring adequate financial resources for development process. • Promotion of an efficient financial system. • Meeting currency requirement of the public •

Reserve Bank of India

Issue of Currency Notes

Banker to Government

Banker to Banks

Monetary & Credit Policy

Foreign Exchange Management

Clearing Hose Agent

Pa Sy Man


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The Reserve Bank of India constantly works towards keeping inflation under check and ensuring adequate supply of liquidity for the productive sector as also towards financial stability. It also formulates, implements and monitors the monetary policy.


Prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public. Permitting banks to fix their own position limits as per international terms & aggregating gap limits.


Performs a wide range of promotional functions to support national objectives. Provides rural credit. Setting up of institutional framework. Service area approach. Financing the industries. Provision of finance to information technology and software industry. Infrastructure financing

• • • • • •


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The Reserve Bank of India ensures good quality coins and currency notes in adequate quantity by: • Issuing and exchanges or destroys currency and coins not fit for circulation.

Mopping up notes and coins unfit for circulation latest security features.

• Advising the Government on designing of currency notes with the

The Reserve Bank of India is mainly empowered with authority under the Foreign Exchange Management Act (FEMA) 1999 to regulate foreign exchange operation. As such, rules and regulations relating to non-resident accounts are issued by the RBI. The RBI also formulates policies to facilitate external trade and payments, facilitates foreign investments in India and Indian investments abroad and promotes orderly development of foreign exchange markets

The RBI acts as a Banker to the Government under section 20 of the RBI Act of 1934. Section 21 provides that the Government should entrust its money remittance, exchange and banking transactions in India to the RBI.


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The RBI maintains accounts of central and state governments. It performs merchant banking function for the central and the state governments. It also: • Encourages development and orderly functioning of Government securities market • Advises central and state governments in better cash management.

• Negotiated dealing system for security dealing. • Establishment of clearing corporation of India Ltd. (CCIL) for settlement of security deals. • Introduction of Real Time Gross Settlement (RTGS)

Electronic payment facilities like Electronic Clearing System (ECS), Electronic Funds Transfer (EFT), and National Electronic Funds Transfer (NEFT) and Cheque truncation.

• Providing messaging network and encryption facilities for secured messaging through the Institute for Development and Research in Banking Technology (IDRBT).

The Reserve Bank of India acts as a banker to all scheduled banks. Commercial banks including foreign banks, co-operative banks & regional rural banks are eligible to be included in the second schedule of the Reserve Bank of India Act subject to fulfilling conditions laid down under Section 42 (6) of the Reserve Bank of India Act 1934..


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Prescribes regulations for sound functioning of banks and financial institutions, including non-banking finance companies • Promotes best practices in risk management and corporate governance to protect depositors' interest and to enhance public confidence in the financial system of the country • Encourages use of technology in banks to provide cost-effective service to consumers.

The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India.

Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies.

The Board is constituted by co-opting four Directors from the Central Board as members for a term of two years and is chaired by the Governor. The


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Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of banking regulation and supervision, is nominated as the Vice-Chairman of the Board.

The Board is required to meet normally once every month. It considers inspection reports and other supervisory issues placed before it by the supervisory departments. BFS through the Audit Sub-Committee also aims at upgrading the quality of the statutory audit and internal audit functions in banks and financial institutions. The audit sub-committee includes Deputy Governor as the chairman and two Directors of the Central Board as members. The BFS oversees the functioning of Department of Banking Supervision (DBS), Department of Non-Banking Supervision (DNBS) and Financial Institutions Division (FID) and gives directions on the regulatory and supervisory issues.

Some of the initiatives taken by BFS include: i. ii. iii. iv. restructuring of the system of bank inspections introduction of off-site surveillance, strengthening of the role of statutory auditors and Strengthening of the internal defenses of supervised institutions.
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The Audit Sub-committee of BFS has reviewed the current system of concurrent audit, norms of empanelment and appointment of statutory auditors, the quality and coverage of statutory audit reports, and the important issue of greater transparency and disclosure in the published accounts of supervised institutions.

Commercial banks ordinarily are simple business or commercial concern which provides various types of financial services to consumers in return for payments in one form or another such as interest discount, fees, commission, and so on . their objective is to make profits. However, what distinguish them from other business concerns ( financial as well as manufacturing ) is the degree to which they have to balance the principal of profit maximization with certain other principal . in India especially . banks are required to modify the performance in profit making if that clashes with their obligations in such areas as social welfare , social justice , and promotion of regional balances in development . bank in general have to pay much more attention to balancing profitability with liquidity.

Scheduled banks are which are included in the second schedule of The Banking Regulation Act 1949, other are non schedule bank (a) must have paid up capital and reserve not less than Rs 5 lakh. (b) it must also satisfy the RBI that its affairs are not conducted in a manner detrimental t the interests of its depositors. Scheduled banks are required to maintain a certain amount of reserves with the RBI they in return , enjoy the
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facility of financial accommodation and remittance at concessional rates from the RBI.

A beginning to set up the RRB was made in later half of 1975 in accordance with the recommendations of banking commission it was intended that the RRB would operate exclusively in rural areas and would provide credit and other facility to small and marginal farmers , agricultural laborer , artisans , and small entrepreneurs. They now carry all types of banking business generally within one to five districts. The RRB can be set up provided by public sector bank sponsor them . the ownership capital of these banks is held by the central govt. (50 %) ,concerned state govt. (15 %), and the sponsor bank (35%) . they are in effect owned by the govt. and there is a little local participation in ownership and administration of these bank also . further they have a large number of branches.


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The various NBFC can be classified as follows: • Housing Finance Institution (companies) • Venture Capital Funds • Factors or Factoring companies

Investment trust are close ended organization, unlike UTI and they have a fixed amount of authorized capital and a stated amount of issued capital. Investment trust provides useful service through conserving and managing property for those who, for some reasons or other cannot manage their own affairs. Investor of moderate means are provide facilities for diversification of investment, expert advice on lucrative investment channels, and supervision of their investment. From the point of view of the economy, they help to mobilize small savings and direct tem to fruitful channels. Thy also have a stabilizing effect on stock market. Unlike in other countries, they render manifold function such as financing, underwriting, promoting and banking.


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Indian Financial System

Most of these companies are not independent, they are investment holding companies, formed by the former managing agents, or business houses. As such, they provide finance mainly to such companies as are associated with these business houses.

Mutual benefit funds or nidhis, as they are called in India, are joint stock companies operating mainly in south India, particularly in Tamil Nadu. The source of their funds are share capital, deposits from their members, and the public. The deposit are fixed and recurring. Unlike other NBFC’S nidhis also accepts demand deposit to some extent. The loans given by this institution are mainly for consumption purposes. These loans are usually secured loans, given against the security of tangible asset such as house property , gold jewelry, or against share of companies, LIC policies, and so on. The terms on which loans are given are quite moderate. The notable points about these institutions are : a) They offer saving schemes which are linked with the assurance to make credit available when required by saver’s b) They make the credit available to those to whom the commercial banks may hesitate to give credit or whom commercial banks have not been able to reach,
c) They possess characteristics such as their local character,

easy approachability, and the absence of cumbersome procedures, which make them suitable for small areas and,


Thakur College Of Science & Commerce

Indian Financial System d) Interest rates on their deposit and the loans are comparable to

those of commercial banks, and they work on the sound principal of the banking. Their operations are similar to those of unit banks. They are incorporate bodies and are governed by the directives of the RBI.

It would help in understanding the nature of merchant banking if we compare it with commercial banking. The MBs offer mainly financial advice and service for a fee, while commercial banks accepts deposit and lend money. When MBs do functions essentially as wholesale bankers rather than retail bankers. It means that they deals with selective large industrial clients and not with the general public in their fund based activities. The merchant banks are different from security dealers, trades and brokers also. They deal mainly in new issues, while the latter deal mainly in existing securities. The range of activities undertaken by merchant banks can be understood from recent advertisement of one of the merchant bankers in India which mentioned the following service offered by it:

1) Management, marketing and underwriting of new issues, 2) Project promotion services and project finance, 3) Syndication of credit and other facilities, 4) Leasing, including project leasing,


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5) Corporate advisory services, 6) Investment advisory services, 7) Bought-out deals, 8) Venture capital, 9) Mutual fund and offshore funds, 10) Investment management including dictionary management, 11) Investment service for non- resident Indians, 12) Management of and dealing in commercial papers,

In India the merchant banking service are provided by the commercial banks, All Indian Financial Institutions, private consultancy firms & technical consultation organizations. In March 1991, SEBI granted permission to VMC project technologies to act as the merchant banker and to undertake public issue management, portfolio management, lead management, and so on. It may be noted that in India, the permission of the SEBI is required to do merchant banking business.

Hire purchase involves a system under which term loan for purchases of goods and services are advanced to be liquidated in stages through a


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contractual obligation. The goods whose purchases are thus financed may be a consumer goods or producer goods or may be simply services such as air travel. Hire-purchase credit may be provided by the seller himself or by any financial institution. Hire-purchase credit is available in India for a wide range of services. Product like automobile, sewing machines, radios, refrigerators, TV sets, bicycles, machinery and equipment, other capital goods, industrial shades, services like educational fees, medical fees, and so on are now financed with help of such credit. However unlike in other countries the emphasis in India is on the provision of installment credit for productive goods & services rather than for purely consumer goods. Other suppliers of hire-purchase finance are retail and wholesale traders, commercial banks, IDBI, ICICI,NSIC,NSIDC, SFCS,SIDCS, Argo-industries corporations (AICs), and so on. In the recent past, banks also have increased their business in his field of installment credit and loans. IDBI indirectly participate in financing hire purchase business by way of rediscounting usance bills/promissory notes arising out of indigenous machinery on deferred payment basis.


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Indian Financial System

A lease is a form of financing employed to acquire the use of asset, through which firm can acquire the use of asset for a stated period without owing them. Every lease involves two parties : user of asset is known as lessee, and the owner of the asset is known as the lessor. While these companies may undertake other activities like consumer credit, car finance, etc. their predominant activity is leasing. Lease financing organizations in India include many private sector manufacturing companies, infrastructure leasing and nationalized banks, IFC,LIC, GIC, Housing financial service Finance limited.(IL&FS), ICICI, IRCI, capital market subsidiaries of leading Development Corporation (HDFC), certain SIDCs and SIICs, and other organizations. The lessee companies include many leading corporation in both public and private sectors, and small manufacturing companies.

Housing finance is provide in the form of mortgage loan i.e. it is provided against the security of immovable property of land and buildings. basically housing finance loan are given by Hosing and Urban Development Corporation, the apex Co-operative Housing Financing Societies and housing brand in different states, central and state government, LIC, Commercial banks, GIC, and a few private housing companies and nidhis.the government provide direct loan mainly to their employees. The participation of


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commercial and urban co-operative banks in direct in mortgage loans has been marginal till recently. LIC has been a major supplier of mortgage loan in indirect and direct forms. It has been giving loans to the state government, apex cooperative housing societies, HUDCO and so on. In addition it has been providing mortgage loan directly to individuals under its various mortgage schemes.

It was set up in July, 1988 as an apex level housing finance institution as wholly owned subsidiary of the RBI. It began its operation with the total capital of Rs.170 crore (Rs 100 crore as share capital, Rs 50 crore as long term loan from RBI and Rs 20 crore through sale of bounds). In September, 1989 it share capital was raised to Rs150 crore. During 1989-90, it issued its second series of bonds whose total subscription amounted to Rs60 crore. These bonds are guaranteed by the central government, and carry an interest rate of 11.5% per annum. The RBI sanctioned it a long-term loan of Rs25 crore in 1989-90. Further, it can borrow in the USA capital market US$50 million under the USAID government guarantee program. Thus the resources base of NHB has been made quite strong. The explicit and the primary aim of NHB is to promote housing finance institution at local and regional levels in the private & joint sector by providing financial and other support.


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Indian Financial System

The term “venture capital” suggest taking risk in supplying capital. However supply of risk capital may not be a prime function in certain cases the emphasis may be on supporting technocrats in setting up projects or on portfolio management. The term venture capital fund is usually used to denote mutual fund or institutional investors that provide equity finance or risk little known, unregistered highly risky, small private businesses, especially in technology-oriented and knowledge intensive business or industries which have long development cycles and which usually do not have access to conventional source of capital because of the absence of suitable collateral and the presence of high risk. VCFs play an important role in supplying management and marketing expertise to such units.


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Indian Financial System

Financial management for managers – ICFAI University Financial market & services – Study material of WIMDR Foreign Exchange Markets – P. Subramaniam Exchange Markets – Julie Stephens Rubinstein on Derivatives – Mark Rubinstein Derivatives FAQ by Ajay Shah and Susan Thomas


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