Financial Institution & Market

Financial Institution & MarketAsit MohantyXavier Univesrsity

Overview of Indian Financial System

Commodity Market vs Financial MarketDeficit Units vs Surplus UnitsLender vs Borrower Mapping of Financial InstrumentsPricing of Financial InstrumentsAsset vs LiabilityFinancial InstitutionsPillars of Financial SectorDirect vs Indirect MarketPrimary Vs Secondary MarketInvestment vs InvestorSaving vs Investment ( I-S Gap)Domestic Saving vs Foreign savingDomestic Financial SavingProductivity of Investment

Basics.Investment Ratio..I%Incremental Capital Output Ratio(ICOR)= ( Productivity)^-1P% Projected GDP % = I% * P%Saving & Investment

Saving Ratio : 38.1% in 2007-08, 30% in 2013-14Foreign Saving

Fund transfer from savers to borrowers ---Direct and Indirect FinanceDirect Finance : borrowers borrow gets fund directly from the lenders in the financial markets, by selling them securities ( also called financial instruments). These are assets who buys them and liabilities to those who sell( issue) them.

The Indirect Finance : The intermediary borrows funds from the savers and then using this fund makes loans to the borrower spenders.

INDIRECT FINANCE & DIRECT FINANCE

INDIRECT FINANCE Financial Institutions&Financial market

SAVERSHouseholdsPrivate CorporateGovt/ PSU

BORROWERSGovernment/PSU Private CorporateHouseholds

DIRECT FINANCEFinancial Markets

Financial IntermediariesObjective : To Intermediate funds from savers to Borrowers in the most risk free manner

INDIRECT FINANCE Financial Institutions

SAVERSHouseholdsBusiness

BORROWERSGovernment BusinessHouseholds

HS in 2012-13 : 21.9%

Financial Institutions. Intermediaries..are the markets in the economy that help to match one persons saving with another persons investment.. . . move the economys scarce resources from savers to borrowers.. . . are opportunities for savers to channel unspent funds into the hands of borrowers.Institutions that allow savers and borrowers to interact are called financial intermediaries.

13The Market For Loanable FundsInterestRateLoanable FundsThe Market For Loanable FundsSupplyInterestRateLoanable FundsThe Market For Loanable FundsSupplyDemandInterestRateLoanable Funds Compensates for the lenders lost opportunity to consume.Real Rate of InterestThe Market For Loanable FundsSupplyDemandInterestRateLoanable Funds5%$1,200

The Market For Loan able FundsSupplyDemandInterestRateLoanable Funds5%$1,200Movement to equilibrium is consistent with principles of supplyand demand.19The Market For Loanable FundsThe supply and demand for loanable funds depends on the real interest rate. Movement to equilibrium is the process of determining the real interest rate in the economy.Saving represents the supply of loanable funds, while investment represents demand.The Market For Loanable FundsSupplyDemandInterestRate5%$1,200Loanable FundsTheory and Structure of Interest rates

As discussed, Market interest Rate is determined by the factors that control the supply and demand for loan able funds . Loanable Funds Theory Demand for Loanable Funds Household demandBusiness/ Corporate demand Government To meet DeficitForeign demand .. Country A issues securities to investors of country BSupply of Loanable Funds Household sector is the largest followed by Government and Business SectorAt equilibrium interest rate, Supply = Demand of Loanable Funds(1+ n%) = (1+r%) * (1+ inf%)Theory and Structure of Interest rates ..Fisher Effect Nominal Interest rate of Interest - Compensates for reduced Purchasing Power Provides a premium for foregoing present consumption ir + E(i) = in where ir is Real interest rate in is nominal interest rate E(i) is expected inflation rate Since ir cannot be negative , higher inflation tends to push up interest rates Key issues impacting Interest rates Impact of Inflation Impact of budget deficit Impact of interest rates in foreign countries

ConclusionFinancial Intermediaries through financial markets and instruments. coordinate borrowing and lending and thereby help allocate the economys scarce resources efficiently.The price in the loanable funds market - interest rate Price discovery-process - is governed by the forces of supply and demand of funds.Problem of lemonsGeorge Akerlof: The Market for Lemons: Quality, Uncertainty and the Market Mechanisms (1970) peach or a lemon that will give him continuous grief

Lemons Problem is also important for Financial Market

The lender ( net savers) doesnt have exact idea about the risk of lending to the borrower. However, the borrower knows about the risk associated with him.

Therefore, the lender will charge average rate of interest to the borrower.

At average rate of Interest , borrowing will be more attractive to sub prime borrower than the prime borrower.

This implies, the rate of interest supposed to be charged (Risk Based Pricing) is higher than this average rate of Interest.

If the borrower defaults because of high probability of default, then the lender will stop lending.

Hence, there is a need of the financial Intermediary.

Information Asymmetry & Lemons One party not having sufficient knowledge about the other party involved in a transaction to make an accurate decision

Adverse SelectionAsymmetric information problem which is there before the transaction occurs leads to adverse selection Belief: Potential bad credit risks are the ones who most actively seek out loans

Fear of adverse selection prevents savers from lending, even though there may be credit-worthy borrowers out there

Moral Hazard & Lemons in Banking and Financial markets Moral Hazard arises after the transaction occurs end use of borrowed funds is used foe some other purpose

Hence the intermediary may decide not to lend

Lenders unable to distinguish between firms with high risk and low riskIn case of Lemon Problem Lenders will only get the price that reflects the average quality The good firms will not want to come to the market at the average price, only the bad firms will! Hence the market will not function well

Tools to help solve the Adverse Selection problem

If buyers can distinguish between a peach and a lemon, they will be willing to pay appropriate value for the peach and the market will grow

How do we achieve this?

Tools to solve the Adverse Selection problemAn independent credit rating Agency Govt. regulation: - Stringent accounting standards and disclosure norms - Make information available at zero cost Financial Intermediation: - Firms with average to low financial performance (low credit rating) end up with Indirect finance and incur a higher cost of intermediation - And Firms with good financial performance (high credit rating) pursue direct finance and hence incur a lower cost of borrowing In developing countries, financial intermediation, i.e. indirect finance, is pursued more often (why?)

Moral Hazard in Debt InstrumentsBorrower takes on projects that are riskier is perceived by the lender

Tools to help solve moral hazard in debt contracts

Balance Sheet and P&L account/ accounting procedure

Debt to be proportionate to net-worth of the borrower Obtain Financial Collateral / Mortgage

Financial Intermediaries.. Intermediaries perform six basic functions 1.Denomination Intermediation - Small amount of savings from individuals and others are pooled so as to give loans of varying size 2. Default Risk intermediation - Willingness to give loans to risky borrowers without hurting the returns to savers 3. Maturity intermediation - Ability to create loans whose maturities may mismatch with the deposit maturity profile 4. Liquidity intermediation - Claims from savers that are highly liquid while loans to borrowers are relatively less liquid 5. Information intermediation - Ability to gather and process information from the financial marketplace far more effectively than the individual saver 6. Currency intermediation - Ability to lend cross-currency

Financial Markets1.Money Market 2. Bond / Debt Market2.1 Corporate Debt/ Bond market 2.2 G sec / Bond Market 3. Stock/ Equity Market 4. Foreign Exchange Market5. Derivative Market 6. Commodity Market

Financial MarketsClassified according to the characteristics of participants and securities involved.

The Primary market is where deficit economic units sell New Instruments.

The Secondary market is where investors trade previously issued securities with each other. SHORT TERM MONEYMARKET

36Money/Short Term MarketThe money market is a market for short-term financial assets/liabilities that are close substitutes of money.Original maturity of the instruments are less than one year and liquid in nature..money market

The most important feature of a money market instrument is that it is liquid and can be turned into money quickly at low est cost and provides an avenue for equilibrating the short-term surplus/supply funds of lenders and the requirements/demand of borrowers.

Short demand and short term supply of funds are equatedat a equilibrium rate of interestThe process of accelerated economic and business growth along with greater global integration has led to the increased need for liquidity in the money market.

Call Money Market

http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx

Call / Notice Money MarketThe call/notice money market forms an important segment of the Indian Money Market.

Under call money market, funds are transacted on an overnight basis and under notice money market, funds are transacted for a period between 2 days and 14 days.Participants: Mainly dominated by Commercial Banks..Inter Bank Call Money MarketAlso Primary DealersProvides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of borrowers.Regulator is RBI

NDS Platformhttp://rbidocs.rbi.org.in/rdocs/Publications/PDFs/NDSOM290410.pdfhttp://rbidocs.rbi.org.in/rdocs/notification/PDFs/98MCNMM01072014.pdf.call MoneyPDIn 1995, the Reserve Bank of India (RBI) introduced the system of Primary Dealers (PDs) in the Government Securities Market, which comprised independent entities undertaking Primary Dealer activity. In order to broad base the Primary Dealership system, banks were permitted to undertake Primary Dealership business departmentally in 2006-07. Further, the standalone PDs were permitted to diversify into business activities, other than the core PD business, in 2006-07, subject to certain conditions. As on 6th July, 2013, there are 8 standalone PDs and 13 banks authorized to undertake PD business departmentally.http://dbie.rbi.org.in/DBIE/dbie.rbi?site=home

http://rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=8170http://www.fimmda.org/modules/content/?p=1015http://stcipd.com/callnotice.aspxhttps://www.ccilindia.com/CallHome.aspxhttp://www.fimmda.org/modules/content/?p=1015https://www.ccilindia.com/Pages/default.aspxhttps://www.ccilindia.com/AboutUs/Pages/CompanyProfile.aspxhttps://www.ccilindia.com/Documents/MemberDirectory/CALL_MMBR_LIST.pdf

Core activities of PDDealing and underwriting in Government securities Dealing in Interest Rate DerivativesProviding broking services in Government securities Dealing and underwriting in Corporate / PSU / FI bonds/ debenturesLending in Call/ Notice/ Term/ Repo/ CBLO market Investment in Commercial PapersInvestment in Certificates of DepositInvestment in Security Receipts issued by Securitization Companies/ Reconstruction Companies, Asset Backed Securities (ABS), Mortgage Backed Securities (MBS)Investment in debt mutual funds where entire corpus is invested in debt securitieshttp://www.rbi.org.in/scripts/AboutUsDisplay.aspx?pg=PrimaryDealer.htm

Dealing SessionDeals in the call/notice money market can be done upto 5.00 pm on weekdays and 2.30 pm on Saturdays or as specified by RBI from time to time.

Call rates/Interest Rate The interest rates charged on call money is known as the call rate. always quoted on annualized basis.Eligible participants are free to decide on interest rates in call/notice money market. Call Money Market in India is volatile.http://www.rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=13326

Call / Notice Money MarketDay-to-day surplus funds are traded Wherein short term requirements of funds are taken care of.maturity 1.14 Days

It is the core of Indian Money Market StructureLiquidity FED funds in the US.Euro Overnight Index Average(EONIA) in EURO, overnight rate in UKSome Banks over leverage in the Call Money Market as a constant source of funds; hence regulatory restrictions imposed Lending to call money market cant exceed 25% of their net worth(NOF) of the banks & borrowing cant exceed 100% of NW(NOF).On a fortnightly average basis .Objective is Financial stability Strictly speaking, in the call money market, funds are lent for overnight..repayable on demand where as notice money deals with fund 2-14 days..here lender issues a notice to the borrower to repay

http://dbie.rbi.org.in/DBIE/dbie.rbi?site=home

http://rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=8170http://www.fimmda.org/modules/content/?p=1015http://stcipd.com/callnotice.aspx

Treasury Bills Market

T-Bill is short term govt. borrowing issued at a discount by RBI on behalf of the Govt. (auction) ..91D.182D.364DHigh liquidity, low/no default risk,assured yield, eligible for inclusion in SLR portfolio (25%) . Also eligible for RepoTreasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity.Suppose the face value of 91 T-Bill is Rs. 100 with issue price of Rs.98.20with Rs.1.80 discount.What is the Yield ? ( 100-98.20)/98.20 *(365/91) = 7.352%If the same T-Bill is traded at Rs. 99 after 40D.Yield( 100-99)/99 *(365/51) = 7.229%T-Bills are issued on Price Based Auction System14 D T Bill is only meant for State.Govt to park their surplus fund..not based on auction system

Treasury Bills Market Price Based Auction System Notified amount is Rs. 1000 Cr.Details of bids received in the decreasing order of bid price PriceAmtImplicit Cumulativeof Bid(in Rs.Cr) yieldAmount199.903000.396%300299.852000.594%500399.802500.792%750499.751500.991%900599.701001.190%10006 99.70 1001.190% 11007 99.65 100 1.389% 1200 The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same price, bid numbers 5 and 6 would get allotment in proportion/pro rata so that the notified amount is not exceeded. In the above case each would get Rs. 50 crore. Bids(7) which are below the cut-off price are rejected.

Treasury Bills Market Price Based Auction SystemUniform Price based Here, all the successful bidders are required to pay at the auction cut-off price, irrespective of the rate quoted by them.in this example all the six successful bidders will pay Rs.99.70

The competitive bids for the auction should be submitted in electronic format on the Negotiated Dealing System (NDS) Notification/ Results91 DaysNotificationhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR45TB0713.pdfresultshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR68TB0713.pdf364 DaysNotificationhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR46TB0713.pdfresultshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR69TL0713.pdf182 DaysNotificationhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR2214TB0613.pdfResultshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR24TBF0713.pdf

55Yield Based Auction System Notified amount is Rs. 1000 Cr.Details of bids received in the increasing order of Yield YieldAmt Issue Price Cumulative(in Rs.Cr) Amount18.1830097.97430028.1920097.93050038.2025097.92775048.2115097.96790058.2210097.965100068.2210097.965110078.2315097.962125088.2310097.9621350The issuer would get the notified amount by accepting bids up to 4. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in proportion so that the notified amount is not exceeded. In the above case each would get Rs. 50 crore. Bids( 7 & 8) which are above the cut-off yield are rejected. The corresponding price of the respective yield will be accordingly calculated

Types of BiddingCompetitive Bidding: Here, the buyer bids at a specific price / yield and is allotted T-Bills if the price / yield quoted is within the cut-off price / yield. Competitive bids are made by well informed investors such as banks, financial institutions, primary dealers, mutual funds, and insurance companies. Non-Competitive Bidding: Investors apply for a certain amount of securities in an auction without mentioning a specific price / yield. It will enable individuals, firms and other mid segment investors who do not have the expertise to participate in the auctionsThis provides retail investors an opportunity to participate in the auction process.However, non-competitive bidding in Treasury Bills is available only to State Governments.The amount is over and above the issue sizeat cut off price/yieldUsually, in T Bill entire non competitive is retained.no ceiling Players in T-BillBanks, Primary Dealers, State Governments, Provident Funds, Financial Institutions, Insurance Companies, NBFCs, FIIs (as per prescribed norms), NRIs & OCBs can invest in T-Bills.

Trends in outstanding auction T-Bills

Trends on details of outstanding Treasury Bills

Repayments and Issuance of Treasury Bills in Jan-Mar 2013

Notification/ Results91 TBhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR83TA072014.pdfhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR108TB0714.pdf182 TBhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR84TB0714.pdfhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR109TB0714.pdf384 TBhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR34TB040714.pdfhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR59T90714.pdfNDS - OMhttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR1847TB0314.pdfhttps://www.ccilindia.com/Pages/default.aspx

62RBISTCICCILFIMMDASEBINSEBSE

Composition of Public (Internal) Debt

Treasury Bill Yield Curve

NDS In order to improve efficiency in the market, the Reserve Bank of India took steps to automate the process of trading and settlement of Government securities transactions and the Negotiated Dealing System (NDS) was introduced in February 2002.

The Negotiated Dealing System (NDS) has two modules one for the primary market and the other for the secondary market

The Reserve Bank uses the primary auction platform (NDS Auction) for primary marketNDS-OMThe Reserve Bank introduced the Negotiated Dealing System-Order Matching system or NDS-OM as it is called, in August 2005. The NDS-OM is an electronic, screen based, anonymous, order driven trading system for dealing in Government securities. The Reserve Bank owns NDS-OM and CCIL maintains it. The platform is in addition to the existing facility of over-the-counter (OTC) or phone market in Government securities.14 Day T Bill14-days Intermediate Treasury Bills are used by Central Government for deployment of short term cash surpluses available with State Governments at the end of their daily transactions. 14 Days Treasury Bills

Cash Management BillDuring 2009-10 the Government of India, in consultation with the Reserve Bank of India, has introduced a new short-term instrument, known asCash Management Bills (CMBs), to meet the temporary cash flow mismatches of the Government. The Cash Management Bills are nonstandard, discounted instruments issued for maturities less than 91 dayshttp://www.rbi.org.in/scripts/BS_ViewBulletin.aspx