Minhaz Husain

Department of Economics

Khwaja Moinuddin Chishti Urdu Arabi- Farsi University ,Lucknow

Financial Institutions and Markets (B.A. Economics-VI Semester) AEC-606

Finance System in India

The economic scene in the post independence period has seen

a sea change; the end result being that the economy has made

enormous progress in diverse fields. There has been a

quantitative expansion as well as diversification of economic

activities. The experiences of the

1980s have led to the conclusion that to obtain all the benefits of

greater reliance on voluntary, market-based decision-making,

India needs efficient financial systems.

The financial system is possibly the most important institutional

and functional vehicle for economic transformation. Finance is a

bridge between the present and the future and whether it be the

mobilisation of savings or their efficient, effective and equitable

allocation for investment, it is the success with which the

financial system performs its functions that sets the pace for the

achievement of broader national objectives.

The term financial system is a set of inter-related

activities/services working together to achieve some

predetermined purpose or goal. It includes different

markets, the institutions, instruments, services and

mechanisms which influence the generation of

savings, investment capital formation and growth. The primary function of the financial system is the

mobilization of savings, their distribution for industrial

investment and stimulating capital formation to

accelerate the process of economic growth.

The process of savings, finance and investment

involves financial institutions, markets, instruments and

services. Above all, supervision control and regulation

are equally significant.

The Organization of the Financial System in

India

The Indian financial system is broadly classified into two broad

groups:

i) Organized sector and (ii) unorganized sector.

i) Organized Indian Financial System

The organized financial system comprises of an impressive

network of banks, other financial and investment institutions and

a range of financial instruments, which together function in fairly

developed capital and money markets. Short-term funds are

mainly provided by the commercial and cooperative banking

structure. Nine-tenth of such banking business is managed by

twenty-eight leading banks which are in the public sector. In

addition to commercial banks, there is the network of cooperative

banks and land development banks at state, district and block

levels. With around two-third share in the total assets in the

financial system, banks play an important role. Of late, Indian

banks have also diversified into areas such as merchant

banking, mutual funds, leasing and factoring.

The organized financial system comprises

the following sub-systems:

1. Banking system

2. Cooperative system

3. Development Banking system

(i) Public sector

(ii) Private sector

4.Money markets and

5. Financial companies/institutions.

ii) Unorganized Financial System

On the other hand, the unorganized

financial system comprises of relatively less

controlled moneylenders, indigenous

bankers, lending pawn brokers, landlords,

traders etc. This part of the financial system

is not directly amenable to control by the

Reserve Bank of India (RBI). There are a

host of financial companies, investment

companies, chit funds etc., which are also

not regulated by the RBI or the government

in a systematic manner.

Indigenous Banking in India

At independence, India had an indigenous

banking system with a centuries-old tradition. This

system had developed the hundi, a financial

instrument still in use that is similar to the

commercial bill of Western Europe. Hundi were

used to finance local trade as well as trade

between port towns and inland centers of

production. They were often discounted by banks,

especially if they were endorsed by indigenous

bankers.

EVALUATION OF

PERFORMANCE OF MUTUAL

FUNDS The performance of a portfolio is measured by combining the risk

and return levels in to a single value. The differential return

earned by a portfolio may be due to the difference in the

exposure risk from that of, say market index. There are three

major methods of assessing a risk adjusted performance. Firstly,

the return per unit of risk; secondly, differential return; thirdly, the

components of investment performance.

Return per Unit of Risk

The first measure determines the performance of a fund in terms

return per unit of risk. The absolute level of return achieved is

related to the level of risk exposure to develop a relative risk

adjusted measure for ranking the fund performance. Funds that

provide the highest return per unit of risk would be judged as

having performed well while those providing the lowest return per

unit of risk would be judged as poor performers.

Differential Return (Alpha)

A second category of risk adjusted performance

measure 1 is the Jenson‟s measure. This measure was

developed by Michael Jenson and is sometimes

referred to as the differential return. This measures

involves the calculation of return that should be

expected for the fund, given the realized risk of the fund

and compare that with the returns realized over the

period. It is assumed that the investor has a passive or

naïve alternative of merely buying the market portfolio

and adjusting for the appropriate level of risk, by

borrowing or lending at a risk-free rate. Given the

assumption, the most commonly used method of

determining the return for a level of risk is by way of the

alpha formulation.

Financial Markets

Financial markets deal in financial

assets and instruments of various

kinds such as currency, deposit,

bills and bonds,etc.

Structure of Financial Market

(A)Money Market (Short-Term Credit

Markets)

(B) Capital Market (Long-Term Fund)

Money Market

(A) Organized Money Market

1-Call Money Market

2-Bill Market (Treasury and Commercial Bill)

3-Bank Loan

(B) Unorganized Money Market

1- Hundis

2- Indigenous Bankers

3- Moneylenders and others

Capital Markets

(A) Organized Capital Market

1- Stock Market

i-Government Bonds

ii- Corporate Bonds and Equities

2- Loan from Banks and NBFIs

(B) Unorganized Capital Market

1- Loan from Moneylenders and others

Rural Financial System Rural financial system has been evolved over a

period of time from the year 1904, when the first

Primary Agricultural Credit Society was organized, by

accepting and implementing important

recommendations of expert committees appointed by

the Government of India/RBI from time to time. During

the pre-reform period, more particularly, after the

advent of the scientific and technological revolution in

the sphere of agriculture, the Government of India

and the RBI have evolved several new concepts,

innovations and novel approaches, which, the Rural

Financial Institutions (RFls) have responded very

favorably by implementing them.

The Banking System The structure of the baking system is determined by

two basic factors – economic and legal. The

Development of the economy and the spread of

banking habit calls for increasing banking services.

The demand for these banking services affects the

banks' structure and organisation. National objectives

and aspirations result in government regulations,

which have a profound influence on‟ the banking

structure. These regulations are basically of two

types. First, regulations which result in the formation

of new banks to meet the specific needs of a group of

economic activities. Secondly, legislation that affects

the structure by means of nationalisation, mergers or

liquidation.

Reserve Bank of India The Reserve Bank of India as the central bank of the country, is

at the head of this group. Commercial banks themselves may be

divided into two groups, the scheduled and the non scheduled.

The Reserve Bank of India (RBI) is the apex financial institution

of the country's financial system entrusted with the task of

control, supervision, promotion, development and planning. RBI

is the queen bee of the Indian financial system which influences

the commercial banks' management in more than one way. The

RBI influences the management of commercial banks through its

various policies, directions and regulations. Its role in bank

management is quite unique. In fact, the RBI performs the four

basic functions of management, viz., planning, organising,

directing and controlling in laying a strong foundation for the

functioning of commercial bank

Functions of Reserve Bank of

India The Reserve Bank of India performs all the typical functions of a good

Central Bank. In addition, it carries out a variety of developmental and

promotional functions attuned to the course of economic planning in the

country:

(1) Issuing currency notes, Le., to act as a currency authority.

(2) Serving as banker to the Government.

(3) Acting as bankers' bank and supervisor.

(4) Monetary regulation and management

(5) Exchange management and control.

(6) Collection of data and their publication.

(7) Miscellaneous developmental and promotional functions and activities.

(8) Agricultural Finance.

(9) Industrial Finance

(10) Export Finance.

(11) Institutional promotion

The commercial banking system may be distinguished into:

A. Public Sector Banks i) State Bank of India State Bank Group

ii) Associate Bank

iii) 14 Nationalized Banks (1969) Nationalized Banks

iv) 6 Nationalized Banks (1980)

v) Regional Rural Banks Mainly sponsored by Public Sector

Banks

B. Private Sector Banks i) Other Private Banks;

ii) New sophisticated Private Banks;

iii) Cooperative Banks included in the second schedule;

iv) Foreign banks in India, representative offices, and

v) One non-scheduled banks

Cooperative Bank

The cooperative banking sector has been

developed in the country to supplant the village

moneylender, the predominant source of rural

finance, as the terms on which he made finance

available have generally been usurious and

detrimental to the development of Indian

agriculture. Although the sector receives

concessional finance from the Reserve Bank, it is

governed by the state legislation. From the point

of view of the money market, it may be said to lie

between the organized and the unorganised

markets.

Primary cooperative Credit Societies

The primary cooperative credit society is an association of borrowers

and non-borrowers residing in a particular locality. The funds of the

society are derived from the share capital and deposits of members

and loans from Central Co-operative banks. The borrowing power of

the members as well as of the society is fixed. The loans are given to

members for the purchase of cattle, fodder, fertilizers, pesticides,

implements etc.

Central Co-operative Banks

These are the federations of primary credit societies in a district.

These banks finance member societies within the limits of the

borrowing capacity of societies. They also conduct all the business of

a joint-stock bank.

State Co-operative Banks

The State Cooperative Bank is a federation of Central cooperative

banks and acts as a watchdog of the cooperative banking structure in

the State. Its funds are obtained from share capital, deposits, loans

and overdrafts from the Reserve Bank of India. The State Co-

operative Banks lend money to central cooperative banks and

primary societies and not directly to farmers.

Land Development Banks

The Land Development Banks, which are

organized in three tiers, namely, State,

Central and Primary level, meet the long term

credit requirements of farmers for

developmental purposes, viz, purchase of

equipment like pump sets, tractors and other

machineries, reclamation of land, fencing,

digging up new wells and repairs of old wells

etc. Land Development Banks are cooperative

institutions and they grant loans on the

security of mortgage of immovable property of

the farmers.

Money Market

Money market is concerned with the supply and

the demand for investible funds. Essentially, it is a

reservoir of short-term funds. Money market

provides a mechanism by which short-term funds

are lent out and borrowed; it is through this

market that a large part of the financial

transactions of a country are cleared. It is place

where a bid is made for short-term investible

funds at the disposal of financial and other

institutions by borrowers comprising institutions,

individuals and the Government itself.

Thus, money market covers money, and financial

assets which are close substitutes for money. The

money market is generally expected to perform

following three broad functions:2

(i) To provide an equilibrating mechanism to even

out demand for and supply of short term funds.

(ii) To provide a focal point for Central bank

intervention for influencing liquidity and general

level of interest rates in the economy.

(iii) To provide reasonable access to providers and

users of short-term funds to fulfill their borrowing

and investment requirements at an efficient market

clearing price.

Repo Market REPO and reverse REPO operated by RBI in dated

government securities and Treasury 'bills '(except 14

days) help banks to manage their liquidity as well as

undertake switch to maximize [the return. REPOs are

also used to signal changes in interest rates. REPOs

bridge securities and banking business.

In order to activate the REPOs market so that it

serves as an equilibrating force between the money

market .and the securities market, REPOs and

reverse REPO transactions 'among select institutions

have been allowed since April 1997 in respect of all

dated Central Government securities besides

Treasury Bills of all maturities. Reverse REPOs ease

undue pressure on overnight call money rates. PDs

are allowed liquidity support in the form of reverse,

Capital Market The capital market is the place where the medium-term and

long-term financial needs of business and other undertakings are

met by financial institutions which supply medium and long-term

resources to borrowers. These institutions may further be

classified into investing institutions and development banks on

the basis of the nature of their activities and the financial

mechanism adopted by them. Investing institutions comprise

those financial institutions which garner the savings of the people

by offering their own shares and stocks, and which provide long-

term funds, especially in the form of direct investment in

securities and underwriting capital issues of business

enterprises. These institutions include investment banks,

merchant banks, investment companies and the mutual funds

and insurance companies. Development banks include those

financial institutions which provide the sinews of development,

i.e. capital, enterprise and know-how, to business enterprises so

as to foster industrial growth.

Financial intermediation

The Institutions in the financial market such as

Banks & other non banking financial

intermediatory undertakes the task of accepting

deposits of money from the public at large and

employing them deposits so pooled in the forms

of loans and investment to meet the financial

needs of the business and other class of society

i.e. they collect the funds from surplus sector

through various schemes and channalised then to

the deficit sector.

These financial intermediaries act as moblisers of public

saving for their productive utilization. Funds are

transferred through creation of financial liabilities such

as bonds and equity shares. Among the financial

institutions commercial banks accounts for more than

64% of the total financial sector assets. Thus financial

intermediation can enhance the growth of economy by

pooling funds of small and scattered savers and

allocating then for investment in an efficient manner by

using their in formational advantage in the loan market.

They are the principal moblisers of surplus funds to

productive activity and utilize this funds for capital

formation hence promote the growth.

Non-banking Finance

Company (NBFC)

A Non-Banking Financial Company (NBFC) is a

company registered under the Companies Act,

1956 and is engaged in the business of loans and

advances, acquisition of shares, securities,

leasing, hire-purchase, insurance business, and

chit business.

There are different categories of NBFC's operating

in India under the supervisory control of RBI.

They are:

1. Non-Banking Financial Companies (NBFCs)

2. Residuary Non-banking Finance

companies(RNBCs).

3. Miscellaneous Non-Banking Finance Companies

(MNBCs)

Type of Services provided by

NBFCs

NBFCs provide range of financial services to their

clients. Types of services under non-banking

finance services include the following:

1. Hire Purchase Services

2. Leasing Services

3. Housing Finance Services

4. Asset Management Services

5. Venture Capital Services

6. Mutual Benefit Finance Services (Nidhi)

Financial Sector Reforms &

Liberalization measures for

NBFCs During the period from 1992-93 to 1995-96 Indian Government

took many steps to reform the financial sector like liberalized

bank norms, higher ceiling on term loans, allowed to set their

own interest rates, freed to fix their own foreign exchange open

position subject of RBI approval and guidelines issued to

ensure qualitative improvement in their customer service.

Foreign equity investments in NBFCs are permitted in more

than17 categories of NBFC activities approved for foreign equity

investments such as merchant banking, stock broking, venture

capital, housing finance, forex broking, leasing and finance,

financial consultancy etc. Guidelines for foreign investment in

NBFC sector have been amended so as to provide for a

minimum capitalization norm for the activities, which are not fund

based and only advisory, or consultancy in nature, irrespective of

the foreign equity participation level.

MERCHANT BANKING IN INDIA In India Grind lays Bank was authorized to carry

merchant banking services and obtained a license

form Reserve Bank of India in 1967.Grindlays which

started with management of capital issues,

recognized the needs of an emerging class of

entrepreneurs for diverse financial services ranging

from production planning and systems design to

market research.. Apart form meeting specially the

needs of small-scale units, it provided management

consultancy, services to large and medium sized

companies.

Consequent to the recommendations of Banking

Commission in 1972, that Indian banks should offer

merchant banking services as part of the multiple

services they could provide their clients, State Bank of

The commercial banks that followed State Bank of

India were Central Banks of India, Bank of India and

Syndicate Bank in 1977: Bank of Baroda, Standard

Chartered Bank and Mercantile Bank in 1978, and

United bank of India. United Commercial Bank,

Punjab National Bank, Canara bank and Indian

overseas Bank in late „70s and early „80s. Among the

development banks, ICICI started merchant banking

activities in 1973, followed by IFCI (1986) and IDBI (!

991).

Mutual Funds Mutual funds are financial intermediaries which collect the

savings of investors and invest them in a large and well

diversified portfolio of securities such as money market

instruments, corporate and Government bonds and equity

shares of joint stock companies. A mutual fund is a pool of

commingle funds invested by different investors, who have not

contract with each other. Mutual funds are conceived as

institutions for providing small investors with avenues of

investments in the capital market. Since small investors

generally do not have adequate time, knowledge, experience

and resources for directly accessing the capital market, they

have to rely on an intermediary which undertakes informed

investment decisions and provides the consequential benefits of

professional expertise. The raison d‟etre of mutual funds is their

ability to bring down transaction costs. The advantages for the

investors are reduction in risk, export professional management

,diversified portfolios, liquidity of investment and tax benefits . By

pooling their assets through mutual funds, investors achieve

MUTUAL FUNDS IN INDIA

The first mutual fund to be set up was the Unit

Trust of India in 1964 under an act of Parliament .

During the years 1987-1992,even new mutual

funds were established in the public sector. In

1993, the government changed the policy to allow

the entry of private corporations and foreign

institutional investors in to the mutual fund

segment. By the end of march 2000, apart from

UTI there were 36 mutual funds, 9 in the public

sector and 27 in the private sector.

There are tow major categories of mutual funds

They are:

1. Closed-end mutual funds.

2. Open-end mutual funds.