10 Inoiaw Financia. System ;-No. | Formal Financial Sectors ihuformal Financial Sectors ‘The formal financial sector is featured by the existence of an organised, institutional and regulated system fulfilling the financial needs to the modem economy. The informal nancial sector is featured by uno ganised, non-institutional and unregulated sys tem providing financial needs to the traditional ‘economy. Stall farmers, lower-income households and small-scale enterprises are not considered in formal financial sectors. Savings and credit facilis for small farmers in rural areas and for lower-income households and smalhscale enterprises in urban areas ate provided by the informal financial sector, ‘There is linger and complex process of approval cof loan, resulting in long clays for loan delivery: ‘There is much simple and direct processing ofoan approval and a minimum delay in disbursement. ‘Transaction costs are high and repayment rates are low, Transaction costs are low and repayment rates are high. Formal financial sectors have investment op- portunities for savings which have been mobil- ised but which have ot been lent Informal financial sectors do not have investment ‘opportunities for savings witch have been mobil- ised butt which have not been lent, The volume and availability of leanable funds ‘There is an availability of loanable funds regue depend upan seasonal fluctuations, larly in the formal sector. [| FINANCIAL SYSTEM IN INDIA The Concept and Meaning Financial system assists to channelise funds from surplus-to-deficit units. Deficit units are those where current expenditure exceeds current income; surplus units are those where current income exceeds current expenditure. An efficient financial system efficiently mobilises savings (xe., money resources) ‘nto different investment avenues and helps in accelerating the rate of economic development. It also plays a crucial role in allocating scarce capital resources to productive use. It provides a link between savings and investments for the creation of new wealth and allows portfolio adjustment in the composition of the existing wealth, Indian financial system consists of regulatory bodies, financial institutions/intermediaries, financial markets, financial instruments and financial services. The expression ‘financial system’ is the combination of ‘finance’ and ‘system’. While ‘finance’ is the monetary wealth of a state, an institution or a person, ‘system’ implies a set of complex and inter-related factors organised in a particular form. So, the primary function of a financial system is: () mobilisation of savings; (i) their distribution into industrial investment; and (ii) stimulation of capital formation to accelerate the process of economic development. Objectives The objectives of the financial system are: > To accelerate the growth of economic development and to encourage rapid industrialisation; > ‘To act as a medium to various economic factors such as industry, agricultural sector, government, etc. > To provide necessary financial support to industry and to finance housing and small-scale industries;‘Tue Financiat Sysrem ano THe Economy 11 > To accelerate development of backward and rural areas, infrastructure and livelihood; > To control the interest rate and to safeguard the financial environment. Financial system ensures that transactions are effected smoothly and quickly on an ongoing basis. It enables agents to accelerate the financial growth and economic prosperity of the unit. The uses of the financial system are as follows: > It provides an ideal link between depositors/savers and investors; Te encourages savings and investment in the economy; IL acilitates expansion of financial markets over a period of time; It promotes banking sector as well as financial institutions; It involves an efficient operation of the payment mechanism; It enhances liquidity of financial claims through securities trading: It assists in the diversification and reduction of financial risk It promotes allocation of financial resources; Itassists in generating new financial instruments over a period of time; > It influences the pace of economic development. yyy vryy [LFUNCTIONS OF FINANCIAL SYSTEM There are two main functions of the financial system in India, These are: (i) controlling functions and (i) promotional functions. Let us have a brief discussion on these: Contr ‘The central government imposes certain controls over the financial and business activities of different organisations through: (i) the Department of Economic Affairs (DEA); (ji) the Department of Company Affairs (DCA); (il) SEBI; (v) Stock Exchanges; (v) RBI; and (vi) IRDA. Department of Economic Affairs in India under the Ministry of Finance formulates and monitors the economic policies and programmes that have a bearing on the domestic and international aspects of economic management. The Ministry of Corporate Affairs administers several statutes relating, to the corporate sector including The Companies Act, 1956. It also administers various other Acts including: (The Chartered Accountants Act, 1949; (i) The Cost and Works Accountants Act, 1959; {ii The Company Secretaries Act, 1980; (y)The Partnership Act, 1932; (v) The Societies Registration Act, 1860; (vi) The Companies (Donation to National Fund) Act, 1951; (vii) The Monopolies and Restrictive Trade Practices (MRP) Act, 1969; (vii) The Competition Act, 2002 as amended by the ‘Competition (Amendment) Act, 2007; and (ix) Limited Liability Partnership (LLP) Act, 2008. ‘The SEBI also aims at facilitating an efficient mobilisation and allocation of resources through the securities market, stimulating competition, and encouraging innovation. Its regulation is expected to be flexible, cost-effective and confidence-inspiring, There are three basic objectives of the SEBL They are as follows: > To investors, the SEBI provides a high degree of protection of their rights and interests, through adequate, accurate and authentic information disclosures on a continuing basis:412. Inpian Financia. System > To issters, it provides a marketplace in which they can confidently raise finance in an easy, efficient and fair manner; > To the market intermediaries, it offers a competitive, professionalised and expanding market with an adequate and efficient infrastructure so that they can render better and more responsible services to investors and issuers. Te stock exchange acts as a misror to the stock market. The share and stockbrokers constitute a service sector that provides intending investors with the required advise for making profitable investments in various securities. Stock exchanges are the organised securities markets regulating trading in shares, debentures and other securities in the interests of investors, Also, itis imperative to have in place an effective market surveillance mechanism, The surveillance fanction is an extremely vital link in the chain of activities performed ‘The Reserve Bank of India as a central bank performsits functions under the guidance ofthe Board for Financial Supervision (BFS). The primary objective of the BES is to undertake a consolidated supervision of the financial seetor comprising: () commercial banks; (i) financial institutions; and fi) ‘on-banking finance companies. RBI plays an important part in the zegulatory functions as follows > Supervision of financial institutions and restrictions on interest and bank rates; Selective credit control anc controlling foreign exchange; Framing rules for effective portfolio management and the distribution, diversification and reduction of risk; Imposing monetary control and prevention of unfair trade practices; Formulating policies on licencing, investment or credit; > Acting as the goverrunent’s and other banks’ banker. ‘The IRDA was formed by an Act of Parliament known as the IRDA Act, 1999, which was amended in 2002 to incorporate some emerging requirements. The mission of the IRDA as stated in the Act is ‘fo protect the interests of the policyholders, to regulate, promote and ensure orderly growth ‘of the insurance indusiry and for masters connected therewith or incidental thereto’ ¥ yy¥ ¥ Promotional Functions The promotional activities of financial systems are as follows: > Mobilising and allocating savings: Financial system can make a bridge between severs and investors in mobilising and allocating savings effectively for accelerating economic growth, > Providing efficient operation of the payment mechanism: Tt provides appropriate payment mechanism for the purposes of exchange of goods and services and channelises money resources across the globe. In fact, appropriate payment and settlement system in business sector is provided by banks through cheques, promissory notes, credit and debit cards, internet banking facilities, etc., while the clearing, and settlement mechanism in the stock market is performed by depositories and clearing corporations of stock exchanges. > Managing and reducing risk inthe financial market: Risk management is an important function of financial system which is performed by holding diversified portfolios and by buying financial insuzance services. Truly speaking, financial risk is traded in the financial markets through derivatives which are risk management mechanisms.‘Tue Financia. Sysrem ano THe Economy 13, > Monitoring corporate performance: Credit financing is a significant function to the corporate sector, while operators are encouraged to monitor the performance of the investment. Financial markets as well as financial institutions canassist to monitor corporate performance with the help of merger and acquisition mechanism. > Providing portfolio adiustment fociity: Portfolio adjustment facilities are provided by banks, -mutual funds for buying and sellinga number of financial assets in a rapid and reliable manner. > Reducing transaction cost: Reduction of transaction cost is an important issue to those who ate participants in the financial system creating appropriate financial structure for reducing transaction cost. > Sustaining financial expanding process: Financial expanding process can only be sustained with the help of increase of financial assets and increase of financial market participants, intermediaries and instruments. This is very much required for sound financial system. > Creating financial aunreness to captivate investors; ettrepreneurs; and borrowers: The responsible function of financial system isto ereate financial awareness to captivate investors, entrepreneurs and borrowers for bringing together in the economy. This can be done by organising seminars, workshops and dialogues, ete. and conducting development and research activities in order to update the system as well. Providing training to investors, intermediaries and employees in order to upgrade their skills are also required for sound financial system. J STRUCTURE OR COMPONENTS OF INDIAN FINANCIAL SYSTEM ‘The financial system in India comprises financial regulators; financial institutions/intermediaries; financial. markets; financial services and financial instruments. Financial regulators in India mainly include: () the Department of Economic Affairs (DEA); (ii) the Department of Company Affairs (DCA); (i) SEBI; (iv) Stock Exchanges; (v) RBI; and (vi) IRDA. Financial institutions mainly consist of: {i} commercial and co-operative banks; (fi) Regional Rural Banks (RRBs); (ii) non- banking financial companies (NBFCs); and (iv) development financial institutions including: all India financial institutions, state-level financial institutions and other financial institutions like public sector mutual funds, private sector mutual funds, life insurance and general insurance companies. The financial market, in India, comprises: (i) the money market; (ii) the government securities market (i) the foreign exchange market; (iv} the capital market; and (v) the derivatives ‘market. There are diverse financial services operating in India. These are: (j) fee-based services; (i) fund-based services; and (lil) insurance services. Financial instruments comprise: direct/primary instruments; indirect instruments; and derivatives instruments. Exhibit 15 depicts the structure of the financial system in India. Let us have a brief idea of the structure of the Indian financial system. Regulatory Bodies The financial system in India is regulated by independent regulators in the banking, insurance, and capital markets, Apart from that, the central government plays the role of a regulator in a number of sectors. The regulators ensure that market participants behave in a desired manner so that the securities market continues to be a major source of finance for corporates and the government, and the interests of investors are protected. Policy formulation and the regulation of the Indian financial market are made under the guidance of the Ministry of finance (MOF) and the Reserve Bank of India (RBI), The Securities and Exchange Board of India (SEBI) regulates‘Struct of indian rane aye 1 | Exhibit 1.5 Structure of indian Financial System WLSAg TONY NIN] BL‘Tue Financial Sysrem Ano THe Economy 15 and supervises the securities market, and the Insurance Development and Regulatory Authority (IRDA) regulates the insurance market. The SEBI is the apex regulatory body for the securities ‘market. The RBI as the country’s central bank plays its zole in banking supervision by an enactment in 1949, The RBI, on the other hand, is responsible for the zegulation of a certain well-defined segment of the securities market. As the manager of public debt, the RBI is responsible for primary {ssues of government securities. The RBI’s mandate also includes: (i) the regulation of all contracts in government securities; (i) gold-related securities; and (ii) money market securities. The RBI exercises a tight regime of exchange control, particularly under the Foreign Exchange Management ‘Act in June 3000, which replaced the earlier Foreign Exchange Regulation Act of 1973. Currently, the responsibility of regulating the securities market primarily rests with the SEBI, but is shared by the Department of Economie Affairs; the Department of Company Affairs; and the RBI. The Capital Market Division of the Department of Economic Affairs, under the Ministry of Finance, is ‘entrusted with the responsibility of formulating suitable policies for the development of the capital market in consultation with SEBI, the RBI and other agencies. It is, therefore, evident that the responsibility for regulating the financial system is discharged by the following regulatory bodies: > Department of Economic Affairs (DEA); > Department of Company Affairs (DCA); > Reserve Bank of India (RBI); > Securities and Exchange Board of India (SEBD; > Stock Exchanges; > Insurance Development and Regulatory Authority (IRDA). [A detailed discussion on these regulatory bodies has been mace in Chapter 19, Regulatory Framework: Investors’ Protection. nancial Institutions/Intermedia Financial institutions/intermediaries in India comprise banking financial institutions; non-banking, financial institutions; and other financial institutions. These are briefly discussed as under: Banking Financial Institutions Fourteen mojor private sector banks were nationalised to meet the requirements of the planning and ‘economic policy. This was an important milestone in the history of Indian banking in 1969. Subsequently, {n 1980, another six private banks were also nationalised by the Government of India. Scheduled banks in India comprise: (} scheduled commercial banks (SCBs) and (i) scheduled co-operative banks. SCBs form the foundation of the financial system in India, Presently, SCBs carey more than three fourth of the assets ofall financial institutions in India. SCBs — with more than 80,500 branches ~ are functioning ‘across the country. So far as structure of commercial banking is concerned, SCBs are of 4types:() public sector banks; fi) private sector banks; (i) foreign banks in India; and (iv) Regional Rural Banks (RRBs). Non-Banking Financial Entities Nor-banking financial entities ~ partially, or wholly, regulated by the RBI - comprise: () Non- banking Financial Companies (NBECs) consisting of equipment leasing companies, hire purchase finance companies, loan companies and investment companies {including primary dealers and tesiduary non-banking (RNBC) companies); (i) Mutual Benefit Financial Company (MBEC); (i) ‘Mutual Benefit Company (MBC); (iv) Miscellaneous Non-banking Company (MNBC)16 Ino1aN FinaNcial Syste ‘Non-banking Finance Companies (NBFCs) In terms of Section 45-1(9) read with Section 45+() of the RBI Act, 1934, as amended in 1997, the principal business of non-banking financial companies is that of receiving deposits or of financial institutions such as: {i} lending; (ji) investing in securities; and (ii) hire, purchase, finance or equipment leasing, Therefore, NBFCs include: > Equipment leasing company; > Hire purchase finance company > Loan company; > Investment company (including primary dealers); > Residuary non-banking company Mutual Benefit Financial Company (MBFC): An MBFC is any company which is notified by the central government as a nidhi company as per the Companies Act, 2013. ‘Mutual Benefit Company (MBC): An MBC is a company which works on the lines of a nidhi company but is not declared by the central government. Miscellaneous Non-banking Company (MINBC): MNBC is a chit fund company which is engaged Jn managing, conducting or supervising as a promotes, foreman or agent in any transaction or ‘arrangement. MNBC enters intoan agreement with a specified mamber of subscribers. Each one of them shall subscribe a certain sum, in instalments, over a definite period and shall in turn, as determined by tender or in such manner as may be provided for in the arrangement be entitled to the price amount. Other Financi Institutions There are other financial intermediaries including the banking and non-banking financial institutions. These are as follows: > Mutual Funds > UTI; > Public Sector Mutual Funds; Private Sector Mutual Funds; > Insurance Companies > Life Insurance; > General Insurance; > Merchant Bankers > Stock Broking Firms > Depositories > Development Financial Institutions ‘These development financial institutions can be categorised into three broad heads, These are: (0 all-ndia financial institutions (ATFIs); (i) state-level institutions; and (i) other institutions. Of these, the AIFls are the most important in terms of assets and range of operations. The AlFls comprise: (i all India development danks; (ii) specialised financial institutions; and (ii) investment institutions, The major AIFIs are as follows > The Industrial Development Bank of India (IDBI); > IFCILtd;‘Tue Francia. System ano THe Economy 17 cic Ltd; Industrial Investment Bank of India Ltd (IIB); ‘Small Industries Development Bank of India (SIDBI); National Housing Bank (NHB); National Bank for Agriculture and Rural Development (NABARD); Export Import Bank of India (EXIM Bank); ‘Tourism Finance Corporation of India Led (TFCD; Unit Trust of India (UTD); Life Insurance Corporation of India (LIC); General Insurance Corporation of India (GIC) and its subsidiaries; Infrastructure Development Finance Company of India Ltd (IDFC). ‘These institutions performall over India. Other institutions comprise: the Export Credit and Guarantee Coxporation (ECGO) and the Deposit Insurance and Credit Guarantee Corporation (DICGC). State-level institutions consist of: State Financial Corporations (SECs) and State Industrial Development Corporations (SIDCs). The SEC was established under the SECs Act, 1951, The exception is that of the Tamil Nadu Industrial and Investment Corporation Ltd, established in 1949 ander the Companies Act. There are at present 18 SECs in the country. Likewise, the SIDCs were established ~ under the Companies Act ~ as wholly owned undertakings of state governments for the promotion and development of medium-and large-scale industries in their respective states, There are 28 SIDCs inthe country. A detailed discussion has been provided in Chapter M: Money an dndion Batking Syste, Chupler 13: Development Banks and Financial bsstitutfons; and Chapter 14: Insursnice aud Mutat Funds yuveNy yyy ¥ ¥ Financial Assets/Instruments The two prerequisites of financial assets or instruments are: marketability and liquidity. This depends upon the tradability of the instruments of investment. In India, there are a wide variety of ‘instruments in the financial system. These are as follows: > Direct/Primary Instruments: > Equity Shares; > Preference Shares; . > Debt Instruments. > Indirect Instruments: > Mutual Funds Units; > Insurance Policies; > Time Deposits; > Provident Funds and Pension Funds. > Derivatives Instruments: > Forward; > Futures; > Options; > Swaps.18 Ino1an Financia Svsvem Equity shares; preference shares; debt instruments; other debt instruments; mutual funds units; and derivatives instruments are tradable and marketable in financial markets. There is, however, a limited market of public sector unit bonds. There are other financial assets, which are not quoted and not marketable: (j) time deposits including: bank deposits, company deposits, post office deposits, NSC, ete; (it) provident and pension fonds; (ii) insurance policies of LIC, GIC, ete. We have discussed these financial instruments below: Direct/Primary Instruments Equity Shares > Equity shares are also known as ordinary shares, which means, other than preference shares. Equity shareholders are the real owners of the company. They have a control over the management of the company. > Equity shareholders are eligible to get dividend if the company earns profit. Fquity share capital cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is the value of unpaid value of shares. Equity shares do not enjoy any preferential right in respect of claim of dividend or repayment of capital > Equity shareholders having the voting rights in the company are regarded as the owners of the company. > The equity shareholders get dividend only after making the payment of dividends on preference shares. The rate of dividend of equity shares depends upon the surplus profits of the company, and equity shares do not carry any fixed rate of dividend a5 such, > In case of winding up of a company, the equity share capital is refimded only after meeting, the claims of others. ¥ > The money raised through issuing such shares is known as equity share capital or ownership capital or owners’ fund, Equity Shares with Differential Rights Section 43 of Companies Act provides for issue of equity share capital with differential rights as to dividend, voting or otherwise in accordance with such rules as may be prescribed. Rule 4 of Companies (Share Capital and Debentures) Rules, 2014 deals with equity shares with differential rights, It provides that a company limited by shares shall not issue equity shares with differential rights as to dividend, voting or otherwise, unless it complies with the following conditions, namely > the articles of association of the company authorises the issue of shares with differential rights; > the issue of shares is authorised by an ordinary resolution passed at a general meeting of the shareholders; Provided that where the equity shares of a company are listed on a recognised stock exchange, the issue of such shares shall be approved by the shareholders through postal ballot > the shares with differential rights shall not exceed 26 per cent of the total postissue paid up equity share capital including equity shares with differential rights issued at any point of time; > the company has consistent track record of distributable profits for the last three years;‘Toe Financiat SysreM ano THE Economy 19 > the company hasnot defaulted in filing financial statements anel annual returns for three financial years immediately preceding the financial year in which it is decided to issue such shares, > the company has no subsisting default in the payment of a declared dividend to its shareholders or repayment ofits matured deposits or redemption of its preference shares or debentures that have become due for redemption or payment of interest on such deposits or debentures or payment of dividend; > thecompany has not defaulted in payment of the dividend on preference shares or repayment of any term loan ftom a public financial institution or statedevel financial institution or scheduled bank that has become repayable or interest payable thereon or dues with respect to statutory payments relating to its employees to any authority or default in crediting the amount in Investor Education and Protection Fund to the ceniral government; > the company has not been penalised by court or teiburial during the last three years of any offence under the Reserve Bank of India Act, 1934, the Securities and Exchange Board of India Act, 1992, the Securities Contracts Regulation Act, 1956, the Foreign Exchange Management Act, 1999 or any other special act, under which such companies being regulated by sectoral regulators Preference Shares > Preference shares having preferential rights in respect of dividend and return of capital carry fixed rate of dividend. Dividend is paid to the preference shareholders before payment to the equity shareholders. At the time of liquidation of a company, the preference shareholders has right to got the return of their capital before anything is paid to the equity shareholders. > They do not have any voting right in the company > Normally, preference shares have no fixed maturity period except in the case of redeemable preference shares. Preference shares can be redeesable only atthe time of the company liquidation. > > Debentures > A debenture refers to a document which either creates a debt or acknowledges it. Debenture issued under the company’s common seal by a company is in the form of a certificate acknowledging indebtedness, The date of repayment is specified in the debentures. > Debentures are issued against a charge on the assets of the company. Debenture holders have no tight to vote at the meetings of the companies, > Debentures and bonds are debt instruments of a company. The companies ean raise long: term funds by issuing debentures that carry assured rate of return for investors in the form of a fixed rate of interest. It is known as debt capital or borrowed capital of the company. > Debentures consist of long-term fixed maturity period. Normally, debentures consist of 10-20 years maturity period and are repayable with the principle investment at the end of the maturity period. > Debenture holders have priority of claim in income of the company over equity and preference shareholders, > Debenture holders are considered as creditors of the company. Debenture holders cannot have the control over the performance of the business concern.20 INDIAN Financiat SysreM Indirect Instruments Indirect instruments comprise: (i) mutual funds units; (i) insurance policies; (i) time deposits; (iv) provident funds; and (v) pension funds, Financial institutions and commercial banks accumulate ‘money resources from the public by issuing indirect instruments and mobilising money resources into investment — in the form of loans to others ~ and acquiring securities from the capital market. Derivatives Instruments > The term ‘financial derivatives’ refers to financial instruments which mainly include options and futures, These instruments derive their value from the price and otherrelated variables ~ of the underlying asset; > They do not have worth of their own and derive thefr value from other financial assets, or security. Therefore, derivatives are instruments which have no independent value. Theit value depends upon the underlying asset; > The underlying asset may be financial or non-financial. Financial derivatives are divided into four categories: (i) forward contract, (i) futures contract, (ii) options conteact and (iv) swaps contract; > A forward contract is made between two parties through an agreement for buying or selling an asset at a specified point of time in the future, The price, which is paid or received by the parties, is determined mutually at the time of entering into the contract; > Futures contract is a standardised forward contract made between two parties either for buying (long) or selling (short) the underlying asset. It is made at a specified price, at a specified future date through a specified stock exchange to impart liquidity to the transaction, Stack exchange sets the standardised terms of quality, quantity, price quotation and date; In the case of an option contract, an option is the right (but not the obligation) to buy or sell something ata stated price and at a stated date. The maker of the option is described as the ‘option writer; the holder of the option is described as the option buyer. The agreed price ~at which the option holder has right to buy or sell ~is called the strike price. Buying is called a long position; selling is expressed as a short position; > A swap is an agreement ~ between two or more parties — to exchange a stream of cash. flows over a period of time in the future. In fact, a swap is a contract whereby parties agree to exchange contract bound obligations. The parties ~ that agree to the swap ~ are known as counter parties. There are two commonly used swaps. These are: (i) interest rate swaps and (i) currency swaps. A detailed discussion has been made in Chapter 4: Capital Market Instruments, I Markets A financial market can be defined as one in which financial assets are created or transferred. While a real transaction involves exchange of money for real goods or services, a financial transaction involves the creation or transfer of a financial asset. Financial assets, of financial instruments, represent a claim to the payment of a sum of money, sometime in the future, and/or periodic payment in the form of interest or dividend, ¥ Finan‘The Financial System ano THE Economy 21 Salient Features Financial market refers to a transmission mechanism between the investors and borrowers through which mobilisation of funds is facilitated. It consists of regulatory bodies, money market, capital market and foreign exchange market. The salient features of financial markets are stated below: > Financial market is a market where lenders of funds and the botrowers of funds come together for mobilisation of funds; > Corporate sectors raise short-term as well as long-term funds from financial markets (ce., ‘money market as well as primary capital market); > Financial instrtements/products are exchanged or traded from one investor to another; > Institutions that facilitate the trade in financial instruments/products are stock exchanges (BSE, NSE and others); > It deals with the multicurrency requirements which are met by the exchange of currencies called foreign exchange market. The transfer of funds takes place in this market depending uupon the exchange rate. Functions ‘The main functions of financial market are summatised as follows: > Itoffers investment avers to investors; > Itassists in the channelising of savings in the economy and allows an optimal allocation of capital in corporate sectors; > New issue market provides services for communication between the investors and borrowers of funds; > It provides infarmation relating to the market price of securities or financial products that comes from the stock market; > A stock exchange basically permits security prices to be determined by competitive forces; > The stock exchanges provide a market in which the members ofthe stock exchanges and the investors participate to ensure liquidity to the latter; > The foreign exchange market is a mechanism through which the currency of one country can be exchanged (Le., bought or sold) for the currency of another country in the case of export and import transactions; > Ie facilitates the low cost of transactions and informations; > It indicates the inherent strength of the economy; Financial markets comprise: money market; securities market; foreign exchange market; and derivatives market. These are explained as follows: ‘Money Market > Money market is used for the lending and borrowing of short-term funds. It deals with ‘monetary assets whose period of maturity is less than or up to one yeas. It meets the short- term requirements of borrowers and provides short-term returns to lenders. Basically, money market is the place where short-term surplus funds of lenders (Le., financial institutions22_Inoian Financial. Sysre and individuals) are borrowed by the borrowers (ie., individuals, institutions and also the government) for short period; > The money market in India can be divided into twa components: (i) the organised money market and (ii) the unorganised money market, or unauthorised money market. Both components consist of several constituents, As far as the organised money market is concerned, there is a reasonable real interest rate. The organised money market consists of: () the RBI; (i) SBI, along with its seven associated state banks; (ii) 20 public sector commercial banks including; the foreign banks, regional rural banks, development banks, SBI DFHIL, STCIL, MMMTs; and (iv) other non-banking financial intermediaries including’ LICL, GiCland UTI; > The main instruments of the organised money market are: (i) call money; {i} commercial bills; (ii) treasury bills; iv) certificates of deposit; and (v) commercial papers. There is an xorbitant rate of interest in the case of the unorganised money market which consists of: @) indigenous bankers; (ii) moneylenders; and (ii) other unregulated non-banking financial intermediaries like chit funds, etc. The main instrument of unorganised money market is hundi, which is an indigenous bill of exchange. A hundi is a negotiable instrament written ‘na vernacular language. But it is mostly in the nature of bills of exchange. The detailed discussion on money market has been made in Chapter 3, Money Markets: Organisation and Operations Capital Market > The capital market is divided into two parts: primary/new issue market and secondary/ stock market, A primary capital market is that segment of the capital market where mobilisation of finance is made from investors to corporate capital structures by issue ‘of new securities. New securities in the form of Initial Public Offering (IPQ) and Follow-up Offerings (FPO) are sold by the issuer to the public in the primary market (Exhibit 1.6); > The secondary capital marketis known as ‘aftermarket’/stock market where securities which have been issued before are traded. The main objective of secondary market is to help both buyers and sellers of securities to come together and to facilitate the transfer of securities. Its important to note that while mobilisation of finance is directly made from investors to issuer company in the primary capital market, funds and securities are transferred, from one investor to another, in the secandary market; > Thus, while the primary market facilitates capital formation in the economy directly, secondary market provides liquidity to the securities for the benefit of holders of securities. In India, the secondary market is represented by the stock exchange network A detailed discussion on capital market has been made in Chapter 5, Primary Capital Markets: Organisation and Operations and Chapter 6, Secondary Capital Markets: Organisation and Operations.INDIAN FINANCIAL MARKETS | ‘Tie Fivanciat System ano THe Economy 23 f _ “canter I 1 Repost overnment me = PrimarymNeow ISecondry Markat| Issue tarket Stock Market mater Sevorviary laces Issue Market | |” Stock Market Capital Market and Money Market: Dist ‘The points of difference between the capital market and money market are summarised as follows: (0) Pubic asus i) Private Pacement (i) Bonus saves Exchanges + Regional steck Exhibit 1.6 Financia! Markets in india guishing Features Points ‘Maney Market ‘Capital Market Funds ‘Money market is concerned with short-term |The capital market deals with long-term funds for the business enterprises, funds for the corporate sectors Securities [It comprises securities Tike treasury bills, commercial paper, trade bills, ceposicertfi- cates, ete Itineludes securities ike shares, debentures, bonds and government secuilies, ete (Continued)24 Inoian Financia Sysrem Points “Money Market Capital Market Market ‘Themoney market's participants are the RBI, |The capital markets participants are mer Participants | commercial banks, non-banking, financial | chant bankers, stockbrokers, underwriters, ‘companies, primary dealers, ec ‘mutual fimds, financial institutions, depos tory, depository participants, individual in- vestors and institutional investors ee, Secondary There is no sound secondary market The capital is cvided into two separate seme marker ‘ments, namely primary capital market and seconciary capital market (Le. stock market). Market The RBI mainly regulates the money market | The SEDI as the market regulator controls, regulator _| in India, regulates and monitors the capital market. Primary and Secondary Markets: Distinguishing Features The points of distinction between the primary market and secondary market are stated below: are merchant hankers, stockbrokers, under ‘writers, matual funds, financial institutions, epository, depository participants, inelvide ‘al investors and insbitutional investors, ete Points Primary Market Secondary Market Function ‘The main function of primary market is | Secondary market functions to provide to raise long term funds through fresh is | continuous and ready market for the exist. sue of securities, ing long-term securities ‘Securities ‘New securities in the form of IPOs and | The secondary capital maikat is known as FPOs are sold by the issuer company to | ‘aftermarket’ or'stock market’ where secu, the public in the primary market. ties, which have been issued in the primary. ‘market, are traded thnough stock exchamges, Nature of Mobilisation of finanee is directly made | Funds and securities are transferred fom the Mobilisation of | from investors to issuer company in pri- | hands of one investor tothe hands of another Funds mary capital market, inthe secondacy market. Participants The primary capital market's participants | The secondary capital market's participants are stockbrokers, underwriters, mutual funds, financial institutions, depository, de- ppository participants, individual investors and institutional investors, ete Market Liquidity It facilitates capital formation in the economy directly. Te provides liquidity to the securities for the benefits of holders of securities Listing Requirement ‘According to the Companies Act, 2013, a company intending to offer shares or de- bentures to public through prospectus is ‘mandatory require to lists securities on 1 recognised stock exchange or more thast ‘ane recognised stock exchange. The listing, fon the stock exchanges is dane within six days from the finalisation of the issue ‘The Securities Contracts (Regulations) Ack, 1956 (SCRA) makes it mandatory for the company to comply with conditions oflsting. A-company desiring to get listing at stock exchange has to meet the xequirement in ac. condance with SEDI (Listing Obligations and Disclosure Requirements) Regulations, 2015, and is required to pay the speciflsting fees. Prices Determination of ‘The offer prices aro determined by the is suer company as well as merchant bank- ‘eras lead managers with due compliance with SEBL requirement for new issue of securities, ‘The price of the securities is determined by forces of demand and supply of the market and there are ups and downs of ‘market price over the time,‘THe FiwaNciat SYSTEM AND THE Economy 25 Foreign Exchange Market > The foreign exchange market deals with multi-currency requirements, which are met by the exchange of currencies. The transfer of finds takes place in this market depending upon the exchange rate. In fact, there is no marketplace (ie., geographic location) for the foreign exchange market. It is a mechanism through which the currency of one country can be exchanged {.e., bought or sold) for the currency of another country in export and import transactions. It comprises all foreign exchange traders who are connected to each other across the globe, They deal with each other through electronic systems; > A market where money denominated in one currency is traded with money denominated in another currency due to buying and selling, of goods, services rendered to foreigners, investment in short-lerm and long-term securities across the international boundaries, foreign bilateral and muiltilateral assistance, etc. is called the foreign exchange market. The primary function of the foreign exchange market is to facilitate trade between different countries and to enable investment being mace by one country in another; > Currently, a number of instruments are available in the Indian forex market: () Spot, Cash and Tom; (ii) Forwards; (ii) FX Swaps; (iv) Currency Swaps; (v) FX Options (include Cost Reduction structures and Covered Calls and Puts); and (vi) Exchange Traded Currency Futures and Options; > The main players in the foreign exchange markets are: (i) commercial banks; (i) the central bank -the RBI in India; (ii) exchange brokers; (iv) customers; and (v) overseas forex markets. This is one of the most developed and integrated markets across the globe. According, to Section 2(b) of the Foreign Exchange Regulation Act, 1973, foreign exchange means foreign currency and includes: (i) all deposits, credits and balances payable in any foreign currency and any drafts, travellers’ cheques, letters of credit and bills of exchange, expressed or drawn, in Indian currency but payable in any foreign currency and (i) any instrument payable, at the option of the crawee 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. A detailed discussion has been made in Chapter 10, Foreign Exchange Market: Organisation and Operations. Long-term Debt Market > Debt market is the important component of capital market where investors sell and buy debt securities. Debt market is a platform for trading of the fixed income securities. There are three main segments in the debt markets in India, viz., government securities (G-Sec Market) comprising central government and state government securities, public sector unit (PSU) bonds and corporate securities; > There are a variety of instruments offered in the debt market comprising commercial paper; certificates of deposit; treasury bills; long-term debt instruments; government of India dated. securities; state government securities; public sector undertaking bonds; bonds of public financial institutions; corporate debentures; floating rate bonds; and zero-coupon bonds; > With a view to financing its fiscal deficit, the government used to Hloat fixed income instruments in order to borrow money. This is done by issuing G-Sees that are sovereign securities issued by the Reserve Bank of India (RBI) on behalf of the Government of India. The corporate bond market comprises financial institution (FI} bonds, public sector unit (PSU) bonds and corporate bonds/debentures controlled by SEBI. The G-Sec as the26. Inovan Financial, Sysvem most dominant category of debt markets forms a major part of the market in the form of outstanding issues, market capitalisation and trading value, A detailed discussion has been macie in Chapter 9, Debt Markets: Organisation and Operations. Derivatives Market > Financial markets are, by nature, extremely volatile and hence the tisk factor isan important ‘concern in capital markets. There is no denying the fact that the last two decades have witnessed a tremendous increase in the volume of international trade and business due 40 globalisation and liberalisation in economic policy, As a result, while financial markets have experienced rapid variations in interest and exchange rates, stock market prices reveal growing financial risk in India as well as abroad. This emphasises the importance of risk ‘management against uncertainty and risk, To reduce this uncertainty and risk, the concept of financial derivatives comes into the picture; > Derivatives are products whose values are derived fram one or more basic variables called bases. These bases can be underiying assets (for instance, forex, equity, etc.) or reference rates, Financial derivatives are divided into four categories: (f) forward contract; (i) futures contract; (ii) options contract; and (iv) swaps contract. The derivatives market performs 3 number of economic functions: > They help in transferring risks from risk-averse people to riskoriented people; > They help in the discovery of future as well as current prices; > They catalyse entrepreneurial activity; > They increase the volume traded in markets because of participation of risk-averse people in greater numbers; > Management of risk is the most important function of derivatives. Financial derivatives provide a powerful tool for limiting risks ~ that individuals and organisations face in the ordinary conduct of their business; > They increase savings and investments in the long run. A detailed discussion on derivative markets has been made in Chapter 8, Derivative Markets: Organisation avd Operations ancial Services > ‘There are different types of financial services in the financial markets. In fact, there is no uniform or standard scheme of the classification of financial services, The financial services industry can be classified into three broad categories: (i) fee-based services; fi) fund-based services; and (ii) insurance services (Exhibit 1.7). { ( Fee based services Fund based seevices| Ineurance services Exhibit 1.7. Types of Financial Services‘Tue Financia System ano THe Economy 27 > Fee-ased financial services are provided by financial institutions/non-banking financial companies and banking, organisations, in specialised fields, to earn a substantial income ~ by way of a fee; dividend; commission; discount; and brokerage ~ on operations. They basically render services to stakeholders in the economy. The major fee-based financial services are: (i) issue management and merchant banking; (ji) corporate advisory services; (i) mutual funds; (iv) asset securitisation; and (¥) credit rating, > In fundbased services, the financial services firm raises funds ~ through equity, debt and deposits ~ and invests the same in securities or lends out to those who are in need of capital. We will be discussing some of these fund-based services such as: (j leasing and hire purchase; {i) venture capital; (ii) factoring: (iv) forfaiting: (v) housing finance; (vi) credit cards; and (vii) bill discounting, These are explained in Ciuuplers 15-17. [PRE-REQUISITES OF SOUND FINANCIAL SYSTEM Financial stability is essential for sustained economic growth, which can only be achieved with sound financial system. Though there is a sound macro-economic management, weak financial system may undermine local economies, making them more vulnerable to external shocks, and may threaten global financial markets. As we know, a sound financial system assists to increase of financial assets/ instruments as a percentage of GDP and to promote the functioning of financial intermediaries However, the fundamentals of sound financial system are as follows (Exhibit 1.8): > Sound Regulatory Framework: Regulatory framework can maintain the stability of and confidence in the financial system by ensuring the solvency and financial soundness of financial institutions, ensuring the smooth operation of payments mechanism. Sound regulatory framework is very much indispensable in order to regulate the financial sy effectively and protect the stakeholders’ interest in efficient manner; tes of Sound Financial System \ Provequi oun eco Sauna Pubic sata note Regulatory, Foreign toceens. of Central Framework | |lexchang na om | [Exchange ‘Management x Toproprate Proper isisure ana] [Wel-nctnng | sag Sytem intrmaon Sten ‘Spa Moret Exhibit 1.8 Prerequisites of Sound Financial System28 Inplan Financia System > Effective Foreign Exchange Rale: The effective exchange rate is an index describing the strength of a currency relative to a basket of other currencies. Foreign exchange zate plays an important role in monetary system in the economy for the financial transactions across the globe. An improving in the effective exchange rate signifies a strengthening of the home curtency with respect to other currencies considered in its calculation. Bflective exchange rates ave useful for estimating whether a currency has appreciated overall relative to tracing partners. Effective foreign exchange rate may influence the financial system positively; > Sound Public Finance and Debt Martagement: Public Finance is concerned with the financial activities of government pertaining to revenue, expenditure and debt operations and their Gfiects on the economy, and it evaluates the impact of those financial activities of govern- ‘ment on individuals as well as corporate bodies. On the other hand, public debt manage- ment is the process of establishing and executing a policy for managing governments’ debt in order to raise the required amount of funding, achieve its risk and cost objectives, and to ‘meet any other debt management goals. It is well known that prudent public debt manage- ment can assist economies to reduce their borrowing cost, control financial risk and extend their domestic debt market. Debt can facilitate financial stability and support economies in developing their domestic financial system as well; = Strategic Role of Central Bonk: Functions of a central bank comprise implementing monetary policies; setting the interest rate to manage both inflation and the country’s exchange rate: Controlling the country’s entire money supply; performing as the government's banker and the bankers’ bank; managing the country’s foreign exchange; making full employment land supervising the banking industry. Hence, strategic role of Central bank enhances the development of sound financial system; > Appropriate Banking System: Banking system, a key component of the financial system, plays 1 significant role in the financial system and the economy in allocating funds from savers to ‘borrowers in an efficent manner. This is done by (i) improving the information problems between investors and borrowers and ensuring a proper use of the depositors’ funds; (i) smoothing, of risk and insurance to depositors; (i) contributing to the growth of the economy. Moreover, the banking system facilitates internal and international trade by provicing references and guarantees, on behalf oftheir customers on the basis of which sellers can supply goods on ered "Thus, the appropriate banking system plays a crucial role inthe financial system of a country; > Proper Disclosure arid Information System: A financial information system is an organised approach to collecting and interpreting information, A welkrun financial disclosure and information system is essential in a sound financial system for appropriate decision-making. Moreover, information disclosure is a vital component of regulation in financial markets for understanding the functioning of financial markets; > Wellfinctioning Capital Markets: Wellfunctioning capital markets usually encourage households as well as institutional investors by mobilising their suxplus funds (savings) to teach their most productive uses (investments) in order to create a diverse form of savings and investments options like some at higher risk, some at lower risk, some shorter term and some longer term, They also contribute to economic growth and reduce poverty and inequality through financial development. However, a completely developed capital market facilitates the financial interactions among financial institutions, households as well as institutional investors including banks and governments together.