INDIAN FINANCIAL SYSTEM

FINANCIAL SYSTEM: A financial system is an orderly structure and mechanism that is available in an
economy to mobilize the monetary resources/capital from various surplus sectors of the economy and
allocate and distribute the same to various needy sectors. It is a composition of various institutions,
markets, regulations and laws, transactions, claims and liabilities. It acts as an intermediary and facilitates
the flow of funds from areas of surplus to areas of deficit. It performs the following functions:
1.
Savings function: Financial system helps in directing the public savings into the hands
of producers of goods and services through various money and capital market instruments that would
yield income in future.
2.
Liquidity function: Financial markets help the investors to liquidate their investments in
financial instruments like stocks, bonds etc.
3.
Payments function: Financial system helps in making payments for various goods and
services through convenient methods like cheque system, credit cards etc.
4.
Risk function: The financial system helps in protecting the people against risks
associated with life, income and health through various insurance policies.
5.
Policy function: As India is a mixed economy, the financial system in the country is
governed by certain policies and regulations framed by the government from time to time.
Financial Markets:
Financial assets represent a claim to the payment of a sum sometime in the future and/or periodic
payment in the form of interest or dividend. Financial markets can be defined as the markets where
financial assets are either created or transferred.
Based on the maturity period of the financial assets issued, financial markets are classified into two
categories:
1.
Money Market: It deals with securities having a short-term maturity period of one year or
less than one year. The instruments that come under this category are- treasury bills, bills of
exchange, certificate of deposits etc.
2.
Capital Market: It deals with securities having a maturity period of more than one year.
Instruments that come under this category are debentures, equity and preference stock, etc.
Money Market Instruments:
Following are some of the money market instruments:
Call money:
The money that is lent for one-day is referred to as call money. The day-to-day surplus funds, usually of
banks, are traded in the call money markets. The money that is lent for a period of 2-15 days is referred to
as notice money.
Features:
Purpose of borrowing call money:
- To help the commercial bill market to discount commercial bills
- To help banks in meeting their CRR requirement, to meet sudden demands for funds, and to meet
temporary mismatches.

Participants in call money market:

(a)
Participants who can both borrow as well as lend: Scheduled banks, nonscheduled commercial banks, foreign banks, state, district and urban cooperative banks, and
intermediaries like Discount and Finance House of India (DFHI) and State Trading Corporation of
India (STCI) etc.
(b)
Participants who can lend only in this market:
Financial institutions like LIC, UTI, IDBI etc., mutual funds like SBI mutual fund, Canbank
mutual fund etc.,
Call rates: Call rates are the interest paid on the call money borrowed. High call rates
indicate a tight liquidity position in the financial market and low call rates indicate an easy liquidity
position in the market. Call rates are extremely volatile in nature due to the following reasons:
(a) The call rates usually go up in the first week when banks need to meet the CRR
requirements and go down in the second week when the CRR requirements are met.

(b) Banks borrow call money in order to meet the disequilibrium caused due to overextension
of loans by banks in excess of their own resources.
(c) Call rates increase when the institutional lenders withdraw funds for meeting business
requirements and when the corporates withdraw funds to pay advance tax.
Commercial Papers (CPs):
Commercial Papers are short-term, unsecured promissory notes issued at a discount to face value by
well known companies with a high credit- rating. They are sold directly by the issuers to the investors or
through agents like merchant banks. CPs help companies with high credit-rating obtain funds at cheaper
rates for financing accounts receivables and inventories and are usually issued at discount reflecting the
prevailing market rates.
Features:
Maturity: The maturity period varies from 15 days to one year.
CPs are unsecured in nature.
Denominations: They are issued in multiples of Rs. 5 lakh and the amount invested by a
single investor should not be less than Rs. 5 lakh.
They usually have a buy-back facility.
They are negotiable by endorsement and delivery and are highly flexible instruments.
Issuing of CPs does not require any underwriting or prior approval from the RBI.
Requirements to be fulfilled for issuing CPs:
(a)
The companys tangible net worth as per the latest audited
balance sheet and fund-based working capital should not be less than Rs. 4 crore.
(b)
The company needs to obtain a board resolution authorizing the
issue of CPs.
(c)
The company should obtain credit rating from one of the agencies
approved by the RBI. The minimum credit rating shall be P-2 of the CRISIL or such equivalent
ratings by other agencies.
CPs can be raised to the extent of 100% of the working capital credit limit.
CPs being a discount paper does not attract interest tax but the trading income, which is
the difference between the cost of acquisition and resale value, is subjected to capital gains tax.
Certificate of Deposits (CDs)
Certificate of deposits are issued by banks in the form of usance promissory notes. Individuals,
corporations, companies, trusts, funds, associations etc. can subscribe to CDs.
Features:
Purpose of issuing CDs: Banks issue CDs as they help in exercising control over the cost
of funds and assure the availability of funds for specific period.
From the investors point of view, CDs form a better way of deploying their short-term surplus funds.
CDs offer higher yields when compared to conventional deposits, while the secondary market offers
liquidity.
CDs are issued at a discount to face value. Bank CDs are always discount bills while
CDs of Development Financial Institutions can be coupon bearing as well.
The maturity for CDs issued by banks varies from 15 days to one year and the maturity
period for CDs issued by financial institutions varies from one year to three years.
CDs have zero default risk as the investors are assured of interest and principal payment.
CDs should be issued in denomination of Rs. 1 lakh (1 unit) of Maturity Value (MV)/Face
Value (FV). The minimum marketable lot for a CD, whether in physical or demat form will be Rs. 1
lakh and in multiples of Rs. 1 lakh.
They are highly liquid in nature.
CDs are freely transferable by endorsement and delivery and there is no lock-in-period
for transferring to others.
CAPITAL MARKETS:
Capital market deals in long-term sources of funds with a maturity period of more than one year. They
provide resources needed by medium and large-scale industries.
Framework of Capital Market:
Capital Market is divided into categories:

(a) Primary Market: Primary market helps companies in raising funds through issue of
securities like shares and debentures.
The capital issues of the companies were earlier controlled by the Capital Issue Control Act, 1947 and
the pricing of the issue was determined by the Controller of Capital Issues (CCI). The CCI controls
have been replaced by the guidelines issued by the Securities and Exchange Board of India under
the SEBI Act, 1992.
SEBI's functions include:
Regulating the business in stock exchanges and any other securities markets.
Registering and regulating the working of collective investment schemes, including
mutual funds.
Prohibiting fraudulent and unfair trade practices relating to securities markets.
Promoting investor's education and training of intermediaries of securities markets.
Prohibiting insider trading in securities with the imposition of monetary penalties on erring
market intermediaries.
Regulating substantial acquisition of shares and takeover of companies.
Calling for information from, carrying out inspections, conducting inquiries and audits of
the stock exchanges and intermediaries and self regulatory organizations in the securities market.
Powers given to SEBI include:
Power to call for periodic returns from the stock exchanges.
Power to call upon the stock exchange or any member of the exchange to furbish
relevant information.
Power to appoint any person to make inquiries into the affairs of the stock exchange.
Power to amend bye-laws of stock exchange.
Power to compel a public company to list its shares in any stock exchange.
Methods of Issuing Securities:
The different methods by which a company can raise capital through the issue of securities are:
1 Public Issue: It involves raising funds directly from public.
2 Rights Issue: Under this method, additional finance is raised from the existing
members by offering securities to them on a pro-rata basis.
3
Bonus Issue: Under this method, profits are distributed to existing shareholders by way
of fully-paid bonus shares, for which no additional payment is made by the shareholders.
4
Private Placement: It involves direct sale of securities (by a private or public limited
companies) to a limited number of sophisticated investors like UTI, LIC, etc. Credit-rating
agencies, trustees, and financial advisors like mutual funds act as intermediaries in this case. It is
particularly useful for investors who do not want to disclose their information to the public.
5
Bought-out Deals (BODs): In case of BODs, a company initially places its equity
shares with a sponsor/ merchant banker, who in turn offloads those shares to the general public
at an appropriate time. The shares are generally offloaded through Over the Counter Exchange of
India (OTCEI) or a recognized stock exchange of India.
Advantages:
It involves less time and the issuers obtain funds immediately.
It is cheaper than public issue.
(b) Secondary Market: The securities already issued in the primary market are traded in the
secondary market. It provides liquidity to the securities held by the investors. It operates through
stock exchanges that regulate the trading activities in this market and ensure safety to the
investors. Under the Securities Contract Act, 1956, government has powers to supervise and
control the stock exchanges; and to correct any irregularities that exist.
Stock Exchanges: They are auction markets for securities. A buyer in the market is termed as bull and
the seller is called a bear. Transactions at stock exchanges commence with the placement of an order.
Types of Orders:

Limit Orders: These orders are limited by a fixed price.

Best Rate Order: These are to be executed at the best possible price.


Immediate or cancel order: This order has to be immediately executed at the
quoted price or it is cancelled.

Limited Discretionary Order: This kind of order provides discretion to the broker
to execute the order at a price that is approximate to the price fixed by the client.

Stop Loss Order: If the loss is beyond a particular limit then the broker is
authorized to sell the security immediately to stop any further occurrence of loss.

Open Order: Under this kind of order, the client does not fix any time or price
limit.
Once the order is executed, delivery is received from the market in the form of share certificate and
transfer deed. Delivery of the share certificate may be of the following types:
Spot delivery: Transaction is settled on the date of contract.
Hand Delivery: Transaction is completed in 14 days from the date of contract.
Specified Delivery: Transaction is completed beyond 14 days as specified at the time of
bargain.
National Stock Exchange (NSE)
The main objectives of NSE are to facilitate speedy transactions and settlement, and to help the small
investors in buying or selling their securities. The NSE has a wide reach through satellite linkage. The
NSE has a computerized trading mechanism which allows flexibility while placing an order, allows brokers
to place limits on price or on the order or even on the time frame. It provides protection to the investors by
not disclosing his identity till the transaction is executed.
Government Securities Market
Government securities market includes all those securities that are issued by the Central government and
the state governments and other entities that are wholly owned by the government. They are also referred
to as gilt-edged securities as the interest and repayment of principal are completely secured in this case.
Depending upon the issuing body, securities can be classified into five categories:

Central government securities

State government securities

Securities guaranteed by the Central Government for All India Financial

Institutions like IDBI, IFCI, etc.

Securities guaranteed by state government for state institutions like State

Electricity Boards and Housing Boards.

Treasury bills issued by the RBI.

The three forms in which government securities can be held are:
1. Stock Certificate: In case of stock issued by government, a stock certificate is given to the owner,
which specifies that he is a registered holder in the book of Public Debt Office (PDO).
i.
It indicates the interest rate, interest due dates and face value of the
stock.
ii.
It is not transferable by endorsement. Transfer can take place only by
means of a transfer deed, by which the transferees name is substituted in the place of the
transferors name in the books of the PDO.
iii.
Interest payment by way of interest warrants and principal repayments
are issued by the PDO to the domicile of the holder or to the specified local office of the RBI or any
branch of the agent bank conducting government securities business in India.
2. Promissory Notes:
They contain promise by the President of India or the Governor of a state for payment of
the consideration along with interest, to the holder.
They are negotiable instruments payable to the order of the specified persons and
transferable by endorsement.
3. Bearer Bonds:
They certify the bearer for entitlement to the specified sum along with interest payable by
way of interest warrants.
They are transferable by physical delivery.

TREASURY BILLS: Treasury bills are short-term promissory notes that are issued by the government to
meet their short-term obligations. The RBI acts as a banker to the Government of India and acts as an
agent for issuing T-Bills. The various investors of T-bills include banks (that invest in T-bills to meet their
SLR requirements), primary dealers, financial institutions, insurance companies, provident funds, NBFCs,
FIIs and state governments.
Features:

The treasury bills are issued for a minimum amount of Rs. 25,000 and in multiples of Rs
25,000 thereof. They are issued at discount and are redeemed at face value.

They are highly liquid and have a highly active secondary market.

Earlier, the GOI (Government of India) issued 4 types of T-Bills viz, 14- day, 91-day, 182day and 364-day T-Bills. However, the 14-day and 182-day T-Bills have been withdrawn from May
14, 2001. At present, the treasury bills are being issued with two types of maturity:
1.
91-day treasury bills
2.
364-day treasury bills
The bills are available in paper as well as in scripless form.
Note: As per the monetary and credit policy of April 2001, the 14-day Treasury Bill and 182-day Treasury
Bill auctions have been discontinued and instead, the notified amount in the 91-day Treasury Bill auctions
has been increased to Rs.250 crore with effect from May 14, 2001. The notified amount of 364-day
Treasury Bills was enhanced to Rs.1, 000 crore from Rs.750 crore with effect from April 3, 2002.

Based on the nature of the issue, T-Bills can be classified into three categories:
(a) Ad hoc T-Bills: These are issued in favour of the RBI and are not issued to the
public. They are issued to serve two purposes:
(i)
To replenish cash balances of the Central Government
(ii)
To provide a medium of investment for temporary surpluses to
state governments, semi-government departments and foreign central banks.
Note: The new system of Ways and Means Advances (WMA) replaced the system of Ad hoc
Bills in March 1997.
(b) On Tap T-Bills: In case of On Tap T-bills, there is no limit to the amount of
investment in these types of securities. They are generally used by the state governments,
banks and provident funds as a liquidity management tool since the RBI is ready to rediscount
them at any point of time.
(c) Auctioned T-Bills: These T-bills are issued through auctions conducted by the
RBI. In this case, the yield is determined on the basis of the bids tendered and accepted at the
auction. The RBI neither rediscounts nor participates in the auctions of these T-bills.

The yield on a T-bill can be computed as:

where, F is the face value
P is the purchase price
d is the maturity period in days.
Public Sector Undertakings Bonds:
During the late 80s, several public sector companies entered the capital market to raise money through
the issue of bonds, including well-known public sector companies like NTPC, NHPC, ITI, Railway Finance
Corporation, Konkan Railway Corporation, etc. These public sector bonds are essentially of two types:
9%
tax-free
bonds,
and
1.3%
taxable
bonds.
These Public Sector bonds are traded on stock exchanges, imparting liquidity to investors investment.
They are also available from merchant banking subsidiaries of some banks. Now some of the PSU bonds
are looking very attractive, with a high Yield-To-Maturity (YTM).
Features:
1. Interest income eligible for deduction under Section 80L of I.T. Act (subject to declaration by the
Central Government).
2. Loan facility available against pledge of bonds as security from sector Banks/Institutions.
3. Nomination facility available.

4.
5.
6.
7.
8.

Market making facility provided to ensure continuous liquidity.

Highest Credit Rating of AAA from credit rating agencies.
Switch option into any other bond of the same institution.
Listing on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
They usually have a maturity period of 7 years and are secured against fixed/floating charge on fixed
assets, book debts, etc.
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