MANAGEMENT OF FINANCIAL SERVICES

MODULE 1

Definition of Financial Services

As per section 65(10) of the Finance Act, 1994, “banking and financial services” means the
following services provided by a banking company or a financial institution including a non
banking financial company, namely;

(i) financial leasing services including equipment leasing and hire-purchase by a body corporate;

(ii) credit card services;

(iii) merchant banking services;

(iv) securities and foreign exchange (forex) broking;

(v) asset management including portfolio management, all forms of fund management, pension fund
management,  custodial depository and trust services, but does not include cash management;

(vi) advisory and other auxiliary financial services including investment and portfolio research and
advice, advice on mergers and acquisition and advice on corporate restructuring and strategy; and

vii) provision and transfer of information and data processing.

Financial services can be defined as the products and services offered by institutions like banks
of various kinds for the facilitation of various financial transactions and other related activities in
the world of finance like loans, insurance, credit cards, investment opportunities and money
management as well as providing information on the stock market and other issues like market
trends
Financial services refer to services provided by the finance industry. The finance industry
encompasses a broad range of organizations that deal with the management of money. Among
these organizations are banks, credit card companies, insurance companies, consumer finance
companies, stock brokerages, investment funds and some government sponsored enterprises.

Functions of Financial Services

 Facilitating transactions (exchange of goods and services) in the economy.

 Mobilizing savings (for which the outlets would otherwise be much more limited).
 Allocating capital funds (notably to finance productive investment).
 Monitoring managers (so that the funds allocated will be spent as envisaged).
 Transforming risk (reducing it through aggregation and enabling it to be carried by those more
willing to bear it).

Characteristics and Features of Financial Services

1. Customer-Specific: Financial services are usually customer focused. The firms providing these
services, study the needs of their customers in detail before deciding their financial strategy,
giving due regard to costs, liquidity and maturity considerations. Financial services firms
continuously remain in touch with their customers, so that they can design products which can
cater to the specific needs of their customers. The providers of financial services constantly
carry out market surveys, so they can offer new products much ahead of need and impending
legislation. Newer technologies are being used to introduce innovative, customer friendly
products and services which clearly indicate that the concentration of the providers of financial
services is on generating firm/customer specific services.
 2. Intangibility: In a highly competitive global environment brand image is very crucial. Unless the
financial institutions providing financial products and services have good image, enjoying the
confidence of their clients, they may not be successful. Thus institutions have to focus on the
quality and innovativeness of their services to build up their credibility.
3. Concomitant: Production of financial services and supply of these services have to be
concomitant. Both these functions i.e. production of new and innovative financial services and
supplying of these services are to be performed simultaneously.
4. Tendency to Perish: Unlike any other service, financial services do tend to perish and hence
cannot be stored. They have to be supplied as required by the customers. Hence financial
institutions have to ensure a proper synchronization of demand and supply.
5. People Based Services: Marketing of financial services has to be people intensive and hence it’s
subjected to variability of performance or quality of service. The personnel in financial services
organisation need to be selected on the basis of their suitability and trained properly, so that
they can perform their activities efficiently and effectively.
6. Market Dynamics: The market dynamics depends to a great extent, on socioeconomic changes
such as disposable income, standard of living and educational changes related to the various
classes of customers. Therefore financial services have to be constantly redefined and refined
taking into consideration the market dynamics. The institutions providing financial services,
while evolving new services could be proactive in visualizing in advance what the market wants,
or being reactive to the needs and wants of their customers.

Scope of Financial Services

Financial services cover a wide range of activities. They can be broadly classified into two,
namely:

1. Traditional Activities

Traditionally, the financial intermediaries have been rendering a wide range of services
encompassing both capital and money market activities. They can be grouped under two heads,
viz.

1. Fund based activities and

2. Non-fund based activities.

Fund based activities: The traditional services which come under fund based activities are the
following:

 Underwriting or investment in shares, debentures, bonds, etc. of new issues (primary market
activities).
 Dealing in secondary market activities.
 Participating in money market instruments like commercial papers, certificate of deposits,
treasury bills, discounting of bills etc.
 Involving in equipment leasing, hire purchase, venture capital, seed capital etc.
 Dealing in foreign exchange market activities. Non fund based activities
Non fund based activities: Financial intermediaries provide services on the basis of non-fund
activities also. This can be called ‘fee based’ activity. Today customers, whether individual or
corporate, are not satisfied with mere provisions of finance. They expect more from financial
services companies. Hence a wide variety of services, are being provided under this head. They
include:

 Managing the capital issue i.e. management of pre-issue and post-issue activities relating to the
capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market
their issue.
 Making arrangements for the placement of capital and debt instruments with investment
institutions.
 Arrangement of funds from financial institutions for the clients project cost or his working
capital requirements.
 Assisting in the process of getting all Government and other clearances.

2. Modern Activities

Beside the above traditional services, the financial intermediaries render innumerable services in
recent times. Most of them are in the nature of non-fund based activity. In view of the
importance, these activities have been in brief under the head ‘New financial products and
services’. However, some of the modern services provided by them are given in brief here under.

 Rendering project advisory services right from the preparation of the project report till the
raising of funds for starting the project with necessary Government approvals.
 Planning for M&A and assisting for their smooth carry out.
 Guiding corporate customers in capital restructuring.
 Acting as trustees to the debenture holders.
 Recommending suitable changes in the management structure and management style with a
view to achieving better results.
 Structuring the financial collaborations/joint ventures by identifying suitable joint venture
partners and preparing joint venture agreements.
 Rehabilitating and restructuring sick companies through appropriate scheme of reconstruction
and facilitating the implementation of the scheme.
 Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political risk by
using swaps and other derivative products.
 Managing in-portfolio of large Public Sector Corporations.
 Undertaking risk management services like insurance services, buy-back options etc.
 Advising the clients on the questions of selecting the best source of  funds taking into
consideration the quantum of funds required, their cost, lending period etc.
 Guiding the clients in the minimization of the cost of debt and in the determination of the
optimum debt-equity mix.
 Promoting credit rating agencies for the purpose of rating companies which want to go public by
the issue of debt instrument.
 Undertaking services relating to the capital market, such as 1)Clearing services, 2)Registration
and transfers, 3)Safe custody of securities, 4)Collection of income on securities.
Institutional framework of Indian financial system

Introduction:

Economic growth and development of any country depends upon a well-knit financial
system. Financial system comprises, a set of sub-systems of financial institutions financial
markets, financial instruments and services which help in the formation of capital. Thus a
financial system provides a mechanism by which savings are transformed into investments
and it can be said that financial system play an significant role in economic growth of the
country by mobilizing surplus funds and utilizing them effectively for productive purpose.

The financial system is characterized by the presence of integrated, organized and regulated
financial markets, and institutions that meet the short term and long term financial needs of
both the household and corporate sector. Both financial markets and financial institutions
play an important role in the financial system by rendering various financial services to the
community. They  operate in close combination with each other.

Financial System

The word "system", in the term "financial system", implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy.  The financial system is concerned about money, credit and
finance-the three terms are intimately related yet are somewhat different from each other.
Indian financial system consists of financial market, financial instruments and financial
intermediation

Role/ Functions of Financial System:

A financial system performs the following functions:

* It serves as a link between savers and investors. It helps in utilizing the mobilized savings
of scattered savers in more efficient and effective manner. It channelises flow of saving into
productive investment.
* It assists in the selection of the projects to be financed and also reviews the performance
of such projects periodically.
* It provides payment mechanism for exchange of goods and services.
* It provides a mechanism for the transfer of resources across geographic boundaries.
* It provides a mechanism for managing and controlling the risk involved in mobilizing
savings and allocating credit.
* It promotes the process of capital formation by bringing together the supply of saving and
the demand for investible funds.
* It helps in lowering the cost of transaction and increase returns. Reduce cost motives
people to save more.
* It provides you detailed information to the operators/ players in the market such as
individuals, business houses, Governments etc.

Features of Financial System:

a) It plays a vital role in the economic development of a country

b) It encourages both savings and investment

c) It links savers and investors

d) It helps in capital formation

e) It helps in allocation of risk

f) It facilitates expansion of financial markets

g) It aids in financial deepening and broadening

Components/ Constituents of Indian Financial system:

The following are the four main components of Indian Financial system

1. Financial institutions
2. Financial Markets
3. Financial Instruments/Assets/Securities
4. Financial Services.

Financial institutions:

Financial institutions are the intermediaries who facilitates smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the
surplus units and allocate them in productive activities promising a better rate of return.
Financial institutions also provide services to entities seeking advises on various issues
ranging from restructuring to diversification plans. They provide whole range of services to
the entities who want to raise funds from the markets elsewhere. Financial institutions act
as financial intermediaries because they act as middlemen between savers and
borrowers. Were these financial institutions may be of Banking or Non-Banking institutions.

Financial Markets:

Finance is a prerequisite for modern business and financial institutions play a vital role in
economic system. It's through financial markets the financial system of an economy works.
The main functions of financial markets are:

1. to facilitate creation and allocation of credit  and liquidity;

2. to serve as intermediaries for mobilization of savings;
3. to assist process of balanced economic growth;
4. to provide financial convenience

Financial Instruments

Another important constituent of financial system is financial instruments. They represent a

claim against the future income and wealth of others. It will be a claim against a person or
an institutions, for the payment of the some of the money at a specified future date.

Financial Services:

Efficiency of emerging financial system largely depends upon the quality and variety of
financial services provided by financial intermediaries. The term financial services can be
defined as "activites, benefits and satisfaction connected with sale of money, that offers to
users and customers, financial related value".
How technology is impacting the finance and banking sector

Technology is changing the way businesses operate and deliver products to consumers in many
sectors. We have alarms that detect poisonous substances in our air, medical equipment that can
identify life-threatening conditions before they become an issue, or smarter computer software to
make controlling vital equipment easier than ever before. An industry that has seen huge
innovations in recent years is the use of technology within the financial world. The new
buzzword ‘FinTech’ is becoming common place in the sector and with an ever-evolving
corporate and consumer focus, the need to keep up with advancements is seeing more choice and
an improved user-experience across the board. In a report compiled by PwC, 77% of financial
institutions will increase internal efforts to innovate, with many businesses embracing the
disruptive nature of FinTech. There are key areas that are incorporating technology into financial
activities to help develop the customer journey including:

Customer service

Perhaps the biggest way that FinTech is disrupting the finance and banking sector is through
customer service. In the past, a good customer service team was vital for any company involved
in finance. Anything that involved the handling of money or financial matters required trained
staff to be able to help sort out problems and provide assistance to people.

However, chatbots have rapidly become the norm for customers to interact with. An AI which
evolves and gets smarter is something which is good on paper, but in theory, it both lacks a
human touch and also renders a lot of people surplus to requirement. Why pay a staff member
when a machine will work for less?

Online banking

Banking was traditionally something that was done in the non-virtual world. People would go
into town to their bank to withdraw money, transfer funds from one place to another, and sort out
their finances. You’d speak to a helpful staff member and interact with people in a brick and
mortar building. However, these kinds of premises are rapidly becoming redundant. Online
banking is getting more and more sophisticated on a daily basis – we can transfer money or pay
for goods with just the push of a button. Using sites such as finance.co.uk, we can switch
between banks and choose products for our requirements; the list is endless. We live in an age
where we can access our bank accounts on phones, computers and tablets. This is the kind of
thing that is disrupting the banking sector and is one of the bigger impacts on the industry and
consumers.

Fraud detection

The investigation and identification of fraud used to be an equal effort from both man and
machine. The system would help to track potential fraudulent transactions, but it would be up to
the staff who were trained to find fraud to look through all the information and determine if there
was fraudulent activity on the account or not.

However, AI is progressing beyond the capacity of the people designing it, and they’re now
starting to be able to detect fraud and identify it. The machine can track through the history of
the victim, and then calculate and predict the likelihood of fraud based on previous patterns. This
can all be done at a much faster speed than a human could, which means that a lot of fraud teams
don’t need to be as big as they are, and can instead be cut down to a small handful of individuals.

Overall, these are just a few of the different ways that technology is altering the way that the
finance industry works. The primary disruption stems from progress. Progress in any field is
usually a form of disruption, because the existing people and technology are rendered obsolete,
and need to be upgraded or removed. The human element of the finance industry is really what’s
at stake here. We’ve known for years that technology will progress to the point that it becomes
more efficient than the people who made them. And the real problem with this is that there’s a
very compelling case for a world based on machines. They’re smarter, faster, less prone to
mistakes and much more economically viable. So when it comes to choosing a way to provide
financial services to people, the choice is sadly obvious and many businesses are concerned they
will lose out to the innovators in this sector if they do not embrace these developments. FinTech
can be a more effective way to work. The benefits of intuition, improvisation and other things
that machines can’t do are outweighed by what they can. The most significant factor is managing
the balance between technology and manual intervention, and how harmonising this will further
revolutionise the industry for both businesses and consumers.

Financial stability

Financial stability is a state in which the financial system, i.e. the key financial markets and the
financial institutional system is resistant to economic shocks and is fit to smoothly fulfil its basic
functions: the intermediation of financial funds, management of risks and the arrangement of
payments.

Financial stability is one of the most widely discussed issues in today’s economic literature. The
relevance of analyses on financial stability was first recognised during the international financial
crises at the end of the 90s, also strengthened by the financial and economic crisis emerging in
2007. These developments prompted the need for continuously providing the professional public
opinion with an up-to-date and reliable picture of the condition of a given country’s financial
sector. Owing to the mutual relations of dependence – affording interpretation on both a vertical
and horizontal level – the analyses need to cover the whole financial intermediary system; in
other words, in addition to the banking system, it is also necessary to analyse non-bank
institutions that in some form take part in financial intermediation. These include numerous types
of institutions, including brokerage firms, investment funds, insurers and other (various) funds.
When analysing the stability of an institutional system, we examine the degree in which the
whole of the system is capable of resisting external and internal shocks. Of course, shocks do not
always result in crises, but an unstable financial environment can in itself impede the healthy
development of the economy.

Factors affecting the stability of the financial system

Different theories define the causes of financial instability; their relevance may vary according to
the period and countries drawn into the scope of analysis. Among the problem factors affecting
the whole of the financial system, literature commonly defines the following ones: rapid
liberalisation of the financial sector, inadequate economic policy, noncredible exchange rate
mechanism, inefficient resource allocation, weak supervision, insufficient accounting and
audit regulation, poor market discipline.

The aforementioned causes of financial crises emerge not only collectively, but also individually,
or in a random combination, therefore the analysis of financial stability is an extremely complex
task. The focus on individual branches distorts the overall picture, thus the issues need to be
examined in their complexity in the course of analysing financial stability.

In trying to identify the main factors affecting financial stability, there are certain circumstances
and conditions which can be listed as having the greatest potential for making financial shocks
more likely to emerge or at least for facilitating the dissemination of financial disturbances.
First, increased cross-border integration and the presence of large international financial
institutions facilitate the dissemination of financial shocks across countries. Cross-border
integration linking markets across national boundaries, while allowing a more efficient
international allocation of capital, has the potential of increasing financial contagion. We have
seen a reduction in the so-called home bias with investors searching for investment opportunities
in equity and debt markets around the world, and an increase in the preference for being present
in local markets, as is also now the case in emerging market economies. The presence of large
international financial institutions requires the authorities to adopt an integrated and consolidated
approach as risks are transmitted internationally, increasing the complexity of their supervisory
roles. Efficient cooperation between home and host supervisors is essential.

Second, financial innovation in products and markets, together with the existence of large
financial conglomerates facilitate the transmission of financial shocks in domestic financial
markets. The widespread use of securitization mechanisms may lead to increased concentration
in credit markets. This is a trend that needs to be closely monitored as small and medium size
banking institutions work as credit originators, packing and securitizing portfolios to larger
banks. In particular, the quality of the origination process has to be closely monitored by larger
institutions and by bank supervisors. In addition to the potential risk of concentration, the use of
new and more complex financial products, such as credit derivatives, asset backed securities and
others, allow risks to be transferred away from regulated institutions to agents not fully prepared
to absorb those risks. Derivative instruments are quite helpful to deepen the underlying assets’
markets and to improve the risk sharing across the economy; however, they tend to operate well
only within a range of prices. Outside this range, derivative instruments tend to lose liquidity
quite rapidly, becoming ineffective as hedging instruments and having the potential to augment
financial shocks.
Finally, strong growth in asset prices and the growing importance of household credit are
potential sources of financial instability. The welldocumented boom in equity prices and more
recently real estate prices, generate substantial wealth effects that when reversed can affect
macroeconomic equilibrium in an adverse way, and can lead to misallocation of capital. The
unwinding of stretched positions in these asset markets can be disorderly and have profound
effects on financial stability. With low and stable inflation and lower interest rates household
credit has soared in a number of countries. This is an important and favourable development that
allows better inter-temporal allocation of resources, but also creates new challenges for bank
regulators and supervisors.
Pursuing Financial Stability: Challenges
i) Consistent Macroeconomic Policy Framework
The implementation of a consistent macroeconomic policy framework is crucial to
maintain monetary and financial stability. The framework should be consistent in achieving
its macroeconomic objectives and should avoid the buildup of imbalances that may lead to
financial instability. Providing guidance to market participant as to how the policy operates helps
smooth out the impact of policy decisions. In addition, flexibility to react to shocks that often
affect the economy helps mitigate the risks of generating financial crises. The combination of a
forward-looking monetary policy, aiming at a low and stable inflation, a flexible exchange rate
regime and fiscal discipline is one meaningful macroeconomic policy framework that has served
well a number of countries in supporting financial stability.
ii) Financial System Monitoring
The use of monitoring tools, including macroprudential analysis focused on the financial
system as a whole, is of utmost importance to identify potential sources of instability, to
limit system-wide distress, and to avoid large output costs. Therefore, it is necessary to have
relevant, reliable, timely, and complete standardised data. It is important to note, however, that
such information is distorted and meaningless if similar accounting standards are not adopted. It
is also important to periodically perform systemic stress tests to analyse the potential impact of
adverse macroeconomic shocks under various economic conditions and with different monetary
policy responses.
iii) Market Infrastructure
Market infrastructure plays a central role since financial stability is greatly influenced by
the environment in which intermediaries operate. Just as there are cultural differences, there
are also structural differences across countries. Nations have diverse history, values, political and
economic systems, legal frameworks, and taxation structures which play a central role in the
development of their singular financial systems. Those national influences interact and certainly
affect practices and procedures. Thus, a modern system of contract law, bankruptcy law, efficient
judicial proceedings, accounting and auditing standards, corporate governance practices,
transparency and data dissemination requirements, not to mention an efficient payment and
settlement system, are all required as a basis for a resilient financial system. Having an effective
credit bureau, containing both positive and negative credit information regarding potential
borrowers, is very instrumental to ensure the quality of origination.
iv) Safety Buffers
Safety buffers must be built in good times to face unexpected instability.
Such buffers could include: self-insulation against external shocks through the accumulation of
international reserves, reducing the volatility of exchange rate movements, mitigating the impact
of adverse developments on domestic prices and, therefore, lowering the probability of financial
disruption; and definition of required regulatory capital in appropriate levels to deal with
unexpected losses in the asset portfolio, respecting the business cycle without inappropriately
reducing the supply of credit.
v) Adoption of Common International Standards
Adherence and convergence to high-quality standards and practices are one of the key
ingredients for the efficient allocation and use of scarce economic resources and are
expected to lower the cost of capital and reduce room for regulatory arbitrage. With
increased globalization and interdependence of the world economy, financial intermediaries need
to operate on a level playing field. Unnecessary market burdens or restrictions only create
competitive distortions.
vi) Corporate Bonds and Securities Market
The strategy should also articulate the development of markets and financial instruments
to raise private capital for the financing of long-term investments, especially considering the
growing pension fund and insurance industries and the appetite of international investors. It is
also important to have strong and liquid secondary capital markets.
vii) Enhance the Quality and Availability of Cross-Border Information to Stakeholders
Enhancing the quality and availability of cross-border information facilitates the decision-
making process, risk evaluation and pricing of financial instruments. With the
acknowledged advances in communication channels and tools, and also computer technology,
timely access to, and storage of, data has made market analysis less costly and much faster. With
a growing number of firms listed in world-wide markets seeking to lower the cost of capital, and
with international investors looking for investment opportunities with higher returns across
countries, better disclosure, high quality accounting regimes, transparency, and good governance
are necessary. With regards to country specific information, “financial stability reports” can be
used to enhance the quality of information.
viii) Risk management
The strategy should also encourage the development of prudent and efficient internal risk
management systems, ensuring that they are properly monitored and managed, relating
regulatory requirements to risk management practices and increased transparency.
ix) Market discipline
Market discipline must be fostered through prudential regulation and supervision,
enabling market forces to exert discipline. Moral suasion, reprimands, and penalties are
potential measures to be taken by supervisors when failure to comply with regulations is
identified. It is also important to note that market participants must have the right incentives to
exert discipline; the correct instruments to exercise discipline; sufficient information to more
accurately assess the financial position and performance of an enterprise; and the ability and time
to process information correctly.Timely public disclosure can also reduce the severity of market
disturbances, since market participants are informed on an ongoing basis, and thus are not as
likely to overreact to information on current conditions.
x) Cooperation
Supervisory authorities around the world and multilateral institutions should foster
international cooperation through the exchange of views and ideas, and by enhancing
information sharing between home and host supervisors (e.g. memoranda of understanding,
regular meetings, regional associations). Data dissemination (e.g. IMF’s SDDS) and regional
coordination are particularly important when a domestic crisis could spread across countries with
similar economic structures or close financial linkages.
Domestic supervisors, such as the central bank, the ministry of finance, the securities
regulator, and the deposit insurance institution, should cooperate through the effective
exchange of information and establishment of global directives for market participants.
Cooperation and coordination are essential in dealing with systemic crises.

Development finance
Development finance is the efforts of local communities to support, encourage and catalyze
expansion through public and private investment in physical development, redevelopment and/or
business and industry. It is the act of contributing to a project or deal that causes that project or
deal to materialize in a manner that benefits the long-term health of the community.

Development finance requires programs and solutions to challenges that the local business,
industry, real estate and environment creates. As examples, we need unique financing
approaches to address environmentally contaminated land and specific solutions to unlocking
capital access in underserved markets and industries. Each of the problems that we seek to solve
in development require unique and targeted solutions.

There are dozens of terms within the development finance industry including debt, equity, loans,
bonds, credits, liabilities, remediation, guarantees, collateral, credit enhancement, venture/seed
capital, angels, short-term, long-term, incentives, and gap financing.

Ultimately, development finance aims to establish proactive approaches that leverage public
resources to solve the needs of business, industry, developers and investors.

Universal Banking - Meaning

Universal banking is a combination of Commercial banking, Investment banking, Development

banking, Insurance and many other financial activities. It is a place where all financial products
are available under one roof. So, a universal bank is a bank which offers commercial bank
functions plus other functions such as Merchant Banking, Mutual Funds, Factoring, Credit cards,
Housing Finance, Auto loans, Retail loans, Insurance, etc.

Universal banking is done by very large banks. These banks provide a lot of finance to many
companies. So, they take part in the Corporate Governance (management) of these companies.
These banks have a large network of branches all over the country and all over the world. They
provide many different financial services to their clients.

ln India, two reports in 1998 mentioned the concept of universal banking. They are, the
Narasimham Committee Report and the S.H. Khan Committee Report. Both these reports
advised to consolidate (bring together) the banking industry through mergers and integration of
financial activities. That is, they advised a combination of all banking and financial activities.
That is, they suggested a Universal banking.
Advantages of Universal Banking

The benefits or advantages of universal banking are:-

1. Investors' Trust : Universal banks hold stakes (equity shares) of many companies. These
companies can easily get other investors to invest in their business. This is because other
investors have full confidence and faith in the Universal banks. They know that the
Universal banks will closely watch all the activities of the companies in which they hold
a stake.
2. Economics of Scale : Universal banking results in economic efficiency. That is, it results
in lower costs, higher output and better products and services. In India, RBI is in favour
of universal banking because it results in economies of scale.
3. Resource Utilisation : Universal banks use their client's resources as per the client's
ability to take a risk. If the client has a high risk taking capacity then the universal bank
will advise him to make risky investments and not safe investments. Similarly, clients
with a low risk taking capacity are advised to make safe investments. Today, universal
banks invest their client's money in different types of Mutual funds and also directly into
the share market. They also do equity research. So, they can also manage their client's
portfolios (different investments) profitably.
4. Profitable Diversification : Universal banks diversify their activities. So, they can use
the same financial experts to provide different financial services. This saves cost for the
universal bank. Even the day-to-day expenses will be saved because all financial services
are provided under one roof, i.e. in the same office.
5. Easy Marketing : The universal banks can easily market (sell) all their financial
products and services through their many branches. They can ask their existing clients to
buy their other products and services. This requires less marketing efforts because of their
well-established brand name. For e.g. ICICI may ask their existing bank account holders
in all their branches, to take house loans, insurance, to buy their Mutual funds, etc. This is
done very easily because they use one brand name (ICICI) for all their financial products
and services.
6. One-stop Shopping : Universal banking offers all financial products and services under
one roof. One-stop shopping saves a lot of time and transaction costs. It also increases the
speed or flow of work. So, one-stop shopping gives benefits to both banks and their
clients.

Disadvantages of Universal Banking

The limitations or disadvantages of universal banking are:-

1. Different Rules and Regulations : Universal banking offers all financial products and
services under one roof. However, all these products and services have to follow different
rules and regulations. This creates many problems. For e.g. Mutual Funds, Insurance,
 Home Loans, etc. have to follow different sets of rules and regulations, but they are
provided by the same bank.
2. Effect of failure on Banking System : Universal banking is done by very large banks. If
these huge banks fail, then it will have a very big and bad effect on the banking system
and the confidence of the public. For e.g. Recently, Lehman Brothers a very large
universal bank failed. It had very bad effects in the USA, Europe and even in India.
3. Monopoly : Universal banks are very large. So, they can easily get monopoly power in
the market. This will have many harmful effects on the other banks and the public. This is
also harmful to economic development of the country.
4. Conflict of Interest : Combining commercial and investment banking can result in
conflict of interest. That is, Commercial banking versus Investment banking. Some banks
may give more importance to one type of banking and give less importance to the other
type of banking. However, this does not make commercial sense.

Financial Intermediaries

A financial intermediary is an institution or individual that serves as a middleman among

diverse parties in order to facilitate financial transactions. Financial intermediary is an entity that
acts as the middleman between two parties in a financial transaction, such as a commercial bank,
investment banks, mutual funds and pension funds. Financial intermediaries offer a number of
benefits to the average consumer, including safety, liquidity, and economies of scale involved in
commercial banking, investment banking and asset management. Although in certain areas, such
as investing, advances in technology threaten to eliminate the financial intermediary,
disintermediation is much less of a threat in other areas of finance, including banking and
insurance.

Through the process of financial intermediation, certain assets or liabilities are transformed into
different assets or liabilities. As such, financial intermediaries channel funds from people who
have surplus capital (savers) to those who require liquid funds to carry out a desired activity
(investors).

A financial intermediary is typically an institution that facilitates the channeling of funds

between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary
institution (such as a bank), and that institution gives those funds to spenders (borrowers). This
may be in the form of loans or mortgages. Alternatively, they may lend the money directly via
the financial markets, and eliminate the financial intermediary, which is known as financial
disintermediation.

Functions performed by financial intermediaries

1. Financial intermediaries channel funds between borrowers and lenders.

2. Transforming assets – the function of transforming assets or liabilities into other assets or
liabilities

• Liabilities – deposits
• Assets – loans

– this is the principal activity of most financial institutions.

3. Facilitate the acquisition/payment of goods & services via lower transactions costs – Chequing
services provided by banks improve economic efficiency.

4. Facilitate the creation of a “portfolio” – A portfolio is a collection of financial assets – The

financial system provides economies of scale & scope. Economies of Scope: cost savings that
stem from engaging in complementary activities. Economies of Scale: obtained when the unit
cost of an operation decreases as more of it is done.

5. Ease liquidity constraints – Reallocate consumption/savings patterns . Often the liquidity

required to make certain purchases is not in line with the immediate flow of income available to
individuals. The ability to influence the allocation of consumption and investment is probably the
most important function of intermediation.

6. Provide security – Intermediation provides a host of services that reduce or shift risk. –
Financial institutions can also influence the riskiness of financial transactions.

7. Reduce asymmetric information problem. Asymmetric information: This is a situation where

there is imperfect knowledge. In particular, it occurs where one party has different information to
another. A good example is when selling a car, the owner is likely to have full knowledge about
its service history and likelihood to break-down. The potential buyer, by contrast, will be in the
dark and he may not be able to trust the car salesman. Banks have a comparative advantage in
offering specialized services that help to reduce this problem. Banks can also take advantage of
this asymmetric information problem, with dire consequences.

8. Financial intermediaries reduce adverse selection and moral hazard problems, enabling them
to make profits. Moral hazard - borrower has incentives to engage in undesirable (immoral)
activities making it more likely that won’t pay loan back. Adverse selection - Potential
borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be
selected.

9. Brokerage⇒ an “agency” function – Brokers are agents who bring would-be buyers and sellers
together so transactions can be made.

Role of the Financial Intermediaries

The reason for the all-pervasive nature of the financial intermediaries like banks and insurance
companies lies in their uniqueness. As outlined above, Banks often serve as the “intermediaries”
between those who have the resources and those who want resources. Financial intermediaries
like banks, are asset based or fee based on the kind of service they provide along with the nature
of the client they handle. Asset based financial intermediaries are institutions like banks and
insurance companies whereas fee based financial intermediaries provide portfolio management
and syndication services.
Advantages and disadvantages of financial intermediaries

There are two essential advantages from using financial intermediaries:

1. Cost advantage over direct lending/borrowing

2. Market failure protection; The conflicting needs of lenders and borrowers are reconciled,
preventing market failure

The cost advantages of using financial intermediaries include:

1. Reconciling conflicting preferences of lenders and borrowers

2. Risk aversion intermediaries help spread out and decrease the risks

3. Economies of scale - using financial intermediaries reduces the costs of lending and
borrowing

4. Economies of scope - intermediaries concentrate on the demands of the lenders and

borrowers and are able to enhance their products and services (use same inputs to
produce different outputs)

Various disadvantages have also been noted in the context of climate finance and development
finance institutions. These include a lack of transparency, inadequate attention to social and
environmental concerns, and a failure to link directly to proven developmental impacts.

Types of financial intermediaries

According to the dominant economic view of monetary operations, the following institutions are
or can act as financial intermediaries:

 Banks

 Mutual savings banks

 Savings banks

 Building societies

 Credit unions

 Financial advisers or brokers

 Insurance companies
  Collective investment schemes

 Pension funds

 cooperative societies

 Stock exchanges

Financial innovation

Financial innovation is the act of creating new financial instruments as well as new financial
technologies, institutions, and markets. Recent financial innovations include hedge funds, private
equity, weather derivatives, retail-structured products, exchange-traded funds, multi-family
offices, and Islamic bonds . The shadow banking system has spawned an array of financial
innovations including mortgage-backed securities products and collateralized debt obligations
(CDOs).

There are three categories of innovation—institutional, product, and process. Institutional

innovations relate to the creation of new types of financial firms such as specialist credit card
firms like MBNA, discount broking firms such as Charles Schwab, and internet banks. Product
innovation relates to new products such as derivatives, securitized assets, and foreign currency
mortgages. Process innovations relate to new ways of doing financial business, including online
banking and telephone banking.

Central bank

A central bank, reserve bank, or monetary authority is an institution that manages a state's
currency, money supply, and interest rates. Central banks also usually oversee the commercial
banking system of their respective countries. In contrast to a commercial bank, a central bank
possesses a monopoly on increasing the monetary base in the state, and usually also prints the
national currency, which usually serves as the state's legal tender. Central banks also act as a
"lender of last resort" to the banking sector during times of financial crisis. Most central banks
usually also have supervisory and regulatory powers to ensure the solvency of member
institutions, prevent bank runs, and prevent reckless or fraudulent behavior by member banks.

Central banks in most developed nations are institutionally designed to be independent from
political interference. Still, limited control by the executive and legislative bodies usually exists.

Reserve Bank of India

The RBI, as the central bank of the country, is the centre of the indian financial and monetary
system. As the apex institution, it has been guiding, monitoring, regulating, controlling and
promoting the destiny of the indian financial system since its inception. It commenced its
operations on 1 April 1935 in accordance with the Reserve Bank of India Act, 1934. The Act,
1934 (II of 1934) provides the statutory basis of the functioning of the Bank. The original share
capital was divided into shares of 100 each fully paid, which were initially owned entirely by
private shareholders. Following India's independence on 15 August 1947, the RBI was
nationalised on 1 January 1949.

The RBI plays an important part in the Development Strategy of the Government of India. It is a
member bank of the Asian Clearing Union. The general superintendence and direction of the
RBI is entrusted with the 21-member central board of directors: the governor; four deputy
governors; two finance ministry representatives (usually the Economic Affairs Secretary and the
Financial Services Secretary); ten government-nominated directors to represent important
elements of India's economy; and four directors to represent local boards headquartered at
Mumbai, Kolkata, Chennai and the capital New Delhi. Each of these local boards consists of five
members who represent regional interests, the interests of co-operative and indigenous banks.

The central bank was an independent apex monetary authority which regulates banks and
provides important financial services like storing of foreign exchange reserves, control of
inflation, monetary policy report. A central bank is known by different names in different
countries. The functions of a central bank vary from country to country and are autonomous or
quasi-autonomous body and perform or through another agency vital monetary functions in the
country. A central bank is a vital financial apex institution of an economy and the key objects of
central banks may differ from country to country still they perform activities and functions with
the goal of maintaining economic stability and growth of an economy.

The bank is also active in promoting financial inclusion policy and is a leading member of the
Alliance for Financial Inclusion (AFI). The bank is often referred to by the name Mint Street.
RBI is also known as banker's bank. The Bank was constituted for the need of following:

 To regulate the issue of banknotes

 To maintain reserves with a view to securing monetary stability and

 To operate the credit and currency system of the country to its advantage

Structure

The central board of directors is the main committee of the central bank. The Government of
India appoints the directors for a four-year term. The Board consists of a governor, and not more
than four deputy governors; four directors to represent the regional boards; 2 — usually the
Economic Affairs Secretary and the Financial Services Secretary — from the Ministry of
Finance and 10 other directors from various fields. The bank is headed by the governor and the
post is currently held by economist Shaktikanta Das. There are currently three deputy governors
BP Kanungo, N S Vishwanathan and Mahesh Kumar Jain.

Functions of the Reserve Bank

The functions of the Reserve Bank can be categorised as follows:

1. Monetary policy

2. Regulation and supervision of the banking and non-banking financial institutions, including
credit information companies

3. Regulation of money, forex and government securities markets as also certain financial
derivatives

4. Debt and cash management for Central and State Governments

5. Management of foreign exchange reserves

6. Foreign exchange management—current and capital account management

7. Banker to banks

8. Banker to the Central and State Governments

9. Oversight of the payment and settlement systems

10. Currency management

11. Developmental role

12. Research and statistics

1. Monetary policy

One of the most important functions of central banks is formulation and execution of monetary
policy. In the Indian context, the basic functions of the Reserve Bank of India as enunciated in
the Preamble to the RBI Act, 1934 are: “to regulate the issue of Bank notes and the keeping of
reserves with a view to securing monetary stability in India and generally to operate the currency
and credit system of the country to its advantage.” Thus, the Reserve Bank’s mandate for
monetary policy flows from its monetary stability objective. Essentially, monetary policy deals
with the use of various policy instruments for influencing the cost and availability of money in
the economy. As macroeconomic conditions change, a central bank may change the choice of
instruments in its monetary policy. The overall goal is to promote economic growth and ensure
price stability.

Monetary Policy in India

Over time, the objectives of monetary policy in India have evolved to include maintaining price
stability, ensuring adequate flow of credit to productive sectors of the economy for supporting
economic growth, and achieving financial stability. Based on its assessment of macroeconomic
and financial conditions, the Reserve Bank takes the call on the stance of monetary policy and
monetary measures. Its monetary policy statements reflect the changing circumstances and
priorities of the Reserve Bank and the thrust of policy measures for the future. Faced with
multiple tasks and a complex mandate, the Reserve Bank emphasises clear and structured
communication for effective functioning of the monetary policy. Improving transparency in its
decisions and actions is a constant endeavour at the Reserve Bank. The Governor of the Reserve
Bank announces the Monetary Policy in April every year for the financial year that ends in the
following March. This is followed by three quarterly reviews in July, October and January.
However, depending on the evolving situation, the Reserve Bank may announce monetary
measures at any point of time. The Monetary Policy in April and its Second Quarter Review in
October consist of two parts: Part A provides a review of the macroeconomic and monetary
developments and sets the stance of the monetary policy and the monetary measures. Part B
provides a synopsis of the action taken and the status of past policy announcements together with
fresh policy measures. It also deals with important topics, such as, financial stability, financial
markets, interest rates, credit delivery, regulatory norms, financial inclusion and institutional
developments. However, the First Quarter Review in July and the Third Quarter Review in
January consist of only Part ‘A’.

Monetary Policy Framework

The monetary policy framework in India, as it is today, has evolved over the years. The success
of monetary policy depends on many factors:

i) Operating Target

There was a time when the Reserve Bank used broad money (M3) as the policy target. However,
with the weakened relationship between money, output and prices, it replaced M3 as a policy
target with a multiple indicators approach. As the name suggests, the multiple indicators
approach looks at a large number of indicators from which policy perspectives are derived.
Interest rates or rates of return in different segments of the financial markets along with data on
currency, credit, trade, capital flows, fiscal position, inflation, exchange rate, and such other
indicators, are juxtaposed with the output data to assess the underlying trends in different sectors.
Such an approach provides considerable flexibility to the Reserve Bank to respond more
effectively to changes in domestic and international economic environment and financial market
conditions.

ii) Monetary Policy Instruments

The Reserve Bank traditionally relied on direct instruments of monetary control such as Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Cash Reserve Ratio indicates the
quantum of cash that banks are required to keep with the Reserve Bank as a proportion of their
net demand and time liabilities. SLR prescribes the amount of money that banks must invest in
securities issued by the government. In the late 1990s, the Reserve Bank restructured its
operating framework for monetary policy to rely more on indirect instruments such as Open
Market Operations (OMOs). In addition, in the early 2000s, the Reserve Bank instituted
Liquidity Adjustment Facility (LAF) to manage day-to-day liquidity in the banking system.
These facilities enable injection or absorption of liquidity that is consistent with the prevailing
monetary policy stance.
The repo rate (at which liquidity is injected) and reverse repo rate (at which liquidity is absorbed)
under the LAF have emerged as the main instruments for the Reserve Bank’s interest rate
signalling in the Indian economy. Repo rate is the rate at which the central bank of a country
(Reserve Bank of India in case of India) lends money to commercial banks in the event of any
shortfall of funds. Repo rate is used by monetary authorities to control inflation. Reverse repo
rate is the rate at which the central bank of a country (Reserve Bank of India in case of India)
borrows money from commercial banks within the country. It is a monetary policy instrument
which can be used to control the money supply in the country. The armour of instruments with
the Reserve Bank to manage liquidity was strengthened in April 2004 with the Market
Stabilisation Scheme (MSS). The MSS was specifically introduced to manage excess liquidity
arising out of huge capital flows coming to India from abroad. In addition, the Reserve Bank also
uses prudential tools to modulate the flow of credit to certain sectors so as to ensure financial
stability. The availability of multiple instruments and their flexible use in the implementation of
monetary policy have enabled the Reserve Bank to successfully influence the liquidity and
interest rate conditions in the economy. While the Reserve Bank prefers indirect instruments of
monetary policy, it has not hesitated in taking recourse to direct instruments if circumstances
warrant such actions. Often, complex situations require varied combination of direct and indirect
instruments to make the policy transmission effective. The recent legislative amendments to the
Reserve Bank of India Act, 1934 enable a flexible use of CRR for monetary management,
without being constrained by a statutory floor or ceiling on the level of the CRR. The
amendments to the Banking Regulation Act, 1949 also provide further flexibility in liquidity
management by enabling the Reserve Bank to lower the SLR to levels below the pre-amendment
statutory minimum of 25 per cent of net demand and time liabilities (NDTL) of banks.

2. Regulation and supervision of the banking and non-banking financial institutions,

including credit information companies

The Reserve Bank’s regulatory and supervisory domain extends not only to the Indian banking
system but also to the development financial institutions (DFIs), non-banking financial
companies (NBFCs), primary dealers, credit information companies and select segments of the
financial markets. In respect of banks, the Reserve Bank derives its powers from the provisions
of the Banking Regulation Act, 1949, while the other entities and markets are regulated and
supervised under the provisions of the Reserve Bank of India Act, 1934. The credit information
companies are regulated under the provisions of Credit Information Companies (Regulation) Act,
2005. As the regulator and the supervisor of the banking system, the Reserve Bank has a critical
role to play in ensuring the system’s safety and soundness on an ongoing basis. The objective of
this function is to protect the interest of depositors through an effective prudential regulatory
framework for orderly development and conduct of banking operations, and to maintain overall
financial stability through various policy measures. India’s financial system includes commercial
banks, regional rural banks, local area banks, cooperative banks, financial institutions and non-
banking financial companies. The banking sector reforms since the 1990s made stability in the
financial sector an important plank of the Reserve Bank’s functions. Besides, the global financial
markets have, in the last 75 years, grown phenomenally in terms of volumes, number of players
and instruments. The Reserve Bank’s regulatory and supervisory role has, therefore, acquired
added importance. The Board for Financial Supervision (BFS), constituted in November 1994, is
the principal guiding force behind the Reserve Bank’s regulatory and supervisory initiatives.
There are various departments in the Reserve Bank that perform these regulatory and supervisory
functions. The Department of Banking Operations and Development (DBOD) frames regulations
for commercial banks. The Department of Banking Supervision (DBS) undertakes supervision of
commercial banks, including the local area banks and all-India financial institutions. The
Department of Non-Banking Supervision (DNBS) regulates and supervises the Non-Banking
Financial Companies (NBFCs) while the Urban Banks Department (UBD) regulates and
supervises the Urban Cooperative Banks (UCBs). Rural Planning and Credit Department
(RPCD) regulates the Regional Rural Banks (RRBs) and the Rural Cooperative Banks, whereas
their supervision has been entrusted to NABARD.

3. Regulation of money, forex and government securities markets as also certain financial
derivatives

The Reserve Bank operationalises its monetary policy through its operations in government
securities , foreign exchange and money markets.

Monetary Operations

Open Market Operations

Open Market Operations in the form of outright purchase/sale of Government securities are an
important tool of the Reserve Bank’s monetary management. The Bank carries out such
operations in the secondary market on the electronic Negotiated Dealing System – Order
Matching (NDS-OM) platform by placing bids and/or taking the offers for securities. All the
secondary market transactions in Government Securities are settled through Clearing
Corporation of India Limited (CCIL). The entire settlement is under Delivery versus Payment
mode. The netted funds settlement is carried out through members’ Current Account maintained
at the Reserve Bank and through Designated Settlement Bank for those members who do not
maintain current account with the Reserve Bank. The securities settlement is done in SGL/
CSGL Accounts of members maintained at the central bank. CCIL acts as central counter party
to all Government securities trade facilitating smooth settlement and also guaranteeing
settlement, thus reducing gridlocks and mitigating cascading impact that default by one member
could have on the system.

Liquidity Adjustment Facility Auctions

The liquidity management operations are aimed at modulating liquidity conditions such that the
overnight rates in the money market remains within the informal corridor set by the repo and
reverse repo rates for the liquidity adjustment facility (LAF) operations. In a repo transaction, the
Reserve Bank infuses liquidity into the system by taking securities as collateral, while in a
reverse repo transaction it absorbs liquidity from the system with the Reserve Bank providing
securities to the counter parties. The LAF auctions are also conducted electronically with the
market participants, such as, banks and Primary Dealers. The LAF auctions are conducted either
only once or two times in a day with the operations effectively modulating overnight liquidity
conditions in the market.

Market Stabilisation Scheme

The Market Stabilisation Scheme (MSS) was introduced in April 2004 under which Government
of India dated securities / treasury bills could be issued to absorb surplus structural / durable
liquidity created by the Reserve Bank’s foreign exchange operations. MSS operations are a
sterilisation tool used for offsetting the liquidity impact created by intervention in the foreign
exchange markets. The dated securities / treasury bills are the same as those issued for normal
market borrowings for avoiding segmentation of the market. The MoU between the Reserve
Bank and the Government of India envisaged an annual ceiling, to be fixed through mutual
consultations, for MSS operations along with a threshold which would trigger a review of the
ceiling. The issuances under MSS are matched by an equivalent cash balance held by the
Government in a separate identifiable cash account maintained and operated by the Reserve
Bank. While these issuances do not provide budgetary support to the Government, interest costs
are borne by the Government. These securities are also traded in the secondary market. By
design, the MSS has the flexibility of not only absorbing liquidity but also of injecting liquidity,
if required, through unwinding as well as buy-back of securities issued under the MSS.

Domestic Foreign Exchange Market Operations

Operations in the domestic foreign exchange markets are conducted within the Reserve Bank’s
framework of exchange rate management policy. The exchange rate management policy in
recent years has been guided by the broad principles of careful monitoring and management of
exchange rates with flexibility, without a fixed target or a pre-announced target or a band
coupled with the ability to intervene if and when necessary. It also allows underlying demand
and supply conditions to determine the exchange rate movements over a period in an orderly
way. Subject to this predominant objective, the exchange rate management policy is guided by
the need to reduce excess volatility, prevent the emergence of destabilising speculative activities,
help maintain adequate level of reserves and develop an orderly foreign exchange market. The
Reserve Bank also collates, computes and disseminates RBI Reference exchange rate on daily
basis.

Money Market

The Reserve Bank also carries out regulation and development of money market instruments
such as call / notice / term money market, repo market, certificate of deposit, commercial paper
and Collateralised Borrowing and Lending Obligations (CBLO). The call / notice / term money
market operations are transacted / reported on the Negotiated Dealing System – Call (NDS Call)
platform.

4. Debt and cash management for Central and State Governments

Since its inception, the Reserve Bank has undertaken the traditional central banking function of
managing the government’s banking transactions. The Reserve Bank of India Act, 1934 requires
the Central Government to entrust the Reserve Bank with all its money, remittance, exchange
and banking transactions in India and the management of its public debt. The Government also
deposits its cash balances with the Reserve Bank. The Reserve Bank may also, by agreement, act
as the banker to a State Government. Currently, the Reserve Bank acts as banker to all the State
Governments in India, except Jammu & Kashmir and Sikkim. It has limited agreements for the
management of the public debt of these two State Governments. As a banker to the Government,
the Reserve Bank receives and pays money on behalf of the various Government departments.
As it has offices in only 27 locations, the Reserve Bank appoints other banks to act as its agents
for undertaking the banking business on behalf of the governments. The Reserve Bank pays
agency bank charges to the banks for undertaking the government business on its behalf. The
Reserve Bank has well defined obligations and provides several services to the governments. The
Central Government and State Governments may make rules for the receipt, custody and
disbursement of money from the consolidated fund, contingency fund, and public account. These
rules are legally binding on the Reserve Bank. The Reserve Bank also undertakes to float loans
and manage them on behalf of the Governments. It also provides Ways and Means Advances – a
short-term interest bearing advance – to the Governments, to meet the temporary mismatches in
their receipts and payments. Besides, it arranges for investments of surplus cash balances of the
Governments as a portfolio manager. The Reserve Bank also acts as adviser to Government,
whenever called upon to do so, on monetary and banking related matters. The banking functions
for the governments are carried out by the Public Accounts Departments at the offices / branches
of the Reserve Bank, while management of public debt including floatation of new loans is done
at Public Debt Office at offices / branches of the Reserve Bank and by the Internal Debt
Management Department at the Central Office. For the final compilation of the Government
accounts, both of the centre and states, the Nagpur office of the Reserve Bank has a Central
Accounts Section.

Management of Public Debt

The Reserve Bank manages the public debt and issues new loans on behalf of the Central and
State Governments. It involves issue and retirement of rupee loans, interest payment on the loan
and operational matters about debt certificates and their registration. The union budget decides
the annual borrowing needs of the Central Government. Parameters, such as, interest rate, timing
and manner of raising of loans are influenced by the state of liquidity and the expectations of the

market. The Reserve Bank’s debt management policy aims at minimising the cost of borrowing,
reducing the roll-over risk, smoothening the maturity structure of debt, and improving depth and
liquidity of Government securities markets by developing an active secondary market. While
formulating the borrowing programme for the year, the Government and the Reserve Bank take
into account a number of factors, such as, the amount of Central and State loans maturing during
the year, the estimated available resources, and the absorptive capacity of the market.

5. Banker to the Central and State Governments

Banker to the Central Government

Under the administrative arrangements, the Central Government is required to maintain a

minimum cash balance with the Reserve Bank. Currently, this amount is Rs.10 crore on a daily
basis and Rs.100 crore on Fridays, as also at the end of March and July. Under a scheme
introduced in 1976, every ministry and department of the Central Government has been allotted a
specific public sector bank for handling its transactions. Hence, the Reserve Bank does not
handle government’s day-to-day transactions as before, except where it has been nominated as
banker to a particular ministry or department. In 2004, a Market Stabilisation Scheme (MSS) was
introduced for issuing of treasury bills and dated securities over and above the normal market
borrowing programme of the Central Government for absorbing excess liquidity. The Reserve
Bank maintains a separate MSS cash balance of the Government, which is not part of the
Consolidated Fund of India. As banker to the Government, the Reserve Bank works out the
overall funds position and sends daily advice showing the balances in its books, Ways and
Means Advances granted to the government and investments made from the surplus fund. The
daily advices are followed up with monthly statements.

Banker to the State Governments

All the State Governments are required to maintain a minimum balance with the Reserve Bank,
which varies from state to state depending on the relative size of the state budget and economic
activity. To tide over temporary mismatches in the cash flow of receipts and payments, the
Reserve Bank provides Ways and Means Advances (WMA) to the State Governments. The
WMA scheme for the State Governments has provision for Special and Normal WMA. The
Special WMA is extended against the collateral of the government securities held by the State
Government. After the exhaustion of the special WMA limit, the State Government is provided a
normal WMA. The normal WMA limits are based on three-year average of actual revenue and
capital expenditure of the state. The withdrawal above the WMA limit is considered an overdraft.
A State Government account can be in overdraft for a maximum 14 consecutive working days
with a limit of 36 days in a quarter. The rate of interest on WMA is linked to the Repo Rate.
Surplus balances of State Governments are invested in Government of India 14-day Intermediate
Treasury bills in accordance with the instructions of the State Governments

6. Foreign exchange management—current and capital account management

The Reserve Bank oversees the foreign exchange market in India. It supervises and regulates it
through the provisions of the Foreign Exchange Management Act, 1999. Like other markets, the
foreign exchange market has also evolved over time, and the Reserve Bank has been modulating
its approach towards its function of supervising the market.

Evolution

For a long time, foreign exchange in India was treated as a controlled commodity because of its
limited availability. The early stages of foreign exchange management in the country focused on
control of foreign exchange by regulating the demand due to limited supply. Exchange control
was introduced in India under the Defence of India Rules on September 3, 1939 on a temporary
basis. The statutory power for exchange control was provided by the Foreign Exchange
Regulation Act (FERA) of 1947, which was subsequently replaced by a more comprehensive
Foreign Exchange Regulation Act, 1973. This Act empowered the Reserve Bank, and in certain
cases the Central Government, to control and regulate dealings in foreign exchange payments
outside India, export and import of currency notes and bullion, transfer of securities between
residents and non-residents, acquisition of foreign securities, and acquisition of immovable
property in and outside India, among other transactions. Extensive relaxations in the rules
governing foreign exchange were initiated, prompted by the liberalisation measures introduced
since 1991 and the Act was amended as a new Foreign Exchange Regulation (Amendment) Act
1993. Significant developments in the external sector, such as, substantial increase in foreign
exchange reserves, growth in foreign trade, rationalisation of tariffs, current account
convertibility, liberalisation of Indian investments abroad, increased access to external
commercial borrowings by Indian corporates and participation of foreign institutional investors
in Indian stock market, resulted in a changed environment. Keeping in view the changed
environment, the Foreign Exchange Management Act (FEMA) was enacted in 1999 to replace
FERA with effect from June 1, 2000. FEMA aimed at consolidating and amending the laws
relating to foreign exchange with the objective of facilitating external trade and payments and for
promoting the orderly development and maintenance of foreign exchange markets in India.
Emphasising the shift in focus, the Reserve Bank in due course also amended (since January 31,
2004) the name of its department dealing with the foreign exchange transactions to Foreign
Exchange Department from Exchange Control Department.

Liberalised Approach

The Reserve Bank issues licences to banks and other institutions to act as Authorised Dealers in
the foreign exchange market. In keeping with the move towards liberalisation, the Reserve Bank
has undertaken substantial elimination of licensing, quantitative restrictions and other regulatory
and discretionary controls. Apart from easing restrictions on foreign exchange transactions in
terms of processes and procedure, the Reserve Bank has also provided the exchange facility for
liberalised travel abroad for purposes, such as, conducting business, attending international
conferences, undertaking technical study tours, setting up joint ventures abroad, negotiating
foreign collaboration, pursuing higher studies and training, and also for medical treatment.

Moreover, the Reserve Bank has permitted residents to hold foreign currency up to a maximum
of USD 2,000 or its equivalent. Residents can now also open foreign currency accounts in India
and credit specified foreign exchange receipts into it.

7. Banker to banks

Banks are required to maintain a portion of their demand and time liabilities as cash reserves
with the Reserve Bank, thus necessitating a need for maintaining accounts with the Bank.
Further, banks are in the business of accepting deposits and giving loans. Since different persons
deal with different banks, in order to settle transactions between various customers maintaining
accounts with different banks, these banks have to settle transactions among each other.
Settlement of inter-bank obligations thus assumes importance. To facilitate smooth operation of
this function of banks, an arrangement has to be made to transfer money from one bank to
another. This is usually done through the mechanism of a clearing house where banks present
cheques and other such instruments for clearing. Many banks also engage in other financial
activities, such as, buying and selling securities and foreign currencies. Here too, they need to
exchange funds between themselves. In order to facilitate a smooth inter-bank transfer of funds,
or to make payments and to receive funds on their behalf, banks need a common banker. In order
to meet the above objectives, in India, the Reserve Bank provides banks with the facility of
opening accounts with itself. This is the ‘Banker to Banks’ function of the Reserve Bank, which
is delivered through the Deposit Accounts Department (DAD) at the Regional offices. The
Department of Government and Bank Accounts oversees this function and formulates policy and
issues operational instructions to DAD.

Reserve Bank as Banker to Banks

To fulfill this function, the Reserve Bank opens current accounts of banks with itself, enabling
these banks to maintain cash reserves as well as to carry out inter-bank transactions through
these accounts. Inter-bank accounts can also be settled by transfer of money through electronic
fund transfer system, such as, the Real Time Gross Settlement System (RTGS). The Reserve
Bank continuously monitors operations of these accounts to ensure that defaults do not take
place. Among other provisions, the Reserve Bank stipulates minimum balances to be maintained
by banks in these accounts. Since banks need to settle funds with each other at various places in
India, they are allowed to open accounts with different regional offices of the Reserve Bank. The
Reserve Bank also facilitates remittance of funds from a bank’s surplus account at one location
to its deficit account at another. Such transfers are electronically routed through a computerised
system. The computerisation of accounts at the Reserve Bank has greatly facilitated banks’
monitoring of their funds position in various accounts across different locations on a real-time
basis. In addition, the Reserve Bank has also introduced the Centralised Funds Management
System (CFMS) to facilitate centralised funds enquiry and transfer of funds across DADs. This
helps banks in their fund management as they can access information on their balances
maintained across different DADs from a single location. Currently, 75 banks are using the
system and all DADs are connected to the system.

As Banker to Banks, the Reserve Bank provides short-term loans and advances to select banks,
when necessary, to facilitate lending to specific sectors and for specific purposes. These loans are
provided against promissory notes and other collateral given by the banks.

Lender of Last Resort

As a Banker to Banks, the Reserve Bank also acts as the ‘lender of last resort’. It can come to the
rescue of a bank that is solvent but faces temporary liquidity problems by supplying it with much
needed liquidity when no one else is willing to extend credit to that bank. The Reserve Bank
extends this facility to protect the interest of the depositors of the bank and to prevent possible
failure of a bank, which in turn may also affect other banks and institutions and can have an
adverse impact on financial stability and thus on the economy.
8. Management of foreign exchange reserves

The Reserve Bank, as the custodian of the country’s foreign exchange reserves, is vested with
the responsibility of managing their investment. The legal provisions governing management of
foreign exchange reserves are laid down in the Reserve Bank of India Act, 1934. The Reserve
Bank’s reserves management function has in recent years grown both in terms of importance and
sophistication for two main reasons. First, the share of foreign currency assets in the balance
sheet of the Reserve Bank has substantially increased. Second, with the increased volatility in
exchange and interest rates in the global market, the task of preserving the value of reserves and
obtaining a reasonable return on them has become challenging. The basic parameters of the
Reserve Bank’s policies for foreign exchange reserves management are safety, liquidity and
returns. Within this framework, the Reserve Bank focuses on:

a) Maintaining market’s confidence in monetary and exchange rate policies.

b) Enhancing the Reserve Bank’s intervention capacity to stabilise foreign exchange markets.

c) Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks

during times of crisis, including national disasters or emergencies.

d) Providing confidence to the markets that external obligations can always be met, thus
reducing the costs at which foreign exchange resources areavailable to market participants.

e) Adding to the comfort of market participants by demonstrating the backing of domestic

currency by external assets.

The traditional approach of assessing reserve adequacy in terms of import cover has been
widened to include a number of parameters about the size, composition, and risk profiles of
various types of capital flows. The Reserve Bank also looks at the types of external shocks to
which the economy is potentially vulnerable. The objective is to ensure that the quantum of
reserves is in line with the growth potential of the economy, the size of risk-adjusted capital
flows and national security requirements.

9. Oversight of the payment and settlement systems

The regulation and supervision of payment systems is being increasingly recognised as a core
responsibility of central banks. Safe and efficient functioning of these systems is an important
pre-requisite for the proper functioning of the financial system and the efficient transmission of
monetary policy.

The Reserve Bank, as the regulator of financial systems, has been initiating reforms in the
payment and settlement systems to ensure efficient and faster flow of funds among various
constituents of the financial sector. The increasing monetisation in the economy, the country’s
large geographic expanse, people’s preference for paper-based instruments and rapid changes in
technology are among factors that make this task a formidable one.
Development, Consolidation and Integration

The Reserve Bank has adopted a three-pronged strategy of consolidation, development and
integration to establish a modern and robust payment and settlement system which is also
efficient and secure.

The consolidation revolves around expanding the reach of the existing products by introducing
clearing process in new locations. The reach is also facilitated by the use of latest technology,
such as, mechanised cheque processing, image-based cheque processing systems, and
interconnection of the clearing houses. The Reserve Bank has also taken steps towards
integrating the payment system with the settelement systems for government securities and
foreign exchange. To facilitate settlement of Government securities transactions, it created the
Negotiated Dealing System, a screen-based trading platform. The NDS facilitates the dealing
process and provides for electronic reporting of trades, on-line information dissemination and
settlement in a centralised system. For settlement of trade in foreign exchange, Government
securities and other debt instrument, it has set up the Clearing Corporation of India Limited
(CCIL). This plays the role of a central counter party to transactions and guarantees settlement of
trade, thus managing the counter party risk.

The National Electronic Clearing Service (NECS), facilitates credits to bank accounts of
multiple customers against a single debit of remitter’s account. NECS (Debit) when launched
would facilitate multiple debits to destination account holders against a single credit to the
sponsor bank. The system has a pan-India characteristic leveraging on Core Banking Solutions
(CBS) of member banks, facilitating all CBS bank branches to participate in the system,
irrespective of their location. As at the end of September 2009 as many as 114 banks with 30,780
branches were participating in NECS.

The Reserve Bank has introduced an Electronic Funds Transfer scheme to enable an account
holder of a bank to electronically transfer funds to another account holder with any other
participating bank.

The Real Time Gross Settlement system settles all inter-bank payments and customer
transactions above rupees one lakh. Participants in this system include banks, financial
institutions, primary dealers and clearing entities. All systemically important payments including
securities settlement, forex settlement and money market settlements are processed through the
RTGS system.

Pre-paid payment instruments facilitate purchase of goods and services against the value
stored on these instruments. To encourage the use of this safe payment mechanism, the Reserve
Bank has issued guidelines that lay down the basic eligibility criteria and the conditions for
operating such payment systems in the country.

The Reserve Bank has also issued guidelines for the use of mobile phones as a medium for
providing banking services. Only banks which are licensed and supervised in India and have a
physical presence in India are permitted to offer mobile banking services in the country. The
guidelines focus on systems for security and inter-bank transfer arrangements through authorised
systems.

The Reserve Bank encouraged the setting up of the National Payments Corporation of India
(NPCI) to act as an umbrella organisation for operating the various retail payment systems in
India. NPCI is expected to bring greater efficiency in retail payment by way of uniformity and
standardisation as also expansion of reach and innovative payment products to augment customer
convenience.

Legal Framework

The Payment and Settlement Systems Act, 2007 provides for regulation and supervision of
payment systems in India and designates the Reserve Bank as the authority for the purpose. As
per the Act, only payment systems authorised by the Reserve Bank can be operated in the
country. The Act also provides for the settlement effected under the rules and procedures of the
system provider to be treated as final and irrevocable.

10. Currency management

Management of currency is one of the core central banking functions of the Reserve Bank for
which it derives the necessary statutory powers from Section 22 of the RBI Act, 1934. Along
with the Government of India, the Reserve Bank is responsible for the design, production and
overall management of the nation’s currency, with the goal of ensuring an adequate supply of
clean and genuine notes. In consultation with the Government, the Reserve Bank routinely
addresses security issues and targets ways to enhance security features to reduce the risk of
counterfeiting or forgery of currency notes. The Paper Currency Act of 1861 conferred upon the
Government of India the monopoly of note issues, thus ending the practice of private and
presidency banks issuing currency. Between 1861 and 1935, the Government of India managed
the issue of paper currency. In 1935, when the Reserve Bank began operations, it took over the
function of note issue from the Office of the Controller of Currency, Government of India.

Currency Management

The Reserve Bank carries out the currency management function through its Department of
Currency Management located at its Central Office in Mumbai, 19 Issue Offices located across
the country and a currency chest at its Kochi branch . To facilitate the distribution of notes and
rupee coins across the country, the Reserve Bank has authorised selected branches of banks to
establish currency chests. There is a network of 4,281 Currency Chests and 4,044 Small Coin
Depots with other banks. Currency chests are storehouses where bank notes and rupee coins are
stocked on behalf of the Reserve Bank. The currency chests have been established with State
Bank of India, six associate banks, nationalised banks, private sector banks, a foreign bank, a
state cooperative bank and a regional rural bank. Deposits into the currency chest are treated as
reserves with the Reserve Bank and are included in the CRR. The reverse is applicable for
withdrawals from chests. Like currency chests, there are also small coin depots which have been
established by the authorised bank branches to stock small coins. The small coin depots
distribute small coins to other bank branches in their area of operation. The Department of
Currency Management makes recommendations on design of bank notes to the Central
Government, forecasts the demand for notes, and ensures smooth distribution of notes and coins
throughout the country. It arranges to withdraw unfit notes, administers the provisions of the RBI
(Note Refund) Rules, 2009 (these rules deal with the payment of value of the soiled or mutilated
notes) and reviews/rationalises the work systems and procedures at the issue offices on an
ongoing basis. The RBI Act requires that the Reserve Bank’s affairs relating to note issue and its
general banking business be conducted through two separate departments – the Issue Department
and the Banking Department. All transactions relating to the issue of currency notes are
separately conducted, for accounting purposes, in the Issue Department. The Issue Department is
liable for the aggregate value of the currency notes of the Government of India (currency notes
issued by the Government of India prior to the issue of bank notes by the Reserve Bank) and
bank notes of the Reserve Bank in circulation from time to time and it maintains eligible assets
for equivalent value. The assets which form the backing for note issue are kept wholly distinct
from those of the Banking Department. The Issue Department is permitted to issue notes only in
exchange for notes of other denominations or against prescribed assets. This Department is also
responsible for getting its periodical requirements of notes/coins from the currency printing
presses/mints, distribution of notes and coins among the public as well as withdrawal of
unserviceable notes and coins from circulation. The mechanism for putting currency into
circulation and its withdrawal from circulation (that is, expansion and contraction of currency,
respectively) is effected through the Banking Department.

Currency Distribution

The Government of India on the advice of the Reserve Bank decides on the various
denominations of the notes to be printed. The Reserve Bank coordinates with the Government in
designing the banknotes, including their security features. For printing of notes, the Security
Printing and Minting Corporation of India Limited (SPMCIL), a wholly owned company of the
Government of India, has set up printing presses at Nashik, Maharashtra and Dewas, Madhya
Pradesh. The Bharatiya Reserve Bank Note Mudran Pvt. Ltd. (BRBNMPL), a wholly owned
subsidiary of the Reserve Bank, also has set up printing presses at Mysore in Karnataka and
Salboni in West Bengal. The Reserve Bank estimates the quantity of notes (denomination-wise)
that is likely to be required and places indents with the various presses. The notes received from
the presses are then issued for circulation both through remittances to banks as also across the
Reserve Bank counters. Currency chests, which are maintained by banks, store soiled and re-
issuable notes, as also fresh banknotes. The banks send notes, which in their opinion are unfit for
circulation, back to the Reserve Bank. The Reserve Bank examines these notes and re-issues
those that are found fit for circulation. The soiled notes are destroyed, through shredding, so as to
maintain the quality of notes in circulation.

Coin Distribution

The Indian Coinage Act, 1906 governs the minting of rupee coins, including small coins of the
value of less than one rupee. One rupee notes (no longer issued now) and coins are legal tender
in India for unlimited amounts. Fifty paisa coins are legal tender for any sum not exceeding ten
rupees and smaller coins for any sum not exceeding one rupee. The Reserve Bank acts as an
agent of the Central Government for distribution, issue and handling of the coins (including one
rupee note) and for withdrawing and remitting them back to Government as may be necessary.
SPMCIL has four mints at Mumbai, Noida (UP), Kolkata and Hyderabad for coin production.
Similar to distribution of banknotes, coins are distributed through various channels such as
Reserve Bank counters, banks, post offices, regional rural banks and urban cooperative banks.
The Reserve Bank offices also sometimes organise special coin melas for exchanging notes into
coins through retail distribution. Just as unfit banknotes are destroyed, unfit coins are also
withdrawn from circulation and sent to the mint for melting.

Exchange of Notes

Basically there are two categories of notes which are exchanged between banks and the Reserve
Bank – soiled notes and mutilated notes. While soiled notes are notes which have become dirty
and limp due to excessive use or a two-piece note, mutilated note means a note of which a
portion is missing or which is composed of more than two pieces. While soiled notes can be
tendered and exchanged at all bank branches, mutilated notes are exchanged at designated bank
branches and such notes can be exchanged for value through an adjudication process which is
governed by Reserve Bank of India (Note Refund) Rules, 2009. Under current provisions, either
full or no value for notes of denomination up to Rs.20 is paid, while notes of Rs.50 and above
would get full, half, or no value, depending on the area of the single largest undivided portion of
the note. Special adjudication procedures exist at the Reserve Bank Issue offices for notes which
have turned extremely brittle or badly burnt, charred or inseparably stuck together and, therefore,
cannot withstand normal handling.

Combating Counterfeiting

To combat the incidence of forged notes, the Reserve Bank has taken certain measures like
publicity campaigns on security features of bank notes and display of “Know Your Bank note”
poster at bank branches including at offsite ATMs. The Reserve Bank, in consultation with the
Government of India, periodically reviews and upgrades the security features of the bank notes
to deter counterfeiting. It also shares information with various law enforcement agencies to
address the issue of counterfeiting. It has also issued detailed guidelines to banks and
government treasury offices on how to detect and impound counterfeit notes.

11. Developmental role

The Reserve Bank is one of the few central banks that has taken an active and direct role in
supporting developmental activities in their country. The Reserve Bank’s developmental role
includes ensuring credit to productive sectors of the economy, creating institutions to build
financial infrastructure, and expanding access to affordable financial services. Over the years, its
developmental role has extended to institution building for facilitating the availability of
diversified financial services within the country. The Reserve Bank today also plays an active
role in encouraging efficient customer service throughout the banking industry, as well as
extension of banking service to all, through the thrust on financial inclusion. Towards this goal,
which has evolved over many years, the Reserve Bank has taken various initiatives.

Rural Credit
Given the predominantly agrarian character of the Indian economy, the Reserve Bank’s role has
been to ensure timely and adequate credit to the agricultural sector at affordable cost. Section 54
of the RBI Act, 1934 states that the Bank may maintain expert staff to study various aspects of
rural credit and development and in particular, it may tender expert guidance and assistance to
the National Bank (NABARD) and conduct special studies in such areas as it may consider
necessary to do so for promoting integrated rural development.

Priority Sector Lending

The focus on priority sectors can be traced to the Reserve Bank’s credit policy for the year 1967-
68, and institution of a scheme of ‘social control’ over commercial banks in 1967 by the
Government of India to remove certain deficiencies observed in the functioning of the banking
system, such as, bulk of bank advances directed to large and medium-scale industries and
established business houses. In order to provide access to credit to the neglected sectors, a target
based priority sector lending was introduced from the year 1974, initially with public sector
banks. The scheme was gradually extended to all commercial banks by 1992. The scope and
extent of priority sectors have undergone several changes since the formalisation of description
of the priority sectors in 1972. The guidelines on lending to priority sector were revised with
effect from April 30, 2007. The guiding principle of the revised guidelines on lending to priority
sector has been to ensure adequate flow of bank credit to those sectors of the society/ economy
that impact large segments of the population and weaker sections, and to the sectors which are
employment-intensive, such as, agriculture and small enterprises. The broad categories of
advances under priority sector now include agriculture, micro and small enterprises sector,
microcredit, education and housing.

Lead Bank Scheme

The Reserve Bank introduced the Lead Bank Scheme in 1969. Here designated banks were made
key instruments for local development and were entrusted with the responsibility of identifying
growth centres, assessing deposit potential and credit gaps and evolving a coordinated approach
for credit deployment in each district, in concert with other banks and other agencies. The
Reserve Bank has assigned a Lead District Manager for each district who acts as a catalytic force
for promoting financial inclusion and smooth working between government and banks.

Special Agricultural Credit Plan

With a view to augmenting the flow of credit to agriculture, Special Agricultural Credit Plan
(SACP) was instituted and has been in operation for quite some time now. Under the SACP,
banks are required to fix self-set targets showing an increase of about 30 per cent over previous
year’s disbursements on yearly basis (April – March). The public sector banks have been
formulating SACP since 1994. The scheme has been extended to Private Sector banks as well
from the year 2005-06.

Kisan Credit Cards

The Kisan Credit Card (KCC) Scheme was introduced in the year 1998-99 to enable the farmers
to purchase agricultural inputs and draw cash for their production needs. On revision of the KCC
Scheme by NABARD in 2004, the scheme now covers term credit as well as working capital for
agriculture and allied activities and a reasonable component for consumption needs. Under the
scheme, the limits are fixed on the basis of operational land holding, cropping pattern and scales
of finance. Seasonal sub-limits may be fixed at the discretion of the banks. Limits may be fixed
taking into account the entire production credit needs along with ancillary activities relating to
crop production, allied activities and also non-farm short term credit needs (consumption needs).
Limits are valid for three years subject to annual review. Security, margin and rate of interest are
as per RBI guidelines issued from time to time.

Natural Calamities – Relief Measures

In order to provide relief to bank borrowers in times of natural calamities, the Reserve Bank has
issued standing guidelines to banks. The relief measures include, among other things,
rescheduling / conversion of short-term loans into term loans; fresh loans; relaxed security and
margin norms; treatment of converted/rescheduled agriculture loans as ‘current dues’; non-
compounding of interest in respect of loans converted / rescheduled; and moratorium of at least
one year.

Financial Inclusion

Post liberalisation and deregulation of the financial sector within the country, it was observed
that banking industry has shown tremendous growth in volume and range of services provided
while making significant improvements in financial viability, profitability and competitiveness.
However, banks had not been reaching and bringing vast segments of the population, especially
the underprivileged sections of society, into the fold of basic banking services to the desired
extent. This prompted the need for the RBI to develop a specific focus towards Financial
Inclusion for inclusive growth.

12. Research and statistics

The Reserve Bank has over time established a sound and rich tradition of policy-oriented
research and an effective mechanism for disseminating data and information. Like other major
central banks, the Reserve Bank has also developed its own research capabilities in the field of
economics, finance and statistics, which contribute to a better understanding of the functioning
of the economy and the ongoing changes in the policy transmission mechanism.

Internal Research

The research undertaken at the Reserve Bank revolves around issues and problems arising in the
current environment at national and international levels, which have critical implications for the
Indian economy. The primary data compiled by the Reserve Bank becomes an important source
of information for further research by the outside world. The Reserve Bank also disseminates
data and information regularly in the form of several publications and through its website. The
Reserve Bank has made focused efforts to provide quality data to the public at large, which has
emanated from its internal economic research and robust statistical system, established and
strengthened over the years. It endeavours to provide credible statistics and information to users
across the spectrum of market participants, businesses, the media, professionals and the
academics. This is done through various tools, such as, website, press releases, and weekly,
monthly, quarterly and annual publications. India is among the first few signatories of the
Special Data Dissemination Standards (SDDS) as defined by the International Monetary Fund
for the purpose of releasing data and the Reserve Bank contributes to SDDS in a significant
manner.

Data and Research Dissemination

The Reserve Bank releases several periodical publications that contain a comprehensive account
of its operations as well as information of the trends and developments pertaining to various
areas of the Indian economy. Besides, there are periodical statements on monetary policy,
official press releases, and speeches and interviews given by the top management which
articulate the Reserve Bank’s assessment of the economy and its policies. The Reserve Bank is
under legal obligation under The RBI Act to publish two reports every year: the Annual Report
and the Report on Trend and Progress of Banking in India. Besides these and the regular
periodical publications, it also publishes reports of various committees appointed to look into
specific subjects, and discussion papers prepared by its internal experts. The Reserve Bank has
also set up an enterprise-wide data warehouse through which data is made available in
downloadable and reusable formats. Users now have access to a much larger database on the
Indian economy through the Reserve Bank’s website. This site has a user-friendly interface and
enables easy retrieval of data through pre-formatted reports. It also has the facility for simple and
advanced queries. Under the aegis of the Development Research Group in the Department of
Economic Analysis and Policy, the Reserve Bank encourages and promotes policy-oriented
research backed by strong analytical and empirical basis on subjects of current interest. The
DRG studies are the outcome of collaborative efforts between experts from outside the Reserve
Bank and the pool of research talent within. The annual Report on Currency and Finance has
now been made into a theme-based publication, providing in-depth information and analysis on a
topical subject. It has become a valuable reference point for research and policy formulation.

Data and Research Dissemination

The Handbook of Statistics on the Indian Economy constitutes a major initiative at improving
data dissemination by providing statistical information on a wide range of economic indicators.
The Handbook was first published in 1996 and over the years, its coverage has improved
significantly. The Reserve Bank’s two research departments – Department of Economic Analysis
and Policy and Department of Statistics and Information Management – provide analytical
research on various aspects of the Indian economy

Main supervisory agencies in the Indian financial sector

Agency Jurisdiction
Main supervisory agencies in the Indian financial sector

Agency Jurisdiction

Securities and Exchange Board of Stock exchanges, merchant bankers, market intermediaries, rating
India (SEBI) agencies, mutual funds

Insurance Regulatory and Insurance companies

Development Authority (IRDA)

National Bank for Agriculture State and central cooperative banks, regional rural banks, agricultural
Development (NABARD) and rural development banks

National Housing Bank (NHB) Housing finance companies

RBI framework for the supervision of Banks and financial institutions in India

The Reserve Bank of India (RBI), the country's central bank, carries out the supervision and
regulation of banks and non-bank finance companies under the provisions of the Banking
Regulation Act of 1949 and the Reserve Bank of India Act of 1934. The High Level
Coordination

a) Banks

India's banking system dominates its financial sector, with over 60 percent of the combined
assets, and is the focus of prudential supervision, the framework for which has evolved since the
establishment of the RBI in 1935. Earlier, both banking and non-banking companies were
governed under the provisions of the Indian Companies Act of 1913, which was amended in
1936 to include a chapter on banks. This evolved into the Banking Companies Act of 1949 was
renamed the Banking Regulation Act of 1949 from 1 March 1966, at which date certain
provisions were extended to cooperative banks.

The Banking Regulation Act is a comprehensive piece of legislation which provides the RBI
with the authority and the instruments to make supervisory interventions through the life cycle of
banking companies. The RBI can issue directions, obtain information, inspect the books and
accounts, appoint nominees to boards, effect change in management, impose monetary and other
penalties, cancel the license, and cause merger, amalgamation, or closure of banks. The act also
incorporates a powerful enabling clause to issue directions to banks on matters of policy and
administration.

Traditionally, on-site inspection has been the main instrument of supervision, with a
comprehensive off-site surveillance system introduced only in 1995. Under this system, banks
submit quarterly data, which are processed and stored electronically and used for supervisory
analysis and intervention. The RBI had, however, begun limited inspection of banks with their
consent as far back as 1940 to arrive at their "free and exchangeable value of assets" for the
purpose of determining their eligibility for scheduling under the RBI act. In 1946 the objective
was widened to include a determination of "whether the affairs of the bank were being conducted
in a manner detrimental to the depositors," thus adding a qualitative appraisal of management
and operations to a quantitative assessment of solvency.

Since 1958, banks have been inspected annually to ensure their compliance with directions and
regulations. These inspections now also aim at assessing the risk management capabilities of the
banks. With the implementation of Risk Based Supervision, which is currently being tested,
supervisory resources (including inspection frequency and focus) will be based on the risk
profile of individual banks.

The approach followed has been one of gradual strengthening of the prudential framework, with
creeping targets normally announced well in advance to prevent sudden shocks. For example, the
capital adequacy ratio was increased from 4 percent to 9 percent over a five-year period while
the contraction of the delinquency period for nonperforming loans to ninety days was announced
three years before scheduled implementation in 2004.

The position of compliance with standards and practices dispensed by the Basel Committee on
Banking Supervision (committee of the Bank of International Settlement, or BIS, which is based
in Basel, Switzerland) has been evaluated by three groups since 1998: internally; through a group
of outside experts set up by the Committee on Standards and Codes; and by the International
Monetary Fund. The assessments have found the supervisory system for banks largely compliant
with the Twenty-five Basel Core Principles of Effective Banking Supervision and identified gaps
mainly in the areas of consolidated supervision, country risk management, and interagency
cooperation.

There have been no systemic crises in the commercial banking system since India's economic
liberalization of 1991, despite instances of individual institutional stress. The challenges now
arise from the difficulty that the supervisors may face in taking appropriate action in a system
dominated by state-owned banks.

b) Non-banks

Traditionally, non-bank trading and manufacturing companies accepted public deposits to

finance their working capital requirements and were subject to the provisions of the Companies
Act. In the 1950s, there was an expansion in the deposit-taking activities of financial non-banks,
notably hire-purchase companies. Bankers protested the "diversion" of potential bank deposits by
unregulated entities. This led to the Banking Laws (Miscellaneous) Provisions Act of 1963,
which authorized the RBI to specify the terms and conditions applicable to public deposits, to
call for information about these deposits, and to issue directions, conduct inspections, and
impose penalties. In 1966, by which time non-bank deposits had reached 8 percent of bank
deposits, the RBI issued comprehensive directions.

The prudential framework for supervision is more focused on the deposit-taking non-bank
finance companies, and by an amendment to the RBI act in 1997, the RBI now has legislative
authority to give such companies directions on prudential norms and take corrective action
including prohibiting them from accepting further deposits or alienating assets; imposing
penalties and filing for their winding up. The instruments of supervision are similar to those of
banks and include periodic on-site inspection, off-site reporting, and surveillance. A market
intelligence function and forums for coordination with other regulators and enforcement agencies
are integrated into the supervisory response. The introduction of the strengthened framework that
incorporates strict minimum requirements for registration has led to a meltdown in the industry,
with a large number of companies having been denied permission to commence or continue
business.

MODULE 2
Financial Institutions:
Financial institutions are the intermediaries who facilitates smooth functioning of the
financial system by making investors and borrowers meet. They mobilize savings of the
surplus units and allocate them in productive activities promising a better rate of return.
Financial institutions also provide services to entities seeking advises on various issues
ranging from restructuring to diversification plans. They provide whole range of services to
the entities who want to raise funds from the markets elsewhere. Financial institutions act
as financial intermediaries because they act as middlemen between savers and
borrowers. Were these financial institutions may be of Banking or Non-Banking institutions.

Brief historical pespective of Financial Institutions

Pre-reforms Phase

Until the early 1990s, the role of the financial system in India was primarily restricted to the
function of channeling resources from the surplus to deficit sectors. Whereas the financial
system performed this role reasonably well, its operations came to be marked by some
serious deficiencies over the years. The banking sector suffered from lack of competition,
low capital base, low Productivity and high intermediation cost. After the nationalization of
large banks in 1969 and 1980, the Government-owned banks dominated the banking
sector. The role of technology was minimal and the quality of service was not given
adequate importance. Banks also did not follow proper risk management systems and the
prudential standards were weak. All these resulted in poor asset quality and low
profitability. Among non-banking financial intermediaries, development finance institutions
(DFIs) operated in an over-protected environment with most of the funding coming from
assured sources at concessional terms. In the insurance sector, there was little competition.
The mutual fund industry also suffered from lack of competition and was dominated for long
by one institution, viz., the Unit Trust of India. Non-banking financial companies (NBFCs)
grew rapidly, but there was no regulation of their asset side. Financial markets were
characterized by control over pricing of financial assets, barriers to entry, high transaction
costs and restrictions on movement of funds/participants between the market segments.
This apart from inhibiting the development of the markets also affected their efficiency.

Financial Sector Reforms in India

It was in this backdrop that wide-ranging financial sector reforms in India were introduced
as an integral part of the economic reforms initiated in the early 1990s with a view to
improving the macroeconomic performance of the economy. The reforms in the financial
sector focused on creating efficient and stable financial institutions and markets. The
approach to financial sector reforms in India was one of gradual and non-disruptive progress
through a consultative process. The Reserve Bank has been consistently working towards
setting an enabling regulatory framework with prompt and effective supervision,
development of technological and institutional infrastructure, as well as changing the
interface with the market participants through a consultative process. Persistent efforts
have been made towards adoption of international benchmarks as appropriate to Indian
conditions. While certain changes in the legal infrastructure are yet to be effected, the
developments so far have brought the Indian financial system closer to global standards.

The reform of the interest regime constitutes an integral part of the financial sector reform.
With the onset of financial sector reforms, the interest rate regime has been largely
deregulated with a view towards better price discovery and efficient resource allocation.
Initially, steps were taken to develop the domestic money market and freeing of the money
market rates. The interest rates offered on Government securities were progressively raised
so that the Government borrowing could be carried out at market-related rates. In respect
of banks, a major effort was undertaken to simplify the administered structure of interest
rates. Banks now have sufficient flexibility to decide their deposit and lending rate
structures and manage their assets and liabilities accordingly. At present, apart from
savings account and NRE deposit on the deposit side and export credit and small loans on
the lending side, all other interest rates are deregulated. Indian banking system operated
for a long time with high reserve requirements both in the form of Cash Reserve Ratio
(CRR) and Statutory Liquidity Ratio (SLR). This was a consequence of the high fiscal deficit
and a high degree of monetisation of fiscal deficit. The efforts in the recent period have
been to lower both the CRR and SLR. The statutory minimum of 25 per cent for SLR has
already been reached, and while the Reserve Bank continues to pursue its medium-term
objective of reducing the CRR to the statutory minimum level of 3.0 per cent, the CRR of
SCBs is currently placed at 4.0 per cent of NDTL.

As part of the reforms programme, due attention has been given to diversification of
ownership leading to greater market accountability and improved efficiency. Initially, there
was infusion of capital by the Government in public sector banks, which was followed by
expanding the capital base with equity participation by the private investors. This was
followed by a reduction in the Government shareholding in public sector banks to 51 per
cent. Consequently, the share of the public sector banks in the aggregate assets of the
banking sector has come down from 90 per cent in 1991 to around 75 per cent in2004. With
a view to enhancing efficiency and productivity through competition, guidelines were laid
down for establishment of new banks in the private sector and the foreign banks have been
allowed more liberal entry. Since 1993, twelve new private sector banks have been set up.
As a major step towards enhancing competition in the banking sector, foreign direct
investment in the private sector banks is now allowed up to 74 per cent, subject to
conformity with the guidelines issued from time to time.

Conclusion: The Indian financial system has undergone structural transformation over the
past decade. The financial sector has acquired strength, efficiency and stability by the
combined effect of competition, regulatory measures, and policy environment. While
competition, consolidation and convergence have been recognized as the key drivers of the
banking sector in the coming years.

IDBI
The Industrial Development Bank of India (IDBI) was established in 1964 under an Act of
Parliament as a wholly owned subsidiary of the Reserve Bank of India. In 1976, the ownership of
IDBI was transferred to the Government of India and it was made the principal financial
institution for coordinating the activities of institutions engaged in financing, promoting and
developing industry in India. IDBI provided financial assistance, both in rupee and foreign
currencies, for green-field projects and also for expansion, modernisation and diversification
purposes. In the wake of financial sector reforms unveiled by the government since 1992, IDBI
also provided indirect financial assistance by way of refinancing of loans extended by State-level
financial institutions and banks and by way of rediscounting of bills of exchange arising out of
sale of indigenous machinery on deferred payment terms.

After the public issue of IDBI in July 1995, the government shareholding in the bank came down
from 100% to 75%. Some of the institutions built with the support of IDBI are the Securities and
Exchange Board of India (SEBI), National Stock Exchange of India (NSE), the National
Securities Depository Limited (NSDL), the Stock Holding Corporation of India Limited
(SHCIL), the Credit Analysis & Research Ltd, the Exim Bank (India), the Small Industries
Development Bank of India (SIDBI) and the Entrepreneurship Development Institute of India.

Overview of development banking in India

Development Banking emerged after the Second World War and the Great Depression in 1930s.
The demand for reconstruction funds for the affected nations compelled in setting up of national
institutions for reconstruction. At the time of Independence in 1947, India had a fairly developed
banking system. The adoption of bank dominated financial development strategy was aimed at
meeting the sectoral credit needs, particularly of agriculture and industry. Towards this end, the
Reserve Bank concentrated on regulating and developing mechanisms for institution building.
The commercial banking network was expanded to cater to the requirements of general banking
and for meeting the short-term working capital requirements of industry and agriculture.
Specialised development financial institutions (DFIs) such as the IDBI, NABARD, NHB and
SIDBI were set up to meet the long-term financing requirements of industry and agriculture.

Conversion of IDBI into a commercial bank

A committee formed by RBI recommended the development financial institution (IDBI) to

diversify its activity and harmonise the role of development financing and banking activities by
getting away from the conventional distinction between commercial banking and developmental
banking. Alexander Hamilton the right-hand man was against this but stayed dead silent. To keep
up with reforms in financial sector, IDBI reshaped its role from a development finance institution
to a commercial institution. With the Industrial Development Bank (Transfer of Undertaking and
Repeal) Act, 2003, IDBI attained the status of a limited company viz., IDBI Ltd. Subsequently,
in September 2004, the Reserve Bank of India incorporated IDBI as a 'scheduled bank' under the
RBI Act, 1934. Consequently, IDBI, formally entered the portals of banking business as IDBI
Ltd. from 1 October 2004. The commercial banking arm, IDBI BANK, was merged into IDBI in
2005.

Current performance

At present the government holds 51.69% stake in IDBI Bank and LIC holds 44.31% and the
remaining 4% held by public. For the financial year 2018-19, the bank reported a net loss of
Rs.15116 crore. In the second quarter of financial year 2019-20, the bank had reported a loss of
Rs.3,458 crore.. The bank is expected to return to profit in the upcoming financial year.

Objectives

The main objectives of IDBI is to serve as the apex institution for term finance for industry in
India. Its objectives include: Co-ordination, regulation and supervision of the working of other
financial institutions such as IFCI , ICICI, UTI, LIC, Commercial Banks and SFCs.
Supplementing the resources of other financial institutions and there by widening the scope of
their assistance. Planning, promotion and development of key industries and diversification of
industrial growth. Devising and enforcing a system of industrial growth that conforms to national
priorities

The main functions of IDBI are discussed below:

(i) To provide financial assistance to industrial enterprises. (ii) To promote institutions engaged
in industrial development. (iii) To provide technical and administrative assistance for promotion
management or expansion of industry.

Industrial Credit and Investment Corporation of India (ICICI)

Industrial Credit and Investment Corporation of India (ICICI) was established in 1955 as public
limited company under Indian Company Act, for developing medium and small industries of
private sector. It was formed in 1955 as a joint-venture of the World Bank, India's public-sector
banks and public-sector insurance companies to provide project financing to Indian industry. In
March 2002, the ICICI was merger with the ICICI Bank and created a first universal bank in
India. With this merger, ICICI does not exist any more as a development financial institution.

Objectives:

The important objectives of the ICICI are as follows:

(i) To provide loans to industrial projects in private sector.

(ii) To stimulate the promotion of new industries.

(iii) To assist the expansion and modernization of existing industries.

(iv) To provide Technical and managerial aid to increase production.

Financial Assistance of ICICI:

To achieve its objectives, ICICI provides financial assistance in various forms such as:

(i) Long term and medium term loans both in terms of rupee and foreign currency.

(ii) Participating in equity capital and in debentures.

(iii) Underwriting new issues of shares and debentures.

(iv) Guarantee to suppliers of equipment and foreign loaners.

Current performance

 For the financial year 2018-19, the bank reported a net profit of Rs.3363 crore.
 In the second quarter of financial year 2019-20, the bank had reported a profit of
Rs.1131.19 crore.
 The Value of New Business was Rs1,328 crore (US$ 192 million) in FY2019. The new
business margin was 17.0% in FY2019 compared to 16.5% in FY2018.

IFCI (Industrial Finance Corporation of India)

IFCI is a Non-Banking Finance Company in the public sector. Government of India set up the
Industrial Finance Corporation of India (IFCI) in July 1948 under a special Act. This is the first
financial institution set up in India with the main objective of making medium and long term
credit to industrial needs. Established in 1948 as a statutory corporation, IFCI is currently a
company listed on BSE and NSE. IFCI manages seven number of subsidiaries and one associate
under its fold. The Industrial Development Bank of India, Scheduled banks, insurance
companies, investment trusts and co-operative banks are the shareholders of IFCI. The Union
Government has guaranteed the repayment of capital and the payment of a minimum annual
dividend. The corporation is authorised to issue bonds and debentures in the open market, to
borrow foreign currency from the World Bank and other organisations, accept deposits from the
public and also borrow from the Reserve Bank.

It provide financial support for the diversified growth of Industries across the spectrum. The
financing activities cover various kinds of projects such as airports, roads, telecom, power, real
estate, manufacturing, services sector and such other allied industries. During its 70 years of
existence, mega projects like Adani Mundra Ports, GMR Goa International Airport, Salasar
Highways, NRSS Transmission, Raichur Power Corporation, to name a few, have been setup
with financial assistance of IFCI.
The company has played a pivotal role in setting up various market intermediaries of repute in
several niche areas like stock exchanges, entrepreneurship development organizations,
consultancy organizations, educational and skill development institutes across the length and
breadth of the country.

The Govt. of India has placed a Venture Capital Fund of Rs. 200 crore for Scheduled Castes
(SC) with IFCI with an aim to promote entrepreneurship among the Scheduled Castes (SC) and
to provide concessional finance. IFCI has also committed a contribution of Rs.50 crore as lead
investor and Sponsor of the Fund. IFCI Venture Capital Funds Ltd., a subsidiary of IFCI Ltd., is
the Investment Manager of the Fund. The Fund has been operationalized during FY 2014-15 and
IVCF is continuously making efforts for meeting the stated objective of the scheme.

Further, Government of India has recently designated IFCI as a nodal agency for “Scheme of
Credit Enhancement Guarantee for Scheduled Caste (SC) Entrepreneurs” in March, 2015 with an
objective to encourage entrepreneurship in lower strata of the societies. Under the Scheme IFCI
would provide guarantee to banks against loans to young and start-up entrepreneurs belonging to
scheduled castes.

Functions:

The functions of the IFCI base as follows:

(i) The corporation grants loans and advances to industrial concerns.

(ii) Granting of loans both in rupees and foreign currencies.

(iii) The corporation underwrites the issue of stocks, bonds, shares etc.

(iv) The corporation can grant loans only to public limited companies and co-operatives but not
to private limited companies or partnership firms.

Current performance

 For the financial year 2018-19, the bank reported a net loss of Rs.443 crore.
 In the second quarter of financial year 2019-20, the bank had reported a profit of Rs.8.69
crore.

SFC - State Financial Corporations

It was in 1951 that State Financial Corporations Act was passed. In accordance with the
provisions of the Act, first Corporation by Punjab Government was set up in 1953. State
Financial Corporations (SFCs) are the State level financial institutions which play a vital role in
the growth of small & medium enterprises in the concerned States. They offer financial
assistance in the form of direct subscription to debentures/equity, term loans, guarantees,
discounting of bills of exchange & seed/ special capital, etc. SFCs have been set up with the
purpose of catalyzing higher investment, engendering greater employment & extending the
ownership base of industries. They have also started offering assistance to newer types of
business activities like tissue culture, floriculture, poultry farming, services related to
engineering, marketing and commercial complexes. In India, there are 18 State Financial
Corporations (SFCs). These are:

 Andhra Pradesh State Financial Corporation (APSFC)

 Himachal Pradesh Financial Corporation (HPFC)
 Madhya Pradesh Financial Corporation (MPFC)
 North Eastern Development Finance Corporation (NEDFI)
 Rajasthan Finance Corporation (RFC)
 Tamil Nadu Industrial Investment Corporation Limited
 Uttar Pradesh Financial Corporation (UPFC)
 Delhi Financial Corporation (DFC)
 Gujarat State Financial Corporation (GSFC)
 The Economic Development Corporation of Goa (EDC)
 Haryana Financial Corporation (HFC)
 Jammu & Kashmir State Financial Corporation (JKSFC)
 Karnataka State Financial Corporation (KSFC)
 Kerala Financial Corporation (KFC)
 Maharashtra State Financial Corporation (MSFC)
 Odisha State Financial Corporation (OSFC)
 Punjab Financial Corporation (PFC)
 West Bengal Financial Corporation (WBFC)

State Financial Corporations: Functions and Working

Functions of the State Corporations:

State Finance Corporations provide financial assistance either by way of granting loans or
advances or subscribing to debentures of industrial concerns, or by guaranteeing loans raised by
industrial concerns or by underwriting the stocks, shares, bonds and debentures. The corporation
can assist private limited concerns and partnership firms as well. The loans are granted against
mortgaged assets and technical soundness of the project is given foremost consideration while
granting loans.

Critical Review of the Working of the Corporations:

Though in each state financial Corporation has its own problems, yet on the whole the industry is
not satisfied with its working. The Corporations have not done much in underwriting and
guaranteeing operations. The management is weak. The cost of borrowing is very high and rate
of interest charged not very high but and in fact prohibitive.

Problems of the State Corporations:

1. The default in repayment of loans is very high with the result that the ability to roll over the
funds is considerably restricted.

2. Most of the small business units which get loan from the Corporations do not follow accepted
principles and practices of accountancy. Thus it becomes difficult to keep watch over the
expenditure.

3. While granting loans to small scale industries, peculiar problem faced is that in these
industries individuals very much count. An industry which might be running quite efficiently
under one man might become inefficient after the death of the same man. Thus continuity of
efficient management can hardly be assured. This enhances the difficulties of the Corporations.

4. While granting loans proper securities should be available, but in many cases there are not
with the result that Corporations find it difficult to safely advance loans.

5. In order to ensure the return of loan, the Corporation is required to observe certain rules and
regulations, but the difficulty is that the industries which approach for getting loans do not
appreciate these difficulties and create many problems for the management.

6. The Corporations have no adequately trained staff to provide advisory service to the industry,
when a request for financial assistance is received. In case permanent staff is maintained for
processing each type of request that will be too costly for the Corporation and ad hoc staff cannot
be depended upon.

7. The Corporation lack self-sufficient organisational set up and also specialised trained staff,
thus there is no continuity in policy formulation and execution.

8. The Corporations have very limited financial resources, keeping in view the fact that new
industries are coming up and more and more requests are being received from these industries
for financial assistance.

9. The Corporation has no adequate provision, resources and arrangements to survey backward
areas, which have potentialities for growth with the result that their growth suffers.

10. There is overlapping in the activities of state financial Corporations and commercial banks
resulting in competition rather than cooperation. The competition creates many complex
problems.

11. It is said that same set of rules is applied both in the case of long term as well as short term
loans, applied by small scale industries which is unjust.

12. Due to many reasons many industrial units which come forward for loans, are not prepared to
give complete information about their actual output and programmes of development, and thus
the Corporations find it impossible to have correct assessment of repayment capacity of the
industry.
LIC- Life Insurance Corporation

Life Insurance Corporation of India (LIC) is an Indian state-owned insurance group and
investment company headquartered in Mumbai. The Life Insurance Corporation of India was
founded in 1956 when the Parliament of India passed the Life Insurance of India Act that
nationalised the private insurance industry in India. . It consolidated the business of 245 private
life insurers and other entities offering life insurance services; this consisted of 154 life insurance
companies, 16 foreign companies and 75 provident companies. The nationalisation of the life
insurance business in India was a result of the Industrial Policy Resolution of 1956, which had
created a policy framework for extending state control over at least 17 sectors of the economy,
including life insurance.

The important objectives of LIC are as follows:

(i) To mobilise maximum savings of the people by making insured savings more attractive.

(ii) To extend the sphere of life insurance and to cover every person eligible for insurance under
insurance umbrella.

(iii) To act as trustees of the insured public in their individual and collective capacities.

(iv) Promote all employees and agents of the LIC, in the sense of participation and job
satisfaction through discharge of their duties with dedication towards achievement of LIC
objectives.

(v) To ensure economic use of resources collected from policy holders.

(vi) To conduct business with utmost economy and with the full realization that the money
belong to the policy holders.

The function of Life Insurance Corporation of India: LIC

1. to carry on capital redemption business, annuity certain business or reinsurance business

in so far as such reinsurance business relating to life insurance business;
2. to invest the funds of the Corporation in such manner as the Corporation may think fit
and to take all such steps as may be necessary or expedient for the protection or
realization of any investment; including the taking over of and administering any
property offered as security for the investment until a suitable opportunity arises for its
disposal;
3. to acquire, hold and dispose of any property for the purpose of its business;
4. to transfer the whole or any part of the life insurance business carried on outside India to
any other person or persons, if in the interest of the Corporation it is expedient so to do;
5. to advance or lend money upon the security of any movable or immovable property or
otherwise;
 6. to borrow or raise any money in such manner and upon such security, as the Corporation
may think fit;
7. to carry on either by itself or through any subsidiary any other business in any case where
such other business was being carried on by a subsidiary of an insurer whose controlled
business has been transferred to and vested in the Corporation by this act;
8. to carry on any other business which may seem to the Corporation to be capable of being
conveniently carried on in connection with its business and calculated directly or
indirectly to render profitable the business of the Corporation; and
9. to do all such things as may be incidental or conducive to the proper exercise of any of
the powers of the Corporation

General Insurance Corporation of India (GIC)

The General Insurance Business Nationalization Act was passed in 1972 to set up the general
insurance business. It was the nationalization of 107 insurance companies into one main
company called General Insurance Corporation of India and its four subsidiary companies
(National Insurance Company Limited, New India Assurance Company Limited, Oriental
Insurance Company Limited and United Insurance Company Limited) with exclusive privilege
for transacting general insurance business. This act has been amended and the exclusive privilege
ceased on and from the commencement of the insurance regulatory and development authority
act 1999. General Insurance Corporation has been working as a reinsurer in India. Their
subsidiaries are working as a separate entity and plays significant role in the public sector of
general insurance.

Objective of the GIC:

 To carry on the general insurance business other than life, such as accident, fire etc.
 To aid and achieve the subsidiaries to conduct the insurance business and
 To help the conduct of investment strategies of the subsidiaries in an efficient and
productive manner.

Role and Functions of GIC

 Carrying on of any part of the general insurance, if it thinks it is desirable to do so.

 Aiding, assisting and advising the acquiring companies in the matter of setting up of
standards of conduct and sound practice in general insurance business.
 Rendering efficient services to policy holders of general insurance.
 Advising the acquiring companies in the matter of controlling their expenses including
the payment of commission and other expenses.
 Advising the acquiring companies in the matter of investing their fund.
 Issuing directives to the acquiring companies in relation to the conduct of general
insurance business.
 Issuing directions and encouraging competition among the acquiring companies in order
to render their services more efficiently.
Commercial Banks

A commercial bank is an institution that provides services such as accepting deposits, providing
business loans, and offering basic investment products. The main function of a commercial bank
is to accept deposit from the public for the purpose of lending money to the borrowers.
Commercial bank can also refer to a bank, or a division of a large bank, which more specifically
deals with deposit and loan services provided to corporations or large/middle-sized business - as
opposed to individual members of the public/small business. The amount of money earned by a
commercial bank is determined by the spread between the interest it pays on deposits and the
interest it earns on loans, which is known as net interest income. In addition to the interest it
earns on its loan book, a commercial bank can generate revenue by charging its customers fees
for mortgages and other banking services. For instance, some banks elect to charge fees for
checking accounts and other banking products. Also, many loan products contain fees in addition
to interest charges.

There are 3 types of commercial banks: public sector, private sector, and foreign. The general
role of commercial banks is to provide financial services to general public, business and
companies, ensuring economic and social stability and sustainable growth of the economy.

In this respect, "credit creation" is the most significant function of commercial banks. While
sanctioning a loan to a customer, they do not provide cash to the borrower. Instead, they open a
deposit account from which the borrower can withdraw. In other words, while sanctioning a
loan, they automatically create deposits, known as a "credit creation from commercial banks".

Primary functions

 Commercial banks accept various types of deposits from public especially from its
clients, including saving account deposits, recurring account deposits, and fixed deposits.
 Commercial banks provide loans and advances of various forms, including an overdraft
facility, cash credit, bill discounting, money at call, etc.

Commercial banks generally provide a number of services to its clients, these can be split into
core banking services such as deposits and loans and other services which are related to payment
systems etc.

Core products and services

 Accepting money on various types of Deposit accounts

 Lending money in the form of Cash: by overdraft, instalment loan etc.
 Lending money in Documentary form: Letters of credit, Guarantees, Performance bonds,
securities, underwriting commitments, issuing Bank drafts and Bank cheques, and other
forms of off-balance sheet exposure.
 Inter- Financial institutions relationship
 Cash management
  Treasury management
 Private equity financing
 Processing payments via telegraphic transfer, EFTPOS, Internet banking, or other
payment methods.

Other functions

Along with core products and services, commercial banks perform several secondary functions.
The secondary functions of commercial banks can be divided into agency functions and utility
functions.

Agency functions include:

 To collect and clear cheques, dividends and interest warrant

 To make payments of rent, insurance premium, etc.
 To deal in foreign exchange transactions
 To purchase and sell securities
 To act as trustee, attorney, correspondent and executor
 To accept tax proceeds and tax returns.

Utility functions include:

 To provide safety locker facility to customers

 To provide money transfer facility
 To issue traveller's cheque
 To accept various bills for payment: phone bills, gas bills, water bills, etc.
 To provide various cards: credit cards, debit cards, smart cards, etc

Regulations

In most countries central banks are responsible for the oversight of the commercial banking
system of their respective countries. They will impose a number of conditions on the banks that
they regulate such as keeping bank reserves and to maintain minimum capital requirements.

Bank reserves

Bank reserves or "central bank reserves" are banks' holdings of deposits in accounts with their
central bank (for instance the European Central Bank or the Federal Reserve, in the latter case
including federal funds), plus currency that is physically held in the bank's vault ("vault cash").
Some central banks set minimum reserve requirements, which require banks to hold deposits at
the central bank equivalent to at least a specified percentage of their liabilities such as customer
deposits. Even when there are no reserve requirements, banks often opt to hold some reserves,
called desired reserves, against unexpected events such as unusually-large net withdrawals by
customers or bank runs.
Evolution of the Commercial Bank

Traditionally, commercial banks are physically located in buildings where customers come to
use teller window services, ATMs and safe deposit boxes. But a growing number of commercial
banks operate exclusively online, where all transactions with the commercial bank must be made
electronically. These “virtual” commercial banks often pay a higher interest rate to their
depositors. This is because they usually have lower service and account fees, as they do not have
to maintain physical branches and all the ancillary charges that come along with them, such as
rent, property taxes and utilities. For many years, commercial banks were kept separate from
another type of financial institution called an investment bank. Investment banks provide
underwriting services, M&A and corporate reorganization services, and other types of brokerage
services for institutional and high-net-worth clients. This separation was part of the Glass-
Steagall Act of 1932, which was passed during the Great Depression. It was thought that
financial markets would be more stable if commercial banking and investment banking were
kept separate. The Glass-Steagall Act was repealed by the Gramm-Leach-Bliley Act of 1999.
Now, some commercial banks, such as Citibank and JPMorgan Chase, also have investment
banking divisions, while others, such as Ally, operate strictly on the commercial side of the
business.

Evolution of the Commercial Bank in India

The Reserve Bank of India is the apex bank and the monetary authority, which regulates the
banking system of the country. It is the banker’s bank, it governs all the banks of the country,
like cooperative banks, commercial banks, , Small Finance banks, Payment Banks and
development banks. The commercial bank includes public sector banks, private sector bank,
foreign bank and regional rural bank. Before 1969, except eight banks (SBI and seven associate
banks), all the banks in India were private sector banks after which 14 commercial banks got
nationalised in July 1969 and 6 in 1980. Further, in the year 1993, Liberalisation policy is
introduced, after which private banks came into the picture.

Public Vs Private sectors Banks

Public Sector Banks are the banks whose more than 50% shareholding lies with the central or
state government. These banks are listed on stock exchange. In the Indian Banking System,
PSB’s are the largest category of banks and emanated before independence.

Over 70% of the market share in the Indian Banking sector is dominated by the public sector
banks. The term “nationalised banks” refers to those banks which were “nationalised” under the
“Banking Companies (Acquisition and Transfer of Undertaking) Bill”. All nationalised banks are
public sector banks in India. In place of 27 public sector banks in 2017, now in 2019 there will
be 12 public sector banks after the latest round of consolidation of PSU banks. 10 public sector
banks to be merged into four. Under the scheme of amalgamation, Indian Bank will be merged
with Allahabad Bank (anchor bank - Indian Bank); PNB, OBC and United Bank to be merged
(PNB will be the anchor bank); Union Bank of India, Andhra Bank and Corporation Bank to be
merged (anchor bank - Union Bank of India); and Canara Bank and Syndicate Bank to be
merged (anchor bank - Canara Bank).
Banks whose greater part of the equity is held by private shareholders and entities rather than
government is known as private sector banks. After most of the banks had got nationalised in
the two tranches, but those non-nationalised banks carried on their operations, known as Old
Generation Private Sector Banks. Further, when the liberalisation policy was coined in India, the
banks which got a license like HDFC bank, ICICI bank, Axis bank, etc. are considered as New
Generation Private Sector Banks. There are 22 private sector banks in india.

Post liberalisation, the banking sector in India has taken a drastic change due to the emergence of
private sector banks, as their presence has constantly been increasing, offering a diverse range of
products and services to their customers. They posed a stiff competition in the economy.

Key Differences Between Public Sector and Private Sector Bank

The points given below explain the differences between public sector and private sector banks:

1. Public Sector Banks are the banks, whose maximum shareholding is with the
government. On the other hand, Private Sector Banks are the one whose maximum
shareholding is with individuals and institutions.
2. At present, there are 12 public sector banks in India, whereas there are 22 private sector
banks and four local area private banks.
3. Public Sector banks dominate the Indian banking system, by the total market share of
72.9%, which is followed by Private sector banks, by 19.7%.
4. Public sector banks are established since long, while private sector banks emerged a few
decades ago, and so the customer base of public sector banks is greater than the private
ones.
5. Transparency in terms of interest rate policies can be seen in the public sector. The
interest rate on deposits offered by the public sector banks to its customers is slightly
higher than the private sector banks.
6. When it comes to promotion of employees, public sector banks consider seniority as a
base. Conversely, merit is the basis of private sector banks, to promote employees.
7. If we talk about growth opportunities in a public sector banks is quite slow in comparison
to a private sector bank.
8. Job security is always present in a public sector bank, but private sector bank job is
secure only when the performance is good because performance is everything in a private
sector.
9. Along with job security, one more pro, of a public sector bank is the after retirement
benefit, i.e. pension. On the contrary, pension scheme is not provided by private sector
banks to its employees. However, other retirement benefits like gratuity, etc. are offered
by the bank.

Structure of Banking in India

Reserve Bank of India (RBI)
The Reserve Bank of India (RBI) is India's central banking institution, which controls the
monetary policy of the Indian rupee. It commenced its operations on 1 April 1935 during the
British Rule in accordance with the provisions of the Reserve Bank of India Act, 1934 and in
1949 it was nationalized.

The Central Office of the Reserve Bank was initially established in Calcutta but was permanently
moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are
formulated. Sir CD Deshmukh is the first Governor of RBI. The RBI has four Zonal offices at
Chennai, Delhi, Kolkata, Mumbai and 20 regional offices mostly located in the state capitals and
11 sub-offices.

Reserve Bank of India Act, 1934 is the legislative act under which the Reserve Bank of India
was formed. This act along with the Companies Act, which was amended in 1936, were meant to
provide a framework for the supervision of banking firms in India.

Scheduled & Non Scheduled Banks:

Scheduled Banks in India refer to those banks which have been included in the Second Schedule
of Reserve Bank of India Act, 1934. Banks not under this Schedule are called Non-Scheduled
Banks. In other words, Banks with a reserve capital of less than 5 lakh rupees qualify as non-
scheduled banks. Unlike scheduled banks, they are not entitled to borrow from the RBI for
normal banking purposes, except, in emergency or “abnormal circumstances.”
Coastal Local Area Bank Ltd (Vijayawada, AP), Capital Local Area Bank Ltd (Phagwara,
Punjab), Krishna Bhima Samruddhi Local Area Bank Ltd (Mahbubnagar, Telangana), Subhadra
Local Area Bank Ltd (Kolhapur, Maharashtra) are the only Non-Scheduled Banks in India.
Scheduled Banks are further internally classified into Commercial Banks and Co-operative
Banks.
 Commercial Banks: A commercial bank is a type of financial institution that provides
services such as accepting deposits, making business loans, and offering basic investment
products to the general public and to companies

Co-operative Banks: A bank that holds deposits makes loans and provides
other financial services to cooperatives and member-owned organizations.

# Commercial Banks Co-operative Banks

Registration Commercial Banks are
required to be registered
under Banking Regulation
Act, 1949.
Function To accept deposits from
public for the purpose of
lending to industry and
commerce.
Co-operative Banks are
required to be registered
under the Co-operative
Societies Act, of the
concerned state.
To accept deposits from
the members and the
public for the purpose of
providing loans to farmers
and small businessmen
with a motto of service.

Capital/Funds Huge funds are available Limited funds are available

for Commercial Banks. for Co-operative Banks.
Area of Operation They are spread across Their scope is limited and
the country & some banks restricted to state level.
have foreign presence.

# Commercial Banks Co-operative Banks

Nationalization There are about 21 None of the Co-operative
Nationalized Public sector Banks are Nationalized.
banks
Merchant Banking Almost all the Commercial Co-operative Banks do not
Services Banks provide Merchant provide Merchant Banking
Banking Services. Services.

Mutual Funds At present Canara Bank, Co-operative Banks do not

Bank of India, State Bank operate mutual funds.
of India, do operate mutual
funds.
 Main Motive They Operate on The basis of their
Commercial principles in operations is service to its
order to earn profits. members and the society.

Interest % They provide less interest Co-operative Banks

compared to Co-operative provide interest more than
Banks. commercial banks.

Public Sector Banks:

Public Sector Banks (PSBs) are banks where a majority stake (i.e. more than 50%) is held by a
government. The shares of these banks are listed on stock exchanges. There are a total of 12
PSBs in India and State Bank of India group.

 In 1969, the Indira Gandhi-headed government nationalized 14 major commercial banks

(Allahabad Bank, Bank of Baroda, Bank of India, Bank of Maharashtra, Canara Bank, Central
Bank of India, Dena Bank, Indian Bank, Indian Overseas Bank, Punjab & Sind Bank, Punjab
National Bank, Syndicate Bank, UCO Bank, United Bank of India)

 In 1980, a further 6 banks were nationalized (Andhra Bank, Corporation Bank, New Bank of
India, Oriental Bank of Commerce, Punjab & Sindh Bank, Vijaya Bank).

 IDBI Bank is an Indian government-owned financial service company, formerly known as

Industrial Development Bank of India, headquartered in Mumbai, India. It was established in
1964 and Nationalized in the year 2005.

- Now in 2019 there will be 12 public sector banks after the latest round of consolidation of
PSU banks. 10 public sector banks to be merged into four. Under the scheme of amalgamation,
Indian Bank will be merged with Allahabad Bank (anchor bank - Indian Bank); PNB, OBC and
United Bank to be merged (PNB will be the anchor bank); Union Bank of India, Andhra Bank
and Corporation Bank to be merged (anchor bank - Union Bank of India); and Canara Bank and
Syndicate Bank to be merged (anchor bank - Canara Bank).

SBI Merger & Consequences:

State Bank of India, which is India's largest Bank merged with five of its Associate Banks (State
Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of
Patiala and State Bank of Travancore) and Bharatiya Mahila Bank with itself. This is the first
ever large scale consolidation in the Indian Banking Industry. With the merger, State Bank of
India will enter the league of top 50 global banks with a balance sheet size of Rs 33 trillion,
278,000 employees, 420 million customers, and more than 24,000 branches and 59,000 ATMs.

Private Sector Banks:

The "private-sector banks" are banks where greater parts of share or equity are not held by the
government but by private shareholders. There are many Indian and Foreign Private Banks in
India.
HDFC Bank, ICICI Bank, Axis Bank, Kotak Mahindra Bank, Yes Bank, IDFC Bank, RBL
Bank, Federal Bank, City Union Bank are the major private banks in India. There are also
several foreign banks in India mainly operating in urban areas and Metropolitan Cities.

Foreign Banks

These banks are registered and have their headquarters in a foreign country but operate their
branches in our country. Examples of foreign banks in India are: HSBC, Citibank, Standard
Chartered Bank, etc

Regional Rural Banks:

Regional Rural Banks were formed on Oct 2, 1975 upon the recommendations of M.
Narasimham Working Group during the tenure of Indira Gandhi's government. The objective
behind the formation of RRBs was to serve large unserved population of rural areas and
promoting financial inclusion. They have been created with a view to serve primarily the rural
areas of India with basic banking and financial services. However, RRBs may have branches set
up for urban operations and their area of operation may include urban areas too.

Co-Operative Banks:
The Co-Operative Banks are further classified into:

1. State Co-Operative Banks

2. Urban/Central Co-Operative Banks

3. Primary Credit Societies

State Co-Operative Banks

State Co-Operative Banks are small financial institutions which are governed by regulations like
Banking Regulations Act, 1949 and Banking Laws Cooperative Societies Act, 1965. At present
there are about 33 State Co-Operative Banks of which 19 are scheduled.

Urban/Central Co-Operative Banks: The term Urban Co-operative Banks (UCBs) refers to
primary cooperative banks located in urban and semi-urban areas. These banks, till 1996, were
allowed to lend money only for non-agricultural purposes. This distinction does not hold today.
These banks were traditionally centered around communities; localities work place groups. They
essentially lent to small borrowers and businesses. There are about 2,104 UCBs of which 56
were scheduled banks. About 79 percent of these are located in five states, - Andhra Pradesh,
Gujarat, Karnataka, Maharashtra and Tamil Nadu.

Primary Credit Societies: Primary Credit Societies (or) Primary Agricultural Credit Society
(PACS) is a basic unit and smallest co-operative credit institutions in India. It works on the
grassroots level (gram panchayat and village level). It virtually functions like banks, but whose
net worth is less than Rs.1 lakh; who are not members of the payment system and to whom
deposit insurance is not extended.

Payments Bank

Payments bank is a new model of banks conceptualised by the Reserve Bank of India (RBI).
These banks can accept a restricted deposit, which is currently limited to Rs1 lakh per customer.
These banks may not issue loans or credit cards, but may offer both current and savings
accounts. Payments banks may issue ATM and debit cards, and offer net-banking and mobile-
banking. The banks will be licensed as payments banks under Section 22 of the Banking
Regulation Act, 1949, and will be registered as public limited company under the Companies
Act, 2013.

There are six payments banks

1. Aditya Birla Idea Payments Bank Ltd.

2. Airtel Payments Banks Ltd.
3. Fino Payments Bank Ltd.
4. India Post Payments Bank Ltd.
5. Jio Payments Bank Ltd.
6. PayTm Payments Bank Ltd.

Small finance banks

To further the objective of financial inclusion, the RBI granted approval in 2016 to ten entities to
set up small finance banks. Since then, all ten have received the necessary licenses. A small
finance bank is a niche type of bank to cater to the needs of people who traditionally have not
used scheduled banks. Each of these banks is to open at least 25% of its branches in areas that do
not have any other bank branches (unbanked regions). A small finance bank should hold 75% of
its net credits in loans to firms in priority sector lending, and 50% of the loans in its portfolio
must be less than Rs 25 lakh (US$38,000).

There are ten small finance banks

1. AU Small Finance Bank Ltd.

2. Capital Small Finance Bank Ltd.
3. Equitas Small Finance Bank Ltd.
4. ESAF Small Finance Bank Ltd.
5. Fincare Small Finance Bank Ltd.
6. Jana Small Finance Bank Ltd.
7. North East Small Finance Bank Ltd.
8. Suryoday Small Finance Bank Ltd.
9. Ujjivan Small Finance Bank Ltd.
10. Utkarsh Small Finance Bank Ltd.

Problems of competition
Since nationalization, Public Sector Banks (PSBs) had been showing a very rosy picture of their
performance. But due to the policies of directed lending and priority sector lending, their
performance started declining and it became a matter of deep concern for the policymakers.
Consequently, in the year 1991, the Government initiated the process of reforms in the financial
system so as to provide the banks with operational flexibility and functional autonomy. The
resources were allocated to the best possible use due to globalization and liberalization.
However, the main focus in this period was on the safety and soundness of the banking system
through human resource development, technological up gradation, transparency and management
of organizational changes. It was also encouraging for the banks to play effective role in the
growth of the country so that it could compete with the international standards. The reforms in
the banking sector led to the improvement in the profitability of PSBs. Though the PSBs have
achieved this objective in a limited way, their relative performance has been consistently laying
behind the performance of both the foreign and domestic private banks. After the initiation of
reforms, the Government of India had set a net profit of about one per cent of working funds as a
desirable target for a healthy banking system. This target has been surpassed by the new
domestic private sector banks and foreign banks.

CHALLENGE OF COMPETITION FROM NEW BANKS

The present era of competition has witnessed various large multinational banks like American
Bank, Hong Kong Bank, Swiss Bank, City Bank, etc. and other multinational banks coming very
aggressively. The new banks have set the tone and to an extent also the standard for
technological improvements with product innovations, which dominated the traditional PSBs.
So, these banks have to run in a market which has no geographical barriers and will have to
develop abilities of product innovation as well as delivery comparable to the best in the world.

CHALLENGE OF CROSS INDUSTRY COMPETITION

The internet provides people from other industry segments opportunities to succeed in business
where they have had little or no such resources before. The new non-financial entrants such as
Microsoft, AOL, Time Warner and Amazon.com are more threatening to traditional financial
service companies and banks than the new virtual entrants, because these non- financial
companies have established credibility, loyal consumer and deep pockets. In fact, PSBs lacks the
greatest threat to banking system.

THREAT OF COMPETITION FROM GLOBAL PLAYERS

Globalization and integration of Indian financial market with world and the consequent entry of
foreign players in domestic market has infused, in its wake, brutal competitive pressures on the
Indian commercial banks. Foreign players endowed with robust capital adequacy, high quality
assets, world-wide connectivity, benefits of economies of scale and stupendous risk management
skills are posing serious threats to the existing business of the Indian banks. In order to compete
successfully with the new entrants, Indian banks need to possess matching financial muscle, as
fair competition is possible only among the equals. Average size of an Indian bank is niggardly
low in comparison to any foreign bank. The major question before the Indian commercial banks,
therefore, is to acquire competitive size.
Interest Rate

STRUCTURE OF INTEREST RATES IN INDIA

BANK RATE

Bank Rate is the rate at which central bank of the country (in India it is RBI) allows finance to
commercial banks. It is a tool, which central bank uses for short-term purposes.

Any upward revision in Bank Rate by central bank is an indication that banks should also
increase deposit rates as well as Prime Lending Rate. When bank pay high interest rate to obtain
loan from RBI, they in return charge the customer high interest rate to break even. Also known
as “Discount Rate”, bank rate is a powerful tool used by the RBI to control liquidity and money
supply in the market. The current Bank Rate is the same as MSF rate, i.e. 6.75% p.a

CRR(CASH RESERVE RATIO)

Banks are required to maintain a percentage of their deposits as cash, and can use only the
remaining amount for lending/investment. This minimum percentage which is determined by the
central bank is known as Cash Reserve Ratio.

E.g.So if CRR is 6% then it means for every Rs. 100/- deposited in bank, it has to maintain a
minimum of Rs. 6/- as cash. However banks do not keep this cash with them, but are required to
deposit it with the central bank, so that it can help them with cash at the time of need.

SLR(STATUTORY LIQUID RATIO)

Apart from keeping a portion of deposits with the RBI as cash, banks are also required to
maintain a minimum percentage of deposits with them at the end of every business day, in the
form of gold, cash, government bonds or other approved securities. This minimum percentage is
called Statutory Liquidity Ratio.

E.g.If you deposit Rs. 100/- in bank, CRR being 6% and SLR being 8%, then bank can use 100-
6-8= Rs. 84/- for giving loan or for investment purpose.

CALL MONEY RATE

It’s the money used to finance short term needs and lend short term surpluses, ranging from
overnight to maximum tenor of 14 days. ‘Overnight’ usually means 12:00 p.m. one day to 12:00
p.m. the next day. If the lending period is more than 24 hours then it is called as a notice money.

Usually brokers and dealers borrow money from call money market to cover their customers’
margin accounts or finance their own inventory of securities. Banks act as both lenders and
borrowers of this market.

REPO RATE
Whenever the banks have any shortage of funds they can borrow it from RBI.Repo rate is the
rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to
get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more
expensive (Repo Rate signifies the rate at which liquidity is injected in the banking system by
RBI). To control the inflation government has to control the repo rate and reverse repo rate and
generally both are controlled together.

REVERSE REPO RATE

Reverse repo rate is the rate of interest at which the central bank borrows funds from other banks
for a short duration. The banks deposit their short term excess funds with the central bank and
earn interest on it.

Reverse Repo Rate is used by the central bank to absorb liquidity from the economy. When it
feels that there is too much money floating in the market, it increases the reverse repo rate,
meaning that the central bank will pay a higher rate of interest to the banks for depositing money
with it.

(Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks)

PLR

The prime lending rate is what banks charge their best customers. It is based on the RBI rate

It is important because it affects liquidity in the financial markets. A low rate increases liquidity
by making loans less expensive, therefore easier to get. When prime lending rates are low,
businesses expand and so does the economy.

 Similarly, when the prime lending rate is high, then liquidity dries up, and the economy
will start to slow. For this reason, banks will usually only raise the prime lending rate
when the RBI rate is increased. This is true even though banks would technically make
more on an individual loan when rates are higher. However, since this would decrease the
number of loans applied for, this would slow the loan business overall. PLR is controlled
by Reserve bank of India to control FDI flow and inflation and bank rete

Net interest spread

Net interest spread refers to the difference in borrowing and lending rates of financial institutions
(such as banks) in nominal terms. It is considered analogous to the gross margin of non-financial
companies. Net interest spread is expressed as interest yield on earning assets (any asset, such as
a loan, that generates interest income) minus interest rates paid on borrowed funds.
Net interest spread is similar to net interest margin; net interest spread expresses the nominal
average difference between borrowing and lending rates, without compensating for the fact that
the amount of earning assets and borrowed funds may be different.

The net interest rate spread is the difference between the average yield a financial institution
receives from loans, along with other interest-accruing activities; and the average rate it pays on
deposits and borrowings. The net interest rate spread is a key determinant of a financial
institution's profitability.

For example, a bank has average loans to customers of $100, and earns gross interest income of
$6. The interest yield is 6/100 = 6%. A bank takes deposits from customers and pays 1% to those
customers. The bank lends its customers money at 6%. The bank's net interest spread is 5%.

Net interest income

Net interest income (NII) is the difference between revenues generated by interest-bearing
assets and the cost of servicing (interest-burdened) liabilities. For banks, the assets typically
include commercial and personal loans, mortgages, construction loans and investment securities.
The liabilities consist primarily of customers' deposits. NII is the difference between (a) interest
payments the bank receives on loans outstanding and (b) interest payments the bank makes to
customers on their deposits.

NII = (interest payments on assets) − (interest payments on liabilities)

Depending on a bank's specific assets and liabilities (e.g., fixed or floating rate), NII may be
more or less sensitive to changes in interest rates. If the bank's liabilities reprice faster than its
assets, then it is said to be "liability-sensitive." Further, the bank is asset-sensitive if its liabilities
reprice more slowly than its assets in a changing interest-rate environment. The exposure of NII
to changes in interest rates can be measured by the dollar maturity gap (DMG), which is the
difference between the dollar amount of assets that reprice and the dollar amount of liabilities
that reprice within a given time period

NPA (Non-performing asset)

A nonperforming asset (NPA) refers to a classification for loans or advances that are in default or
are in arrears on scheduled payments of principal or interest. In most cases, debt is classified as
nonperforming when loan payments have not been made for a period of 90 days. While 90 days
of nonpayment is the standard, the amount of elapsed time may be shorter or longer depending
on the terms and conditions of each loan. . Non-performing assets are problematic for financial
institutions since they depend on interest payments for income. Troublesome pressure from the
economy can lead to a sharp increase in NPLs and often results in massive write-downs.
With a view to moving towards international best practices and to ensure greater transparency, it
has been decided to adopt the ‘90 days’ overdue’ norm for identification of NPA, from the year
ending March 31, 2004. Accordingly, with effect from March 31, 2004, a non-performing asset
(NPA)is a loan or an advance where;

 Interest and/or installment of principal remain overdue for a period of more than 91 days
in respect of a term loan,
 The account remains ‘out of order’ for a period of more than 90 days, in respect of an
Overdraft/Cash Credit (OD/CC),
 The bill remains overdue for a period of more than 90 days in the case of bills purchased
and discounted,
 Interest and/or installment of principal remains overdue for two harvest seasons but for a
period not exceeding two half years in the case of an advance granted for agricultural
purposes, and
 Any amount to be received remains overdue for a period of more than 90 days in respect
of other accounts.
 Non submission of Stock Statements for 3 Continuous Quarters in case of Cash Credit
Facility.
 No active transactions in the account (Cash Credit/Over Draft/EPC/PCFC) for more than
91days

Further classify non-performing assets further into the following three categories based on the
period for which the asset has remained non-performing and the realisability of the dues:

1. Sub-standard assets: a sub standard asset is one which has been classified as NPA for a
period not exceeding 12 months.
2. Doubtful Assets: An asset would be classified as doubtful if it has remained in the
substandard category for a period of 12 months.
3. Loss assets: where loss has been identified by the bank, internal or external auditor or
central bank inspectors. But the amount has not been written off, wholly or partly.

Sub-standard asset is the asset in which bank have to maintain 15% of its reserves. All those
assets which are considered as non-performing for period of more than 12 months are called as
Doubtful Assets. All those assets which cannot be recovered are called as Loss Assets.

Reasons for occurrence of NPAs

NPAs result from what are termed “Bad Loans” or Non Performing Loans. Default, in the
financial parlance, is the failure to meet financial obligations, say non-payment of a loan
installment. These loans can occur due to the following reasons:

1. Usual banking operations /Bad lending practices

2. A banking crisis (as happened in USA, South Asia and Japan)

3. Overhang component (due to environmental reasons, natural calamities,business
cycle,Disease Occurrence,etc...)

4. Incremental component (due to internal bank management, like credit policy, terms of credit,
etc...)

Problems caused by NPAs

NPAs do not just reflect badly in a bank’s account books, they adversely impact the national
economy. Following are some of the repercussions of NPAs:

 Depositors do not get rightful returns and many times may lose uninsured deposits. Banks
may begin charging higher interest rates on some products to compensate NPL losses
 Bank shareholders are adversely affected
 Bad loans imply redirecting of funds from good projects to bad ones. Hence, the
economy suffers due to loss of good projects and failure of bad investments.
 When bank do not get loan repayment or interest payments, liquidity problems may ensue

Recovering Losses

Lenders generally have four options to recoup some or all losses resulting from nonperforming
assets. When companies struggle to service debt, lenders take proactive steps to restructure loans
to maintain cash flow and avoid classifying loans as nonperforming. When defaulted loans are
collateralized by borrowers' assets, lenders can take possession of the collateral and sell it to
cover losses.

Lenders can also convert bad loans into equity, which may appreciate to the point of full
recovery of principal lost in the defaulted loan. When bonds are converted to new equity shares,
the value of the original shares is usually eliminated. As a last resort, banks can sell bad debts at
steep discounts to companies that specialize in loan collections. Lenders typically sell defaulted
loans that are unsecured or when methods of recovery are not cost-effective.

Bank Capital

Bank capital is the difference between a bank's assets and liabilities, and it represents the net
worth of the bank or its value to investors. The asset portion of a bank's capital includes cash,
government securities, and interest-earning loans (e.g., mortgages, letters of credit, and inter-
bank loans); the liabilities section of a bank's capital includes loan-loss reserves and any debt it
owes. A bank's capital can be thought of as the margin to which creditors are covered if the bank
would liquidate its assets. Bank capital represents the value of a bank's equity instruments that
can absorb losses and have the lowest priority in payments if the bank liquidates. While bank
capital can be defined as the difference between a bank's assets and liabilities, national
authorities have their own definition of regulatory capital. The main banking regulatory
framework consists of international standards enacted by the Basel Committee on Banking
Supervision through international accords of Basel I, Basel II, and Basel III. These standards
provide a definition of the regulatory bank capital that market and banking regulators closely
monitor.

Capital-adequacy norms and capital market support

Book Value of Shareholders' Equity

The bank capital can be thought of as the book value of shareholders' equity on a bank's balance
sheet. Because many banks revalue their financial assets more often than companies in other
industries that hold fixed assets at a historical cost, shareholders' equity can serve as a reasonable
proxy for the bank capital. Typical items featured in the book value of shareholders' equity
include preferred equity, common stock and paid-in capital, retained earnings, and accumulated
comprehensive income. The book value of shareholders' equity is also calculated as the
difference between a bank's assets and liabilities.

Regulatory Bank Capital

Because banks serve an important role in the economy by collecting savings and channeling
them to productive uses through loans, the banking industry and the definition of bank capital are
heavily regulated. While each country can have its own requirements, the most recent
international banking regulatory accord of Basel III provides a framework for defining regulatory
bank capital.

According to Basel III, regulatory bank capital is divided into tiers. These are based on
subordination and a bank's ability to absorb losses with a sharp distinction of capital instruments
when it is still solvent versus after it goes bankrupt. Common equity tier 1 (CET1) includes the
book value of common shares, paid-in capital, and retained earnings less goodwill and any other
intangibles. Instruments within CET1 must have the highest subordination and no maturity.

Tier 1 capital includes CET1 plus other instruments that are subordinated to subordinated debt,
have no fixed maturity and no embedded incentive for redemption, and for which a bank can
cancel dividends or coupons at any time. Tier 2 capital consists of unsecured subordinated debt
and its stock surplus with an original maturity of fewer than five years minus investments in non-
consolidated financial institutions subsidiaries under certain circumstances. The total regulatory
capital is equal to the sum of Tier 1 and Tier 2 capital.

Capital Adequacy Ratio - CAR

The Capital Adequacy Ratio (CAR) is a measure of a bank's available capital expressed as a
percentage of a bank's risk-weighted credit exposures. The Capital Adequacy Ratio, also known
as capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the
stability and efficiency of financial systems around the world. Two types of capital are
measured: tier one capital, which can absorb losses without a bank being required to cease
trading, and tier two capital, which can absorb losses in the event of a winding-up and so
provides a lesser degree of protection to depositors.

The reason minimum capital adequacy ratios (CARs) are critical is to make sure that banks have
enough cushion to absorb a reasonable amount of losses before they become insolvent and
consequently lose depositors’ funds. The capital adequacy ratios ensure the efficiency and
stability of a nation’s financial system by lowering the risk of banks becoming insolvent.

During the process of winding-up, funds belonging to depositors are given a higher priority than
the bank’s capital, so depositors can only lose their savings if a bank registers a loss exceeding
the amount of capital it possesses. Thus the higher the bank’s capital adequacy ratio, the higher
the degree of protection of depositor's assets.

Tier One and Tier Two Capital

Tier one capital is the capital that is permanently and easily available to cushion losses suffered
by a bank without it being required to stop operating. A good example of a bank’s tier one
capital is its ordinary share capital.

Tier two capital is the one that cushions losses in case the bank is winding up, so it provides a
lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank loses
all its tier one capital.

The two capital tiers are added together and divided by risk-weighted assets to calculate a bank's
capital adequacy ratio. Risk-weighted assets are calculated by looking at a bank's loans,
evaluating the risk and then assigning a weight. When measuring credit exposures, adjustments
are made to the value of assets listed on a lender’s balance sheet. All the loans the bank has
issued are weighted based on their degree of credit risk. For example, loans issued to the
government are weighted at 0.0%, while those given to individuals are assigned a weighted score
of 100.0%.

Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by
banks and other institutions to reduce the risk of insolvency. The capital requirement is based on
a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of
credit is considered to be riskier and requires more capital than a mortgage loan that is secured
with collateral.
Why Capital Adequacy Ratio Matters

The reason minimum capital adequacy ratios (CARs) are critical is to make sure that banks have
enough cushion to absorb a reasonable amount of losses before they become insolvent and
consequently lose depositors’ funds. The capital adequacy ratios ensure the efficiency and
stability of a nation’s financial system by lowering the risk of banks becoming insolvent.
Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its
financial obligations.

During the process of winding-up, funds belonging to depositors are given a higher priority than
the bank’s capital, so depositors can only lose their savings if a bank registers a loss exceeding
the amount of capital it possesses. Thus the higher the bank’s capital adequacy ratio, the higher
the degree of protection of depositor's assets.

Off-balance sheet agreements, such as foreign exchange contracts and guarantees, have credit
risks. Such exposures are converted to their credit equivalent figures and then weighted in a
similar fashion to that of on-balance sheet credit exposures. The off-balance sheet and on-
balance sheet credit exposures are then lumped together to obtain the total risk-weighted credit
exposures.

Importance of Capital adequacy ratio

a) Ensuring Solvency of Banks

The capital adequacy ratio is important from the point of view of solvency of the banks and their
protection from untoward events which arise as a result of liquidity risk as well as the credit risk
that banks are exposed to in the normal course of their business.

The solvency of banks is not a matter that can be left alone to the banking industry. This is
because banks have the savings of the entire economy in their accounts. Hence, if the banking
system were to go bankrupt, the entire economy would collapse within no time. Also, if the
savings of the common people are lost, the government will have to step in and pay the deposit
insurance.

Hence, since the government has a direct stake in the issue, regulatory bodies are involved in the
creation and enforcement of capital ratios. In addition to that capital ratios are also influenced by
international banking institutions.

b) Limits The Amount of Credit Creation

Theoretically, reserve requirements are supposed to limit the amount of money that can be
created by banking institutions. However, in some countries, like the United Kingdom and
Canada, there is no reserve requirement at all. However, here too banks cannot go on creating
unlimited money. This is because the capital adequacy ratio also impacts the amount of credit
that can be created by the banks.
Capital adequacy ratios mandate that a certain amount of the deposits be kept aside
whenever a loan is being made. These deposits are kept aside as provisions to cover up the
losses in case the loan goes bad. These provisions therefore limit the amount of deposits that can
be loaned out and hence limit creation of credit. Changes to the capital adequacy ratio therefore
can have a significant impact on the inflation in the economy.

c) Credit Exposure

The capital adequacy ratios are laid based on the credit exposure that a particular bank has.
Credit exposure is different from the amount loaned out. This is because banks can have credit
exposure if they hold derivative products, even though they have not actually loaned out any
money to anybody. Therefore, the concept of credit exposure and how to measure it in a
standardized way across various banks in different regions of the world is an important issue in
formulating capital adequacy ratios. There are two major types of credit exposures that banks
have to deal with.

 Balance Sheet Exposure: Balance sheet exposure is the amount of risk that a bank is exposed to
on account of the activities that are listed on its balance sheet. This would include the credit
exposure that result from the loans that have been sanctioned. It would also result from the
credit exposure that is the result of the securities that have been purchased by the bank. Hence
an analyst can simply look at the balance sheet and come to an exact estimate of the credit
exposure of any bank.
 Off Balance Sheet Exposure: On the other hand, there are some risky activities that a bank takes
that are not listed on the balance sheet. For instance, bank may issue guarantees to some
parties on behalf of some other parties. These guarantees are not financial transactions that can
be listed on the balance sheet.

However, they do create credit risk in the process. Similarly the bank may purchase
derivative products which do not have any effect on the balance sheet today. However,
they may expose the bank to significant amounts of risks. The amounts of catastrophic
risks that can be caused by derivatives have been witnessed by the banks during the
subprime mortgage crisis.

An analyst therefore needs to measure the credit risk that has been generated by off balance sheet
activities. In order to accurately calculate the credit exposure that arises due to such risks, the
analyst requires additional information from the banks.

FEATURES OF CAPITAL ADEQUACY

1. Capital adequacy provides protection to depositors & creditors.

2. Capital adequacy relates to the firm’s overall use of financial leverage.

3. It measures the relationship between firm’s market value of assets & liabilities with the
corresponding book value.

NEED OF CAPITAL ADEQUACY

Adequate capital is required:

a) To support the growth

b) To absorb losses not covered by earnings

c) To provide protection to fiduciary accounts.

d) To ensure the public confidence in trust company system.

MODULE 3
What is a Non-Banking Financial Company (NBFC)?

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture activity,
industrial activity, purchase or sale of any goods (other than securities) or providing any services
and sale/purchase/construction of immovable property. A non-banking institution which is a
company and has principal business of receiving deposits under any scheme or arrangement in
one lump sum or in installments by way of contributions or in any other manner, is also a non-
banking financial company (Residuary non-banking company).

NBFCs are doing functions similar to banks. What is difference between banks & NBFCs?

NBFCs lend and make investments and hence their activities are akin to that of banks; however
there are a few differences as given below:

i. NBFC cannot accept demand deposits;

ii. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;
iii. deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks.

WHAT ARE NBFCs?

Non-bank financial companies(NBFCs) are financial institutions that provide banking

services without meeting the legal definition of a bank, i.e. one that does not hold a banking
license.

NBFCs include a loan company, an investment company, asset finance company ( i.e. a
company conducting the business of equipment leasing or hire purchase finance) and
Residuary Non-Banking Companies. NBFCs are incorporated under the Companies Act,
1956.

NBFCs can be classified into two broad categories, viz.,

(i) NBFCs accepting public deposit (NBFCs-D) and

(ii) NBFCs not accepting/holding public deposit (NBFCs-ND).

 An NBFC must be registered with the Reserve Bank of India (RBI) and have specific
authorization   to accept deposits from the public.
 NBFC must display the Certificate of Registration or a certified copy thereof at the
Registered office and other offices/branches.
 Registration of an NBFC with the RBI merely authorizes it to conduct the business of
NBFC. RBI does not guarantee the repayment of deposits accepted by  NBFCs.
.NBFCs cannot use the name of the RBI in any manner while conducting their
business.
 The NBFC whose application for grant of Certificate of Registration (CoR) has been
rejected or cancelled by the RBI is neither authorized to accept fresh deposits nor
renew existing deposit. Such rejection or cancellation is also published in newspapers
from time to time

DIFFERENCE BETWEEN  NBFCs AND BANK

NBFCs operate almost like banks, except for running accounts, where money can be easily
withdrawn by writing cheques or using a debit card.NBFCs are doing functions akin to that
of banks; however there are a few differences:

 An NBFC cannot accept demand deposits;

 An NBFC is not a part of the payment and settlement system and as such an NBFC
cannot issue cheques drawn on itself; and
 Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is
not available for NBFC depositors unlike in case of bank.

History of NBFCs in India

The Reserve Bank of India Act, 1934 amended on 1 December 1964 by Reserve Bank
Amendment Act, 1963. In this new 'Chapter III-B' introduced to Regulate 'Deposit Accepting'
NBFCs.
Different types of Committees to Review existing framework of NBFCs

James S. Raj Committee

In early 1970s Government of India asked Banking Commission to Study the Functioning of
Chit Funds and Examining activities of Non-Banking Financial Intermediaries. In 1972, Banking
Commission recommended Uniform Chit Fund Legislation to whole country.

Reserve Bank of India prepared Model Bill to regulate the conduct of chit funds and referred to
study group under the Chairmanship of James S. Raj.

In June 1974, study group recommended ban on Prize Chit and other Schemes. Directed the
Parliament to enact a bill which ensures uniformity in the provisions applicable to chit funds
throughout the country.

Parliament enacted two acts. Prize Chits and Money Circulation Schemes (Banning) Act, 1978
and Chit Funds Act, 1982

Chakravarty Committee

During Planning Era, Reserve Bank of India tried best to 'Manage Money's and evolve 'Sound
Monetary' system but no much appreciable success in realising social objectives of monetary
policy of the country.

In December 1982, Dr Manmohan Singh, Governor of RBI appointed committee under the
Chairmanship of 'Prof. Sukhamoy Chakravarty' to review functioning of monetary system in
India.

Committee recommended assessment of links among the Banking Sector, the Non-Banking
Financial Institutions and the Un-organised sector to evaluate various instruments of Monetary
and Credit policy in terms of their impact on the Credit System and the Economy.

TYPES OF NBFC

Originally, NBFCs registered with RBI were classified as:

(i) Equipment leasing company:Means any company which is a financial institution

carrying on as its principal business,the activity of leasing of equipment or the financing of
such  activity.

(ii) Hire-purchase company- Means any company which is a financial institution carrying
on as its principal business hire purchase transactions or the financing of such transactions.
(iii) Loan company—means any company which is a financial institution carrying on as its
principal business the providing of finance whether of making loans or advances or
otherwise for any activity other then its own

(iv) investment company- means any company which is a financial institution carrying on
as its principal business the acquisition of securities

RBI REGULATIONS

The RBI Act regulates different types of NBFC'S under the provision of Chapter III- B and
Chapter III- C

i) Corporate NBFCs fall under Chapter III-B, and

ii) Uncorporate NBFCs fall under Chapter III-C

 REGISTRATION – In terms of Section 45-IA of the RBI Act, 1934, it is mandatory

that every NBFC should be registered with RBI to commence or carry on any
business of non-banking financial institution as defined in clause (a) of Section 45 I
of the RBI Act, 1934.
 NET OWNED FUNDS- Under Section 45 I(a) of the RBI Act, 1934 NBFC should have
a minimum net owned fund of Rs 25 lakh to Rs 200 lakh
 MAINTENANCE OF ASSETS-The NBFCs are required to invest in India in approved
securities atleast 5% or higher percentage as specifiedby the RBI  from time to
time,of the outstanding deposits at the close of the business on the second
preceeding quarter
 RESERVE FUND-Every NBFC must create a reserve fund to which atleast 20% of its
net profit must be transferred before the declaration of any dividend
 POWER OF REGULATION/PROHIBITION-The RBI can by general/special order
regulate or prohibit the issue by any NBI the issue of any prospectus or
advertisement soliciting deposits of money from the public
 POWER TO COLLECT INFORMATION FROM ANY NBI's-The RBI can issue
direction to NBIs to furnish information relating to/connected with deposits.
 POWER TO CALL FOR INFORMATION FROM FIs AND ISSUE DIRECTIONS-To
regulate the credit system,the RBI can ask for information from FIs relating to their
business as well as directions for the conduct of their business
 PENALTIES-If any prospectus/advertisement inviting deposit from the
public,whoever willfully makes a false statement in any material particular knowing it
to be false or willfully omits to make a material statement,would be punishable with
imprisonment for a term upto three years and would also be liable to a fine.Failure
by a person to produce any book/account/other documents or to furnish any
statement/information/particulars is punishable with fine.The penalty imposed by the
RBI is payable within 30 days from the date on which the notice demanding payment
is served on the NBFC .

The Regulatory and Supervisory objective is to:

 Ensure healthy growth of the financial companies;

 Ensure  that  these  companies  function  as  a  part  of  the financial system within
the policy framework, in such a manner that their existence and functioning do not
lead to systemic aberrations;
  The quality of surveillance and supervision exercised by the Bank over the NBFCs is
sustained by keeping pace with the developments that take place in this sector  of
the financial system. 

  Two aspects of NBFCs functioning

A) REGULATORY FRAMEWORK
B) SUPERVISORY FRAMEWORK

A) REGULATORY FRAMEWORK

 Ensure that NBFCs  serve the financial system efficiently.

 Protect the interest of depositors.
 The activities of NBFCs were being regulated by the provisions of Chapter III-B of the
RBI Act, 1934 for over three decades. The emphasis of these regulations was,
however, on the acceptance of deposit by NBFCs mainly as an adjunct to monetary
and credit policy. 
 Entry norms for NBFCs and prohibition of deposit acceptance by unincorporated
bodies engaged in financial business.
 Compulsory registration, maintenance of liquid assets and creation of reserve fund.
 Power of the RBI to issue directions for NBFCs.

Basic Structure

 Comprehensive regulation and supervision of deposit taking NBFCs and limited

supervision over those not accepting public deposits.
 Prescription of prudential norms akin to those applicable to banks.
 Submission of periodical returns for the purpose of off-site surveillance
 Asset liability and risk management system for NBFCs
 Punitive action like cancellation of Certificate of Registration (CoR), prohibition from
acceptance of deposits and alienation of assets.  

For Protection Of Depositors'Interest

 Co-ordination with State Governments to curb unauthorized and fraudulent activities.

 Publicity for depositors' education and awareness, workshops / seminars for trade
and industry organizations

B) SUPERVISORY ASPECTS:

Reserve Bank of India has instituted a comprehensive supervisory mechanism

 On-site Inspection
 Off-site Surveillance System
 Market intelligence

ON-SITE INSPECTION:

It includes that an NBFC

1. Is complying with regulatory stipulation and supervisory guidelines

2. Has adequate capital and liquidity
3. Is being properly managed
4. Has adequate systems and controls in place

OFF-SITE SURVEILLANCE: 

It  includes to be an in house review and an analytical system based on receipt of various
statutory returns and other statements from the supervised entites at fixed intervals.

MARKET INTELLIGENCE:

It includes a system of capturing developments that takes place in the financial services
sector through various channels including press,electronic media and put the information to
proper use with utmost sensitivity so that RBI  remains alert in its actions.

Control by RBI and SEBI- A perspective on future role

NBFCs may be regulated either by the Securities and Exchange Board of India (SEBI) or RBI,
depending on the nature of activity it is engaged in. RBI and SEBI generally avoid dual
regulation of the same entity, that is, an entity registered with and regulated by Sebi is unlikely to
be permitted to undertake activities that require registration with, and licensing and regulation
by, RBI, and vice versa.

RBI generally regulates NBFCs that are primarily engaged in lending, finance and leasing
activities. Such NBFCs are required to register themselves with RBI under the provisions of the
RBI Act. Moreover, any company in which financial assets represent more than 50% of its total
assets and the income from such assets represents more than 50% of the company’s gross income
is also required to be registered with RBI as an NBFC. For an NBFC to be registered with RBI, it
should have a net owned fund of Rs2 crore. RBI has, for regulation purposes, broadly
categorized NBFCs into those accepting deposits and those which do not. Deposits include any
receipt of money by way of deposit or loan other than share capital, capital contributed by
partners of a firm or any amounts received from any bank or banking company.

Broadly speaking, NBFCs are regulated by the RBI Act, the Non-Banking Financial Companies
(Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions,
2007 (applicable to NBFCs that do not take deposits), Non-Banking Financial (Deposit
Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007
(applicable to NBFCs that do take deposits). RBI further issues circulars, guidance notes and
policy papers from time to time in relation to the operations and functioning of RBI NBFCs.

Further, NBFCs not accepting deposits but having an asset size of Rs100 crore or more as per the
last audited balance sheet are notified as “systemically important". RBI governs NBFCs
depending on whether they are deposit-taking, non- deposit-taking or are systemically important
NBFCs. Systemically important NBFCs are governed more strictly by RBI compared with other
non-deposit-taking NBFCs. Systemically important NBFCs are required to comply with cash
adequacy ratios, single borrower limits, single investment exposure limits, etc., which are not
applicable to NBFCs not accepting public deposits.

Recently, Sebi included systemically important NBFCs and certain other types of NBFCs not
accepting public deposits as “qualified institutional buyer" for the purposes of the Securitization
and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Sarfesi
Act). This amendment would entitle these NBFCs to subscribe to security receipts issued by
securitization and reconstruction companies and would become entitled to protections accorded
to qualified institutional buyers under the Sarfesi Act.

The multiplicity of regulations, directions and certain overlapping categorizations has often led
to confusion. Given that NBFCs have emerged as a very important segment of the Indian
financial system, any form of rationalization and simplification of the regulatory framework
would be more than welcome by the industry.

Mutual fund
A mutual fund is a professionally managed investment fund that pools money from many
investors to purchase securities. These investors may be retail or institutional in nature.

Mutual funds have advantages and disadvantages compared to direct investing in individual
securities. The primary advantages of mutual funds are that they provide economies of scale, a
higher level of diversification, they provide liquidity, and they are managed by professional
investors. On the negative side, investors in a mutual fund must pay various fees and expenses.

Primary structures of mutual funds include open-end funds, unit investment trusts, and closed-
end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade
on an exchange. Mutual funds are also classified by their principal investments as money market
funds, bond or fixed income funds, stock or equity funds, hybrid funds or other. Funds may also
be categorized as index funds, which are passively managed funds that match the performance of
an index, or actively managed funds. Hedge funds are not mutual funds; hedge funds cannot be
sold to the general public and are subject to different government regulations.

Functions of mutual funds

 The basic function of mutual fund companies is buying and selling securities on behalf of
its unit holders,
 It enables small investors to hold a share in a large and diversified portfolio of assets,
which reduces the risks of investment.
 The savings so mobilized are pooled in a large, diversified and sound portfolio of equity,
bonds, securities etc.
 Investors in the mutual funds are given the share in its total funds, which is evidenced by
the unit certificates.
  Mutual funds assure professional management, which helps in earning higher rate of
return.
 It helps the small investors who do not have adequate time and knowledge, expertise,
experience and resources for directly accessing profitable avenues in capital and money
markets.

Features of Mutual Funds

a)   Portfolio Diversification/Risk Diversification

Most Mutual Funds invest in 50 to 100 different investments based on market capitalisation,
sectors and many other demographics. *Only on a rare occasion do all stocks decline at the same
time and in the same proportion. Hence, Mutual Funds offer a diversified investment portfolio
even with a small amount of investment that would otherwise require big capital. Even with big
capital, it is extremely difficult and time-consuming to purchase and manage a wide range of
investments individually.

While investing in few shares or debentures directly is possible, the risk of potential loss is all on
the investor. However, Mutual Funds reduce the risk of loss as the portfolio is largely diversified
and the purchases are backed by research and experience of the fund house. Moreover, the loss is
also shared with other investors in the same fund. This diversification of risk is one of the key
benefits of a collective investment instrument like mutual funds.

* Only Sector funds invest across one industry making them less diversified and therefore more
volatile.

  b) Professional Management

Mutual Fund schemes are managed by qualified experienced professionals who work towards the
fund's defined objective. These financial experts are accompanied by a specialized investment
research team. The experts and their teams diligently and judiciously study companies, their
products and performance. After thorough analysis, the best investment option most aptly suited
to achieve the scheme's objective is chosen. This continuous process adds value to your
investment and helps obtain higher returns.

While, investors may differ in their investment needs based on their financial goals, currently,
they have over 8000+ schemes to choose from to meet their goals. Therefore, mutual funds make
the best way one can invest in Equities, Debt or Commodities (mainly Gold)

  c) Affordability

A mutual fund invests generally buy and sell various asset classes in large volumes allowing
investors to benefit from lower trading costs. Investors can get exposure to such portfolios with
an investment as modest as Rs.500/-* in mutual funds through a Systematic Investment Plan.
Such portfolio would otherwise be extremely expensive to purchase and maintain for an investor
investing directly in stock market.
*Subject to requirements of the Asset Management Company (AMC).

  d) Liquidity

With open ended funds, investors can redeem (encash) all or part of their investments at
prevailing net asset value, at any point of time. Mutual Funds are more liquid than most
investments in shares, deposits, and bonds. In addition, a standardised process enables quick and
efficient redemption allowing investors to get cash in hand as soon as possible. For closed ended
schemes, investors can redeem their investments at prevailing Net Asset Value, subject to exit
load at specific intervals, if provided in the scheme. In certain schemes, where lock in period is
mentioned, investor cannot redeem his investment until that period.

  e) Transparency

Mutual Funds are the most transparent form of investment. Investors receive detailed
information and timely updates about the nature of investments made, fund manager's investment
strategy behind the investments, the exact amount invested in each type of security, etc.
Moreover, the performance of a Mutual Fund is reviewed by various publications and rating
agencies, making it easy for investors to compare one fund to another.

f) Rupee-cost Averaging

Rupee cost averaging or SIP provides the investor a disciplined approach of investing specific
amount at regular intervals regardless of the unit price of the investment. Therefore, the money
invested fetches more units when the price is low and lesser when the price is high. Thus,
allowing you to achieve a lower average cost per unit over time. The strategy helps smoothen out
market ups and downs in the long run, while reducing the risk of investing in volatile markets.

g)  Regulations

All Mutual Funds are required to register with Securities Exchange Board of India (SEBI). With
investor interest at the helm, SEBI has laid down strict regulations to safeguard investors against
possible frauds. It is even mandatory for Mutual Fund distributors to register with Association of
Mutual Funds in India (AMFI) and abide the norms laid by the Securities and Exchange Board of
India (SEBI) and AMFI for the distributors.

h)   Choice of Investment

Mutual Funds are the only product category that caters to every one’s needs. You will always
find a mutual fund that matches your time horizon – long, medium, or short; and your risk-taking
ability – low, medium, high. All this irrelevant of how much you invest, be it a very small
investment or a huge Lumpsum. Your adviser will help choose the right fund/s for you keeping
in mind your profile.
  i) Minimizing Costs

Mutual Funds help investors to benefit from economies of scale as mutual funds pool money
from vast number people with common interest and invest their money in the relevant asset
class/classes. This helps the investors share the cost of management of their money.

Role of Mutual funds

• The overall economic development is promoted.

• The mutual fund industry itself, offers livelihood to a large number of employees of mutual
funds, distributors, registrars and various other service providers.

• Higher employment, income and output in the economy boost the revenue collection of the
government through taxes and other means.

• Mutual funds can also act as a market stabilizer, and are viewed as a key participant in the
capital market of any economy.

Mutual fund 3-tier structure

 There is a SPONSOR (the First tier), who thinks of starting a mutual fund. The Sponsor
approaches the securities & Exchange Board of India (SEBI), which is the market
regulator and also the regulator for mutual funds.
 Once SEBI is convinced, the sponsor creates a PUBLIC TRUST (the Second tier) as per
the Indian Trusts Act, 1882.
 Trusts have no legal identity in India and cannot enter into contracts, hence the Trustees
are the people authorized to act on behalf of the Trust. Contracts are entered into in the
name of the Trustees.
  Once the Trust is created, it is registered with SEBI after which this trust is known as the
mutual fund. Sponsor is not the Trust; i.e. Sponsor is not the Mutual Fund. It is the Trust
which is the Mutual Fund.
 The Trustees role is not to manage the money. Their job is only to see, whether the money
is being managed as per stated objectives. Trustees may be seen as the internal regulators
of a mutual fund.
 Trustees appoint the Asset Management Company (AMC - the Third tier), to manage
investor's money. The AMC in return charges a fee for the services provided and this fee
is borne by the investors as it is deducted from the money collected from them.

Example-

 In the case of HDFC –

 HDFC Limited & Standard Life Investments Limited are its sponsors.
 HDFC Mutual Fund has been created as a Trust.
 HDFC Trustee Company  Limited is the Trustee of HDFC Mutual Fund.
 HDFC Asset Management Company is an AMC appointed by HDFC Trustee Company
Limited to manage the funds of HDFC Mutual Fund.

Mutual fund schemes

 Various investors have different investment preferences

 Mobilize different pools of money to accommodate preferences – mutual fund schemes
 Investment in terms of ‘Units’
 Units * face value = unit capital
 NAV is true worth of a unit of the scheme
 NAV = Unit holders fund in the scheme / No. of units
 NFO – New Fund offer

Other players in mutual fund

 Custodian – All securities held by a mutual fund are kept with the Custodian. HDFC
Bank Limited & Citibank NA are the custodians for HDFC Mutual Fund.
 Registrar & Transfer Agent – Are responsible for the administrative aspects associated
with the mutual funds such as processing applications, issuing statements etc. CAMS are
the R&T agent for HDFC Mutual Fund.
 Auditors – One of the most important part of a mutual fund organisation structure are its
Auditors who should be reputed enough to safeguard the interest of mutual fund holders.
Deloitte Haskins & Sells are HDFC Mutual Fund’s auditor.
 It is important to note that the auditors of a Mutual Fund must be different from the
auditors of the AMC (as required by SEBI). Auditors of HDFC AMC are HariBhakti &
Co. This ensures that auditors of the mutual funds and AMC are independent and are not
influenced in any manner.

Types of mutual fund

Constituents of mutual funds

 Sponsors
 Trustee
 AMC
 Custodian
 RTA
 Auditors
 Fund accountants
 Distributors
 Collecting bankers

SEBI regulation of AMC

 Investment of funds not contrary to the provision of SEBI regulation

 AMFI - The Association of Mutual Funds in India – to promote the interest of MF
industry
 AMC are members of AMFI- follow AMFI code of ethics and standard
 Directors of AMC should have adequate professional experience in finance and financial
services
 Key personnel of AMC should not found guilty of violation of any law
  Key personnel should not worked for any AMC during the period when its registration
was suspended or cancelled by SEBI
 Prior approval of the trustees is required for appointing directors on the board of AMC
 50% directors should be independent directors
 AMC minimum net worth Rs 10cr
 AMC can not invest in its own schemes unless the intention to invest is disclosed in offer
document.
 AMC cannot charge any fee for the investment
 Appointment of an AMC can be terminated by a majority of the trustee or 75% of unit
holder
 Any change in the AMC is subject to prior approval of SEBI and unit holder

Expenses

 Initial issue expenses – borne by AMC

 Recurring expenses – SEBI laid down expenses which can be charged :

i. Fees for various service provider

ii. Selling expenses
iii. Expenses on investor communication
iv. Listing fees and depository fees
v. Service tax

Entry and exit load – load is an amount which is paid by the investor to subscribe or redeem the
units from the scheme

Advantages and disadvantages to investors

Mutual funds have advantages and disadvantages compared to investing directly in individual
securities:

Advantages

 Low Cost: Affordable investment option for people who do not want to make a large
initial investment.
 Increased diversification: A fund diversifies holding many securities. This diversification
decreases risk.
 Daily liquidity: Shareholders of open-end funds and unit investment trusts may sell their
holdings back to the fund at regular intervals at a price equal to the net asset value of the
fund's holdings. Most funds allow investors to redeem in this way at the close of every
trading day.
 Professional investment management: Open-and closed-end funds hire portfolio
managers to supervise the fund's investments.
 Ability to participate in investments that may be available only to larger investors. For
example, individual investors often find it difficult to invest directly in foreign markets.
 Service and convenience: Funds often provide services such as check writing.
  Government oversight: Mutual funds are regulated by a governmental body.
 Transparency and ease of comparison: All mutual funds are required to report the same
information to investors, which makes them easier to compare to each other.

Disadvantages

Mutual funds have disadvantages as well, which include:

 Fees
 Less control over timing of recognition of gains
 Less predictable income
 No opportunity to customize

mutual fund's performance

A mutual fund is a pool of stocks, bonds or other funds from which an investor can purchase
shares. Whether the mutual fund is actively managed or passive, like an index fund, it offers you
an efficient way to diversify your portfolio. Some mutual funds, like asset allocation funds, offer
a well-diversified investment in just one product. As with any investment, evaluating a mutual
fund's performance and choosing one or several that meet your investment goals and risk
tolerance involves thorough research. Use these steps to review a mutual fund and decide if it is
the right choice for your portfolio.

First, classify the mutual fund to determine if it fits within your scope. For example, if you are
seeking a mutual fund that provides steady income, a mid-cap value fund will leave you very
disappointed. To find out the style of mutual fund, look up the fund on a financial website such
as Morningstar. You can find all the basic facts about a mutual fund and have access to tools that
further help you evaluate the fund. In your categorization of the mutual fund, also identify a few
peers, or comparable funds from other fund companies, to compare your chosen fund. Using a
mutual fund screener tool, such as the one provided by Morningstar, can help you with this task.

Next, review the historical performance data and compare your chosen mutual fund with a few of
its peers. Look at the risk-return trade-off for each fund and determine whether it meets your risk
tolerance. Morningstar ranks each fund's risk and historical returns against other funds within its
universe so you can easily determine if a fund assumes a greater risk than average. Ideally, select
a fund that assumes low risk but still produces good returns. The balance between the two
depends, again, on your risk tolerance and investment objectives.

Dig deeper into the historical performance numbers to determine the consistency of the fund's
returns. Do the five-year average returns look great because of one phenomenal year that could
have just been contributed to luck? Try to select a fund that consistently outperforms its
benchmark and one that has withstood a few market downturns and mitigated downside risks.
These numbers illustrate the ability of the mutual fund managers. Sometimes, however, when the
market crashes, not even the best managers can save a portfolio from a loss. For this reason, also
compare the fund's upside and downside capture data against comparable funds.

Finally, take a look into the fund's expenses and fee structure. Tactical mutual funds that have
heavy trading or are very actively managed have higher annual expenses. Factor in these costs as
they directly affect your performance. While a fund that charges higher management fees is not
necessarily better or worse because of the fees, still be cognizant of reasonable fees for the type
of fund you choose. Again, comparing the fund with its peers can reveal whether the fees are
reasonable.

Unit Trust of India

Unit Trust of India (UTI) is a statutory public sector investment institution which was set up in
February 1964 under the Unit Trust of India Act, 1963 . UTI began operations in July 1964. It
provides opportunity for small-savers to invest in areas where their risk is diversified. The Unit-
holders, if necessary, can sell their units to UTI at the prices determined by UTI. One of the
attractions is that the investment in UTI has an income-tax rebate and the income from the UTI is
exempted; from income-tax subject to certain limits.

UTI Mutual Fund was carved out of the erstwhile Unit Trust of India (UTI) as a SEBI registered
mutual fund from 1 February 2003. The Unit Trust of India Act 1963 was repealed, paving way
for the bifurcation of UTI into – Specified Undertaking of Unit Trust of India (SUUTI); and UTI
Mutual Fund (UTIMF). UTI Mutual Fund is promoted by the four of the largest Public Sector
Financial Institutions as sponsors, viz., State Bank of India, Life Insurance Corporation of India,
Bank of Baroda and Punjab National Bank with each of them holding an 18.24% stake in the
paid up capital of UTI AMC. T Rowe Price Group Inc (TRP Group) through its wholly owned
subsidiary T Rowe Price Global Investment Services Ltd. (TRP) has acquired a 26% stake in
UTI Asset Management Company Limited (UTI AMC). UTI Mutual Fund is the oldest and one
of the largest mutual funds in India with over 10 million investor accounts under its 230
domestic schemes / plans as on September 30, 2017. UTI Mutual Fund has a nationwide
distribution network, which is spread across the length and breadth of the country. Its distribution
network comprises over 48000 AMFI/NISM certified Independent Financial Advisors and 150
Financial Centers. UTI Mutual Fund has been the pioneer for launching various schemes viz.
UTI Unit Linked Insurance Plan (ULIP) with life & accident cover (Launched in 1971), UTI
Mastershare (Launched in 1986), India's first Offshore Fund – India fund (Launched in 1986),
UTI Wealth Builder Fund, the first of its kind in the Indian mutual fund industry combining
different asset classes i.e. equity and gold which are lowly correlated

Objectives:

The primary objectives of the UTI are:

(i) To encourage and pool the savings of the middle and low income groups.

(ii) To enable them to share the benefits and prosperity of the industrial development in the
country.
Organisation and Management:

UTI was established with an initial capital of Rs. 5 crore, contributed by the RBI, LIC, SBI and
its subsidiaries and scheduled banks and financial institutions. The initial capital of Rs. 5 crore
was divided into 1,000 certificates of Rs. 50,000 each. To supplement its financial resources, the
trust can borrow from the Reserve Bank of India, the amount being repayable on demand’ or
within a period of 18 months. UTI is managed by a Board of Trustees, consisting of a chairman
and four members nominated by Reserve Bank of India, one member nominated by LIC, one
member nominated by the State Bank of India, and two members elected by the contributing
institutions.

Functions of UTI:

The UTI functions are discussed below:

(i) To accept discount, purchase or sell bills of exchange, promissory note, bill of lading,
warehouse receipt, documents of title to goods etc.,

(ii) To grant loans and advances.

(iii) To provide merchant banking and investment advisory service.

(iv) To provide leasing and hire purchase business.

(v) To extend portfolio management service to persons residing outside India.

(vi) To buy or sell or deal in foreign exchange dealings.

(vii) To formulate unit scheme or insurance plan in association with or as agent of GIC.

(viii) To invest in any security floated by the Central Government, RBI or foreign bank.

Activities of UTI:

The UTI can sell and purchase the units issued by it, investing, acquire, hold or dispose off
securities. Keep money on deposit with the scheduled banks and undertake related functions
incidental or consequential to that. All the units issued by the UTI are of the value of Rs. 10
each. These units were put on sale at face value and thereafter at prices fixed daily by the UTI.
Units can be purchased in ten or multiples of ten.

Schemes of UTI:

The familiar schemes of UTI are given below:

(i) Unit scheme—1964.

(ii) Unit Linked Insurance Plan—1971.

(iii) Children Gift Growth Fund Unit Scheme—1986.

(iv) Rajyalakhmi Unit Scheme—1992.

(v) Senior Citizen’s Unit Plan—1993.

(vi) Monthly Income Unit Scheme.

(vii) Master Equity Plan—1995.

(viii) Money Market Mutual Fund—1997.

(ix) UTI Growth Sector Fund—1999.

(x) Growth and Income Unit Schemes.

Advantages of Unit Trust:

The advantages of Unit Trust are:

(i) The investment is safe and the risk is spread over a wide range of securities.

(ii) The Unit-holders will be getting regular and good income, as 90 percent of its income will be
distributed.

(iii) Dividends up to Rs. 1,000 received by the individual are exempt from income-tax.

(iv) There is a high degree of liquidity of investment as the units can be sold back to the trust at
any time at prices fixed by trust.

Reserve Bank of India Framework for/Regulation of Bank Credit

The banking system in India is regulated by the Reserve Bank of India (RBI), through the
provisions of the Banking Regulation Act, 1949. Some important aspects of the regulations that
govern banking in this country, as well as RBI circulars that relate to banking in India, will be
explored below.

Exposure limits

Lending to a single borrower is limited to 15% of the bank’s capital funds (tier 1 and tier 2
capital), which may be extended to 20% in the case of infrastructure projects. For group
borrowers, lending is limited to 30% of the bank’s capital funds, with an option to extend it to
40% for infrastructure projects. The lending limits can be extended by a further 5% with the
approval of the bank's board of directors. Lending includes both fund-based and non-fund-based
exposure.

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)

Banks in India are required to keep a minimum of 4% of their net demand and time liabilities
(NDTL) in the form of cash with the RBI. These currently earn no interest. The CRR needs to be
maintained on a fortnightly basis, while the daily maintenance needs to be at least 95% of the
required reserves. In case of default on daily maintenance, the penalty is 3% above the bank rate
applied on the number of days of default multiplied by the amount by which the amount falls
short of the prescribed level. Cuurent (February 2019) CRR rate is 4%.

Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that the
commercial banks in India are required to maintain in the form of cash, gold reserves, RBI
approved securities before providing credit to the customers. The excess SLR holdings can be
used to borrow under the Marginal Standing Facility (MSF) on an overnight basis from the RBI.
The interest charged under MSF is higher than the repo rate by 100 bps, and the amount that can
be borrowed is limited to 2% of NDTL. (To learn more about how interest rates are determined,
particularly in the U.S., consider reading more about who determines interest rates.) Current
(February 2019) SLR rate is 19.5%.

Provisioning

Non-performing assets (NPA) are classified under 3 categories: substandard, doubtful and loss.
An asset becomes non-performing if there have been no interest or principal payments for more
than 90 days in the case of a term loan. Substandard assets are those assets with NPA status for
less than 12 months, at the end of which they are categorized as doubtful assets. A loss asset is
one for which the bank or auditor expects no repayment or recovery and is generally written off
the books.

For substandard assets, it is required that a provision of 15% of the outstanding loan amount for
secured loans and 25% of the outstanding loan amount for unsecured loans be made. For
doubtful assets, provisioning for the secured part of the loan varies from 25% of the outstanding
loan for NPAs that have been in existence for less than one year, to 40% for NPAs in existence
between one and three years, to 100% for NPA’s with a duration of more than three years, while
for the unsecured part it is 100%.

Provisioning is also required on standard assets. Provisioning for agriculture and small and
medium enterprises is 0.25% and for commercial real estate it is 1% (0.75% for housing), while
it is 0.4% for the remaining sectors. Provisioning for standard assets cannot be deducted from
gross NPA’s to arrive at net NPA’s. Additional provisioning over and above the standard
provisioning is required for loans given to companies that have unhedged foreign exchange
exposure. 
Priority sector lending

The priority sector broadly consists of micro and small enterprises, and initiatives related to
agriculture, education, housing and lending to low-earning or less privileged groups (classified as
"weaker sections"). The lending target of 40% of adjusted net bank credit (ANBC) (outstanding
bank credit minus certain bills and non-SLR bonds) – or the credit equivalent amount of off-
balance-sheet exposure (sum of current credit exposure + potential future credit exposure that is
calculated using a credit conversion factor), whichever is higher – has been set for domestic
commercial banks and foreign banks with greater than 20 branches, while a target of 32% exists
for foreign banks with less than 20 branches.

The amount that is disbursed as loans to the agriculture sector should either be the credit
equivalent of off-balance-sheet exposure, or 18% of ANBC – whichever of the two figures is
higher. Of the amount that is loaned to micro-enterprises and small businesses, 40% should be
advanced to those enterprises with equipment that has a maximum value of 200,000 rupees, and
plant and machinery valued at a maximum of half a million rupees, while 20% of the total
amount lent is to be advanced to micro-enterprises with plant and machinery ranging in value
from just above 500,000 rupees to a maximum of a million rupees and equipment with a value
above 200,000 rupees but not more than 250,000 rupees.

The total value of loans given to weaker sections should either be 10% of ANBC or the credit
equivalent amount of off-balance sheet exposure, whichever is higher.  Weaker sections include
specific castes and tribes that have been assigned that categorization, including small farmers.
There are no specific targets for foreign banks with less than 20 branches.

The private banks in India until now have been reluctant to directly lend to farmers and other
weaker sections. One of the main reasons is the disproportionately higher amount of NPA’s from
priority sector loans, with some estimates indicating it to be 60% of the total NPAs. They
achieve their targets by buying out loans and securitized portfolios from other non-banking
finance corporations (NBFC) and investing in the Rural Infrastructure Development Fund
(RIDF) to meet their quota.

Willful defaulters

A willful default takes place when a loan isn’t repaid even though resources are available, or if
the money lent is used for purposes other than the designated purpose, or if a property secured
for a loan is sold off without the bank's knowledge or approval. In case a company within a
group defaults and the other group companies that have given guarantees fail to honor their
guarantees, the entire group can be termed as a willful defaulter.

Willful defaulters (including the directors) have no access to funding, and criminal proceedings
may be initiated against them. The RBI recently changed the regulations to include non-group
companies under the willful defaulter tag as well if they fail to honor a guarantee given to
another company outside the group.
The Bottom Line

The way a country regulates its financial and banking sectors is in some senses a snapshot of its
priorities, its goals, and the type of financial landscape and society it would like to engineer. In
the case of India, the regulations passed by its reserve bank give us a glimpse into its approaches
to financial governance and shows the degree to which it prioritizes stability within its banking
sector, as well as economic inclusiveness.

Though the regulatory structure of India's banking system seems a bit conservative, this has to be
seen in the context of the relatively under-banked nature of the country. The excessive capital
requirements that have been set are required to build up trust in the banking sector while the
priority lending targets are needed to provide financial inclusion to those to whom the banking
sector would not generally lend given the high level of NPA’s and small transaction sizes.

Since the private banks, in reality, do not directly lend to the priority sectors, the public banks
have been left with that burden. A case could also be made for adjusting how the priority sector
is defined, in light of the high priority given to agriculture, even though its share of GDP has
been going down.

Commercial Paper:

Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically

for the financing of accounts payable and inventories and meeting short-term liabilities.
Maturities on commercial paper rarely range longer than 270 days. Commercial paper is usually
issued at a discount from face value and reflects prevailing market interest rates. Commercial
paper is not usually backed by any form of collateral, making it a form of unsecured debt. As a
result, only firms with high-quality debt ratings will easily find buyers without having to offer a
substantial discount (higher cost) for the debt issue.

Features / Characteristics of Commercial Paper

1. It is a negotiable instrument.

2. It is an unsecured instrument as it is not backed by any assets of the company.

3. It can be sold by the issuing company, directly to the investors.

Advantages of Commercial Papers

1. It is a cost effective way of financing working capital. It is cheaper than bank loans.

2. No security is required.
3. Commercial paper dealer often offers financial advice.

4. It is a simple instrument.

5. Very less documentation between the issuer and the investor.

6. It is flexible in terms of maturities of the underlying promissory note.

7. It can be tailored to match the cash flow of the issuer.

8. A good credit rated company can diversify its sources of finance from banks to the short-term
money market at a cheaper cost.

9. For the investors, higher returns obtained than if they invest their funds in any bank.

10. For the companies, they are better known to the financial world and hence placed in a better
position to borrow long-term funds in future.

11. There is no limitation on the end-use of funds raised through commercial papers.

12. They are highly liquid.

Disadvantages of Commercial Papers:

i. It is available to few selected blue chip and profitable companies.

ii. By issuing commercial papers, the credit available from banks may get reduced.

iii. Issue of commercial paper is strictly regulated by RBI.

Framework of Indian Commercial Paper Market

Commercial Paper in India is a new addition to short-term instruments in Indian Money

market since 1990 onward. The introduction of Commercial paper as the short-term monetary
instrument was the beginning of a reform in Indian Money market on the background of trend of
Liberalization which began in the world economy during 1985 to 1990. A commercial paper in
India is the monetary instrument issued in the form of promissory note. It acts as the debt
instrument to be used by large corporate companies for borrowing short-term monetary funds in
the money market. An introduction of Commercial Paper in Indian money market is an
innovation in the Financial system of India. Prior to injection of Commercial Paper in Indian
money market i.e. before 1990, the corporate companies had to depend upon the crude and
traditional method of borrowing working capital from the commercial banks by pledging the
inventory of raw materials as Collateral security. It involved more loss of time for the borrowing
companies in availing the short-term funds for day-to-day production activities. The commercial
paper has become effective instrument for these corporate companies to avail the short-term
funds from the money market within shortest possible time limit by avoiding the hassles of direct
negotiation with the commercial banks for availing the short-term loans.

Commercial Paper market

The introduction of commercial paper as debt instrument has promoted commercial paper market
as one of the components of Indian money market. In this commercial paper market, the issuers
of commercial paper create supply while the subscribers to commercial paper create demand for
these papers. The interaction between supply and demand for commercial papers promotes the
commercial paper market. The main issuers of Commercial paper in this market are incorporated
manufacturers and the main subscribers to the Commercial papers are the banking companies.
Commercial Paper is issued by the issuers at a discount to face value of Commercial paper. The
face value of Commercial Paper is in the denomination of Rs. 0.5 million and multiples thereof.
The maturity period of Commercial paper in the Commercial Paper market ranges between
minimum of 7 days and maximum of 1 year from the date of issue. The subscriber to the
commercial paper is the investor, and a single investor in the Commercial paper market is not
allowed to invest less than Rs. 0.5 million. The other issuers of Commercial paper in this market
are Primary dealers and All India Financial Institutions. The other investors or subscribers to
Commercial paper in this market are individuals, Non-Resident Indians and Foreign Institutional
Investors.

All eligible participants shall obtain the credit rating for issuance of Commercial Paper either
from Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information
and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd.
(CARE) or the India Ratings & Research Pvt. Ltd. (Ind-Ra) or such other credit rating agency
(CRA) as may be specified by the Reserve Bank of India from time to time, for the purpose. The
minimum credit rating shall be A-3 [As per rating symbol and definition prescribed by Securities
and Exchange Board of India (SEBI)]. The issuers shall ensure at the time of issuance of CP that
the rating so obtained is current and has not fallen due for review.

Indian CP market has picked up on highergrowth pace in last five years and has beenrelatively
more active - indicating a paradigmshift in corporates' preference for CPs over bankcredit as a
better means of funding at lower andcompetitive cost. The Reserve Bank of India’s (RBI’s)
Monetary Policy Report for October 2018 shows that funding from non-bank sources to the
commercial sector was more than Rs 5.6 trillion between April and september. What’s surprising
is that Rs 2.53 trillion of borrowings was in commercial paper. As the chart shows, it is a marked
difference from the position in the first half of fiscal year 2018 (FY18), when commercial papers
accounted for just one-tenth of the total borrowing by the commercial sector from non-banks.
Indeed, for the last fiscal year up to mid-March, commercial papers accounted for just 6.2% of
the funding by non-bank sources, with the largest chunk (17%) being private placements.

Effective cost/interest yield.

Like treasury bills, yields on commercial paper are quoted on a discount basis—the discount
return to commercial paper holders is the annualized percentage difference between the price
paid for the paper and the face value using a 360-day year.

The effective pre-tax interest yield of commercial paper is calculated by the following formula:

360
Face Value - Net Amount Realized
X
Maturity
Net Amount Realized
Period
Example:
Let us calculate the pre-tax effective cost of the following commercial paper.
Face value = Rs 600,000
Maturity period = 90 days
Net amount realized = Rs 595,000
Discount & other
= 2%
charges
Rs600,000 - (Rs595,000 -
360
Effective Rs12,000)
= X
cost/Interest yield
90
Rs 595,000 - Rs12,000
= 11.66%

Discount  =  Rs 600,000  x  2%  =  Rs 12,000.

MODULE 4
The Economics of Insurance –

What is Insurance

Insurance is a contract, represented by a policy, in which an individual or entity receives

financial protection or reimbursement against losses from an insurance company. The company
pools clients' risks to make payments more affordable for the insured.

Insurance policies are used to hedge against the risk of financial losses, both big and small, that
may result from damage to the insured or her property, or from liability for damage or injury
caused to a third party. There are a multitude of different types of insurance policies available,
and virtually any individual or business can find an insurance company willing to insure them,
for a price. The most common types of personal insurance policies are auto, health, homeowners,
and life.
An entity which provides insurance is known as an insurer, insurance company, insurance carrier
or underwriter. A person or entity who buys insurance is known as an insured or as a
policyholder. The insurance transaction involves the insured assuming a guaranteed and known
relatively small loss in the form of payment to the insurer in exchange for the insurer's promise
to compensate the insured in the event of a covered loss. The loss may or may not be financial,
but it must be reducible to financial terms, and usually involves something in which the insured
has an insurable interest established by ownership, possession, or pre-existing relationship.

The insured receives a contract, called the insurance policy, which details the conditions and
circumstances under which the insurer will compensate the insured. The amount of money
charged by the insurer to the insured for the coverage set forth in the insurance policy is called
the premium. If the insured experiences a loss which is potentially covered by the insurance
policy, the insured submits a claim to the insurer for processing by a claims adjuster. The insurer
may hedge its own risk by taking out reinsurance, whereby another insurance company agrees to
carry some of the risk, especially if the primary insurer deems the risk too large for it to carry.

Insurance Policy Components

When choosing a policy, it is important to understand how insurance works. Three important
components of insurance policies are the premium, policy limit, and deductible. A firm
understanding of these concepts goes a long way in helping you choose the policy that best suits
your needs.

A policy's premium is its price, typically expressed as a monthly cost. The premium is
determined by the insurer based on your or your business's risk profile, which may include
creditworthiness. For example, if you own several expensive automobiles and have a history of
reckless driving, you will likely pay more for an auto policy than someone with a single mid-
range sedan and a perfect driving record. However, different insurers may charge different
premiums for similar policies; so, finding the price that is right for you requires some legwork.

The policy limit is the maximum amount an insurer will pay under a policy for a covered loss.
Maximums may be set per period (e.g., annual or policy term), per loss or injury, or over the life
of the policy, also known as the lifetime maximum. Typically, higher limits carry higher
premiums. For a general life insurance policy, the maximum amount the insurer will pay is
referred to as the face value, which is the amount paid to a beneficiary upon the death of the
insured.

The deductible is a specific amount the policy-holder must pay out-of-pocket before the insurer
pays a claim. Deductibles serve as deterrents to large volumes of small and insignificant claims.
Deductibles can apply per-policy or per-claim depending on the insurer and the type of policy.

Policies with very high deductibles are typically less expensive because the high out-of-pocket
expense generally results in fewer small claims. In regards to health insurance, people who have
chronic health issues or need regular medical attention should look for policies with lower
deductibles. Though the annual premium is higher than a comparable policy with a higher
deductible, less expensive access to medical care throughout the year may be worth the trade-off.

Principles

Insurance involves pooling funds from many insured entities (known as exposures) to pay for the
losses that some may incur. The insured entities are therefore protected from risk for a fee, with
the fee being dependent upon the frequency and severity of the event occurring. In order to be an
insurable risk, the risk insured against must meet certain characteristics. Insurance as a financial
intermediary is a commercial enterprise and a major part of the financial services industry, but
individual entities can also self-insure through saving money for possible future losses.

Insurability

Risk which can be insured by private companies typically shares seven common characteristics.

1. Large number of similar exposure units: Since insurance operates through pooling resources,
the majority of insurance policies are provided for individual members of large classes, allowing
insurers to benefit from the law of large numbers in which predicted losses are similar to the
actual losses. Exceptions include Lloyd's of London, which is famous for insuring the life or
health of actors, sports figures, and other famous individuals. However, all exposures will have
particular differences, which may lead to different premium rates.
2. Definite loss: The loss takes place at a known time, in a known place, and from a known cause.
The classic example is death of an insured person on a life insurance policy. Fire, automobile
accidents, and worker injuries may all easily meet this criterion. Other types of losses may only
be definite in theory. Occupational disease, for instance, may involve prolonged exposure to
injurious conditions where no specific time, place, or cause is identifiable. Ideally, the time,
place, and cause of a loss should be clear enough that a reasonable person, with sufficient
information, could objectively verify all three elements.
3. Accidental loss: The event that constitutes the trigger of a claim should be fortuitous, or at least
outside the control of the beneficiary of the insurance. The loss should be pure, in the sense that it
results from an event for which there is only the opportunity for cost. Events that contain
speculative elements such as ordinary business risks or even purchasing a lottery ticket are
generally not considered insurable.
4. Large loss: The size of the loss must be meaningful from the perspective of the insured.
Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and
administering the policy, adjusting losses, and supplying the capital needed to reasonably assure
that the insurer will be able to pay claims. For small losses, these latter costs may be several times
the size of the expected cost of losses. There is hardly any point in paying such costs unless the
protection offered has real value to a buyer.
5. Affordable premium: If the likelihood of an insured event is so high, or the cost of the event so
large, that the resulting premium is large relative to the amount of protection offered, then it is not
likely that the insurance will be purchased, even if on offer. Furthermore, as the accounting
profession formally recognizes in financial accounting standards, the premium cannot be so large
that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance
of loss, then the transaction may have the form of insurance, but not the substance (see the U.S.
 Financial Accounting Standards Board pronouncement number 113: "Accounting and Reporting
for Reinsurance of Short-Duration and Long-Duration Contracts").
6. Calculable loss: There are two elements that must be at least estimable, if not formally
calculable: the probability of loss, and the attendant cost. Probability of loss is generally an
empirical exercise, while cost has more to do with the ability of a reasonable person in possession
of a copy of the insurance policy and a proof of loss associated with a claim presented under that
policy to make a reasonably definite and objective evaluation of the amount of the loss
recoverable as a result of the claim.
7. Limited risk of catastrophically large losses: Insurable losses are ideally independent and non-
catastrophic, meaning that the losses do not happen all at once and individual losses are not
severe enough to bankrupt the insurer; insurers may prefer to limit their exposure to a loss from a
single event to some small portion of their capital base. Capital constrains insurers' ability to sell
earthquake insurance as well as wind insurance in hurricane zones. In the United States, flood
risk is insured by the federal government. In commercial fire insurance, it is possible to find
single properties whose total exposed value is well in excess of any individual insurer's capital
constraint. Such properties are generally shared among several insurers, or are insured by a single
insurer who syndicates the risk into the reinsurance market.

Legal

When a company insures an individual entity, there are basic legal requirements and regulations.
Several commonly cited legal principles of insurance include:

1. Indemnity – the insurance company indemnifies, or compensates, the insured in the case of
certain losses only up to the insured's interest.
2. Benefit insurance – as it is stated in the study books of The Chartered Insurance Institute, the
insurance company does not have the right of recovery from the party who caused the injury and
is to compensate the Insured regardless of the fact that Insured had already sued the negligent
party for the damages (for example, personal accident insurance)
3. Insurable interest – the insured typically must directly suffer from the loss. Insurable interest must
exist whether property insurance or insurance on a person is involved. The concept requires that
the insured have a "stake" in the loss or damage to the life or property insured. What that "stake"
is will be determined by the kind of insurance involved and the nature of the property ownership
or relationship between the persons. The requirement of an insurable interest is what
distinguishes insurance from gambling.
4. Utmost good faith – (Uberrima fides) the insured and the insurer are bound by a good faith bond
of honesty and fairness. Material facts must be disclosed.
5. Contribution – insurers which have similar obligations to the insured contribute in the
indemnification, according to some method.
6. Subrogation – the insurance company acquires legal rights to pursue recoveries on behalf of the
insured; for example, the insurer may sue those liable for the insured's loss. The Insurers can
waive their subrogation rights by using the special clauses.
7. Causa proxima, or proximate cause – the cause of loss (the peril) must be covered under the
insuring agreement of the policy, and the dominant cause must not be excluded
8. Mitigation – In case of any loss or casualty, the asset owner must attempt to keep loss to a
minimum, as if the asset was not insured.

Indemnification
To "indemnify" means to make whole again, or to be reinstated to the position that one was in, to
the extent possible, prior to the happening of a specified event or peril. Accordingly, life
insurance is generally not considered to be indemnity insurance, but rather "contingent"
insurance (i.e., a claim arises on the occurrence of a specified event). There are generally three
types of insurance contracts that seek to indemnify an insured:

1. A "reimbursement" policy
2. A "pay on behalf" or "on behalf of policy"
3. An "indemnification" policy

From an insured's standpoint, the result is usually the same: the insurer pays the loss and claims
expenses.

If the Insured has a "reimbursement" policy, the insured can be required to pay for a loss and
then be "reimbursed" by the insurance carrier for the loss and out of pocket costs including, with
the permission of the insurer, claim expenses.

Under a "pay on behalf" policy, the insurance carrier would defend and pay a claim on behalf of
the insured who would not be out of pocket for anything. Most modern liability insurance is
written on the basis of "pay on behalf" language which enables the insurance carrier to manage
and control the claim.

Under an "indemnification" policy, the insurance carrier can generally either "reimburse" or "pay
on behalf of", whichever is more beneficial to it and the insured in the claim handling process.

An entity seeking to transfer risk (an individual, corporation, or association of any type, etc.)
becomes the 'insured' party once risk is assumed by an 'insurer', the insuring party, by means of a
contract, called an insurance policy. Generally, an insurance contract includes, at a minimum, the
following elements: identification of participating parties (the insurer, the insured, the
beneficiaries), the premium, the period of coverage, the particular loss event covered, the amount
of coverage (i.e., the amount to be paid to the insured or beneficiary in the event of a loss), and
exclusions (events not covered). An insured is thus said to be "indemnified" against the loss
covered in the policy.

When insured parties experience a loss for a specified peril, the coverage entitles the
policyholder to make a claim against the insurer for the covered amount of loss as specified by
the policy. The fee paid by the insured to the insurer for assuming the risk is called the premium.
Insurance premiums from many insureds are used to fund accounts reserved for later payment of
claims – in theory for a relatively few claimants – and for overhead costs. So long as an insurer
maintains adequate funds set aside for anticipated losses (called reserves), the remaining margin
is an insurer's profit.

Social effects

Insurance can have various effects on society through the way that it changes who bears the cost
of losses and damage. On one hand it can increase fraud; on the other it can help societies and
individuals prepare for catastrophes and mitigate the effects of catastrophes on both households
and societies.

Insurance can influence the probability of losses through moral hazard, insurance fraud, and
preventive steps by the insurance company. Insurance scholars have typically used moral hazard
to refer to the increased loss due to unintentional carelessness and insurance fraud to refer to
increased risk due to intentional carelessness or indifference. Insurers attempt to address
carelessness through inspections, policy provisions requiring certain types of maintenance, and
possible discounts for loss mitigation efforts. While in theory insurers could encourage
investment in loss reduction, some commentators have argued that in practice insurers had
historically not aggressively pursued loss control measures—particularly to prevent disaster
losses such as hurricanes—because of concerns over rate reductions and legal battles. However,
since about 1996 insurers have begun to take a more active role in loss mitigation, such as
through building codes.

Methods of insurance

According to the study books of The Chartered Insurance Institute, there are variant methods of
insurance as follows:

1. Co-insurance – risks shared between insurers

2. Dual insurance – having two or more policies with overlapping coverage of a risk (both the
individual policies would not pay separately – under a concept named contribution, they would
contribute together to make up the policyholder's losses. However, in case of contingency
insurances such as life insurance, dual payment is allowed)
3. Self-insurance – situations where risk is not transferred to insurance companies and solely
retained by the entities or individuals themselves
4. Reinsurance – situations when the insurer passes some part of or all risks to another Insurer,
called the reinsurer

Life Insurance;

 Life insurance (or life assurance, especially in the Commonwealth of Nations) is a

contract between an insurance policy holder and an insurer or assurer, where the insurer
promises to pay a designated beneficiary a sum of money (the benefit) in exchange for a
premium, upon the death of an insured person (often the policy holder).
 Depending on the contract, other events such as terminal illness or critical illness can also
trigger payment.
 The policy holder typically pays a premium, either regularly or as one lump sum. Other
expenses, such as funeral expenses, can also be included in the benefits.

Types of Life Insurance

 Protection policies – designed to provide a benefit, typically a lump sum payment, in the
event of a specified occurrence. A common form—more common in years past—of a
protection policy design is term insurance.
 Investment policies – the main objective of these policies is to facilitate the growth of
capital by regular or single premiums. Common forms (in the U.S.) are whole life,
universal life, and variable life policies.
Claim Settlement Process
 On the happening of the event, the beneficiary is required to send claim intimation form
to the insurance company as soon as possible. Claim intimation should contain details
such as Date, Place, and Cause of Death. On successful submission of claim intimation
form, an insurance company can ask for additional information about
1. Certificate of Death
2. Copy of Insurance Policy
3. Legal Evidence of title in case insured has not appointed a beneficiary
4. Deeds of assignment
On successful submission of all the document, the insurance company shall verify the claim
and settle the same.

Benefits of Life Insurance

 Risk Coverage: Insurance provides risk coverage to the insured family in form of
monetary compensation in lieu of premium paid.
 Difference plans for different uses: Insurance companies offer a different type of plan to
the insured depending on his need for insurance. More benefits come with the more
premium.
 Promotes Savings/ Helps in Wealth creation: Insurance policies also come with the
saving plan i.e. they invest your money in profitable ventures.
 Guaranteed Income:  Insurance policies come with the guaranteed sum assured amount
which is payable on happening of the event.
 Loan Facility: Insurance companies provide the option to the insured that they can
borrow a certain sum of amount. This option is available on selected policies only.  
 Tax Benefits: Insurance premium is tax deductible under section 80C of the income tax
Act, 1961.

Reinsurance

Reinsurance is insurance that is purchased by an insurance company, in which some part of its
own insurance liabilities is passed on ("ceded") to another insurance company. The company that
purchases the reinsurance policy is called a "ceding company" or "cedent" or "cedant" under
most arrangements. The company issuing the reinsurance policy is referred simply as the
"reinsurer". In the classic case, reinsurance allows insurance companies to remain solvent after
major claims events, such as major disasters like hurricanes and wildfires. In addition to its basic
role in risk management, reinsurance is sometimes used to reduce the ceding company's capital
requirements, or for tax mitigation or other purposes.

A company that purchases reinsurance pays a premium to the reinsurance company, who in
exchange would pay a share of the claims incurred by the purchasing company. The reinsurer
may be either a specialist reinsurance company, which only undertakes reinsurance business, or
another insurance company. Insurance companies that accept reinsurance refer to the business as
'assumed reinsurance'.
There are two basic methods of reinsurance:

1. Facultative Reinsurance, which is negotiated separately for each insurance policy that is
reinsured. Facultative reinsurance is normally purchased by ceding companies for
individual risks not covered, or insufficiently covered, by their reinsurance treaties, for
amounts in excess of the monetary limits of their reinsurance treaties and for unusual
risks. Underwriting expenses, and in particular personnel costs, are higher for such
business because each risk is individually underwritten and administered. However, as
they can separately evaluate each risk reinsured, the reinsurer's underwriter can price the
contract more accurately to reflect the risks involved. Ultimately, a facultative certificate
is issued by the reinsurance company to the ceding company reinsuring that one policy.
2. Treaty Reinsurance means that the ceding company and the reinsurer negotiate and
execute a reinsurance contract under which the reinsurer covers the specified share of
all the insurance policies issued by the ceding company which come within the scope of
that contract. The reinsurance contract may oblige the reinsurer to accept reinsurance of
all contracts within the scope (known as "obligatory" reinsurance), or it may allow the
insurer to choose which risks it wants to cede, with the reinsurer obliged to accept such
risks (known as "facultative-obligatory" or "fac oblig" reinsurance).

There are two main types of treaty reinsurance, proportional and non-proportional, which are
detailed below. Under proportional reinsurance, the reinsurer's share of the risk is defined for
each separate policy, while under non-proportional reinsurance the reinsurer's liability is based
on the aggregate claims incurred by the ceding office. In the past 30 years there has been a major
shift from proportional to non-proportional reinsurance in the property and casualty fields.

Functions

Almost all insurance companies have a reinsurance program. The ultimate goal of that program
is to reduce their exposure to loss by passing part of the risk of loss to a reinsurer or a group of
reinsurers.

a) Risk transfer

With reinsurance, the insurer can issue policies with higher limits than would otherwise be
allowed, thus being able to take on more risk because some of that risk is now transferred to the
re-insurer.

b) Income smoothing

Reinsurance can make an insurance company's results more predictable by absorbing large
losses. This is likely to reduce the amount of capital needed to provide coverage. The risks are
spread, with the reinsurer or reinsurers bearing some of the loss incurred by the insurance
company. The income smoothing arises because the losses of the cedant are limited. This fosters
stability in claim payouts and caps indemnification costs.
c) Surplus relief

Proportional Treaties (or “pro-rata” treaties) provide the cedent with “surplus relief”; surplus
relief being the capacity to write more business and/or at larger limits.

d) Arbitrage

The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a

lower rate than they charge the insured for the underlying risk, whatever the class of insurance.

In general, the reinsurer may be able to cover the risk at a lower premium than the insurer
because:

 The reinsurer may have some intrinsic cost advantage due to economies of scale or some
other efficiency.
 Reinsurers may operate under weaker regulation than their clients. This enables them to
use less capital to cover any risk, and to make less conservative assumptions when
valuing the risk.
 Reinsurers may operate under a more favourable tax regime than their clients.
 Reinsurers will often have better access to underwriting expertise and to claims
experience data, enabling them to assess the risk more accurately and reduce the need for
contingency margins in pricing the risk
 Even if the regulatory standards are the same, the reinsurer may be able to hold smaller
actuarial reserves than the cedant if it thinks the premiums charged by the cedant are
excessively conservative.
 The reinsurer may have a more diverse portfolio of assets and especially liabilities than
the cedant. This may create opportunities for hedging that the cedant could not exploit
alone. Depending on the regulations imposed on the reinsurer, this may mean they can
hold fewer assets to cover the risk.
 The reinsurer may have a greater risk appetite than the insurer.

e) Reinsurer's expertise

The insurance company may want to avail itself of the expertise of a reinsurer, or the reinsurer's
ability to set an appropriate premium, in regard to a specific (specialised) risk. The reinsurer will
also wish to apply this expertise to the underwriting in order to protect their own interests.

f) Creating a manageable and profitable portfolio of insured risks

By choosing a particular type of reinsurance method, the insurance company may be able to
create a more balanced and homogeneous portfolio of insured risks. This would make its results
more predictable on a net basis (i.e. allowing for the reinsurance). This is usually one of the
objectives of reinsurance arrangements.
Insurance Industry and its Regulation.

Insurance industry - Efficiency and the structure of the Insurance Industry;

The insurance industry of India consists of 57 insurance companies of which 24 are in life
insurance business and 33 are non-life insurers. Among the life insurers, Life Insurance
Corporation (LIC) is the sole public sector company. Apart from that, among the non-life
insurers there are six public sector insurers. In addition to these, there is sole national re-insurer,
namely, General Insurance Corporation of India (GIC Re). Other stakeholders in Indian
Insurance market include agents (individual and corporate), brokers, surveyors and third party
administrators servicing health insurance claims.

Market Size

Government's policy of insuring the uninsured has gradually pushed insurance penetration in the
country and proliferation of insurance schemes.

Gross premiums written in India reached Rs 5.53 trillion (US$ 94.48 billion) in FY18, with Rs
4.58 trillion (US$ 71.1 billion) from life insurance and Rs 1.51 trillion (US$ 23.38 billion) from
non-life insurance. Overall insurance penetration (premiums as % of GDP) in India reached 3.69
per cent in 2017 from 2.71 per cent in 2001.

In FY19 (up to October 2018), premium from new life insurance business increased 3.66 per
cent year-on-year to Rs 1.09 trillion (US$ 15.46 billion). In FY19 (up to October 2018), gross
direct premiums of non-life insurers reached Rs 962.05 billion (US$ 13.71 billion), showing a
year-on-year growth rate of 12.40 per cent.

Insurance Regulatory Framework:

1. Insurance Regulatory and Development Authority of India (IRDAI), is a statutory body

formed under an Act of Parliament, i.e., Insurance Regulatory and Development Authority Act,
1999 (IRDAI Act 1999) for overall supervision and development of the Insurance sector in India.

2. The powers and functions of the Authority are laid down in the IRDAI Act, 1999 and
Insurance Act, 1938. The key objectives of the IRDAI include promotion of competition so as to
enhance customer satisfaction through increased consumer choice and fair premiums, while
ensuring the financial security of the Insurance market.

3. The Insurance Act, 1938 is the principal Act governing the Insurance sector in India. It
provides the powers to IRDAI to frame regulations which lay down the regulatory framework for
supervision of the entities operating in the sector. Further, there are certain other Acts which
govern specific lines of Insurance business and functions such as Marine Insurance Act, 1963
and Public Liability Insurance Act, 1991.
4. IRDAI adopted a Mission for itself which is as follows:

 To protect the interest of and secure fair treatment to policyholders;

 To bring about speedy and orderly growth of the Insurance industry (including annuity
and superannuation payments), for the benefit of the common man, and to provide long
term funds for accelerating growth of the economy;
 To set, promote, monitor and enforce high standards of integrity, financial soundness, fair
dealing and competence of those it regulates;
 To ensure speedy settlement of genuine claims, to prevent Insurance frauds and other
malpractices and put in place effective grievance redressal machinery;
 To promote fairness, transparency and orderly conduct in financial markets dealing with
Insurance and build a reliable management information system to enforce high standards
of financial soundness amongst market players;
 To take action where such standards are inadequate or ineffectively enforced;
 To bring about optimum amount of self-regulation in day-to-day working of the industry
consistent with the requirements of prudential regulation.

5. Entities regulated by IRDAI:

a. Life Insurance Companies - Both public and private sector Companies

b. General Insurance Companies - Both public and private sector Companies. Among them, there
are some standalone Health Insurance Companies which offer health Insurance policies.

c. Re-Insurance Companies

d. Agency Channel

e. Intermediaries which include the following:

 Corporate Agents
 Brokers
 Third Party Administrators
 Surveyors and Loss Assessors.

6. Regulation making process:

 Section 26 (1) of IRDAI Act, 1999 and 114A of Insurance Act, 1938 vests power in the
Authority to frame regulations, by notification.
 Section 25 of IRDAI Act, 1999 lays down for establishment of Insurance Advisory
Committee consisting of not more than twenty five members excluding the ex-officio
members. The Chairperson and the members of the Authority shall be the ex-officio
members of the Insurance Advisory Committee.
 The objects of the Insurance Advisory Committee shall be to advise the Authority on
matters relating to making of regulations under Section 26.
  Accordingly the draft regulations are first placed in the meeting of Insurance Advisory
Committee and after obtaining the comments/recommendations of IAC, the draft
regulations are placed before the Authority for its approval.
 Every Regulation approved by the Authority is notified in the Gazette of India.
 Every Regulation so made is submitted to the Ministry for placing the same before the
Parliament.

7. The Authority has issued regulations and circulars on various aspects of operations of the
Insurance companies and other entities covering:

 Protection of policyholders’ interest

 Procedures for registration of insurers or licensing of intermediaries, agents, surveyors
and Third Party Administrators;
 Fit and proper assessment of the promoters and the management
 Clearance /filing of products before being introduced in the market
 Preparation of accounts and submission of accounts returns to the Authority.
 Actuarial valuation of the liabilities of life Insurance business and forms for filing of the
actuarial report;
 Provisioning for liabilities in case of non-life Insurance companies
 Manner of investment of funds and periodic reports on investments
 Maintenance of solvency
 Market conduct issues

Supervisory Role:

1. The objective of supervision as stated in the preamble to the IRDAI Act is “to protect the
interests of holders of Insurance policies, to regulate, promote and ensure orderly growth of the
Insurance industry”, both Insurance and Reinsurance business. The powers and functions of the
Authority are laid down in the IRDAI Act, 1999 and Insurance Act, 1938 to enable the Authority
to achieve its objectives.

2. Section 25 of IRDAI Act 1999 provides for establishment of Insurance Advisory Committee
which has Representatives from commerce, industry, transport, agriculture, consume for a,
surveyors agents, intermediaries, organizations engaged in safety and loss prevention, research
bodies and employees’ association in the Insurance sector are represented. All the rules,
regulations, guidelines that are applicable to the industry are hosted on the website of the
supervisor and are available in the public domain.

3. Section 14 of the IRDAI Act,1999 specifies the Duties, Powers and functions of the Authority.
These include the following:

 To grant licenses to (re) Insurance companies and Insurance intermediaries

 To protect interests of policyholders,
 To regulate investment of funds by Insurance companies, professional organisations
connected with the (re)Insurance business; maintenance of margin of solvency;
  To call for information from, undertaking inspection of, conducting enquiries and
investigations of the entities connected with the Insurance business;
 To specify requisite qualifications, code of conduct and practical training for
intermediary or Insurance intermediaries, agents and surveyors and loss assessors
 To prescribe form and manner in which books of account shall be maintained and
statement of accounts shall be rendered by insurers and other Insurance intermediaries;

Prudential approach: Reporting, Risk monitoring and intervention:

1. Reporting Requirements:

Insurers are required to submit various returns like financial statements on an annual basis duly
accompanied by the Auditors’ opinion statement on the annual accounts; reports of valuation of
assets, valuation of liabilities and solvency margin; actuarial report and abstract and annual
valuation returns giving information about the financial condition for life Insurance business;
Incurred But Not Reported claims in case of general Insurance business; Reinsurance plans on an
annual basis; and monthly statement on underwriting of large risks in case of general Insurance
companies; details of capital market exposure on a monthly basis; Investment policy, Quarterly
and annual returns on investments.

2. Solvency of Insurers:

In order to monitor and control solvency requirements, it has been made mandatory to the
insurers to submit solvency report on quarterly basis. In case of any deviation, the Supervisor
initiates necessary and suitable steps so as to ensure that the Insurer takes immediate corrective
action to restore the solvency position at the minimum statutory level.

Computation of solvency margin takes into account the inherent risk that respective line of
business poses to the insurer. Higher requirements are placed for risky lines of business
compared to others posing less risk to the insurers. Even though the insurers are required to
maintain a minimum solvency ratio of 150% at all times, the actual solvency margin maintained
by insurers are well above the required solvency margin leading to the solvency margin ratio
significantly higher than 150% on average.

Quarterly solvency ratio reports have to be submitted to the Supervisor, maintaining minimum
solvency ratio of 150%. This provides the regular a mechanism to monitor the solvency position
periodically over the financial year in order to ensure compliance with the requirements and
hence to initiate suitable action in the event of any early warning signal on the Insurer’s financial
condition.

3. Asset-Liability Management:

Under Asset-Liability Management reporting, Insurer must provide the year wise projected cash
flows, in respect of both assets and liabilities. Insurers must maintain mismatching reserves in
case of any mismatch between assets and liabilities as a part of the global reserves. Further, Life
insurers are required to submit a report on sensitivity and scenario testing exercise in the
prescribed format. Non-life insurers must submit a report on ‘Financial Condition’ covering the
sensitivity analysis of the financial soundness in meeting the policyholders’ liabilities.

The supervisor requires management of investments to be within the insurer’s own organization.
In order to ensure a minimum level of security of investments in line with Insurance Act
Provisions, the regulations prescribe certain percentages of the funds to be invested in
government securities and in approved securities. The regulatory framework lays down the
norms for the mix and diversification of investments in terms of Types of Investment, Limits on
exposure to Group Company, Insurer’s Promoter Group Company. Investment Regulations lay
down the framework for the management of investments. The exposure limits are also prescribed
in the Regulations. The Investment Regulations require a proper methodology to be adopted by
the insurer for matching of assets and liabilities.

4. Reinsurance:

Transfer of risk through Reinsurance is recognized only to the extent specified in the regulations.
Due safeguards are built in to ensure that adjustments are made to provide for quality of assets
held. No other risk transfer mechanism exists in the current system. In order to minimize the
counterparty risk, the re-insurers with whom business is placed must have the minimum
prescribed rating by an independent credit rating agency as specified in the regulations.
Legislation has specified the minimum capital requirements for an Insurance company. It further,
prescribes that Insurance companies can capitalize their operations only through ordinary shares
which have a single face value.

Reinsurer

General Insurance Corporation of India (GIC of India) is the sole National Reinsurer, providing
Reinsurance to the Insurance companies in India. The Corporation’s Reinsurance programme has
been designed to meet the objectives of optimising the retention within the country, ensuring
adequate coverage for exposure and developing adequate capacities within the domestic market.
It is also administering the Indian Motor Third Party Declined Risk Insurance Pool – a
multilateral Reinsurance arrangement in respect of specified commercial vehicles where the
policy issuing member insurers cede Insurance premium to the Declined Risk pool based on the
underwriting policy approved by IRDAI.

5. Corporate Governance:

In order to protect long- terms interests of policyholders, the IRDAI has outlined appropriate
governance practices applicable to Insurance companies for maintenance of solvency, sound
long-term investment policy and assumption of underwriting risks on a prudential basis from
time to time. The IRDAI has issued comprehensive guidelines for adoption by Insurance
companies on the governance responsibilities of the Board in the management of the Insurance
functions. These guidelines are in addition to provisions of the Companies Act, 1956, Insurance
Act, 1938 and other applicable laws.
Corporate Governance Guidelines issued by IRDAI, requires insurers to have in place requisite
control functions. The oversight of the control functions is vested with the Boards of the
respective insurer. It lays down the structure, responsibilities and functions of Board of Directors
and the senior management of the companies. Insurers are required to adopt sound prudent
principles and practices for the governance of the company and should have the ability to quickly
address issues of non-compliance or weak oversight and controls.

The Guidelines mandated the insurers to constitute various committees viz., Audit Committee,
Investment Committee, Risk Management Committee, Policyholder Protection Committee and
Asset-Liability Management Committee. These committees play a critical role in strengthening
the control environment in the company.

6. On and off site Supervision:

Onsite Inspections:

The Authority has the power to call for any information from entities related to insurance
business – Insurance companies and the intermediaries, as may be required from time to time.

On site inspection is normally carried out on an annual basis which includes inspection of
corporate offices and branch offices of the companies. These inspections are conducted with
view to check compliance with the provisions of Insurance Act, Rules and regulations framed
thereunder.

The inspection may be comprehensive to cover all areas, or may be targeted on one, or a
combination of, key areas. When a market-wide event having an impact on the insurers occurs,
the Supervisor obtains relevant information from the insurers, monitors developments and issues
directions as it may consider necessary. Though there is no specific requirement, events of
importance trigger such action. The supervisor reviews the “internal controls and checks” at the
offices of Insurance companies, as part of on-site inspection.

Off-site Inspection:

The primary objective of off-site surveillance is to monitor the financial health of Insurance
companies, identifying companies which show financial deterioration and would be a source for
supervisory concerns. This acts as a trigger for timely remedial action.

The off-site inspection conducted by analyzing periodic statements, returns, reports, policies and
compliance certificates mandated under the directions issued by the Authority from time to time.
The periodicity of these filings is generally annual, half-yearly, quarterly and monthly and are
related to business performance, investment of funds, remuneration details, expenses of
management, business statistics, auditor certificates related to various compliance requirements.

The statutory and the internal auditors are required to audit all the areas of functioning of the
Insurance companies. The particular area of focus is the preparation of accounts of the company
to reflect the true and fair position of the company as at the Balance Sheet date. The auditors also
examine compliance or otherwise with all statutory and regulatory requirements, and in
particular whether the Insurance company has been compliant with the various directions issued
by the supervisor. In addition, the Authority relies upon the certifications which form part of the
Management Report. The Board is required to certify that the management has put in place an
internal audit system commensurate with the size and nature of its business and that it is
operating effectively.

All Insurance companies are required to publish financial results and other information in the
prescribed formats in newspapers and on their websites at periodic intervals.

7. Micro Insurance and Rural & Social Sector Obligations

The IRDAI had issued micro Insurance regulations for the protection of low income people with
affordable Insurance products to help cope with and recover from common risks with
standardised popular Insurance products adhering to certain levels of cover, premium and benefit
standards. These regulations have allowed Non Governmental Organisations (NGOs), Self Help
Groups (SHGs) and other permitted entities to act as agents to Insurance companies in marketing
the micro Insurance products and have also allowed both life and non-life insurers to promote
combi-micro Insurance products.

The Regulations framed by the Authority on the obligations of the insurers towards rural and
social sector stipulate targets to be fulfilled by insurers on an annual basis. In terms of these
regulations, insurers are required to cover year wise prescribed targets (i) in terms of number of
lives under social obligations; and (ii) in terms of percentage of policies to be underwritten and
percentage of total gross premium income written direct by the life and non-life insurers
respectively under rural obligations.

Pension Funds

Fund from which pensions are paid, accumulated from contributions from employers,
employees, or both. A pension fund, also known as a superannuation fund in some countries,
is any plan, fund, or scheme which provides retirement income.

Pension funds typically have large amounts of money to invest and are the major investors in
listed and private companies. They are especially important to the stock market where large
institutional investors dominate. The largest 300 pension funds collectively hold about $6 trillion
in assets.

Classifications

a) Open vs. closed pension funds

Open pension funds support at least one pension plan with no restriction on membership while
closed pension funds support only pension plans that are limited to certain employees.
Closed pension funds are further subclassified into:

 Single employer pension funds

 Multi-employer pension funds
 Related member pension funds
 Individual pension funds

b) Public vs. private pension funds

A public pension fund is one that is regulated under public sector law while a private pension
fund is regulated under private sector law.

In certain countries the distinction between public or government pension funds and private
pension funds may be difficult to assess. In others, the distinction is made sharply in law, with
very specific requirements for administration and investment. For example, local governmental
bodies in the United States are subject to laws passed by the states in which those localities exist,
and these laws include provisions such as defining classes of permitted investments and a
minimum municipal obligation.

Pension Plans

Pension Plans are also known as retirement plans. In this, you may invest some portion of your
income into the designated plan. The main objective behind this is to get regular income post
retirement. Considering the ever-growing inflation, these plans have become indispensable. Even
if you have substantial savings in your bank account, still you may need one. It is because
savings usually get spent in meeting contingent needs. So, a best pension plan will support you
when all other income streams cease to exits.

In India, pension plans have two stages – the accumulation stage and the vesting stage. In the
former, the investors pay annual premiums until the time they reach the age of retirement. On
reaching the retirement age; the second stage, the vesting stage begins. During this stage of the
pension plan, the retiree will start receiving annuities until the time of their death or the death of
their nominee.

What are the tax implications of pension plans?

The contributions that are made to a pension plan, under section 80CCC, are tax-exempt up to a
maximum ceiling of INR 1.5 lakh. The contributions include amount spent on buying a new
pension plan or renewing an existing plan of similar nature. Both residents and non-residents
may claim tax deductions which are offered by this section. However, Hindu Undivided Family
is not eligible to make such claims under the given section.

The withdrawals, however, are not tax-free. Only one-third of the corpus that is distributed to the
retiree (soon after reaching the retirement age) by the pension plan is tax-free. The rest of the
money is distributed as an annuity and is subject to taxation depending on the retiree’s tax rate at
the time of retirement.
What are the different types of pension plans available in India?

There are different kinds of pension plans which you can check below:

 plans that are sponsored by an insurer where the investment is solely in debt and are best
suited for investors who are conservative
 plans that are unit linked and invest in both equity and debt
 the National Pension Scheme which invests either 100 percent in government securities,
100 percent in debt securities (other than government securities) or a maximum of 75
percent in equity

What are the advantages of pension plans?

Some of the advantages of investing in Pension Plans are listed below:

a. Option in Investment

Pension funds give investors the option to invest in either the safe government securities or take
some risk and invest in debt and equity investments depending on their risk profile. The risk is
balanced by the prospect of higher returns that are generated by the investment.

b. Long-term savings

These plans serve as a long-term savings scheme regardless of whether you opt for a lump sum
payments or multiple payments of small amounts, the savings is assured. Pension plans create an
annuity which can be invested further and give rise to a steady flow of cash post your retirement.

c. Choose how you want to get paid

Depending on what your age or what your plans are, you can either invest a lump sum amount
and get annuity payments right away or you may choose a deferred annuity plan which will let
your corpus earn more interest until the payouts begin.

d. Works as a life insurance cover

There are pension plans that give the investor the lump sum amount when they retire or in the
case of the death of the individual, whichever scenario occurs earlier. This means that your
pension policy also serves as a life insurance cover.

e. Negates the effect of Inflation

It is a good way of negating the effects of inflation, by investing in pension plans. These plans
pay a lump sum amount during your retirement which amounts to a maximum of ⅓ of the corpus
that is accumulated and the remaining ⅔ of the corpus is used in generating a steady cash flow.
f. Access a lump sum amount during an emergency

You may make adjustments to your pension policy to access the lump sum payout in case of an
emergency. This can be done to cover one’s long-term health care as well.

What are the disadvantages of pension plans?

a. Limited amount of deduction allowed

Though pension plans qualify you to a tax deduction, the maximum allowed deduction on life
insurance premiums is INR 1.5 lakh under the Income Tax Act.

b. Taxation on the annuity

When you receive the annuity after your retirement, it is taxable as on that date.

c. High returns require high-risk taking

To make sure that the payout at the time of your retirement is adequate, you may have to seek
high-risk options in order to obtain higher returns. The traditional non-risky investment options
may not be enough to override the effects of inflation.

d. Best suited for early investors

If you are not an early investor, this investment option may be a little late for you. As the returns
earned by someone who invests at age 21 as opposed to someone aged 30 or 35 years, will get a
substantially larger return.
MODULE 5
Leasing

 Leasing refers to a contractual agreement in which the owner of the asset, permits another
person or party, to use this asset for a specific period in return of consideration.
 The owner of the asset is called the lessor and one who pays periodic rentals for using the
asset is called the lessee.
 The parties in the lease agreement can be individuals, partnership firms, financial
institutions and corporate bodies, which lease equipments, assets etc.
 The lessor shall be eligible for depreciation on the asset. the entire lease rentals will be
taxed as income of the lessor. The lessee, correspondingly, will not claim any
depreciation and will be entitled to expense off the rentals

Features of leasing

 The lessee select an asset.

 The lessor or the finance company purchases that asset.
 The lessee use the asset during the lease.
 The lessor recovers all of the cost of the asset with interest through installments paid by
the lessee.
 The lessee has the option to acquire ownership of the asset.
 One of the prerequisites of leasing is the existence of an asset at the start and during the
tenure of the lease.
 Lease is not a sale of asset; therefore the asset should be delivered back to the lessor at
the expiry of the lease.
 The economic life of the asset should be equal to or more than the period of the lease.
 The asset should be movable and hence can be relocated.
 The finance company is the legal owner of the asset during the period of lease.
 The lessee has control over the asset.

Leasing process

 Selection of lease

 Appraisal by lessor

 Approval by lessor

 Acceptance of the offer

 Agreement between the lessor and the lessee

Advantages of Leasing:
 1. Balanced Cash Outflow: The biggest advantage of leasing is that cash outflow or
payments related to leasing are spread out over several years, hence saving the burden of
one-time significant cash payment. This helps a business to maintain a steady cash-flow
profile.
2. Quality Assets: While leasing an asset, the ownership of the asset still lies with the lessor
whereas the lessee just pays the rental expense. Given this agreement, it becomes
plausible for a business to invest in good quality assets which might look unaffordable or
expensive otherwise.
3. Better Usage of Capital: Given that a company chooses to lease over investing in an asset
by purchasing, it releases capital for the business to fund its other capital needs or to save
money for a better capital investment decision.
4. Tax Benefit: Leasing expense or lease payments are considered as operating expenses,
and hence, of interest, are tax deductible.
5. Off-Balance Sheet Debt: Although lease expenses get the same treatment as that of
interest expense, the lease itself is treated differently from debt. Leasing is classified as
an off-balance sheet debt and doesn’t appear on company’s balance sheet.

6. Better Planning: Lease expenses usually remain constant for over the asset’s life or lease
tenor, or grow in line with inflation. This helps in planning expense or cash outflow when
undertaking a budgeting exercise.
7. Low Capital Expenditure: Leasing is an ideal option for a newly set-up business given
that it means lower initial cost and lower CapEx requirements.
8. No Risk of Obsolescence: For businesses operating in the sector, where there is a high
risk of technology becoming obsolete, leasing yields great returns and saves the business
from the risk of investing in a technology that might soon become out-dated. For
example, it is ideal for the technology business.
9. Termination Rights: At the end of the leasing period, the lessee holds the right to buy the
property and terminate the leasing contract, this providing flexibility to business.

Disadvantages of Leasing:

1. Lease Expenses: Lease payments are treated as expenses rather than as equity payments
towards an asset.
2. Limited Financial Benefits: If paying lease payments towards a land, the business cannot
benefit from any appreciation in the value of the land. The long-term lease agreement
also remains a burden on the business as the agreement is locked and the expenses for
several years are fixed. In a case when the use of asset does not serve the requirement
after some years, lease payments become a burden.
3. Reduced Return for Equity Holders: Given that lease expenses reduce the net income
without any appreciation in value, it means limited returns or reduced returns for an
equity shareholder. In such case, the objective of wealth maximization for shareholders is
not achieved.
4. Debt: Although lease doesn’t appear on the balance sheet of a company, investors still
consider long-term lease as debt and adjust their valuation of a business to include leases.
5. Limited Access of Other Loans: Given that investors treat long-term leases as debt, it
might become difficult for a business to tap capital markets and raise further loans or
other forms of debt from the market.
6. Processing and Documentation: Overall, to enter into a lease agreement is a complex
process and requires thorough documentation and proper examination of an asset being
leased.
7. No Ownership: At the end of leasing period the lessee doesn’t end up becoming the
owner of the asset though quite a good sum of payment is being done over the years
towards the asset.
8. Maintenance of the Asset: The lessee remains responsible for the maintenance and proper
operation of the asset being leased.
9. Limited Tax Benefit: For a new start-up, the tax expense is likely to be minimal. In these
circumstances, there is no added tax advantage that can be derived from leasing expenses.

Types of Lease:

On the basis of above dimensions, leases are classified into following:

Finance Lease and Operating Lease: Finance lease, also known as Full Payout Lease,
is a type of lease wherein the lessor transfers substantially all the risks and rewards
related to the asset to the lessee. Generally, the ownership is transferred to the lessee at
the end of the economic life of the asset. Lease term is spread over the major part of the
asset life. Here, a lessor is only a financier. An example of a finance lease is big industrial
equipment.

On the contrary, in operating lease, risk and rewards are not transferred completely to the
lessee. The term of a lease is very small compared to the finance lease. The lessor
depends on many different lessees for recovering his cost. Ownership along with its risks
and rewards lies with the lessor. Here, a lessor is not only acting as a financier but he also
provides additional services required in the course of using the asset or equipment. An
example of an operating lease is music system leased on rent with the respective
technicians.

Sale And Lease Back and Direct Lease: In the arrangement of sale and lease back, the
lessee sells his asset or equipment to the lessor (financier) with an advanced agreement of
leasing back to the lessee for a fixed lease rental per period. It is exercised by the
entrepreneur when he wants to free his money, invested in the equipment or asset, to
utilize it at the whatsoever place for any reason.

On the other hand, a direct lease is a simple lease where the asset is either owned
by the lessor or he acquires it. In the former case, the lessor and equipment supplier are
one and the same person and this case is called ‘bipartite lease’. In a bipartite lease, there
 are two parties. Whereas, in the latter case, there is three different parties viz. equipment
supplier, lessor, and lessee and it is called tripartite lease. Here, equipment supplier and
lessor are two different parties.

Single Investor Lease and Leveraged Lease: In single investor lease, there are two
parties – lessor and lessee. The lessor arranges the money to finance the asset or
equipment by way of equity or debt. The lender is entitled to recover money from the
lessor only and not from the lessee in case of default by a lessor. Lessee is entitled to pay
the lease rentals only to the lessor.

Leveraged lease, on the other hand, has three parties – lessor, lessee and the financier or
lender. Equity is arranged by the lessor and debt is financed by the lender or financier.
Here, there is a direct connection of the lender with the lessee and in a case of default by
the lessor; the lender is also entitled to receive money from the lessee. Such transactions
are generally routed through a trustee.
Domestic and International Lease: When all the parties to the lease agreement reside in
the same country, it is called domestic lease.
The International lease is of two types – Import Lease and Cross Border Lease. When
lessor and lessee reside in the same country and equipment supplier stays in the different
country, the lease arrangement is called import lease. When the lessor and lessee are
residing in two different countries and no matter where the equipment supplier stays, the
lease is called cross-border lease.
 Sales Aid Lease: Under this arrangement the lessor agrees with the manufacturer to
market his product through his leasing operations, in return for which the manufacturer
agrees to pay him a commission.
 Specialized Service Lease: In this type of agreement, the lessor provides specialized
personal services in addition to providing its use.
 Small Ticket and Big Ticket Leases: The lease of assets in smaller value is generally
called as small ticket leases and larger value assets are called big ticket leases.

Hire Purchase
What is a 'Hire Purchase'

A hire purchase is a method of buying goods through making installment payments over time.
The term "hire purchase" originated in the United Kingdom and is similar to rent-to-own
arrangements in the United States. Under a hire purchase contract, the buyer is leasing the goods
and does not obtain ownership until the full amount of the contract is paid.
BREAKING DOWN 'Hire Purchase'
To begin a hire purchase, a payment is often required up front. The rest of the amount due is
submitted through scheduled payments, similar to an installment loan or a vehicle lease. The
ownership of the good purchased through a hire purchase is not officially transferred to the buyer
until all required payments have been submitted. Companies offering hire purchase options earn
a profit by applying additional costs to the monthly payment which serves as interest charges for
the purchase.

Benefits of Using a Hire Purchase

Businesses commonly employ this manner of leasing goods to enhance the appearance of
earnings metrics. For instance, by leasing assets, it may be possible to keep the debt used to pay
for the assets and the asset itself off the balance sheet, resulting in higher operational and return-
on-asset (ROA) figures.

In circumstances where a buyer either cannot continue to make the required payments or is no
longer interested in purchasing the item, it can be returned to the company at which the hire
purchase arrangement was made. This may render the original agreement void, as the associated
asset has been returned to the store that currently maintains ownership rights on the asset in
question.

Risks of Using a Hire Purchase

In the United States, consumer rent-to-own arrangements are controversial because they can be
used in an attempt to circumvent proper accounting standards. This can include the lack of credit
checks as well as payment amounts that result in higher-than-average amounts of interest
effectively being paid.

There have been allegations that U.S. rent-to-own businesses bypass certain consumer protection
laws by referring to the purchase contracts as rental agreements instead as an extension of credit.
Rental agreements are exempt from the Truth in Lending Act that requires the clear disclosure of
interest rates on consumer loan products. This allows rent-to-own businesses to refrain from
explicitly stating the associated interest rate paid based on the product's price compared to the
monthly payment amounts.

Additionally, if a buyer using a hire purchase fails to make the required payments, the company
sponsoring the purchase can repossess the item. Whether a repossession is voluntary or
involuntary, the buyer is generally not eligible to receive any funds back that have already been
placed toward the purchase.

Tax consideration of Hire Purchase

 Income tax aspect: The hirer is entitled to the tax shield on depreciation, which is
calculated with reference to the cash purchase price and tax shield on the consideration
for hire.

• Sales tax aspect: Hire purchase transactions are liable to sales tax.

o With the aim of levying sales tax, a sale is deemed to take place if only the hirer exercises
an option to purchase.

o When the hirer exercises the option to purchase, the sale tax amount must be fixed with
reference to the depreciated value of goods

o The state in which the goods have been delivered is entitled to levy and collect sales tax

o There is no uniform rate of sale tax applicable to hire purchase transaction because the
rate varies from one state to another

 Interest tax aspect: An interest tax has to be paid on the interest earned less bad debts by
hire purchase company.
Factoring

 Factoring is a financial transaction and a type of debtor finance in which a business sells
its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.

 Factoring, as a fund based financial service, provides resources to finance receivables as

well as facilitates the collection of receivables.

 A business will sometimes factor its receivable assets to meet its present and immediate
cash needs

 As per international institute for the Unification of private law, Rome – Factoring means
an arrangement between a factor and his client which includes at least two of the
following services to be provided by the factor: (i) Finance, (ii) Maintenance of accounts,
(iii) Collection of debts and (iv) Protection against credit risk.

 However the above definition applies only to factoring in relation to supply of goods and
services: (i) across national boundaries, (ii) to trade or professional debtors, (iii) when
notice of assignment has been given to the debtors.

 The factor:

a) The factor enters into agreement with seller for rendering factor services to it.

b) On receipt of copies of sale documents as referred to above makes payment to the seller
of the 80% of the price of the debt.

c) The factor receives payment from the buyer on due dates and remits the money to seller
after usual deductions.

d) The factor also ensures that the following conditions should be met to give full effect to
the factoring arrangements

I. The invoice, bills or other documents drawn by the seller should contain a clause that
these payments arising out of the transaction as referred to might be factored.

II. The seller should confirm in writing to the factor that all the payments arising out of these
bills are free from any encumbrances, charge, lien, pledge etc

III. The seller should execute a deed of assignment in favor of the factor to enable him to
recover the payment at the time or after default.

IV. The seller should confirm that all conditions to sell-buy contract between him and the
buyer have been compiled with and the transactions completed
 V. The seller should procure a letter of wavier from bank in favour of factor in case the bank
has a charge over the assets sold out to buyer

Functions of factor

 Maintenance / Administration of sales ledger – maintain clients sales ledger-factor gives

periodic report to client on current status of his receivables.

 Provision of Collection facility-factor undertake to collect the receivables on behalf of

client

 Financing trade debts-factor purchases the book debt of his client at a price – 80-85% of
debt

 Credit control and credit protection-debts are factored with out recourse-set credit limit in
consultation with client for approved customer-factor assumes the risk of default.

 Advisory services – factor provides advices such as customer perception of client’s

product, audit of the procedures followed for invoicing, delivery and dealing with sales
return.

Types of factoring

 Recourse factoring: The factor has recourse to the client if the debt
purchased/receivables factored turns out to be irrecoverable.

 Non recourse factoring: The factor does not have the right of recourse. The additional
fee charged by him as a premium for risk bearing is referred as del credere

 Advance factoring: The factor pays a pre-specified portion, ranging 75% to 90%,of the
factored receivables in advance, the balance being paid upon collection on the guaranteed
payment date. The client has to pay interest(discount) on the advance/repayment between
the payment date and date of actual collection.

 Maturity factoring: Also known as collection factoring. Here the factor makes payment
only either on the guaranteed payment date or on the date of collection.

 Full factoring: Comprehensive form of factoring combining the features of almost all the
factoring service specially those of non recourse and advance factoring. It is also known
as old line factoring.

 Disclosed factoring: The name of the factor is disclosed in the invoice by the supplier of
goods asking buyer to make payment to factor. The supplier may continue to bear risk of
non payment by buyer.
  Undisclosed factoring: The name of factor is not disclosed in the invoice although the
factor maintains the sales ledger of the supplier. The entire realization of the business
transaction is done in the name of supplier.

 Domestic factoring: Here the three parties namely buyer, client or supplier and factor
are domiciled in the same country.

 Export/International/Cross border factoring: Here four parties involved –

exporter/client, importer/buyer, export factor and import factor. It is also called two
factor system factoring as it results in two separate agreement: (i) between exporter and
export factor and (ii) between the export factor and import factor.

Benefits of factoring

 Time Savings. Factoring can save you time and effort that would otherwise be spent on
collecting from customers. That energy can be redirected to other business-building
endeavors, like sales, marketing and client development.

 Good Use for Growth. You can use the instant cash to generate growth, maybe hiring
another salesperson who will bring in more business.

 Doesn’t Require Collateral. Unlike traditional bank loans, factoring doesn’t require you
to risk your home or other property as collateral.

 Quicker set up and funding:  Most accounts receivable factoring lines can be approved,
set up, and actively funded in just a few weeks compare to Banks.

 Less Costly than equity: In need of financing many businesses turn to equity investors but
equity financing is costly compare to factoring

Forfaiting
 Form of financing of receivables pertaining to international trade

 Denotes the purchase of trade bills in discount by financial institution without recourse to
seller.

 All risk and collection problems are fully the responsibility of the purchaser or forfaiter

Features of forfaiting

 The exporter sells and delivers the goods to the importer on a deferred payment basis.

 Importer draws series of promissory notes in favour of exporter.

  The promissory notes/bills are guaranteed by a bank referred to as Aval.

 Exporter enters into a forfaiting arrangement with a forfaiter.

 Payment by forfaiter to exporter is face value of bill less discount

 Forfaiter may hold these notes/bills till maturity for payment by the importers bank.

Forfaiting vs Factoring

a) A forfaiter discounts the entire value of the bill whereas factoring arrangement is only
partial ranging between 75-85%.

b) The forfaiters decision to provide financing depends upon the financial standing of
avaling bank whereas factor consider the credit standard of the exporter.

c) Forfaiting is a pure financing arrangement while factoring also includes ledger

administration, collection and so on.

d) Factoring is essentially a short term financing deal whereas forfaiting finances bills
arising out of deferred credit transaction spread over 3 to 5 years.

e) A factor does not guard against exchange rate fluctuations whereas a forfaiter charges a
premium for such risk.

Factoring vs Bills Discounting

 Bill discounting is always with recourse whereas factoring can be either with recourse or
without recourse

 In bill discounting the drawer undertakes the responsibility of collecting the bills and
remitting the proceeds to the financing agency whereas in factoring factor does the same.

 Bill discounting facility implies only provision of finance but a factor also provides other
services like sales ledger maintenance and advisory services.

 Discounted bills may be rediscounted several times before its maturity which is not
possible in factoring

 Factoring implies provision of bulk finance against several unpaid invoices in batches
whereas bill financing allow each bill to be separately discounted.

 Factoring is off balance sheet mode of financing whereas bill discounting not.

 Bill discounting involves more paper work compare to factoring.

 Bill discounting does not involve assignment of debts as is the case with factoring
Depositories - Background
 The earlier settlement system on Indian stock exchanges was very inefficient as it was
unable to take care of the transfer of securities in speedy manner

 Securities were in the form of physical certificate

 This led to settlement delays, theft, forgery, mutilation, bad delivery and cost

 To wipe out these problem depositories act 1996 was passed

 An organization, bank or an institution that holds and assists in the trading of securities.

 A depository institution provides financial services to personal and business customers.

Deposits in the institution include securities such as stocks or bonds.

 The institution holds the securities in electronic form also known as book-entry form, or
in dematerialized or paper format such as a physical certificate.

At present there two depositories in india:

a) National securities depository ltd (NSDL)

b) Central depositary services(india) ltd (CDSL)

Depository system

 Is a system of dematerialisation of share certificates through scripless trading in which

transaction in securities take place by book entry/paperless share method.

 In India operates within the framework of Depositories Act 1996 and SEBI Depositories
and Participants Regulation 1996

Player in depository system

 Depository participant

 Beneficial owner/investor

 Issuer and Registrars

 Depository

 Clearing house/corporation
  Banking system

 Stock brokers

Functions of Depository Participant(DPs)

 Depository participant provides the service of opening a demat account to the investor;

 Different schemes like three-in-one demat account, free demat account etc to lure the
investors to open an account with them.

 However, they are making an investment in to securities more reachable by providing

services like transaction SMS on registered mobile number, contract note for every
transaction at your door, E-trading platform, investment advice etc.

 Investor should take accessibility, charges and service factors of Depository

participant(DPs) into consideration before opening an account with them.

Structure of Depository System

1. Central Depository

2. Share Registrar Transfer Agent - Share Registrar is an authority who controls the issue of
securities. Along with this, the transfer agent arranges for the transfer of securities in the
case of buying or selling of securities.

3. Clearing and Settlement Corporation - This agency settles the transfer of funds between
the seller and buyer.

4. Depository Participant

Procedure/Mechanism in the Depository system

 Notification by Stock Exchange

 Dematerialization Form

 Registering of shares

 Crediting the investor account

 Trading of Shares in a Depository system

 Purchase of shares from the existing shares in the market

 Sale of shares
  Clearing house – it act as central mechanism for consolidating and settling transaction

Benefits of Depository system

 Depository system takes hold of all securities in the country listed in that particular stock
exchange.

 Introduction of electronic system enables speedy transactions and accuracy.

 In a depository system, the security holders can sell and buy securities by which liquidity
is brought to the securities.

 Blank transfers are avoided and holding of shares in Benami names is also prevented.

 Registration and stamp charges for the sale of securities could be easily collected by the
government which was evaded under the previous system.

 Depository promotes more activity in the capital market as trading in genuine share. is
ensured under Depository system.

 Depository avoids use of stationery and prevents delay in registration of transfers.

 Dividend and interest on securities are properly distributed through this system and in the
case of convertible debentures, on the due date, the securities are converted into company
shares.

 Depository acts as collateral security for the raising of 1oans from any financial
institution

 Reduction of paper work

 No bad delivery

 Faster settlement cycle

 Increase liquidity of securities

Credit card

 A credit card is a payment card issued to users (cardholders) as a method of payment.

 It allows the cardholder to pay for goods and services based on the holder's promise to
pay for them.
  The issuer of the card (usually a bank) creates a revolving account and grants a line of
credit to the cardholder, from which the cardholder can borrow money for payment to a
merchant or as a cash advance.

Usage of credit card

 A credit card issuing company, such as a bank or credit union, enters into agreements
with merchants for them to accept their credit cards.

 The credit card issuer issues a credit card to a customer at the time or after an account has
been approved by the credit provider.

 The cardholders can then use it to make purchases at merchants accepting that card.
When a purchase is made, the cardholder agrees to pay the card issuer.

 The cardholder indicates consent to pay by signing a receipt with a record of the card
details and indicating the amount to be paid or by entering a personal identification
number (PIN).

 Electronic verification systems allow merchants to verify that the card is valid and has
sufficient credit, through credit card payment terminal or point-of-sale (POS) system.

 For card not present transactions (e.g., e-commerce) merchants additionally verify
additional information such as the security code printed on the back of the card, date of
expiry, and billing address.

 minimum due amount- charges interest on the unpaid balance.

 Online payment allowed

 Grace period – 20 to 55 days.

 E-statement sent customer

Feature of credit card one by one.

1. Alternative to cash

Credit card is a better alternative to cash. It removes the worry of carrying various currency
denominations to pay at the trade counters. It is quite easy and way fast to use a credit card rather
than waiting for completion of cash transactions.

As an alternative, credit card helps a cardholder to travel anywhere in the world without a need
to carry an ample amount of cash. It also reduces the possible risk of money theft and gives its
user a complete peace of mind.
2. Credit limit

The credit cardholder enjoys the facility of a credit limit set on his card. This limit of credit is
determined by the credit card issuing entity (bank or NBFC) only after analyzing the credit
worthiness of the cardholder.

The credit limit is of two types, viz.,

1. Normal credit limit, and

2. Revolving credit limit.

Normal credit limit is usual credit given by the bank or NBFC at the time of issuing a credit
card.

Revolving credit limit varies with the financial exposure of the credit cardholder.

3. Aids payment in domestic and foreign currency

Credit card aids its cardholder to make payments in any currency of choice. In other words, it
gives its holder a unique facility to make payments either in domestic (native) currency or if
necessary, also in foreign (non-native) currency, that too as and when required.

Credit card reduces the cumbersome process of currency conversion. That is, it removes the
financial complexities often encountered in converting a domestic currency into a foreign
currency. It is because of this feature, a credit cardholder can possibly make payments to
merchants present in any corner of the world.

4. Record keeping of all transactions

Credit card issuing entities like banks or NBFCs keeps a complete record of all transactions
made by their credit cardholders. Such a record helps these entities to raise appropriate billing
amounts payable by their cardholders, either on a monthly or some periodic basis.

5. Regular charges
Regular charges are basic routine charges charged by the credit card issuing entity on the usage
of credit card by its cardholder. These charges are nominal in nature.

The regular charges are primarily classified into two types, viz.,

1. Annual charges, and

2. Additional charges.

Annual charges are collected on per annum or yearly basis.

Additional charges are collected for other supplementary services provided by the credit card
issuing entity. Such services include, add-on-card (an additional credit card), issue of a new
credit card, etc.

6. Grace period

The grace period is referred to those minimum numbers of additional days within which a credit
cardholder has to pay his credit card bill without any incurring interest or financial charges.

7. Higher fees on cash withdrawals

Credit-card issuer makes charges on cash withdrawals made through credit card at the ATM
outlets and other desks. Generally, cash withdrawal fees are quite higher than fees charged by the
bank or NBFC for the other regular credit transactions. On cash withdrawn done through a credit
card, interest is charged from the same day. That is, interest is charged since the day on which
cash is withdrawn. Usually, no grace period is provided for cash transactions.

8. Additional charges for delay in payment

The credit card payment is supposed to be made within a due date as mentioned on the bill of a
credit card. If payment is not paid on time, then a credit-card issuer charges some additional
costs, which are resulted due to delay in payment. These charges are charged to compensate
(recover) the interest cost, administration cost and any other related costs bared by the credit card
issuing entity.
9. Service tax

Service tax is included in the total amount charged to the credit cardholder. This mandatory
service tax imposed by the government also increases the final end cost bared by a credit
cardholder. Many credit card providers (issuing entities) have policies of reversing the service
tax charged on the purchase of gas, fuel and other similar goods.

10. Bonus points

The competition among the credit card providers is unbending (adamant). Offering various
incentives is usually a trendy (fashionable) way to improve the sale of the products in the
ordinary course of business. Following this trend, credit card providers also give bonus points on
the financial value of the transactions compiled by their customers.

11. Gifts and other offers

At a later stage (i.e. after crossing pre-determined number of bonus points) accumulated bonus
points are redeemed either by converting them into gifts, cash back offers, or any other similar
compelling offers. To collect many bonus points, the credit cardholder has to carry out a
considerable number of transactions through his credit card.

Retail Financing

 Relating to the sale of financial products or services to consumers, rather than producers
or intermediaries.

 Retail banking also known as Consumer Banking is the provision of services by a bank to
individual consumers, rather than to companies, corporations or other banks.

 Wholesale banking is the provision of services by banks to organizations such as

Mortgage Brokers, large corporate clients, mid-sized companies, real estate developers
etc.

Retail finance products

 Current accounts
  Savings accounts

 Debit cards/ ATM cards

 Credit cards

 Traveler's cheques

 Mortgages

 Home equity loans/Housing finance

 Personal loans

 Certificates of deposit/Term deposits

 Agriculture finance

 Auto finance

 Consumer durable loan

 Gold loan

 Insurance

 Mutual fund

 Capital market – shares and bonds

CREDIT RATING

 Is the symbolic indicator of the current opinion of the rating agency regarding the relative
ability of the issuer of the financial instruments to meet service/debt obligation.

 Evaluation of the credit risk of a prospective debtor

 Debtor - an individual, a business, company or a government

 Timeframe of rating process is 4-6 weeks

 An evaluation by a credit rating agency- CRISIL, ICRA, FITCH, SMERA etc

The main features which are involved with the credit ratings are as follows:-

1) It is used to estimate the worthiness of the credit for the company, country or any individual
company.

2) Credit rating is been done after considering various factors such as finacncial, non-financial
parameters, and past credit history.

3) The rating which gets done is simple and it facilitates universal understanding. Credit rating
also makes it widely accepted as the symbols which are used are generalized and made common
for all.

4) The process of credit rating is very detailed and it involves lots of information such as
financial information, client's office and works information and other management information.
It involves in-depth study.

Advantages of credit rating

 For investors- indicating the underlying credit quality of an debt issue

 Investor informed about company as any effect of changes in business/economic

condition

 For corporate borrower- can raise fund at a cheaper rate with good rating- benefit to
lesser known companies

 For banks and financial institutions – helps when they decide on lending and investment
strategies

 For countries - rely on foreign investors to purchase their debt, and these investors rely
heavily on the credit ratings given by the credit rating agencies

 Companies with rated instrument improve their own image and avail of the rating as a
marketing tool to create better image

 the rated company can economies and minimize cost of public issues by controlling
expenses on media coverage etc

 Rating provides motivation to the company for growth as the promoters feel confident in
their own efforts and are encouraged to undertake expansion of their operations or new
projects.

Regulatory framework

 Regulated by SEBI
 Registration with SEBI is mandatory with initial fee of Rs 50000.

 CRA is a body corporate engaged in the business of rating of securities offered by way of
public/right issues.

 CRA can be promoted by financial institution/bank/company/foreign bank with RBI

approval/foreign rating agencies with 5 yr experience.

 Minimum net worth is Rs 5cr

 Should have adequate infrastructure

 Should follow code of conduct specified by SEBI

 Should enter written agreement with each client

 Maintenance of books of account and records

Credit rating Process

1. Request for rating from issuer

2. CRA Signs rating agreement with issuer/company

3. CRA assigns an analytical team

4. Obtains and analyses information relating to issuer financial statements, cash flow
projections and other relevant information

5. Discussions on management philosophy and plans

6. Analytical team conducts site visits(if required) and performs analysis

7. Management interaction with rating team

8. Analysts present their report to a rating committee

9. Rating committee will decide the rating

10. Rating decision is communicated to the issuer with the reasons supporting the rating.

11. Issuer either accept or appeal the rating decision

12. Once the issuer accepts the rating, CRA disseminate the rating to general public through
media
 13. CRA constantly monitors all ratings with reference to new political, economic and
financial developments and industry trends.

Credit Rating Watch

 During review exercise- rating analyst might become aware of imminent events like
merges, which affect rating

 Issuer rating is put on credit watch for 90days

 Four situation –

a) Negative change : downgrade

b) Positive change : upgrade

c) Stable : no change

d) Developing: future events unclear – negative or positive change

Rating methodology

 Manufacturing company

i. Business risk analysis – Industry risk, market position of the issuing entity, operating
efficiency and legal position

ii. Financial risk analysis- Accounting quality, earning prospects, adequacy of cash flow,
financial flexibility, interest and tax sensitivity

iii. Management risk- track record of management, evaluation of capacity to overcome

adverse situations, goals and strategies

 Financial service company

i. Financial analysis

ii. Management analysis

iii. Regulatory and competitive environment analysis

 Banks – CRAMEL MODEL

i. C (capital adequacy)

ii. R (resource raising ability)

iii. A (asset quality)

iv. M (management evaluation)

v. E (earning potential)

vi. L (liquidity)

Rating symbols for long term instruments

 AAA – Highest safety

 AA – High safety

 A – Adequate safety

 BBB – Moderate safety

 BB – Inadequate safety

 B – High risk of default

 C – Very high risk of default

 D - Default

Rating symbols for Short term instruments

 A1 – Very strong degree of safety

 A2 – Strong degree of safety

 A3 – Moderate degree of safety

 A4 – Minimal degree of safety

 D - Default

Venture capital

Venture capital is financing that investors provide to startup companies and small businesses
that are believed to have long-term growth potential. For startups without access to capital
markets, venture capital is an essential source of money.

Risk is typically high for investors, but the downside for the startup is that these venture
capitalists usually get a say in company decisions.
Venture capital (VC) is a type of private equity, a form of financing that is provided by firms
or funds to small, early-stage, emerging firms that are deemed to have high growth potential,
or which have demonstrated high growth (in terms of number of employees, annual revenue,
or both). Venture capital firms or funds invest in these early-stage companies in exchange for
equity, or an ownership stake, in the companies they invest in. Venture capitalists take on the
risk of financing risky start-ups in the hopes that some of the firms they support will become
successful. Because startups face high uncertainty, VC investments do have high rates of
failure. The start-ups are usually based on an innovative technology or business model and
they are usually from the high technology industries, such as information technology (IT),
clean technology or biotechnology.

The typical venture capital investment occurs after an initial "seed funding" round. The first
round of institutional venture capital to fund growth is called the Series A round. Venture
capitalists provide this financing in the interest of generating a return through an eventual
"exit" event, such as the company selling shares to the public for the first time in an initial
public offering (IPO) or doing a merger and acquisition (also known as a "trade sale") of the
company.

In addition to Angel investing, equity crowdfunding and other seed funding options, venture
capital is attractive for new companies with limited operating history that are too small to
raise capital in the public markets and have not reached the point where they are able to
secure a bank loan or complete a debt offering. In exchange for the high risk that venture
capitalists assume by investing in smaller and early-stage companies, venture capitalists
usually get significant control over company decisions, in addition to a significant portion of
the companies' ownership (and consequently value). Start-ups like Uber, Airbnb, Flipkart,
Xiaomi & Didi Chuxing are highly valued startups, commonly known as unicorns, where
venture capitalists contribute more than financing to these early-stage firms; they also often
provide strategic advice to the firm's executives on its business model and marketing
strategies. Venture capital is also a way in which the private and public sectors can construct
an institution that systematically creates business networks for the new firms and industries,
so that they can progress and develop. This institution helps identify promising new firms
and provide them with finance, technical expertise, mentoring, marketing "know-how", and
business models. Once integrated into the business network, these firms are more likely to
succeed, as they become "nodes" in the search networks for designing and building products
in their domain. However, venture capitalists' decisions are often biased, exhibiting for
instance overconfidence and illusion of control, much like entrepreneurial decisions in
general.

Origin and growth of venture capital

 Before World War II (1939–1945), money orders (originally known as "development

capital") remained primarily the domain of wealthy individuals and families.

 Only after 1945 did "true" private equity investments begin to emerge, notably with the
founding of the first two venture capital firms in 1946: American Research and
Development Corporation (ARDC) and J.H. Whitney & Company.
 Georges Doriot, the "father of venture capitalism" founded INSEAD in 1957

 One of the first steps toward a professionally managed venture capital industry was the
passage of the Small Business Investment Act of 1958

 During the 1960s and 1970s, venture capital firms focused their investment activity
primarily on starting and expanding companies

 The growth of the venture capital industry was fueled by the emergence of the
independent investment firms

 The late 1990s were a boom time for venture capital

 The revival of an Internet-driven environment in 2004 through 2007 helped to revive the
venture capital environment.

Stages of venture capital financing

 There are typically six stages

1. Seed funding: The earliest round of financing needed to prove a new idea, often
provided by angel investors. Equity crowdfunding is also emerging as an option for seed
funding.

2. Start-up: Early stage firms that need funding for expenses associated with marketing and
product development

3. Growth (Series A round): Early sales and manufacturing funds. This is typically where
VCs come in. Series A can be thought of as the first institutional round. Subsequent
investment rounds are called Series B, Series C and so on...

4. Second-Round: Working capital for early stage companies that are selling product, but
not yet turning a profit. This can also be called Series B round and so on.

5. Expansion: Also called Mezzanine financing, this is expansion money for a newly
profitable company

6. Exit of venture capitalist: VCs can exit through secondary sale or an IPO or an
acquisition. Early stage VCs may exit in later rounds when new investors (VCs or Private
Equity investors) buy the shares of existing investors. Sometimes a company very close
to an IPO may allow some VCs to exit and instead new investors may come in hoping to
profit from the IPO.

 Bridge Financing is when a startup seeks funding in between full VC rounds. The
objective is to raise smaller amount of money instead of a full round and usually the
existing investors participate.
 Between the first round and the fourth round, venture-backed companies may also seek to
take venture debt

Venture capital industry in India

 Recent origin in India

 Earlier Development finance institutions(DFIs) partially playing role of VC

 DFIs started coming with VC schemes as early as 1986 to provide finance to technology
based entrepreneurs

 On Nov 25 1988, Controller of capital issues ( CCIs) issued comprehensive guidelines for
setting up venture capital companies(VCC)

 On July 25 1995, SEBI issued guidelines for VCCs

 In 1995, finance ministry announced tax exemption on income by VC from start up

manufacturing firms

 SEBI venture capital fund regulation were issued on 1996

 SEBI appointed Chandrasekhar Committee to identify the impediments in the growth of

VC

 Venture capital funds were regulated by:

a) SEBI Venture capital funds regulation 2000

b) SEBI Foreign venture capital investors regulation act 2000

 SEBI Alternative investment fund regulation 2012 has replaced SEBI VCF regulation.

 Alternative investment fund(AIF) – VC fund incorporated as trust/company which :

- Privately pooled investment vehicle collecting funds from Indian/foreign

investors

- Not covered under other regulators

 SME Fund – small and medium sized enterprises

 Infrastructure fund – focusing infrastructure sector

 Social venture- promoting social welfare

 Venture capital industry grown in India with the emergence of investors from India and
foreign nations