FINANCIAL SYSTEM

1. FINANCIAL SYSTEM

2. Overview of Indian Financial System Various players • Banks • NBFCs- deposit taking and non deposit taking) • Insurance companies • Chit funds, CIS schemes etc • Capital market and money market players like mutual funds • Financial intermediaries • Regulators-SEBI, RBI, IRDA,PFRDA

3. Banking sector- most important players in the financial system- consists of scheduled commercial banks, cooperative banks (rural & urban) • Scheduled commercial banks in turn consist of public sector, private sector and foreign banks. There are 26 PSBs including SBI & associates • There are 146 scheduled commercial banks in India as on date • Total deposits in the banking system are Rs.80.5 lakh Cr and gross advances are Rs.70 lakhcrore. Y-o-y growth is 13.9% and 11.6% respectively. • PSBs still command 75% of market share despite entry of private sector and foreign banks • Banks alos perform the important task of facilitating govt borrowing by investing in government securities

4. NBFCs like Muthoot Finance, Manappuram finance etc- they cannot perform normal banking activities. There are deposit taking and non deposit taking NBFCs. • NBFCs also perform financial intermediation. For instance lending against gold and reach those segments not served by banking system. They however, charge higher rates of interest and had higher solvency requirements till recently. • Certain NBFCs are eager for a bank license. • Banks in turn lend to NBFCs for on lending activities.

5. Insurance companies- both life & non life insurance companies- LIC has the biggest market share and its market cap is estimated to be close to INR 4 lakhs • In India insurance penetration is very low. Hence, this sector is very important. Government intends to pass legislation to bring 49% FDI to the sector which will bring Rs.50,000 Cr. • Health of the insurance industry is measured by means of solvency ratio. They have to maintain sufficient solvency ratio to process claims of customers. • Apart from life insurance, health and motor insurance are also available. The most important indicator of insurance business is new business premiums generated during the year. This is defined as the amount of capital relative to premiums written • IRDA wants 150% minimum solvency ratio by end of 2014.

6. Money market- refers to the market for short term funds like 14 days and upto less than 1 year. Major money market instruments are commercial papers, certificate of deposits etc. • The interest rates charged on these instruments determine the short term rates for various instruments and serves as a sort of benchmark • For instruments such as CPs and CDs ratings, general liquidity conditions, demand for funds etc determine the rates. • Major players in MM are banks and mutual funds.

7. Capital market refers to the market for longer term funds This comprises the stock market and various players such as brokers, stock exchanges etc regulated by SEBI. • Indian capital market is in a developed state with the NSE seeing active trading in the derivative segment apart from the cash segment. Daily trading in the F&O segment is quite high. • Corporates raise funds through Capital market by means of FPOs, IPOs etc. They play an important role in channelizing savings into investments.

8. Monetary and fiscal policies • Monetary and fiscal policy can influence the Gross National product or national Income (Y) which is the sum of Consumption (c), Investment (I), Government expenditure (G) and net exports (X). Y = C+I+G+X • Fiscal and monetary policies are administered by Govt of India and RBI respectively. The Govt and RBI make use of various monetary policy tools to achieve growth and economic stability . • Fiscal & monetary policies can make overall economc situation brighter or check and unwarranted boom • They encourage investment and production in certain priority sectors and discourage them in non priority sectors • They are capable of influencing technological choice and investment and production patterns. • Fiscal & monetary policies can determine aggreate demand and associated levels of output, employment, wages, profits etc.

9. MONETARY POLICY • Monetary policy refers to use of instruments within the control of central banks to regulate aggregate demand and regulate credit flows by varying the asset pattern of credit institutions, principally commercial banks. • Monetary policies also affect the economy through influencing the cost of credit . Since credit forms a vital function of economic activity, the cost and availability of credit is of significance. Measures of money stock RBI employs 4 measures of money stock namely, M1, M2, M3 and M4 M1: This is the sum of notes in circulation ( currency notes, coins etc) and deposits (demand deposits with banks and other deposits with RBI). Demand deposits more than half of money supply M2: M1 + Post office savings deposits M3: M1 + Time deposits with banks. Usually referred as aggregate monetary resources. Reserve money: Currency in circulation + bankers’ deposits with RBI + other deposits with RBI

10. Monetary and fiscal policy can increase/decrease money supply. For instance, if Govt wants to borrow more and run deficits, money supply will increase. Bank deposits: This is an important source of money supply. Orginates in 2 ways • Active creation of deposits; when banks create deposits by extending credit. • Passive creation; When accounts are opened against cash receipts or through cheques. In the first case, money supply in the system increases immediately since it a part of it might be deposited either with itself or with some other banks. In the second case, there is no immediate money creation but only a transfer of savings. However, even in the second case, it helps to augment credit at a later stage. Monetary and fiswcal policies attempt to control credit by impacting the credit creation capacity of banks.

11. Monetary policy instruments • General(Quantitative) methods and • Selective (qualitative) methods The general methods Affect the total quantity of credit and impact the economy generally while selective methods impact credit flow by re directing credit to certain specific segments. • General Credit Controls There are 3 major instruments namely; 1) the Bank rate 2) Open Market Operations (OMO) and 3) Variable Reserve requirements Bank Rate: This is the rate at which RBI lends banks or the rate at which RBI discounts bank’s bills. In a broader sense it is the rate at which RBI provides financial accommodation to commercial banks. It affects cost of credit. However, this rates has lost relevance now since bill discounting business is negligible. At present it is 9%. Bank rate also impact money market rates. Theoretically, bank rate changes can affect money supply and in turn the demand and price levels.

12. Open market operatios (OMO). Usually refers to purchas and sale by RBI of forex, gold, company shares, Government securities etc. However, in index, OMO means purchase and sale of Government securities. OMOs help to vary the money supply. For instance, when the central bank purchases securities, equivalent money is released and this increases commercial bank reserves. Credit creation and money supply will also increase. Converse is true when the central bank wish to curtail money supply. This is also used to aid Government borrowing programme. Govt manages fiscal deficits through borrowing. Borrowing programme for FY 15 is Rs.6 lakh cr. OMOs are conducted by RBI through auctions every fortnight through securities worth Rs.15,000 Cr. Also used to provide funds to banks during times of liquidity tightness and busy seasons.

13. Variable reserve ratio: This refers to the amount of funds banks keep as reserves with the central bank, generally as a percentage of their deposits. This can be varied by the central bank at any time as per its discretion. In India this is called cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) currently at 4% and 22% respectively. If CRR is cut, money supply increases and vice versa. It also indirectly impacts money market rates through liquidity conditions. Banks to maintain 95% of CRR on a daily basis.CRR calculated on the basis of Net demand & Time Liabilities of banks. Banks do not earn any interest on CRR balances kept with RBI. Interest on CRR is a long standing demand. Even small changes in CRR can lead to wide variations in money supply and hence this is a potent tool to influecne money supply.

14. Statutory Liquidity Ratio (SLR): Amount of NDTL banks invest in Government securities. Can be Central Govt securities and state Govt securities. At present, SLR requirement is 22% of NDTL. It was brought down from 24% since April 2014. SLR, by forcing banks to invest in Government securities, help in meeting Govt borrowing programmes. However, the move to induce banks to lend by cutting SLR ay not have the desired impact since banks already hold excess SLR. Moreover, since economy is barely turning the corner, credit demand has not yet picked up.

15. Selective credit controls: These are aimed at restricting the quality of credit while general credit controls emphasized regulation of quantity of credit. The RBI is empowered to give directions to individual banks/group of banks to direct credit to certain segments. Not lend to certain segments The BR ACT empowers RBI to give direction to banks as to • The purposes for which advances may or may not be made • The margin to be made in respect of secured advances ( like LTV for gold loans) • The maximum quantum of advances or financial accommodation which may eb given to any one company firm, association etc(eg proposal to cut group exposure limit from 40% to 25% of net worth) • Maximum amount upto which guarantees may be given by a banking company on behalf of any firm, association individual etc. • Rate of inteerst and other terms and conditions.

16. The techniques of selective credit controls generally used are • Minimum margins for lending against certain securities • Ceilings on the amount of credit for certain purposes and • Discriminatory rates of interest on certain types of advances’ Moral suasion: Apart from general and selective credit control mechanisms, RBI has been informally communicating with banks the need to provide credit to certain segments through discussions, letters etc. This combined with government influence over commercial banks, has helped in directed lending in a big way.

17. Monetary policy during present times The instruments of monetary policy has evolved over the years. Apart from usual instruments of CRR, OMOs and SLR, repos are also widely used to manage system liquidity. There are both overnight repos and term repo facilities available which enable banks to borrow funds for short term needs and manage liquidity. A snapshot of liquidity and rates A snapshot of liquidity

18. Definitions of some terms: LAF: This is Liquidity Adjustment Facility and is the window through which commercial bans borrow from RBI overnight funds. The rate at which funds are borrowed is repo rate currently at 8%. Capped at 0.75% of NDTL. Term repo: Under this window, funds are not borrowed overnight but for periods ranging from 7-28 days. This window has been introduced to develop money markets and to have a term money market structure. Marginal Standing facility (MSF). To meet emergency fund requirements. Usually 1% above the repo .Currently at 9%. Repo, reverse repo and MSF rates move at repo rate + and – 1% bands. Thus change in the repo rate automatically changes other two rates. Banks can borrow from repo and term repo window depending on the extent of excess SLR

19. FISCAL POLICY Fiscal policy is concerned with raising revenue through taxes and other means and deciding on the pattern of expenditure Fiscal policy operates through the Budget. Budget is an estimate of Government expenditure and revenue for the ensuing financial year presented to the Parliament. During an election year, there is a vote-on account and not a full fledged budget. An estimate of all anticipated revenue and expenditure of the Union Government for the ensuing financial year is laid out during the last working day of February and is called the Annual Financial Statement. It also covers the transactions of Central Govt within and outside India during the year as well as the ensuing year. All receipts and disbursements are recorded under two separate heads- the Consolidated Fund of India and Public Account of India. All revenue received, loan raised etc form part of Cosolidated Fund and withdrawal from it require authoirty under an Act of Parliament unlike that from Public Account funds. .

20. Structure of the Budget: Budget is divided vertically into revenue receipts and expenditure and horizontally into revenue account and capital account. All revenue and expenditure which are currently incurred/accrued are revenue receipts/expenditure. For instance, taxes are a part of revenue receipts while expenditure on Govt administration is revenue expenditure. All receipts/expenditure which are incurred/accrue over a period of time are called capital receipts/expenditure. For eg repayment of loan is a capital receipt while spendingh on defence equipment is a capital expenditure. The Budget estimates are given by the Controller general of Accounts (CGA).

21. \ The gap between total expenditure and receipts is known as fiscal deficit which is bridged through borrowings. The borrowings equiv alent to deficits is managed by RBI on behalf of the Govt . For this Govt securities are auctioned to banks and SLR stipulates banks to maintain certain minimum investments in Govt securities. Govt borrowing programme for current financial year (2014-15) is INR 6 lakhcrore. 60% is completed during first half year. The target is to achieve a fiscal deficit target of 4.1% for FY 2015. Revenue deficit is the gap between revenue expenditure and revenue receipts. Primary deficit is the gap between fiscal deficit and inteerst payments on government borrowings.

22. The constitution of India has earmarked separate sources of revenue for the Centre and States. Moroever, the Finance Commission is constituted every Five Years to make recommendations as to the devolution of finances between Centre and States. The Finance commission provides recommendations As to • The distribution between the Union and states of net tax proceeds and share of states in such taxes • The principles governing grants in aid of states in need of assistance. • Any other matter referred to the commission by the President of India The 14th Finance Commission headed by Dr. Y.V.Reddy is in operation now. As part from the Finance Commission, the Planning Commission prepares the Five Year Plans. Now there is a proposal to scrap the Plan panel.

23. The importance of Budget is significant, especially in developing economies. Central Govt expenditures alone account for almost a fifth of GDP. In a developing country like Inia,. A Budget msut serve the following objectives. • Accelerate the pace of development by resource mobilisation and effective allocation • Facilitate improvement in productive capability of private enterprises • Effect improvement in income distribution • Promote exports and encourage import substitution • Achieve economic stabilisatyion Apart from the above, various fiscal incentives and disincentives may also be employed in the Budget.

24. MONEY A& CAPITAL MARKET Money Market refers to the market for short term funds and capital market is the market for longer term funds Money Market: The major constituents of money markets are commercial banks, mutual funds and a strong central bank. The central bank is considered as the ‘presiding deity’ in the money market. In Inda there are both organized and unorganised versions of money market- unorganized versions consist of money lenders indigenous lenders. This segment is characterized lack of uniformity and is outside RBI control. As the RBI observes rightly, a developed money market is very important for smooth conduct of monetary policy and it is through this market than RBI comes in direct contact with market players.

25. Important functions of a money market are as follows: • Augmenting system liquidity • Efficient function helps to minimize volatility in money market • By imparting funds at lower cost, helps lower cost of funds • A developed money market ensures quick transfer of funds from one place to another • By providing an avenue for short term surplus funds, helps financial institutions to enhance profitability. • Enhances the amount of liquidity available to the entire country • Augments the supply of funds

26. CAPITAL MARKET Capital market is usually referred to as the market for long term funds. However, many a time, the same institutions receive and supply long term and short term funds. To that extent, the distinction between the two is blurred. Both the markets are inter dependent. Commercial banks, cooperative banks, insurance companies etc are constituents of capital market. capital market has three main components- the lenders, borrowrs and financial intermediaries. Capital market comprises of not only initial fund raising (IPOs) but also trading of shares in the secondary market. developed countries have well developed money markets and capital markets. In India, our money markets and capital market is fairly well developed.

27. Importance of capital market • Capital market determines the pace of economic development by channelizing savings into capital formation. In India, rate of capital formation is slow at present. • A developed capital market provides number of investment opportunities for small investors • They help in augmenting resources by attracting and lending funds on a global scale. • An organized capital market can pool together even the scattered savings and augment the availability of investible funds. • A developed capital market provides investment opportunities for small investors

28. Developments Indian capital market • Open outcry system replaced by screen based trading system • Framing of insider trading regulations • FIIs allowed to invest in equities • Development of Futures & Options segment