Professional Documents
Culture Documents
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• Financial System – Various Types Of Classification • Transforming financial assets acquired through the market
• Functions Of Financial Institution and constitution them into a different, and more widely
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preferable, type of asset-which becomes their liability. This is
Dear students, today is our first lecture on Management of
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the function performed by financial intermediaries, the
Financial Institution. Before we get deep into the subject, the
most important type of financial institution.
primary basic thing for us to understand is the significance, role,
importance and function of financial institution. • Exchanging of financial assets on behalf of customers.
• Exchanging of financial assets for their own accounts.
What is the Significance and Definition of Financial
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• Assisting in the creation of financial assets for their
System? customers, and then selling those financial assets to other
We all know that the growth of output in any economy market participants.
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depends on the increase in the proportion of savings/
investment to a nation’s output of goods and services. So the
financial system and financial institutions help in the diversion
• Providing investment advice to other market participants.
• Managing the portfolios of other market participants.
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of rising current income into savings/investments. So now you are aware that financial intermediaries include
We can define financial system as a set of institutions, depository institutions (commercial banks, savings and loan
instruments and markets, which foster savings and channels associates, savings banks, and credit unions), which acquire the
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them to their most efficient use. The system consists of bulk of their funds by offering their liabilities to the public
individuals (savers), intermediaries, markets and users of mostly in the form of deposits: insurance companies (life and
savings. Economic activity and growth are greatly facilitated by property and casualty companies); pension funds; and finance
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financial institutions play important roles. Deep and liquid their assets- can be in loans and/or securities. These
markets provide liquidity to meet any surge in demand for investments are referred to as direct investments. Market
liquidity in times of financial crisis. Such markets are also participants who hold the financial claims issued by financial
necessary to derive appropriate reference rates for pricing intermediaries are said to have made indirect investments.
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mechanism, i.e., they provide transactions services, their deposit segments.
liabilities constitute a major part of the national money supply, Very often financial markets are classified as money markets
and they can, as a whole, create deposits or credit, which is and capital markets, although there is no essential difference
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money. Banks, subject to legal reserve requirements, can advance between the two as both perform the same function of
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credit by creating claims against themselves, while other transferring resources to the producers. This conventional
institutions can lend only out of resources put at their disposal distinction is based on the differences in the period of maturity
by the savers, and the latter as mere “purveyors” of credit. of financial assets issued in these markets. While money
While the banking system in India comprises the commercial markets deal in the short-term claims (with a period of maturity
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banks and co-operative banks, the examples of non-banking of one year or less), capital markets do so in the long-term
financial institutions are Life Insurance Corporation (LIC), Unit (maturity period above one year) claims. Contrary to popular
Trust of India (UTI), and Industrial Development Bank of usage, the capital market is not only co-extensive with the stock
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India (IDBI). We shall discuss this in detail later.
There are also few other ways to classify financial institution.
market; but it is also much wider than the stock market.
Similarly, it is not always possible to include a given participant
in either of the two (money and capital) markets alone.
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Like they can be classified as intermediaries and non-
Commercial banks, for example, belong to both. While treasury
intermediaries. As we have seen earlier, intermediaries
bills market, call money market, and commercial bills market are
intermediate between savers and investors; they lend money as
examples of money market; stock market and government
well as mobilise savings; their liabilities are towards the ultimate
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reduce or overcome transaction costs. They are able to do so
through economies of scale in lending and borrowing. They
provide large volumes of finance on the basis of small deposits
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or unit capital. This is called “size-transformation” function.
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Further, they distribute risk through diversification and thereby
reduce it for savers as in the case of mutual funds. This is called
“risk-transformation” function. Finally they offer savers
alternate forms of deposits according to their liquidity
preferences, and provide borrowers with loans of requisite
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maturities. This is known as “maturity-transformation”
function.
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A financial system also ensures that transactions are effected
safely and swiftly on an on-going basis. It is important that
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both buyers and sellers of goods and services should have the
confidence that instruments used to make payments will be
accepted and honoured by all parties. The financial system
ensures the efficient functioning of the payment mechanism.
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6. Portfolio management.
Questions to Discuss
1. What is the Significance And Definition of Financial System?
2. What is the Importance Of Financial Institutions?
3. What is the Role Of Financial Intermediaries?
4. What are the various classifications of Financial Institutions?
5. What are the functions of Financial Institutions?
Notes:
LESSON 2:
INTRODUCTION TO INDIAN FINANCIAL SYSTEM
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• Providing A Payments Mechanism intermediary is an important economic benefit for financial
markets.
• Asset/ Liability Management Of The Financial Institutions
Reducing the Costs of Contracting and Information
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• Nature Of Liabilities
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• Liquidity Concerns Processing
• Brokerage and asset transformation
You can also reduce the cost of contracting and information
processing. Suppose you are an investor purchasing financial
• Advantages of financial institutions
assets. You should take the time to develop skills necessary to
• Criteria To Evaluate Financial Institutions understand how to evaluate an investment. Once these skills are
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After getting aware of the characteristics of financial institution, developed you should apply them to the analysis of specific
let us understand some other related concepts. financial assets that are candidates for purchase (or subsequent
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What do you Mean by Maturity Intermediation?
The commercial bank by issuing its own financial claims in
sale). If you as an investor wants to make a loan to a consumer
or business you will need to write the loan contract.
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essence transforms a longer-term asset into a shorter-term one Although there are some people who enjoy devoting leisure
by giving the borrower a loan for the length of time sought and time to their task, most prefer to use that time for just that-
the investor/depositor a financial asset for the desired leisure. Most of us find that leisure time is in short supply, so
investment horizon. This function of a financial intermediary is to sacrifice it, we have to be compensated; the form of
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called maturity intermediation. compensation could be a higher return that we obtain from an
investment.
You should understand that maturity intermediation has two
implications for financial markets. First, it provides investors In addition to the opportunity cost of the time to process the
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with more choices concerning maturity for their investments; information about the financial asset and its issuer, there is the
borrowers have more choices for the length of their debt cost of acquiring that information. All these costs are called
obligations. Second, because investors are naturally reluctant to information processing costs. The costs of writing loan
commit funds for a long period of time, they will require that contracts are referred to as contracts are referred to as contracting
long-term borrowers pay a higher interest rate than on short- costs. There is also another dimension to contracting costs, the
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term borrowing. A financial intermediary is willing to make cost of enforcing the terms of the loan agreement.
longer-term loans, and at a lower cost to the borrower than an With this in mind, consider the two examples of financial
individual investor would, by counting on successive deposits intermediaries- the commercial bank and the investment
providing the funds until maturity. Thus, the second company. People who work for these intermediaries include
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implication is that the cost of longer-term borrowing is likely to investment professionals who are trained to analyse financial
be reduced. assets and manage them. In the case of loan agreements, either
standardised contracts can be prepared, or legal counsel can be
What is Reducing Risk Via Diversification?
part of the professional staff that writes contracts involving
Next shall discuss the way to reduce the risk through
more complex transactions. The investment professional can
diversification. Consider the example of the investor who places
monitor compliance with the terms of the loan agreement and
funds in an investment company. Suppose that the investment
take any necessary action to protect the interests of the financial
company invests the funds received in the stock of a large
intermediary. The employment of such professionals is cost-
number of companies. By doing so, the investment company
effective for financial intermediaries because investing funds is
has diversified and reduced its risk. Investors who have a small
their normal business.
sum to invest would find it difficult to achieve the same degree
of diversification because they do not have sufficient funds to In other words, there are economies of scale in contracting and
buy shares of a large number of companies. Yet by investing in processing information about financial assets because of the
the investment company for the same sum of money, investors amount of funds managed by financial intermediaries. The
can accomplish this diversification, thereby reducing risk. lower costs accrue to the benefit of the investor who purchases
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one time the exclusive domain of commercial banks, but now being uncertain, you do not mean that it cannot be predicted.
other depository institutions offer this service. Debit cards are There are some liabilities where the “law of large numbers”
offered by various financial intermediaries. I am sure all of us makes it easier to predict the timing and/or amount of cash
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present over here must be having at least one debit card apart outlays. This is the work typically done by actuaries, but of
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from credit cards. And you all must also be aware that a debit course even actuaries cannot predict natural catastrophes such as
card differs from a credit card in that, in the latter case, a bill is floods and earthquakes.
sent to the credit card holder periodically (usually once a month) Table 2
requesting payment for transactions made in the past. In the
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case of a debit card, funds are immediately withdrawn (that is, Nature of Liabilities of Financial Institutions
debited) from the purchaser’s account at the time the transaction Liability type Amount of Cash Outlay Timing of Cash Outlay
takes place
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The ability to make payments without the use of cash is critical
for the functioning of a financial market. In short, depository
Type I
Type II
Type III
Type IV
Known
Known
Uncertain
Uncertain
Known
Uncertain
Known
Uncertain
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institutions transform assets that cannot be used to make
payments into other assets that offer that property.
Let us illustrate each one of them
Asset/ Liability Management of the Financial
Type I Liabilities
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Institutions Both the amount and the timing of the liabilities are known
To understand the reasons mangers of financial institutions with certainty. A liability requiring a financial institution to pay
invest in particular types of financial assets and the types of Rs.50, 000 six months from now would be an example. For
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investment strategies they employ, it is necessary that you have a example, depository institutions know the amount that they are
general understanding of the asset/ liability problem faced. committed to pay (principal plus interest) on the maturity date
The nature of the liabilities dictates the investment strategy a of a fixed-rate deposit, assuming that the depositor does not
financial institution will pursue. For example, depository withdraw funds prior to the maturity date.
institutions seek to generate income by the spread between the
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Type I Liabilities
return that they earn on assets and the cost of their funds. That
however, are not limited to depository institutions. A major
is, they buy money and sell money. They buy money by
product sold by life insurance companies is a guaranteed
borrowing from depositors or other sources of funds. They sell
investment contract, popularly referred to as a GIC. The
money when they lend it to businesses or individuals. In
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Treasury bill rate plus one percentage point, the depository funds, insurance companies, banks and depositors with a share
institution knows it has a liability that must be paid off in three of a large asset or issuing debt type liabilities against equity type
years, but the dollar amount of the liability is not known. It assets. While providing asset transformation, financial firms
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will depend on three-month Treasury bill rates over the three differ in the nature of transformation undertaken and in the
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years. nature of protection or guarantees, which are offered. Banks
Type IV Liabilities and depository institutions offer liquidity, insurance against
There are numerous insurance products and pension contingent losses to assets and mutual funds against loss in
obligations that present uncertainty as to both the amount and value of assets.
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the timing of the cash outlay. Probably the most obvious Through their intermediary activities banks provide a package of
examples are automobile and home insurance policies issued by information and risk sharing services to their customers. While
doing so they take on part of heir risk. Banks have to manage
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property and casualty insurance companies. When, and if, a
payment will have to be made to the policyholder is uncertain.
Whenever damage is done to an insured asset, the amount of
the risks through appropriate structuring of their activities and
hedge risks through derivative contracts to maximize their
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the payment that must be made is uncertain. profitability.
What are the Liquidity Concerns? Financial institutions provide three transformation services.
By liquidity concerns what do you understand? Because of the Firstly, liability, asset and size transformation consisting of
mobilization of funds and their allocation (provision of large
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financial institution may have the right to change the nature of borrowers long-term loans which are better matched to the cash
the obligation, perhaps incurring some penalty. For example, in flows generated by their investment. Finally, risk transformation
the case of a certificate of deposit, you as a depositor may by transforming and reducing the risk involved in direct lending
request the withdrawal of funds prior to the maturity date; by acquiring more diversified portfolios than individual savers
can. The expansion of the financial network or an increase in
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borrowers, renders deposits liquid and reduces the risk of
lending. communitarian spirit, not competition and profit motive.
The ability of the financial intermediaries to ensure the most • The financing of investment which results in the
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efficient transformation of mobilized funds into real capital has displacement or retrenchment of labour should be
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not, however, received the attention it deserves. Institutional discouraged.
mechanisms to ensure end use of funds have not been efficient • The scope for financing various sectors is ultimately
in their functioning, leaving the investor unprotected. Efficient constrained by domestic saving. The substantial increase in
financial intermediation involves reduction of the transaction the total saving in India is unlikely to take place now.
cost of transferring funds from original sabers to financial
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• The working of the Indian financial system should not be
investors. The total coat of intermediation is influenced by
corporate-sector-centric.
financial layering, which makes the individual institution’s costs
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additive in the total cost of intermediating between savers and
ultimate borrowers. The aggregate cost of financial
intermediation from the original saver to ultimate investor is
• There are limits to the overall and industrial growth, and,
therefore, a “ceiling” on the targeted rate of growth has to be
imposed.
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much higher in developing countries than in developed • The only legitimate role of the financial markets is
countries. infrastructural, hence they should not exist to provide
opportunities to make quick, disproportionate pecuniary
Criteria to Evaluate Financial Institutions
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gains.
Given the controversy regarding the contribution of financial
sector, it is necessary to have a framework to evaluate the • It is the primary markets activity of supporting new,
performance of the country’s financial sector. Let us first look at economically and socially productive real investment, trade,
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the criteria formulated, in the form of questions, by Richard D. and flows of goods and services, which is of foremost
Erb, the former Deputy Managing Director of the International importance. The enthusiasm, hyperactivity, and
Monetary Fund: (i) Do institutions find the most productive preoccupation with the secondary markets ought to be
investments? (ii) Do institutions revalue their assets and avoided.
liabilities in response to changed circumstances? (iii) Do Summary
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investors and financial institutions expect to be bailed out of Financial institutions provide various types of financial services.
mistakes and at what price? (iv) Do institutions facilitate the Financial intermediaries are a special group of financial
management of risk by making available the means to insure, institutions that obtain funds by issuing claims to market
hedge, and diversify risks? (v) Do institutions effectively participants and use these funds to purchase financial assets.
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monitor the performance of their users, and discipline those Intermediaries transform funds they acquire into assets that are
not making proper and effective use of their resources? (vi) more attractive to the public. By doing so, financial
How effective is the legal, regulatory, supervisory, and judicial intermediaries do one or more of the following: (1) provide
structure? (vii) Do financial institutions publish consistent and maturity intermediation; (2) provide risk reduction via
transparent information? diversification at lower cost; (3) reduce the cost of contracting
These criteria, useful as they are, do not encompass social and and information processing; or (4) provide a payments
ethical aspects of finance which ought to be regarded as mechanism.
important as economic aspects. Therefore, the relevant The nature of their liabilities determines the investment strategy
normative criteria, organising principles, and value premises pursued by all financial institutions. The liabilities of all
which should guide the functioning of the financial system are: financial institution will generally fall into one of the four types
• Finance is not the most critical factor in development. shown in Table 2.
• The use of finance must be imbued with the virtues of
austerity, self--limit, and minimisation.
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Learning objectives human and physical capital are its important sources and any
After reading this lesson, you will understand increase in them requires higher saving and investment, which
the financial system helps to achieve. Second, the financial
• Effects of financial system on saving and investment
system contributes to growth not only via technical progress
• Relationship between financial system and economic but also in its own right. Economic development greatly
development depends on the rate of capital formation. The relationship
• A cautionary approach- between capital and output is strong, direct, and monotonic
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• The process of financial development (the position which is sometimes referred to as “capital
fundamentalism”). Now, the capital formation depends on
• Criteria to evaluate financial sector
whether finance is made available in time, in adequate quantity,
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Students, today in the class let us discuss the correlation of and on favourable terms-all of which a good financial system
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financial system and the economic development. The role of achieves. Third, it also enlarges markets over space and time; it
financial system in economic development has been a much- enhances the efficiency of the function of medium of exchange
discussed topic among economists. Is it possible to influence and thereby helps in economic development.
the level of national income, employment, standard of living,
We can conclude from the above that in order to understand the
and social welfare through variations in the supply of finance?
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importance of the financial system in economic development,
In what way financial development is affected by economic
we need to know its impact on the saving and investment
development?
processes. The following theories have analyzed this impact: (a)
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There is no unanimity of views on such questions. A recent
literature survey concluded that the existing theory on this
subject has not given any generally accepted model to describe
The Classical Prior Saving Theory, (b) Credit Creation or Forced
Saving or Inflationary Financing Theory, (c) Financial Repression
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Theory, (d) Financial Liberalisation Theory.
the relationship between finance and economic development.
The Prior Saving Theory regards saving as a prerequisite of
The importance of finance in development depends upon the
investment, and stresses the need for policies to mobilise saving
desired nature of development. In the environment-friendly,
voluntarily for investment and growth. The financial system has
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third view also. Let us briefly explain these viewpoints one by time, there are some people whose current expenditures is less
one. than their current incomes, while there are others whose current
expenditures exceed their current incomes. In well-known
In his model of economic growth, Solow has argued that
terminology, the former are called the ultimate savers or
growth results predominantly from technical progress, which is
surplus--spending-units, and the latter are called the ultimate
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the financial system in economic development. making financial services such as remittance, discounting,
acceptance and guarantees available. Finally, it not only
Relationship Between Financial System and
encourages greater investment but also raises the level of
Economic Development resource allocational efficiency among different investment
channels. It helps to sort out and rank investment projects by
sponsoring, encouraging, and selectively supporting business
units or borrowers through more systematic and expert project
appraisal, feasibility studies, monitoring, and by generally
Economic Development
keeping a watch over the execution and management of
projects.
The contribution of a financial system to growth goes beyond
increasing prior-saving-based investment. There are two strands
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of thought in this regard. According to the first one, as
Savings & Investment or
Capital Formation emphasized by Kalecki and Schumpeter, financial system plays a
positive and catalytic role by creating and providing finance or
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credit in anticipation of savings. This, to a certain extent,
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ensures the independence of investment from saving in a given
Surplus Spending Deficit Spending period of time. The investment financed through created credit
Economic Units Economic Units generates the appropriate level of income. This in turn leads to
an amount of savings, which is equal to the investment already
undertaken. The First Five Year Plan in India echoed this view
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Income Minus Income Minus when it stated that judicious credit creation in production and
(Consumption + (Consumption + availability of genuine savings has also a part to play in the
Own investment)
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process of economic development. It is assumed here that the
investment out of created credit results in prompt income
generation. Otherwise, there will be sustained inflation rather
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Surplus or Saving Deficit or Negative
Saving than sustained growth.
The second strand of thought propounded by Keynes and
Tobin argues that investment, and not saving, is the constraint
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Financial System on growth, and that investment determines saving and not the
other way round. The monetary expansion and the repressive
policies result in a number of saving and growth promoting
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achieve much growth with minimum of capital. The
conventional thinking has always stressed the need for
substitution of capital for other factors but the scope and
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possibilities for this kind of substitution, particularly in the
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light of factor endowments, have never been really explored.
For growth, much additional capital, and, therefore, much
finance, is not always required; through depreciation allowances,
better composition of capital, appropriate technology, and
higher productivity, a lot of growth can be achieved. The
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methodology used for estimating the financial resource
requirements (incremental capital-output ratio) is also riddled
Financial Sector and Economic Development: a other conditions of growth were favourable were usually
capable of devising adequate financial institutions
Cautionary Approach
(Habakkuk).
Many economists have taken a cautionary view of the role of
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financial markets in development. The capital market • The role of finance in development is a subsidiary one
enthusiasm and optimism implicit in certain theories of (Newlyn).
finance, viz., Capital Asset Pricing Model and Efficient Market The Process of Financial Development
Hypothesis with their multiple unrealistic, restrictive How does financial development occur? Is it influenced by
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assumptions, have been questioned in different ways. economic development? Does the former always precede the
First, it has been argued that the financial sector can perform the latter? The literature talks about “supply leading” and “demand
developmental role if it functions efficiently, but in practice, it is following” financial development. Under the former, financial
not efficient. Tobin’s analysis in this respect is highly instructive. development occurs first and stimulates economic growth.
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With logic and examples, he has explained how the prices in Under the latter, as trade, commerce and industry expand, the
financial markets rarely reflect intrinsic values; how very little of financial institutions, instruments, and services needed by them
the work done by the securities industry has to do with also expand as a matter of response. The financial development
financing real investment; how the allocation of funds by is said to be “active” in the first case, and “passive” in the
financial markets is hardly optimal; and that the services of second one.
financial system do not come cheap. According to him, financial Such a characterisation of the process of financial development
system serves us all right. But its functioning does not merit is not very apt. It is difficult to establish precisely the sequence
complacency. Financial activities generate high private reward of real and financial sector developments; the cause and effect
disproportionate to their social productivity. The ‘casino effect’ relationship between them is difficult to disentangle. It will be
of financial markets cannot be forgotten. The speculation in more correct to say that their growths are intertwined,
financial markets is a negative-sum game for the general public. symbiotic, and mutually reinforcing. While financial markets
More recently, through the application of chaos and fractal accelerate development, they, in turn, grow with economic
analyses to financial markets, it has been shown that they are development. In the words of Schumpeter, “the money market
characterized by asymmetry, turbulence, discontinuity, is always the headquarters of the capitalist system, from which
stampedes, non-periodicity, and inefficiency. orders go out to its individual divisions, and that which is
plans for further development. All kinds of credit requirements industrial growth, and, therefore, a “ceiling” on the targeted rate
come to this market; all kinds of economic project are first of growth has to be imposed. (l) The only legitimate role of
brought into relation with each other and contend for their the financial markets is infrastructural, hence they should not
realization in it; all kinds of purchasing power flows to it to be exist to provide opportunities to make quick, disproportionate
sold. This gives rise to a number of arbitrage operations and pecuniary gains. (m) It is the primary markets activity of
intermediate manoeuvres, which may easily veil the supporting new, economically and socially productive real
fundamental thing. Thus, the main function of the money or investment, trade, and flows of goods and services, which is of
capital market is trading in credit for the purpose of financial foremost importance. The enthusiasm, hyperactivity, and
development. Development creates and nourishes this market. preoccupation with the secondary markets ought to be avoided.
In the course of development, it becomes the market for
Questions to Discuss:
sources of income themselves.”
1. What are the effects of Financial System on saving and
Criteria To Evaluate Financial Sector Investment?
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At the end of the discussion let us evaluate financial sector
2. Discuss the relationship Between Financial System and
critically. Given the controversy regarding the contribution of
Economic Development?
financial sector, it is necessary to have a framework to evaluate
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the performance of the country’s financial sector. Let us first 3. Discuss a cautionary approach on Financial Sector and
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look at the criteria formulated, in the form of questions, by Economic Development?
Richard D. Erb, the former Deputy Managing Director of the 4. What are the criteria To Evaluate Financial Sector?
International Monetary Fund: (i) Do institutions find the most Notes:
productive investments? (ii) Do institutions revalue their assets
and liabilities in response to changed circumstances? (iii) Do
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investors and financial institutions expect to be bailed out of
mistakes and at what price? (iv) Do institutions facilitate the
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management of risk by making available the means to insure,
hedge, and diversify risks? (v) Do institutions effectively
monitor the performance of their users, and discipline those
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not making proper and effective use of their resources? (vi)
How effective is the legal, regulatory, supervisory, and judicial
structure? (vii) Do financial institutions publish consistent and
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transparent information?
These criteria, useful as they are, do not encompass social and
ethical aspects of finance, which ought to be regarded as
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Financial Development: Some Concepts introduction of a new financial instrument or service or practice,
In this section we discuss a few concepts, which describe the or introducing new uses for funds, or finding out new sources
phenomenon of change and development in a financial system.
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of funds, or introducing new processes or techniques to handle
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All these concepts are closely inter-related, and at present they are day-to-day operations, or establishing a new organisation-all
widely referred to in the discussions on financial markets. these changes being on the part of existing financial
Efficiency institutions. In addition, the emergence and spectacular growth
What do you mean by efficiency? The ultimate focus of the of new financial institutions and markets is also a part of
efficiency in financial markets is on the nonwastefulness of financial innovation. The word “new” here means not only the
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factor use and the allocation of factors to the socially most coming into being of what did not exist till then but also the
productive purposes. The following five concepts are useful in new way of using existing instruments, practices, technology,
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judging the efficiency of a financial system.
Information Arbitrage Efficiency
and so on. Similarly, the use or adoption of an already existing
financial instrument, by financial institution(s), which
previously did not do, so is also regarded as an innovation. The
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This is the degree of gain possible by the use of commonly marked transformation in the roles of financial institutions and
available information. If one can make large gains by using the departure from the conventional notions regarding their
commonly available information, financial markets are said to functions also constitute financial innovation. As per one
be inefficient. Thus, the efficiency is inversely related to this type definition, financial innovations are “unforecastable
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of gain. Under conditions of perfect market, the possibilities of improvements” in the array of available financial products and
such a gain are nil because the prices in such a market already processes.
reflect fully and immediately all relevant and ascertainable
Financial innovations bring about wide ranging changes as well
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intrinsic value of an asset is the present value of the future financialisation may occur with the growth of
stream of cash flows associated with the investment in that institutionalisation or intermediation and securitisation
asset, when the cash flows are discounted at an appropriate rate simultaneously, or it may occur with the growth of one at the
of discount. This again would happen when markets are cost of other.
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This is perhaps the latest terminological addition to the world ceilings while the open market rates of return are rising.
of finance, which, incidentally, is a new example of the invasion The terms securitisation and disintermediation are often used
of social thinking by technology. After innovations, industrial interchangeably. Although these terms are very closely related,
engineering and social engineering, we now have financial one should be careful in using them interchangeably. A decline
engineering. It basically means financial innovations; the two in the share of only a particular type of financial intermediary,
terms have often been used interchangeably. The dictionary say commercial banks, does not necessarily mean
meanings of innovation and engineering perhaps give a clue to disintermediation. Similarly, securitisation in the second sense
the possible difference between financial innovations and does not involve disintermediation.
financial engineering. To innovate means to introduce new
methods, new ideas, and make changes. To engineer means to Broad, Wide, Deep and Shallow Markets
arrange, contrive, to bring about artfully or skilfully. All these are closely related terms. The broad and wide financial
market attracts funds in greater volume and from all types of
Financial engineering thus connotes development of new
national and international investors. In such a market, financial
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financial technology to cope with financial changes. It involves
institutions offer, even globally, 24-hour sales and trading
construction, designing, deconstruction, and implementation
capability in debt and equity instruments. The deep market is
of innovative financial institutions, processes, and instruments.
one where there are always sufficient orders for buying and
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It means the formulation of creative solutions to problems in
selling at fine quotations both below and above the market
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finance. The development and use of skills, means, techniques,
price, and where there are good opportunities for swap deals. A
tools for changing and managing cash flows and investment
swap deal is a medium-term or long-term arrangement between
features of financial instruments form a part of financial
two parties in which each party commits to service the debt of
engineering. In today’s highly volatile markets, it seeks to limit
the other. In other words, a swap is the exchange of future
financial risk by creating financial instruments for hedging,
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streams of payment between two or more parties. The shallow
speculation, arbitraging, and by fine-tuning portfolio
market, on the other hand, means an underdeveloped market,
adjustments. It also seeks to maximise profits quickly. The
its underdevelopment being the result of financial repression
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creation of financial derivatives and securitisation are its two
examples. Computer power and human insight are combined
to spot arbitrage opportunities, measure risk, and to react to
or administered finance.
Financial Repression
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news very fast in financial engineering. It represents economic conditions in which the government’s
regulatory and discretionary policies distort financial prices or
Financial Revolution interest rates (i.e., the real interest rates are kept low or negative),
Some people believe that a veritable financial revolution has discourage saving, reduce investment, and misallocate financial
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taken place in the world of finance in the recent past. The resources. The government-directed credit program, and direct
concept of financial revolution is an extension of the concepts rather than indirect credit controls predominate in a repressed
of financial innovations and engineering. It is meant to convey system. As indicated above, it is also known as the system of
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that, of late, the magnitude, speed, and spread of changes in administered interest rates and finance.
the financial sector the world over has been simply tremendous,
prodigious, phenomenal; that it has undergone a “future Financial Reforms, Financial Liberalisation, and
shock”. It indicates that life in the world of finance is no longer Deregulation
easy and that financial markets now work 24 hours a day. The Financial reforms involve instituting policies, which will increase
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innovations in computers and satellite communications, and the allocative efficiency of available saving, promote the growth
the linking up of the two have completely changed the of real sector, and enhance the health, stability, profitability, and
production, marketing, and delivery of financial products. And viability of the financial institutions. In theory, they need not
as with every revolution, not all changes have been for the best, necessarily increase the market -orientation of the system, but in
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and there have been unexpected consequences. practice at present, they have come to mean greater market
Diversification orientation. Therefore, liberalisation, deregulation, and reforms
In one sense, diversification means the existence or the mean the same thing currently. They refer to the policy of
development of a very wide variety of financial institutions, reducing or removing completely the legal restrictions, physical
markets, instruments, services, and practices in the financial or administrative or direct controls, ceilings on interest rates,
system. In another but related sense, it refers to the presence of restrictions on the flow of funds, official directives regarding
opportunities for investors to purchase a large mix or portfolio sectoral and other allocations of funds, restrictions on the scope
of varieties of financial instruments. With the diversified of activities of banks and other financial institutions, and so
portfolio, investors can minimise the risk for a given rate of on, which exist under the administered finance. It is obvious
return, or they can maximise the return for a given risk. that liberalisation is the process in which the intervention or
interference of the government in financial markets is reduced
Disintermediation
and the markets are allowed, as far as possible, to function on
It refers to the phenomenon of decline in the share of financial
the basis of free market or competitive principles.
intermediaries in the aggregate financial assets in an economy
because people “switch out of’ their liabilities into direct
securities in the open market. Such a flow of funds out of these
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obligation of the original lender. The payments to the investors
It aims to impart greater transparency and accountability in
are made to the extent of cash flows realised from the
operation, and to restore credibility and confidence in the
underlying assets. What happens is that a number of assets of
financial system. It relates to income recognition, assets
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a given lender having similar characteristics are pooled together,
classification, provisioning for bad and doubtful debts, and
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and undivided interests in this pool are sold in the form of
capital adequacy. The prudential regulation is the policy of the
what are called Pass Through Certificates (PTC). The tenor
State with regard to macro and micro prudential concerns.
(maturity) of the PTC generally matches the average maturity of
1ntegration the pooled assets. The cash flows from the underlying assets are
It refers to the establishment of close connections or effective passed through, after retaining management fees, to the holders
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linkages between different constituents or parts, and between of PTC in the form of periodic (monthly) payments of interest
different sub-parts of the financial system. As a result, there are and principal. The redemption of securities is made only to the
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substantial flows of funds between them, and there is a greater
correspondence between interest rates in different parts of the
financial system. Financial integration is the opposite of the
extend of the cash flows realised from the underlying assets.
The securitisation essentially involves the “collateralised
financing” rather than the “sale of assets”. The ever-increasing
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maturitywise, geographical, institutional, seasonal, instrumental, resource requirements and the desire to maintain high levels of
segmentation or partitioning or compartmentalisation of the disbursements while keeping the overall size of assets within
financial markets. certain limits have led financial institutions to innovate in the
form of securitisation. The deal between ICICI and Citibank to
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of the banking system coupled with real sector reforms, there and real-time credit monitoring. The risk management
has been a gradual transformation of the Indian economy. framework for market risk using internal models is being
The capital markets have demonstrated improved market developed by Indian banks. Use of derivatives for market risk
efficiency and transparency. The institutionalisation of SEBI, management is on the increase. Banks are now moving towards
the incorporation of NSE, the enactment of Depositories Act, the Basel II framework for capital allocation and risk
screen-based trading, entry of FIIs and mutual funds, access to management. Banks are actively considering measures to contain
international capital markets through ADRs, GDRs, FCCBs etc. impact of operational risks to manageable limits.
have all contributed to this transformation. Inspite of the The challenges for the banks in the times to come would be to
Monday mayhem on our bourses following the election results, counter increased competition, meeting the demanding
the following week’s figures indicated that there were net standards of customers, stepping up of income and to move
inflows through the FII route. Our systems for managing towards becoming “one-stop financial hyper-markets”. The key
market volatility in the Stock Exchanges also clicked into place as for this would be in technological advances, going in for risk-
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was evident with the “circuit breakers” for sudden market bundling and rebundling through new financial products,
swings getting into operation. sound risk management architecture and enhancing share-
The money markets have now gradually become a conduit for holder value.
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providing an equilibrating mechanism for evening out short- Our reforms model would dynamically incorporate measures
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term surpluses and deficits in the financial system. Measures are for risk management, adequate capital allocation, sound
being taken to have a pure inter- bank call/ notice money regulatory and supervisory practices. These would provide
market. Collateralised borrowing and lending obligation necessary conditions for a long-term growth path towards our
(CBLO) has been operationalised as a money market country becoming one of the largest economies.
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instrument through the Clearing Corporation of India Ltd.
Summary
(CCIL).
The ultimate goal of the financial system is to accelerate the rate
The G-sec market has seen significant liquidity and depth post-
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1990. The initial reforms of moving to an auction based system
for issuing Government debt, terminating the system of
of economic development. While financial markets may
accelerate development, they themselves, in turn, develop with
economic development. The relationship between economic
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automatic monetisation of fiscal deficit were complementary to development and financial development is thus symbiotic.
interest rate deregulation in the banking sector. Primary Dealers Efficient financial markets are characterised by the absence of
were institutionalized. FIIs were allowed to invest in G- information-based gain, by correct evaluation of assets, by
securities and T-bills in primary and secondary markets subject maximisation of convenience and minimisation of transactions
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to certain ceilings. Other measures included issuance of uniform costs, and by maximisation of marginal efficiency of capital. In
accounting norms for repo and reverse repo transactions, facility reality, the contribution of the financial system to growth is
for anonymous screen-based order-driven trading system for G- highly constrained because it does not work efficiently and
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secs on stock exchanges, introduction of exchange-traded capital is not the most important barrier to growth. The role of
interest rate derivatives on the National Stock Exchange (NSE), finance in development is believed to be secondary by many
relaxation in regulation relating to sale of securities by experts. A framework to evaluate the working of any financial
permitting sale against an existing purchase contract, facilitating sector must include economic, commercial as well as social and
the roll over of repos and switch over to the DVP III mode of ethical criteria. Financial innovations refer to wide-ranging
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settlement. Market Stabilisation Scheme (MSS) has been changes in the financial system. The introduction of new
introduced to differentiate the liquidity absorption of a more financial institutions, markets, instruments, services,
enduring nature by way of sterilisation from the day-to-day technology, organisation, and so on are parts of financial
normal liquidity management operations. innovations. Financial engineering connotes skilful
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Our Forex policies are in line with global best practices. Forex development and use of new financial technology, creative
reserves of over $118 billion are now a buffer for crisis solutions, and tools to cope with financial changes. It involves
prevention, providing confidence to the markets and protection construction, designing, deconstruction of innovative financial
against exchange rate volatility. Substantial delegation of powers instruments, institutions and processes to reduce risk and to
to the banking system in the area of international trade, maximise profits quickly. Financial revolution means that the
remittances, borrowings and investments has helped bring magnitude, speed, and spread of changes in the financial sector
about greater openness and reassured the global market players are simply phenomenal. The markets, which attract funds in
of our inherent strengths. large volume and from all types of investors, are known as
The impact of reforms on the banking industry has been broad financial markets. The markets, which provide
substantial. There has been an increase in operational efficiency opportunities for sufficient orders at fine rates below and above
and profitability. NPA levels are coming down. There is greater the market price, are called deep financial markets. Markets that
use of technology for transaction processing and information are underdeveloped due to governmental regulations and
management using computer and communication devices. Our controls are termed as shallow financial markets. Financial
banks have now a greater awareness of credit risk management. repression exists when the regulatory policies of the
Further progress on this front would have to be taken up by government distort interest rates, discourage saving, reduce
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Questions to Discuss:
1. What do you mean by efficiency? Discuss five concepts are
useful in judging the efficiency of a financial system.
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2. What do you understand by innovations, privatization and
securitisation?
3. Discuss the Indian Financial Markets & Banking System-
Reforms Model for Economic Growth.
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Notes:
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LESSON 5:
THE INDIAN FINANCIAL SYSTEM ON THE EVE OF PLANNING
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and always will hold an important position in our economy. Let of this institution is that it functions with a personal touch that
us understand how? is often lacking in a modern banking system.
Currency and Money Supply Structure and Growth of Modern Banks
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Currency and exchange form an essential part of any financial You know that the growth of the modern banking business in
system. Prior to Independence, the Indian currency had not India was negligible till the beginning of the present century.
been standardised. For about 60 years till 1893, it had remained During the second half of the 18th century, agency houses used
on the silver standard and subsequently on the gold exchange to perform banking business as an adjunct to their main
standard. During this period (with the exception of the war business. The foundation of modern banking was laid during
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years), even though gold could be procured through import the early part of the nineteenth century with the establishment
without any restrictions, the system did not fulfill the other of three Presidency Banks, namely the Bank of Bengal (1806),
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essential requirements of the gold standard. First, gold coins
were not very much in circulation. Second, the currency authority
did not accept the responsibility of selling gold without limit. It
Bank of Bombay (1840), and the Bank of Madras (1846).
During the second half of the 19th century, some exchange
banks and Indian joint stock banks also were set up. In 1900,
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had acquired legally the option of offering gold or sterling there were nine Indian joint-stock banks, eight exchange banks,
against rupees. As sterling was on the gold standard, the rupee and three Presidency Banks. In the total private deposits of Rs
can be said to have been on the gold exchange standard. With 3146 lakh in 1900, the shares of each of these types of banks
the abandonment of the gold standard by England in were respectively 25.68 per cent, 33.38 per cent and 40.94 per
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September 1931, the sterling exchange standard came to be cent. The slow rate of growth of the banking business till the
established in India. beginning of the present century was due to (a) a high rate of
Paper currency has been used in India since the beginning of the failure of banks, because most of them had been created in a
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19th century. Currency notes were issued by the commercial speculative rush; (b) stagnant economic conditions during this
banks and their use was extremely limited. In 1861, the period; (c) a decline in prices; and (d) the passing of the
government acquired the monopoly of issuing notes. An idea Currency Act, 1861 which took away the power of banks to
of the progress of monetisation can be obtained from the issue notes.
volume of notes issued and their circulation. While the volume During the first half of the present century, the banking system
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increased from Rs 11 crore in 1874 to Rs 1199 crore in 1948, the progressed rapidly. The deposits in banks increased from Rs 82
circulation increased from Rs 10 crore to Rs 1188 crore during crore in 1910 to Rs 957 crore in 1948. Except during the
the same period. If we take the total money supply (currency depression of the 1930s, the rate of economic progress was
and demand deposits), it increased from Rs 285 crore in 1935 quite high in this period. The World Wars contributed to raising
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and to Rs 384 crore in 1939, and to Rs 2052 crore in 1945. the level of economic activity and the monetary resources in the
Thereafter, it declined to Rs 1970 crore in 1948, and to Rs 1833 economy. In 1921, the three Presidency Banks were
crore in 1950.3 Thus the major increase in the volume of amalgamated to form the Imperial Bank of India (IBI).
money in India occurred during the Second World War. Although the IBI functioned as a quasi-central bank, the money
Currency constituted a major portion of the money supply. The market was without a proper central bank until 1935 when the
percentage of currency to total money supply increased from Reserve Bank of India (RBI) was established. After the
57.22 per cent in 1935 to 65.61 per cent in 1950 and 66.68 per establishment of the RBI, the IBI used to act as the agent of
cent in 1952. the RBI in places where the RBI did not have any offices of its
Banking Sector own. Similarly, even after 1935, the IBI continued to act as a
The two most important constituents of the money market in banker for other banks (to a very limited extent). It used to
India are the modern banks and the indigenous bankers. discount hundis and grant demand loans against government
Modern banking became an effective force only after 1910. securities. All these functions are now performed by the State
Before that the indigenous bankers dominated the scene. Until Bank of India (SBI), and the special position of SBI in the
1860, they financed trade, acted as bankers to the company banking system today stems from these historical antecedents.
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Table 1 Structure of Commercial Banking in 1950
Category of Banks No. of Banks Deposits
Deposits are the mainstay of any bank. The proportion of
1 All banks 1205
(Rs lakh)
130428
fixed deposits with the banks appears to have declined
(8) (1251) significantly over the period 1921-1950. Before the First World
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2 Commercial banks 605 100217
(8) (1249) War, fixed deposits of the five big banks were as high as 70 per
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3 Indian joint-stock banks 584 82770
(5) (1197) cent or more, of the total deposits. Later there was a decline in
4. Imperial Bank 1
(3)
23164
(1183)
this ratio. It was around 60 to 65 per cent till 1925, 45 percent in
5. (a) Class A 1 banks
(b) Class A2 banks
74
73
52270
4659
1935, and 32 per cent in 1950. The most common maturity
(c) Class B banks
(d) Class C banks
189
123
2176
370
period of fixed deposits then was one year. The major factors
(e) Class D banks 124 131 behind this marked decline in fixed deposits were: (a) inflation
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6. Exchange banks 15 17039
(3) (52) during the war years; (b) competition from post office savings
accounts and life insurance companies; (c) growing opportunity
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Note: Figures in brackets relate to the year 1870.
Source: RBI, Banking and Monetary Statistics in India, Bombay,
and increasing preference for investment in industrial securities;
and (d) decline in interest rates on fixed deposits.
Table 2 presents some important banking ratios over the period
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1954. 1921-1950. It will be observed that generally the credit/deposit
Although the number of commercial banks in 1950 was small, ratio was pretty low. The most popular form of bank credit was
they accounted for 77 per cent of deposits of the entire banking cash credit/ overdraft, followed by loans. The practice of bill
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system. The share of Indian joint-stock banks, and the Imperial financing declined sharply over this period. Except at the end of
Bank in total deposits was 63.46 per cent and 13.06 per cent the Second World War, the call money market was not active.
respectively. During 1910-50, Indian joint stock banks expanded Inactivity of bill and call markets meant that various
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rapidly at the expense of both the IBI and the exchange banks. constituents of the organised money market were very loosely
Within the joint-stock banking sector, scheduled banks linked and virtually functioned in isolation. As a result, the
accounted for 63 per cent of deposits in that sector. Within the money market was characterised by sharp imbalances between
class Al banks, the top 5 to 7 banks’ accounted for the major the supply and demand for funds, both regionally and
portion of deposits. On the basis of the available evidence, the seasonally. The spread of interest rates between regions and
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following conclusions emerge with respect to the banking seasons, therefore, varied sharply. As expected, unless compelled
system in India. (a) There was a high degree of concentration by circumstances, banks did not invest heavily in government
in-the banking business. The top seven6 joint-stock banks and securities. In 1935 and 1945, the ratios of investment in
the ill I accounted for most of the banking business. (b) The government securities were high for different reasons. In 1935,
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degree of concentration increased till 1935 and declined the lack of alternative investment opportunities due to a slack in
thereafter. (c) The smaller banks were responsible for providing business must have led banks to utilise funds for holding
banking facilities in about two-thirds of the places on the government securities. In 1945, the compulsions of war finance
banking map of India. It was these banks that mobilised. must have forced them to invest in government securities. As
savings from sources which the big banks would not tap, and it soon as the war was over, the ratio declined significantly.
was they that catered to the financial needs of such borrowers From the other available information, it would appear that
who would have been shunned by the big banks. Thus, there was a tendency to invest more in short--term government
qualitatively, the services of smaller banks were of much securities (less than five years maturity) than in long-term
importance. (Bank of India, Central Bank of India, Allahabad securities. While the share of the former increased from 21 per
Bank, Punjab National Bank, Bank of Baroda, Bank of Mysore, cent in 1945 to 29 per cent in 1950, that of the latter declined
and Indian Bank of Madras) from 31 per cent to 17 per cent during the same years. The
banks did not invest in industrial securities to any significant
extent. The ratio of their investment in industrial securities to
total investments was around 4 per cent in 1949 and 1950.
Table 2 Some Banking Ratios of the Imperial Bank of India (1921 to 1950) (Percentage)
Ratio 1921 1935 1939 1945 1950
1. Credit/Deposit 60.65 33.67 42.58 26.40 43.09
(50.95)* (55.93) (40.82) (51.22)
2. Loans/total advances 36.22 23.99 25.05 28.50 93.79
3. Cash credits overdrafts/ Total advances 43.70 66.31 63.77 64.42 -
4. Bills discounted and purchased/total
20.07 9.70 11.18 7.00 6.21
advances
(21.89)
5. Total advances/tota1 assets 53.98 21.16 37.25 25.00 39.97
(43.48) (46.28) (34.14) (39.77)
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6. Government Securities/ Total assets 13.05 47.18 44.72 56.02 38.80
(34.33)* (32.19) (43.0) (31.0)
7. Money at call/tota1 advances 0.63 0.56 0.52 8.58 2.98
Notes: (i) Figures in brackets are for Class A1 banks.
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(ii)* Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India, Bombay, 1954.
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Notes
(i) Figures in brackets are for Class A1 banks.
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(ii) Figures are for 1936.
Source: RBI, Banking and Monetary Statistics of India,
Bombay, 1954.
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An important aspect of the growth of commercial banking,
which serves as an indicator of the progress of the banking
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habit, volume of transactions, and the velocity of deposits i.e.,
the number of times each deposit is used to settle transactions
in a given period of time is the volume of cheque clearances. By
1947, there were 29 clearing houses in the country of which
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Learning Objective
After reading this lesson, you will understand Table Growth of Cooperative Banking (1916 to 1950) (Amount in Rs Lakh)
• Evaluation of stock funds 1916 1935 1950 1916 1935 1950 1916 1935 1950 1938 1950
1. Number 6 11 14 239 615 498 14509 76045 116534 202 288
• Evaluation of Government securities
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2. Total Working 77 1163 3045 323 2940 4987 375 2492 3522 411 1273
Capital
Let us evaluate some of the securities in today’s lecture. We shall 3.
Loans and
deposits
56 573 1625 220 1713 2397 40 185 393 375 1159
discuss them in brief here and later on have a detailed held from
individuals
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discussion on each of the banks. 4. Loans due '58 498 1412 288 2040 2892 402 2342 2496 370 1046
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Commercial Banks
Commercial banks provided mainly short-term credit to the
Notes
industrial sector. Further, they provided credits mainly to the
large-scale units. Thus, before 1950 there were two important 1. Data on primary agricultural credit societies separately was
gaps in the field of industrial finance-the lack of supply of not available for the years 1935, but was available for the year
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long-term funds to all industrial units, and the lack of supply 1950. Assuming the ratio in 1950 to be applicable for other
of any form of capital to small-scale industrial units. Attempts years, the figures have been calculated for those years.
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were made to bridge these gaps by setting up certain industrial
banks in the private sector. In 1923, there were about eight
industrial banks, of which four were liquidated by 1935. In the
2. Loans and deposits in case of primary agricultural credit
societies are from both members and non members.
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3. Data on land mortgage banks is for both primary and central
intervening period, other banks came up with the result that land mortgage banks.
there were about seven such banks working in 1936-37. These
Source: RBI, Banking and Monetary Statistics of India,
banks used to accept some deposits from the public. The
Bombay, 1954.
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that persisted till the end of the period under discussion was Presidency Banks or district treasuries, or post offices. The Post
the inadequate supply of short--term as well as long-term Office Savings Banks (POSB) took over the savings bank
funds to the agricultural sector. In order to supplant money business of district treasuries in 1886, and that of Presidency
lenders and indigenous bankers, efforts were being made since Banks in 1896. Thus by 1896, the POSBs had monopolised the
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the second decade of the present century to organise co- small savings business.
operative credit institutions. In the forty years since their
inception, cooperative banks made very little progress in Apart from the POSB deposits, the Postal Department did not
absolute terms; their progress was particularly negligible in offer any other financial asset to the, investors till 1915.
relation to the demand for funds in the agricultural sector. The Subsequently, it offered various certificates of different
setting up of the RBI in 1935 and its efforts to channelise more maturities at different periods of time. The Government also
funds to this sector did help the cooperative movement, but introduced, between April 1941 and April 1947, the Post Office
not to the desired extent. The total working capital, deposits Defence Saving Deposits. Among these assets, deposits
from individuals, and loans due to state, central, and primary remained, during the entire period under discussion, the major
cooperative banks were, in 1950, only Rs 115 crore, Rs 44 crore financial asset issued by small savings organisations. In
and Rs 68 crore, respectively. In the same year Land Mortgage comparison with the period after 1950, the diversity in schemes
Banks (LMBs) had working capital, deposits, and loans of Rs offered was very limited.
13 crore, Rs 12 crore, and Rs 10 crore, respectively. The POSB deposit receipts increased from Rs 366 lakh in 1896
to Rs 9875 lakh in 1950. The outstanding deposits in these two
years were Rs 904 lakh, and Rs 16,866 lakh. The amount of
2,8211akh in 1950. Thus, the total volume of small savings was average amount of capital issues applied for and sanctioned
Rs 17,687 1akh in 1950. The number of small savings banks during 1945 to 1952, was Rs 193 crore and Rs 141 crore
had increased from 6,343 to 9,256 between 1896 and 1950. respectively. Understandably, there were marked ups and downs
in the new issue activity. The three years following each of. the
Insurance Funds
two World Wars were characterised by an unusually high
The life insurance business in India began on sound lines with
amount of capital issues. The annual average amount of capital
the enactment of the Indian Life Insurance Companies Act,
issues was Rs 183 crore during 1918 to 1920; while during 1945-
1912. It was carried on by Indian and foreign life insurance
47 this figure was Rs 255 crore. In both cases, the boom was
companies, provident societies, and the Post and Telegraph
followed by a steep fall in capital issues in the subsequent 4-5
department. In addition, certain provinces transacted insurance
years. As expected, during the depression years, there was a
business for their own employees. Indian and foreign
marked slack in the new issue activity.
companies conducted general insurance business also for
emergencies such as fire, marine and miscellaneous. A major proportion of capital was raised by the issuance of
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ordinary shares. In contrast with the period after 1960,
Over time, the volume of general insurance business declined
debentures were not very popular in India during the period
relatively to that of life insurance. As far as the business of life
before 1950. It has been pointed out by Muranjan that the
insurance is concerned, the foreign companies’ share in it
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unpopularity of debentures was due to the following reasons-
declined significantly, and Indian companies’ share increased. Of
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unfamiliarity of the general public with this form of
the total premium of all life insurance companies, the latter’s
investment, the preference of rich classes for speculative scrips,
share was 50 per cent in 1928 and 83 per cent in 1950. The
heavy stamp duties on purchases and transfers of debentures,
volume of business of provident societies, and of the Post and
and the avoidance of debentures by insurance and other
Telegraph department has always been negligible.
financial institutions with large investible resources.
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The size and growth of the insurance business in India is
The security prices also reflect the tenor of the working of stock
shown in Table below.
markets. The available data on index numbers of security prices
Category
1. Life insurance business in force
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Table Insurance Funds in India in 1928, 1948 and 1950 (Rs lakh)
1928 1948 1950
for the period 1927 to 1949 help us to draw some important
conclusions. First, unlike the later period, prices of government
securities and fixed-yield industrial securities showed marked
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(a) Number of companies 70 275 244
(b) Sum insured 13502 73505 82545
(c) Premium Income 670 3607 4150 fluctuations. The index number of government security prices
2. Non-Life Insurance
(a) Number of companies 128 157 174 varied in the range of 82 to123. It should, however, be noted
(b) Premium income 354 1507 1663
that these fluctuations occurred before the establishment of the
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1933. There was a boom between 1934 and 1946 (except 1938
sector industrial units and the government increased
and 1939); prices again declined substantially during 1947-49.
significantly during the first half of the 20th century. The
The ordinary share prices reached their nadir in 1932 (index was
increased pace of industrialisation during this period which was
64.4), and their zenith in 1946 (index was 264.9).
caused by the two World Wars, protection to domestic
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1947. By the 1940s, the gilt-edged market had become fairly Year Private Small saving Total capital of Paid-up. Premium. Gross issues State
deposits of deposits and all co-op capital of income of of Provident
wide and active. Banks, life insurance companies, princes and all banks certificates
(outstanding)
societies. joint-stock Insurance Government Fund
cos cos securities
princely state governments, and private trusts, took an interest
in this market. Securities of different maturities were being 1890 25 6 -- 24 0.11 2.0 0.49
1900 31 10 -- 36 0.52 - 1.37
issued, and innovative steps like giving attractive names to these 1910 82 16 3 63 2.0 2.50 3.59
1920 220 27 36 164 8.0 21.35 19.71
issues were undertaken to make them popular. During the 1930 221 75 91 282 25.0 37.25 58.24
1939 261 135 109 290 - 28.42 72.46
Second World War, to ensure their sale, many issues were made 1941 364 95 112 302 59.0 147.36 75.03
1943 719 118 132 339 - 146.53 83.96
on a tap basis rather than by prescribing a specific subscription 1945 109 221 146 389 - 221.79 93.02
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period. The foundation of the policy of maintaining stability in 1947
1948
799
957
268
247
164
--
479
570
47.7
47.5
382.37
-
97.55
79.36
the gilt-edged market was laid down during the Second World
War when a large amount of funds was needed by the
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government. In subsequent years, although the reasons for a Note: If there is any discrepancy in figures in this Table and
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large amount of funds changed, the policy of maintaining figures quoted earlier on any item, it is not an error, it may be
stability continued. The setting up of the RBI in 1935 facilitated due to differences in sources, definition of item and coverage,
the pursuit of such a policy. Earlier the IBI used to buy and sell etc. Figures for 1947 and later are for the Indian Union. Source:
securities depending on the position of its own resources. It Muranjan, S.K., op. cit., p. 32; and RBI, Banking and Monetary
rarely operated in the market out of consideration for market Statistics of India, Bombay, 1954.
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stability.
Interest Rates
Treasury bills (TBs) were first issued in India in October 1917. A detailed study or the level and structure or interest rates
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Originally, these bills were of different maturities-of three, six,
nine, and twelve months. On a few occasions, bills of maturity
of four and eight months were also issued. On several
before 1950 is too big a topic to be attempted here. We would
like to point out here only three important features or the
interest rates during this period.
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occasions, joint issues of more than one maturity were also
First, the interest rates on the same type or deposits and
made. Since 1933-34, only bills of three months’ duration have
advances differed for different banks. While the IBI did not pay
been in vogue. Treasury bills used to be sold by tender and on
any interest on current deposits, exchange banks and Indian
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tap; the latter method was adopted generally for the purpose of
joint-stock banks offered interest on them. The average rate of
provincial governments, semi--government institutions, and
interest on current deposits by one or the leading commercial
some foreign holders. During the pre-war years, these bills were
banks in India was 2.56 per cent in 1921, 1.29 per cent in 1935
often issued to induce an inflow of foreign funds. During the
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and 0.26 per cent in 1943. Similarly, the interest rates on fixed
war years, the consideration changed to one of providing liquid
and savings deposits varied from one type of bank to another.
assets to the banks. Although the RBI offered the facility of
On advances also, these rates varied a great deal. In short, from
discounting TBs to banks, they did not have a wide appeal
the point or view or interest rates, the banking system was not
among banks and other institutions. The IBI was the main
homogeneous. This aspect of interest rates has certainly
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started during this period. The amount of TBs sold by tender also quite high in the Indus and Gangetic plains. In Mumbai,
was Rs 87 crore in 1919 and Rs 85 crore in 1948. There was a Ahmedabad, and Kolkata, which were the areas or
substantial decline in this amount in the intervening years (Rs manufacturing, finance, and business, the rates were relatively
51 crore in 1947, for instance). low. Such geographical differentials in the interest rates were
dependent on such factors as: (a) the degree or closeness or links
between the Central Bank and the concerned locality; (b) the size
of capital supply in general, and deposits in particular, in the
locality; (c) whether funds can be attracted and transferred to
different places; (d) whether the major activity in the area is
agriculture, manufacturing or commerce. With the progress
towards integration in the banking system, growth of branch
banking, increase in the spread of offices of the RBI,
improvement in remittance facilities, growth in transport and
communication and the resultant facilities for the quick transfer
of funds, geographical differentials in the interest rates have
completely disappeared.
Third, the level of interest rates even in the organised sector
during the major part of this period was quite high. This needs
to be emphasised because during the planning period, a case has
been made in certain circles for a cheap money policy on the plea
that, historically, borrowers and lenders in India have been used
to a low cost of finance. A plea such as this is based on the
experience of a very brief period in the economic history of
India. The yield of 3.5 per cent government securities ruled
between 4 to 7 per cent during 1870--1949 except for the
periods, 1891-1915, and 1936-1949 when it varied between 3 to
4 per cent. The average interest rate charged by banks for lending
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was 6 to 7 per cent during this period except for 1932-1949. The
rate of interest of the Bank of Bombay varied between 6.2 to
9.8 per cent during 1890 to 1899. Further, in the first decade of
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the 19th century, agency houses charged 10 to 12 per cent on
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their loans. Around the same time, investments in
governments fetched the high yield of 8 to 9 per cent, and
commercial bills were discounted at a rate between 6 and 12 per
cent. Similarly, even in the slack season, commercial banks
charged 10 to 11 per cent against wheat pits in the 1920s. On
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current deposits, the Central Bank of India paid an interest rate
between 2 and 2.5 per cent till 1931. It is only after 1933 that
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interest rates declined steeply; they have been maintained at a
low level since the beginning of the planning period.
Summary
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On the whole, the Indian Financial system was fairly developed
even on the eve of planning. Though banking business was
concentrated in the hands of few large banks, yet the services of
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industry.
Questions to Discuss:
1. Evaluate the banking system.
2. Evaluate the insurance Funds.
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Notes:
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Learning Objective these, the RBI and SEBI have special role and responsibility. We
After reading this lesson, you will understand shall first discuss the functioning of the RBI followed by the
SEBI.
• Organisation and management of RBI
• Function and Roles of RBI What is the Organisation and Management of RBI
The Reserve Bank of India was established on April 1,1935,
• Treasury Bills
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under the Reserve Bank of India Act, 1934. The main functions
Today we shall discuss one of the most important aspects of of the Bank are to act as the note-issuing authority. Banker’s
Financial Institution in India. Bank, Banker to the government and to promote the growth
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Introduction of the economy within the framework of the general economic
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A study of financial institutions in India can appropriately policy of the government, consistent with the need to maintain
begin with a brief discussion of the regulatory framework of price stability. The Bank also performs a wide range of
the country. Since the financial markets are characterised by promotional functions to support the pace of economic
various degrees of imperfections, the need for regulation- development. The Reserve Bank is the controller of foreign
prudential or otherwise-even in a liberalised framework cannot exchange. It is the watchdog of the entire financial system. The
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be denied. The financial system deals in other people’s money Bank is the sponsor bank of a wide variety of top-ranking
and, therefore, their confidence, trust and faith in it is crucially banks and institutions such as SBI, IDBI, NABARD and NHB.
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important for its smooth functioning. Financial regulation is
necessary to generate, maintain and promote this trust. One
reason why the public trust may be lost is that some of the
The Bank sits on the board of all banks and it counsels the
Central and State Government and all public sector institutions
on monetary and money matters. No central bank, even in the
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savers or investors or intermediaries may imprudently take too developed world, is saddled with such onerous responsibilities
much risk, which could engender defaults, bankruptcies, and and functions.
insolvencies. Thus a regulation is needed to check imprudence The RBI, as the central bank of the country, is the centre of the
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in the system. Indian Financial and Monetary System. As the apex institution,
The task of efficient regulation is rendered difficult by the very it has been guiding, monitoring, regulating, controlling, and
nature of financial assets, which are mobile, easily transferable or promoting the destiny of the IFS since its inception. It is quite
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negotiable; and also by the nature of financial markets which are young compared with such central banks as the Bank of
prone to a systemic risk. The modern trading technology and England, Riksbank of Sweden, and the Federal Reserve Board
the possibility of high leveraging enable market participants to of the US. However, it is perhaps the oldest among the central
take large stakes, which are disproportionate with their own banks in the developing countries. It started functioning from
investments. There are also frequent instances of dishonest, April1, 1935 on the terms of the Reserve Bank of India Act,
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unfair, fraudulent, and unethical practices or activities of the 1934. It was a private shareholders’ institution till January 1949,
market intermediaries or agencies such as brokers, merchant after which it became a state-owned institution under the
bankers, custodians, trustees, etc. The regulation becomes Reserve Bank (Transfer to Public Ownership) of India Act,
necessary to ensure that the investors are protected; that 1948. This act empowers the central government, in
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disclosure and access to information are adequate, timely, and consultation with the Governor of the Bank, to issue such
equal; that the participants measure up to the rules of the directions to it, as they might consider necessary in the public
market place; and that the markets are both fair and efficient. In interest. Further, the Governor and all the Deputy Governors
this context, it is said that fairness and efficiency are two sides of of the Bank are appointed by the Central Government.
the same coin; if the market is unfair, in the end, it is also The Bank is managed by a Central Board of Directors, four
inefficient. Local Boards of Directors, and a committee of the Central
The regulatory framework or apparatus for the financial sector in Board of Directors. The functions of the Local Boards are to
India broadly consists of the Ministry of Finance of the advise the Central Board on matters referred to them; they are
Government of India which administers the Companies Act, also required to perform duties as are delegated to them. The
1956, and the Securities Contracts (Regulation) Act, 1956; the final control of the Bank vests in the Central Board, which
Reserve Bank of India and the Board of Financial Supervision comprises the Governor, four Deputy Governors, and fifteen
(BFS) under its aegis; the Securities and Exchange Board of Directors nominated by the central government. The committee
India (SEBI), Insurance Regulatory Authority; the Governing of the Central Board consists of the Governor, the Deputy
Boards of various stock exchanges and the apex financial Governors, and such other Directors as may be present at a
institutions such as the IDBI, SIDBI, NHB and NCB. Among given meeting. The internal organisational set-up of the Bank
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the British model depends on an active securities market where companies and accretions to provident funds) and the
open market operations can be conducted at the discount rate. absorptive capacity of the market.
The effectiveness of open market operations however depends
In India, banks, insurance companies and provident funds are
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on the member banks’ dependence on the central bank and the
statutorily required to invest a portion of their liabilities,
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influence it wields on interest rates. Later models, especially
premium income or accretions, as the case may be, in
those in developing countries showed that central banks play an
Government and other approved securities, which ensures a
advisory role and render technical services in the field of foreign
captive market for these securities, facilitating the easy
exchange, foster the growth of a sound financial system and act
absorption of new issues. The Bank tries to ensure that over a
as a banker to government.
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reasonably long period it will be neither a net purchaser of
What are the Functions and Roles of RBI securities from the market nor a net seller so that the loans
raised are absorbed by the market outside the Bank to the
Functions of the Bank
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The RBI functions within the framework of a mixed economic
system. With regard to framing various policies, it is necessary
maximum extent.
The Bank actively operates in the gilt-edged market to ensure
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to maintain close and continuous collaboration between the the success of Government loan operations. For instance, the
government and the RBI. In the event of a difference of Bank grooms the market by acquiring securities nearing maturity
opinion or conflict, the government view or position can always to facilitate redemption. If maturing stocks are held by
be expected to prevail. investors to the last, conditions in the money market are likely
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The Preamble of the RBI Act, 1934 states that “Whereas it is to be disturbed as most of the cash paid out seeks avenues of
expedient to constitute a Reserve Bank for India to regulate the reinvestment, but, in practice, all the investors are not equally
issue of bank notes and the keeping of reserves with a view to eager to wait for cash repayment on the redemption date and
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securing monetary stability in (India) and generally to operate then undertake reinvestment, as they can reinvest the proceeds
the currency and credit system of the country to its advantage”. at times of their own choosing if these were realized earlier, the
To elaborate, the main functions of the RBI are: Bank, therefore, stands ready as the stock approaches maturity
to buy all the stocks offered for sale at these terms. Thus, in
• To maintain monetary stability so that the business and
carrying out the loan operations of the Government the Bank
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economic life can deliver welfare gains of a properly endeavours on the one hand to minimize the effects of such
functioning mixed economy. operations on the money market and Government securities
• To maintain financial stability and ensure sound financial market, and on the other to obtain the best possible terms for
institution so that monetary stability can be safely pursued the Government concerned. The close involvement in the
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and economic units can conduct their business with market by its continuous presence and the willingness to deal in
confidence. the securities at process determined by it give the Bank a good
• To maintain stable payments system so that financial degree of flexibility when it is seeking occasions for
transactions can be safely and efficiently executed. implementing a shift in policy on prices.
• To promote the development of financial infrastructure of The timing of the issue of new loans is normally left to the
markets and systems, and to enable it to operate efficiently Reserve Bank. The Central Government and the state
i.e., to play a leading role in developing a sound financial Governments float market loans separately, but through the
system so that it can discharge its regulatory function Reserve Bank. For the management of the public debt of the
efficiently. Government, the Bank charges a commission. In addition, the
• To ensure that credit allocation by the financial system
Reserve Bank also charges for all new issues both by Central and
broadly reflects the national economic priorities and societal State Government loans, besides recovering brokerage and
concerns. expenses incurred by the Bank on account of printing of loan
notifications, telegrams, advertisements, etc.
You must be well aware that Treasury Bills are the main
instrument of short-term borrowing by the Government, and
serve as a convenient gilt-edged security for the money market.
The qualities of high liquidity, absence of risk of default, and
negligible capital depreciation in case of sale before maturity
make them an ideal form of short-term investment for banks
and other financial institutions.
In certain countries, unlike in India, Treasury Bills are an
important tool for the central bank for influencing the level of
liquidity in the money market through open market operations.
Sale of Treasury Bills helps to absorb any excess liquidity in the
money market and, conversely, their purchase by the central
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bank has the effect of relieving stringency. Since neither the
Government nor the money market wishes to hold surplus
cash, the central bank steps in and restores the equilibrium by
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selling to or purchasing from the money market Treasury Bills
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(and similar other securities) accordingly as the Government
payments are larger than its receipts or vice versa. In this way, the
Government is able to borrow cheaply to meet its immediate
needs and to use its temporary surplus to by back before
maturity some of its outstanding debt.
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The Reserve Bank, as the agent of the Government, issues
Treasury Bills at a ‘discount’. These are negotiable securities and
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can be rediscounted with the Bank at any time before maturity
upon terms and conditions determined by it from time to time.
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Questions to Discuss:
1. Discuss the Organisation and Management of RBI.
2. What are the Functions of RBI?
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Learning Objective The fiscal operations of the Government exercise a direct and
After reading this lesson, you will understand significant impact on the monetary and credit system, which the
Bank is required to regulate. It follows that monetary and credit
• The Reserve Bank as Banker and advisor to Government
policies can be implemented more effectively if there is
• Authorities invested with RBI coordination between them and the economic policies of the
• Autonomy for Central Bank Government. Hence, the Bank takes an active interest in the
In today’s lesson, we shall discuss the management the advisory formulation of fiscal and other policies of the Government and
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and promotional aspects of RBI, Treasury Bills, and finally the tenders advice calculated to promoter the attainment of the
autonomy of the Central Bank. national economic goals.
Daily operations in the gilt-edged and foreign exchange markets
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The Reserve Bank as Banker to Government
and close contacts with the commercial banks and other financial
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You have been studying since childhood that The Reserve Bank
is the Central Bank of India. It is the banker to the Central institutions and with the business world in general have
Government statutorily and to the State Governments by virtue equipped the Reserve Bank with the technical knowledge of,
of agreements entered into with them. The Bank provides a full and practical experience in, these spheres which contribute
range of banking services for these Governments such as greatly to the Bank’s competence to give financial advice to
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acceptance of moneys on deposit, withdrawal of funds by Government. Like all central banks, the Bank acts as adviser to
cheques, receipt and collection of payments to Government and the Government not only on policies concerning banking and
financial matters but also on a wide range of economic issues
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transfer of funds by various means throughout India. The
Governments’ main accounts are held in the Bank. A large
number of branches of agency banks, sub-agency banks and
including those in the field of planning and resource
mobilisation. It has of course a special responsibility in respect
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Treasury agencies also undertake Government business because of policies and measures concerning new loans, agricultural
the Bank has branches/offices mainly in the State capitals and a finance, co-operative organisaton, industrial finance and
few big cities in the country. The Government revenue collected legislation affecting banking and credit.
through the agency banks is remitted to the Government The Bank’s advice is sought on certain aspects of formulation
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revenue collected through the agency banks are remitted to the of the country’s Five Year Plans, such as the financial pattern,
Government accounts at the Bank in due course. mobilisation of resources and institutional arrangements with
regard to banking and credit matters. As the agency for
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means advances” (i.e., temporary advances made in order to 20, 50, 100, 500 and 1000. The responsibility of the Bank is not
bridge the temporary gap between receipts and payments) to only to put currency into or withdraw it from circulation but
both the central and state governments. The maximum also to exchange notes and coins of one denomination into
maturity period of these advances is- three months. However, those of other denominations as demanded by the public. All
in practice, the gap between receipts and payments in respect of affairs of the Bank relating to note issue are conducted through
the central government used to be met by the issue of ad hoc its Issue Department. In order to discharge its currency
treasury bills, while the one in respect of the state governments functions, the Bank has 15 full-fledged issue offices and 2 sub-
is met by the ways and means advances. The arrangements in offices, and 4127 currency chests in which the stock of new and
this regard have been changed in the recent past. The ways and re-issuable notes, and rupee coins are stored. Of these, 17 chests
means advances to the state governments are subject to some were with the RBI, 2877 with the SBI and associate banks, 791
limits. These advances are of the following types: (a) normal or with nationalised banks, 423 with treasuries, and 19 with private
clean advances i.e., advances without any collateral security; (b) sector banks (these numbers are not fixed and can be varied as
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secured advances, i.e., those which are secured against the pledge per the requirement).
of central government securities; and (c) special advances, i.e., The Bank can issue notes against the security of gold coins and
those granted by the Bank at its discretion. The interest rate gold bullion, foreign securities, rupee coins, Government of
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charged by the Bank on these advances did not, till May 1976, India securities, and such bills of exchange and promissory
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exceed the Bank rate. Thereafter, the Bank has been operating a notes as are eligible for purchase by the Bank. The RBI notes
graduated scale of interest based on the duration of the have a cent per cent backing or cover in these approved assets.
advance. Earlier i.e., till 1956, not less than 40% of these assets were to
Apart from the ways and means advances, the state consist of gold coin and bullion and sterling/foreign securities.
governments have made heavy use of overdrafts from the RBI. In other words, the proportional reserve system of note issue
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An overdraft refers to drawals of credit by the state existed in India till 1956. Thereafter, this system was abandoned
governments from the RBI in excess of the credit (ways and and a minimum value of gold coin and bullion and foreign
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means advances) limits granted by the RBI. In other words,
overdrafts are unauthorised ways and means advances drawn by
the state governments on the RBI. The management of the
securities as a part of total approved assets came to be adopted
as a cover for note issue.
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Supervising Authority
states’ overdrafts has gradually become one of the major
The RBI has vast powers to supervise and control commercial
responsibilities of the RBI on account of the persistence of
and co-operative banks with a view to developing an adequate
large proportions of those overdrafts.
and sound banking system in the country. It has, in this field,
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The issue, management and administration of the public the following powers: (a) to issue licenses for the establishment
(central and state governments) debt are among the major of new banks; (b) to issue licenses for the setting up of bank
functions of the RBI as the banker to the government. The branches; (c) to prescribe minimum requirements regarding
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Bank charges a commission from the governments for paid-up capital and reserves, transfer to reserve fund, and
rendering this service. maintenance of cash reserves and other liquid assets; (d) to
inspect the working of banks in India as well as abroad in
respect of their organisational set-up, branch expansion,
mobilisation of deposits, investments, and credit portfolio
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One of the essential functions of the RBI is to maintain the market, and as the stabilizer of that market and the rupee
stability of the external value of the rupee. It pursues this exchange rate has become all the more important with the
objective through its domestic policies and the regulation of the introduction of the floating exchange rate system and the rupee
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foreign exchange market. As far as the external sector is convertibility on trade, current and capital accounts (the last one
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concerned, the task of the RBI has the following dimensions: to take place in the near future). In the recent past, it has
(a) to administer the Foreign Exchange Control; (b) to choose intervened significantly to achieve exchange rate stability
the exchange rate system and fix or manage the exchange rate
Promoter of the Financial System
between the rupee and other currencies; (c) to manage exchange
Apart from performing the functions already mentioned, the
reserves; and (d) to interact or negotiate with the monetary
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RBI has been rendering ‘developmental’ or ‘promotional’
authorities of the Sterling Area, Asian Clearing Union, and
services, which have strengthened the country’s banking and
other countries, and with international financial institutions
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such as the IMF, World Bank, and Asian Development Bank.
The RBI administers the Exchange Control in terms of the
financial structure. This has helped in mobilising savings and
directing credit flows to desired channels, thereby helping to
achieve the objective of economic development with social
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Foreign Exchange Regulation Act (FERA), 1947 which has been justice. It has helped in deepening and widening the financial
replaced by a more comprehensive Foreign Exchange system. As a part of its promotional role, the Bank has been
Regulation Act, 1973. The FERA is now replaced by the pre-empting credit for certain sectors at concessional rates.
Foreign Exchange Management Act (FEMA), which is
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In the money market, the RBI has continuously worked for the
consistent with full capital account convertibility and the
integration of its unorganised and organised sectors by trying
objective of progressively liberalising capital account
to bring indigenous bankers into the mainstream of the
transactions. The objective of exchange control is primarily to
banking business. In order to improve the quality of finance
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regulate the demand for foreign exchange within the limits set
provided by the money market, it introduced two Bill Market
by the available supply. This is sought to be achieved by
Schemes, one in 1952, and the other in 1970. With a view to
conserving foreign exchange, by using it in accordance with the
increasing the strength and viability of the banking system, it
plan priorities, and by controlling flows of foreign capital. In
carried out a program of amalgamations and mergers of weak
India, during most of the years since 1957, foreign exchange
banks with the strong ones. When the social control of banks
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earnings have been far less than the demand for foreign
was introduced in 1968, it was the responsibility of the RBI to
exchange, with the result that the latter had to be rationed in
administer it in the country for achieving the desired objectives.
order to maintain exchange stability. This is done through
After the nationalisation of banks, the RBI’s responsibility to
exchange control, which is imposed both on receipts and
develop banking system on the desired lines increased. It has
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Rural Credit Survey. And that was followed by studies of the financial systems. It plays an important role in building up and
All-India Rural Credit Review Committee in 1968, the maintaining confidence in the underlying stability of the IFS. In
Committee to Review Arrangements for Institutional Credit for short, the RBI helps to create and maintain a stable, efficient,
Agriculture and Rural Development in 1978, and the and well-functioning financial system in India.
Agricultural Credit Review Committee in 1986.
Autonomy for Central Bank
As a part of its efforts to increase the supply of agricultural Autonomy for Central Bank is a crucial issue. The Reserve Bank
credit, the Bank has been working to strengthen co-operative of India Act does not assure autonomy to the bank. It is true
banking structure through the provision of finance, that the Central Bank can only be independent within the
supervision, and inspection. It provides to co-operative banks government but not from the government. In US there are
(through state co-operative banks), short-term finance at a adequate safeguards to ensure that the Federal Reserve is not
concessional rate for seasonal agricultural operations and compelled to act against its own judgement. In India there have
marketing of crops. It subscribes to the debentures of Land been historic accords limiting this access of government to RBI
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Development Banks. It operates the National Agricultural but they are breached in practice, RBI should not be involved in
Credit (long-term operations) Fund, and the National underwriting government securities. It acts as a principal and as
Agricultural Credit (Stabilisation) Funds through which it an agent in the securities market. The dual role of RBI as an
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provides long-term and medium-term finance to co-operative issuer and regulator of debt gives rise to conflict of policies of
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institutions. It established the Agricultural Refinance debt management and monetary policy. The advisory group on
Cooperation (now known as NABARD) in July 1963 for monetary and financial policies headed by M. Narsimham
providing medium-term and long -term finance for agriculture. suggested (September, 2000) the separation of debt
It also helped in establishing an Agricultural Finance management and monetary policy functions and the setting up
Corporation. of an independent debt management office by the
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The role of the Bank in diversifying the institutional structure Government.
for providing industrial finance has been equally important. All Further the fiscal profligacy of the government is abetted by the
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the Special Development Institutions at the central and state
levels and many other financial institutions mentioned earlier
were either created by the Bank on its own or it advised and
system of pre-emption of large portion on net accrual of banks
deposits through the prescription of statutory liquidity ratio.
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The Indian banking system was operating for a long time with
rendered help in setting up these institutions. The UTI, for a high level of reserve requirements in the form of Statutory
example, was originally an associate institution of the RBI. A Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). SLR and
number of institutions providing financial and other services CRR keeps in changing form time to time as the need be. As of
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such as guarantees, technical consultancy, and so on have come date the SLR is 25% and CRR is 4-4.5%. Reduction in statutory
into being on account of the efforts of the RBI. pre-emption is constrained as long as fiscal deficit remains high.
Through these institutions, the RBI has been providing short- The Report of the Committee on the Financial System, 1991
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term and long-term funds to the agricultural and rural sectors, has pointed out that SLR should not be used to mobilise
to small-scale industries, to medium and large industries, and resources for financing budgetary deficits but as a prudential
to the export sector. It has helped to develop guarantee services measure. It has also stated that CRR should be used for
in respect of loans to agriculture, small industry, exports and pursuing monetary policy objectives.
sick units. It also co-ordinates the efforts of banks, financial In the context of globalisation of the financial system Reserve
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institutions and government agencies to rehabilitate sick units. Bank needs autonomy to define benchmarks or anchors such as
The Bank has evolved and put into practice the consortium, co- inflation and money supply to guide policy and use its
operative, and participatory approach to lending among banks judgement to assess the impact of the ever changing financial
and other financial institutions. By developing the practice of environment on the design and implementation of policy.
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inter-institutional participation, of expertise pooling, and of Reform of the banning system is not complete unless it
geographical presence, it has helped to upgrade credit delivery includes the Central Bank. The emphasis on market as a source
and service capability of the financial system. By issuing of financial discipline required an autonomous Central Bank,
appropriate guidelines, in 1977, regarding the transfer of loans which can strike right balance with the operation of market
accounts by borrowers, it has evolved a mutually acceptable forces. The responses would be quick and effective only if the
system of lending, so that the banking business grows in a Central Bank is autonomous.
healthy manner and without cut-throat competition. Central banks, which mandated to pursue monetary and
To preserve and enhance the stability of the banking and financial stability should enjoy autonomy in the execution of
financial system is an important part of the “promotional” role policy and be accountable for the achievement of the objective.
of the RBI. In fact, financial stability has now assumed relatively There is consensus that the monetary authority’s primary
greater importance as one of the tasks of the RBI. This is objective should be price stability, that the central bank should
evident in its work to formulate prudential norms for banks have sufficient independence to vary its operational instrument
and financial institutions, its intervention in the foreign and its main instrument is its control over short-term interest
exchange market, and its participation in the operation of rates. The profound transformation of the financial
“safety nets” i.e., the legal and organisational structure for environment had a major effect both on the relationship
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• Designing regulatory constraints such as capital standards so
as to make them less vulnerable to financial arbitrage
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• Limiting the impact of those forms of intervention that
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provide perfection without commensurate over sight which
reduce the incentive to prudent behavior
Central bank’s incentive for stability requires supporting policies
in terms of sustainable fiscal positions and greater flexibility in
labour market. Further the effectiveness of market forces
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depends on fostering ownership structures through
privatisation, which are more responsive to market, and
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removing obstacles to the adjustment of capital and labour.
The systemic orientation has to be sharpened by upgrading
payment and settlement systems to contain the knock on effects
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of failures of institutions. A right balance between the market
and the central bank as a source of financial discipline has to be
struck.
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Summary
Regulation of the financial system and its various component
sectors occurs in almost all countries. A useful way to organise
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LESSON 10:
MONETARY POLICY OF RBI
Learning Objectives of banking, and the filling in of gaps in the financial structure
After reading this lesson, you will understand become necessary.
• Monetary policy of RBI Objectives of Monetary Policy
• Objectives of monetary policy In the present day, it is generally accepted that the main objective
of monetary policy is the promotion of economic growth with
• Scope of monetary and fiscal policies
price stability, to elaborate, monetary policy has to be directed
• Monetary management towards attaining a high rate of growth, while maintaining
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• Banks and credit creation reasonable stability of the internal purchasing power of money.
• Instruments of monetary control The central bank attempts to ensure an adequate level of
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liquidity to support the rate of economic growth envisaged and
• Money supply
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to assist in the fullest possible utilization of resources without
After the overview of the whole financial institutions let us generating inflationary pressures. However, it is difficult to say
now get to the functioning of the financial system. with any degree of precision as to what is adequate under a
Monetary Policy of RBI given situation. But, as a working rule, the rate of increase in
You must know that the monetary policy is regarded as an money supply has to be somewhat higher than the projected
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indispensable tool of economic management. Monetary policy rate of growth of real national income to meet the demand for
refers to the use of official instruments under the control of the money likely to arise as income grows and correspondingly the
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central bank to regulate the availability, cost and use of money
and credit with the aim of achieving optimum levels of output
and employment, price stability, balance of payments
savings component, after taking into account the degree of
monetisation in the economy, an excessive growth in liquidity
relative to the requirements of real output would result in the
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equilibrium or any other goals set by the State, an appropriate build-up of inflationary pressures.
monetary policy by adjusting money supply to the needs of A central bank has necessarily to function within the ambit of
growth, directing the flow of funds in keeping with the overall the current economic milieu of the country. If the dominant
economic priorities, and providing institutional facilities for
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affecting the reserves position of commercial banks. mobilization of the savings of the community, and promotion
The efficacy of monetary policy depends on the prevailing of capital formation and, above all, extend support to the
economic situation and structural factors like the proportion of authorities in the task of allocation of resources by assisting in
currency in money supply, size of public debt, non-monetised the maintenance of an appropriate structure of relative prices.
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sector in the economy and presence of active sub-markets. Scope of Monetary and Fiscal Policies
Again, the manner in which monetary policy is operated hinges Monetary policy is but one aspect of the broader economic
on the particular needs of the situation, such as the degree of policy of a country, the other important component being fiscal
imbalance in the overall supply-demand situation, trends in policy. Both monetary and fiscal policies have repercussions on
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agricultural and industrial production and the general price level, the whole economy, affecting the price level, level of economic
and the balance of payments situation. Since these conditions activity, employment and balance of payments. While monetary
are constantly changing, the authorities have to adapt to the policy influences economic trends through the cost and
circumstances the choice and mix of various techniques, putting availability of credit, fiscal policy is a more important
emphasis as required on controlling the sources of money determinant of aggregate demand in as much as it directly
supply or interest rates policy. affects the financial resources and purchasing power in the
Monetary policy also encompasses institutional changes in the hands of the public.
banking and credit structure. While the level of savings is In the developing countries the central banks have been called
basically a function of the level of income, the absence or upon to play a positive and energetic role in administering
underdeveloped state of financial institutions inhibits the monetary policy to achieve the desired economic goals. In these
effective mobilization of savings for purposes of development, countries, fiscal policy is necessarily expansionary which means
the institutionalization of savings provides the potential saver that the central bank has to provide large funds to the
with a choice of financial assets with varying degrees of safety, Government in the form of loans and advances for purposes
liquidity and yield, in this context, wider geographical and of economic growth. Resort to central bank credit for meeting
functional coverage of institutional credit facilities, especially that budgetary deficits results in an expansion of money supply and
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Therefore, the monetary and fiscal policies need to be properly
coordinated to be really effective.
Monetary Management
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In recent years, the objective of monetary policy in India has
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been twofold. It has to facilitate the flow of an adequate
volume of bank credit to industry, agriculture and trade to meet
their genuine needs and provide selective encouragement to
sectors which stand in need of special assistance such as the
weaker sections of the community and the neglected sectors and
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areas in the country. Al the same time, to keep inflationary
pressures under check it has to restrain under credit expansion
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and also ensure that credit is not diverted for undesirable
purposes. As the central monetary authority, the Reserves
Bank’s chief function is to ensure the availability of credit to the
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extent that is appropriate to sustain the tempo of development Banks and Credit Creation
and promote the maintenance of internal price stability. Deposits with banks may originate in two ways- through either
‘passive’ creation or ‘active’ creation. The former occurs when
The focus of monetary policy had to be adjusted from time to
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Instruments of Monetary Control extends credit, either the whole of it or a part, depending upon
One of the most important functions of a central bank is the extent of banking habit would eventually find its way to the
monetary management-regulation of the quantity of money deposit stream, either with itself or with other banking
and the supply and availability of credit for industry, business institutions. Under the fractional reserve system, banks can
and trade. The monetary or credit management activities of the create deposits by a multiple of the reserves since the payments
bank are two types: general monetary and credit management made with the proceeds of bank loans are eventually
functions- total supply of money and credit and the general redeposited with banks leading to additional reserve funds.
level of interest rates. The central bank relies on two types of
Even in the countries with a widespread banking habit, there is
instruments, the direct and the indirect, the direct instruments
a limit to the ability of banks to generate deposits, which is set
of monetary control are reserve requirements, administered
by various economic and institutional factors. In developing
interest rates and credit controls; and the indirect instrument of
countries, the scope for credit creation by banks is much less
control is open market operations.
than in countries with a well-developed banking system. While
the Reserve Bank can regulate the amount of money creation by
banks through control of their cash reserves, in practice, the
regulation of money supply is not wholly under the Bank’s
of the Government over which the Bank has no control, and advances to the State Governments. However, it should be
although the Bank ahs opportunities of tendering advice to noted that the concept of net bank credit to the Central
Government on this matter. If the Government meets its Government is not the same as the Central Government’s
budgetary deficits by borrowing from the Reserve Bank, there budgetary deficit, especially since all term borrowings, including
will be an increase in money supply, both in currency and bank the increase in the banks’ holdings of Central Government
deposits; it may be relevant to note that there is no statutory securities, are treated in the budget as resources of the
limit on the extension of credit by the Bank to Government, Government while all holding of short-term paper (Treasury
another source of variations in money supply over which the bills) including the holding of non-bank institutions enter the
Banks, influence is restricted is the country’s external payments budgetary deficit.
position. Bank credit to the commercial sector, including that
Money Supply extended to public sector commercial undertakings, represents
The total expansion of money supply depends on the creation the gross commercial and co-operative banks’ credit and
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of high-powered money (reserve base) and the multiplier action investments in the commercial sector’s shares, bonds and
upon it, the components of the reserve money are currency debentures, and the Reserve Bank’s credit to the commercial
with the public, other deposits with the RBI, and bankers’ sector, viz., loans and advances to financial institutions, internal
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deposits with the RBI. Money multiplier is the mean value of bills purchased and discounted, holding of capital and bonds
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the ratio of money supply or aggregate monetary resources to of financial institutions, and investments in debentures.
reserve money. It is the interacting variable between these two The net foreign exchange assets of the Reserve Bank and the
monetary aggregates. Reserve requirements consist of cash foreign exchange assets of banks together constitute the net
reserve ratio and statutory liquidity ratio. The impact of any foreign exchange assets of the banking sector. In the former are
variation in the ratio is direct, precise and certain. Reserve
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included the Bank’s holdings of foreign securities, gold coin
requirements bear on the volume of credit by affecting the credit and bullion and balances held abroad; from the total is
base of bank reserves. Altering the ratios will affect the credit- deducted the balance in IMF Account excluding the amount of
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creating capacity of banks, volume of credit and therefore of
money supply. The impact of any change in reserve ratios on
money supply depends, besides the extent of multiple credit
quota subscription in rupees, the effect of the external sector on
money supply is measured by the movement in net foreign
exchange assets. Whenever there is an increase in net foreign
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creation by banks, on the ratio of bank reserves to total assets this is an expansionary factor even as a decrease is a
reserves, which is defined as the currency with the public and contractionary factor.
bank reserves. Net bank credit to Government is determined by the
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its stock of securities and the dates of maturity of the different
After discussing the monetary policy in our last lesson let us
loans.
now discuss the tools of monetary policy.
REPO auction was allowed since 1992-93. Since November
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What are Open Market Operations? 1999 REPOs are offered on a daily fixed rate basis to provide
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Open market operations can be continuous and flexible in signals to money market rates and impart stability to short-term
influencing bank reserves. Effects depend on the medium of interest rates by setting a floor to call rates.
operation, short bills like Treasury Bills or long-term securities,
till the initiation of several measures to promote primary and REPOs and Reverse REPOS
secondary markets in Government securities since 1992-93, the In order to activate the REPOs market so that it serves as an
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market was quite narrow. There was no choice of amount. The equilibrating force between the money market and the securities
amount was determined by the budgetary requirements and the market, REPO and reverse REPO transactions among select
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interest rate by the need to keep the cost of borrowing low. As
the corollary to the financial liberalization measures, the
automatic monetisation of the fiscal deficit was limited to Ways
institutions have been allowed since April 1997 in respect of all
dated Central Government securities besides Treasury Bills of
all maturities, a system of announcing a calendar of REPO
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and Means Advances at market related interest rates form April auctions to enable better treasury management by participants
1,1997 and development of money market and securities was introduced in January 1997.
market by way of introduction of new instruments, auction Reverse REPOs ease undue pressure on overnight call money
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system for Government securities (including repos/reverse rates. PDs are allowed liquidity support in the form of reverse
repos) and instituting a network of primary and satellite dealers REPO facility.
with a view to enabling the emergence of open market Reverse REPO transactions can be entered into by non-bank
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operations as the principal instrument of liquidity entities who are holders of SGL accounts with the Reserve
management. Bank with banks, primary dealers in Treasury Bills of all
REPOs maturities and all dated central government securities. The first
REPO and reverse REPO operated by RBI in dated step if the transaction by non-bank entites should be by way of
government securities and Treasury Bills (except 14 days) help purchase of securities eligible for REPOs from banks/primary
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banks to manage their liquidity as well as undertake switch to dealers and the second step will be by way of selling back
maximize the return. REPOs are also used to signal changes in securities to banks/primary dealers. Non-bank entities are
interest rates. REPOs bridge securities and banking business. however not allowed to enter into REPO transactions with
A REPO is the purchase of one loan against the sale of banks/primary dealers. The transactions have to be effected at
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another. They involve the sale of securities against cash with a Mumbai.
future buy back agreement. There are no restrictions on tenor of Interbank REPOs
REPOs. They are well established in US and spread to Euro Commercial banks and select entities can conduct REPO
market in the second half of 1980s to meet the trading demand transactions in PSU bonds and private corporate debt securities.
from dealers and smaller commercial banks with limited access These transactions provide liquidity support to the debt market
to international interbank funding. REPOs are a substitute for Delivery Versus Payment (DVP) was introduced in April 1999
traditional interbank credit. as a regulatory safeguard.
REPOs are part of open market operations undertaken to In July 1999 non-bank participants in the money market were
influence short-term liquidity. With a view to maintain an allowed to access short-term liquidity through REPOs on par
orderly pattern of yields and to cater to the varying requirements with banks.
of investors with respect to maturity distribution policy or to It may be noted that according to the international accounting
enable them to improve the yields on their investment in practices, the funds advanced by the purchaser of a security
securities, RBI engages extensively in switch operations. In a under a firm repurchase agreement are generally treated as
triangular switch, one institution’s sale/purchase of security is
matched against the purchase/sale transaction of another
the balance sheet of the seller even the smallest scale. Changes in reserve requirements operate
directly and immediately by affecting the quantum of loanable
What do you Understand by Discount Policy?
resources with banks: an increase reduces the banks capacity to
Discount loans are loans from the central bank to depository
lend and a reduction in effect places funds with them. The
institution and that the discount rate is the interest rate charged
effects of changing reserve requirements are similar in some
on these loans. Discount policy, which primarily involves
respects to but different in others from those of open market
changes in the discount rate, affects reserves in the banking
operations. They are similar in that they both change instantly
system because when a discount loan is extended, the central
the reserve position of banks and set in motion secondary
bank increases a bank’s reserves by an equal amount.
forces leading to multiple expansion or contraction of credit.
In addition to its use as a tool to influence reserves in the The two instruments differ in that changes in reserve
banking system and the money supply, discounting is requirements are much more effective than open market
important in preventing financial panics. An important role of operations (and also discount rate) in situations where the
RBI is intended to be as the lender of last resort; it was to
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banks have a volume of reserves far in excess of the legal
provide reserves to banks when no one else would in order to requirements or where a large expansion of credit is desired, to
prevent bank failures from spinning out of control, thereby elaborate, where large-scale and widespread liquidity exists, a rise
preventing bank and financial panics. Discounting is a
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in reserve requirements will be more useful in eliminating the
particularly effective way to provide reserves to the banking
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excess reserves. Once this is done, open market operations are
system during a banking crisis because reserves are immediately more suitable as a flexible instrument to tighten or ease credit
channeled to the banks that need them most. operations, as it is selective in its application and can also be
What is the Reserve Requirement? used on a day-to-day basis. Conversely, the reserve requirements
Changes in reserve requirements affect the demand for reserves: can be lowered to bring about an increase in general liquidity in
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A rise in reserve requirements means that banks must hold the banking system, and thereafter through open market
more reserves, and a reduction means that they are required to operations the liquidity can be maintained at the desired level.
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hold less. All depository institutions, including commercial
banks, savings and loan associations, mutual savings banks,
and credit unions, are all subject to reserve requirements.
Unlike the Bank rate whose effectiveness depends, among other
things, upon the attitude of the commercial banks and the
borrowers, open market operations can be so regulated that
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Reserve requirements have been rarely used as a monetary policy bank reserves change to the level desired by the central bank. In
tool because raising them can cause immediate liquidity the final analysis, however, the use of one instrument rather
problems for banks with low excess reserves. Continually than another at any point of time is determined by the nature
of the situation and the range of influence it is desired to wield
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Instruments of General Credit Control meet the task; instead, all three need to be employed in
Instruments of credit control are of two types: general of appropriate combination.
quantitative and selective of qualitative. The instruments of
In India, the statutory basis for the regulation of the credit
general credit control are the Bank rate, also known as the
system by the Bank is embodied in the Reserve Bank of India
discount rate, reserve requirements and open market
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Act and the Banking Regulation Act. The former confers on the
operations. All the three methods by affecting the lendable
Bank the usual powers available to central banks generally, while
resources of the commercial banks affect the total volume of
the latter provides special powers of direct regulation of the
credit and hence total money supply. In the case of selective
operations of the commercial and co-operative banks.
credit controls the impact is not so much on the total amount
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of credit as on the direction of credit, i.e., on the amount that is Goals of Monetary Policy
put to use in a particular sector of the economy, and they bring Reserve Bank of India focuses on the following main six basic
to bear a restraining influence on the borrowers. goals of monetary policy:
The three instruments are designed to affect the liquidity in the • High employment
economy by acting on the quantum of bank reserves. Open • Economic growth
market operations and reserve requirements directly affect the • Price stability
reserve base while the Bank rate produces its impact indirectly
• Interest-rate stability
through variations in the cost of acquiring the reserves. The
effects of Bank rate changes are not confined to the banking • Stability of financial markets
system and the money market; they produce wider • Stability in foreign exchange markets
repercussions on the economy as a whole. However, its action is
High Employment
indirect, its influence on money and credit being through
Promoting high employment consistent with a stable price level
primary changes in short-term money rates and secondary
is a worthy goal for two main reasons: (1) the alternative
repercussions on long-term interest rates or yields; i9t is not
situation, high unemployment, causes much human misery,
also as flexible for day-to-day adjustments as open market
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to fund suitable matchups, is beneficial to the economy. For society may compete with other groups to make sure that its
example, a worker who decides to look for a better job might be income keeps up with the rising level of prices.
unemployed for a while during the job search. Workers often Interest-Rate Stability
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decide to leave work temporarily to pursue other activities Interest-Rate stability is desirable because fluctuations in interest
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(raising a family, travel, returning to school), and when they rates can create uncertainty in the economy and make it harder to
decide to reenter the job market, it may take some time for plan for the future, fluctuations in interest rates that affect
them to fund the right fob. The benefit of having some consumers’ willingness to buy houses, for example, make it
unemployment is similar to the benefit of having a nonzero more difficult for consumers to decide when to purchase a
vacancy rate in the market for rental apartments. house and for construction firms to plan how many houses to
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Another reason that unemployment is not zero when the build. Upward movements in interest rates generate hostility
economy is at full employment is due to what is called toward central banks like RBI and lead to demands that their
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structural unemployment, a mismatch between job
requirements and the skills or availability of local workers.
Clearly, this kind of unemployment is undesirable.
power be curtailed.
Stability of Financial Markets
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Financial crises can interfere with the ability of financial markets
Nonetheless, it is something that monetary policy can do little to channel funds to people with productive investment
about. opportunities, thereby leading to a sharp contraction in
The goal for high employment should therefore not seek an economic activity. The promotion of a more stable financial
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unemployment level of zero but rather a level above zero system in which financial crises are avoided is thus an important
consistent with full employment at which the demand for labor goal for a central bank.
equals the supply of labor. This level is called the natural rate The stability of financial markets is also fostered by interest-rate
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economic growth when unemployment is low. Conversely, if interest-rate fluctuations have been a particularly severe problem
unemployment is high and factories are idle, it does not pay for for savings and loan associations and mutual savings banks.
a firm to invest in additional plants and equipment. Although Stability in Foreign Exchange Markets
the two goals are closely related, policies can be specifically aimed
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interest-rate stability and high employment in the short run way by abolishing the system of automatic monetisation of
(but probably not in the long run). For example, when the fiscal deficit, which was taking place through the issuance of
economy is expanding and unemployment is falling, both ad hoc treasury bills. This has been achieved through the
inflation and interest rates may start to rise, if the central bank signing of two agreements between the GOI and the RBI.
tries to prevent a rise in interest rates, this may cause the • Interest rates structure has been simplified and deregulated.
economy to overheat and stimulate inflation. But is a central
• Far-reaching changes in the external sector of the economy
bank raises interest rates to prevent inflation, in the short run
have been effected. Substantial elimination of imports and
unemployment may rise, the conflict among goals may thus
exchange controls, introduction of market-determined
present central banks like RBI with some hard choices.
exchange rate system, rupee convertibility, encouragement to
FDI, and greater access to external capital markets are some
of these changes.
Summary
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The goals of monetary policy include a stable price level,
economic growth, high employment, stable interest rates, and
predictable and steady currency exchange rates. Unfortunately,
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monetary policies involve difficult trade-offs, and policies that
help to achieve one goal may make another less attainable.
The conduct of monetary policy involves actions that affect the
RBI’s balance sheet. Open market purchases lead to an
expansion of reserves and deposits in the banking system and
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hence to an expansion of the monetary base and the money
supply. An increase in discount loans leads to an expansion of
flexibility. Although the RBI will continue to prescribe 4. Discuss the recent policy developments.
prudential guidelines, it has now moved out of
microregulation.
• The borrowers also have been empowered to reinforce
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Notes:
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LESSON 13:
THE SECURITIES AND EXCHANGE BOARD OF INDIA
Learning objectives The SEBI was established on April 12, 1988 through an
After reading this lesson, you will understand administrative order, but it became a statutory and really
powerful organisation only since 1992. The CICA was repealed
• Securities contracts (regulation) act, 1956
and the office of the CCI was abolished in 1992, and the SEBI
• Securities and exchange board of India was set up on 21 February 1992 through an ordinance issued on
• Objectives and regulatory approach 30 January 1992. The ordinance was replaced by the SEBI Act
• Powers, scope, and functions on 4 April 1992. Certain powers under certain sections of SCRA
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and CA have been delegated to the SEBl. The regulatory powers
Discussion on SEBI is important for our discussion. It is one
of the SEBI were increased through the Securities Laws
of most important regulatory authority in India. It is gaining
(Amendment) Ordinance of January 1995, which was
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more importance day by day with new issues cropping up.
subsequently replaced by an Act of Parliament. The SEBI is
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Securities Contracts (Regulation) Act, 1956 under the overall control of the Ministry of Finance, and has its
The objective of the Securities Contracts (Regulation) Act head office at Mumbai. It has now become a very important
(SCRA) is to regulate the working of stock exchanges or constituent of the financial regulatory framework in India.
secondary market with a view to prevent undesirable The philosophy underlying the creation of the SEBI is that
transactions or speculation in securities, and thereby to build up
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multiple regulatory bodies for securities industry mean that the
a healthy and strong investment market in which public could regulatory system gets divided, causing confusion among
invest with confidence. It empowers the GOI to recognise and market participants as to who is really in command. In a
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derecognise the stock exchanges, to stipulate laws and by-laws
for their functioning, and to make the listing of securities on
stock exchanges by Public Limited Companies (PULCOs)
multiple regulatory structure, there is also an overlap of
functions of different regulatory bodies. Through the SEBI,
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the regulation model which is sought to be put in place in India
mandatory. It prohibits securities transactions outside the is one in which every aspect of securities market regulation is
recognised stock exchanges. It lays down that all contracts in entrusted to a single highly visible and independent
securities except spot delivery contracts can be entered into only organisation, which is backed by a statute, and which is
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between and through the members of recognised stock accountable to the Parliament and in which investors can have
exchanges. It prescribes conditions or requirements for listing trust.
of securities on the recognised stock exchanges. It empowers
Constitution and Organisation
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The year 1991 witnessed a big push being given to liberalisation government is empowered to supersede the SEBI in public
and reforms in the Indian financial sector. For sometime interest, or if, on account of grave emergency, it is unable to
thereafter, the volume of business in the primary and secondary discharge its functions or duties, or if it persistently defaults in
securities markets increased significantly. As a part of the same complying with any direction issued by the government, or if
reform process, the globalisation or internationalisation of the its financial position and administration deteriorates.
Indian financial system made it vulnerable to external shocks. The work of the SEBI has been organised into five operational
The multi-crore securities scam rocked the IFS in 1992. All these departments each of which is headed by an executive director
developments impressed on the authorities the need to have in who reports to the Chairman. Besides, there is a legal
place a vigilant regulatory body or an effective and efficient department and the investigation department. The departments
watchdog. It was felt that the then existing regulatory have been divided into divisions. The various departments and
framework was fragmented, ill coordinated, and inadequate and the scope of their activities are as follows:
that there was a need for an autonomous, statutory, integrated
(i) The Primary Market Policy, Intermediaries, Self-Regulatory
organisation to ensure the smooth functioning of the IFS. The
Organisations (SROs), and Investor Grievance and Guidance
SEBI came into being as a response to these requirements.
Department. It looks after all policy matters and regulatory
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products, registration and monitoring of members of stock The overall objective of the SEBI, as enshrined in the Preamble
exchanges, administration of some of the stock exchanges, of the SEBI Act, 1992 is “to protect the interests of investors
market surveillance and monitoring of price movements and in securities and to promote the development of, and to
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insider trading and EDP and SEBI’s data base. regulate the securities market and for matters connected
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therewith or incidental thereto”. To elaborate, the SEBI
(iv) The Secondary Market Exchange Administration,
regulates stock exchanges and securities industry to promote
Inspection and Non-member Intermediaries Department: It
their orderly functioning. It protects the rights and interests of
looks after the smaller stock exchanges of Guwahati,
investors, particularly individual investors, and guides/educates
Magadh, Indore, Mangalore, Hyderabad, Bhubaneshwar,
them. It prevents trading malpractices and aims at achieving a
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Kanpur, Ludhiana and Cochin. It is also responsible for
balance between self-regulation by securities industry and its
inspection of all stock exchanges, and registration, regulation
statutory regulation.
and monitoring of non-member intermediaries such as sub-
brokers.
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(v) Institutional Investment (Mutual Funds and Foreign
Having regard to the emerging nature of the securities markets
in India, the SEBI necessarily has the twin task of regulation
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Institutional Investment), Mergers and Acquisitions, and development. Its regulatory measures are always meant to
Research and Publications, and International Relations and be subservient to the needs of the market development.
IOSCO Department: It looks after policy, registration, Underlying those measures is the logic that rapid and healthy
regulation and monitoring of Foreign Institutional market development is the outcome of well-regulated
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Investors (FIls), domestic mutual funds, mergers and structures. In this spirit, the SEBI endeavours to create an
substantial acquisitions of shares, and IOSCO (International effective surveillance mechanism and encourage responsible and
Organisation of Securities Commissions) membership, accountable autonomy on the part of all players in the market,
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international relations, and research, publication and Annual who are expected and required to discipline themselves and
Report of SEBI. observe the rules of the market. The self-regulation and
regulation by exception are thus the comer stones of its
(vi) Legal Department looks after all legal matters under the regulatory framework. The SEBI believes that self-regulation
supervision of the General Counsel. can work only if there is an effective regulatory body overseeing
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(vii) Investigation Department carries out inspection and the activities of self-regulatory organisations.
investigation under the supervision of the Chief of The SEBI also aims at facilitating an efficient mobilisation and
Investigation: allocation of resources through the securities markets,
The SEBI has regional offices at Kolkata, Chennai and Delhi. It stimulating competition, and encouraging innovations. Its
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has also formed two non-statutory advisory committees regulation is expected to be flexible, cost -effective and
namely, the Primary Market Advisory Committee and Secondary confidence- inspiring. To investors, the SEBI provides a high
Market Advisory Committee with members from market degree of protection of their rights and interests through
players, recognised investor associations, and other eminent adequate, accurate, and authentic information and disclosure of
persons. such information on a continuous basis. To issuers, it provides
SEBI is a member of IOSCO, an international body a market place in which they can confidently raise all the finance
comprising of security regulators from over 100 countries. It they need in an easy, fair, and efficient manner. To the market
participates in the Development Committee of IOSCO, which intermediaries, it offers a competitive, professionalised and
provides a platform for regulators from emerging markets to expanding market with adequate and efficient infrastructure so
share their views and experiences. that they can render better and more responsible service to the
investors and issuers.
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the SEBI. The amendments also provide for the deletion of
the existing provision relating to disqualification of a member
of the SEBl Board on his being appointed as a director of a
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company. The SEBl has also been empowered to demand
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explanations, to summon the attendance and call for
documents from all categories of market intermediaries in order
to enable it to investigate irregularities, impose penalties, and
initiate prosecution. The SEBl has also been empowered now
to notify its regulations and file complaints in courts without
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the prior approval of the GOI.
However, in the exercise of its powers and in performing its
Powers, Scope, and Functions
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The scope of operations of the SEBI is very wide; it can frame
functions, the SEBl is bound by such directions on questions
of policy as the GOl may give in writing from time to time.
Although it has the opportunity to express its views before any
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or issue rules, regulations, directives, guidelines, norms in
respect of both the primary and secondary markets, direction is given, the decision of the GOI is final in every case.
intermediaries operating in these markets, and certain financial Questions to Discuss:
institutions. It has powers to regulate (i) depositories and
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• The governing boards and various committees of stock
Highlights of Sebi’s Performance exchanges (SEs) have been recognised, restructured and
Since the enactment of the SEBl Act in 1992, financial broad-based.
institutions, agencies, and market intermediaries mentioned
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• Inspection of all 22 SEs has been carried out to determine,
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above are now being governed by the guidelines, rules, and
inter alia, the extent of compliance with the directives of the
regulations notified by the SEBI from time to time. Due to lack
SEBI.
of space, it is not possible to present their exhaustive list here.
We give below only the major policy measures and reforms • Computerised 0r screen-based trading has been achieved on
introduced by the SEBl during 1992 to 1996. almost all exchanges except some of the smaller ones.
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• Corporate membership of SEs is now allowed, encouraged,
Primary Securities Market
and preferred. The Articles of Association of SEs have been
• The issues of capital by companies no longer require any
brokers and 6 per cent for corporate brokers introduced. ‘I’here has to be an arms-length relationship between the
• Both the brokers and sub-brokers have been brought within trustees, the asset management company, and the custodian.
the regulatory fold for the first time now; and the concept of The SEBI (Mutual Funds) Regulations, 1993 were revised to
the dual registration of stock brokers with the SEBI and the provide for portfolio disclosure, standardisation of accounting
SEs has been introduced. The total number of registered policies, valuation norms for determining net asset value and
brokers and sub-brokers was 8,746 at the end of March pricing.
1996, of which 1917 were corporate members. The UTI has been organised under the UTI Act, 1963, and it
• Penal action can now be taken directly by the SEBI against has evolved as a distinct institution. Therefore, certain special
any member of a stock exchange for violation of any dispensations have been provided to it under the SEBI
provision of the SEBI Act. regulatory framework. Subject to this, the UTI also has been
brought under the SEBI since July 1994. As a result, new
• It has been made mandatory for the stock” brokers to
schemes of the UTI also now fall under the jurisdiction of the
disclose the transaction price and brokerage separately in the
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SEBI.
contract notes issued by them to their clients.
• The daily margin and additional margin for volatile scrips are Miscellaneous
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now levied on a weekly and marked-- to-market basis. • FIls are also required to be registered with the SEBI. The
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• The SEs have amended their Listing Agreements such that total number of them so registered were 367 as of 31 March
the issuers have now to provide shareholders with cash flow 1996.
statements in a prescribed format, along with the complete • It is required that the capital of companies to be registered as
balance sheet and profit and loss statement. depositories must be Rs 100 crore. Similarly custodians are
• The trading hours in almost all the SEs have now been required to have a net worth of Rs 50 crore, and they are to
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increased from 21/2 hours to 3 hours per day. get their systems and procedures evaluated externally.
• Compulsory audit of the brokers’ books and filing of the • Venture capital funds (VCFs) allowed to invest in unlisted
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audit reports with the SEBI has now been made mandatory.
• A system of market making in less liquid scrips on selected
companies, to finance turnaround companies, and to provide
loans.
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SEs has been introduced. • As per the approved modified takeover code recommended
by the Bhagawati Committee, the minimum public offer of
• Insider trading has been prohibited and such trading has
20 per cent purchase, when the threshold limit of 10 per cent
been made a criminal offence punishable in accordance with
equity is crossed, is made mandatory. Those in control are
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a minimum net worth requirement of Rs 6 lakh who can escrow deposits have to be higher for conditional public
carry on the activities both as RI and STA, and category II offers unless the acquirer agrees to buy a minimum of 20 per
with a minimum net\worth requirement of Rs 3 lakh who cent.
can carry on anyone of these activities. There were 209 RI and
STA in Category I and 125 in Category II at the end of Investor Protection Measures
The SEBI has introduced an automated complaints handling
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March 1996.
system to deal with investor complaints. To create an awareness
• Till end-August 1997, merchant bankers (MBs) were
among the issuers and intermediaries of the need to redress
classified into four categories, each with different investor grievances quickly, the SEBI has been issuing
responsibilities and commensurate with capital requirements. fortnightly press releases publishing the names of the
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With effect from September 1997, such a classification has companies against whom maximum number of complaints
been abolished and there will be only one entity now, have been received. To help investors in respect of delay in
namely, merchant bankers. A system of penalty points for receiving refund orders in case of oversubscribed issues, a facility
MBs for defaults committed by them has been introduced. It in the form of stockinvest has been introduced. To ensure that
is provided that they can be suspended or deauthorised after no malpractice takes place in the allotment of shares, a
a maximum of 8 penalty points. The MBs have to fulfill representative of the SEBI supervises the allotment process. It
capital adequacy requirements also. During 1995-96, 231 MBs has also accorded recognition to several genuine, active investor
were granted registration, while registration of nine MBs was associations. It issues advertisements from time to time to
cancelled. The number of MBs was 1,012 in 1995-96 and 790 guide and enlighten investors on various issues related to the
in 1994-95. securities market and of their rights and remedies.
Mutual Funds
As on 31 March 1996, 26 mutual funds (MFs) excluding the
UTI were registered with the SEBI. MFs are required to have a
board of trustees or trustee company separate from the asset
management company, and securities belonging to the various
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reflects the fallibility, weaknesses, and the failure of SEBI. The
How has the SEBI performed so far? Has it been effective? The Verma panel reversed the recommendations of the Patel
SEBI’s task is no doubt challenging, complex and difficult, and Committee and recommended the production of virtually the
it needs to be fully supported in its efforts. But there are certain
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old carry forward or badla system of trading. There have been
aspects of its working which need improvement and correction.
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instances of issues and other market activities, which the SEBI
1) The SEBI’s Annual Report, 1995-96 claims an increasing and ought not to have allowed but did, although it knew about the
a very high success rate in resolving investor complaints. But malpractices involved in them. The allotment of shares by
the reality is different. The market surveys conducted by L.C. Sterling Tea, and making of a right issue by New World Medical
Gupta revealed that 90 per cent of the respondent-investors India Ltd. are recent instances.
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felt that the system of dealing with investor complaints was 4) The regulatory ineffectiveness of the SEBI in certain cases
not effective; 85 per cent of shareholders felt that they were has been due to its concentration on symptoms rather than
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not adequately protected; and 70 per cent of investors
indicated that they had actually suffered because of weak
investor protection. Price rigging, a serious menace to the
the root causes. The present settlement or delivery system is
highly conducive for manipulative operations and unhealthy
speculation. The SEBI has kept on tinkering with the trading
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investors, has, in fact, become more common in recent years. laws instead of doing away with such an outdated delivery
2) On reading the rules, regulations, guidelines, directions and system.
norms issued by the SEBI, one doubts whether one is living The SEBI’s failure appears to be partly deliberate also. There is a
in the “liberalised” or “prudential regulation as opposed to
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is difficult for anybody to determine what rules are currently 1956, and Capital Issues (Control) Act, 1947 .The SEBI was set
in force. As a result, SEBI officials may wield undue power up in 1988 through an administrative order, and it became a
by providing their own interpretation of the rules. statutory body in 1992. The SEBI is governed by a six-member
3) There is a widespread feeling in the financial markets that the Board of Governors appointed by the GOI and RBI.
SEBI is not really serious about reforming the system and Operationally, it is divided into seven departments. Its head
protecting the individual and small investors. It has quite office is at Mumbai and regional offices are at Delhi, Kolkata
often failed to penalise the people responsible for causing and Chennai.
abnormal price fluctuations on the stock market. There has Its objectives are to protect the investors, and to regulate the
been a lack of will, dithering and hesitancy on the part of financial system in order to bring about its healthy
SEBI to strike against the wrong doers. Even certain well-- development. Self-regulation and regulation by exception are
publicised market manipulations have gone unpunished. said to be the cornerstones of its policies. It seeks to increase
the efficiency of mobilisation and allocation of resources
through the securities market.
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by them from other business concerns (financial as well as
• General structure and methods of commercial banking manufacturing) is the degree to which they have to balance the
principle of profit maximisation with certain other principles.
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• Employment of funds by commercial bankers
In India especially, banks are required to modify their
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Commercial banks are the oldest, biggest, and fastest growing performance in profit making if that clashes with their
financial intermediaries in India. They are also the most obligations in such areas as social welfare, social justice, and
important depositories of public saving and the most promotion of regional balance in development. In any case,
important disbursers of finance. Commercial banking in India compared to other business concerns, banks in general have to
is a unique system, the like of which exists nowhere in the
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pay much more attention to balancing profitability with
world. The truth of this statement becomes clear as one studies liquidity. It is true that all business concerns face liquidity
the philosophy and approaches that have contributed to the constraint in various areas of their decision-making and,
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evolution of the banking policy, programmes and operations in
India. This however is too big a subject to be discussed here in
detail. We will therefore confine ourselves to presenting only an
therefore, they have to devote considerable attention to liquidity
management. But with banks, the need for maintenance of
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liquidity is much greater because of the nature of their liabilities.
outline of the said philosophy and approaches, and discussing Banks deal in other people’s money, a substantial part of which
the actual working of banks in detail. is repayable on demand. That is why for banks, unlike other
Commercial banks are organised on a joint stock company business concerns, liquidity management is as important as
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system, primarily for the purpose of earning a profit. They can profitability management.
be either of the branch banking type, as we see in most of the This is reflected in the management and control of reserves of
countries, with a large, network of branches, or of the unit commercial banks. They are expected to hold voluntarily a part
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banking type, as we see in the United States, where a bank’s of their deposits in the form of ready cash, which is known as
operations are confined to a single office or to a few branches cash reserves; and the ratio of cash reserves to deposits is
within a strictly limited area. Although the commercial banks known as the (cash) reserve ratio. As banks are likely to be
attract deposits of all kinds-Current, Savings and Fixed-their tempted not to hold adequate amounts of reserves if they are
resources are chiefly drawn from current deposits, which are left to guide themselves on this point, and since the temptation
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repayable on demand. So they attach much importance to the ‘may have extremely destabilizing effect on the economy in
liquidity of their investments and as such they specialise in general, the Central Bank in every country is empowered to
satisfying the short-term credit needs of business other than prescribe the reserve ratio that all banks must maintain. The
the long-term. Central Bank also undertakes, as the lender of last resort, to
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The banking system in India works under the constraints that supply reserves to banks in times of genuine difficulties. It
go with social control and public ownership. The public should be clear that the function of the legal reserve
ownership of banks has been achieved in three stages: 1955, requirements is two-fold: to make deposits safe and liquid, and
July 1969, and April 1980. Not only the public sector banks but to enable the Central Bank to control the amount of checking
also the private sector and foreign banks are required to meet deposits or bank money which the banks can create. Since the
targets in respect of sectoral deployment of credit, regional banks are required to maintain a fraction of their deposit
distribution of branches, and regional credit-deposit ratios. The liabilities as reserves, the modem banking system is also known
operations of banks have been determined by Lead Bank as the “fractional reserve banking”.
Scheme, Differential Rate of Interest Scheme, Credit Another distinguishing feature of banks is that while they can
Authorization Scheme, inventory norms and lending systems create as well as transfer money (funds), other financial
prescribed by the authorities, the formulation of the credit institutions can only transfer funds. In other words, unlike
plans, and Service Area Approach. other financial institutions, banks are not merely financial
intermediaries. This aspect of bank operations has been
variously expressed. Banks are said to create deposits or credit or
money, or it can be said that every loan given by banks creates a
multiplier or credit multiplier or money multiplier. The import the banks make loans. The process moves rather slowly and
of this is that banks add to the money supply in the economy, with jerks, and not as promptly and smoothly as implied.
and since money supply is an important determinant of prices, Subject to such qualifications, there is no doubt that modem
nominal national income, and other macro-economic variables, banks can create money in the process of their working.
banks become responsible in a major way for changes in
Functions of the Commercial Banks and the Services
economic activity. Further, as indicated in chapter one, since
banks can create credit, they can encourage investment for some Rendered by Them
time without prior increase in saving. The two essential functions of commercial banks may best be
summarized as the borrowing and lending of money. They
Let us briefly discuss the basis and process of creation of
borrow money by taking all kinds of deposits. Deposits may be
money by banks. In modem economies, almost all exchanges
received on current account whereby the banker incurs the
are affected by money. Money is said to be a medium of
obligation of paying legal tender on demand, or on fixed
exchange, a store of value, a unit of account. There is much
deposit account whereby the banker incurs the obligation of
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controversy as to what, in practice in a given year, is the measure
paying legal tender after the expiry of a fixed period, or on
of supply of money in any economy. We do not need to go
deposit account hereby the banker undertakes to pay the
into that controversy here. Suffice it to say that every one agrees
customer an agreed rate of interest on it in return for the right
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that currency and demand deposits with banks are definitely to
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to demand from him an agreed period of notice for
be included in any measure of money supply. Thus, apart from
withdrawals. Thus a commercial banker whether it is through
the currency issued by the government and the Central Bank,
current account or fixed deposit account, mobilizes the savings
the demand or current or checkable deposits with banks are
of the society. Then he provides this money to those who are in
accepted by the public as money. Therefore, since the loan
need of it by granting overdrafts or fixed loans or by
operations of banks lead to the creation of checkable deposits,
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discounting bills of exchange or promissory notes. Thus the
they add to the supply of money in the economy. To
primary function or a com-mercial banker is that of a broker
recapitulate, the money-creating power of banks stems from the
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fact that modem banking is a fractional reserve banking, and
that certain liabilities of banks are accepted (used) by the public
as money.
and a dealer in money. By discharging this function efficiently, a
commercial banker renders very valuable service to the
community by increasing the productive capacity of the country
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and thereby accelerating the pace of economic development. He
The process of money creation works as follows. Assume that gathers the small savings of the people, thus reducing to the
the legally required reserve ratio is 10 per cent and that banks are lowest limits idle money. Then he combines these
maintaining just that ratio. Assume further that a bank in the smallholdings in amounts large enough to be profitably
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economy receives a brand new input of Rs. 1,000 of reserves employed in those enterprises where they are most called for
either as a deposit or as proceeds of a sale of government bond and most needed. Here, he makes capital effective and gives
to the Central Bank or in some other form. There is thus a industry the benefits of capital, both of which rise would have
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creation of Rs. 1,000 of bank money, but there is yet no remained idle. Take for instance, the practice of discounting
multiple expansion of money. If banks were required to keep bills. By converting future claims into present money, the
100 per cent cash reserve balances, no bank would be in a commercial banker bridges the time element between the sale
position to create extra money out of a new deposit of Rs.l,000 and the actual payment of money. This will enable the seller to
with it. catty on his business without any hindrance and the buyer will
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But since a bank is required to hold only 10 per cent of its get enough time to realise the money.
deposits as cash reserves, it now has Rs. 900 as excess reserves, Thus we have seen that a banker receives deposits, which he has
which it can utilise to invest or to give a loan. Assume that the to repay according to his promise, and makes them affordable
bank gives a loan of Rs. 900, and the borrower who takes the to those people who are really in need of them. He is actually
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loan in cash or cheque deposits it either with the same bank or distributing his deposits between the borrowers and his own
with some other bank. Either way, there has been a creation of vaults. Herein lies the most delicate of the functions of
money and the total amount of bank money created at this commercial bankers.
stage is Rs. 1,000 + Rs. 900 = Rs. 1,900. This process of
Besides these two main functions a commercial banker
creation can continue till no bank anywhere in the system has
performs a variety of other functions, which may be grouped
reserves in excess of the required 10 per cent reserve, and the
under two main heads viz., the agency services and the general
total money supply created in the economy is Rs. 10,000. The
utility services.
ratio of new deposits to the original increase in reserves is called
the money multiplier or credit multiplier or deposit multiplier. Agency Services
This multiplier will be equal to the reciprocal of the required A commercial bank provides a range of investment services.
reserve ratio. Customers can arrange for dividends to be sent to their bank
The process of creation of bank money does not work in and paid directly into their bank accounts, or for the bank to
practice to the full capacity or to the full potential as has been detach coupons from bearer bonds and present them for
described above. Banks may have a reserve ratio, which is higher payment and to act upon announce-ments in the Press of
than the required reserve ratio. drawn bonds, coupons payable, etc. Orders for the purchase or
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etc., on behalf of its customers. It also acts as a correspondent branches or by anyone bank to another, to pay a specified sum
or representative of its customers, other banks and financial to the person concerned. A letter of credit is a document issued
corporations. by a banker, authorizing some other banker to whom it is
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Most of the commercial banks have an executor and trustee addressed, to honour the cheques of a person named in the
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depart-ment; some may have affiliated companies to deal with document, to the extent of a stated amount in the letter and to
this branch of their business. They aim to provide, therefore, a charge the same to the account of the grantor of the letter of
complete range of trustee, executor or advisory services for a credit. A letter of credit includes a promise by the issuing banker
small charge. The business of banks acting as trustees, to accept all bills to the limits of credit. When the promise to
accept is conditional on the receipt of the documents of title to
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executors, administrators, etc., has continuously expanded with
considerable usefulness to their customers. By appointing a goods, it is called a documentary letter of credit. Where the
bank as an executor or trustee of his Will the customer secures promise is unconditional it is called a clean letter of credit.
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the advantage of continuity, and avoids having to make
changes; impartiality in dealing with beneficiaries and in the
exercise of discretions; and the legal and specialised knowledge
Letters of credit may again be classified as revocable and
irrevocable. A revocable letter of credit is one, which can be
cancelled at any time by the issuing banker. But the banker will
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pertaining to executor and trustee services. When a person dies still be liable for bills negotiated before cancellation. An
without making a Will the next-of-kin can employ the bank to irrevocable letter of credit is, one, which cannot be cancelled
act as administrator and to deal with the estate in accordance before the expiry of the period of its currency. ‘Circular letter of
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with the rules relating to intestacies. Alternatively, if a testa-tor Credit’ is generally intended for travellers who may require
makes a Will but fails to appoint an executor, or if an executor money in different countries. They may be divided into
is unable or unwilling to act, the bank can usually undertake the traveller’s letters of credit and guarantee letters pf credit. A
travellers letter of credit carries the instruction of the issuing
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invest-ments and distribution of income; a customer’s of interest or he may insist on sufficient security for the grant
investments can be trans-ferred into the bank’s name or control, of the credit. There is yet another type which is known as
thus enabling it to act immediate-ly upon a notice of rights ‘Revolving Credit’. Here the letter is so worded that the amount
issue, allotment letters, etc. Alternatively, where it is not desired of credit available automatically reverts to the original amount
after the bills negotiated under them are duly honoured.
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constructed strong rooms, each containing a large number of the developments in computerised book-keeping, which the
private steel safes of various sizes. These may be used by non- banks in some countries have already introduced. Some banks
customers for a small fee as well as by regular customers. Each are reported to be experi-menting with the use of electronic
licensee is provided with the key of an individual safe and thus machines, which will scan cheques and dispense notes or coins,
not only obtains protection for his valuables, but also retains thus saving time at the counter.
full personal control over them, The safes are accessible at any
Overseas Trading Services
time during banking hours and often longer.
Recognition of overseas trade has led modem commercial
For shopkeepers and other customers who handle large sums banks to set up branches specializing in the finance of foreign
of mon-ey after banking hours, ‘night safes’ are available at trade and some banks in some countries have taken interest in
many banks. Night safes take the form of a small metal door in export houses and factor-ing organisations. Assisted by banks
the outside wall of the bank, accessible from the street, behind affiliated to them in overseas territo-ries, they are able to provide
which there is a chute connecting with the bank’s strong room. a comprehensive network of services for foreign banking
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Customers who require this service are provided with a leather business, and many transactions can be carried through from
wallet, which they lock before placing in the chute. The wallet is start to finish by a home bank or its subsidiary. In places where
opened by the customer when he calls at the bank the next day banks are not directly represented by such affiliated
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to credit the contents into his account. undertakings, they have working arrangements with
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Another function of great value, both to bankers and to correspondents so that the banks are in a position to undertake
businessmen, is that of a referee as to the respectability and foreign banking business in any part of the world.
financial status of the customer. The banks provide more than just a means for the settlement
Among the services introduced by modern commercial banks of debts between traders both at home and abroad for the
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during the quarter of a century or so, the bank giro and credit goods they buy and sell; they are also providers of credit and
cards deceive special mention. The bank giro is a system by enable the company to release the capital which would otherwise
which a bank customer with many payments to make, instead be tied up in the goods exported. The following is an outline
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of drawing a cheque for each item, may simply instruct his bank
to transfer to the bank accounts of his creditors the sum due
of some of the services provided by banks for overseas traders.
For centuries past the bill of exchange has been one of the chief
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from him, and he writes one cheque debiting his account with means of settlement in trade. Its function is to enable a seller or
the total amount. Credit advices containing the name of each exporter of goods to obtain cash as soon as possible after the
creditor with the name of his bank and branch will be cleared dispatch of goods, and yet enable the buyer or importer to
through the ‘credit clearing’ of the clearing house, which defer payment until the goods reach him, or later.
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and the ship owner’s receipt for the goods for the carriage,
companies, which receive, say, six equal sums on six dates in a
called a bill of lading). The exporter will sell (negotiate) the
year, the scheme is only an extension of the standing order
bill with the documents to local bankers, who with the
facility; but for the public utilities and traders which send out
documents and thus, in effect, the goods in their possession,
invoices for valuable amounts at differing times, the scheme is
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may be by a cheque on an Indian bank or by a telegraphic
Usually the arrangement between the buyer and seller of the transfer.
goods will be that the shipping documents which accompany
the bill are to be detached upon payment or acceptance of the Information and other Services
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bill, by whoever pays or accepts it namely, the importer or a As part of their comprehensive banking services, many banks
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bank on his behalf. The documents thus become available to act as a major source of information on overseas trade in all
the buyer, so that he can take delivery of the goods when the aspects. Some banks produce regular bulletin on trade and
ship arrives, re-sell them in the ordinary way, and from the economic conditions at home and abroad, and special reports
proceeds recoup himself or his bank, or make funds available to on commodities and markets. In some cases they invite
enquiries for those wishing to extend their foreign trade, and are
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meet the bill when it matures.
able through their correspondents to furnish the names of
An overseas buyer may arrange through his bank in the home
reputa-ble and interested dealers of goods and commodities
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coun-try to open a documentary credit in favour of the seller.
This is an undertaking that the bank will honour drafts drawn
in accordance with the terms of credit, if accompanied by
and to advise on the appointment of suitable agents. For
businessmen travelling abroad letters of introduction,
indicating the purpose of journey taken, can be issued
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stipulated shipping documents, insurance policies, etc. and
addressed to banking correspondents in the various centres it is
presented not later than the date of expiry of the credit. The
proposed to visit. In this way it is often possible to establish
terms usually cover the nature, price and quantity of the goods,
new avenues of business. On request, banks obtain for
the methods of shipment, the documents to be attached and
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currency, this depending on the condition of sale. It may be Commercial bank furnish advice and information outside the
either revocable or irrevocable. The former may be cancelled at scope merely of trade. If it is desired to set up a subsidiary or
any time, but the latter cannot be cancelled without the consent branch overseas (or for an overseas company to set up in the
of both parties, and therefore provides much greater protection home country) they provide detailed information on local legal
to the exporter. requirements on company formation, tax requirements,
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foreign bank to instruct its Indian banking correspondent to community and redistributes them into more useful channels.
advise the credit to the exporter. As an additional safeguard, an It enables large pay-ments to be made over long distances with
Indian exporter may require his bank not only to advise but minimum expenses. It consti-tutes the very life blood of an
also to undertake responsibility by adding its confirmation. advanced economic society. In the words of Walter Leaf: “The
This is known as a ‘confirmed credit’. Having received the banker is the universal arbiter of the world’s econo-my,”
advice, on shipment of the goods, the exporter must lodge the General Structure and Methods of Commercial
documents within the time allowed by the credit. If the
Banking
documents are in order as stipulated in the credit, the exporter
will then receive immediate payment if it pro-vides for sight Certain Sound Commercial Banking Principles
payment; if it calls for a bill drawn payable after sight, the bank Just as in the case of any other commercial enterprise, the
will accept the bill, which will then be available for discount. If commer-cial banks also strive to earn a profit. But is profitability
for any reason the exporter in unable to present the document everything, which a banker should pay attention to? Can a
he must request the importer to instruct bank to extend or commercial banker employ his funds in a risky manner in
amend the credit. anticipation of wild fall profits? The answer is definitely in the
negative. He is a custodian of other’s surplus funds. Therefore
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paves the way for future economic development and. which, if The first item appearing on the asset side of bank’s balance
disturbed, will create monetary disequilibria with all the evil sheet is cash in hand, including cash reserve at the central bank
effects incidental thereto. Obviously, a banker should take the and demand deposits with other banks. This is the most liquid
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necessary precautions 10 keep his assets as ‘liquid’ as possible. of all assets. From the point of view of profitability, a banker is
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But what is meant by liquidity? tempted to minimise his cash holdings; while from the point
By liquidity we mean the capacity to produce cash on demand. of view of liquidity, he is tempted to maximise his cash
No doubt the most liquid asset is cash in the vaults of a bank. holdings. To maintain more resolves than what is necessary is
It is necessary for a banker to keep a certain percentage of the to impair the profits. The English bankers usually maintain a
cash ratio of 8 per cent while, in India, a higher cash ratio is
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deposits in the form of liquid cash as reserve, either in his own
vault or with his bank, generally the central bank. But such desirable owing to the undeveloped and unpredictable nature
liquid cash does not earn anything and it is purely idle money, of the money market.
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intended to provide the necessary liquidity by meeting the
immediate withdrawals of deposits. As a rule, successful
banking is dependent on the capacity of these reserves to meet
A banker is generally guided by experience in deciding what
propor-tion of his deposits in cash will enable him readily to
meet all demands. In addition to the minimum requirements
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the immediate requirements. When liquidity is provided by indicated by experience, a good banker must necessarily allow
liquid cash, a banker should invest his excess money in. some for unpredictable needs. In this con-nection certain important
assets, which are liquid in nature and at the same time, which considerations influencing the cash resolves of a banker may be
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customer’s claims. But if an asset is to be turned into cash depositors will seldom demand the payment of legal tender
quickly, it must be shift able in nature, i.e. the liquidity of an currency and will content themselves by the transfer of rights
asset depends on the question of shifting it to the central bank which the bank can do by mere book entries. Secondly the
or to others willing to supply cash. For instance if a blinker habits of the customers, and the business conditions of the
holds a first class bill of exchange, among his other assets, locality have an important bearing of the cash reserves. Certain
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which satisfies the eligibility rules of the central bank, it can be businesses carried on by the depositors may make heavy
rediscounted with the central bank, when the banker is short of occasional de-mands which the banker will have to meet with
funds. A government security satisfies the quality of an idle adequate provision of liquid cash. Thirdly, it is also dependent
asset, viz. shift ability because it is in great demand in the stock on the resolves kept by other banks of the locality. If certain
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exchange. But liquidity implies not only shift ability but also banks are keeping higher amounts of resolves, other banks will
shift ability without loss. To take an example, the ordinary be compelled to increase their cash ratio in their bid for
shares of an industrial concern may be shift able but only at a popularity. Further the nature of accounts and the size of
discount. Here shiftability is possible only at a loss and hence average deposits also influence the resolves. For instance, if the
the asset cannot be considered as a sound banking asset. accounts are of a fluctuating nature, a higher cash resolve may be
The conclusion that we arrive at from the above discussion is required. So also the resolves of a bank having only a few large
that commercial bankers, while employing their funds, should deposits will be generally large because of the chance of heavy
pay regard both for profitability and liquidity. And liquidity in demands. On the other hand, if the bank has a large number
its turn is dependent on shiftability without loss. It is a point of small sized deposits, the danger of large withdrawals by any
to be remembered always that liquidity should not be sacrificed individual customer will be less and hence it need not keep a
at the alter of profitability. At the same time no less important large amount of liquid cash. Again, the presence of a bankers’
is it to remember that to maintain excessive liquidity is to clearing house greatly reduces the need of liquid cash to be kept
sacrifice earnings, without which banking operations cannot be by a bank because he has only to provide for the difference
carried on successfully. A good banker would, therefore, follow between the cheques drawn by him on other banks. Lastly, the
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1. What is the theoretical basis of banking operations?
2. Discuss the functions of the commercial banks and the
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services rendered by them.
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3. Discuss the general structure and methods of commercial
banking.
4. Discuss the employment of funds by commercial bankers.
Notes:
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LESSON 16:
LENDING FUNCTION
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manufacturing, trading and services sectors. These corporate
• Security Offered for Loans
basically require funds for long-term investment as well as for
• Purpose of Loan day-to-day operations. Thus the need for credit arises from the
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Need for Lending supply side as well as the demand side of the economy. Thus,
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Having raised the funds the banks will have to ensure that the at any point of time, in the credit market, there will always be
same will be deployed into proper avenues so that they sustain some players to extend credit and a few others who will be
profitably. The two major applications of banking funds are seeking credit. However, to ensure that the borrowing and
credit accommodation and investments in securities. Of these, lending takes place in the credit market, the needs of the
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the former has evolved as the prime function of the banks both borrower should be met by the lender. In order to facilitate this,
due to the regulatory prescriptions as well as for profitable different types of credit facilities have originated in the credit
sustenance. market.
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According to Section 6 of the Banking Regulation Act, 1949, the
business of banking is defined as follows:
Types of Credit
Most of the credit facilities that are offered in the credit market
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“Banking means accepting for the purpose of lending or are in the form of loans. A loan is a broad term used to explain
investment of deposits of money from the public, repayable the different types of short/medium and long-term credit
on demand or otherwise, and withdrawable by cheque, draft, facilities extended in the credit market. Irrespective of their
order or otherwise.” nature, all loans are contractual agreements entered into by the
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the quality of the borrower and liquidity risk that may arise by
borrowing short and lending long in order to attain greater As mentioned earlier, the credit requirement arises from both
spreads. Further, the spreads earned in this activity will also be the demand and the supply side of the economy. The loans
exposed to risks arising both from interest rates and the that are extended to the supply side can be classified, as
exchange rates. commercial loans while the demand side loans will be
individual loans. Commercial loans are extended for two
Thus, while lending, the bank should essentially try to balance
purposes: Firstly, to acquire fixed assets and secondly, for the
its spreads and the risk levels. The significance of the lending
purpose of maintaining/running the business. Likewise, there
activity to the banking business can further be explained by the
are broadly three purposes for the individual loans:
fact that a shrinkage in the credit asset portfolio leads to greater
consumption, acquisition of durables and housing finance.
impact on the NII of the bank when compared to the
This classification of the credit facilities into commercial and
shrinkage in any other asset in its portfolio.
individual credit facilities is simple and broad but it does not
The need for lending thus arises both due to the regulatory help understand the critical aspects of the lending activity. To
prescriptions as well as for profitability purpose. Having enable such understanding, we shall examine the loans as
understood the need for lending, let us also look into the need described by the banks in their annual reports. Banks present
for credit. their entire advances in three different ways based on the nature
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depending on how a project gets implemented. The repayment will lock the funds of the firm. Banks offer receivable finance
process, which is generally on installment basis, will commence facility, which imparts liquidity to these receivables. When there
after the entire credit amount is disbursed. The installments can is a payment lag due to the geographical consideration, the bank
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be monthly, quarterly, half-yearly or annual payments. The acts as an intermediary, collecting funds from the buyer on
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frequency of the installment depends on the cash flow stream behalf of the seller. Such facility will be fee-based since the bank
of the borrower. Based on this repayment schedule, the tenor does not actually extend any credit and only enables the
of the credit facility is decided. This forms the base for the collection of funds. This does not result in extending credit.
classification of the loans into short, medium or long-term When bank extends credit, it will instead of collecting funds
from the buyer and passing it over to the seller, will actually
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loans. When the tenor is less than three years, it is a short-term
loan. Such loans are generally extended to households for the provide credit for the sale and will collect the funds from the
purchase of consumer durables. When the tenor ranges from 3- buyer at a later point of time. This is the fund based receivables
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5 years, it is a medium-term loan’ which is generally required by
the small and medium-sized firms for acquiring fixed assets.
financing facility offered by the bank.
When receivable finance is extended either for cash sales or credit
sales, there will be a few essential documents for bill financing
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And in cases where the repayment period exceeds 5 years then a
long-term loan facility that is extended to large corporate/ viz. bill of exchange document of title to goods (lorry/rail way
projects for the acquisition of fixed assets during project receipt, airway bill), invoice, etc.
implementation stage. Bill of Exchange (B/E)
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Operating Credit: In most of the cases, when credit is sought through receivable
Unlike the installment credit, the operating credit is for meeting finance, a B/E will be created. A B/E is a negotiable
the financial requirements of the daily operations. Since the firm instrument. In terms of Section 5 of the Negotiable
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cannot know its exact requirements on any given day, the bank Instruments Act, 1881, a B/E is an instrument in writing
provides an operating account (current account) after deciding containing an unconditional order, signed by the maker (in this
on the credit limit. The firm can withdraw from this account case the seller), directing a certain person (in this case the buyer)
using a cheque facility as and when it requires the funds. The to pay a certain amount of money only to, or to the order of, a
repayment mechanism for such credit facility is also different certain person (in this case a bank) or to the bearer of the
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from the installment credit. The firm will repay into the same instrument.
current account as and when it has surplus cash. Generally, this Lorry Receipt (LR)/Railway Receipt (RR)/Airway Bill
credit is extended for a period of 1-2 years, but since the firms These documents are evidences of dispatch of goods and
are going concerns, this credit facility may actually be rolled over
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date is after the bill is presented to the buyer, then the terms of covered by Bank/Government Guarantees” and hence are not
payment will be known as “Days After Sight”. Within this reported under unsecured loans category.
broad classification, depending on the mode of financing, bills
Secured Advances:
can be further categorized as:
Secured advances on the other hand, have impersonal security
• Clean Bills i.e. the security has to be a tangible asset against which the loan
• Documentary Bills is to be granted. Primary Security is an asset against which the
• Supply Bills loan is given and Collateral Security is a security, which is given
in addition to the existing primary security. These primary and
Clean Bills: collateral securities can be movable or immovable assets and
In transactions where the seller would have already delivered the depending on the same the charge created on the security may
goods and the documents to the buyer, the seller can avail the vary.
receivables finance facility using the Clean Bill. The seller can avail Charge on the movable properties can be created in the
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this facility without any supporting documents. Since the following five different ways:
delivery of goods and documents has already taken place, it
• Pledge
implies that the transaction would have been on credit basis.
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Hence, a Clean Demand B/E can be raised in this case. • Hypothecation
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• Assignment
Documentary Bill:
In certain cases, the seller would have only dispatched the goods • Banker’s Lien
without transferring the document of title for goods and/or • Set-Off
invoice, etc. In such cases, the seller can avail the bill finance A brief discussion on each of these methods of creating a
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facility through the Documentary Bill. To suit the cash and charge on security is followed hereunder.
credit sales, a Documentary B/E can be either a Documentary
Pledge:
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Demand Bill or a Documentary Usance Bill. When the
transaction is a cash sale, the Documentary Demand Bill is used
in which case the buyer has to pay the bank the amount and
According to Section 172 of the Indian Contract Act, 1872,
pledge is defined as: “Pledge is a contract whereunder deposit
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collect the documents. In the case of a credit sale, using the of goods is made a security for a debt and the right to property
Documentary Usance Bill, the buyer collects the documents first vests in the pawnee so far as it is necessary to secure the debt.”
without payment by accepting the bill. On the due date of the In other words, a pledge arises when the lender or the pledgee
bill, the buyer has to pay to the bank the bill amount. In both takes possession of the goods or bearer securities for extending
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the cases the seller avails the finance from the bank. a credit facility to the borrower or the pledgor. The pledgee can
retain the possession of the goods until the pledgor repays the
Supply Bill: entire debt amount and in case of a default, the pledgee has the
A Supply Bill is used in a buyers market i.e. when the buyer is a
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right to sell the goods in his possession and adjust its proceeds
large corporation or a government body; the seller has to first towards the amount due.
deliver the goods without raising the B/E. After the buyer is
The delivery of goods in a pledge can be either by actual delivery
satisfied with the quality of the goods, then the invoice has to
or constructive delivery. In the former case, the pledgor will
be raised. The documents like B/E and LR/RR will not be
handover the physical possession of the goods to the pledgee.
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loan. The second parameter that is used for classifying the loans transfer of the bill of lading. Such type of lending is usually
is the security of the loan. Security for the loans can be personal considered by a bank.
or impersonal. Based on the type of security, all advances made
While lending against pledge, the bank always maintains a
by the banks to any type of borrower can be classified into
margin between the value of the goods and the amount of
unsecured or secured advances.
credit allowed. For instance, if the bank is extending a credit of
Security Offered for Loans Rs.l lakh against the pledge of goods, then the value of the
Loans are generally c1assified into secured or unsecured loans. goods pledged should be more than Rs.l lakh. Further, in a
The features of these two types of loans are discussed below: pledge transaction, the underlying goods are usually either the
Unsecured Advances: raw material or the work-in-process or the finished goods.
When the advance given by the bank has a personal security of These would be required by the borrower in the regular course
any individual or the borrower with or without a guarantor, it of business. In such a case the borrower needs to take prior
will be c1assified as an unsecured advance. In the absence of any approval from the bank to withdraw any goods that are pledged
tangible security, though personal security is given by an with the bank since the goods will be in the custody of the
individual by way of an obligation for repayment, the loans are bank. In addition to this, the borrower will also have to submit
treated as unsecured. However, all those loans that have the
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kept under the lock and key of the banker. The borrower, had offered to the debtor). Such right exists when the amount
however, will have to submit a statement on the goods of the debts are certain, when the parties are the same and when
indicating the additions and withdrawals of the same to the there is no contract, express or implied to the contrary.
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bank. All the above mentioned methods of offering security are
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In addition to the fact that the bank does not have the related to movable assets. However, apart from movable assets,
possession of the goods under Hypothecation, it is also a fact there can also be immovable properties that are offered as
that there is no statutory status given to a Hypothecation security. The process of offering immovable, as security is
transaction. In this regard, it is, however, to be noted that known as Mortgage.
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Hypothecation has a close link to floating charge. While there is Mortgage
no law governing the Hypothecation of goods, Section According to Section 58 of the Transfer of Property Act, 1882, a
125(4)(f) of the Companies Act, 1956 that refers to the Floating
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Charge on undertaking or any property, may be related to
Hypothecation. As per this Section, floating charge, creates an
mortgage is defined as follows: “Mortgage is the transfer of an
interest in specific immovable property for the purpose of
securing the existing or future debt, or the performance of an
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immediate charge on the property charged but however, allows engagement which may give rise to pecuniary liability.” Thus
the borrower to use the property for its business just as in the through a mortgage, the interest and the rights on the
case of Hypothecation. This makes the charge in Hypothecation mortgaged property are transferred from the mortgagor
transaction similar to the type of floating charge. (borrower) in favor of the mortgagee (bank). The principal and
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Assignment: the interest amount that has been secured for is known as
Assignment is a charge in case of an “Actionable Claim” which mortgage-money. There are essentially, six ways of
is defined under Section 3 of the Transfer of Property Act, 1882 mortgaging:
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contingent. “
mortgage and equitable mortgage are the most important.
Assignment is a charge created on assets such as receivables,
A simple mortgage takes place without delivering possession of
debtors, etc. For example, policyholders can take a loan against
the mortgaged property. This type of mortgage binds the
the Life Insurance policy from a bank. In such cases, the LIC
mortgagor to pay the mortgage-money expressly or impliedly,
policy is assigned by the policyholder to the bank. If a bank
and in case of any failure to repay the amount, the mortgagee
finances a firm against book debts, then such book debts are
has the right to sell the mortgaged property and use the
assigned to the bank.
proceeds of the same towards the payment of the mortgage-
Lien: money. Such a mortgage is created through a document known
Banker’s Lien is a general lien and is defined under section 171 as “Deed of Mortgage” and is usually registered with the
of the Indian Contract Act, 1872 as follows: “Bankers, factors, Registrar of Assurances.
wharfingers, attorneys and policy-brokers, may, in the absence An equitable mortgage arises when a mortgagor delivers to the
of contract to the contrary, retain as a security for a general creditor the documents of title to immovable property, in order
balance of account, any goods bailed to them; but no other to create a security on the same at certain places, which are
persons have a right as a security for such a balance, goods notified, in the official gazette. It will be necessary to deliver the
bailed to them, unless there is an express contract to that effect.” documents at these specified places by the borrower to the
status of the borrower or lender. Equitable mortgage is also for the amount of financing that have to be done for various
known as mortgage by deposit of title-deeds. sectors. Apart from such guidelines, RBI has identified the
Having discussed the classification of loans based on the sectors where the financing facility offered is much less than
security offered, we now proceed towards the last type of what is required and set targets for the banks to meet while
classification of advances as given in a bank’s balance sheet financing these sectors. While there were many neglected sectors,
which is based on the purpose of the loan. it was primarily the agricultural and the SSI sector that were of
major concern. India being an agrarian economy and with most
Purpose of Loan of its population living in the rural and semi-urban areas, the
There are basically three purposes for which the banks extend development of the agricultural and the SSI sectors was crucial
their loans and based on these purposes the sectorial for the economic development of the nation. Considering this,
classification of banks’ advances are made. Ever since the RBI has set targets as follows:
nationalisation, the banks have been providing financial
• Agricultural Sector: The advances given to the agricultural
assistance to the neglected sectors of the economy. Accordingly,
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sector are classified into direct and indirect advances and the
the RBI has laid down specific guidelines to direct funding for
combined target for these two types of advances was set at
these sectors. Apart from this, advances are also made to the
18 percent.
public sector units. Based on such advances, the sectorial
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classification of loans has accordingly been made as under: • SSI Sector: While there is no target set for the advances to
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be made for the SSI sector as a whole, there is a sub-target of
• Priority Sector
40 percent set for the advances made to the cottage
• Public Sector
industries, khadi and village industries, artisans, tiny
• Banking Sector industries (plant and machinery outlay up to Rs.25 lakh) or
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• Others other SSI units availing credit up to Rs25 lakh.
Priority Sector Advances The other guidelines issued by the RBI that govern the priority
sector lending to various sectors are given below.
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In order to channelise the flow of credit to certain key sectors of
the economy, the RBI, in the credit policy for 1967-68, has
identified the priority sectors. Initially, the priority sector
Agriculture
As mentioned above, the advances made to the agriculture
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comprised of agriculture, exports and small-scale industries sector are of two types -direct and indirect. Direct loans include
(SSI). Following this, banks were given a target of one-third of both short-term and medium-term loans. For the short-term,
the outstanding credit to the priority sector by the end of farmers are given credit against Pledge/Hypothecation of
March, 1979. Subsequently, in 1985, the floor for the priority agricultural produce (including warehouse receipts) for a period
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sector advances was set at 40 percent and within this target, a not exceeding 6 months. The credit amount involved, for such
sub-target of 10 percent is set for the weaker sections. The RBI’s crop loans is Rs.1 lakh. The medium-term loans are extended
definitions for the priority sector and the weaker sections within for the purpose of the purchase of agricultural implements and
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this priority sectors are given below: machinery, development of irrigation potential, reclamation and
• Priority Sector - Agriculture., Small-Scale Industries SSI), land development schemes, construction of farm buildings and
Transport, Retail trade, Small Business, Professional and structures, etc., construction and running of storage facilities,
Self-Employed persons, Education, Housing and production of irrigation charges, etc.
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Consumption. Other types of direct advances made to the farmers include the
Within this classification, the RBI has also defined the weaker following:
sections as follows: • Short-term advances made to cultivators of traditional
• Small and marginal farmers with land holding of 5 acres or plantations (tea, coffee, rubber and spices) irrespective of the
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less, landless laborers, tenant farmers and share croppers; size of holdings would be treated as direct agricultural
• Artisans or small industrial activity viz. manufacturing,
advances under priority sector.
processing and servicing in villages and small towns with a • Advances granted for development of sericulture and for
population not exceeding 50000 involving utilisation of grainages under sericulture.
locally available natural resources and/or human skills. • Advances up to Rs.5 lakhs granted for financing distribution
Individual credit requirement should not exceed Rs.25000 to of input such as cattle feed, poultry feed, etc.
be considered as part of the weaker sections; Apart from the above mentioned direct loans, the RBI has also
• Scheduled Castes and Scheduled Tribes; specified certain indirect loans that are to be categorized as
• Beneficiaries of Differential Interest Rate (DRI) scheme; priority sector. The indirect advances in agriculture have,
• Self-Employment Program for Urban Poor (SEPUP);
however, been restricted to 4.5 percent of the overall target of
18 percent set for the agricultural sector. Within this upper limit
• Beneficiaries of Integrated Rural Development Program
of 4.5 percent, the banks can give indirect agri-loans to
(IRDP). organisations/boards/individuals providing fertilizers,
electricity, spraying operations, etc. In addition to this, indirect
finance includes loans given to co-operative marketing societies,
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improvement scheme in the rural areas under special project
Advances granted to (i) private retail traders dealing in essential agriculture (SI-SPA) was classified as indirect finance to
commodities (fair price shops) and consumer cooperative stores agriculture under priority sector.
and (ii) other private retail traders with credit limits not
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During February 1999, RBI had introduced the advances made
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exceeding Rs.5 lakh.
to food and agro-processing industries and investments in
Services (small Business venture capital into the priority sector lending.
The advances made to the firms providing services (other than Loans to the software industries (having credit limit not
professional services) will be covered here. The original cost exceeding Rs.1 crore from the banking system).
price of the equipment used and the working capital limits of
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The above mentioned guidelines give the priority sector
such firms should not exceed more than Rs.10 lakh and Rs.5
advances that arc to be made by the scheduled commercial banks
lakh respectively. Further, the aggregate of these shall not exceed
more than Rs.1 lakh.
Transport iza D (SCBs) only. The RBI has issued separate guidelines for the
priority sector advances of foreign banks. From July 1993,
foreign banks are required to make 32 percent of their net bank
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Advances given to the road transport operators coming under credit to the priority sectors. The definition of priority sector to
this category will be given to the extent of financing ten vehicles. foreign banks also includes the export credit. Within the overall
Bank credit to NBFCs for the purpose of on-lending to small target set for the priority sector, a sub-target of 10 percent is set
road and water transport operators (fleet of vehicles. not more for SSI and export credit. The shortfall, if any, in meeting the 10
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than 10) is also considered as priority sector. This implies that if percent target will have to be made by depositing the same with
a company XYZ Travels Ltd. has a fleet of nine vehicles and the Small Industries Development Bank of India (SIDBI).
takes credit for its 10th vehicle from a bank, then the credit
Public Sector/Banking Sector/Other Sectors
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i.e. based on the nature, security and purpose, the bank will be
In the individual category, the total advances given to
in a better position to analyze its loan profile from various
professionals and self-employed, whose borrowing limits do
angles. This kind of classification helps the reader of a balance
not exceed Rs. 5 lakh of which not more than Rs. l lakh for
sheet to understand the bank better.
working capital purpose are covered. However, in case of
professionally qualified medical practitioners (setting up practice Having decided on the type of credit it will be offering, the bank
in rural and semi-urban areas), the borrowing limit shall not will then have to take crucial decisions regarding the loan
exceed Rs.l0 lakh, of which, the working capital should not be appraisal and disbursal, loan pricing and other loan
more than Rs.2 lakh. Within the above ceiling, the medical components. Once the bank decides on the type of credit
practitioner will also be given an advance for the purchase of advances it will be making, the loan appraisal and disbursal
one motor vehicle. follows. We shall now try to get an insight into these aspects of
lending.
Housing
Direct housing loans only up to Rs.5 lakh in rural/semi-urban
areas and up to Rs.l0 lakh in urban and Metropolitan areas, are
treated as priority sector advances. All investments in bonds
issued, by NHB/Housing and Urban Development Authority
All the types of advances that are made by the bank, which are Rs.55 lakh, there will be the margin amount which is to be
discussed above, will be debt finances. And prior to the brought-in by the borrower. To arrive at this margin money, the
disbursal of any amount as advances, the bank should be well bank will have to first arrive at Maximum Permissible Bank
aware of the cash requirements of the borrower and the type of Finance (MPBF).
advance it should make in order to suit such requirement of the The three methods that can be used to assess the credit amount
borrower. This type of appraisal differs greatly from the initial are
appraisal that the bank conducts while deciding on the approval
of the loan. The initial appraisal basically involves an analysis of Turnover Method
the market, technological, financial, managerial analysis and Based on the forecasts made for the turnover of the firm, a
suggests the bank the feasibility of making any advances with percentage of the same will be taken as the amount to be
such analysis. Once the bank decides to sanction the loan financed for the working capital.
proposal, the other critical issues that need to be catered to are Earlier, banks were to assess the credit requirements of
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the decisions relating to the way of financing, i.e. which mode borrowers with fund based working capital up to Rs.l crore
of funding will suit the clients cash requirements and the from the banking system in a simplified method of fixing a
manner in which the amount has to be disbursed. limit of minimum of 20 percent of the assessed turnover with
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Firms basically need bank funds as project finance or as working a minimum margin of 5 percent to be brought in by the
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capital. Project finance is generally used for financing, long-term borrowers. Now the method can be adopted for fund based
assets of the firm. Consider the following illustration: working capital liability of Rs.5 crore.
Cash Budget Method
Project details of LLG Steels Ltd.: (Rs. lakh)
Land 125.00 This method assesses the requirement of the funds by the firm
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Site Development
Building
15.00
75.00
at various periods and then decides on the MPBF. This method
Plant and Machinery 25.00 suits the seasonal industries. Based on the seasonality, banks
Pre-operative Expenses 5.00
can set the peak and non-peak limits for the bank finance.
245.00
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The above figures show the total financial requirement for the
Tandon Committee Method
Tandon gave three methods of assessing the MPBF, which are
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project, which the firm submits, to the bank. In any type of as follows:
lending activity, banks do not fund the entire amount required
by the borrower. They require the borrower to bring in some Method I 0.75 (CA - CL)
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amount as the margin money. In case of the financing, of the Method II 0.75 (CA) - CL
long-term assets, this margin will be normally 25 percent of the
Method III 0.75 (CA - CCA) – CL
total amount for each type of asset that the bank is willing to
finance. Thus in the above illustration, as the bank will be
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financing, land, site development, building and plant and Core current assets are to be financed by the long-term sources
machinery, the margin money will be Rs.60 lakh (240 x 0.25). of the borrowers.
The balance of the amount i.e. Rs.180 lakh will be provided by CA and CL are Current Assets and Current Liabilities
the bank as a term loan and/or lease finance. Having decided on respectively and CCA are the Core Current Assets.
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will make projections of the market demand, etc. and arrive at approaches depending on tile nature of the business and the
the amount of working capital it requires at a particular level of size of the firm and assess the MPBF.
production. Consider the working capital requirement of LLG
Assuming that the current liabilities of LLG Steels Ltd. are
Steels Ltd.:
Rs.25 lakh the MPBF using the Tandon Committee’s method
Rs. lakh
II will be as follows:
Inventory 20.00
Debtors 8.00 The Current Assets = Rs.55 lakh
Receivables 5.00
Cash 10.00
Others 12.00
The Current Liabilities = Rs.25 lakh
55.00 MPBF = 0.75(CA) - CL = 0.75(55) - 25
= 16.25
The decision relating to the amount to be financed will be
followed by the method of financing, the same. Financing, of
the working capital will be through cash credit (CC), working
capital demand loan (WCDL) and/or bill financing,
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2. What are the types of credit?
3. Discuss the nature of credit?
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4. What is the security offered for Loans?
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5. Discuss the purpose of Loan.
6. Systems Hardware Ltd. Has submitted its project report for
getting credit facility from the Dhan Bank Ltd. The following
are the details relating to project finance and working capital
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requirements of the firm:
Rs in Lakh
Land
Site development
Building
Plant and machinery
Pre-operative expenses
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75.00
5.00
55.00
125.00
10.00
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Total 270.00
Rs in Lakh
Inventory 45.00
Debtors 15.00
Receivables 10.00
Cash 10.00
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Others 8.00
Total 78.00
LESSON 17:
LOAN POLICY
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be taken both prior to and after sanctioning the credit. These adherence to the regulatory prescriptions will also be an
decisions generally relate to the amount of credit to be extended important consideration. By stating the related regulatory
during a financial year, the industries to focus on, the aspects in the policy, the loan officers will be fully aware of the
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geographical spread, the type of credit to offer, the type of importance of the policy measures. .
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proposals to finance, the disbursal mechanism, the collateral
Volume and Mix of Loans
value, the method of pricing, the repayment schedule, the
The policy should specify the targeted composition of the loan
monitoring process, etc. These macro and micro level
portfolio, such composition being in terms of industry/
considerations of the lending activity contribute to the
location/size/ interest rate/security. Decisions regarding the
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achievement of the bank’s objectives. The bank’s management
loan portfolio will depend on the size of the bank, the credit
should thus, ensure that lending decisions fall in line to
requirements in its operational areas and the expertise available
subserve the bank’s overall objectives.
Need for a Loan Policy
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While lending decisions are crucial for the bank, it is neither
with the bank. In an agrarian type of economy most of the
loan demands may come from the farmers. Likewise, if the
bank size is small, it may have to put a limit to individual loan
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feasible nor desirable for the top management to review and proposals to be in proportion to its total loan portfolio.
clear every single loan proposal that the -bank receives. This Generally, exposure levels, which the banks can have for the
arises not only due to the process involved in such an activity various types of borrowers, are given by the apex regulatory
but also due to the numbers. Furthermore, for most of the body. While fulfilling the, regulatory prescription it is desirable
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loan proposals, whichever industry they may belong to, the to develop more detailed limits within the bank.
modus operandi remains the same - analyzing, selecting,
Geographical Spread
sanctioning and monitoring. Hence, the, top management
There will be various locations from where a bank conducts its
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policy should thus, state the key trade areas of the bank for
policy document that carefully specifies the dos and don’ts while extending credit. Further, within the trade areas, there may be
sanctioning the loan proposals. As loan proposals differ widely certain areas with a primary focus and a few others, which may
from each other, there cannot be a strict methodology for be given the secondary focus. Such a classification may also
accepting or rejecting the proposals. Instead, guidelines can be
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the help of a credit file, which keeps track of the historical record
• Benefit from economies of scale of the borrower. In this context, the loan policy can specifically
Financial Efficiency mention the inputs required for maintaining the credit files for
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Repayment of the loan by the clients depends greatly on their varying types of loans. The credit file maintained for a borrower
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financial soundness. Hence, financial analysis becomes an should reveal all the parameters considered while accepting the
imperative part of credit risk analysis. It includes an analysis of proposal. It is useful to keep a record of any specific events/
the following: experiences which indicate whether the decision taken for
• Financial leverage granting such a loan was sound or not. The contents of the
credit file should include all details of the borrower including
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• Coverage ratios
detailed financial statements and analysis, collateral provided
• Cost of capital and the value of the same, details of compensating balances,
• Ability to raise funds
• Working capital management iza D etc. Moreover, since most of the customers are not one time
borrowers, it will be all the more necessary for the bank to
maintain such credit files of the customers.
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• Interest rate risk management
Lending Rates
Management Evaluation
The interest charged should reflect the credit risk present in the
While the above mentioned factors assess the ability of the
credit disbursal. The major issue will thus be to adjust the rate
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• Sensitivity to interest rate structures, tax policies, etc. that the loan policy may contain:
Above is the broad classification of the various parameters used
to evaluate a loan proposal. The parameters used for evaluating
• Type and extent of collaterals
will vary depending on the type of the borrower, the nature of
the project and the purpose of funds. The list provided above • Compensating balances 2 / margin.
is not an exhaustive one and depending on the loan proposal, • Statutory limits for different types of loans
the bank will select the evaluating variables. Once a broad list of • Monitoring mechanism
such parameters is identified, the loan policy may also specify
• Loan-Deposit ratio
benchmarks so that uniform evaluation can be ensured.
• Incentive schemes for the loan officers.
Loan Administration
• Loan repayment pattern
Efficient administration is the key to the success of the lending
policy. And for improving its efficiency, the authority of the • Communication practices
loan executives should be clearly stated as also their • Extension of renewals of past-due installment loans
responsibilities. The loan policy should state the sanctioning (rescheduling the loan)
powers of the loan officers regarding the credit limits. The credit
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standards. It will have to suggest measures to cope with certain
grey areas and find a solution to the critical questions relating to
a bad loan before it drifts into an undesirable and
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uncontrollable situation
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Summary
By listing the lending parameters, defining responsibilities and
having in place a proper system of checks and balances, the loan
policy does provide a framework for bank lending. In addition
to this, a good loan policy should have two other features -
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firstly, it has to establish the credit culture for the bank and
secondly, it has to be contemporary. If a loan policy is able to
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establish a credit culture for the bank, then it will also enable a
new entrant into the organization to understand the procedures
of the bank easily. And due to the dynamic operating
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environment, there may be certain changes in the bank
objectives, the pricing methodologies practiced, the exposure
levels, etc. and all these require a revision in the loan policy.
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Learning Goals: However, one issue that arises during such computation is
After reading this lesson, you will be understand whether to use the average cost of funds or the marginal cost
of funds. This becomes a fairly simple issue if the liabilities and
• Objectives of loan pricing
the assets of the bank are examined. If we consider a bank’s
• Cost plus loan pricing model balance sheet, the liabilities of the bank will be deployed into
Being the purveyors of credit, primary activity of banks is various assets including advances and investments. In certain
lending. Apart from ensuring proper application of the surplus situations when the bank does not have suitable deployment
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funds mobilized, lending also enables these banks to maintain opportunity by way of loans or investments, it will temporarily
profitability. Deployment of funds should be at a rate that deploy the same into the money market and will utilize the
covers the cost of funds and leaves a margin to the lender after same for the future credit proposals. Along with these funds,
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meeting the expenses. This margin should on one hand cover incremental deposits will also be used for offering credit. When
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the risks a bank is exposed to due to their lending activity and the funds deployed in the money market are used for extending
on the other hand provide certain income. Pricing thus has an the credit, then it is desirable for the bank to consider the
implication on the profitability and the sustenance of the bank. average costs of funds while pricing the loans. This is basically
While a bank can adopt a pricing policy for greater margins, it due to the fact that various sources of funds would have been
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may, however, have an adverse affect on their business volume. used for the deployment into the money market. An average
A bank needs to thus, adopt a pricing policy that ensures cost of funds will be essential since in a declining interest rate
profitability while increasing the business volumes. Arriving at scenario, by considering only the marginal cost of funds, the
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such a price level is difficult for the simple reason that there are a
number of factors, both internal and external to the bank that
influences such a decision. The aspects related to loan pricing
higher interest rates on the banks funds will eat into the
profitability of the bank.
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Alternatively, if the bank does not have any surplus funds
that are discussed in this lesson can be broadly categorised into deployed into the money market, then the future credit
the following: requirements will have to be funded using the incremental
• Determinants of loan pricing deposits only. Under such circumstances the incremental or the
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• Methodologies of loan pricing marginal cost of funds can be used while assessing the loan
price. Thus, in loan pricing, the use of the average cost of funds
Objectives of Loan Pricing and the marginal cost of funds will depend on the composition
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Prior to deciding the price of any product, it is essential to first of asset-liability position.
identify the objective the price of the product should attain for
the firm i.e. should it ensure high returns, higher business or Risk-Reward
should it just enable a break even. Similar is the case when the The relation between risks and returns will have to be
bank decides to fix its loan price. Banks generally have three considered taking three different loan attributes- the tenor of
the loan, the credit risk of the customer and the size of the
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Margins ensure profitability, the balanced risk-reward profile term. This is due to the fact that the risk involved in lending foe
ensures sustenance, and the market rate ensures the presence of longer periods is greater when compared to the lending for
the bank in the market. While all the three objectives are shorter periods. Considering this, if a bank would like to earn
important and interrelated, prioritizing them, however, will be a greater returns, it would have to lend for longer periods. But for
policy decision to be taken by the bank. this, the bank should also have funds with marching maturity.
However, the sources of funds for a bank do not generally
Margins:
include long-term funds. In such cases, the bank may borrow
To ensure margins, the bank should have surplus income after
short and lend long, which may lead to an enhanced level of
having met its cost of funds and cost of servicing. For this
risk. Due to the presence of this risk, the bank should decide on
purpose, the bank can ascertain the cost of its funds, add the
a level of risk-reward that it is prepared to accept and then
overall cost of servicing to which it can add the necessary
decide on the maximum tenor of its loans.
margins it would like to maintain for taking the risk and to earn
a profit. The total of this will give the rate at which the loan has The second major attribute that influences the risk, reward
to be priced. proportion of the bank is the credit risk involved in the lending
function. All loans have a certain element of risk involved in
them due to the probability of default. The level of risk,
sovereign debt to corporate debt. Due to the presence of this The last factor that affects the loan pricing decision is the market
risk, the returns will also vary, with greater returns being rate. If the rates charged by the bank are higher than the market
attached to higher risk levels. This linkage between the credit risk rates, then it will lose its business to those offering cheaper
and the returns highlights the need for the bank to first decide rates. On the other hand, if it lowers its rates below the market
on the level of risk-reward it would prefer to maintain. Having rates, then though the volume of the business may increase,
laid down the tolerable risk level and the approximate returns but the lower returns will reduce its profitability. To prevent loss
for the same, the bank can accept or reject the loan proposals of business and lower profits, thee bank should ensure that
based on the risk they are exposed to. loan prices remain close to the prevailing interest rate structure
Apart from the above mentioned attributes, the size of the in the market.
loan also influences the risk-reward ratio. While the affect of Considering the various factors influencing the loan pricing
term to maturity and the credit risk on the risk-reward ratio decision of the bank and the alternatives in pricing, the bank
could be clearly observed, the same may not be possible in the will next have to develop loan pricing model. If the objective of
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case of the size of the loan. The key issues to be considered the bank is to earn spreads, then the pricing model will first
here will be the relationship, the servicing costs and the risk focus on the cost analysis of the bank and then ensure that the
involved have with the size of the loan. price charged covers its costs and leaves a margin. Similarly,
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Considering the servicing costs, as the size of the loan increases, when the risk-reward objective is set as the top priority, the
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these costs come down as it will be cheaper to service a single customer evaluation and a price that reflects the risk involved by
loan account of Rs. 10 lakh each. Loans which are made in small extending such credit becomes essential. And finally, if the
denominations and which involve greater clerical and bank’s chief objective is market presence, then it will ensure that
management time, carry high cost per rupee of loan extended its rates move in tandem with the rates of the other players in
the market. However, this cannot be pursued irrespective of its
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and vice versa. Example of this can be a credit card facility where
the time involved for management is greater than the tem loan. ability to sustain.
Compensation for this high service costs are the high interest However, prudence lies in actually integrating these three
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rates charged for the credit card facility. On the other hand, loan
of larger denominations will take comparatively lesser time for
management and may be a useful proposition. However, the
objectives and emerging with a price that not only covers the
banks’ lending costs and gives a return on it, but also ensures
that the bank is able to sustain the risk level taken and at the
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greater exposure to one client will result in higher risk. To same time keeps itself close to the prevailing market rates.
understand this, consider the Capital Structure theories. It can Discussed below is a pricing model that uses various
be recalled form the traditional approach of capital structure that approaches to build in these three objectives. The basic model
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the gains on account of increased leverage will be higher than of the cost plus pricing is used to arrive at the loan price. Within
the increased cost of equity thus having a positive impact on the this, various methods of assessing the risk premium and the
value of the firm up to a particular level of leverage. Thus the required profit margin are discussed. Following this approach,
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ratio of debt to equity, which does not adversely affect the value the bank can build in a pricing methodology that ensures a
of the firm, will be safe for the creditor/bank. The bank can price, which covers the costs and the risks and leaves a profit
lend to a single customer as long as this degree of leverage is margin.
maintained. However, if the debt amount goes beyond this
level for the firm, then the credit risk for the bank will rise. The Cost Plus Loan Pricing Model
This model basically focuses on arriving at a loan price that
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rise in the credit risk will again lead to a rise in the servicing
costs, which have actually been falling due to the size of loan. ensures a certain margin after covering the cost of the funds,
This is basically due to the fact that with the size of the loan operations costs, cost of servicing. The process involved in
being large and the credit risk increasing, the bank will have to arriving at a contractual rate based on this model consists of the
following steps:
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from such services, the servicing costs of deposits will also have
proposal with a similar maturity. The cost of funds will thus be
to be met from the interest income.
the average cost of pooled funds and not the average cost of
total funds. This approach to assessing the cost of funds will Risk Premium
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enable price matching as well as maturity matching. However it Risk margin will be set after considering the different types of
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may not be possible to adopt a pooled funds approach in risks the loan is exposed to. For a proper assessment of this,
respect of all sources of funds. It is, therefore, desirable to risk unbundling becomes essential. Provisions are generally
adopt this pooled funds approach at least in respect of high made to tackle the risk element in the assets.
cost funds so that the price decided on the basis of average Profit Margin
funds does not result in reduction of spreads. Further, in the
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After considering all the costs involved with the lending activity
case of average cost of funds, the bank cannot use the same rate as well as adjusting for the risk the bank will then look towards
for loans of differing tenors.
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While the price arrived based on the average cost of funds
results in a flat yield curve, it is not always seen in the market
including a profit margin. This margin would depend on the
returns it would like to earn from the lending activity.
Having considered the various components that the bank’s
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and it will not be in tune with the concept of upward sloping margin can comprise of; it can be observed that the margin
yield curve. Therefore, it is possible to change margins at mentioned in Eq.(1) is set to meet the other expenses
different rates to address this problem. (operating ,and the servicing costs), the provisions for risk and a
Thus, it can be observed that in the pooled cost of funds residue which forms the profit margin. Since the cost of funds
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approach the margins are fixed. However, when the average cost represent the interest expenses, the margin will not require to
of funds is considered, the margins for loans with higher meet them. Thus, when a bank is unable to segregate its other
maturities will be less while the margins for the loans of lower expenses and quantify its risks, this type of loan pricing can be
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maturities will be higher. To avoid such fluctuations in the adopted. Based on the type of security, the nature of the loan
actual margins when the average cost of funds is considered, the and the purpose for which the funds are borrowed, the bank
bank will have to set margins based on the tenor of the loan can set a range for the margins to be included in pricing. The
instead of having a fixed margin for loans of differing upper end margins can be used for loans with higher maturities,
maturities i.e. set higher margins for loans with higher more risk, etc. and vice versa.
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maturities. Sometimes, the bank will be able to identify its operating and
Margins servicing costs and build it into its pricing model as a percentage
The word margin is used in a very broad sense in the above to the size of the loan. The loan price can then be assessed as
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further disintegrated as follows: recovery rate can be computed by considering the guarantees and
Loan Price = Cost of Funds + Cost of Servicing + value of collaterals attached to the loan. The recovery rate refers
Provisions for Risk + Profit Margin..…(4) to the percentage of the outstanding balance that can be
recovered by measures such, as enforcement securities, legal
Here the margin will be solely to meet the profits of the bank.
action, etc.
This can, be arrived at based on the Return on Equity, which the
bank would expect to maintain. When a default is expected from a loan, the bank will adjust the
recovered amount towards the principal. Thus, based on the
In its very basic framework, the cost plus pricing method
probability of payment and recovery -rate, the expected rate
discussed above is based only on the costs and since costs set
when the bank expects the payment of interest as well as the
the floor for pricing, the interest rate arrived at that first stage
principal amount, will be
(using (Eq. (3)) can be considered as the Hurdle Rate. This is
the rate below which a bank cannot offer any credit if it has to Expected Return = P1(r) + P2 P (1 + r) x R ………….(6)
remain profitable. To arrive at this hurdle rate, estimation of P
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Where,
costs, expenses incurred and expected returns become essential.
However, by assessing the risk premium and the required P2 = Probability of default
P = Principal component
returns, the bank can actually improvise on its pricing approach.
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R = Recovery rate.
But to arrive at this price, the bank should be able to quantify its
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risks and also decide on the required margin. In the above formula, P1(r) gives the returns using the
Discussed below is the procedure by which the bank can contractual rate and the probability of total repayment of the
gradually build a loan price that incorporates all parameters i.e. loan in the normal course of payment while the second part i.e.
the cost of funds, cost of servicing, risk premium and the P2{ [P(l + r) x R]/P – 1 } gives the returns using the recovery
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profit margin. The loan price using the Eq. (3) can be obtained rate and the probability of default. The expected rate when there
simply by assessing the cost of funds and its servicing costs and is only principal repayment will be assessed as follows:
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adding the margin amount. The profit margin, which the bank
sets, should enable the bank to earn its required ROE. When
the ROE is met then the price charged which is known as the
Expected Rate = P1(r) + P2 (R - 1)…………….(7)
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Contractual Rate will become the expected return for that loan.
However, the bank will earn this expected return as long as there In the above equation, the second part i.e. P2 (R - 1) gives the
is no default in the repayment of the loan. In case there is a principal that is recovered.
default, the contractual rate will not give the bank the expected
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Quantifying Risk Premium Such an exercise will, to a certain extent, reduce the loss in return
Generally, while performing the financial appraisal for the due to defaults. From the above equations, for a given
proposal, the internal rate of return (IRR) is calculated. If the contractual rate, the expected returns from the proposal can be
payments are made regularly by the clients, then the expected assessed by considering the probability of the repayment/
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rate of return will be equal to the contractual rate. default and the recovery rate. Using this approach, it is also
possible to decide the contractual rate to be offered once the
required rate is determined. The required rate, which includes
Expected Return = P1(r)……………………………..(5)
the cost of funds, transaction costs and the spreads, can be used
where,
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will be the expected return for VFL? Based on the answer
you get, assess the rate at which the loan should have been
financed to get a return of 22 percent.
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4. L&M Bank Ltd. has received a 4-year loan proposal from a
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Deep Mines Ltd., which has a A+ credit rating, attracting a
risk premium of 2 percent. The PLR for a 2-year loan of the
bank is at 13.5% and the implicit forward rate for two years
form now is 15 percent. If the bank follows a prime-time
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pricing method, what should be the loan price?
Notes:
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LESSON 19:
NON PERFORMING ASSETS (NPA)
Learning objectives Further, international rating agencies like, Standard & Poor have
After reading this lesson, you will understand lowered India’s credit rating to sub-investment grade. Such
negative aspects have often outweighed positives such as
• Introduction
increasing forex reserves and a manageable inflation rate.
• Indian Economy and NPAs
Under such a situation, it goes without saying that banks are no
• Global Developments and NPAs exception and are bound to face the heat of a global downturn.
• Meaning of NPAs One would be surprised to know that the banks and financial
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• Why such a huge level of NPAs exists in Indian banking institutions in India hold non-performing assets worth Rs.
system (IBS)? 1,10,000 crores. Bankers have realized that unless the level of
NPAs is reduced drastically, they will find it difficult to survive.
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• Why NPAs have become an issue for banks and financial
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institutions in India? Global Developments and NPAs
• RBI Guidelines on income recognition (interest income on The core banking business is of mobilizing the deposits and
NPA) utilizing it for lending to industry. Lending business is generally
encouraged because it has the effect of funds being transferred
• Accounting Standard 9 (AS 9)
from the system to productive purposes, which results into
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• Are RBI guidelines on NPAs and ICAI Accounting Standard economic growth.
9 on revenue recognition, consistent with each other?
However lending also carries credit risk, which arises from the
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• RBI guidelines on classification of bank advances
• How to classify bank advances, if recovery is highly unlikely?
failure of borrower to fulfill its contractual obligations either
during the course of a transaction or on a future obligation.
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• Credit Risk and NPAs A question that arises is how much risk can a bank afford to
• Public Trust and NPAs take? Recent happenings in the business world - Enron,
WorldCom, Xerox, Global Crossing do not give much
• How important is credit rating in assessing the risk of
confidence to banks. In case after case, these giant corporates
default for lenders?
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• Can Universal Banking solve the problem of NPA for DFIs? welcome. The history of financial institutions also reveals the
• Capital Adequacy Ratio (CAR) of RBI and Basle Committee fact that the biggest banking failures were due to credit risk.
on Banking Supervision (BCBS) Due to this, banks are restricting their lending operations to
• Excess Liquidity? secured avenues only with adequate collateral on which to fall
back upon in a situation of default.
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for a period of 180 days. However with effect from March 2004,
India face the problem of swelling non-performing assets default status would be given to a borrower if dues are not paid
(NPAs) and the issue is becoming more and more for 90 days. If any advance or credit facilities granted by bank to
unmanageable. In order to bring the situation under control, a borrower becomes non-performing, then the bank will have
some steps have been taken recently. The Securitisation and to treat all the advances/credit facilities granted to that borrower
Reconstruction of Financial Assets and Enforcement of as non-performing without having any regard to the fact that
Security Interest Act, 2002 was passed by Parliament, which is an there may still exist certain advances / credit facilities having
important step towards elimination or reduction of NPAs. performing status.
Indian Economy and NPAs Why such a Huge Level of NPAs Exists in the Indian
Undoubtedly the world economy has slowed down, recession is
at its peak, globally stock markets have tumbled and business Banking System (IBS)?
itself is getting hard to do. The Indian economy has been much The origin of the problem of burgeoning NPAs lies in the
affected due to high fiscal deficit, poor infrastructure facilities, quality of managing credit risk by the banks concerned. What is
sticky legal system, cutting of exposures to emerging markets by needed is having adequate preventive measures in place namely,
FIIs, etc. fixing pre-sanctioning appraisal responsibility and having an
effective post-disbursement supervision. Banks concerned
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banking system, the banking industry cannot afford defaults by
borrower s since NPAs affects the repayment capacity of banks. Standard Assets
Further, Reserve Bank of India (RBI) successfully creates excess Such an asset is not a non-performing asset. In other words, it
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liquidity in the system through various rate cuts and banks fail carries not more than normal risk attached to the business.
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to utilize this benefit to its advantage due to the fear of Sub-standard Assets
burgeoning non-performing assets. It is classified as non-performing asset for a period not
RBI Guidelines on Income Recognition (interest exceeding 18 months
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Banks recognize income including interest income on advances Asset that has remained NPA for a period exceeding 18 months
on accrual basis. That is, income is accounted for as and when it is a doubtful asset.
is earned.
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The prima-facie condition for accrual of income is that it should
not be unreasonable to expect its ultimate collection. However,
Loss Assets
Here loss is identified by the banks concerned or by internal
auditors or by external auditors or by Reserve Bank India (RBI)
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NPAs involves significant uncertainty with respect to its inspection.
ultimate collection. In terms of RBI guidelines, as and when an asset becomes a
Considering this fact, in accordance with the guidelines for NPA, such advances would be first classified as a sub-standard
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income recognition issued by the Reserve Bank of India (RBI), one for a period that should not exceed 18 months and
banks should not recognize interest income on such NPAs until subsequently as doubtful assets.
it is actually realized. It should be noted that the above classification is only for the
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What does Accounting Standard 9 (AS 9) on Revenue purpose of computing the amount of provision that should
be made with respect to bank advances and certainly not for the
Recognition Issued by ICAI say? purpose of presentation of advances in the banks balance sheet.
The Accounting Standard 9 (AS 9) on ‘Revenue Recognition’
The Third Schedule to the Banking Regulation Act, 1949, solely
issued by the Institute Of Chartered Accountants of India
governs presentation of advances in the balance sheet.
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(ICAI) requires that the revenue that arises from the use by
others of enterprise resources yielding interest should be Banks have started issuing notices under the Securitisation Act,
recognized only when there is no significant uncertainty as to its 2002 directing the defaulter to either pay back the dues to the
measurability or collectability. bank or else give the possession of the secured assets
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its auditors before declaring any dividends on its shares. assign a probability of default.
In case of loss assets, guidelines specifically require that full Credit rating agencies generally slot companies into risk buckets
provision for the amount outstanding should be made by the that indicate company’s credit risk and are also reviewed
concerned bank. This is justified on the grounds that such an periodically. Associated with each risk bucket is the probability
asset is considered uncollectible and cannot be classified as of default that is derived from historical observations of
bankable asset. default behavior in each risk bucket.
Also in case of doubtful assets, guidelines requires the bank However, credit rating is not foolproof. In fact, Enron was
concerned to provide entirely the unsecured portion and in case rated investment grade till as late as a month prior to it’s filing
of secured portion an additional provision of 20%-50% of the for Chapter 11 bankruptcy when it was assigned an in-default
secured portion should be made depending upon the period status by the rating agencies. It depends on the information
for which the advance has been considered as doubtful. available to the credit rating agency. Besides, there may be
For instance, for NPAs which are upto 1-year old, provision conflict of interest, which a credit rating agency may not be able
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should be made of 20% of secured portion, in case of 1-3 year to resolve in the interest of investors and lenders.
old NPAs upto 30% of the secured portion and finally in case Stock prices are an important (but not the sole) indicator of the
of more than 3 year old NPAs upto 50% of secured portion credit risk involved. Stock prices are much more forward looking
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should be made by the concerned bank. in assessing the creditworthiness of a business enterprise.
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In case of a sub-standard asset, a general provision of 10% of Historical data proves that stock prices of companies such as
total outstandings should be made. Enron and WorldCom had started showing a falling trend
many months prior to it being downgraded by credit rating
Reserve Bank Of India (RBI) has merely laid down the
agencies.
minimum provisioning requirement that should be complied
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with by the concerned bank on a mandatory basis. However, Usage of Financial Statements in Assessing the Risk
where there is a substantial uncertainty to recovery, higher of Default for Lenders
represent credit risk that has already materialized and default has The key accounting ratios generally used for the purpose of
already taken place. ascertaining the creditworthiness of a business entity are that of
On the other hand managing credit risk is a much more debt-equity ratio and interest coverage ratio. Highly rated
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forward-looking approach and is mainly concerned with companies generally have low leverage. This is because; high
managing the quality of credit portfolio before default takes leverage is followed by high fixed interest charges, non-payment
place. In other words, an attempt is made to avoid possible of which results into a default.
default by properly managing credit risk. Capital Adequacy Ratio (CAR) of RBI and Basle
Considering the current global recession and unreliable
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to develop an effective internal credit risk models for the taken into consideration that the bank’s capital refers to the
purpose of credit risk management. ability of bank to withstand losses due to risk exposures.
How important is credit rating in assessing the risk of default To be more precise, capital charge is a sort of regulatory cost of
for lenders? keeping loans (perceived as risky) on the balance sheet of banks.
Fundamentally Credit Rating implies evaluating the The quality of assets of the bank and its capital are often closely
creditworthiness of a borrower by an independent rating agency. related. Quality of assets is reflected in the quantum of NPAs.
Here objective is to evaluate the probability of default. As such, By this, it implies that if the asset quality were poor, then higher
credit rating does not predict loss but it predicts the likelihood would be the quantum of non-performing assets and vice-
of payment problems. versa.
Credit rating has been explained by Moody’s a credit rating Market risk is the risk arising due to the fluctuations in value of
agency as forming an opinion of the future ability, legal a portfolio due to the volatility of market prices.
obligation and willingness of a bond issuer or obligor to make Operational risk refers to losses arising due to complex system
full and timely payments on principal and interest due to the and processes.
investors.
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by the borrower or else the former will take action by way of
!!! taking over the possession of assets. Besides assets, banks can
One should also not forget that the banks are faced with the also takeover the management of the company. Thus the
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problem of increasing liquidity in the system. Further, Reserve bankers under the aforementioned Act will have the much
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Bank of India (RBI) is increasing the liquidity in the system needed authority to either sell the assets of the defaulting
through various rate cuts. Banks can get rid of its excess companies or change their management.
liquidity by increasing its lending but, often shy away from such But the protection under the said Act only provides a partial
an option due to the high risk of default. solution. What banks should ensure is that they should move
rd. F
In order to promote certain prudential norms for healthy with speed and charged with momentum in disposing off the
banking practices, most of the developed economies require all assets. This is because as uncertainty increases with the passage
of time, there is all possibility that the recoverable value of asset
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banks to maintain minimum liquid and cash reserves broadly
classified into Cash Reserve Ratio (CRR) and the Statutory
Liquidity Ratio (SLR).
also reduces and it cannot fetch good price. If faced with such a
situation than the very purpose of getting protection under the
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Cash Reserve Ratio (CRR) is the reserve which the banks Securitisation Act, 2002 would be defeated and the hope of
have to maintain with itself in the form of cash reserves or by seeing a must have growing banking sector can easily vanish.
way of current account with the Reserve Bank of India (RBI), Conclusion
computed as a certain percentage of its demand and time
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one which every banking company shall maintain in India in the no legal Act framed to safeguard the real interest of banks.
form of cash, gold or unencumbered approved securities, an However with the introduction of Securitisation Act, 2002
amount which shall not, at the close of business on any day be banks can now issue notices to their defaulters to repay their
less than such percentage of the total of its demand and time dues or else make defaulters face hard and tough actions under
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liabilities in India as on the last Friday of the second preceding the aforementioned Act. This enables banks to get rid of sticky
fortnight, as the Reserve Bank of India (RBI) may specify from loans thereby improving their bottomlines. Also a hallmark of
time to time. a good business is approaching it with a fresh, new perspective
A rate cut (for instance, decrease in CRR) results into lesser and requires management that is fully awake, fully alive and of
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funds to be locked up in RBI’s vaults and further infuses greater course fully focused on making things better.
funds into a system. However, almost all the banks are facing Also, the passing of the Securitisation Act, 2002 came as a
the problem of bad loans, burgeoning non-performing assets, bonanza for investors in banking sector stocks that in turn
thinning margins, etc. as a result of which, banks are little resulted into an improvement in their share prices.
reluctant in granting loans to corporates.
Questions to Discuss:
As such, though in its monetary policy RBI announces rate cut
1. NPAs of the bank as on 31/03/2004 are as follows:
but such news are no longer warmly greeted by the bankers.
Assess the amount of Provisioning the bank has to make as on
High Cost of Funds due to NPAs 31/03/2004
Quite often genuine borrowers face the difficulties in raising
funds from banks due to mounting NPAs. Either the bank is Nature of Asset
Standard
Amount (Rs Lakh)
1450
reluctant in providing the requisite funds to the genuine Sub -standard
Doubtful asset(secured)
540
borrowers or if the funds are provided, they come at a very high -1 Year
-1 -3Years
210
-
cost to compensate the lender’s losses caused due to high level -more than 3 Years
Loss
90
45
of NPAs.
LESSON 20:
STATUTORY RESERVE REQUIREMENT
Learning objectives made market related. At the same time, the RBI helped create an
After reading this lesson, you will understand array of other market related financial products. At the next
stage, the interest rate structure was simultaneously rationalized
• Introduction
and banks were given the freedom to determine their major
• Reforms rates.
• Cash reserve ratio As a result of these developments, RBI could use OMO as an
• Reduction in CRR effective instrument for liquidity management including to curb
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• Flexibility in the treatment of CRR short-term volatilities in the foreign exchange market. Another
important and significant change introduced during the period
• Statutory liquidity requirement (SLR)
is the reactivation of the Bank Rate by initially linking it to all
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• Statutory liquidity ratio of regional rural banks other rates including the Reserve Bank’s refinance rates (April
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The core business of banks is mobilising the deposits and 1997). The subsequent introduction of fixed rate repo
utilising the same for credit accommodation. However, it (December 1997) helped in creating an informal corridor in the
should be taken into consideration that the banks are not money market, with the repo rate as floor and the Bank Rate as
allowed to use the entire amount for extending credit. In order the ceiling. The use of these two instruments in conjunction
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to promote certain prudential norms for healthy banking with OMO enabled RBI to keep the call rate within this
practices, most of the developed economies require all banks to informal corridor for most of the time. Subsequently, the
maintain minimum liquid and cash reserves. As such, banks are introduction of Liquidity Adjustment Facility (LAF) from June
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required to ensure that these statutory reserve requirements are
met before directing on their credit plans.
2000 enabled the modulation of liquidity conditions on a daily
basis and also short term interest rates through the LAF
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Statutory reserve requirements could broadly be classified into window, while signaling the stance of policy through changes in
the Bank Rate.
• Cash Reserve Ratio (CRR) and
• Statutory Liquidity Ratio (SLR). Reforms
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Cash Reserve Ratio - Reduction and Rationalisation
Reduction in CRR
The Reserve Bank has been pursuing its medium-term
Among the unrealized medium-term objectives of reforms in
objective of reducing Cash Reserve Ratio (CRR) to the statutory
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monetary policy, the most important is reduction in the
minimum level of 3.0 per cent. Taking into account the
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prescribed CRR for banks to its statutory minimum of 3.0 per
progress achieved in the areas of enforcing prudential standards
cent. The movement to 3.0 per cent can be designed in three
and operationalising the LAF, RBI has reduced CRR from 11.0
possible ways, viz., the traditional way of pre-announcing a
per cent in August 1998 to 5.0 per cent in June 2002 while
time-table for reduction in the CRR; reducing CRR as and when
withdrawing certain exemptions. Further, the modalities of
opportunities arise as is being done in recent years; and as a one-
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CRR maintenance have been rationalised with the introduction
time reduction from the existing level to 3.0 per cent under a
of a lagged (by one fortnight) maintenance system. In addition,
package of measures. In the initial years, the first approach was
RBI is remunerating the eligible CRR balances maintained by
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effective but had to be abandoned when the timetable had to be
disrupted to meet the eruption of global financial uncertainties
and pressures on forex market. Hence, the second approach of
banks at the Bank Rate. As a further step in this direction of
moving towards the statutory minimum level of CRR, it is
proposed:
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lowering CRR when opportunities arise has been adopted, and
now it has been brought down to 5.5 percent. However, if it is To reduce CRR from 5.0 per cent to 4.75 per cent effective from
felt that this approach takes a longer time and a compressed the fortnight beginning November 16, 2002. (With this
time-frame is desirable to expedite development of financial reduction, CRR has been reduced by as much as 3.75 percentage
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markets, it is possible to contemplate a package of measures in points over the past two years).
this regard. The package could mean the reduction of CRR to At present, banks are required to maintain a minimum of 50
the statutory minimum level of 3.0 per cent accompanied by per cent of the required reserves in the first week and a
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several changes such as in the present way of maintenance of minimum of 65 per cent in the second week of the reporting
cash balances by banks with RBI. With the lagged reserve fortnight. Despite this flexibility given to banks on the daily
maintenance system now put in place, banks can exactly know maintenance, the actual daily CRR maintenance of majority of
their reserve requirements. With the information technology banks in relation to the prescribed level is now quite high. While
available with banks and with the operationalisation of Clearing moving towards a low CRR, it is necessary that the demand for
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Corporation of India Ltd. (CCIL) shortly and with the bank reserves in the inter-bank market is modulated and the
development of repo market, it would be appropriate if CRR is volatility in CRR maintenance is minimised. In this direction:
maintained on a daily basis. However, till banks adjust to such Banks will be required to maintain a minimum of 80 per cent
changes in the maintenance of CRR, a minimum balance of 95 of required CRR amount on a daily basis during a fortnight
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per cent of the required reserves on a daily basis may have to be with effect from the fortnight beginning November 16, 2002.
maintained when CRR is reduced to 3.0 per cent. The other The minimum level of 80 per cent would be applicable for all
elements of package have to be worked out carefully. Access the days in a reporting fortnight.
Flexibility in the Treatment of CRR Interest on Cash Balances Maintained with RBI
Normally, banks maintain minimum cash in their own vaults
since it is an idle asset, without the benefit of earning any under CRR
interest. In the context of date change at the turn of the century, At present, all scheduled commercial banks are paid interest at
in order to meet any additional demand for bank notes as a the Bank Rate on eligible cash balances maintained with RBI
contingency, banks may have to keep larger vault cash for under CRR requirement, without detailed scrutiny by RBI, on
meeting their business transactions. At present, such cash in the basis of quarterly interest claim statement submitted by
hand with the bank though an eligible asset for SLR, is not banks. Such interest payment is made to all banks within one
counted for CRR requirements. To facilitate banks to tide over month after the end of the quarter. Based on the
the contingency during the millennium change, it has been recommendations of the Regulations Review Authority, it has
decided to treat cash in hand maintained by the banks for been decided to:
compliance of CRR for a limited period of two months
effect from April 2003. In order to facilitate this, banks are urged reckoned for SLR purposes. Accordingly, it has been decided
to put in place proper technology including adoption of the that:
software package which will help transmission of Form A data SLR holdings of RRBs in the form of deposits with sponsor
by banks directly to RBI. banks maturing beyond March 31, 2003 may be allowed to be
Statutory Liquidity Requirement (Slr) retained till maturity. These deposits may be converted into
SLR = statutory liquidity ratio. Banks in India are required to government securities, on maturity, in case the concerned RRBs
maintain 25 per cent of their demand and time liabilities in have not achieved the 25 per cent minimum level of SLR in
government securities and certain approved securites. These are government securities by that time.
collectively known as SLR securities Although deposits with sponsor banks contracted before April
The RBI has announced a “Special Liquidity Support” measure 30, 2002 would be reckoned for SLR purpose till maturity,
under which banks will be eligible to avail of liquidity to the RRBs are advised to achieve the target of maintaining 25 per
extent of their holdings of dated Government of India cent SLR in government securities out of the maturity proceeds
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Securities/Treasury Bills over the SLR required to be of such deposits with sponsor banks as well as from their
maintained. The rate of interest on this facility would be 2.5 per incremental public deposits at the earliest
cent over the bank rate. This means that liquidity will be The RBI has announced a very strong support system for
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available to the banking system at a cost of 10.50 per cent anticipated enhanced liquidity needs during the century date
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(present bank rate is 8 per cent). The banking system is period. All the following measures announced by the RBI
estimated to hold securities in excess of the SLR requirements would be valid for the period December 1, 1999 to January 31,
to the extent of around Rs 600 billion. Thus, theoretically, this 2000
amount of liquidity will be available to the banking system
Questions to Discuss:
rd. F
during this period. The RBI has also asked those who do not
hold any significant amount of excess SLR, to get into standby 1. What do you understand by statutory reserve requirement?
arrangement with banks who hold excess SLR securities. 2. Explain cash reserve ratio (CRR).
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During this period, the cash held by banks will be counted
towards the maintenance of CRR. Currently, banks’ holding of
3. Explain statutory liquidity requirement (SLR).
Notes:
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cash in their vaults is reckoned for SLR purposes. It was feared
that during this period, banks may have to hold cash in hand
much in excess of their normal holdings. This would cause a
reduction in the bank’s balances in their current accounts with
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adequacy of the bank:
• Capital funds
Ratio of the Paid-up Capital to Reserve
• Risk adjusted assets and off-balance sheet items The size of the reserve of banks in relation to their paid-up
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• Foreign exchange and interest rate related contracts capital is an important index of their financial position and
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A financial intermediary needs capital to commence its strength. It is also a pointer to the management policy regarding
operations and to continue its existence as a running business. the retention of earnings. However, since the banks carry on
More so, a financial intermediary needs more capital to act as a their business mainly with the depositors’ funds, an increase in
buffer, since the losses if and when they arise, may be the paid-up capital may not keep pace with that in the reserve.
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substantial. Capital provides a cushion to absorb possible Equity Ratio
losses so that entities dealing with them are protected all the Equity Ratio is the ratio of its equity capital over its loans and
time. This will help sustain the existence of the intermediary,
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which is very vital for proper functioning of the economic
system. The capital will provide a margin of safety that
investments, where loans and investments means all earning
assets, including loans and government securities.
Capital-Deposit Ratio
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preferably would allow the intermediary to continue operations
The capital-deposit ratio was used in past in the USA and in the
without loss of momentum and at the least, would buy time
UK to measure capital adequacy. The banking authorities in
in which it may re-establish its operational momentum.
India have considered the adequacy of capital in relation to
The significance for capital varies depending on the activity of
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requirements, etc. Comparatively for NBFCs is needed for sharply. In the US, in early 20th Century – banks were asked to
entering into fund based activities apart form servicing its maintain a capital fund equal to 10 percent of its deposit
depositors and acquisition of assets. liabilities as a margin of safety. It should be noted that the
Apart from specifying an entry capital for the intermediaries, deposits by themselves contain no risks until they are used to
regulatory authorities (warranted by legislations) fixed a
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make loans and investments; and the extent of the risk varies
proportion of capital and reserve to assets, on the basis of the with the character of the assets into which deposits are
type of intermediary. converted.
These requirements termed as Capital Adequacy Requirements By following the above said thumb-rules, one may have an idea
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are specified for banks and for NBFCs in particular, this chapter on the extent of coverage of assets on the liabilities. Here it is
will dwell on the Capital Adequacy Requirements as applicable necessary to caution ourselves that it is practically impossible to
to Commercial Banks. determine the capital adequacy of a particular bank or even of
Capital Adequacy of Banks the commercial banking system, since it is not possible to know
In the Indian context, the capital adequacy of banks is all the the future demand that will be made out of capital. Adequate
more important in view of existence of nationalized banks and capital is desirable and necessary, but capital alone cannot ensure
the social status of bank management. An adequate capital fund the safety of a bank and due consideration has to be given to
is needed to bring about solidarity, scope, operation and the the quality and character of its assets, the caliber of its
ultimate strength to a bank. As important players, involved in management and its modus operandi.
helping of the capital formation in this era of intensive Capital to Risk-Weighted Assets Ratio
infrastructural investment, banks need to possess adequate To assess the adequacy of capital based on the quality of assets,
capital funds to discharge this responsibility. the Capital to Risk-Weighted Assets Ratio (CRAR) or the
At the same time, a saver who is depositing his money in a Capital Adequacy Ratio (CAR) is now being focused upon.
bank assumes that the risks associated with the investment of Introduced in 1988 by the Basle Capital Adequacy Accord, this
the funds will be borne by this intermediary. Therefore, the
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November 1988. The committee has adopted weighted risk account in the Indian books specifically for the purposes of
assets approach, which assigns weights to both on off-balance meeting the capital adequacy norms.
sheet exposures of a bank according to the perceived risk. While
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iv. Statutory reserves kept in Indian books.
the framework is being applied by the banking supervisory
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authorities in the G-10 countries, the committee has suggested v. Remittable surplus retained in Indian books which is not
that the banking supervisory authorities of the non- G-10 repatriable so long as the banks function in India.
countries could also try to adopt the framework, particularly, in vi. Cap9ital reserve representing surplus arising out of sale of
respect of banks conducting significant international business in assets in India held in a separate account and which is not
their jurisdictions. eligible for repatriation so long as the banks function in
rd. F
Indian Standards: Narasimham Committee India.
vii. Interest-free funds remitted form abroad for the purposes
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Narasimham committee constituted by the Government of
India, to examine all aspects of banking procedures submitted
its reports in the early 90s. The committee observed that the
of acquisition of property and held in a separate account in
Indian books.
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capital ratios of Indian banks are generally low and some banks The net credit balance, if any, in the inter-office account with
are seriously undercapitalized. The banks in India should Head office / overseas branch will not be reckoned as capital
conform to the standards laid in the Basle Committee on funds. However, any debit balance in Head Office account will
Banking Regulations and Supervisory Practices appointed by the have to be set-off against the capital.
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equitable as it requires those institutions with a higher risk accumulations of post-tax profits and not encumbered by any
profile to maintain a higher level of capital funds. known liability and should not be routinely used for absorbing
normal loan or operating losses. Cumulative perpetual
Capital Adequacy Norms preference shares should be fully paid-up and should not
As mentioned earlier the Capital Adequacy Ratio is the ratio of
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ceiling of 5 percent applicable to investments in shares of
In the category of Hybrid debt capital instruments fall in a
corporate bodies and they would be assigned 100 percent of
number of capital instruments, which combine certain
total of Tier I elements for the purpose of compliance with the
characteristics of equity and certain characteristics of debt. Each
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norms.
has a particular feature which can be considered t affect its quality
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as capital. Where these instruments have close similarities to Risk Adjusted Assets and off-Balance Sheet Items
equity, in particular when they are able to support losses on an Risk adjusted assets would mean weighted aggregate of funded
on-going basis without triggering liquidation, they may be and non-funded items as detailed below. Degrees of credit risk
included in Tier II capital. expressed as percentage weightings have been assigned to
balance sheet assets and conversion factors to of-balance sheet
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For Subordinated Debt to be eligible for inclusion in Tier II
capital, the instrument should be fully paid-up, unsecured, items. The value of each asset/item shall be multiplied by the
subordinated to the claims of other creditors, free of restrictive relevant weights to produce risk-adjusted values of assets and
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clauses and should not be redeemable at the initiative of the
holder or without the consent of the banks’ supervisory
of off-balance sheets. The aggregate will be taken into account
for reckoning the minimum capital ratio. The weights allotted
to each of the items of assets and off-balance sheet items are
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authorities. These instruments often carry a fixed maturity and.
As they approach maturity, they should be subjected to furnished below
progressive discount for inclusion in Tier II capital. The Risk Weights on Different Items of Assets and off-
subordinated debt instruments should have a minimum
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12. Loans guaranteed by Government of India/State Government
13. In cases where guarantees have been invoked and the 0
concerned state Government has remained in default as on other risk weighted assets for calculation of CRAR.
31-03-2000, a risk weight of 20 percent on such advances
should be assigned. If State Governments continue to be in
default in respect of such invoked guarantees even after 31-03- B. Off-Balance Sheet Items
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2001, a risk weight of 100 percent should be assigned
14. Loans granted to public sector undertakings of Government The credit risk exposure attached to off-balance sheet items has
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of India / State Government
15. Others
to be first calculated by multiplying the face amount of each of
the off-balance sheet items by the ‘credit conversion factor’ as
100
indicated in the table below. This will have to be again
multiplied by the weights attributable to the relevant
100
counterparty as specified above.
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16. Premises, furniture and fixtures 100
17. Other assets 100
ii. Subsidies received against IRDP advances and kept in a maturity of over one year (e.g. formal
standby facilities and credit lines)
separate account. 8. Similar commitments with an original 0
maturity up to one year, or which can
be unconditionally canceled at any
2. Equity investments in subsidiaries, intangible assets and time.
losses deducted from Tier I capital should be assigned zero 9. Aggregate outst anding foreign
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assigned ‘zero’ risk weight as per international practice. 4. Sale and repurchase agreement and
asset sales with recourse, where the
100
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underwriting facilities
7. Other commitments with original 50
maturity of over one year
Assets Percentage Weight
8. Similar commitments with an original 0
1. Cash 0 maturity up to one year, or which can
2. Balance with monetary authority 0 be unconditionally canceled at any time
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3. Investments in government securities 0
4. Balances in current account with other 20
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banks
5. All other claims on banks including but 20
not limited to funds loaned in money
markets, deposit placements,
investments in CDs, FRNs, etc
Note
6. Investment in non- bank sectors
7. Loans and advances, bills purchased
100 Cash margins/deposits shall be deducted before applying the
and discounted and other credit
facilities
conversion factor. After applying the conversion factor as
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a. Claims gua ranteed by GOI 0 indicated above, the adjusted off-balance sheet value shall again
b. Claims guaranteed by State Governments 0
c. Claims on public sector undertakings of GOI 100 be multiplied by the weight attributable to the relevant
d. Claims on public sector undertakings of State 100
counterparty as specified in funded risk assets above.
Governments
e. Others
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8. All other banking and infrastructural
assets
100
100
Foreign Exchange and Interest Rate Related
Contracts
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Foreign exchange contracts include the following:
Notes
i. Cross-currency interest rate swaps
1. Netting may be done only for advances collateralized by cash
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margins or deposits and in respect of assets where ii. Forward foreign exchange contracts
provisions for depreciation or for bad and doubtful debts iii. Currency futures
have been made. iv. Currency options purchased
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2. Equity investments in subsidiaries, intangible assets and v. Other contract of a similar nature
losses deducted from Tier I capital should be assigned zero As in the case of other off-balance sheet items, a two-stage
weight. calculation prescribed below shall be applied.
3. The investments in subordinated debt instruments and
Step 1
bonds issued by other banks or Public Financial Institutions
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50 percent should be limited to amount guaranteed and not Less than one year 2
Between one and two years 5
the entire outstanding balance in the accounts. For each additional year 3
Step 2
The adjusted value thus obtained shall be multiplied by the risk
weightage allotted to the relevant counterparty as given in II A
above.
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Maintenance of CRAR
After assessing the capital funds and the risk weighted assets,
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the bank will have to compute the ratio of the capital to risk
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weighted assets. The minimum CRAR was initially set at 8
percent. However, to meet the international standards, this is
being raised to 9 percent with effect from March 31, 2000.
Reporting
Banks should furnish an annual return commencing form the
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year ended March 30, 1992, indicating:
a. Capital funds
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b. Conversion of off-balance sheet/non-funded exposures
c. Calculation of risk weighted assets and
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d. Calculation of capital funds ratio.
The format for the returns is given as a break-up and aggregate
in respect of domestic and overseas operation will have to be
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proper banking of their capital for the risks they face while
operating in the ever changing market environment.
Questions to Discuss
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Notes:
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rd. F
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Learning objectives Reserve Bank Of India and commercial banks. The apex banks
After reading this lesson, you will understand or state cooperative banks obtain their funds from share capital,
deposits, loans from commercial banks, the Reserve Bank of
• Introduction
India and the Government.
• Central Cooperative banks
Characteristics of Co-operative Banks
• State or provincial cooperative banks or apex banks
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Some distinguishing characteristics of the nature of co-
• Agricultural credit-intensive development scheme operative banks are as follows:
• The agricultural refinance and development corporation 1. They are organised and managed on the principles of co-
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• Nabard operation, self-help, and mutual help. They function with the
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Cooperative banks, another component of the Indian banking rule of “one member one vote”.
organisation, originated in India with the enactment of the 2. They function on “no profit no loss” basis. For commercial
cooperative credit societies act of 1904, a number of cooperative banks also, profitability is no longer the main objective, but
active credit societies. Under the act of 1904, a number of in their case this change has been brought about as a result
rd. F
cooperative credit societies were started. Owing to the increasing of social or public policy, while co-operative banks, by their
demand of cooperative credit, a new act was passed in 1912, very nature, do not pursue the goal of profit maximisation.
which provided for the establishment of cooperative central
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banks by a union of primary credit societies or by a union of
primary credit societies or by a union of primary credit societies
3. Co-operative banks perform all the main banking functions
of deposit mobilisation, supply of credit and provision of
remittance facilities. However, it is said that the range of
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and individuals. services offered is narrower and the degree of product
The chief functions of these banks were: (1) attracting deposits differentiation in each main type of service is much less in
from non-agricul-turists, (2) using excess funds of some the case of co-operative banks, compared to commercial
societies temporarily to make up for shortage in other arid (3) to banks. In other words, co-operative banks are characterised
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supervise and guide the affiliated societ-ies. In 1914, the Mac by functional specialization. It should be added that this is
lagan Committee was appointed to examine the cooperative true, with much less force now, because many changes have
movement and to make recommendations regarding the taken place in the co-operative banking system since the
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improvement of the movement. It recommended the Banking Commission arrived at the above-mentioned
establishment of a State Cooperative Apex Bank. On this conclusion. For example, co-operative banks now provide
recommendation a Central Coop-erative Bank was established housing loans also. The UCBs provide working capital loans
in Bombay. Other provinces also took ac-tion on similar lines. and term loans as well. The State Co-operative Banks (SCBs),
Although these may be considered as the early beginnings in the Central Co-operative Banks (CCBs) and Urban Co-operative
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direction of establishing cooperative banks to meet the financial Banks (UCBs) can normally extend housing loans upto Rs
needs of agriculturists, the movement received momentum lakh to an individual. The scheduled UCBs, however, can
only after the Second World War. lend upto Rs 3 lakh for housing purposes. The UCBs can
Cooperative banking India is federal in its structure. At the provide advances against shares and debentures also.
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lower rung, there are primary credit societies, then there are the 4. As said earlier, co-operative banks do banking business
central unions or central cooperative banks and at the top there mainly in the agricultural and rural sector. However, certain
are the Provincial Cooperative Banks or State Cooperative types of banks viz., UCBs, SCBs and CCBs operate in semi-
Banks, otherwise known as “Apex” banks. The primary urban, urban, and metropolitan areas also. The urban and
societies may be compared with joint banks. Their main non-agricultural business of these banks has grown over the
function is that of lending money to villagers on easier terms. years. The co-operative banks demonstrate a shift from rural
Much of their work is done by members themselves on an to urban, while the commercial banks, from urban to rural.
honorary basis. They have their own funds supplemented by 5. Co-operative banks are perhaps the ‘first government-
funds drawn from the Central Cooperative Banks through the sponsored, government-supported, and government-
banking unions where such unions exist. The Banking unions subsidised financial agency in India. They get financial and
are federations of primary societies and they act as either other help from the RBI, NABARD, central government and
‘coordinating unions’ or ‘supervisory unions’ between primary state governments. They constitute the “most favoured”
societies and central cooperative banks. The central cooperative banking sector with no risk of nationalisation. For
banks obtain the funds from share capital, deposits, loans from commercial banks, the RBI is a lender of last resort, but for
the apex banks, and where apex banks do not exist, from the’ co-operative banks, it is the lender of first resort, which
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policy of co-operative banks. Consequently, compared to securities and are treated on par with government securities
commercial banks, they have less freedom and flexibility in for making advance. There are three types of such
conducting their operations. debentures: ordinary, rural, and special. These debentures are
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6. Cooperative banks belong to the money market as well as to almost entirely subscribed by such institutional investors as
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the capital market. Primary agricultural credit societies provide banks, LIC, and the government.
short-term and medium-term loans. Land Development Types, Structure and Growth of Co-Operative Banks
Banks (LDBs) provide long-term loans, UCBs meet working The following figure present the structure and progress of co-
capital as well as fixed capital requirements, and SCBs and operative banking in India.
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CCBs also provide both short-term and term loans.
Similarly, they accept short-term and long-term deposits, and
some of them mobilise resources through the issue of
debentures.
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7. Co-operative banks are financial intermediaries only partially.
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The sources of their funds (resources) are: (a) central and
state governments, (b) the RBI and NABARD, (c) other co-
operative institutions, (d) ownership funds, and (e) deposits
or debenture issues. It is interesting to note that intra-
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institutions in this federal structure” However, the apex few account for a major part of their business.
institutions from the point of view of promotion, supply of • These banks still rely very heavily on referencing facilities
resources, supervision and control, are the government, RBI, from the government, the RBI, and NABARD. They have
NABARD, and National Co-operative Bank of India (NCBI). yet not been able to become self-reliant in respect of
The SCBs and SLDBs are in an intermediate position between resources through deposit mobilisation.
the institutions just mentioned on the one hand, and the co-
• They suffer from dangerously low or weak quality of loan
operative banks on the other.
assets, and from highly unsatisfactory recovery of loans.
The SCBs co-ordinate and regulate the working of CCBs. They
• They suffer from infrastructural weaknesses and structural
act as custodians of surplus funds of the CCBs and
flaws. They do not look like banks and do not inspire
supplement them by attracting deposits and by obtaining loans
confidence in the potential members, depositors and
from the RBI. The CCBs mobilise resources in districts to
borrowers.
finance their members, and they also charnel’s funds from the
• They suffer from too much officialisation and politicisation.
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SCBs to primary credit societies. The PACSs at the village1evel
form the base of the co-operative_ banking. Although they are Undue governmental interventions have prevented them
expected to be multi-purpose societies, they mostly deal in from developing steadily as a self-reliant and resilient credit
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credit. system.
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Problems and Policy Central Cooperative Banks
As in the case of commercial banks, the quantitative growth of The Central Cooperative Banks are independent units inasmuch
co-operative banks has not been accompanied by a qualitative as the provincial cooperative banks have no powers to control
growth. There have always been a number of weaknesses in or supervise the affairs of central banks. They are of two kinds
viz pure’ and ‘mixed’. Those banks; the membership of which
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their performance. Many of these weaknesses were identified by
the All India Rural Credit Survey Committee (AIRCSC) in the is confined to cooperative organisations, only are Included in
early 1950s. By that time, co-operative banks had been in the the ‘pure’ type, while those banks, the membership of which is
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business for 45 years and the AIRCSC had concluded that co-
operatives had failed, but that they must succeed. As a result,
open to cooperative organisations as well as to individuals, ate
included in the ‘mixed’ type. The Pure type of central banks can
be seen in Kerala, Bombay, Orissa, etc, while the mixed type can
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special measures were introduced by the government and the
RBI to revive and strengthen co-operative banks. Even after a be seen in the case of Andhra, Assam, Chennai, Mysore, etc.
span of 50 years, an assessment of the co-operative banks The pure type of banks is based on strict cooperative principles,
shows that many of the weaknesses of the co-operative credit while the mixed type does not adhere to any such strict
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system identified by the Rural Credit Survey Committee principles. However, the latter has an advantage over the former
continue to persist. in so far as they can draw their funds from the non-agricultural
section, too. But by allowing individuals to hold shares, loan
The Khusro Committee asserts: “No credit system has been
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co-operative systems have by no means been insignificant… As mentioned earlier, the central cooperative banks draw their
Thus looking to the stake of the movement even in the limited funds from share capital, deposits, loan from the State
sphere of credit, the classic assertion of the Rural Credit Survey Cooperative Banks and where the State Banks do not exist,
made 35 years ago still seems valid that Co-operation has failed from the Reserve Bank and other commercial banks: The main
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but Co-operation must succeed…” function of the central banks is to finance the primary credit
societies. In addition to this, they ‘carry on commercial banking
The main weaknesses of co-operative banks are as follows:
activities like acceptance of deposits, the giving of loans and
• The vital link in the co-operative credit system namely, the advances on the sculpt of first-class gilt-edged securities, fixed
PACSs, remain very weak. They are too small in size to be deposit receipts, gold, bullion, goods and documents of title to
economical and viable; besides too many of them are goods, the col-lecting of bills, cheques, handles, the receiving of
dormant, existing only on paper. valuables for safe cus-tody and the performance of services as
• With the expanding credit needs of the rural sector, the an agent to the customer to purchase and sell securities etc. They
commercial banks have come in actively to meet the credit also act, as ‘balancing centres’ making available temporary excess
requirements of this sector, and this has aggravated the funds of one primary to another, which is in need of them.
difficulties of co-operative banks. The theory that co- Defects of the working of the cooperative banks are not likely
operative banks would be buoyed up by the competition to pass uncensored. The linking of commercial banking
from other financial institutions does not appear to have activities with the central banks is often pointed out as against
worked. the principles of coopera-tion. But it should be remembered
that the volume of work is not enough to keep these
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order.
business in that State to be a state cooperative bank (or banks).
Further it has been found that certain cooperative central banks
As in the case of central banks the state cooperative banks may
are utilising the reserves funds as working capital. This is
be pare in which case, it will be a federation of central
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definitely against fundamental principles, which will affect
cooperative banks only, or ‘mixed’ in which case it will be a
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adversely the working of these banks in the final end. It is
federation of both central cooperative banks as well as
highly necessary that adequate reserves should be built up and
individual members. The state banks re-ceive current and fixed
kept apart from working capital so that it may be used only in
deposits from its constituent banks as well as savings deposits
times of emergencies.
and fixed deposits from the general public and from local
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The case against ‘mixed’ societies has already been discussed in boards, municipalities, etc. Further they receive loans at call and
detail. But at present, the mixed type of societies is inevitable, short notice from the commercial banks at current rates of
since to raise enough capital from the agricultural masses itself interest and seasonal loans from the Reserve Bank of India to
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is not possible, because of their poor resources. So the aim
should be to convert the mixed societies into pure societies step
by step as the income of the agricultural masses increases so
finance seasonal agricultural operations. The State Governments
contribute a certain portion of their working capital.
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The principal function of the state banks is to assist the central
that after a certain stage we can dispense with the mixed
banks and to balance excess and deficiencies in the resources of
societies.
central banks.
Further, the lending rates of these banks arc said to be very
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rates of inter-est, the Reserve Bank of India has suggested The working of state banks is not free from complaints. Most
certain measures such as strengthening the cooperative of the companies leveled against the central cooperative banks
movement and improving its efficiency, the mobilising of rural are also valid against the state cooperative banks. Among them,
savings and amalgamating of small uneconomic units into the important are the undesirability of linking commercial
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viable units. The state governments can also add their banking activities with cooperative banking, inadequacy of share
contribution in this direction by giving subsidies to the central capital, utilisation of reserve funds i as working capital and the
banks during the initial stages so that the loss arising from policy in allowing individuals to become share-holders of the
charging low rates of interest may be compensated. banks, which is against cooperative principles.
Recent trends in the working of central cooperative banks Agricultural Credit-Intensive Development Scheme
indicate that there is a decline in their number, as a result of The ACID scheme was conceived with a view to concentrating
amalgamation and reorganization of central banks with the efforts on a selective basis to strengthen the co-operative
object of having one song central banks for each district. The structure and link the credit programme with production
owned funds, apart from the bor-rowed funds, of these banks programmes. The scheme was ap-proved by the Reserve bank’s
show an overall increase during recent years. However, it is Agricultural Credit Board in December 1976 and received the
deplorable that many of them were not able to reach the support of the State Governments, All India Fed-eration of
standard of Rs. 3 lakhs per bank prescribed by the Standing State Co-operative Banks, the Planning Commission and the
Advisory Committee on Agricultural Credit as a ‘desirable Union Ministry of Agriculture, and other concerned agencies.
minimum limit” of owned capital. In the matter of overdues, Under the first phase of the scheme, 41 districts (including
there is a decline in the propor-tion of overdues to loans SFDA and DP AP dis-tricts) in 16 States have been selected for
economy. Some of the important criteria followed in the committee in its second meeting held in April 1978, top priority
selecting the 41 districts were: (a) the districts which have scope under the Action Programme is being given to (1) reduction of
for development and a reasonable strong co-operative credit overdues, (2) full coverage of small farn1ers and (3) increase in
structure; (b) the central co-operative banks of the district borrow-ing members.
should not have heavy overdues (i.e. ordinarily these should be Since the introduction of the Scheme, there have been certain
less than 40 per cent (c) existence of SFDA and DPAP schemes; developments requiring a review of the Scheme, The lead banks
and (d) the districts where regional rural banks were not have been advised to tern1inate the existing plans by December
functioning (though in a few districts, some parts of the 1979 and formulate fresh District Credit Plans for their lead
districts were covered by regional rural banks). districts from January 19S0 and Annual Action Plan by
In particular, the central co-operative banks in these districts will December each year. The District Credit Plans would be a
have the following main objectives viz., (I) to improve their comprehensive credit plan for the District and would indicate
organisational and operational effectiveness; (2) to create an total credit outlays (sector-wise, scheme-wise and institution-
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awareness for grow III and need for diversification; (3) to build wise) for technically feasible and economically viable schemes for
up own resources and manpower so as to ensure gradual financing pro-duction and investments by the bank. Co-
independence from outside help; (4) to progressively operatives, among other finan-cial institutions, are also
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professionalism their managements and (5) to bring about participating agencies in the formulation and implementation
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orientation of policies towards benefiting the common of the plans. In the context of these developments it has been
interests of the rural population, especially the weaker ones. decided to integrate the ACID Programme with District Credit
The selection of the districts for the scheme was done in Plans from 1980 onwards.
consultation will the State Governments at a 2-day meeting in The Agricultural Refinance and Development
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Bombay in January 1977, Subsequently, four zonal meetings Of
Corporation
senior officers of the State Governments, the Chairman and the
In the sphere of long-term agricultural credit, an important
Chief Executive Officers of the state Co-operative Banks and
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land development banks were held at Bombay, Madras, Calcutta
and New Delhi during February and March I 977 for explaining
the objectives of the scheme. As envisaged under the scheme,
development during the Third Five Year Plan had been the
establishment of the Agri-cultural Refinance Corporation. The
Plan elaborated the functions of the Corporation in the
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following terms.
quick surveys of the selected districts in 16 States were
conducted to collect basic data for preparation of district credit “The Corporation will purchase debentures floated by central
plans for the districts. land mortgage banks in the normal course and will also provide
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b. Three nominees of the Reserve Bank. sections of the rural population benefit more by schemes of
refinance by the Bank, that there is simplification of the
c. Three nominees of the Central Government.
procedures so that quick disposal of applications is possible
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d. Three members, two Wit1l experience in cooperative banking and that the Government’s programmes for poverty eradica-
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and one in commercial banking. tion are supported in a meaningful way.
e. Two nominees of the State Governments.
Assistance for Agriculture
f. Two experts in rural economics and rural development. As an apex refinancing agency in the field of rural credit, the
g. A managing director. National Bank provides refinance assistance to the eligible
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h. One or more whole time directors. cooperatives and commercial banks for different purposes and
durations. It provides short term credit for periods not
Functions
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NABARD performs all the functions performed by the
erstwhile Agricultural Refinance and Development Corporation
exceeding 18 months to State Coopera-tive Banks/Regional
Rural Banks for seasonal agricultural operations (crop loans)
marketing of crops, purchase and distribution of fertilizers and
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as well as those performed by the Agricultural Credit working capital requirements of cooperative sugar factories. It
Department of the Reserve Bank in the field of agricultural and also provides medium term credit (I8 months to 7 years) to
rural credit. These include: State Cooperative Banks/Regional Rural Banks for approved
(i) provision of short term, medium term and long tem1 agricultural purposes, pur-chase of shares of processing
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financial assistance of Land Development Banks, State societies and conversion of short term crop loans into medium
Cooperative Banks, RRBs, and commercial banks for term loans in areas affected by natural calamities. Long term
promoting agricultural and rural development: credit for a period of 25 years is provided to State Coopera-tive
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(ii) provision of long term loans to State Governments for a Banks/land development banks/Regional Rural Banks/
peri0d Upl.0 20 years for contribution to the share capital of Commercial banks for investment in agriculture under
cooperative credit institutions; schematic lending. Lending term loans (for periods not
(iii) provision of long term loans to any institutions approved exceeding 20 years) are provided to State Governments to
enable them to contribute to the share capital of the cooperative
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strengthening programme would comprise identification of
overdues and bad debts and to make provisions there against,
reduction in cost of management, rationalisation of loan
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policies and procedures, expansion and diversification of loans
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portfolio, mobilisation of resources both manpower and
financial and their development, etc.
Questions to Discuss:
1. Discuss Central Cooperative banks.
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2. What do you understand by State or provincial cooperative
banks or apex banks?
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3. Discuss Agricultural credit-intensive development scheme.
4. Discuss the agricultural refinance and development
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corporation.
5. Explain the features of NABARD.
Notes:
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2. Figures in brackets under respective institutions indicate the
financial institutions operating in India in today’s class. Today
year of establishment year of incorporation.
we shall focus on IFCI and IDBI.
3. Figures in the brackets under SFCs/SIDCs indicated the
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Introduction number of institutions in that category.
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Financial Institutions play an important role in the Indian
financial system. In fact, most of the financial intermediation Industrial Finance Corporation of India
taking place outside banks can be attributed to the operations At the time of Indian independence, there were lacunae in its
of the financial institutions. Financial Institutions (Fls) provide financial system. One among them was the lack of adequate
project finance to the needy corporates and government industrial financing, especially to meet the medium to long-
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institutions, thereby performing an important role in the term requirements of the industries. In such a set up, it became
infrastructural development in the country. necessary to develop an institutional structure for meeting the
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There are various kinds of financial institutions performing
their role in financial intermediation and infrastructural
development, differing on the basis of their inception and
large fund requirements of the industry. The first step in this
direction was the incorporation of the Institute of Finance
Corporation under the Institute of Finance Corporation Act,
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1948 (IFC Act). Subsequently the IFC Act, 1948 was repealed
operations. Broadly, the existing financial institutions may be
and in its place, the Industrial Finance Corporation (Transfer of
classified as (a) All India institutions like Industrial
Undertaking and Repeal) Act, 1992 (lFCI (Repeal) Act), was
Development Bank of India (lDBI) etc., or (b) Regional/State
formulated which came into force on July 1, 1993. lFCI was
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GOI and RBI was transected to IDBI. IDBI holds 30% of IFls
equity.
All Financial Institution
The management of IFCI is vested in its BODs, comprising
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ECGC DICGC
financial services to the industries. Primarily, its services focus
(1957) (1962) on project finance as it provides assistance to all viable industrial
projects above Rs.50m. IFCI provides assistance to industrial
concerns for their new projects, expansion, diversification and
modernization schemes. Loans are generally extended for a
period of 5-7 years with a moratorium of 2-3 years. Loans are
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housing development, management development, • AB Home Finance
entrepreneurial development etc. IFCI has introduced capital
• LIC Housing Finance
subsidy scheme for converting palaces/castles/forts, etc. of any
• GIC Grih Vitta
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size into heritage hotels. Disbursals during the year have
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registered a growth of 13%. In terms of new sanctions major Financial Resources
sectors are power generation, textiles and iron and steel together Equity, rupee and foreign currency loans and bonds form the
accounting for over 40% of sanctions in FY 1999. IFCI’s loan different types of finance resources for the IFCI. The resource
portfolio is well diversified across industries and geographic management function at IFCI is handled by a separate division
locations. from the headquarters at New Delhi. The requirements for
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IFCI has diversified from its traditional role in pJrojec1 finance funds are communicated by the accounts departments of
to provide finance for leasing and hire purchase concerns, various divisions in the form of monthly cash flow statements
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corporate loans and short-term loans. It also offers a wide range
of financial services including issue management, corporate
advisor and trusteeship. Wholly owned subsidiaries were set up
(current and projected) to the resources Department at New
Delhi. The targets are set in conformity with the projections for
sanctions and disbursements in various activities. Rs.42.6bn
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to enable this diversification of its product portfolio. rupee borrowings were raised- during 1998-99 (67.1%- long-
term; l1.4%-medium-term; and 21.5%- short-term funds). The
These include:
average cost of the aforesaid borrowings Was about 13.5%.
• IFCI Financial Services Ltd. - Merchant Banking Stock IFCI has also issued preference share capital of Rs.3.4bn. The
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Broking and Allied Activities average maturity and average coupon rate of the preference share
• IFCI Investor Services Ltd. - Registrar and Transfer Services capital raised during the year was about 4.5 years and 10.6%
• IFCI Custodial Services Ltd. - Custodial Services respectively.
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(Merchant Banking and Allied Services Division) in July, 1986. mostly from (exiles, iron& steel; metal products, chemicals,
IFCI also provides underwriting and guarantees. synthetic fibers & resins, and food products industries. The
factors that have led to such a high level of NPAs included the
To face the challenges offered by the increasing competition a
slowdown in industrial growth, slack demand conditions,
need was felt to spruce up the activities of the Corporation.
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Committee was mainly to enable it to conform .to the RBI Bank of India was formed in 1982.
guidelines on ALM for financial institutions. In 1986, IDBI created a Small Industries Development Fund
In an effort to manage its interest rate risk, IFCI has been (SIDF) to provide a special focus to the needs of the small scale
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following a policy of linking its interest rate to the prevailing sector. This fund is intended to provide financial as well as non-
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prime lending rate (PLR) at the time of disbursement. In the financial inputs catered to the specific needs of the small scale
case of Foreign currency loans the pricing is one at LIBOR + sector. In 1990, the operations of the fund were hived off in to
spread. Further to tackle the foreign exchange risk management, a wholly owned subsidiary, the small industries development
the repayment for the funds that are borrowed in a foreign bank of India (SIDBI), in order to provide greater focus to the
sector.
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currency is ‘made’ in the same currency resulting in no exchange
rate risk on the part of the Corporation. Through the late ’80s and the early ’90s IDBI played a
significant role in the development of financial markets. While
Future
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To face the competition, there is a need to reorient its strategies.
For this purpose, it is envisaged that in the due course of time
it played a major role in setting up of the Stock Holding
Corporation of India Limited (SHCIL), for providing impetus
to the depository services to the financial institutions in 1987, it
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IFCI may operate as a universal bank that has a major focus on
was also the nodal agency for establishing the National Stock
corporate banking. And in order to tap on the other financial
Exchange (NSE) in 1992. Other institutions promoted by
services that offer greater scope for the corporation, IFCI is
IDBI by direct contribution of capita] include: Credit Analysis
diversifying into bill discounting, trade bills important financing
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India, is also the 10th largest development bank in the world. Tourism Finance Corporation of India (TFCI) and Biotech
Industrial Development Bank of India (IDBI) owes its birth to Consortium of India Limited (which provides aid for
Industrial Development Bank Act (IDBI Act), 1964. As per its commercialization of indigenously developed processes and
charter IDBI is required to play a significant role in (a) planning, products in the field of biotechnology.
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and Rs.139.S0 respectively. setting up. Government of India has also been providing
The Bank continued to maintain sound capital adequacy various loans on a concessional basis, while providing
requirement, as represented by the capital adequacy ratio (CAR), budgetary support to IDBI until 1970. Even after 1970, IDBI
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which at end-March, 2001 stood at 15.8% as against 8(1() last enjoyed budgetary support towards the funds that were
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year. The Debt equity ratio (including contingent liabilities) disbursed through IDA line of credit from the World Bank. It
stood at 6.53:1 (6.08:1). has to be noted that these loans met the foreign currency
requirement of the industry and in such borrowings. FIs
In 2000 -01, IDBI sanctioned and disbursed Rs.287.1 bn and
normally do not bear any direct exchange risk. which is borne
Rs.174.9 bn respectively. Of it direct finance constituted 95.4%
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either by the borrower or the GOI. Government of India, in
of total sanctions and 92.6% of total disbursements. Protect
order to further help IDBI augment its resources, introduced
Non-Project loans given for eligible industrial.
Companies Deposits (Surcharge on Income Tax) Scheme. As
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These types of loans are disbursed by IDBI either for a
particular project of as a-general Joan, either in foreign currency
or Indian Rupees. Normally, these loans are provided for a
per this scheme companies were exempted from paying then
existing surcharge on income tax provided they deposit an
equivalent amount, repayable after five years, with IDBI. This-
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period of 5-7 years with a moratorium of 2-3 years. Also, the scheme was discontinued in April, 1978. In 1981, in response to
loans will be secured by a fixed charge on fixed assets. As in the the shortage of resources faced by the IDBI the Government
case of banks, the rate of interest that is charged will be a of India extended a budgetary support of Rs.50 crore.
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which are not necessarily technology driven. The venture capital increasingly on the market borrowings sourcing money through
assistance was provided to finance cost of fixed assets, certificate of deposits, floating rate bonds, term money bonds
operating and market development expenditure, among other and other commercial borrowings in both rupees and foreign
venture capital related activities. - currencies.
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IDBI provides indirect assistance through refinancing state level In 1994, IDBI act was amended through an ordinance, allowing
institutions for small loans disbursed by them. For approved IDBI to raise equity capital form the market as long as the GOI
loans IDBI makes a fixed spread with government providing a holding did not fall below 51 percent. Also, IDBI’s status was
guarantee for such refinance. changed from a government Undertaking to a. company
The share of different industries in total sanctions during FY registered under the Companies Act, 1956. Subsequent to the
1998 were power 6.2% core (iron & steel, oil, cement, fertilizer) amendment in the Act; IDBl made Rs.21.8bn IPO In July 1992
24.7% chemicals 11.2%m textiles 12.2%, paper 5.48%, other through public offerings of 168m equity shares of Rs. 10 each
industries 30.44% and pharmaceutical 4.11%. at a premium of Rs.120. The issue was over subscribed
approximately 1.4 times. The share was quoted at
Funding
approximately Rs.25 on 28.6.2001.
With its wide-ranging lending requirements with concentration
on long-term finance, IDBI needed huge money at a cheap rate. Current Position
In the 70s, to enable IDBI perform various developmental The valuation of IDBI’s stock, relative to HDFC and ICICl,
activities and also to finance small scale industries, at itself shows that IDBI is not viewed favorably by the market.
concessional rates, RBI created a separate National Industrial Due to IDBI’s relatively high exposure to iron and steel
Credit [Long-Term Operations]-(NIC[LTO]), fund out of its projects, which are languishing due to over capacity and global
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LESSON 25:
DEVELOPMENT FINANCIAL INSTITUTION
Learning objectives resources added on to the list. Broadly, the financial resources of
After reading this lesson, you will understand ICICI are as follows:
• Operations of major Fls in India –ICICI Share Capital
• Regulatory framework for Fls. ICICI is a public limited company and its six lakh shareholders
include Indian promoters (_9.1 %), Indian institutes/Mutual
We will discuss the nature and operations of the present
funds (7%), FIIs (34.8%), Public/ Free float (29.1%). These
financial institutions operating in India in today’s class. Today
figures are pre-IPO issue of 1999, when ICICI came out with a
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we will focus on ICICI.
issue priced at Rs.85. In middle of 1999, ICICI became the first
Industrial Credit and Investment Corporation of Indian company to have an ADR listing on the New, York
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India Ltd. Stock Exchange (NYSE). American Depository Receipts
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ICICI is India’s second largest Financial Institution with assets (ADRs) were issued in the ratio of 2:1 to the domestic equity
totaling Rs.424.5 bn in 1999. Initially, playing a role of a typical shares of ICICI traded on the Bombay Stock Exchange.
development financial institution-of giving long-term loans, it Reserves
has gradually evolved into a one-stop shop for most retail Reserves which are the internal resources- contribute
finance instruments. The corporation has its presence in significantly towards the fund requirements of the ICICI.
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investment and commercial banking, venture capital funding, Generally, internal generations of ICICI meet 50-60% of its
custodial services, InfoTech, brokerage, consultancy and funds requirement.
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advisory services. Compared to IDBI, which is seen as
conservative, ICICI is of late being more aggressive. ICICI has
increased its market share to 42 percent in sanctions and 43
Borrowings
The borrowings of ICICI fall into the following three types:
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percent of disbursements: • Rupee Borrowings
the Government, the World Bank and a steering committee of Borrowing storm the Government of India, institutional
5 prominent businessmen and others. The objective of ICICI borrowings, bonds guaranteed by Government and. other
was to assist the private sector. Later on, its services were public issue of bonds feature under the rupee borrowings
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extended even to the public sector, joint sector and the co- category of ICICl. The borrowings from GOI/RBI were mainly
operative sector. Primarily, assistance was provided for the to support developmental objectives of industrial growth. The
following purposes: bonds issued by the FIs, including the ICICI were guaranteed
• Creation expansion and modernisation of companies in the by the Government and qualified as SLR investments for
private sector. commercial banks. They carried lower interest rates (10-11 %)
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• Encouraging and promoting industrial investment and the and had a 15-year maturity period. In addition to these low cost
expansion of investment markets. Government borrowings, SLR bonds also were a major source
of funds for most of the FIs till 1993. However, in order to
For these purposes, the ICICI provides long and medium term
ensure a level planning ground, access to such low cost funds is
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encourage industrial investment, project finance is the key area financial services.
for fund deployment. Exim Bank
ICICI is into equipment finance also as it supports financing of Export-Import Bank of India (Exim Bank), an apex financial
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imported and locally manufactured equipment by deferred
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institution, was established in 1982 under an act of the
credit. Two types of credit facilities are offered (1) credit facility parliament to finance facilitate and promote India’s international
that enables the manufacturer to extend credit to’ the customer trade.
for purchasing the specified equipment, (2) asset credit facility The vision of Exim Bank is to develop commercially viable
that enables the purchaser to get the credit and repay over a fixed relationships with a targeted set of externally oriented
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period of line. Further, as the cost of funds is rising, ICICI is companies by offering them a comprehensive range of products
also entering into more profitable financing options. Having and services aimed at helping Indian companies to globalise.
began leasing Operations in 1983, ICICI has emerged as the
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single largest lessor in India While offering this service, ICICI
buys the equipment, retains the legal title and leases it. The
The bank has five overseas offices at Washington DC.
Singapore, Rome. Budapest and Johannesburg. The overseas
offices are strategically located to enhance institutional linkages
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average lease period is 5 years and the lease rentals are
determined as per the market rate. As the thrust on the with multilateral agencies viz., World Bank, International
infrastructure sector is growing, big ticket leasing in Monetary Fund, European Bank of Reconstruction and
infrastructure is gaining interest due to the large size of Development. Asian Development Bank, African Development
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operations. Taking advantage of this, ICICI has enhanced its Bank and regional banks like the PTA in Africa and also
operations in big ticket leasing. interacting with various Export Credit Agencies.
The fee based services offered by ICICI include merchant The overseas offices also assist Indian companies in identifying
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banking corporate advisory services, underwriting, corporate partners of business or joint ventures. Exim Bank has forged
finance, etc. In extending these services, ICICI has been alliances with banks, trade and investment promotion agencies
leveraging on in-house skill base, large client network and the in 31 countries through 53- co-operation agreements and
relationship with their clients. With the scope of these fee based Memoranda of Understanding (MoU).
services rising. ICICI has spun off most of these activities into Exim Bank finances exports of Indian machinery, manufacture
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countries are offered buyer’s credit and lines of credit to import finance, investment loans and. export marketing finance.
Indian goods and services. It provides competitive finance at various stages of the business
Exim Bank had posted a 6.6 percent dip in net profit at Rs.154 cycle, covering import of technology, export product
crore for the financial year ended March. 2001 from its previous development export production, export marketing, export
year net profit of Rs.165 crore. This is attributed to low lending credit at pre-shipment and post-shipment stage, and
rate/declining margins and intense competition in financial investment overseas. Finance is provided in Indian rupees and
sector. Sanctions by Exim for the period grew by 20 percent at foreign currency.
Rs.2,174 crore as compared to Rs1,640 crore for 1999-2000. The recent initiative of the government of India to create special
The bank has introduced several new initiatives to promote economic zones (SEZs) to provide an internationally-
India’s international trade. Some of the recent initiatives are competitive and hassle free environment for exports, have
• A program to finance R&D of export oriented companies at opened a new avenue for establishing financing and banking
concessional interest rates; arrangements to attract foreign direct investments in SEZs.
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• Bank’s participation in the equity of Indian ventures abroad; Four export processing zones (EPZs) at Kandla, Santa Cruz,
Kochi and Visakhapatnam have been converted to SEZs. while
• Working capital finance for exporting companies:
six more SEZs are being set up. Globally, Offshore Financial
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• Financing packages for knowledge based industries such as Centers (OFCs) and offshore banks have come to play a vital
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information technology computer software and role in facilitating investment worldwide, and are a focal point
pharmaceuticals; for the collection and channeling of wealth into onshore
• Co-operation agreement with US Exim Bank for promoting financial centers. The Indian banking regulations require
bilateral trade between USA and India: amendments to enable banks and financial institutions to seek
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• Co-operation agreement with PTA Bank - a regional exemption from a wide range of regulations.
development bank in Africa to sponsor Indian consultants It undertakes research studies on subjects concerning
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for PTA Bank funded projects in Africa;
• Co-operation agreements wit business promotion agencies
in Vietnam, Italy, China, UAE, Uzbekistan, African
international trade, international economics, sector and product
studies and country studies and publishes these studies in the
form of occasional papers (OPs). So far the bank has brought
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Development Bank and Eastern & Southern African Trade out 79 OPs.
and National Association of Software & Services Companies. In addition to finance, Exim Bank provides a range of analytical
Exim Bank plays the role of a consultant to share its own information and related services necessary for globalization of
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experience in institution building. It has provided consultancy Indian companies. The advisory services enable exporters to
to many developing countries. Some recent assignments are in evaluate international risks, export opportunities and enhance
South Africa and Zimbabwe. In addition to finance, Exim competitiveness.
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Bank provides a range of analytical information and related Exim Bank assists externally-oriented Indian companies in their
services necessary for globalization of Indian companies. quest for excellence and globalization.
The advisory services enable exporters to evaluate international SIDBI
risks, export opportunities and enhance competitiveness. Exim SIDBI was established in April, 1990 under an act of the Indian
Bank through its wide network of alliances with financial Parliament to serve as the principal financial institution for
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institutions, trade promotion agencies, information providers promotion, financing and development of industry in the
across the globe assists externally-oriented Indian companies in small scale sector ,and to coordinate with similar institutions
their quest for excellence and globalization. Services include engage(in the same. SIDBI offers a wide range of assistance
search for overseas partners, identification of technology through its direct finance, refinance, bills finance, equity finance,
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suppliers negotiating an alliance and consummating a joint venture capital, foreign currency loans, lines of credit and other
venture. schemes of assistance besides support services. It has setup the
Over the years, the bank has evolved from financing and Technology Development and Modernization Fund to
facilitating and promoting India’s foreign trade to developing encourage technology upgradation In small enterprises.
commercially-viable relationship with a target set of externally- Set up under the SIDBI Act, 1989, SIDBI’s operation have been
oriented companies by offering them a comprehensive range of guided by its mandate of serving as the principal financial
products and services aimed at helping Indian companies institution for promotion, financing and development of.
globalise. Indian industry in the small scale sector which forms the
The evolution from traditional export credit programs to backbone of the Indian economy, contributing around percent
overseas investment credit, import credit, advisory and of India’s total manufacturing sector output, around 35 percent
promotional programs and global network of institutional of total manufacturing sector output, around 35 percent of
linkages, reflect the adaptation to the changing global trends. total exports and providing employment to nearly 17 million
The need to utilise all possible financing mechanisms to persons. While entrusting the bank with the significant
promote export capabilities has motivated the bank to go responsibility of performing the role of an apex level
beyond provision of post-shipment credit, and operate institution for the small scale industries (SSI) sector, the statute
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mechanism through nearly 900 primary lending institutions world by the ‘The Banker’, London. SIDBI was the winner of
including commercial banks and State Level institutions, viz. Asian Banking Award, 1999.
SFCs, SIDCs, etc. having over 65,000 outlets throughout India. In order to help the Indian SSI sector cope up with the
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Besides funding of the sector, SIDBI has also been providing challenges posed by the WTO regime, SIDBI would be
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developmental ‘and support services aimed at improving the concentrating on certain specific industry segments for strategic
inherent strength of the SSI units and employment generation interventions where the sector has got inherent advantages. The
and economic rehabilitation of rural poor. The initiatives of the changes in the economy in the last decade which brought in
Bank emphasize on entrepreneurship development, enterprise liberalization, deregulation, competition for the SSIs and
promotion and strengthening, rural industrialization, human
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technology advances particularly in information technology, to
resources development, technology upgradation, environment cite a few hold significance both for SIDBI as well as the SSI
management, etc. sector, and the same have formed the underpinnings of the
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Another feature of SIDBI’s operations has been focused
initiatives and institution building in tandem with Government
of India, NGOs, technical/management institutions,
Bank’s strategies and initiatives.
As a proactive apex level institution, the Bank will continue to
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make its contribution towards strengthening the SSI sector
international agencies and industry associations for reaching out through innovative and tailor made programs.
to the SSI sector. In this regard, the Bank has co-promoted 2
factoring companies, a commercial bank in the private sector viz. NABARD
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IDBI Bank Ltd. and a Technology Bureau for Small Enterprises NABARD is an apex institution, accredited with all matters
in collaboration with Asian and Pacific Center for Transfer of concerning policy, planning and operations in the field of credit
Technology. Besides, SIDBI and Ministry of S51 and ARI. for agriculture and other economic activities in rural areas in
India. It is an apex refinancing agency for the institutions
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banks and select Regional Rural Banks. SIDBI has also launched monitoring, formulation of rehabilitation schemes,
a National Venture Fund for Software and IT Industries restructuring of credit institutions, training of personnel, etc.
(NFSIT) and has co-promoted several state level venture funds It co-ordinates the rural financing activities of all the
in association with respective State Governments. The SIDBI institutions engaged in developmental work at the field level
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Foundation for Micro Credit aims at creating a national network and maintains liaison with Government of India, State
of strong, viable and sustainable Micro Finance Institutions Governments, Reserve Bank of India and other national level
from the informal and formal financial sectors to; provide micro institutions concerned with policy formulation.
finance services to poor. SIDBI also offers fee-based
It prepares, on annual basis, rural credit plans for all districts in
consultancy to developing _ nations on appropriate strategy and
the country these plans form the base for annual credit plans of
approach for growth of small industries including assistance for
all rural financial institutions. It undertakes monitoring and
joint ventures with Indian SSIs. With a view to fostering seed
evaluation of projects refinanced by it. It promotes research in
stage projects in knowledge based sectors having high R&D
the fields of rural banking, agriculture and rural development.
content and preparing them for venture capital assistance, the a
The Committee to Review Arrangements for Institutional
Bank has a program for-innovation and incubation for small
Credit for Agriculture and’ Rural Development (CRAFICARD),
industries which is being taken up In situation with – reputed
set up by the Reserve Bank of India (RBI) under the
technical/research institutions of the country.
Chairmanship of Shri B. Sivaraman, conceived and
For bridging the information gap in the small scale sector, recommended the establishment of the National Bank for
SIDBI has been presenting information relating to different Agriculture and Rural Development. (NABARD). The Indian
facets of the SS! sector in the form of “SIDBI Report on S5I
of NABARD. The reforms taking Place in the financial sector have been
The Bank which came into existence on 12 July, 1982, was affecting all the players in the market, DFIs being no exception
dedicated to the service of the Nation by the Hon’ble Prime to it. While the deregulations have unleashed the competition,
Minister, Smt. Indira Gandhi on 5th November, 1982. the guidelines introduced to streamline the Indian market
players operations with that of the international player have
NABARD was established, in terms of the preamble of the
posed significant challenges for the profitable sustenance of
Act, “for providing, credit for the promotion of agriculture,
these players.
small scale industries, cottage any village industries, handicrafts
and other rura1 crafts and other allied economic activities in rural Significant changes that have been witnessed in the operational
are as wife a view to promoting integrated rural development environment of the Fls are as follows:
any securing prosperity of rural areas and for material connected • Capital adequacy requirements: the capital to risk
therewith or incidental thereto.” weighted assets ratio (CRAR) that the Fls are supposed to
NABARD took over the functions of the erstwhile Agricultural maintain is 9 percent. The details relating to the computation
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Credit Department (ACD) and Rural Planning and Credit Cell of CRAR remain the same as for banks. In addition to this,
(RPCC) of RBI and Agriculture Refinance and Development the non-cumulative preference shares permissible for issue
Corporation (ARDC). Its subscribed and paid-up Capital was under the companies act and which have a maturity of 20
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Rs.100 crore which was enhanced to Rs.500 crore, contributed years will form a part of the tier-1 capital. However, the Fl
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by to Government of India (GOI) and RBI in equal will have to create a corpus to be invested in the government
proportion It is now enhanced to Rs.2,OOO crore. securities having maturity of such preferences shares to
eliminate the reinvestment risk. The corpus should be a
Refinance Support minimum amount, which when invested will equal the
The National Bank’s refinance support to co-operative banks,
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preference shares amount. Adjustment will have to be made
commercial banks and RRBs and loans to state governments in this corpus for the changes taking place in the tax rates. If
and NGOs during the year 1999—2000 aggregated Rs.14,178 a shortfall arises, it has to be provided from the reserves.
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crore compared to Rs.l2366 crore during the previous year
registering a growth of 1.6 percent.
Long-Term Loans to State Governments
Further, transfers from the reserve will also have to be made
for the differential interest rates i.e. if the yield on the G-Secs
at the time of the initiation of the corpus and the yield at
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The National Bank provides long-term loans to state which the interest proceeds are reinvested each year the
governments for contribution to the share capital of co- corpus should not be used for the other operations of the
operative credit institutions subject to certain norms. During FI. The amount and the purpose of the corpus, will have to
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the year 1999- 2000, loans aggregating Rs.91.07 crore were be disclosed separately in the balance sheet, prospectus for
sanctioned to 13 state government for contribution to the share raising resources, etc. The amount of preference shares less
capital of 4 SCBs. 1 SLDB. 46 DCCBs, 61 PLDBs and 9112 the amount of corpus created as above will be considered as
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crore, of which the SCBs accounted for 68 percent while DCCBs for 180 days (earlier it was 365 days).
accounted for 32 percent. Commodity wise, sugar accounted for However, in addition, to those guidelines, the Reserve Bank has
Rs. 3,305.89 crore (71%) cotton Rs. 992.00 crore (21 %) and also released prudential norms for takeout financing by financial
fertilizer Rs.245.00 crore (5%) while other commodities institutions in India. Under a takeout finance management, the
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accounted for Rs.135.64crore (3%). For block capital finance, FII Bank financing an infrastructure project transfers the
authorizations aggregating Rs.167.49 crore were granted in outstanding loan amount to another on a pre-determined
respect of 34 proposals. basis. The taking over institution will have to make provisions
on the NPAs being taken over in their accounts from the date
Investment Credit
of it turning into a NPA in the lending institution’s books.
The refinance budget for schematic lending for the year1999-
2000 was originally fixed at Rs.5,200 crore. However, during the Further, in cases of unconditional takeover, the lending
course of the year taking into account the availability of funds institutions should prescribe a risk weightage of 20% in its
and additional demand from client institutions as also the need books when the credit risk is taken over entirely. The taking over
to maintain a positive growth rate in the various states as institution has to prescribe a risk weightage of 100% in such
compared to the previous year, the refinance budget was cases. The weightage for the lending institution in cases of
enhanced to Rs.5, 215 crore. The total disseminates during the assumption of partial credit risk has been prescribed at 20% on
year reached the programmed level of Rs.5.215 crore registering the loan to be taken over and 100% on amount not taken over.
a growth of 15 percent compared to the disbursement The central bank has also prescribed 100% risk weightage in
ofRs.4.521 crore disbursed during 1998-99. cases of conditional takeover financing for both lending and
taking over institution.
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of credit by Fls does not have any restrictive clauses relating
to the priority sector lending but however, they have to
ensure balance regional development, export promotion etc.
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Summary
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During 1999-2000, financial assistance sanctioned and disbursed
by All India Financial Institutions (AIFIs) at Rs.1, 03,567 crore
and Rs.67, 066 crore, respectively, registered increases of 26.3
percent and 19.1 percent, as compared with 8.6 percent and 8.5
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percent during 1988-99. The substantially higher growth in
both sanctions and disbursements during 1999-2000 was an
indicator of improved investment activity. Financial assistance
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sanctioned by All India Development Banks (AIDBs), which
accounted for the bulk of the sanctions (84.6 percent of total
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sanctions of AIFls) grew by 22.2 percent, while their
disbursements grew by 16.5 percent. During 1999-2000,
specialized financial institutions increased their disbursements
by 61.6 percent. Many of them are entering into venture capital
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LESSON 26:
INSURANCE COMPANIES
Learning objectives the teenager gets into an accident. The reason for this rule is
After reading this lesson, you will understand that insurance companies do not want people to buy policies
as a way of gambling.
• Introduction
• The insured must provide full and accurate information to
• Fundamentals of insurance
the insurance company.
• Adverse selection and moral hazard in insurance
• The insured is not to profit as a result of insurance coverage,
• Selling insurance
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• If a third party compensates the insured for the loss, the
• Growth and organisation of insurance companies insurance company’s obligation is reduced by the amount of
• The practicing financial institution manager the compensation.
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Today we shall discuss the insurance companies, why should • The insurance company must have a large number of
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these investment companies be considered as an important insured so that the risk can spread out among many different
investment alternative. policies.
Insurance Companies • The loss must be quantifiable. For example, an oil company
Insurance companies are in the business of assuming risk on could not buy a policy on an unexplored oil field.
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behalf of their customers in exchange for a fee, called a • The insured company must be able to compute the
premium. Insurance companies make a profit by charging probability of the loss occurring;
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premiums that are sufficient to pay the expected claims to the
company plus a profit. Why do people pay for insurance when
they know that over the lifetime of their policy, they will
The purpose of these principles is to maintain the integrity of
the insurance process. Without them, people may be tempted
to use insurance companies to gamble or speculate on future
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probably pay more in premiums than the expected amount of events. Taken to an extreme, this behavior could undermine the
any loss they will suffer? Because most people are risk averse: ability of insurance companies to protect persons in real need.
they would rather pay a certainty equivalent (the insurance In addition, these principles provide a way to spread the risk
premium) than accept the gamble that they will lose their house
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among many policies and to establish a price for each policy that
or their car. Thus it is because people are risk-averse that they will provide an expectation of profitable return.
prefer to buy insurance and know with certainty what their
wealth will be (their current wealth minus the insurance Adverse Selection and Moral Hazard in Insurance
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premium) than to incur the risk and run the chance that their The implication of adverse selection is that loss probability
wealth may fall. statistics gathered for the entire population may not accurately
reflect the loss potential for the persons who actually want to
Consider how people’s lives would change if insurance were not
buy policies.
available.
The adverse selection problem raises the issue of which policies
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insurance pays off if you die, protecting those who depend on
marketing may account for up to 20% of the total cost of a
your continued earnings. As mentioned, the person who
policy. A good sales force can convince people to buy insurance
receives the insurance payment after you die is called the
coverage that they never would have pursued on their own yet
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beneficiary of the policy. Disability insurance replaces part of
may have a need for.
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your income should you become unable to continue working
Insurance is unique in that agents sell a product that commits due to illness or an accident. An annuity is an insurance
the company to a risk. The relationship between the agent and product that will help if you live longer than you expect. For an
the company varies: independent agents may sell insurance for initial fixed sum or stream of payments, the insurance company
a number of different companies. They do not have any agrees to pay you a fixed amount for as long as you live. If you
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particular loyalty to any one firm and simply try to find the best live a short life, the insurance company pays out less than
product for their customer. Exclusive agents sell the insurance expected. Conversely, if you live unusually long, the insurance
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products for only one insurance company.
Most agents, whether independent or exclusive, are
compensated by being paid a commission. The agents
company may pay out much more than expected.
Term Life
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The simplest form of life insurance is the term insurance policy,
themselves are usually not at all concerned with the level of risk
which pays out if the insured dies while the policy is in force.
of any one policy because they have little to lose if a loss occurs.
This form of policy contains no savings element, once the
(Rarely are commissions influenced by the claims submitted by
policy period expires, there are no residual benefits.
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a policy if they deem the risk unacceptable. decreasing term policies have a constant premium, but the
amount of the insurance coverage declines each year. Term
Growth and Organisation of Insurance Companies policies have been historically hard to sell because once they
Types of Insurance expire, the policyholder has nothing to show for the premium
Insurance is classified by which type of undesirable event is paid. This problem is solved with whole life policies.
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insured. The most common types are life insurance and Whole Life
property and casualty insurance. In its simplest form, life A whole life insurance policy pays a death benefit if the
insurance provides income for the heirs of the deceased. Many policyholder dies. Whole life policies usually require the insured
insurance companies provide retirement benefits as well as life
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retired, they could spend all their money and end up in poverty. much faster than the cost of living and real wages. One factor
One way to avoid this outcome is by purchasing annuities. contributing to this increase is the more sophisticated and
Once an annuity has been purchased for a fixed amount, it expensive treatments constantly being offered. Another way
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makes payments as long as the beneficiary lives. that insurance companies are attempting to deal with increased
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medical costs is by controlling them. This is done by
Annuities are particularly susceptible to the adverse selection
negotiating contracts with physician groups to provide services
problem. When people retire, they know more about their life
at reduced cost and through managed care, where approval is
expectancy than the insurance company knows. People who are
required before services can be rendered.
in good health, have a family history of longevity, and have
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attended to their health all of their lives are more likely to live Property and Casualty Insurance
longer and hence to want to buy an annuity than people in poor Property and casualty insurance was the earliest form of
or average health. To avoid this problem, insurance companies insurance. It protects against losses from fire, theft, storm,
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tend to price individual annuities expensively. Most annuities
are sold to members of large groups where all employees
explosion, and even neglect. Property insurance protect
businesses and owners from the impact of risk associated with
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covered by a particular pension plan automatically receive their owning property. This includes replacement and loss of
benefit distribution by purchasing an annuity from the earnings from income-producing property as well as financial
insurance company. losses to owners of residential property. Casualty insurance
(or liability insurance) protects against liability for harm the
Assets and Liabilities of Life Insurance Companies
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premiums paid into pension funds managed by Life Insurance First, policies tend to be short-term, usually for one year or less.
Company. These funds are long term in nature. Since life Second, whereas life insurance is limited to insuring against one
insurance liabilities are predictable and long-term, life insurance event, property and casualty companies insure against many
companies can invest in long-term assets. The pie chart below different events. Finally, the amount of the potential loss is
shows the tentative distribution of assets of the average life much more difficult to predict than for life insurance. These
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insurance company. Most of the assets are in long-term characteristics cause property and casualty companies to hold
investments such as corporate stocks and bonds. more liquid assets than those of life insurance companies.
Reinsurance
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Mortgages
The Practicing Financial Institution Manager
Insurance Management
Stocks
Insurance companies, like banks, are in the financial
intermediation business of transforming one type of asset into
another for the public. Insurance companies use the premiums
paid on policies to invest in assets such as bonds, stocks,
mortgages, and other loans; the earnings from these assets are
then used to pay out claims on the policies. In effect, insurance
companies transform assets such as bonds, stocks, and loans
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large insurance payoffs are the ones who will want to purchase that makes a claim more likely. For example, life insurance
insurance the most. For example, a person suffering from a companies have provisions in their policies that eliminate death
terminal disease would want to take out the biggest life and benefits if the insured person commits suicide. Restrictive
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medical insurance policies possible, thereby exposing the provisions may also require certain behavior on the part of the
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insurance company to potentially large losses. Both adverse insured that makes a claim less likely. A company renting motor
selection and moral hazard to reduce these payouts is therefore scooters may be required to provide helmets for renters in order
an extremely important goal for insurance companies. to be covered for any liability associated with the rental.
Screening Prevention of Fraud
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To reduce adverse selection, insurance companies try to screen Insurance companies also face moral hazard because an insured
out poor insurance risks from good ones. Effective information person has an incentive to lie to the company and seek a claim
collection procedures are therefore an important principle of
insurance management.
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When you apply for auto insurance, the first thing your
even if the claim is not valid. For example, a person who has
not complied with the restrictive provisions of an insurance
contract may still submit a claim. Even worse, a person may file
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insurance agent does is ask you questions about your driving claims for events that did not actually occur. Thus an important
record (number of speeding tickets and accidents), the type of management principle for insurance companies is conducting
car you are insuring, and certain personal matters (age, marital investigations to prevent fraud so that only policyholders with
status). If you are applying for life insurance, you go through a valid claims receive compensation.
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similar grilling, but you are asked even more personal questions Cancellation of Insurance
about such things as your health, smoking habits, and drug and Being prepared to cancel policies is another insurance
alcohol use. The life insurance company even orders a medical management tool. Insurance companies can discourage moral
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evaluation (usually done by an independent company) that hazard by threatening to cancel a policy when the insured person
involves taking blood samples. Based on this information, the engages in activities that make a claim more likely. If your auto
insurance company can decide whether to accept you for the insurance company makes it clear that if a driver gets too many
insurance or to turn you down because you pose too high a risk speeding tickets, coverage will be canceled, you will be less likely
and thus would be and unprofitable customer for the insurance
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to speed.
company.
Deductibles
Risk-Based Premium The deductible is the fixed amount by which the insured’s loss
Charging insurance premiums on the basis of how much risk a is reduced when a claim is paid off. Deductibles are an
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policyholder poses for the insurance company is a time-honored additional management tool that helps insurance companies
principle of insurance management. Adverse selection explains reduce moral hazard. With a deductible, you experience a loss
why this principle is so important to insurance company along with the insurance company when you make a claim.
profitability. Because you also stand to lose when you have an accident, you
To understand why an insurance company finds it necessary to have an incentive to drive more carefully. A deductible thus
have risk-based premiums, let’s examine an example of risk- makes a policyholder act more in line with what is profitable for
based insurance premiums that at first glance seems unfair. Ram the insurance company; moral hazard has been reduced. And
and Sita, both college students with no accidents or speeding because moral hazard has been reduced, the insurance company
tickets, apply for auto insurance. Normally, Ram will be charged can lower the premium by more than enough to compensate
a much higher premium than Sita. Insurance companies do this the policyholder for the existence of the deductible.
because young males have a much higher accident rate than Another function of the deductible is to eliminate the
young females. Suppose, though, that one insurance company administrative costs of small losses by forcing the insured to
did not base its premiums on a risk classification but rather just bear these losses.
charged a premium based on the average combined risk for
males and females. Then Sita would be charged too much and
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Another important principle of insurance management is that
there should by limits on the amount of insurance provided,
even though a customer is willing to pay for more coverage. The
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higher the insurance coverage, the more the insured person can
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gain from risky activities that make an insurance payoff more
likely and hence the greater the moral hazard. For example, if
Sita’s car were insured for more than its true value, she might
not take proper precautions to prevent its theft, such as making
sure that the key is always removed or putting in an alarm
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system. If her car were stolen, she comes out ahead because the
excessive insurance payoff would allow her to bur an even
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better car. By contrast, when the insurance payment is lower
than the value of her car, she will suffer a loss if it is stolen and
will thus take the proper precautions to prevent this from
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happening. Insurance companies must always make sure that
their coverage is not so high that moral hazard leads to large
losses.
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Questions to Discuss:
1. What are the fundamentals of insurance?
2. Discuss the adverse selection and moral hazard in insurance.
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Notes:
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Learning objectives A mutual fund uses the money collected from the investor to
After reading this lesson, you will understand buy those assets, which are specifically permitted by its stated
investment objective. Thus, an Equity Fund would buy mainly
• Concept
equity assets- ordinary shares, preference shares, warrants etc; a
• Structure Bond Fund would mainly buy debt instruments such as
• Types of mutual fund debentures, bonds, or government securities. It is these assets,
• SIP or SWP or STP which are owned by the investors in the same proportion as
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their contribution bears to the total contributions of all the
• Tax benefits in mutual fund
investors put together.
• Net asset value (NAV) – the concept
When an investor subscribes to the mutual fund, he or she
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• Importance of NAV to the investor buys a part of the assets or the pool of funds that are
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• Advantages of investing in mutual fund outstanding at that time. It is no different from buying
• Disadvantages of investing in mutual fund “shares” of a joint stock company, in which case the purchase
makes the investor a part owner of the company and its assets.
Students, today in the class we shall discuss one of the most
In India, a mutual fund is constituted as a Trust and the
popular investment alternatives available in the market. It is
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investor subscribes to the “units” issued by the fund, which is
popular both with retail investors as well as high networth
where the term Unit Trust comes from. In any case, a mutual
individual because of its capacity to earn more returns with less
fund shareholder or unit-holder is a part owner of the fund’s
risk.
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Let us start with the concept of Mutual Fund. What exactly do
we understand by mutual fund?
asset.
Since each owner is a part owner of a mutual fund, thus it is
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necessary to establish the value of his part. In other words, each
Concept share or unit that an investor holds needs to be assigned a
Investment can be done in different forms. An investor can value. Since the units held by investor evidence the ownership
either invest directly in securities, or can invest through an of the fund’s assets, the value of the total assets of the fund
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investment company. An investment company is a financial when divided by the total number of units issued by the
intermediary that collects money from investors and invests in mutual fund gives us the value of one unit. This is generally
various securities on their behalf. The returns from these called the Net Asset Value (NAV) of one unit or one share.
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investments are passed on to the investors, either periodically, The value of an investor’s part ownership is thus determined
or at the end of a specified time period. The investment by the NAV of number of units held.
company charges fees for its services, referred to as management
A mutual fund is the ideal investment vehicle for today’s
fees.
complex and modern financial scenario. Markets for equity
There are two kinds of investment companies – Open-end and
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changing. Close- End companies are those which have a limited keep track of events, understand their implications and act
investment horizon. The investors invest in the company for a speedily. An individual also finds it difficult to keep track of
specified time period, and the investment company manages for ownership of his assets, investments, brokerage dues and bank
the said period. At the end of the period the investments are transactions etc. A mutual fund is the answer to all these
liquidated and the investors funds are returned along with the situations. It appoints professionally qualified and experienced
returns. staff that manages each of these functions on a full time basis.
In India both close-end and open-end investment companies The large pool of money collected in the fund allows it to hire
are called Mutual Funds. Thus Mutual fund is a trust that such staff at a very low cost to each investor.
pools the savings of a number of investors who share a In effect, the mutual fund vehicle exploits economies of scale in
common financial goal. The money thus collected is then all three areas - research, investments and transaction processing.
invested by the fund manager on behalf of the investors in While the concept of individuals coming together to invest
different types of securities. The income earned through these money collectively is not new, the mutual fund in its present
investments and the capital appreciated realized by the schemes form is a 20th century phenomenon. In fact, mutual funds
are shared by its unit holders in proportion to the number of gained popularity only after the Second World War.
units owned by them.
thousands of mutual funds with different investment some being open-ended and some being closed-ended. The
objectives. Today, mutual funds collectively manage almost as Unit Scheme 1964 commonly referred to as US 64, which is a
much as or more money as compared to banks. This gives the balanced fund, is the biggest scheme with a corpus of about
investor number of options and gives him optimal returns Rs200bn. UTI was floated by financial institutions and is
accompanied by minimum risk. governed by a special act of Parliament. Most of its investors
All in all mutual fund is the best means to invest by not only believe that the UTI is government owned and controlled,
minimizing the risk but also maximizing returns. which, while legally incorrect, is true for all practical purposes.
The following flow chart would make our understanding very The second largest category of mutual funds is the ones floated
clear. by nationalized banks. Canbank Asset Management floated by
Canara Bank and SBI Funds Management floated by the State
The flow chart below describes broadly the working of a
Bank of India are the largest of these. GIC AMC floated by
mutual fund:
General Insurance Corporation and Jeevan Bima Sahayog AMC
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floated by the LIC are some of the other prominent ones. The
aggregate corpus of funds managed by this category of AMCs
is about Rs150bn.
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The third largest category of mutual funds is the ones floated
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by the private sector and by foreign asset management
companies. The largest of these are Prudential ICICI AMC and
Birla Sun Life AMC. The aggregate corpus of assets managed
by this category of AMCs is in excess of Rs250bn.
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Further the Mutual Fund Industry has a Four –tier structure.
The four parties that are required to be involved are:
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• Board of Trustees
• Asset Management Company (AMC)
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• Custodian.
Structure
These four entities operate in the following manner:
Now lets come to the structure of the overall functioning of
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Mutual Fund.
The organisational set up of the Mutual Fund is as follows:
SPONSOR
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CUSTODIAN
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corporate, establishes a mutual fund. The sponsor of a fund is activity.
akin to the promoter of accompany as he gets the fund The AMC are responsible to invest on behalf of the investors
registered with SEBI. The sponsor will form a trust and who have entrusted them with their money .So they are
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appoint a board of trustees. The sponsor will also generally expected to act in the interest of the investors.
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appoint an Asset Management Company as fund managers.
The Custodian
The sponsor, either directly or acting through the trustees, will
Mutual funds are in the business of buying and selling of
also appoint a Custodian to hold the fund assets. All these
securities in large volumes. Handling these securities in terms of
appointments are made in accordance with SEBI Regulations.
physical delivery and eventual safekeeping is therefore a
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As per the existing SEBI regulations, for a person to qualify as a specialized job. The custodian is appointed by the Board of
sponsor, he must contribute at least 40% of the net worth Trustees for safekeeping of physical securities or participating in
prior to registration.
The Trustee
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AMC and posses a sound financial track record over five years any clearing system through approved depository companies on
behalf of the mutual fund in case of dematerialized securities.
The mutual fund industry does not work with the help of one
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A mutual fund in India is constituted in the form of a Public entity. All the four constituents have to operate in harmony and
Trust created under the Indian Trusts Act 1882. The Fund in co-operation with each other. One must not forget that they
Sponsor acts as the Settler of the Trust, contributing to its are inter-related and has to function together.
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initial capital and appoints a trustee to hold the assets for the
Types of Mutual Fund
benefit of the unit-holders, who are the beneficiaries of the
Mutual funds differ from each other on the basis of various
trust. The fund then invites investors to contribute their money
factors like their structure, their investment objectives, and the
in the common pool, by subscribing to units issued by various
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India. While the Provisions of the Indian Trusts Act, govern CLOSE-ENDED
the Board of Trustees where the Trustee is a corporate body, it EQUITY (GROWTH)
companies Act, 1956. The Board or the trustee company, as an INVESTMENT BALANCED
OBJECTIVE
independent body, acts as protector of the unit-holders interest LIQUID
For this specialist function, they appoint an Asset Management OTHER SPECIALIZED FUNDS (MIP, SECTORAL,
etc.)
Company. They ensure that the fund is managed by the AMC TYPES OF OFFSHORE FUNDS
as per the defined objectives and in accordance with the Trust INVESTORS
PENSION FUNDS
Deed and SEBI Regulations.
The trustees being the primary guardians of the unit holders’ MANAGEMENT MANAGED FUNDS
LOAD
The Asset Management Company NO LOAD FUNDS
An open-ended fund is a fund, which remains open for issue consistence. Then there are diversified schemes were the money
and redemption of its shares throughout its duration. This is invested over a wide area thus minimizing risk. So an investor
means an investor can invest or put in his money at any point according to his risk taking ability can invest in these funds.
of time and similarly redeem or withdraw his investment at any
Income Fund
given time depending on the market and other factors.
The aim of such fund is to provide regular and steady income
Examples: Birla Advantage Fund, HDFC equity, Canaganag, etc.
to investors. These funds or schemes generally invest in fixed
As an open-ended fund is required to redeem its shares any
incomes such as bonds and corporate debentures. Capital
time the investors wish to liquidate their holdings, a relatively
appreciation in such schemes may be limited. These are suitable
higher portion of its assets need to be highly liquid.
for retired people and others with a need for capital stability and
Close-Ended Fund regular income.
A close – ended fund can issue shares only in the beginning, The largest segment of the market in terms of traded volume
and cannot redeem them or reissue them till the end of their and outstanding debt is the government securities market. This
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fixed investment duration. This means that once an investor is the most liquid segment of the market with maturity of debt
puts in his money he cannot withdraw till the maturity period. issues ranging from 91day Treasury bill right up to 30 yr dated
Example: UTI’s US 92. A close-ended fund does not face the securities. This class of securities would account for more than
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problem of shortfall, as it does not require to redeem its shares 90% of traded volume in the secondary market. People who are
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before the maturity period of the fund. very low risk takers can opt for these schemes. Here the investor
Equity or Growth Fund gets regular returns at minimum risk, but the returns are not as
The objective of Growth Fund Scheme is to provide capital high as equity.
appreciation over the medium to long term. These schemes Balanced Fund
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normally invest a major portion of their fund in Equities and They aim to provide both growth and income periodically
are willing to bear short-term decline in value for future distributing a part of the income and capital appreciation to the
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appreciation in the net asset value of the scheme. These
schemes are not for the investors seeking regular income or
needing their money back in the short term and are suitable for
investors or reinvesting (in case of reinvestment scheme) such
income and capital appreciation to enhance the net asset value
of the fund. They invest in both shares and fixed income
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investors in their prime earning years or investors seeking securities in the proportion indicated in their offer document.
growth over the long term. Such funds are suitable for investors, who are willing to take
Growth or Equity funds offer two options-Dividend Option some risk and seeks both income and capital appreciation.
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and Growth Option. In Dividend Option, the investor gets the Here a part of the investment is in debt market so the risk is
dividend on a regular basis as and when declared by the AMC. minimum, and the other part is invested in equities to
The dividend is calculated on the face value of that particular maximize returns. Hence the investors enjoy the benefit of high
scheme of the Mutual Fund. This dividend is tax-free in the returns along with security. The aim of balanced funds is to
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hands of investors. In the case of Growth Option, no provide both growth and regular income. In a rising stock
dividend is declared so the NAV continues to appreciate on a market, the NAV of these schemes may not normally keep pace,
regular basis. or fall equally when the market falls. These are ideal for investors
Dividend option comprises of Dividend Pay-Out and looking for a combination of income and moderate growth.
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Dividend Reinvestment. In the case of Dividend Pay-Out Here the maximum exposure is towards Equity as compared to
option, the investors receive the dividend when declared by the debt. However the proportion of equity: debt may change from
AMC and the NAV of that scheme gets reduced in proportion time to time, as the market trend is as well as on the call of
to the percentage of dividend declared. On the other hand, in fund manager. In the recent months the proportion of equity:
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the case of Dividend Reinvestment Option, the dividend debt is 60: 40. This is because the equity market is doing well.
amount gets automatically reinvested in the scheme instead of Balance fund tries to strike a balance between that equity offers
coming in the hands of the investor. Here the number of units and the safety that debt provides, and thus maximizes
gets increased accordingly. In this case too the NAV gets reduced investments at moderate levels of risk.
in accordance with the percentage of the dividend declared.
Liquid Fund
The Growth Option is bifurcated into Growth Plan and Liquid funds are short-term investments, which are not marked
Bonus Plan. In Growth Plan when the company declares to market (not traded). In this case the investors instead of
bonus the investors who have opted for this plan are not keeping the money with them for a very short period say a
entitled for the bonus shares. In this case the NAV of the weekend invests in liquid fund. The aim of Liquid funds is to
scheme keeps on appreciating. On the other hand investors who provide easy liquidity, preservation of capital and moderate
have opted for bonus plan receive the bonus shares and the income. These schemes generally invest in safer short-term
NAV of the scheme decreases in the same proportion. instruments such as treasury bills, certificates of deposit,
Some schemes can be aggressive, where the weightage is more commercial paper and inter-bank call money. Returns on these
on mid-caps. Here the fluctuations are more, or there are schemes may fluctuate depending upon the interest rates
conservative funds where the weightage is on Blue-chip prevailing in the market. These are ideal for Corporate and
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These funds invest in particular industries, instruments sectors Passive management of fund involves selection of a market
or markets. If they are Industry Specific Schemes then they index. After an index is selected, the securities that form a part
invest only in the industries specified in the offer document. of the index are bought in the proportion in which they are
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represented in the index. No further transaction is done and
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The investment of these funds is limited to specific industries
like InfoTech, FMCG, and Pharmaceuticals etc. For Example: these securities are held till a need to liquidate the corpus arises.
Alliance Basic Industries fund, Prudential ICICI Technology If a part of the corpus is required to be liquidated for
fund, etc. redemption purposes, it is liquidated in the same proportion in
which the securities are held. The cost of managing funds
If they are Sector Specific Schemes then they invest passively is quite less as compared to active management. Index
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exclusively in a specified sector. This could be an industry or a funds bases on BSE or NSE are examples of passively
group of industries or various segments such as ‘A’ Group managed funds. Index funds perform in line with the
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shares or initial public offerings.
Then there is Tax Saving Schemes. These schemes offer tax
rebates to the investors under specific provisions of the Indian
performance of the index, which is reflective of the market as a
whole.
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Load Fund
Income Tax laws as the Government offers tax incentives for
A fund incurs two types of costs- marketing costs and
investment in specified avenues. Investments made in Equity
operating costs. While the operating costs of the scheme are
Linked Savings Schemes (ELSS) and Pension Schemes are
charged to the schemes’ earnings, the marketing costs may not
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charged at the time the investors invest in the fund, this is also
minimizing their tax liability.
called Entry Load. In the case of back load fund, investors are
Offshore Funds required to pay the load charges while exiting from the fund.
Funds that invest solely in the foreign markets are referred to as This is also called the Exit Load. There can be a Partial Load
international funds (also called offshore funds) the majority of scheme, wherein a part of the load is borne by the scheme and
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funds have been routed through Mauritius. Funds that invest the rest by the Asset Management Company.
in both domestic and international markets are referred to as
No- Load Fund
Global Funds. At present the Indian mutual funds are not
In these kinds of funds the marketing costs as a part of the
allowed to invest in the international market, nor are the foreign
management fee. The management is allowed to charge an
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operates with a certain target value for his investment. If the Investors need not pay any tax on dividend received from a
investment appreciates beyond the target value, he encashes part mutual fund for a period of three years effective from April 1,
1999. For the investor it does not matter what kinds of mutual
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of the investment. If the investment depreciates below the
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target value, the investor brings in fresh funds equivalent to the fund scheme they have invested in. Dividend whether received
difference. from equity, equity & debt or a debt scheme will all be tax-free
for the investors.
Systematic Withdrawal Plan (SWP)
SWP is a mirror image of the SIP. In a SWP, the investor would While dividends in the hands of the investor are free from tax,
withdraw constant amounts periodically. The learning is the mutual funds are now required to pay a “distribution tax” of
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same viz. that through a SWP the investor can temper gains and 20% from the financial year 2000-2001 (instead of 10% as
losses, though it does not prevent losses. distribution tax last year. The distribution tax is not to be paid
The taxman has, over the years, been more or less kind to
Mutual Funds. With laws varying from time to time, the overall 64 scheme and other open-ended equity oriented scheme of
objective has been to encourage the growth of the Mutual UTI and Mutual Funds are exempt from the levy of this tax for
Funds industry. Currently, a variety of tax laws apply to Mutual a period of three financial years starting from 1.4.1999. An
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Funds, which are broadly listed below: - open-end equity oriented scheme is defined as one where more
than 50% of the scheme’s investible funds are invested in
Capital Gains domestic equities. The 50% is computed taking the annual
Units of Mutual Fund schemes held for a period for more than average of the monthly averages of the scheme’s equity
twelve months are treated as long-term capital assets. In such holdings. The monthly average, in turn, is calculated by taking
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cases, the unit holder has the option to pay capital gain tax at the opening and closing percentage of a particular month’s
either 20% with indexation or 10% without indexation. equity holdings.
Tax Deducted at Source (TDS) Difference Between TDS and Distribution Tax
For any income credited or paid by a fund, no tax is deducted or
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funds and you’ll be safe.
benefit of cost inflation indexation, or a flat rate of 10 % which
ever is lower. That is, persons would have the option of either Calculation of Nav
availing of cost indexation on the capital gains and paying 20 The most important part of the calculation is the valuation of
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the assets owned by the fund. Once it is calculated, the NAV is
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per cent capital gains tax or paying a flat rate of 10 per cent
without cost indexation. As a result, the maximum capital gains simply the net value of assets divided by the number of units
tax payable has been capped at 10 per cent. outstanding. The detailed methodology for the calculation of
the asset value is given below.
Deletion of Sections 54 EA and 54 EB of the Income
Asset Value is Equal to
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Tax Act, 1961 Sum of market value of shares/debentures + Liquid assets/
The above two sections provided relief from capital gains tax if cash held, if any + Dividends/interest accrued Amount due on
investments were made in specified securities and locked in for a
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period of 3 years in the case of 54EA and 7 years in the case of
54EB. Mutual fund units were one of the specified securities
unpaid assets - Expenses accrued but not paid
Details on the above Items
For liquid shares/debentures, valuation is done on the basis of
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and this resulted in a lot of money realized as profit from sale
of securities being reinvested in the market through mutual the last or closing market price on the principal exchange where
funds. the security is traded
With the withdrawal of the exemption to mutual funds, For illiquid and unlisted and/or thinly traded shares/
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investors have lost out on a very viable alternative for tax saving debentures, the value has to be estimated. For shares, this could
and funds also would be faced with the problem of ‘hot be the book value per share or an estimated market price if
money’ as there would no longer be any lock in period for suitable benchmarks are available. For debentures and bonds,
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investments. However this facility will be available till 30th value is estimated on the basis of yields of comparable liquid
September 2000 for all capital gains accrued till 31st march 2000. securities after adjusting for liquidity. The value of fixed interest
bearing securities moves in a direction opposite to interest rate
Net Asset Value (NAV) – the Concept
changes Valuation of debentures and bonds is a big problem
The Net Asset Value is the market value of the assets of the
since most of them are unlisted and thinly traded. This gives
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as follows: example, if a share of a stock fund costs Rs.30 today and Rs.18
one year ago, there has been a gain (or profit) of Rs.12 a share,
or about 66%, before fund expenses. The change in a fund’s
Market value of the funds’ investments + NAV determines its performance. Comparing NAV
Receivables + Accrued Income –
Liabilities – Accrued Expense performance enables investors to differentiate funds on a
Net Asset Value =
No of Shares or Units outstanding
relative basis. NAV per share is a reliable, credible, and accepted
measuring stick for portfolio performance.
Tracking Fund Performance
For the majority of investors, investment performance is
The calculation of the NAV may be illustrated with the help of
ultimately the most important factor in determining which
the following example: mutual fund to invest in. A mutual fund’s performance can be
measured in several different ways, depending on its investment
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Name of the scheme: AB Balanced objectives. Whether a fund aims for long-term growth, current
Size of the scheme: Rs.200 Crore income, or a combination of the two, investors can track fund
performance and judge profitability by:
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Face value of the Share: Rs 10
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No. Of outstanding units: 20 Crore • Following changes in share price or net asset value (NAV)
Market value of the funds investments: Rs.280 Crore
Receivables: Rs.2 Crore • Calculating total return
Accrued Income: Rs.2 Crore • Figuring yield
Liability: Rs.1 Crore
While each calculation enables investors to compare a fund’s
Accrued Expense: Rs.1 Crore
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performance to similar funds offered by different companies,
there is no simple calculation for comparing funds to individual
securities, because each return is figured differently depending
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NAV = 280+2+2 -1-1
20 on the type of investment.
As individual investors, we are all investment managers- of our
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= Rs. 14.1 per share.
own portfolios! Therefore, to accurately answer the question of
how are my investments doing? I we need to gauge our
Importance of Nav to the Investor investment performance at the portfolio level, rather than by
What is NAV? It’s the answer to the question, “how am I each individual security. Utilizing the net asset value (NAV)
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doing?” After taking all the steps needed to find great method of performance tracking allows us to measure the
investment ideas, how do you then measure and compare the performance of our entire portfolio and accurately compare our
success of those ideas as investments? At Marketocracy, we results with the universe of professionally managed funds.
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think the best way to track your performance is to do it the The NAV method is also the only accurate means of accounting
same way that mutual funds track their own performance, using for cash placed into, or taken out of, an investment portfolio.
Net Asset Value per share. New investments in the portfolio are made at the closing NAV
If you’re a typical investor, you want to know how well your on the day of the investment. Similarly, money taken out of a
investments are doing over time. If you only buy one stock and portfolio is taken out at the NAV on the day of the withdrawal.
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then hold onto it, it’s pretty easy to figure out how you’re doing In either case, because a fund ís shares increase or decrease with
by simply comparing the current value of the stock to the the flow of investments, accurate performance measurement is
amount you initially invested. assured. Remember, the net asset value equals the value of the
fund investments divided by the shares outstanding.
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compared to the smaller volumes of the transactions entered Well-Regulated
into by individual investors. The brokers quote a lower rate of All mutual funds are registered with SEBI and they function
commission due to two reasons. The first is competition for within the provisions of strict regulations designed to protect
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the institutional investors’ business. The second reason is that the interest of investors. The options of mutual funds are
the overhead costs for executing a trade does not differ much regularly monitored by SEBI.
for large and small orders. Hence, for a large order, these costs
Transparency
spread over a large volume, enabling the broker to quote a lower
Mutual Funds have to disclose their holdings, investment
commission rate.
pattern and the necessary information before all investors under
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Availability of Various Schemes a regulation framework. Other than this the Asset Management
Mutual funds generally offer a number of schemes to suit the Companies do not have any control over the money of the
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requirements of the investors. Thus the investors can choose
between regular income schemes and growth schemes, between
schemes that invest in the stock market and those that invest in
investors. The bankers manage the entire money. This makes
mutual funds transparent and reliable.
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Disadvantages of Investing in Mutual Fund
the stock market, etc. some schemes provide some added
advantages. For example: automatic reinvestment schemes No choice to the Investors
reinvest the distributed income automatically, thus making the The investors cannot choose the securities they want to invest
in, or the securities they want to sell. They are dependent on the
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Management of a portfolio involves continuous monitoring of long-term performance of the fund. This would harm the
various securities and the innumerable economic and non- long-term interests of the investors.
economic variables that may affect the portfolio’s performance. Expense Ratio
This requires a lot of time and effort on the part of the Management fees charged by the fund reduce the returns
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functioning of the financial markets. Mutual funds are generally available to the investor. Though the maximum limit of the
managed by knowledgeable, experienced professionals whose expense ratio is 2.5%. The higher the expense of the fund the
time is solely devoted to tracking and updating the portfolio. less return is given to the investor.
Thus, investments in a mutual fund not only saves time and
No Discretion in Withdrawal
effort for the investor, it is also likely to produce better results.
While investor in securities can decide the amount of earnings
Liquidity they want to withdraw in a particular period, investors in a
Liquidating a portfolio is not always easy. There may not be a Mutual Fund have no such discretion as the amount of
liquid market for all securities held. In case only a part of the earnings that are to be paid out to the investor in a particular
portfolio is required to be liquidated, it may not be possible to year is decided by the Mutual Fund.
sell all the securities forming part of the portfolio in the same
proportion as they are represented in the portfolio. Investing in Uncertainty
the mutual funds can solve these problems. A mutual fund Today’s environment is characterized by a deep industrial
generally stands ready to buy and sell its units on a regular basis. recession and consequent high level of defaults on loans
Thus, it is easier to liquidate holdings in a mutual fund as provided by banking sector to industry. In such a scenario, it
compared to direct investment in securities.
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9. What are the disadvantages of investing in mutual fund?
Notes:
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Learning objectives raised in their respective areas as a loan for a period of ten years
After reading this lesson, you will understand since may 1970, for every 5 percent of receipts obtained in excess
of the national average of net or gross collections, the state
• Introduction
governments have been getting 2.5 percent as an additional
• Importance of small savings loan. This sharing of proceeds with the states, and the increase
• Types and nature of small savings instruments in it, have been undertaken to induce states to mobilise greater
• Innovations and instruments connected with the small resources and meet their growing financial requirements.
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savings media Whether used by the central or state governments, there is at a
present no direct mechanism to ensure that the funds raised in a
• Growth and composition of small savings
particular area would be spent only there. The resources are
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• Interest rates on small savings ‘drained’ away from rural areas. It is surprising now that when
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• Provident funds the government has set a target by which at least 60 percent of
• Pension fund deposits mobilised by banks in rural areas should be loaned
there, no similar step has been taken with regard to collections
Today you will get to know some facts and details about small
of small savings. They also could be loaned in rural areas
savings and provident funds. Though you must be quite aware
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through primary agricultural credit societies, commercial banks,
of what it is and what it does, nevertheless our discussion
and unit banks, which ought to be set up in such areas.
today would help us make our understanding more clear.
Introduction
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Before we turn to non-banking institutions, it is convenient
and useful to familiarise ourselves with two very important,
Types and Nature of Small Savings Instruments
Small savings media can be divided into two groups:
(a) Post office deposits, and
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highly popular and diversified savings media namely, small (b) Savings certificates and bonds.
savings and provident funds. Post offices function as banks in
Over the years, quite a few changes have been introduced in the
respect of mobilisation of savings and time deposits, but not
media and the facilities made available to the public; some of
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volume of savings, followed by cooperative banks, and the unit plan period. The real diversification of small savings claims has
trust of India. (UTI). In a country like India, where small savers occurred during the 1970s and 1980s.
predominate and where savers are dispersed over a vast area in A number of important characteristics the small savings media
innumerable villages, the work of small savings organisations are as follows:
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per cent per annum. Time deposits, if there is not more than This scheme has been in existence since April 1970. Its maturity
one deposit in the account, can be pledged for obtaining period is 5 years; at present it carries an interest rate of 12.5 per
loans/advance from banks for meeting a temporary need or cent per annum, and it is subject to the same tax concessions as
furnishing a security for entering into a contract. Alternatively, POSBD and POTD. There is no limit to the amount that can
the deposit account can be, after the expiry of the year be invested in it.
prematurely closed in which case the depositor earns interest
National Savings Certificates (NSCs)
at 2 per cent below the rate applicable to the deposit. There
Three issues (II, III, IV) of seven-year NSCs were introduced in
are no facilities for borrowing against deposits from post
1970, out of which II was discontinued from April 1989. Issue
offices as there are from banks.
V of seven-year NSCs was introduced in April 1974. Two six-
(3)Similarly, NSCs art also pledge able. year NSCs (VI and VII issues) were introduced in 1981-82 but
(4)POSB deposits are as liquid as bank demand deposits, they have been discontinued from April 1989. Another six-year
perhaps a little more so. They can be withdrawn by cheque, NSCs (VIII) issue was introduced in May 1989 on which a
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and there are no restrictions on the number of withdrawals. compound rate of interest of 12 per cent is paid, and one can
It is for tips reason that the RBI now includes these deposits invest unlimited amount in this. Interest income from NSCs is
as one of the constituents of money supply in the economy. not tax-free but the amount invested in them’ qualifies for
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(5)As with unit linked insurance plans, RD and CTD provide deduction while calculating taxable income.
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insurance cover to the investor Rs A small saver (who saves Indira Vikas Patras (IVP)
in one of the denominations of Rs 5, 10, 15, and 20) in RD These were introduced in November 1986. the IVP is a bearer
and CTD is eligible for the benefit of protection of his 1
contemplated savings in the event of his death before the bond whose value doubles every 5 years giving a compound
2
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maturity value of the account. . His heir or nominee is rate of return of 13.43 per cent annum. Its purchase price,
entitled to get the full amount of the account as if the therefore, is half of its face value. It is not a registered
depositor had continued to make deposit till the end of the instrument nor does it carry the name of the buyer or the
maturity period.
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(6)Finally, for those who belong to the income-tax brackets,
holder. It is transferable by mere delivery. There is no limit to
investment in them but this investment is not eligible for any
type of tax benefits.
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small savings carry excellent tax benefits.
Many of the innovations and instruments connected with the Kisan Vikas Patras (KVP)
small savings media-some of these have been recently Introduced in April 1988, they also have a maturity period of 5
years and the interest paid on them is 13.43 percent. There is no
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investment in deposit qualifies for exemption from wealth-tax income-tax purposes. Similarly, the total amount (including
within the prescribed limit of Rs 5 lakh but not beyond. interest) withdrawn in a given year is considered as an addition
to the income of the depositor during the year of withdrawal.
Post Office Cumulative Time Deposits (POCTD)
They were introduced in January 1959 but the opening of new Post-Office Monthly Income Scheme (POMIS)
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accounts for these deposits has been discontinued from This fixed deposit scheme was introduced in August 1987. Its
November 1973. The maturity period could be 5 or 10 or 15 maturity period is 6 years; interest rate is.12 per cent per annum
years. The rate of interest was 6.25 per cent on compound basis, and interest is payable every month; minimum investment is Rs
and interest was paid on maturity of deposit. Interest income 5000, and maximum investment is Rs 2,00,000 for single
on deposit was tax-free and deposit amount qualified for account and Rs 4,00,000 for joint account. Interest income is
income-tax rebate as well as wealth-tax exemption. eligible for tax rebate. A bonus of 10 per cent on deposit
amount is payable at the end of 6 years when the deposit
Post Office Time Deposits (POTD) matures.
Post offices have been accepting time deposits of one-year,
The following instruments of post-office savings have not
three-year, and five-year maturity since March 1970, and two-year
assumed much importance as means of saving: National Saving
maturity since August 1973. The current rate of interest on
Annuity Certificates (NSAC); Social Security Certificates (SSC);
these deposits ranges between 10.5 to 12.5 per cent. The interest
five-year National Development Bonds (NDB); Saving
income is tax exempt. The deposit amount is eligible for
(Deposit) Scheme for Retiring People; and Drought Relief
wealth- tax exemption (within the limit of Rs 51akh) but not
Bonds (DRB) or Rahat Patras (RP) replacing Capital Investment
for income tax rebate. There is no limit on investment in these
Bonds (CIB).
deposits.
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plantations are meager.
The monthly income and recurring deposits schemes have been
attracting many investors Small savings organisations, rather A novel scheme, namely, Public Provident Fund, was
surprisingly, have not been able to induce investors to hold introduced in 1968. This was earlier operated through the SBI
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more time deposits with themselves. The competition from and its subsidiaries, but with effect from January 1979, PPF
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commercial banks in rural areas appears to have had an adverse account can also -be opened at head post offices. It was
effect on the growth of deposits with post offices. Table 10.3 originally meant for self-employed persons or the general
shows that five-year deposits have accounted for 65 to 95 per public, but now salaried employees can also take advantage of
cent of total time deposits during 1980-81 to 1995-96. Among it.
the certificates, Kisan Vikas Patras (KVPs) are the most popular,
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The nature of PPF and Employees PF can be understood better
accounting for 50 to 73 per cent of total receipts from all by contrasting the provisions of the two schemes in some
certificates during the 1990s. NSCs and Indira Vikas Patras important respects”. The maturity period of the PPB is 15
respectively. iza D
(IVPs) are the second and third most important certificates years, while the maturity period of the EPF depends on the age
at which the employee joins the Fund. While in the case of
EPF, if the employee joins the contributory PF alternative there
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Interest Rates on Small Savings
The rates of return on small savings have undergone a distinct is a specified contribution to be made by the employer to the
change over the years, particularly after 1970. Before 1968-69, employee’s PF, no such provision is possible in the case of PPF.
interest rates on various small savings schemes were lower than During the term of the PPF scheme, withdrawals to the extent
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those offered by banks, private non-banking companies, and of 50 per cent of the outstanding amount to the credit of the
others after 1969-70, however, interest rates on these schemes concerned person’s account are allowed at the end of the 7th,
have been made comparable; at present, they are more attractive 11th and 15th year. Before the withdrawal facility begins, i.e.,
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than the rates on bank deposits. What is more important is during the first six years, it is possible to get a loan upto 25 per
that, unlike in the earlier period, interest rates on small savings cent of the balance to one’s credit provided two years have
are now changed simultaneously with changes in the Bank rate expired after opening the PPF account. In the case of EPF,
and other rates of interest in the economy Earlier, there was a withdrawal facilities are more restricted. The employee can
tendency for changes in interest rate on small savings to lag withdraw his part of the contributed only when he has reached
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behind changes in rates offered by competing financial 50 years of age. Meanwhile, although he can obtain a loan
intermediaries. However, changes in these rates have now against his PF account, the account holder has to repay the loan
become an integral part of changes in the interest rates structure in the form of an increased contribution, which does not enjoy
in the economy. tax benefits. In the some of PPF, it is possible to vary the
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wealth in the form of PF enjoy. (e) The provision of tax benefits to such savers;
The rules with regard to investments of PFs are laid down in (f) The increase in the minimum rates of contribution by the
the Indian Trusts Act, 1882, and Employees Provident Fund employees and employers;
Act, 1952, which, in essence, specify that funds mobilised
(g)The changes in the pay structure, like raising the basic pay of
through small savings and PF should be invested either wholly
employees; and
or substantially in the central and state government securities,
and also the securities guaranteed by these governments. This (h) The increase in the level of money income in the economy.
has been done to enhance the safety of these savings, but it has Pension Funds
also involved some sacrifice of return for the savers. The rules In other countries, pension funds are a, powerful financial
governing investments by the government PF and private PF intermediary. It was estimated that at the world level, pension
have come to differ over the years. PF contributions of the state funds controlled $6,700 billion in 1995. In India, private
and central government employees used to be and still are pension funds still do not exist but many people have begun to
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merged with the funded debt of the government, and the stress the need for setting up such funds; and a small beginning
Ministry of Finance has recently ruled out changes in this was recently made in this respect. The setting up of the first
practice. investment-based pension fund proposed by the UTI was
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The rules or restrictions with regard to private provident funds, approved by the government in October 1994. This retirement
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superannuation and gratuity funds, however, have undergone benefit plan is meant to enable self-employed people to
the following changes. The prescribed pattern of investment in contribute to a pension fund so as to provide security in their
1955-56 was: NSCs 10 per cent, short-term government old age. It is as open-ended plan in which anyone between the
securities 10 per cent, medium-term securities 30 per cent, and age of 18-52 years can contribute and receive regular monthly
income from 58 years onwards. The subscriptions to the fund
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long-term securities 50 per cent. The obligatory investment in
government securities was 50 per cent in 1970-71, which was are expected to grow by investment in equities and debt in the
reduced to 45 percent in 1971-72, and the residual part (55 per ratio of 40:60. The minimum subscription is to be Rs 10,000 to
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cent) of the PF resources could be invested in state government
securities, government guaranteed securities, small saving
certificates, and post-office time deposits since that year. The
be paid in not more than 20 instalments of a minimum of Rs
500 each. The withdrawal is permitted after 70 years of age, and
even a premature withdrawal is allowed at a discount.
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Special Deposit Scheme (SDS) for this purpose was created Thus, a fund set up by a company, union, government entity, or
recently for a period of three years which was to end in 1996, other organisation to invest the pension contributions of
but was extended further. Private PF investment in SDS has members and employees, and pay out pensions to those people
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progressively reduced from 85 percent in April 1993 to 20 per when they reach retirement age is known as pension funds.
cent now. The SDS investment earns a standard rate of interest Pension funds accumulate huge pools of capital, which they
of 12 per cent. There is now a view that upto 25 per cent of PF invest in the stock and bond markets. Because of the weight of
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collections should be invested in industrial debentures and money, they exert considerable influence on the markets, and
shares of financially sound companies. Investment of PF in their decisions on which shares to hold in which sectors have a
equities will have to be undertaken with extreme caution. substantial impact on prices.
There has been a tremendous growth of investment in PFs Some pension funds employ their own fund managers; others
since the beginning of the planning period. The volume of delegate responsibility to external fund managers. Invariably
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savings of the household sector in the form of PF has they will try to achieve a diversified portfolio of investments,
increased from Rs 19 crore in 1950-51 to Rs 1,172 crore in 1976- some in low risk areas, others in high-risk areas. Actuaries
77, and Rs 7,194 crore in 1988-89 and Rs 25,438 crore in determine how much is going to have to be paid out to
1995-96. For many years now, PF has emerged as one of the pension holders in forthcoming years, and the pension fund
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most important financial assets in the Indian economy; its has to try to achieve a rate of return on its capital that will meet
importance is excelled only by bank deposits and small savings. (or better still exceed) this target.
PF accounted for 13 per cent of savings in financial assets of the
household sector in 1955-56, 24 per cent in 1975-76, and 18 per Questions to Discuss:
cent in 1988--89, and 20.4 per cent in 1995-96. 1. What do you understand by the small savings instruments?
Several factors have contributed to the growth of provident 2. Discuss the importance of small savings.
funds in India: 3. What are the types and nature of small savings instruments?
(a) The adoption of statutory measures to make provident fund 4. Discuss the innovations and instruments connected with the
compulsory for industrial and other establishments; small savings media.
(b) The increase in the number of establishments covered 5. Discuss the growth and composition of small savings.
under the statutory provisions;
6. What is the relevance of Interest rates on small savings?
(c) The expansion in the industrial and service sector of the
7. What are Provident funds?
economy and the consequent increase in the number of
salary-earners; 8. What are Pension fund?
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indicates that there are about 40,700 non-banking finance trading in goods and services or real estate and which is not
companies in the country. Of course, the number includes classified as financial or miscellaneous or residuary non-banking
many small companies operating in the unorganised sector such company.
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as in this, chit funds, etc. The NBFCs registered with the
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‘Regulated Deposit’ is a deposit, which is subject to certain
Reserve Bank of India number only about 745 of which about
ceilings, and other restrictions as imposed by the regulatory
121 have credit ratings with them. Till the others are also
measures. It includes unsecured deben-tures, debentures
brought under the ambit of the regulatory framework, the
secured by movable assets, deposits received by public limited
guidelines and rules issued by the Re-serve Bank of India will
companies from its shareholders, deposits guaranteed by
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continue to be largely imposed on the registered NBFCs alone.
directors in their personal capacity and fixed deposits, etc.
We have to appreciate the fact that it is a Herculean task to
received from public. Effective April 12, 1993 intercompany
supervise effectively all the 40,000 odd finance companies
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scattered all over the country. This task becomes all the more
difficult since these companies do not have a transparent,
uniform or laid down accounting standards, strict vigilance or
borrowings and money received from directors/shareholders of
private companies constitute regulated deposits. ‘Exempted
Deposit’ signifies those types of deposits/borrowings, which
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are outside the scope of the regulatory pleasures. It includes
audit systems or an effective supervisory system as compared to
borrowings from banks and specified financial institutions,
those in the organised financial sector.
money received from Central/State/foreign Governments,
Definitions security deposits, ad-vances received against orders, etc.
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A miscellaneous non-banking company is a company carrying Taking into consideration the fact that the operations of the
on all or any of the following types of business: NBFCs affect adversely the efficacy of fiscal and monetary policy,
a series of measures have been initiated’ during the last few
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and that every one of such subscribers shall in his turn, as banking non-financial companies) was taken in October 1966,
determined by lot or by auction or by tender or in such by issuing two new directives, viz., (i) Non-Banking Financial
manner as may be provided for in the agreement be entitled Companies (Reserve Bank) Directives, 1966 and (ii) Non-
to the prize amount. Banking Non-Financial Companies (Reserve Bank) Directives,
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(b) Conducting any other form of chit, which is different from 1966. These directives extended the control of the Reserve Bank
the type of business referred to in (a). to all: (i) non-banking financial companies and (ii) non-banking,
(c) Undertaking or carrying on or engaging in or executing any non-financial companies accepting deposits and they were
other busi-ness similar to the business referred to in (a) and brought into force with effect from 1 January 1967. The
(b). directives pro-vided for restricting acceptance of deposits to 25
per cent of paid-up capital and free reserves in the case of both
A residuary non-banking company is a company which receives
non-banking financial and non-banking non-financial
any deposit under any scheme or arrangement, by whatever
companies (other than housing finance and hire-purchase
name called, in one lump sum or in installments by way of
finance companies).
contributions or subscrip-tions or by sale of units or certificates
or other instruments, or in any other manner and which, To obviate hardships, particularly to industrial undertakings, in
according to the definitions contained in the Non Banking com-plying with the provisions of the directives within the
Financial Companies (Reserve Bank) Directions, 1977 or the specified time limit, the Reserve Bank made certain
Miscellaneous Non-Banking Companies (Reserve Bank) modifications in the directives on 23 August 1967, as follows:
Directions, 1977, as the case may be, is not (i) an equipment
leasing company, (ii) a hire purchase finance company, (iii) a
finan-cial; the Bank decided that any amount held in the in October 1966, respectively to non-banking companies were
statutory development rebate reserve, created under section further amended during 1973. The principal features of the
4(3) of the Income Tax Act, 1961, may (notwithstanding the amendments were: (i) any loan secured by the creation of a
fact that the period of 8 years specified in that section might mortgage or pledge of the assets of the company or any part
not have been completed in respect of ‘all the assets) be thereof would be exempt from the ceiling restrictions relating
counted as a free reserve and to deposits only if there is a margin of only at least 25 per cent
(ii)In the case of industrial concerns as defined in the directives of the market value of the assets charged as security for the
which (a) have paid dividends on their equity shares at, six loan, the mortgage or pledge, as the case may be, is created in
per cent or more per annum in the five years or in five out of favour, of a trustee which should either be a scheduled
six years immediately preceding 1 January 1967, or (b) have commercial bank or ‘an executor and trustee company which is a
unencumbered fixed assets of a book value in excess of subsidiary of such scheduled commercial bank and the
twice the amount of deposits and the unsecured loans, the company has to execute a trust deed in favour of the scheduled
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time limit of two years, for the adjustment of the deposits commercial bank or its subsidiary. If the Reserve Bank is
already received in excess of 25 per cent of the paid-up capital satisfied that the mortgage or pledge created by a company is
and free reserves including the development rebate reserve, not in the public interest, it may declare that the deposits
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will increase to five years, i. e., upto the end of December sought to be secured by such mortgage of pledge shall not be
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1971. entitled to the benefit of the aforesaid provision. Companies
accepting such secured deposits will, however, have to comply
The directives issued to non-banking companies were amended
with all other provisions contained in the direc-tions as
in December 1971 so as to bring within their purview,
applicable to ordinary deposits or unsecured loans. (ii) Loans
unsecured loans from shareholders as also loans guaranteed by
obtained from a registered moneylender would henceforth be
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directors, ex-managing agents or secretaries and treasurers. Such
treated as deposits for the purposes of the directions.
loans, hitherto exempted from the restrictions relating to
deposits, were subjected to a separate ceiling of 25 per cent of After an examination of the recommendations of the Banking
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the net owned funds of companies with effect from 1 January
1972. A period of 3 years and 3 months was provided for the
adjustment of excess, if any, over the ceiling prescribed, of the
Com-mission in regard to non-banking financial intermediaries
and the Reserve Bank’s view thereon, the Government of
India, decided that statutory powers shall be taken to prohibit
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unsecured loans mentioned above. To provide for the ‘genuine acceptance of deposits by all unincorporated non-banking
business requirements of companies, however, certain institutions and that the existing legal provi-sions and the
categories of loans, particularly loans obtained on guarantees directions issued by the Reserve Bank must be tightened to
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furnished by Government and any loan obtained from foreign plug the loop-holes. In June 1974, the Reserve Bank
source were specifically exempted from the purview of the constituted a Study Group headed by Shri James ‘S. Raj to
directives. examine in depth all aspects of the matter and make suitable
recommendations for implementing Govern-ment’s decision.
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from 1 September, 1973, had clarified that the amounts received amendments:
by such companies by way of contributions or subscriptions or (a) Empower the Reserve Bank to inspect non-banking financial
by sale of units, certificates, etc., or other instruments or any insti-tutions whenever such inspection is considered
other manner or as membership fees or service charges to or in necessary or expe-dient by the Bank;
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respect of any savings, or mutual benefit, thrift or any other (b) Cast a statuary obligation on the auditor of a non-banking
scheme or arrangement also constitute deposits. It was further institu-tion to report to the Reserve Bank the aggregate
clarified that the usual ceiling on deposits (25 per cent of paid- amount of deposits held by it where the institution had
up capital plus free reserves less accumulated balance of loss), failed to furnish to return etc., required to be submitted by it.
would also apply to such deposits. Any amount in excess of
(c) Insert the definition of the term ‘deposit’ in statute itself so
the ceiling existing on 1 September 1973 would have to be
as to place beyond any doubt that any money received by
adjusted before October 1976. All other requirements applicable
non-banking institutions otherwise than by way of share
to other non-banking companies such as these relating to the
capital constitutes deposits.
issue of advertisements, acceptance of deposits on the basis of
application forms, maintenance of registers of deposits and (d) Make the definition of the term ‘financial institution’ precise
furnishing of receipts to depositors, would also apply to these and comprehensive so as to plug the loop-holes;
companies. However, company’s coming within the purview of (e) Make it compulsory not only for non-banking institutions
these directions would be re-quired to submit their returns to but also for brokers to disclose full particulars and
the Reserve Bank twice a year. information before soliciting deposits; and
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reduced ceiling were given time till 31st December 1975, to wipe members. Apart from the restric-tions on the quantum of
out the excess. Miscellaneous non-banking companies viz., deposits that may be accepted by the companies, the Group has
those conducting prize chits/lucky draws/savings schemes etc., recommended minimum capital requirements for starting new
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which had been allowed time up to the end of September 1976, financial companies and also in respect of existing companies
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to wipe out the excess over the ceiling of 25 per cent fixed earlier other than nidhis. Some of the other recommendations made
were allowed further time up to the 31st December 1976, to by it relate to the creation of reserve funds, maintenance of
bring down their outstanding in respect of the unsecured loans, liquid assets, prohibition of grant of loans and advances to the
etc., within the reduced ceiling of 15 per cent. directors and firms and companies in which they are interested
and enactment of the Provisions on the lines of certain sections
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The Companies (Amendment Act), 1974 which came into force
of the Banking Regulation Act, 1949. In view of the
from the’ 1st February 1975, has inserted anew Section 58 A in
substantive nature of the recommendations made by it for the
the Companies Act, 1955 regulating acceptance of deposits by
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non-banking companies. Under the powers vested by the
aforesaid Section, the Cen-tral Government has in consultation
with the Reserve Bank, framed rules governing acceptance of
purpose of tightening the control over the deposit acceptance
activities of the financial companies as also the operational
aspects relating to their working, it has been decided to enact a
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separate comprehensive legislation in place of Chapter III B of
deposits by non-financial companies. The rules came into force
the Reserve Bank of India Act, 1934. The drafting of the
with effect from the 3rd February 1975. Conse-quently, the
legislation is in progress and in the meantime, steps are also
directions issued by the Reserve Bank to non-financial com-
being taken to implement such of the recommendations as
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The main recommendations of the Study Group cover non- force. The amendments to the directions have been finalised.
financial companies, financial companies and companies
As regards companies conducting prize chits benefit savings
conducting prize chits and/or con-ventional chits. These
schemes, etc., the Group had come to the conclusion that such
recommendations had been accepted in principle by the Reserve
schemes benefited primarily the promoters and did not serve
Bank and the Government of India.
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avoid disruption of the productive process consistent with for the purpose, the provisions of the existing enactment were
need to safeguard the depositors’ interests. At the same time considered inadequate.
the ultimate objective should be to discourage further growth
of these deposits and to roll them back gradually so that they Questions to Discuss:
would cease to be a significant source of finance for industry 1. Discuss some of the non-banking financial companies.
and trade. 2. Discuss the Regulatory Measures.
In the case of non-banking financial companies, the Study
Group recommended effective regulation of their activities
considering the large number of depositors involved as well as
the incidence of malpractices in these companies. The Study
Group suggested that such companies should be subjected, by
and large, to the same type of controls as banks under the
Banking Regulation Act, 1949. As the operations of loan
companies are analogous to those of banks, the Study Group
recommended a ceiling of ten times the net owned funds. In
LESSON 30:
NON BANKING FINANCIAL COMPANIES
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Activities of NBFC The growth of NBFCs in India was more pronounces in last
NBFCs with their diversified structure and methods of two decades. Several factors have contributed to the growth of
these institutions. Their tailor made services, customer-
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business are serving the economy in a variety of ways. They
orientation, minimum procedures and simplicity, speed of
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form an integral part of the Country’s financial system with
asset base in excess of 90,000 crore. The growth of NBFC operations and higher rate of interest on their deposits have
Sector in India has been accompanied by a corresponding attracted more and more customers to them. Further, the
growth in the diversified range of financial services and monetary and credit policy followed in the Country in the recent
products they offer. NBFCs help to bridge the credit gaps in past has left a Section of borrowers outside the purview of
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several sectors which traditional institution are unable to fulfill. banking system and these NBFCs increasingly hatred to these
NBFCs are more flexible in their operations and quick in sections. Comprehensive regulation of the Commercial Banks
and the absence or less rigorous regulations over NBFCs have
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decision-making. This gives them a major advantage over Banks
since the latter follow lengthy procedures. In the area of deposit
mobilisation certain points work out to the advantage of
also contributed to the phenomenal growth or the latter in
terms of heir numbers, clientele deposits and net owned fund
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NBFCs. While Public Sector Banks wait for deposits to flow in, (NOF).
NBFCs reach out to the customers to mobilise deposits. However, the growth was not uniform in the past. In the initial
In a broader sense, NBFC means a Company whose principal years (early eighties) there was virtually a boom, when
Entrepreneurs suddenly wokeup to the tremendous
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NBFCs offer a variety or services. The table 1 gives the broad market. However, most of these new-borns ignored that
range of services offered by important Finance Companies in rendering financial services was a complicated and demanding
India. For the purpose of brevity description of individual business, involving the continuous raising and deployment of
service is avoided. funds in a judicious manner and involved the consistent
Table 1 identification and entry into newer and optimally lucrative areas
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This in turn led to resource crunch, with even committed funds especially for finance companies scrips is virtually in a shambles.
not forthcoming from Banks. However, fiscal relief announced Companies, in want of money, are forced to sell-off their asset
in 1992-93 and 1993-94 created favourable climate again for this portfolio. Buyers usually banks and financial institutions might
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industry. The ban on bill discounting, though affected some seek favorable terms, which will mean a higher cost to NBFCs.
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players of the field adversely was blessing in disguise for others, Mergers and acquisitions take place only when it makes business
forcing them to explore other areas. Many turned their attention sense. Since too many small companies will be looking for a
from fund-based activities to the non-fund-based activities like strong partner the deal which may emerge is likely to be
merchant banking activities, investment advisory services, unfavorable to small NBFCs. Bank finance is available only to a
securitisation of debts, forex trading operations, etc.
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few big players.
All the major sectors had responded to economic reform with However, there are reasons to cheer also. In the recent move, the
dynamism and witnessed significant acceleration of their RBI has classified bank credit to NBFCs for on lending to small
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respective growth rate and thereby widening the scope of
activities of NBFCs as well as improving their profit levels.
transport operators as priority sector lending. This move has
prompted Bank to extend more credit to NBFC sector to meet
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But the recent time have seen again a reversal of this trend, the their priority sector lending. Further NBFCs are allowed to
increased competition, depressed stock markets and the explore opportunities of raising funds off shore. One more
prolonged recession have made life difficult for NBFCs. The thing for which NBFCs are really excited about is ‘asset
greed of a few players, sand long-term vision has made the securitisation’. Presently at nascent stage, the concept of
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general public as well as the regulatory authorities view the entire securitisation is picking up very fast in Finance Service Industry,
sector with suspicion. With international majors entering the especially in the auto-finance Sector. Given the various steps
sector is in trouble. The extinction of most of the unfit is taken in the current budget to revive the debt market, it will
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encouraged by the spurt in profit. A number of them went to funding as well as the cost of funding. Their future growth
the Capital market for raising equity with inadequate depends to a large extent on the success they achieve in this area.
preparations and many promises. The quality and composition Another area of concern for NBFCs is to find matching
of assets leave much to be desired, a situation of this kind deployment avenues. As the economy sometimes reels under
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raised doubt about their credibility with both authorities and recession finding quality borrowers has become a difficult task.
the public. The CRB Fiasco has underscored the vulnerability of However there is no denying the fact that this is basically a
the NBFCs. Even the high profile well managed Companies are cyclical problem. As the correlation between the growth of
viewed with suspicion. Players with short-term approach NBFCs and economy is well established, the moment the
obstructed the long-term growth prospectus of the industry. economy picks up NBFCs would again be making money.
Better late than too late. The regulatory authorities have taken Another aspect, which is boosting the morale of the NBFCs
steps in this direction by prescribing entry norms including new sector- the growth of an increasingly affluent middle class.
owned funds (minimum Rs. 25 lakh, say) and capital adequacy Hence a raise in demand for consumer electronics and durables
level. An environment is created in which of course entry is not is expected. This urge has given way for a powerful potential
closed for new companies but the inefficient and loss-making market segment for finance companies in the form of
companies get weeded out. Reserve Bank of India regularly Consumer Financing.
comes out with a list of NBFCs and unincorporated bodies Banks look upon NBFCs as their competitors in terms of both
who are soliciting deposits despite being prohibited from deposit mobilisation and credit expansion. This perception
accessing deposits. This list which will be published regularly needs to be corrected as soon as possible by the industry
will enable prosecution against persons and companies
System. They play a supportive role to the Banks and Financial spot deviant behaviour so that corrective measures can be
Institutions. While there could be a debate on whether NBFCs undertaken swiftly. Further a strong self-regulatory framework is
play any useful role at all in the areas of equipment leasing, definitely desired, and would improve the state of affairs.
share market operations, merchant banking, etc. There can be no
Prospects
dispute on the conclusion that without NBFCs the credit
The sector is heading towards consolidation. Sound companies
delivery system tot eh road transport sector particularly trucks
with soundest of fundamental would emerge stronger, and
and commercial passengers carrying vehicles like buses will
weak companies with poor Balance Sheets would be weeded
collapse leading to a crisis in the total automobile sector. It is
out of the system. NBFCs have survived all over the World and
also certain that a healthy NBFC Sector is vital for the growth of
would continue to survive even in our Country.
the Consumer durable Industry, because Banks and Financial
Institutions cannot manage credit delivery to these Sectors as However, the coming time would be quite crucial for NBFCs.
cost effectively as NBFCs have demonstrated they can. From being a small business unit in a major industrial group,
the financial services are going through a phase where they
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There are areas where NBFCs should not even dream of
themselves are major business with each of its segment being a
competing with Bank and Financial Institutions let alone out
separate industry in itself.
performing them. To amplify this point, with Banks and
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Financial Institutions in the field of Corporate financing Size would be a major determinant of the survival of the
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NBFCs like ITC Classic have all ruined themselves. Bill NBFCs along with promoters credentials and group backing. To
discounting to Corporate by NBFCs is another area where survive a lot of mergers and acquisitions are taking place in the
mistakes have been made and will continue to be made if industry. It is evident that only the top few will be able to
NBFCs do not realise that Bank are much better equipped to withstand the test of times. Already more that 60% of the total
handle this business. business of the NBFCs is in the hands of around 50 players.
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However, there would also be a small NBFCs operating into
Now when almost every Bank is doing what NBFCs have been
niche markets. They would take advantage of their expertise, in
doing, NBFCs will have to first identify areas where they can
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build on the strengths and desist from operating in areas where
other entities (Bank and Financial Institution) have significant
strength. Retail Financing consisting of Car Loans, Consumer
their particular areas and operate at a premium. However, their
operations would be local in nature and their ability to grow
limited.
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Durable Finance, Commercial Vehicle Financing, Mortgage loans Questions to Discuss:
to individuals, share loans, housing loans are areas where 1. Discuss the activities of NBFCs.
NBFCs can have a more cost effective operation than what 2. Discuss the growth of NBFCs.
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shortens the duration of disequilibrium and promotes
our study of Management of Financial Institution is
orderly international relations.
incomplete without the discussion of IMF.
The main object of the Fund is to promote exchange stability
Introduction
i
and encourage multilateral trade and payments. It is also a
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The International Monetary System is the short-term wing of financing institution and has schemes for provision of short-
the international financial system. It encompasses all relations as term finance for meeting the balance of payments purposes. It
between the national market sys-tems. I.M.F is the Apex body provides international liquidity in tune with the requirements
for this system and acts as a central bank of central banks of the of world trade and fosters the growth of world trade and freer
nations. system of payments. Gold was originally the unit of account in
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The establishment of the International Monetary Fund (IMF) which the various currencies were denominated. This was
in 1945 was a landmark in the international monetary field. subsequently, replaced by Special Drawing Rights (SDRs), which
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Before 1945 there was international monetary disorder,
exchange restrictions and a host of other undesirable trade and
exchange practices. The need for international monetary co-
is a standard unit of account, whose value is fixed in terms of a
basket of currencies. These functions of the Fund are reviewed
briefly.
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operation and under-standing was felt soon after the war, and
Fund’s Role of Consultation
the Bretton Woods Conference resulted in the establishment of
In all matters of exchange rate changes, imposition of
IMF and the World Bank. Originally 44 member countries met
restrictions on current account, use of discriminatory practices,
at the Conference and the IMF was set up as per the agreement
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of Executives Directors meets as often as is necessary to decide economic and financial conditions in the member country. At
on all matters pertaining to the role of the Fund. The Managing the time of annual general meeting or at the time of
Director is the chief executive of the Fund and is appointed by negotiating a credit arrangement, representatives of member
the Board of Executive Directors. It has a secretariat in countries hold consultations and discus-sions with the Board
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contribution to the Fund. A member had to contribute its as desired, in exchange for the gold, which it holds.
quota to the Fund in the form of gold up to 25 per cent of its Since August 1975, as agreed by the members in the Interim
quota or 10 per cent of its net gold holdings or U.S. dollars on Committee to reduce the role of gold, about one-sixth of its
September 12, 1946, whichever was less and the rest of the gold holdings was sold in auctions and in non-competitive bids
quota was payable in member currency. Since 1980, the clause of and the proceeds realized amounted to US $ 5.7 billion of
25 per cent of the quota in gold or US dollar was replaced by which $ 1.1 billion representing the capital value of the original
contribution of SDR and convertible currencies. At the time, gold was added to Trust Fund. About one-sixth of the gold
gold was valued at $ 35 per fine ounce and India paid $ 27,5 out of the Fund holdings has been distributed to members so
million in gold for a quota of $ 400 million. The quota of far. The Fund has still two-third of the original quantity of
India stood at 3056 million SDRs after the 10th General Quota gold with it.
increase in 1995. IMF holds substantial gold reserves, which
were received as part of members’ contribution towards their Financial Assistance
Thus, the IMF lends money only to member countries with
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quotas, and liquid reserves in the form of convertible currencies
of member countries. balance of payments problems. A member country with a
payments problem can immediately withdraw from the IME
The total of quotas of 44 nations which gathered at Bretton
the 25 per cent of its quota. A member in greater difficulty may
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Woods in 1944 was fixed at $ 8800 million, By end December
request for more money from the IMF and can borrow up to
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1994, the membership rose to 178 with a total of quotas at
three times its quota provided the member country undertakes
SDRs 144,620 million after the 9th General Review of quotas
to initiate a series of reforms and uses the borrowed money
made in 1990. The work of Tenth general Review of Quotas
effectively. The frequently used mechanisms by the IMF to lend
was undertaken in 1994-95, and Eleventh quota review was
money are
completed in 1998 and the quota increase of 45% was effected
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in 1999. . 1. Standby Arrangements
2. Extended Arrangements
Share Capital of IMF
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In January 1999, the increase of share capital or total quota of
IMF from SDR 145.6 billion (US $ 204; billion) to SDR 212
3. Structural Adjustment Mechanism (with low interest rates)
Areas of Activity
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billion (US $ 297 billion) took effect, with the consent given by • Surveillance is the process by which the IMF appraises its
the requisite 85% of the memberships. The fund’s usable members’ exchange rate policies within the framework of a
resources raised by SDR 45 billion or US. $ 63 billion. India’s comprehensive analysis of the general economic situation
current quota is SDR 3055.5 million, which comes to about and the policy strategy of each member. The IMF fulfils its
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2.098 per cent of the total IMF quota. This quota is now surveillance responsibilities through annual bilateral Article
increased to SDR 4158.2 million, which comes to about 1.961 N consultations with individual countries; multilateral
per cent. Thus, in relative terms, the position of India came surveillance twice a year in the context of its World
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down considerably in the Fund. Economic Outlook (WEO) exercise; and precautionary
When it was set up, India was among the top five quota arrangements, enhanced surveillance and programme
holders. Now she has been pushed down to 13th position in monitoring which provide a member with close monitoring
the list. The current top countries are U.S.A. Japan, Germany, from the IMF in the absence of the use of IMF resources.
Prance, U.K, Italy, Saudi Arabia, Canada, Russia, Netherlands, (Precautionary arrangements serve to boost international
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relative purchasing power parity, it is understood that China • Financial assistance includes credits and loans extended by
would be number two or three and India number five or six. the IMF to member countries with balance of payments
Other Sources of Funds problems to support policies of adjustment and reform. As
The IMF has, in addition to member’s quotas, other sources of of July 31, 1999 the IMF had credit and loans outstanding
funds. In 1962 IMF concluded a General Agreement to borrow to 94 countries for an approved amount of SDR 63.6 billion
(GAB) under which IMF could borrow from the participating (about $87 billion).
members (Group of Ten Developed Countries) specified • Technical assistance consists of expertise and support
amounts of their currencies. The amounts which the Ten provided by the IMF to its members in several broad areas:
Countries (Belgium, Canada, France, West Germany, Italy, the design and implementation of fiscal and monetary
Japan, Netherlands, Sweden, U.K. and USA) undertook to policy; institution building (such as the development of
provide was set in the agreement. Interest and service charges central banks or treasuries); the handling and accounting of
were payable on such loans in agreed terms (upto 5 years) in transactions with the IMF; the collection and refinement of
gold, later replaced by SDR. The IMF borrowed not only from statistical data; training officials at the IMF Institute together
above countries but also from others such as Saudi Arabia on with other international financial organisations, through the
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member towards its quota plus its credit position with the This will give an assurance of financial support from the Fund
Fund (which is the same thing as other countries borrowings in time of need. This facility was introduced in 1952 to meet a
felt need for it although there was no specific provision for it in
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of its currency). If a country has 25 per cent of its quota in
the Fund’s Articles of Agreement. Since then such facility was
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gold, then upto this limit this member can draw upon the
Fund automatically. If that country has also a credit position frequently used by the members and both the Fund and the
of l0 percent of its quota as borrowings by other countries, members are happy for such prior arrangement in the nature of
then that country can borrow automatically upto 35 per cent an overdraft limit. The standby facility is repayable generally in
of its quota (gold tranche of 25 percent plus super gold three years, while other types of borrowings are repayable in 3
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tranche of 10 per cent). to 5 years. A member’s obligation to repurchase also arises if its
exchange reserves rise beyond a limit. The repurchase is made in
(2) Four Credit Tranches: There are four credit tranches, each
terms of the currency borrowed or in any convertible currency or
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equivalent to 25 per cent of its quota. If gold payment is 25
per cent of the quota and the rest of the 75 per cent is paid
in own currency, the Fund can hold upto 200 per cent of a
a currency, which is in demand, and the Fund’s holdings of it
are less than 75 per cent of that country’s quota. A member’s
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indebtedness to the IMF can be repaid in three ways: (1)
member’s quota in its currency and credit tranches would
Repurchase with gold and convertible currencies; (2) The
aggregate to 100 per cent of quota.
drawings of its currency by other countries; and (3) The offset
(3) Compensatory financing facility was started in February 1963 of an earlier creditor position.
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automatic, are subject to the following conditions: borrowings of members from the Fund’s own resources and a
(1) No member should draw in any 12-month period more higher rate for those resources borrowed from outside. The
than 25 percent of its quota. Fund makes a service charge of 0.5 per cent on all purchases
(2) No member should draw in total beyond a point where the other than those in reserve tranche and 0.25 per cent on all
Fund’s holdings of the member’s currency reaches 200 per standby and extended Fund facilities.
cent of its quota which it will have if it has borrowed upto These charges are payable normally in gold or US dollars or
125 per cent of its quota with a gold subscription of 25 per SDRs but as in the case of other provisions of the Fund which
cent and its own currency upto 75 per cent. are operated with flexibility, this may be waived if the nation’s
(3) The combined drawal under compensatory financing and external reserves are below half of its quota. Thus, Fund’s
buffer stock financing should not exceed 75 per cent of the charges were paid by India in rupees only. These charges are very
member’s quota. nominal in view of the fact that Fund does not pay any interest
on currencies held by it. Since 1969, IMF was paying about 11/2
(4) Total holding of IMF of any member’s currency under all
per cent per annum to a creditor position of a member that is,
the above facilities should not exceed 275 percent of the
when its currency held by the Fund fell below 75 per cent of its
quota.
The oil facility was originally designed in 1974.These funds were the country’s balance of payments position would be
lent to countries in balance of payments difficulties due to oil strengthened and its debt repayment capacity revived.
price escalation during 1970-73. Arrangements to borrow SDR Enhanced structural adjustment facility was continued upto
6.9 billion for this Fund from 17 member countries with a 1993 for helping the low-income countries, in strengthening
strong external payments position were made in 1974. This their payments position. Many additional Facilities were created
facility was extended from year to year and by 1982 borrowing from time to time to suit to the changing conditions. Thus, in
members have repaid most of the outstanding debt. April 1993, the Fund created a new temporary facility called
In 1974, the Fund also established an Extended Fund facility to systemic transformation assistance to members with, systemic
provide special medium-term loans to meet the balance of disruption of economies moving from planned economies to
payments deficits over a longer period and to help correct the private market-oriented economies. In December 1997 the
structural imbalances in the economy of a member country. fund, had set up the supplementary Reserve Facility to provide
This assistance is up to three years and in amounts larger than additional finance to members facing exceptional balance of
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that permitted by the member’s quota. . payments problems due to loss of funds following the loss of
In August 1975, a Subsidy Account was set up with market confidence.
contributions from 24 members for an amount of SDR 160 Exchange Rates and Par Values
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million to assist the member countries in balance of payments An important aspect of IMF activities is to maintain orderly
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difficulties due to a rise in oil prices and to provide subsidy to exchange arrange-ments. The exchange rate system set up by the
interest payments on the use of resources made available to Articles of Agreement was called par value system. Each
them through the oil facility. The effective interest rate to member is required to express the par value of its currency in
borrowing members, which include India, is 2.7 per cent as terms of gold as a common denominator or US dollar at a
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against the original rate of 7.7 per cent. The final payment under value of $ 35 per fine ounce of gold. Thus, gold was the basis
this Account was completed in August 1983. of valuation and exchange rate fluctuations were to be kept
In May 1976, a Trust fund was started for providing special within a narrow margin of 1 per cent on either side. While the
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balance of payments assistance to developing countries at highly
concessional rates. The sources of funds for this Trust are the
USA performed this by buying and selling gold for US dollar,
other countries did it through an intervention currency, such as
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realizations from the sale proceeds of one-sixth of IMF gold US dollar of UK sterling.
holdii1g, income from investment and loans and proceeds of The par value can be changed at the initiative of the country but
repayment and donations. Only about 60 member countries with the concurrence of the IMF. For any change up to 10 per
(including India), which are developing, were eligible for this cent in the par value, to make adjustments in the balance of
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assistance. The first auction sale of gold by the Fund took place payments, the Fund would not raise any objection. For any
in June 1976. change beyond 10 per cent, the country has to justify to the
A Supplementary Financing Facility was established in August Fund that it would be needed to correct a “fundamental
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1977 (Wittaveen Facility) with the objective of extending disequilibrium” - a concept that has not been defined by the
financial assistance to members with large payments difficulties, Fund but relates to a structural change in the economies and in
which are larger in relation to their incomes, and quotas with the cost price parities.
Fund. This is usable by members under a standby or under an Besides, members are obligated to avoid control on current
extended arrangement for a period of 1 to 3 years. Some 14- account except under Article XIV which permits member
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member countries agreed to provide SDR 7.8 billion for this countries to have such restrictions on a temporary basis. Some
facility. The borrowings on this Fund by members were started members who opted for this clause continue to have these
in May 1979 and IMF has in turn borrowed from the lending restrictions in some form or the other. Article VIII enjoins on
members at a rate calculated for each of the six months on the the members to free current transactions from all restrictions,
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basis of yield on US Government securities of 5-year maturity. which was adopted by the major developed countries in the
A subsidy account was also started in December 1980 for sixties. About 60 members have accepted Article VIII of the
subsidizing the interest rate on the borrowings of the low- Fund so far and India is one of them since 1994. But a majority
income developing members under this Wittaveen facility. This of members are still following Article XIV provisions, under
facility could not be extended beyond 1982 due to further non- which some forms of control on Current Account transactions
committal of funds by lender-members. . were permitted.
A new Structural Adjustment Facility (SAP) was established in The stable par value system has broadly served the purpose of
October 1985 and became operative in March 1986 financed’ out larger trade and greater international co-operation. This system
of SDR 2.7 billion that are available during 1985-91 from continued to prevail up to August 1971 during which time
repayment of Trust Fund loans and interest dues. This facility is there was international monetary stability and orderly growth in
confined to the lowest income countries with protracted balance world trade.
of payments problems needing a structural adjustment
So long as the dollar convertibility into gold was maintained,
programme. This loan carries a rate of 1/2% of 1 per cent with
IMF served the purpose and dollar and gold shared the honour
a grace period of 5 years and subsequent semi-annual
of serving as an international medium of exchange. While the
repayments extending over five years. The programme of
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obligation to buy and sell gold in interna-tional settlements
since August 1971. This was followed by a system of floating
rates and a temporary regime of central rates and wider margins
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since December 1971.
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The Smithsonian Agreement of December 1971 put back the
broken pieces of the system together into a new shape, based
on (I) A realignment of currency value against the dollar with a
small devaluation of $ (revaluation of gold $ 38 = 1 fine ounce)
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and (ii) A return to fixed parity system by December 1971. But
this system was short-lived and UK sterling was the first to
abandon the fixed parity system in June 1972, followed by
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others in favour of a floating system of exchange -rates. In
February 1973, there was a further devaluation of dollar by 10
per cent in terms of gold in the midst of rampant speculation
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in dollar. A Committee of Twenty and subsequently the
Interim Committee took up to formulate in 1972 a package of
reforms in the international monetary system concerning
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LESSON 32:
THE INTERNATIONAL MONETARY SYSTEM
Learning objectives (1) A member shall avoid manipulating exchange rates to its
After reading this lesson, you will understand advantage or prevent effective balance of payments
adjustment.
• International Monetary reforms and International liquidity
(2) A member shall intervene in the exchange market if
• Special Drawing rights (SDR)
necessary to” counter disorderly conditions.
Today we shall discuss international monetary reforms and
(3) Members should take into account the interests of other
international liquidity and also special drawing rights of the
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members of the Fund in their intervention policy.
IMF.
Members are free to choose their exchange rate arrangements
International Monetary Reforms except to main-tain values in terms of SDR and co-operate with
In respect of exchange rates it was agreed that the floating
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the Fund in the orderly exchange arrangements.
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exchange system, which was a fait accompli, should be legalised.
But members are still under an obligation to collaborate with International Liquidity
the Fund to ensure orderly exchange arrangements and International liquidity is defined to include all the assets gold
promote a system of stable exchange rates. It was also provided and currencies that are freely and unconditionally usable in
that countries may return to a stable but adjustable par value meeting the balance of payments deficits and other
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system at a future date. Meanwhile, floating rates with a wider international obligations of countries. Gold has for long served
band of fluctuations of 2.25 per cent on either side, which was as a unit of account, measure of value and medium of
exchange. In the narrow official sense, the liquid assets used to
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prevailing since the Smithsonian Agreement would continue.
A new concept of “international surveillance of the exchange
rate systems” was developed arid accepted as a new approach to
meet balance of payments deficit by governments or monetary
authorities include gold, convertible foreign exchange assets and
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reserve position with the IMF. In a sense, all owned and
the exchange rate systems. Of the 149 members in the Fund, as
potential borrowings should be included as liquidity. These
at end December 1986, there were about 14 countries
potential borrowings are vast and the scope for them is
independently floating 8 countries in a joint float and 32
expanding with the passage of time. Besides, in a wider sense,
countries linked to the US dollar, 14 to the French Franc, 12 to
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As regards gold, it would no longer function as an international since reserves held by private parties are not available monetary
unit of value or medium of exchange for the purpose of the authorities for meeting balance of payments requirements, only
Fund. The official price for gold is abolished and obligatory gold, official reserves, gold tranche and super-gold tranche
payments and receipts in gold between the Fund and members (creditor position) with the IMF are considered as freely usable
were withdrawn. Members are free, however, to deal in gold liquid assets by the authorities. Gold and super-gold tranche
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among themselves, SDR will be the unit and medium of positions are drawable without conditions like the current
exchange in future. The existing gold stocks of the fund are to account position with banks. SDRs, which have been created by
be disposed of by returning to members half of their original the IMF since 1969, are also included as liquid assets. In a
contributions and by selling the other half in the market narrow sense, thus, the official foreign exchange assets include
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through auctions and to use the proceeds for the Trust Fund. gold, foreign currency deposits and investments in currencies
Provisions are made for greater use and resort to SDRs, referred which are freely convertible if that country has accepted Article
to later. VIII of the IMF Articles of Agreement, whereby no current
Two amendments were made to the Articles of Agreement, in account restrictions are used. India has accepted this position in
connection with the reforms. Firstly, in 1969 an amendment March 1994.
was made to create a system of SDRs, which will be referred to
Need for Reserves
later. Secondly, Articles were amended in 1978 to introduce
With the growth of world trade and payments, the need for
reforms in the international monetary system referred to earlier.
reserves increases to meet the payments and deficit
The principle of surveillance of the Fund over the members’ requirements. Just as in the case of domestic cash requirements
exchange rate systems was embodied in the Second for transactions, precautionary and speculative motives, and
Amendment. So also was the abandonment of gold as an international reserves also serve these three motives. Under a
international unit of account or a medium of exchange for system of fixed par values adopted by the IMF and operative
which SDR .is redesigned. upto 1971, intervention in the markets to maintain the
Surveillance involves the following principles. exchange rates stable used to require a large volume of liquid
assets by the authori-ties. However, under the system of
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central bank’s intervention in the market is necessary, particularly 2. Unsatisfactory Distribution of Reserves.’ The bulk of the
when their deficits are growing. The demand for reserves for reserves, namely, around 60 percent, was held by the
precautionary motives emerges out of the need for developed world and more recently by the combined groups
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contingencies and to maintain their credit standing. The of developed countries oil-producing developing countries.
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speculative demand for reserves may not be felt in a country The poor developing countries and non-oil producing
where all exchange dealings are strictly controlled and supervised countries are left with inadequate reserves.
by the authorities. 3. Unsatisfactory Composition of Reserves: The proportion of
Composition and Level gold to total re-serves in 1952 was 68 per cent, which fell to
The official reserve composition of India in 1971 and the latest 53 per cent in 1968 and future to 23 per cent in 1973. Since
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position are presented below: then gold was completely replaced in official transactions by
the SDRs. Gold, however, continued to play an important
Gold *
End March
1971
182
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End March
1981
226
Jan.
1994
12,665
Dec.
1999
12,790
(Rs. crore;)
June
2002
16,272
role with some countries because of its intrinsic worth,
despite its demonetisations by IMF in 1973. Gold was
revalued in terms of the US dollar from $ 35 to $ 38 per
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Foreign Exchange
. fiancé ounce in 1971 and again to $ 42.2 per fine ounce in
Assets 438 4,822 61,440 1,39,134 2,67,333
SDR Units 112 497 233 18 47 Febl11ary 1973.
Total 732 5,545 74,338 1,51,942 2,83,652
In December 1997, the fund establishes the supplementary
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If reserves are important, the adequacy of reserves of of international transactions and world trade and judge the
international liquidity is equally important. Firstly, adequacy of adequacy of existing international liquidity. The quotas of
reserves may be judged by the relationship of reserves to members would determine their existing subscriptions to the
imports, secondly, by the rate of growth of world trade as Fund, their drawing rights on the Fund under both regular and
compared to the rate of growth of reserves and thirdly, by ‘the special facilities and their share of allocation of SDRs and their
magnitude of balance of payments deficit today as against a voting power in the Fund.
base year. Reserves as percentage of imports for all countries
So far eleven quota increases took place in the past. The eighth
stood at 85 per cent in 1950 but declined to 38 per cent by 1966.
General Review of quotas made in 1984 raised the total quotas
By 1970 when SDR allocation started the inadequacy of reserves
with the Fund by 47.5 per cent to 90 billion. Under the ninth
in relation to imports was glaring.
quota increase, in 1990, total quotas increased further by 51.7%
The adequacy of reserves is also assessed sometimes with to SDR 136.7 billion. Even so, the ratio of Fund quotas to
reference to the degree of fluctuations in exports earnings. The world imports is still lower at 4 per cent at present as compared
symptoms of inadequacy include increased restrictions on to 9 per cent in 1970 and 12 percent in 1965. Such general
current account transacti0l1s such as imports, efforts to curtail increases in quotas had taken place earlier in addition to some
foreign aid, depreciation of currency and greater reliance on trade
were supposed to be lower than the general requirements. over a five year period should be not less than 30 per cent
(reduced to 15 per cent and later removed altogether) implying
Special Drawing Rights (SDR)
thereby that it could use only 70 per cent of the allocation on
The Special Drawing Rights (SDRs) are another source of
average. This puts an obligation on the members using SDRs
augmenting inter-national liquidity. This is an asset specially
to repurchase them also.
intended to take the place of gold and as such called paper gold,
Each SDR is equal to O.88671 gms of fine gold, equivalent to SDR Allocation
one US dollar prior to devaluation in 1971. The value of SDR Starting with January 1970, SDRs were allotted to all member
was changed with the devaluation of dollar in 1971 and 1973. countries of the IMF who accepted the SDR scheme. The first
During 1974 to 1980 the value of SDR was fixed on a daily SDR allocations were made during each of the years 1970-72
basis as a weighed average value of a basket of 16 currencies of totaling SDR 9.3 billion. Further allocations were made for each
countries with more than 1 per cent of world trade. In 1981 of the years during 1979-81, totaling SDR 12 billion. The
these 16 were replaced by 5 major currencies, namely US $ DM, cumulative allocations since the beginning of the scheme were
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UK £ French Franc and Yen. SDR 21,433 million. Such cumulative allocations amounted to
These reserve assets have been created by the Fund since 1969 as only 5-7 per cent of the total world reserves other than gold. In
and when required as part of the long-term strategy of timing of the allocations, the Fund kept in view the global need
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augmenting world liquidity to keep pace with the requirements to supplement the existing reserve assets. Since then, in
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of a growing world economy and world trade. The actual September 1997, a special one-time allocation of SDR 21.4
allocation of SDRs to members would depend on the then billion was made which raised all participants’ cumulative
quotas with the Fund. The acceptability of the SDR as an allocations to a common benchmark ratio of29.3157 88813 per
international liquid asset would depend upon the cent of the quotas based on the Ninth General Review.
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unconditional acceptance of this asset by the members of the Limitations
Fund. The Fund members have been given the option to join The SD Rs cannot be used directly as reserves as they have to be
the SDR scheme and those who have joined are bound to abide
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by the rules of unconditional acceptance for international
payments, conversion into reserve currencies, payment and
converted into reserves of one or other currency before use for
payments. They can be used by official agencies and for
designated purposes only. These are not money as such but are
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receipt of interest etc. About US members had joined it comparable to near money or credit instruments. The fact that
originally in 1970 but now all its members have accepted and are interest is payable on SDRs used by the debtors to the creditors
allotted the SDRs. would indicate that the SDRs are credit facilities.
SDR accounts are kept separate from the General Account of
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Uses
the Fund. The SDR is like a coupon or a credit facility, which can Countries have made considerable use of these facilities since
be exchanged for reserve currency as, needed by the user and their first alloca-tion in 1970. These transfers were partly
approved by the Fund. The governments of the countries are designations by the IMF or by voluntary agreements among the
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holders of the SDR and their accounts in SDRs are maintained members or in transactions with the Fund by members and
by the Fund through book-entries. If a member wants to use partly in transactions by other international bodies who are
the SDR, it requests the Fund to designate another member to holders of SDRs. Since then gold has been replaced by SDR in
accept them in exchange for a reserve currency to use the Fund’s transactions as we has in the international
international payments and the latter member is obliged to
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from the Fund. India has also accepted them under the Enhanced Structural Adjustment Facility (ESAF) was
“Designation” Plans of the Fund. India has very comfortable established in 1987 and enlarged and extended in 1994.
exchange reserve position due to economic reforms affected Designed for low-income member countries with protracted
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since July 1991. balance of payments problems, ESAF drawings are loans and
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not purchases of other members’ currencies. They are made in
India’s IMF Net Position
support of three year programmes and carry an annual interest
India actively participated in IMF operations since 1947 when
rate of 0.5 per cent, with a 5½ year grace period and a 10 year
they were started. India has drawn IMF credits under most of
maturity. Quarterly benchmarks and semi-annual performance
its schemes. Any country can count as its reserves its IMF
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criteria apply; 80 low income countries are currently eligible to
position in gold and super-gold tranches. Similarly, its
use the ESAF.
repurchase obligations with the IMF are to be deducted from its
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official gross -reserves. It is in this context that India’s IMF
position becomes relevant. India’s repurchase obligations were
nil in 1970-71, when it had repaid Rs. 154 crores due to IMF.
Other Facilities
• Systemic Transformation, Facility,(STF) was in effect from
April 1993 to April, 1995. The STF was designed to extends
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But India had a major drawal of about Rs. 815 crores in August financial assistance to transition, economies experiencing
1980 under two credits, namely, Rs. 540 crores from the Special severe disruption in their trade and payments arrangements.
Trust Fund and Rs. 275 crores from the compensatory financing Repurchases are made over 4½ to 10 years.
facility. Our gold tanche position was about 25 per cent of the
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Assist Poorer Countries disbursement, The interest on ESAF loans is 0.5 per cent a year.
The IMF’s executive board established the Enhanced Structural By contrast, charges for standby arrangements are linked to the
Adjustment Facility (ESAF) in 1987 to better address the IMF’s SDR market determined interest rate and repayments are
macroeconomic and structural problems faced by low income made within 3¼ to 5 years of each drawing. A three-year access
countries. It offers loans with lower interest rates and for longer under the ESAF is up to 190 per cent of member’s quota. The
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orderly exchange relations long-term financing of development
among its member countries projects and programmes.
• Assists all members - both • Provides to the poorest developing
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industrial and developing countries whose per capita GNP is
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countries - that find themselves less than $865 a year special financial
in temporary balance of assistance through the International
payments difficulties by Development Association (IDA).
providing short to medium term
credits.
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• Supplements the currency • Encourages private enterprises in
reserves of its members through developing countries through its
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the allocation of SDRs (special
drawing rights); to date SDR
affiliate, the International Finance
Corporation (IFC).
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21.4 billion has been issued to
member countries in proportion
to their quotas.
• Draws its financial resources • Acquires most of its financial
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• Has 'at its disposal' fully paid-in • Has an authorised capital of $184
quotas now totalling SDR 212 billion, of which members pay in
billion (about $300 billion). about 10 per cent.
• Has a staff of 2,300 drawn from • Has a staff of 7,000 drawn from 180
182 member countries. member countries.
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terms than the typical IMF market-related arrangements. The access limits of standby arrangements are 100 per cent of quota
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LESSON 33:
INTERNATIONAL FINANCIAL INSTITUTIONS
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• Asian development bank familiar is the World Bank, formally known as the International
Bank for Reconstruction and development (IBRD). The World
An international inspection of the financial institution would
Bank has two affiliates that are legally and financially distinct
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ease your understanding of the functioning of the financial
entities, the International Development Association (IDA) and
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institution.
the International Finance Corporation (IFC). Exhibit 1
Introduction provides a comparison among IBRD, IDA and IFC in terms of
At the Bretton Woods Conference in 1944 it was decided to their objectives, member countries, lending terms, lending
establish a new monetary order that would expand international qualifications as well as other details. All three organizations
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trade, promote international capital flows and contribute to have the same central goals: to promote economic and social
monetary stability. The IMF and World bank were born out of progress in poor or developing countries by helping raise
this Conference at the end of World War II .The World Bank standards of living and productivity to the point at which
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was established to help the restoration of economies disrupted
by War by facilitating the investment of capital for productive
development becomes self-sustaining.
Toward this common objective, the World Bank, IDA and IFC
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purposes and to promote the long-range balanced growth of have three interrelated functions and these are to end funds, to
International trade. On the other hand, the IMF is primarily a provide advice and to serve as a catalyst in order to stimulate
supervisory institution for coordinating the efforts of member investments by others. In the process, financial resources are
countries to achieve greater cooperation in the formulation of channelled from developed countries to the developing world
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economic policies. It helps to promote exchange stability and with the hope that developing countries, through this
orderly exchange relations among its member countries. It is in assistance, will progress to a level that will permit them, in turn,
this context that the present lesson reviews the purpose and to contribute to the development process of other less
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working of some of the international financial institutions and fortunate countries. Japan is a prime example of a country that
the contributions made by them in promoting economic and has come full circle. From being a borrower, Japan is now a
social progress in developing countries by helping raise major lender to these three organisations. South Korea is
standards of living and productitivity to the point at which moving in a direction similar to that of Japan nearly a quarter
development becomes self-sustaining. of a century ago.
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international financial institutions - World Bank, IBRD, IDA, The World Bank group is a multinational financial institution
IFC and MIGA. The next section discusses the various established at the end of World War II (I944) to help provide
dimensions of the World Bank in detail. A comparison of the long-term capital for the reconstruction and development of
IMF and World Bank is also discussed. The lesson finally number countries. The group is important to multinational
concludes with a discussion of the Asian Development Bank corporations because It provides much of the planning and
tracing its strategic objectives, operating objectives and financial financing for economic development projects involving billions
management. dollars for which private businesses can act as contractors and
suppliers of goods and engine related services.
One major source of financing is international nonprofit
agencies. There are several regional development banks such as The purposes for the setting up of the Bank are
the Asian Development Bank, the African Development Bank • To assist in the reconstruction and development of
and Fund and the Caribbean Development Bank. The primary territories of members by facilitating the investment of
purpose of these agencies is to finance productive development capital for productive purposes, including the restoration of
projects or to promote economic development in a particular economies destroyed or disrupted by war, the reconversion
region. The Inter-American Development Bank, for example, of productive facilities to peacetime needs and
has the principal purpose of accelerating the economic
Corporation
(IFC)
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Objectives of the institutions To promote economic progress in To promote economic
developing countries by providing progress in developing
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financial and technical assistance, countries by helping to
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mostly for specific projects in both mobilise domestic and
public and private sectors. foreign capital to
stimulate the growth of
the private sector.
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Year established 1945 1960 1956
Number of member 144 131 124
countries
(April 1983)
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Types of countries assisted Developing The poorest: 80% All developing
countries other of IDA credits go countries, from the
than the very to countries with poorest to the more
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requirements on
IBRD terms
Types of activities assisted Agriculture and rural development, Agribusiness,
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Equity investments (fiscal IBRD and IDA do not make equity $32 million
1982) investments.
Number of operations (fiscal 150 97 65
1982)
Terms of lending: Generally 15 to 50 years 7 to 12 year
Average maturity period 20 years
Grace period Generally 3 to 10 years An average of 3 years.
5 years
Interest rate (as of April 10.97% 0.0% In line with market
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1, 1983) rates.
Other charges Front-end fee Annual Commitment fee of 1 %
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of 0.25% on commitment charge per year on undisbursed
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loan. of 0.5% on amount of loan.
Commitment undisbursed and
charge of service charge of
0.75% on 0.75% on disbursed
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undisbursed amounts of the
amount of credit.
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Recipients of financing
loan.
Governments,
government
Government.
But they may re-
Private enterprises;
government
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agencies and lend funds to organisations that assist
private state or private the private sector.
enterprises, which organisations.
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can get a
government,
guarantee for the
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IBRD loan.
Government guarantee Essential Essential
Neither sought nor
accepted
Main method of raising funds Borrowings capital Grants from in Borrowings and IFC's
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encouragement of the development of productive facilities made by private investors; and when private capital is not
and resources in less developed countries. available on reasonable terms, to supplement private
• To promote private foreign investment by means of investment by providing, on suitable conditions, finance for
guarantees or participation in loans and other investments
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international investment on business conditions in the The women’s issues category, specifically known as Women In
territories of members and, in the immediate post-war years, Development (WID), is part of a larger emphasis on human
to assist in bringing about a smooth transition from a resources. The importance of improving human capital and
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wartime to a peacetime economy. improving the welfare of families is perceived as a key aspect of
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development. The WID initiative was established in 1988 and it
The World Bank is the International Bank for reconstruction
is oriented to increasing women’s productivity and income.
and development (IBRD)and the international Development
Bank lending for women’s issues is most pronounced in
association (IDA). The IBRD has two affiliates, the
education, population, health and nutrition and agriculture.
International Finance Corporation (IFC) and the Multilateral
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Investment Guarantee Agency (MIGA). The Bank, the IFC and International Development Association
the MIGA are sometimes referred to as the “World Bank The IDA was formed in 1960 as a part of the World Bank
Group”.
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International Bank for Reconstruction and
Group to provide financial support to LDCs on a more liberal
basis than could be offered by the IBRD. The IDA has 137
member countries, although all members of the IBRD are free
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Development to join the IDA. IDA’s funds come from subscriptions from its
The IBRD was set up in 1945 along with the IMF to aid in developed members and from the earnings of the IBRD. Credit
rebuilding the world economy. It was owned by the terms usually are extended to 40 to 50 years with no interest.
governments of 151 countries and its capital is subscribed by Repayment begins after a ten-year grace period and can be paid
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those governments; it provides funds to borrowers by in the local currency, as long as - it is convertible. Loans are made
borrowing funds in the world capital markets, from the only to the poorest countries in the world, those with an annual
proceeds of loan repayments as well as retained earnings. At its per capita gross national product of $480 or less. More than 40
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funding, the bank’s major objective was to serve as an countries are eligible for IDA financing.
international financing facility to function in reconstruction and An example of an IDA project is a $8.3 million loan to
development. With Marshall Plan providing the impetus for Tanzania approved in 1989 to implement the first stage in the
European reconstruction, the Bank was able to turn its efforts longer-term process of rehabilitating the country’s agricultural
towards the developing countries. research system. Cofinancing is expected from several countries
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Generally, the IBRD lends money to a government for the as well as other multilateral lending institutions.
purpose of developing that country’s economic infrastructure Although the IDA’s resources are separate from the IBRD, it has
such as roads and power generating facilities. Funds are directed no separate staff. Loans are made for similar projects as those
towards developing countries at more advanced stages of
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private investors and management (ii) To encourage the spirit is reflected in the fact that voting is rare because consensus
development of local capital markets by carrying out standby is the preferred way of making decisions.
and underwriting arrangements and (iii) To stimulate the Only developing countries can borrow from the Bank. But all
international flow of capital by providing financial and technical members, including the richer nations, gain from economic
assistance to privately controlled finance companies. Loans are growth in developing countries. A world increasingly divided
made to private firms in the developing member countries and between rich and poor is in no one’s interest. Everybody
are usually for a period of seven to twelve years. benefits from increased trade and investment, higher incomes,
The key feature of the IFC is that its loans are all made to fewer social tensions, better health and education and
private enterprises and its investments are made in conjunction environmental protection. The Bank’s member countries -
with private business. In addition to funds contributed by IFC, particularly the industrial countries - also benefit from
funds are also contributed to the same projects by local and procurement opportunities derived from World Bank financed
foreign investors. projects.
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IFC investments are for the establishment of new enterprises as What does the World Bank do?
well as for the expansion and modernisation of existing ones. The World Bank is the world’s largest source of development
They cover a wide range of projects such as steel, textile assistance, providing nearly $30 billion in loans, annually, to its
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production, mining, manufacturing, machinery production, client countries. The Bank uses its financial resources, its highly
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food processing, tourism and local development finance trained staff and its extensive knowledge base to individually
companies. Some projects are locally owned, whereas others are help each, developing country’ onto a path of stable,
joint ventures between investors in developing and developed sustainable and equitable growth. The main focus is on helping
countries. In a few cases, joint ventures are formed between the poorest people and the poorest countries but for all its
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investors of two or more developing countries. The IFC has clients, the Bank emphasises the need for investing in people,
also been instrumental in helping to develop emerging capital particularly through basic health and education; protecting the
markets. environment; supporting and encouraging private business
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The Multilateral Investment Guarantee Agency
(Miga)
development; strengthening the ability of the governments to
deliver quality services efficiently and transparently; promoting
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reforms to create a stable macroeconomic environment
The MIGA was established in 1988 to encourage equity conducive to investment and long-term planning; focusing on
investment and other direct investment flows to developing social development, inclusion, governance and institution
countries by offering investors a variety of different services. It building as key elements of poverty reduction. The Bank is also
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offers guarantees against noncommercial risks; advises. helping countries to strengthen and sustain the fundamental
developing member governments on the design and conditions that help to attract and retain private investment.
implementation of policies, programmes and procedures With Bank support - both lending and advice - governments
related to foreign investments; and sponsors a dialogue
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owned by member countries. The size of a country’s partnership with IFC’s equity investments, investors are
shareholding is determined by the size of the country’s minimising their risks and finding the comfort to invest in
economy relative to the world economy. Together, the largest developing countries and countries undergoing transition to
industrial countries (the Group of seven or G-7) have about 45 market-based economies.
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per cent of the shares in the World Bank and they carry great Where does the World Bank Get it$ Money?
weight in international economic affairs, generally. So it is true The World Bank raises money for its development programmes
that the rich countries have a good deal of influence over the by tapping the world’s capital markets and in the case of the
Bank’s policies and practices. The United States has the largest IDA, through contributions from wealthier member
shareholding - about 17 per cent - which gives it the power to governments. IBRD, which accounts for about three-fourths of
veto any changes in the Bank’s capital base and Articles of the Bank’s, annual lending, raises almost all its money in
Agreement (85 per cent of the shares are needed to effect such financial markets. One of the world’s most prudent and
changes). However, virtually all other matters, including the conservatively managed financial institutions, the IBRD sells
approval of loans, are decided by a majority of the votes cast by AM-rated bonds and other debt securities to pension funds,
all members of the Bank. insurance companies, corporations, other banks and individuals
The Bank’s board of executive directors, which is resident at the around the globe. IBRD charges interest from its borrowers at
Bank’s headquarters in Washington DC, represents all the rates which reflect its cost of borrowing. Loans must be repaid
members. Policies and practices are regularly and frequently in 15 to 20 years; there is a three to five year grace period before
debated and decided upon by the board, so every members’ repayment of principal begins. IDA helps to promote growth
voice is heard. In fact, developing countries, together, have and reduce poverty in the same ways as does the IBRD but
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countries are shareholders who carry ultimate decision making attack deep-seated poverty.
power in the World Bank. Each member nation appoints a But poor people can also benefit quickly from adjustments:
governor and an alternate governor to carry out these farmers get higher prices for their crops and currency devaluation
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responsibilities. The governors, who are usually officials such as helps, workers in export industries: And in the long run, these
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ministers of finance or planning, meet at the Bank’s annual adjustments lead to higher incomes, strengthen civil
meetings each fall. They decide on key Bank policy issues, admit institutions, and create a climate more favourable to private
or suspend country members, decide on changes in the enterprise - all of which benefit the poor. For example, in the
authorised capital stock, determine the distribution of the past few decades, East Asia has achieved some of the most
IBRD’s net income and endorse financial statements and
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remarkable poverty declines in history -27% per cent from
budgets. 1975-85 2 and 35per cent from 1985-95 - alongwith substantial
Economic Reform Programmes improvements in the education and health of the poor.
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World Bank programmes are designed to help the poor and the
record is good. The Bank has lent almost $400 billion since it
Asian Development Bank (ADB)
Introduction
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started more than 50 years ago. During this time, developing
The Asian Development Bank is a multilateral developmental
countries, with the help of the international community,
finance institution founded in 1966 by 31 member
including the Bank, have doubled their incomes, halved infant
governments to promote social and economic progress of
mortality rates and increased life expectancy. The absolute
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Asian and the Pacific region. The Bank gives special attention to
number of poor people is still rising; largely because of rapid
the needs of smaller or less developed countries and gives
population growth. But as a percentage of the world’s
priority to regional/non-regional national programmes.
population, the number of poor is falling. Economic progress
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has been faster than during any similar period in history. History
Economic reform programmes are part of that progress. The In early 1960, the United National Economic Commission for
economic shocks of the 1970s . and early 1980s - high interest Asia and Far East (UNECAFE) estimated that Asia and the
rates, low commodity prices and sluggish growth in the world Pacific region had an annual deficit of US $ one billion. The
economy - hit many developing countries hard. Countries ADB was formed to fill this gap. The inaugural meeting was
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needed to make reforms in the way they ran their economies to held in Tokyo and the newly named bank was installed in
encourage long-term and sustainable development: not Manila (Philippines). The first President was Mr Wanatanade
spending more than a country can afford; ensuring the policy and during his initial years the bank conducted regional surveys
that benefits, the whole country rather than only the elite; to develop a fuller understanding of the social and economic
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investing where scarce resources have impact - for example, in conditions of the Developing Member Countries (DMC).
basic education, and health instead of excessive military In 1974, the Asian Development Fund was established to
spending; and in encouraging a productive private sector. streamline the bank’s means of financing. During 1972-76, the
Far from being the victims of reforms, the poor suffer most Banks’ commitment to the DMCs increased from $316 million
when countries don’t reform. What benefits the poor the most to $776 million. In the late 70s, the bank recognised the need to
is rapid and broad based growth. This comes from having develop additional strategy to reduce poverty in the region, so
sound, macroeconomic policies and a strategy that favours they evolved the concept of multi-project loans, which was a
investment in basic humans capital -primary health care and cost-effective means for funding projects too small for the
universal primary education. . Bank’s involvement.
Reform ‘is not” unique to developing countries. The long In 1978, the Asian Development Fund was increased to 2.15
struggle to reduce the United States’ budget deficit, a struggle billion. 1986 was a significant year for the Bank because the
mirrored in many other industrial countries, is also a form of Peoples Republic of China joined the Bank and India received
economic reform or structural adjustment. Such changes can be her first loan of $100 million to the ICICI (Investment Credit
painful. In the short-term unemployment may rise. Workers in and Investment Corporation of India) for one lending to
private sector enterprises. In 1993, annual lending
1991 was $37.6 billion for 1039 projects. growth focus had diversified emphasis from building
On the borrowing front, in 1991, the Bank offered Dragon irrigation systems in Indonesia to developing rural financial
Bonds, which was a US $ 300 million offering in the capital institutions in the Kyrgyz Republic.
markets of Hong Kong, Singapore and Taipei. • Energy: Energy projects financed power transmission in
The present President is Mr. Tadao Chino, who was Japan’s People’s Republic of China (PRC), Lao People’s Democratic
former Vice Minister of Finance for International Affairs, before Republic (Lao PDR), Maldives, Philippines and Vietnam and
he rook over in January 1999. LPG transmission in India. The broad focus for the energy
sector was restructuring of the power sector; expansion of
Bank Profile power supply and enhancement of power operational
Over the past 31 years, the bank’s membership has grown from efficiency.
31 to 57, of which 41 are from within the region and 16 from
• Transport and communications: The largest number of
outside the region.
growth projects were in the transport and communications
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The Bank gives special attention to the needs of the smaller or sector (ten projects) including three airport projects
less developed countries and priority to regional, sub-regional (Indonesia, Nepal and Philippines), two port projects
and national projects and programmes. (Indonesia and the PRC), two railway projects (Bangladesh
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The Bank’s principal functions are and the PRG) and three road projects (Fiji, Lao PDR and Sri
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i. To extend loans and equity investments for the economic Lanka). Significant emphasis was placed on promoting
and social development of its Developing Member sector and institutional reforms to enhance the
Countries (DMCS); commercialisation of the private sector -participation in, the
ii. To provide technical assistance for the preparation and provision and operation of transport and communications
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execution of development projects and programmes and for infrastructure. The Bank also assisted in the improvement of
advisory services; ports and air transport network in Indonesia to support
growth initiatives in the East Asian region.
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iii. To promote and facilitate investment of public and private
capital for development purposes; and
iv. To respond to requests for assistance in coordinating
• Capital and financial markets: The numerous projects in
the capital and financial markets sector reflected the key role
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that these sectors play in the development process and the
development policies and plans of its DMCs. Bank’s emphasis on being a catalyst of financial resources
Shareholders rather than simply a provider of financial assistance. The role
The two largest shareholders of the Bank, as of 31 December of the Bank in promoting reforms in the capital and financial
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1997, were Japan and the United States, each accounting for 16 markets became particularly critical in the wake of the
per cent of the total subscribed capital. Forty one regional financial crisis shaking East Asian markets. The five financial
members accounted for 63 per cent of total shareholding while sector loans included, among others, a $4 billion financial
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16 non-regional members contributed 37 per cent, of the total. sector programme for the Republic of Korea as part of a
total assistance package amounting to more than $57 billion
Location
to be contributed by the ADB, IMF, World Bank and
The Bank’s head quarters are in Manila, Philippines. It has
bilateral sources. In addition, the Bank provided $300 billion
resident missions in Bangladesh, Cambodia, India, Indonesia,
for the financial market reform programme in Thailand
Nepal, Pakistan, Sri Lanka and Vietnam and has opened
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technical assistance projects; and help ensure project quality. programme was an integral component of efforts to
promote economic growth. Technical assistance operations
Strategic Objectives continued to support the preparation of numerous projects
The Bank’s strategic development object1ves, as defined in the promoting economic growth and to assist in policy reforms,
Bank’s medium-term strategic framework (1995-1998) are institution building and the creation of an enabling
Economic Growth environment for private sector development.
In 1997, the Bank lent $6.4 billion for 28 traditional, growth Poverty Reduction
projects. The unusually large volume of lending for economic Poverty reduction is a strategic objective of the Bank. Poverty
growth, projects was because of the programme loan to the remains a trap for more than 950 million people in, the Asian
Republic of Korea. Excluding the financial sector programme and Pacific region, with a large part, of this total facing absolute
for the Republic of Korea, the total lending for growth projects poverty. The total number of poor in the region represents
was $2.4 billion. These projects covered most of the Bank’s nearly three-quarters of all the world’s poor. While the absolute
DMCs and were widely spread across sectors including number of poor persons in the region is expected to decrease,
agriculture, energy, industry finance, transport and gradually, by the year 2000, the region will still have more than
communication. half of the world’s poor. The roots of poverty lie in a complex
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of countries that have been most successful in reducing poverty. needs and improving the living conditions of the urban poor.
Sustained rates of economic growth, in turn, provide Gender Development
opportunities for the poor to participate in and benefit from Improving the status of women is one of the strategic
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this growth. Support for basic social services, particularly
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objectives of the Bank. Gender development is no longer seen
education and health services, helps the poor participate more as merely an issue of human rights or social justice; investment
effectively. . in women now is widely recognised as crucial to achieving
At the same time, the Bank pursues poverty reduction through sustainable development.
initiatives that are oriented toward the needs of specific Economic analysis recognises that low levels of education and
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countries. These initiatives are based on particular country-level training, poor health and nutritional status and limited access to
conditions and concerns and have a specific country-based focus. resources not only depress the quality of life for women but
Poverty reduction efforts increasingly are becoming an element
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of country strategy studies and country programming
also limit their productivity and subsequently, contribution to
economic efficiency, economic growth and development..
Public policies and investments that raise the status of women
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Supporting Human Development have specific benefits such as improved public health, lower
The Bank has continued to emphasise its strategic objective of infant and maternal mortality, lower fertility rates, increased life
promoting human development by expanding investments in expectancy and reduced welfare costs.
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the critical sectors of education, health and nutrition, water Development programmes -that include measures to expand
supply and sanitation and urban development. Human economic opportunities for women and increase their incomes,
development is an expanding area of activity for the Bank. Of a combined with efforts to improve women’s health and
total of 72 projects approved during 1997, excluding private
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better quality of life now and for future generations cannot be institutional and policy reforms and build staff capacity in
achieved without investing in human development. environmental agencies, enabling them to effectively carry out
Education their mandate for environmental protection and
The Bank aims to support the education sector in its DMCs by management;
investing in basic education, improving the quality of education • Promoting cooperation among countries in the region or
and making education in general –– and skills training in subregion to address transboundary environmental concerns
particular - more relevant to market needs. and to enhance possible environmental benefits occurring
from sub regional cooperation;
Health and Nutrition
The Bank’s main strategies for supporting the health • Ensuring, through the use of environmental assessment
improvement efforts of its DMCs are to focus on primary and review procedures, that Bank--funded projects are
health care services, the control of communicable diseases and environmentally sustainable;
capacity building. • Financing projects that promote the sound management of
natural resources and rehabilitate and protect .the
environment;
DMC staff awareness on current and emerging The Bank aims to achieve better, project quality and
environmental issues; and development impact. An important ingredient of project
• Ensuring inter-agency collaboration to avoid costly quality is effective implementation. While implementation, of
duplication of efforts and to enable the Bank to focus its projects is mainly the responsibility of its DMCs, the Bank
assistance in critical areas. emphasises project administration and portfolio review to
enhance project effectiveness and efficiency. The four attributes
Operating Objectives of project quality are
Operating objectives in each DMC fall within four areas 1. Economic and financial viability
1. Policy support; 2. Social impact
2. Capacity building of development management; 3. Implementability
3. Creating/Strengthening productive capacity, infrastructure and 4. Sustainability
services;
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Emphasis is placed on tile, broader objectives of capacity
4. Regional cooperation. building, beneficiary participation, and project performance,
Sector Coverage rather than simply on the physical completion of projects.
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The Bank’s operations cover a wide spectrum of activities that Operation Evaluation
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have been classified according to the following sectors The Bank evaluates projects and programmes final1ced by it to
1. Agriculture and natural resources obtain a systematic and comprehensive assessment of the
2. Energy extent to which the project or programme objectives have been,
3. Industry and non-fuel minerals or are likely to be, achieved. Feedback from this activity is used
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to improve the Bank’s policies and procedures and quality of
4. Finance the design and execution of its lending to DMCs.
5. Transport and communications
6. Social infrastructure
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7. Combinations of some of the sectors (1) to (6)
Evaluation Activities Include
1. Project completion reporting and independent performance
evaluation of a project or programme, including evaluation
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Project Process of the efficiency of its implementation after the project or
Before any project is identified for Bank financing, Bank staff programme is completed; and
review the country’s economy, particularly its national and 2. Intensive analysis of both ongoing and completed projects
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sectorial development programmes and determines the concerning certain specific issues or subjects of broader
prospects for its success. Country programming missions visit significance to the Bank’s strategic objectives and policies.
DMCs regularly to discuss topics of mutual interest with
Private Sector Development
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Lending Policies intermediation role of transferring resources from global
The Bank is authorised to make, participate in, or guarantee markets to developing countries to promote socio-economic
loans to its DMCs or their governments or any of their development. The ultimate goal of the financial policy of the
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Bank is to achieve effective financial intermediation. Its major
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agencies, public or private enterprises operating within such
countries, as well as to international or regional entitles elements include net income and reserves policy, liquidity policy,
concerned with economic development in the region. Loans are loan product and credit risk policy, borrowing policy and capital
approved by the Bank only for projects or programmes of high management policy.
development priority. The Bank provides financing to its Borrowings
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borrowers to cover foreign exchange expenditures and also The Bank has been an active borrower in world capital markets
finances local currency expenditures in certain cases. since 1969. Its borrowing programme is broadly determined by
Financial Resources
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The financial resources of-the Bank consist of Ordinary Capital
Resources (OCR) comprising subscribed capital, reserves and
a number of factors, including the Bank’s lending operations,
cash flow requirements, its liquidity policy and its perception of
current and future market conditions. In the initial years of
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operations, the Bank’s capital was the major source of funds for
funds raised through borrowings; and special funds,
ordinary lending but since the early 1980s, Bank borrowings
comprising contributions made by member governments,
have accounted for a greater share than capital and reserves.
repayments from past loans and amounts previously set aside
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from paid-in capital. Loans from OCR lending operations are Liquidity Management
generally made to member governments which have attained a It is the policy of the Bank to maintain liquid assets amounting
somewhat higher level of economic development. Loans from to at least 40 per cent of the total of undisbursed balances of
the Asian Development Fund (ADF) are made on highly pool based loans at the end of the year. The main purpose of
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concessional terms and almost exclusively to DMCs with a low the liquidity policy is to ensure the uninterrupted availability of
per capita gross national product and limited debt-repayment funds to meet loan disbursements, debt servicing and other
capacity. expenditures. Investment of liquid assets is governed by the
Lending Windows Investment Authority approved by the board of directors.
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The Bank has three lending windows for OCR loans. These are Review Questions
1. The pool based multicurrency loan window where loan 1. What are the goals and function of World Bank, the IDA
disbursements are made in a variety of currencies of the and the IFC?
Bank’s choice; 2. How did Bretton woods agreement provide a stable
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2. The pool based single currency loan window in US dollars; monetary environment?
and 3. What does World Bank Do? What are its purposes?
3. The Market Based Loan (MBL) window which provides 4. What are the objectives of Asian Development Bank ?
single currency loans to private sector borrowers and to
5. How do inflation and interest rate determine the value of
financial intermediaries in the public sector.
currency?
The MBL window provides single currency loans in US, dollars,
Japanese yen, or Swiss francs to private sector borrowers and
government guaranteed financial intermediaries at current terms
prevailing in international financial markets. MBL borrowers
have the option of having the interest rates of their loans in
either fixed or floating rate terms. MBL lending to government
guaranteed financial intermediaries is limited to US $1 billion in
loan commitments.
LESSON 34:
TUTORIAL-4
Tutorial on World Bank and IMF 2. The Bail –out package suggested by IMF for India in 1991
For any socialist or for that matter propounder of Swadeshi, included financial sector reforms and devaluation of rupee.
the very mention of IMF India adhered to the package and seemed to forgot the
( International Monetary fund) and world bank would bring causes for such a crisis. If(we hope it would not) a similar
out the images of a best feasting on a hapless and innocent crisis recurs, what would be the list of measures that may be
victim. The explanation would follow on how Indian was suggested by IMF today? In such a case does India have any
nearly ‘ duped’ in accepting the norms set by IMF that made it choice?
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an easy ‘Prey’ for multinationals( red US government) to sell
out India.
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The fears are probably over exaggerated, but not unfounded
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either. The packages suggested by the IMF and World Bank
were interpreted in some circles as a mere method of arm-
twisting by the west in accepting their norms and principles.
However, it cannot be forgotten how India was saved from a
near default in yester years, the 1991 bal out package being one
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of them. Nor can one afford to see the other side of the story
when the IMF comes forward to lend in an hour of crisis. The
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advocates of free market would not let us forget that the
measures suggested for IMF, as far as India is concerned
worked , at least till the present. If the measures suggested by
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IMF or conditions set by World Bank seem like ‘feeding the
turkey before the feast’, is because of ignorance of working of a
free market economy, say the expert.
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these entities need not exit. What are the main functions of
the world Bank? Do both the entities perform same
functions? How is it different from other entities such as the
Asian Development bank(ADB)
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Learning Objectives The current laws in some countries, including the USA, allow
After reading this lesson, you will understand the government full access to anyones domestic financial
information for almost any reason at all. The act of creating a
• Introduction
foreign bank account helps make some of your assets harder to
• Purposes of offshore banking access by those who should be minding their own business. A
• Benefits of offshore banking good foreign bank will usually not require your Social Security
• Offshore banking locations number, they wont answer questions from US sources about
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your credit and banking history, and they will not provide your
• Operational aspects of offshore banking
financial information to any domestic data collection agency.
• Advantages of offshore banking
An offshore account can also help you with wealth building.
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Today we shall discuss offshore banking in detail. First, there are the tax advantages. Offshore accounts can be
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An Introduction to Offshore Banking arranged in jursdictions that do not impose taxes on income
Offshore banking can be explained as the carrying on of earned abroad. This can be very beneficial when arranged
banking and financial activities in an environment, which is correctly. There is also the ability to earn a higher return on your
essentially free of fiscal, and exchange controls i.e. tax havens or investments with an offshore account.
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low tax areas, commonly referred to as offshore finance centres. Many foreign banks are not as tightly regulated as domestic
These conditions normally would also include favourable ones and can offer higher interest rates on accounts. This is due
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banking regulations or banking laws considerably less stringent
than those in most domestic jurisdictions.
“Offshore Banking” - maybe this term conjures up images of
to their ability to make more lucrative investments and also the
fact that the overhead to operate a bank is lower in many
countries.
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secret Swiss accounts, James Bond, and sipping Martinis at a Finally, the ability to expand your business globally increases
chalet in Lichtenstein. The fact is though that doing a portion when you create an additional bank account outside your own
of your banking in a financial institution outside of your borders. Many offshore banks allow you to do business and
national borders is not only easy, it also offers numerous
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topic. The answer is YES. Many of the largest companies in the are considering a stable country? You usually do not want your
USA do their banking offshore including Exxon and Boeing, account in a country where coup detats are a regular occurrence.
among others. You do not need to be a giant corporation On the other hand, if the financial system is strong enough, it
though to reap the benefits of an offshore bank account as we will withstand even political turmoil as in Panama when Manuel
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the Carribean or Latin America, while a citizen of the U.K. to handle external borrowing or to consolidate intra-group
might prefer an account at an institution located on the Isle of finance or banking transactions. Corporations involved in
Man, all other considerations being equal. international trade may use an offshore bank as a foreign or
multi-currency management centre. Eurocurrency market
Accessing and Managing Your Money
underwriting are often raised through captive offshore banks
Thanks mainly to the internet and advances in international
or finance companies.
communication technology, offshore banking is fairly
straightforward. Most accounts can be arranged with online The activities of international finance companies also fall within
access to your information. the category of offshore banking. These activities may include
external loan raising, provision of confirming finance to clients
Transfers of funds can be done online as well. As far as
and group entities, discounting or factoring of intra-group and
accessing your money, most offshore banks will offer a debit
other debts, and tax effective intra-group loans.
card with your account so you can retrieve your money whenever
you want, wherever you are from most ATMs. As you can see, The leasing of equipment through an offshore based captive
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accessing and managing your funds in an offshore account need finance company is another useful offshore banking concept.
not be any more difficult than doing the same with a domestic This activity may be for the purpose of providing vendor lease
account. finance to group customers or to fund group asset acquisitions.
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Acquiring an Offshore Bank Account Benefits of Offshore Banking
Once you decide that an offshore account is right for you and The benefits of offshore banking can accrue to the banking
you have done some further investigating to select the institution and its clients. Freedom from taxation and exchange
appropriate country to open your account in, the actual process controls are important reasons for the formation of an offshore
of acquiring the account can be relatively straightforward. bank and usually these will be of significant advantage and
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There are a number of legitimate offshore financial planning mutual benefit to both the offshore bank and its client.
and asset management firms who will complete and submit all A tax free or low tax environment will not only allow the
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the paperwork for you for a reasonable fee. The advantage to
this is they usually have connections with the banks they
represent and can arrange your accounts more quickly and easily.
offshore bank to generate a better bottom-line but will also
provide it with a stable operating base by avoiding the vagaries
or contingencies of onshore fiscal policies. The earnings of the
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Also, they can often offer you added perks such as secured credit offshore bank from currency management, participation in
cards, merchant accounts and incorporation services. Be sure to syndicated loans, money market and securities dealings and
compare the fees charged and services offered and always get deposit-taking activities can be protected from the high rates of
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feedback from previous customers. Of course, be wary of any income taxes applicable in domestic banks or financial
offers that sound too good to be true, such as outfits offering institutions which may well be subject to interest withholding
unsecured credit cards with your offshore bank account. taxes imposed by the domestic fiscal authority. However, these
can usually be minimised by careful forward planning.
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reaping the benefits of an offshore bank account. by being able to conclude transactions promptly, particularly in
volatile market conditions.
Offshore Banks are used for a Variety of Purposes.
The banking institution which offers offshore banking facilities
Frequently they may be formed as a subsidiary of a domestic or
to its clients should be able to increase its deposit base at a
international bank to:
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greater rate that its wholly domestic competitors, its clients will
1 Accept deposits outside the controlled environment. This is benefit by receiving their interest income free of any
an increasingly popular activity, particularly for foreign withholding tax and the lower tax base of the offshore bank
currency deposits. should enable it to be more competitive with its interest rates.
2 Book transactions which do not fall within the domestic If the client is also able to structure his own assets through an
jurisdiction such as large internationally syndicated loans offshore trust or investment holding company then his interest
particularly where the participating banks are located in income may also be free from tax in his domestic jurisdiction
various jurisdictions. and his deposits not subject to onshore exchange controls. The
3 Make loans which are tax effective to their clients. availability of banking secrecy in the offshore banking
environment may be a further benefit to the client.
4 Avoid onerous debt-equity ratios and lending restrictions
applicable in the more severely regulated jurisdictions in Corporate groups which establish offshore banks benefit in a
which they operate. variety of ways, including the tax advantages outlined above. In
general, the corporate group will aim to maximise interest
5 Provide their clients with banking secrecy.
deductions against profits in high-tax areas whilst protecting
group interest income from tax by accumulation in an offshore
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regulatory authorities. The absence of banking laws requiring
minimum debt-equity ratios, high capitalisation, and arm’s In order to obtain the benefits previously outlined the offshore
length rules as imposed by most onshore central monetary bank requires an operating environment which is tax free, has a
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authorities, will undoubtedly be of benefit to the corporate low tax rate or provides concessional rates of tax to an offshore
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group. bank. Normally the former is preferred. The need for specific tax
factors will vary with the requirements of the offshore bank. In
The use of an offshore bank as the currency management centre
some instances it may be desirable to utilise double tax treaties.
of a corporate group will provide a flexible and fiscally effective
However, in many circumstances they will be of no benefit and
means of controlling foreign exchange exposure. Group
their exchange of information provisions may be detrimental to
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exchange gains or losses, whether realised or unrealised, can be
the activities of the offshore bank.
consolidated into one entity with resultant cost and
administration benefits Overall foreign exchange risk can be An offshore banking centre which does not impose interest
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reduced and hedging or borrowing costs minimised. Exchange
gains, fees, discounts, and interest income can be treated on a
group basis in the most tax effective way. Centralisation of the
withholding taxes will normally be preferred by clients of the
offshore bank and will also be attractive to the offshore bank as
interest withholding taxes are often part of its funding costs.
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currency management function allows more direct involvement The absence of a dividend withholding tax will also be an
by the group treasurer and the offshore environment permits important consideration for the shareholders of the offshore
him greater flexibility. bank.
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applications must be accompanied by the information specified Offshore banks operate on an offshore basis. Offshore banks
in the offshore bank guidelines. If the application satisfies the provide services only to non-residents of the jurisdiction where
guidelines then a licence will be issued promptly. Normally the such banks are established. For example a Belize-registered
application is a confidential document and may be subject to the offshore bank can provide services to clients from any country,
secrecy provisions of the relevant corporate legislation. except to permanent residents of Belize. This is the main
formal difference between offshore and onshore banks.
Banking Activities
Subject to the terms of its licence the offshore bank will be able What is more important is the environment in which offshore
to undertake any form of banking activity but the most banks operate. Offshore banks carry on banking and financial
common offshore banking operations include: activities in an environment which is free of fiscal and exchange
controls, i.e. tax havens or low tax areas, commonly referred to
Deposit taking
as offshore finance centers. These conditions normally also
Syndicated loans or Eurocurrency under writings include favorable banking legislation which is considerably less
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Corporate loan raising strict than those in most onshore jurisdictions.
Intra-group lending Offshore banks can be controlled by residents of any country in
Foreign currency management most offshore banking jurisdictions. It is much easier to obtain
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a banking license in an offshore location than in strictly
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Provision of confirming finance
controlled domestic jurisdictions. You can enhance your
Lease finance business structure and gain extra advantages compared to your
Debt factoring competitors by establishing an offshore bank.
Management The Purposes of Offshore Banks
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The management and administration of the offshore bank Offshore banks are used in many typical situations. Offshore
should not be conducted in the domestic jurisdictions of the banks are often established by already existing onshore banking
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corporate group and care must be taken to ensure that offshore
deposit-taking activities do not breach domestic banking laws.
If too many of the management activities of the offshore bank
or financial institutions for the following reasons:
Access international credit market
Access international correspondent account networks
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are effected in the domestic locations the offshore bank may be
deemed to be carrying on business there through a branch, with Provide clients with tax effective loans
adverse consequences under both tax and banking legislation. Provide clients with actual banking secrecy
The management functions should therefore be carried out by
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management location. Alternatively it can engage the services of Accept deposits outside the controlled environment
a local trust company or professional management firm who Avoid strict debt-equity ratios and lending restrictions imposed
would work closely with the management of the corporate by more severely regulated onshore jurisdictions
group. Avoid huge minimum capital requirements imposed by more
severely regulated onshore jurisdictions
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needs of small groups or even one person. Offshore banking opens an anonymous account in an anonymous offshore bank.
is traditionally oriented towards fulfilling the needs of the This way, triple-layered protection of confidential commercial
wealthy. information is achieved. Nominee owners and directors are
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Advantages often assigned to ensure anonymity.
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The advantages of offshore banks are two-dimensional. Both - Small Amount of Required Equity Capital
the banking institution and its clients - benefit from the In offshore banking jurisdictions, it is significantly lower than in
advantages of an offshore bank. the onshore locations of the world. For the majority of
Low Tax or Tax Free Environment businessmen it is the only opportunity to establish a foreign
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Offshore banks are either tax exempt or taxes are reduced to commercial bank, since other possibilities are unacceptable due
several per cent of the amount of the profit. This enables an to the requirement of high capital, personnel, reputation and
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offshore bank not only to generate a better bottom-line but will
also provide it with a stable operating base by avoiding the
vagaries or contingencies of onshore fiscal policies. No taxes are
business-planning of the bank. It is no secret that by
establishing an offshore bank large companies and banks can
keep their expenses low and business opportunities are
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levied at the source of income, e.g. on bank interest, dividends boosted.
and other similar payments. Expenses are limited to No Reserve Requirements and Liberal Bank Control
administrative expenditures and annual dues necessary to renew There are no requirements, or they are minimal, on required
an off-shore status. The earnings of the offshore bank from
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fees necessary to renew an offshore status. exchange gains or losses, whether realized or unrealized, can be
consolidated into one entity with resultant cost and
No Exchange Control administration benefits. Overall foreign exchange risk can be
The absence of exchange control will obviously enable the reduced and hedging or borrowing costs minimized. Exchange
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offshore bank to move funds with a greater degree of freedom gains, fees, discounts, and interest income can be treated on a
and flexibility than from within an exchange controlled area. group basis in the most tax effective way. Centralization of the
The offshore bank should benefit from this enhanced flexibility currency management function allows more direct involvement
by being able to conclude transactions promptly, particularly in by the group treasurer and the offshore environment permits
volatile market conditions. him greater flexibility.
Less Strict License Requirements Enormous Business Opportunities
The license requirements for offshore banks are simplified to a Eurobond issues and foreign currency loans are often raised
large extent and quite a lot of applicants are eligible for such a through the medium of an offshore bank to maximize the
license. Unlike the majority of the countries throughout the overall tax effect by enabling the corporate group to disperse the
world, a foreign applicant does not have to be a “world class funds as appropriate within the group. Free income from the
bank” to get a banking license in an offshore jurisdiction. Such group’s confirming finance, discounts from debt factoring and
a license could be issued to a small bank, financial institution, interest derived from leasing or hire purchase transactions can be
trading company or even an individual. protected from the high tax rates applicable in the onshore
jurisdictions. By conducting its banking ordinance activities
through an offshore bank the corporate group will be able to
domestic regulatory authorities. offshore banks, particularly those which are owned by
In general, the corporate group will aim to maximize interest international banking groups.
deductions against profits in high-tax areas whilst protecting The corporate legislation or the offshore banking center is also
group interest income from tax by accumulation in an offshore an important factor and should complement the banking laws.
environment. The offshore bank is therefore a most effective Preferably the corporate law should be consistent with that
means of deploying accumulated group funds. adopted in jurisdictions in which the banking or corporate
group operates. Special factors, such as anonymity of
Choosing the Right Jurisdiction
ownership, corporate secrecy provisions, transfer of corporate
The main in determining the location of an offshore bank are:
domicile and minimal reporting requirements may be attractive
Taxation for some offshore banks.
In order to obtain the benefits previously outlined the offshore
bank requires an operating environment which is tax free, has a Exchange Controls
The flexible banking policies available under suitable offshore
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low tax rate or provides concessional rates of tax to an offshore
bank. Normally the former is preferred. The need for specific banking legislation will be severely restricted unless they are
tax factors will vary with the requirements of the offshore bank. complemented by free movement of funds. The offshore bank
must be able to move its funds freely through the international
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In some instances it may be desirable to utilize double tax
banking network and the offshore banking center should
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treaties. However, in many circumstances they will be of no
benefit and their exchange of information provisions may be provide direct access to that network.
detrimental to the activities of the offshore bank. An offshore Other Criteria
banking center which does not impose interest withholding Various other factors should be considered in selecting a
taxes will normally be preferred by clients of the offshore bank location suitable for offshore banking. These include:
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and will also be attractive to the offshore bank as interest Political and economic stability;
withholding taxes are often part of its funding costs. The
Availability of banking and professional expertise;
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absence of a dividend withholding tax will also be an important
consideration for the shareholders of the offshore bank. Taxes
other than income taxes must also be considered. Stamp duty
Access to telecommunications.
Operational Aspects
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on loan or mortgage documents, receipt taxes and stamp duty
Banking Activities
on securities transfers can be significant cost factors where
appropriate. Subject to the terms of its license the offshore bank will be able
to undertake any form of banking activity but the most
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banking operations and restricted licenses for offshore banks operations of an ordinary onshore bank. However, in some
which conduct their banking activities with non-resident jurisdictions an offshore banking license is issued on a special
entities. condition that the bank may accept deposits from only a limited
The banking legislation of a suitable offshore banking center circle of clients. Usually these are the bank’s share-holders or
should permit: persons mentioned in the bank’s charter or license. Such a
Low capitalization without statutory minimum capital and license is defined as “limited”. In this case the bank may have a
reserve requirements; limited number of clients. Sometimes, an off-shore bank may
begin its activities with “limited” operations and widen the
Loan raising without mandatory debt-equity ratios;
spectrum of its services by acquiring a less regulated license in
Unrestricted lending activities; the future.
Complete foreign ownership of offshore banks; Foundation documents of an offshore bank usually provide
Cash management without minimum liquidity rules; for trust operations. The bank functions as a trustee and
Administration free from excessive reporting obligations; manages the clients’ securities portfolios. Investment
portfolios may include not only financial resources but also
Non-disclosure of client activities.
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application for an offshore bank or financial institution license.
2. What are the purposes of offshore banking?
License applications must be accompanied by the information
specified in the offshore bank guidelines. If the application 3. What are the benefits of offshore banking?
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satisfies the guidelines then a license will be issued promptly. 4. Discuss offshore banking locations.
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Normally the application is a confidential document and may be 5. Discuss operational aspects of offshore banking.
subject to the secrecy provisions of the relevant corporate
6. What are the advantages of offshore banking?
legislation.
Banks with a solid international standing get preferential Notes:
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treatment and certainly can obtain offshore banking licenses in
any jurisdiction in the world. However, Eastern European
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banks for example, even the largest ones, could face some
difficulties. It’s much easier for them to obtain a limited
offshore banking license. Not only large but medium or small
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sized banks, non-banking companies and even individuals are
eligible for an offshore banking license in more liberal
jurisdictions like Nauru and Vanuatu in the South Pacific.
Usually recommendations from other banks, as well as lawyers
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LESSON 36:
E-BANKING
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• Online delivery of financial products Two distinct trends can be discerned in the realm of Internet
• E-banking components Banking. On one hand, Banks and Financial Institutions are
trying to enter into new areas and consolidate their hold on the
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• E-banking support services
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entire financial sector. On the other hand, new Dot Coms are
• Security challenges in e-banking entering the financing business and challenging the banks. It
Definition of E-banking could be said that two opposite things are happening at the
E-banking is defined as the automated delivery of new and same time. The banks, via their consolidation moves are trying
traditional banking products and services directly to customers to preserve their strongholds, while the Dot Coms are trying to
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through electronic, interactive communication channels. E- fragment the market by providing superior services. Banks and
banking includes the systems that enable financial institution Financial Institutions are trying to leverage their Brands and
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customers, individuals or businesses, to access accounts, transact
business, or obtain information on financial products and
services through a public or private network, including the
their position in the industry. While, the Dot Coms are using
their competency in superior service design and experience of
competing in this highly unstable environment. All the players
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Internet. Customers access e-banking services using an share the same objectives: acquiring customers, providing them
intelligent electronic device, such as a personal computer (PC), with new financial information, services, and products, and
personal digital assistant (PDA), automated teller machine doing so in a way that enhances the value proposition of their
(ATM), kiosk, or Touch Tone telephone. While the risks and products and services.
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controls are similar for the various e-banking access channels, Internet Banking allows the Banks (and other Financial Service
this booklet focuses specifically on Internet-based services due providers) to overcome the tradeoff between content and reach.
to the Internet’s widely accessible public network. Accordingly, With the use of Internet, banks can provide their services to a
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this booklet begins with a discussion of the two primary types much wider audience then they could do without it. Even
of Internet websites: informational and transactional. before the coming of Internet, competition had shifted from
Introduction products to services. This was due, in large part, to the advent
Internet has touched almost all aspects of our lives. The of Private Sector Banks.
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emergence of e-commerce has revolutionized the way we live, Before the entry of these banks, the retail banking was more of
shop, entertain and interact. Therefore, it should not come as a a commodity with hardly any differentiation on the basis of
surprise if it tries to influence the way we save and the way we products or services. Banks offered similar products and similar
invest. service. But the new private sector banks changed the scenario
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Today, when the customer is king and the service providers are by differentiating on the basis of service. They started providing
rushing to pay obeisance to the king, financial service providers Telephone based banking and introduced the concept of home
cannot be left behind. In their quest to differentiate their banking. The superior service being provided by these banks
services and gain competitive advantage over their competitors, was the main reason for their rapid growth. But their reach was
the financial service providers are trying to provide their services limited due to logistics of setting up branches and increasing
to the customers in the comfort of their homes. The Internet the reach of their service. Any attempt to increase the branch
has emerged as a convenient channel for these service providers. network would have increased their overheads and any attempt
to widen the areas being served by a branch was likely to lead to
Living in India, we might find these ideas too far fetched but deterioration in the service levels. In other words, these banks
the truth is that Internet has changed the way these services are were caught in a dilemma as they faced the Reach and content
delivered, particularly in countries where the Internet tradeoff. With the advent of Internet these banks have been
penetration is high. The different ways in which Internet is able to overcome this tradeoff.
trying to revolutionize the delivery of the financial services and
products are given below: - By using the Internet, these banks can expand their reach as well
as maintain the standards of their services.
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their financial information more easily. Moreover, online writing out cheques, via the net. Soon these will form only a
interactions allow use of such tools as e-CRM to create a more small part of the total array of services being offered by them.
intimate relationship with the customer and promote and These Banks have embarked on a number of new initiatives to
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deliver other online products and services. protect their stronghold and to leverage the net. They are
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If the Banks do not establish control on EBP, they are likely to offering value-added services to their customers and at the same
loose customers to the new providers of financial services, thus time are trying to get into B2C and B2B e-commerce. They are
affecting other sources of revenue. even trying to get their finger into various transactions between
the Government on one side and the business and the
In India, HDFC Bank, ICICI Bank and Citibank are trying
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customer on the other. Banks are trying to become a part of the
setup an EBP portal. ICICI has already started a portal called
online value chain. For example, they are trying to tie up with
BillJunction.com. Banks are planning to use the Net for
corporates so as to become a part of their supply chain and
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payment of utility bills. They are entering into tie-ups with
utilities like MTNL, Airtel, Orange, and BPL Mobile etc. Right
now, a customer who’s received a bill in the physical form logs
enable electronic transfer of funds between the different
components of the Supply Chain. They are doing this by acting
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as an intermediary between the corporations and their vendors
into the network in order to make an online payment. In the
by enabling online transactions at one place.
future, these bills will be sent to customers through the Net.
Some Banks are trying to setup portals for routing payments
Consumers and Businesses can derive economic benefit on
like Excise Duty and Sales Tax. Not content with that Banks are
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They can pay bills electronically in the same way they do today,
but by consolidating their bills, they can reduce the effort loans, and mortgage, online. They plan to offer other financial
involved in the whole process. They can also access their account products like Bonds and Mutual Funds through their financial
at the same time. They can conveniently access all billers from a service portal. This strategy is aimed by pre-empting the entry
single portal that also provides them banking facilities. This of new startups into this business.
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would enable them to view their account balance while paying Another bit of the Net strategy, involves providing
bills. For portals or the intermediaries that consolidate bills infrastructure for B2C as well as B2B e-commerce. Banks are
from multiple billers at a single online location EBP is a tool to setting up secure payment gateways that will allow online retail
acquire customers and provide them other financial services also. shops to obtain instant credit card verifications. Once the buyer
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Dominance of the EBP market can lead to an entry into other hits the pay button at a B2C portal, the buyer’s credit card details
financial services markets such as credit or debit card payments, will get encrypted and travel securely to the Visa or MasterCard
or indeed into a much broader range of e-commerce markets, approval system through the bank’s payment gateway.
such as payments gateways. The banks are also setting up their own shopping portals.
Online Brokerage HDFC has a stake in a portal called easy2buy.com where HDFC
Online Broking is emerging as another field where traditional bank customers can buy using their bank account number.
service providers are likely to face tough competition from the Federal Bank has similar arrangements with Rediff.com and
Dot Coms. In Taiwan and Korea, 30% of the stock trading has Fabmart.com. ICICI has setup Magiccart.com, an e-tailing site.
already moved online. This is posing a threat to the traditional At the B2B end, Banks are offering Net Banking service that
Full-Service Brokerages. By leveraging the power of the web, allows electronic fund transfers among a company, its vendors
Charles Schwab has emerged as a major threat to Full-Service and dealers. Another service being targeted at this segment is
brokers like Merrill Lynch. In order to preempt the moves into cash management. This will reduce the float, which is present in
these areas by new players, many Banks have already tied up physical processing of the payments.
with Online Brokerages.
ERP/Supply Chain system of their clients. This will enable the Firewall configuration and management,
bank to benefit from the movement towards e-procurement.
Intrusion detection system or IDS (network and host-based),
E-Procurement involves making transactions online and
processing the payment electronically. Network administration,
Security management,
Security Controls for Safeguarding Customer
Internet banking server,
Information;
Authentication processes necessary to initially verify the identity E-commerce applications (e.g., bill payment, lending,
of new customers and authenticate existing customers who brokerage),
access e-banking services; Internal network servers,
Liability for unauthorized transactions; Core processing system,
Losses from fraud if the institution fails to verify the identity Programming support, and
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of individuals or businesses applying for new accounts or credit Automated decision support systems.
on-line;
These components work together to deliver e-banking services.
Possible violations of laws or regulations pertaining to Each component represents a control point to consider.
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consumer privacy, anti-money laundering, anti-terrorism, or the
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Through a combination of internal and outsourced solutions,
content, timing, or delivery of required consumer disclosures;
management has many alternatives when determining the
and
overall system configuration for the various components of an
Negative public perception, customer dissatisfaction, and e-banking system. However, for the sake of simplicity, this
potential liability resulting from failure to process third-party booklet presents only two basic variations. First, one or more
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payments as directed or within specified time frames, lack of technology service providers can host the e-banking application
availability of on-line services, or unauthorized access to and numerous network components as illustrated in the
storage.
E-banking Components
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confidential customer information during transmission or following diagram. In this configuration, the institution’s
service provider hosts the institution’s website, Internet
banking server, firewall, and intrusion detection system. While
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the institution does not have to manage the daily
E-banking systems can vary significantly in their configuration
administration of these component systems, its management
depending on a number of factors. Financial institutions
and board remain responsible for the content, performance, and
should choose their e-banking system configuration, including
security of the e-banking system.
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services internally. Alternatively, financial institutions can authentication, website hosting, payments for e-commerce, and
outsource any aspect of their e-banking systems to third parties. wireless banking activities.
The following entities could provide or host (i.e., allow Weblinking
applications to reside on their servers) e-banking-related services A large number of financial institutions maintain sites on the
Do
for financial institutions: World Wide Web. Some websites are strictly informational,
Another financial institution, while others also offer customers the ability to perform financial
Internet service provider, transactions, such as paying bills or transferring funds between
accounts.
Internet banking software vendor or processor,
Virtually every website contains “weblinks.” A weblink is a
Core banking vendor or processor, word, phrase, or image on a webpage that contains coding that
Managed security service provider, will transport the viewer to a different part of the website or a
Bill payment provider, completely different website by just clicking the mouse. While
Credit bureau, and weblinks are a convenient and accepted tool in website design,
their use can present certain risks. Generally, the primary risk
Credit scoring company. posed by weblinking is that viewers can become confused about
E-banking systems rely on a number of common components whose website they are viewing and who is responsible for the
or processes. The following list includes many of the potential information, products, and services available through that
components and processes seen in a typical institution: website. There are a variety of risk management techniques
institutions should consider using to mitigate these risks. These
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credit card, brokerage, and banking data). Aggregation services legal certainty and promote the growth of electronic commerce.
can improve customer convenience by avoiding multiple log-ins The development of secure digital signatures continues to
and providing access to tools that help customers analyze and evolve with some financial institutions either acting as the
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manage their various account portfolios. Some aggregators use certification authority for digital signatures or providing
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the customer-provided user IDs and passwords to sign in as repository services for digital certificates.
the customer. Once the customer’s account is accessed, the
Website Hosting
aggregator copies the personal account information from the
Some financial institutions host websites for both themselves
website for representation on the aggregator’s site (i.e., “screen
as well as for other businesses. Financial institutions that host a
scraping”). Other aggregators use direct data-feed arrangements
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business customer’s website usually store, or arrange for the
with website operators or other firms to obtain the customer’s
storage of, the electronic files that make up the website. These
information. Generally, direct data feeds are thought to provide
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greater legal protection to the aggregator than does screen
files are stored on one or more servers that may be located on
the hosting financial institution’s premises. Website hosting
services require strong skills in networking, security, and
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Financial institutions are involved in account aggregation both programming. The technology and software change rapidly.
as aggregators and as aggregation targets. Risk management Institutions developing websites should monitor the need to
issues examiners should consider when reviewing aggregation adopt new interoperability standards and protocols such as
services include: Extensible Mark-Up Language (XML) to facilitate data exchange
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Protection of customer passwords and user IDs – both those among the diverse population of Internet users.
used to access the institution’s aggregation services and those Risk issues examiners should consider when reviewing website
the aggregator uses to retrieve customer information from hosting services include damage to reputation, loss of
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aggregated third parties – to assure the confidentiality of customers, or potential liability resulting from:
customer information and to prevent unauthorized activity,
Downtime (i.e., times when website is not available) or inability
Disclosure of potential customer liability if customers share to meet service levels specified in the contract,
their authentication information (i.e., IDs and passwords) with
Inaccurate website content (e.g., products, pricing) resulting
third parties, and
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Internet, electronic bill payment and presentment, electronic provider’s processing controls.
checks, e-mail money, and electronic credit card payments. Restrict employees’ administrative access to ensure that the
Additional information on payments systems can be found in internal controls limiting their capabilities to originate, modify,
other sections of the IT Handbook. or delete bill payment transactions are at least as strong as those
Most financial institutions permit intrabank transfers between a applicable to the underlying retail payment system ultimately
customer’s accounts as part of their basic transactional e- transmitting the transaction.
banking services. However, third-party transfers – with their Restrict by vendor contract and identify the use of any
heightened risk for fraud – often require additional security subcontractors associated with the bill payment application to
safeguards in the form of additional authentication and ensure adequate oversight of underlying bill payment system
payment confirmation. performance and availability.
Bill Payment and Presentment Evaluate the adequacy of authentication methods given the
Bill payment services permit customers to electronically instruct higher risk associated with funds transfer capabilities rather than
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their financial institution to transfer funds to a business’s with basic account access.
account at some future specified date. Customers can make Consider the additional guidance contained in the IT
payments on a one-time or recurring basis, with fees typically
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Handbook’s “Information Security,” “Retail Payment Systems,”
assessed as a “per item” or monthly charge. In response to the
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and “Outsourcing Technology Services” booklets.
customer’s electronic payment instructions, the financial
Financial institutions that use third-party software to host a bill
institution (or its bill payment provider) generates an electronic
payment application internally.
transaction – usually an automated clearinghouse (ACH) credit
– or mails a paper check to the business on the customer’s Determine the extent of any independent assessments or
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behalf. To allow for the possibility of a paper-based transfer, certification of the security of application source code.
financial institutions typically advise customers to make Ensure software is adequately tested prior to installation on the
payments effective 3–7 days before the bill’s due date. live system.
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Internet-based cash management is the commercial version of
retail bill payment. Business customers use the system to
Ensure vendor access for software maintenance is controlled
and monitored.
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initiate third-party payments or to transfer money between Financial institutions that develop, maintain, and host their
company accounts. Cash management services also include own bill payment system.
minimum balance maintenance, recurring transfers between
Financial institutions can offer bill payment as a stand-alone
accounts and on-line account reconciliation. Businesses typically
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funds are available and informs him or her of the methods As institutions begin to offer wireless banking services to
available to access the funds including requesting a check, customers, they should consider the risks and necessary risk
transferring the funds to an account at an insured financial management controls to address security, authentication, and
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institution, or retransmitting the funds to someone else. compliance issues. Some of the unique risk factors associated
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Person-to-person payments are typically funded by credit card with wireless banking that may increase a financial institution’s
charges or by an ACH transfer from the consumer’s account at a strategic, transaction, reputation, and compliance risks are
financial institution. Since neither the payee nor the payer in the discussed in appendix E.
transaction has to have an account with the payment service,
Security Challenges in E-banking
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such services may be offered by an insured financial institution,
Establishment of a comprehensive security control process
but are frequently offered by other businesses as well.
A comprehensive set of security policies and procedures should
Some of the risk issues examiners should consider when
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reviewing bill payment, presentment, and e-mail money services
include:
be developed based on a threat and vulnerability analysis of e-
banking assets.
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The Following are Key Elements of an Effective E-
Potential liability for late payments due to service disruptions,
Liability for bill payment instructions originating from banking
someone other than the deposit account holder, Security Process:
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Losses from person-to-person payments funded by transfers Explicit responsibility should be assigned for establishing and
from credit cards or deposit accounts over which the payee does maintaining corporate security policies
not have signature authority, Sufficient physical controls should be established to provide a
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Losses from employee misappropriation of funds held secure area to house the e-banking systems including armed
pending access instructions from the payer, and guards, CCTV with motion sensors, smoke and fire alarm
Potential liability directing payment availability information to systems, and biometric authentication like fingerprint or retina
the wrong e-mail or for releasing funds in response to e-mail scan
from someone other than the intended payee. Security profiles should be created and specific authorization
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should be performed for all perimeter devices, intrusion over public networks or stored in internal bank databases.
detection systems, applications and databases Banks can use one-way hash functions to compute and verify
Current industry security developments should be continuously checksums for in-transit or stored data. File integrity checkers are
tracked and appropriate software upgrades and service packs also useful tools to ascertain any modified files and restore last
should be installed known good copies, if required.
A rigorous background check should be performed for all Establishment of Clear audit Trails for E-banking
employees, service providers and contractors
Transactions
Authentication of e-banking customers Banks are not only challenged to ensure that effective internal
To ensure legitimate access and reduce the risk of identity theft, controls can be provided in highly automated environments,
banks should use reliable methods for verifying the identity and but also that controls can be independently audited, particularly
authorization of new and existing customers. for all e-banking events and applications. The following should
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Banks can use a variety of authentication mechanisms, including be considered, to determine if clear audit trails are maintained:
PINs, passwords, smart cards, biometrics and digital certificates. Opening, modification or closing of a customer account
Multi-factor authentication systems generally provide greater Any transaction with financial consequences
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assurance, although they may pose greater implementation
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Any authorization granted to a customer to exceed a limit
complexities. The selection of an authentication method
should be based on careful risk analysis of the e-banking Any modification in access rights and privileges of e-banking
system’s transactional capabilities, the sensitivity and value of systems
the stored e-banking data and customer’s ease of usage. Sufficient logs should be maintained for all e-banking
transactions to help establish a clear audit trail and assist in
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Measures to Ensure Segregation of Duties
By their very nature, e-banking systems and applications require dispute resolution. Also, it should be ensured that audit trails
that traditional controls should be reviewed and adapted to are not tampered with and can be used as evidence in a court of
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ensure effectiveness. To establish and maintain segregation of
duties in an e-banking environment, banks should take into
law.
Confidentiality of Bank Information
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consideration the following issues: To preserve confidentiality of key e-banking information, banks
Transaction processes and systems should be designed to should ensure that:
ensure that no single employee can enter, authorize and Data is classified into different groups and are only accessed by
complete a transaction duly authorized and authenticated individuals, agents or
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Segregation should be maintained between those developing or modification using industry standard encryption algorithms
and those administrating e-banking systems and technologies
Internal authorization controls within e-banking systems, All access to restricted data is logged and efforts are made to
applications and databases ensure that access logs are resistant to tampering
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to all individuals all privacy regulations and laws applicable to the jurisdictions to
No individual, agent or system should have the authority to which it is providing e-banking services
change his own authority or access privileges in an authorization Customers are made aware of the bank’s privacy policies
database concerning use of e-banking services
Any modification to an authorization database should be duly Customers may decline (“opt out”) from permitting the bank
authorized by an authenticated source to share with a third party for cross-marketing purposes any
Authorization databases should be resistant to tampering and information about the customer’s personal needs, interests,
corruption and sufficient audit trails should exist to document financial position or banking activity
any modification or tampering Customer data are not used for purposes beyond which they are
Data integrity of e-banking transactions and information specifically allowed or for purposes beyond which customers
have authorized
Data integrity refers to the assurance that information that is in-
transit or in storage is not altered without authorization. Banks The bank’s standards for customer data use must be met when
should ensure that appropriate measures are in place to ascertain third parties have access to customer data through outsourcing
the accuracy, completeness and reliability of e-banking relationships
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E-banking systems, applications and infrastructure are designed
and implemented keeping in mind the need for high-availability 1. What do you understand by e-banking?
for e.g., multiple redundant Internet links, routers, switches, 2. Discuss the characteristics of Internet Banking.
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web servers with an external hardware load balancing device, 3. What do you understand by Electronic Bill Payment?
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high-availability databases with fail-over, etc 4. What are Online Brokerages?
Appropriate processing alternatives for managing demand 5. Discuss Online Delivery of Financial Products.
should be developed when e-banking systems appear to be
reaching defined capacity checkpoints Notes:
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Appropriate business continuity and disaster recovery plans for
critical e-banking processing and delivery systems are in place
Regular disaster recovery drills are performed to check
effectiveness of disaster
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One of the challenges before a Bank, which is trying to become
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e - enabled is that the data is scattered across the countries.
Integration of this data is necessary if the banks have to succeed
on the net. The second challenge is related to the move towards
expanding the basket of financial products being offered by
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