CONTENTS

CHAPTER
NO.
TITLE PAGE
NO.
1 Financial Markets 1-3
1.1 Introdction 1-!
1.! T"e Ma#or O$#ecti%es o& t"is 'td( !-3
! 'ecrit( 'ca)-Introdction *-+
!.1 'ecrit( 'ca) In India-1,,1 --.
!.! 'ecrit( 'ca) In India-!//1 .-,
!.3 0TI 'ca) ,-11
!.* 1arin2s 1ank 1!-1*
!.+ T"e 1CCI A&&air 1*-1+
!.- T"e Enron Case 1+-1-
3 Financial Market Re2lation3Rationale4 15-1.
3.1 O$#ecti%e o& Financial Market Re2lation 1.-1,
3.! Financial Market Re2lation in India !/-!-
3.! 3a4 Gidelines Issed $( Reser%e 1ank o& India
&or t"e Re2lation o& Financial Markets
!/-!3
3.! 3$4 Gidelines Issed $( 'ecrities and E6c"an2e
1oard o& India &or t"e Re2lation o&
'ecrities Markets
!3-!-
3.3 Econo)ics O& Financial Market Re2lation !--35
3.33a4 T"e '(ste)ic Risk Moti%e !5-!.
3.33$4 Clearin2 And 'ettle)ent !.-3/
3.33c4 Market Li7idit( 3/-31
3.33d4 Insider Tradin2 31-3!
3.33e4 E6ternalities 3!-3*
3.33&4 T"e Cons)er Protection Moti%e 3*-3-
3.3324 Mone( Landerin2 35
* Cor8orate Go%ernance39e&ined4 3.
*.1 Cor8orate Go%ernance In Finance 3.-3,
*.! Pro$le)s O& Cor8orate Go%ernance In
Finance
*/-*1
*.3 'trate2( For I)8ro%in2 Cor8orate
Go%ernance
*1-*+
*.* Cor8orate Go%ernance In India *+-*5
+ Conclsion: Findin2s and Reco))endations *.-+1
- 1i$lio2ra8"( +!-+*
5 Glossar( ++-+-
. A88endi6
CONTENTS (TABLES)
TA1LE NO. TITLE PAGE NO.
1 'ca)s in India. +
! 'ecrit( 'ca)s in so)e 9e%elo8ed
Contries.
1!
3 Financial Market Re2lation arond t"e
;orld.
1,
*3A88endi64 Pa()ents &or 8rc"ase o& in%est)ents &or
<"ic" '$sidiar( General Led2ers and
1ank Recei8ts are not "eld drin2 secrit(
sca) o& 1,,1 in India.
+3A88endi64 1anks= s$sidiaries o& $anks and
instittions "oldin2 1ank Recei8ts and
'$sidiar( General Led2ers &or <"ic"
t"ere a88ears to $e no s&&icient $ackin2
drin2 secrit( sca) o& 1,,1 in India.
-3A88endi64 A)ont 8a(a$le $( >etan Parek"?s
Entities to $anks and co)8anies drin2
secrit( sca) o& !//1 in India.
1 Financial Markets
1.1 Introdction
The financial system consists of specialized and non-specialized
financial institutions, of organized and unorganized financial markets, of
financial instruments and services, which facilitate transfer of funds.
Procedures and practices adopted in the markets, and financial
interrelationships are also parts of this system. In product or other service
markets, purchasers part with their money in exchange for something now.
In finance, money now is exchanged for a promise to pay in the future.
!owever, in product or service markets, if the o"#ect sold $ from a car to a
haircut $ is defective, the "uyers often find out relatively soon.
%
&n the other
hand, loan 'uality is not readily o"serva"le for 'uite some time and can "e
hidden for extensive periods. (oreover, "anks and non-"ank financial
intermediaries can also alter the risk composition of their assets more
'uickly than most non-financial industries, and "anks can readily hide
pro"lems "y extending loans to clients that cannot service previous de"t
o"ligations. Theoretically, the financial market facilitates allocation of
resources efficiently, which involves 'uick dissemination of information and
reaction to it.
The financial markets are suscepti"le to manipulation as some
participants have information that others do not that is information
asymmetry is u"i'uitous in financial markets. To overcome this pro"lem
corporate governance is re'uired to ensure that suppliers of finance to
corporations are assured that they get their return on their investment
)
.
*espite the existence of institutional and legal framework numerous
financial scams continue to "e perpetuated "oth in developed and developing
countries.
1.! T"e o$#ecti%es o& t"is std( are :
a+ To examine some of the ma#or misdemeanors which perpetuated in the
financial system in %,,% and )--% in India .
%
.aprio, /erard 0r. and 1oss 2evine, Corporate Governance In Finance: Concepts and International
Observations3)--)+
)
4nderei 5heleifer and 1o"ert 6ishny 3%,,7+ 84 5urvey of .orporate /overnance9
"+ :nderstand the financial regulatory measures which have "een adopted
after the %,,% share scam in India and why despite such measures adopted
security scam has recurred in )--%.
c+ ;xamine the theoretical structure of corporate governance for analyzing
security scams that have occurred in the %,,-s and the new millennium.
The second section contains a summary of the events that occurred leading
to the share scams and financial frauds in India and a"road during the recent
decade that shook the financial markets. The third section surveys the
rationale for regulation of securities markets and the functional procedures
adopted in India in the aftermath of the scams. The fourth section looks at
the theoretical underpinnings of corporate governance which, is followed "y
a discussion of the shortcomings of the regulatory set up in India which fails
to prevent the recurrence of financial misdemeanors.
<inancial 2i"eralization is a phenomenon that is almost all pervasive in the
world today. =hile li"eralization has led to su"stantial "enefits in terms of
increased transparency, it has ushered in opportunities of corporate
misgovernance. This implies that the mechanism "y which legal institutions
ensure that suppliers of funds receive the return on investment is not
sufficient or appropriate. 1ecent trends through the %,,-s in India and
a"road reveal how corporate governance has not "een effective permitting
unscrupulous and opportunistic individuals to manipulate the market in their
favor. The process of financial market regulation ensures that important
guidelines are issued regarding how primary dealers 3"rokers+ should
operate with regards to mode of operation, conduct, litigation, amount of
"usiness to "e handled, management of risk, internal control etc.
These security scams and financial scandals discussed here involved
the manipulation of huge amounts of money. The perpetrators of these gross
transgression had such a comprehensive knowledge of how the system
worked that they manipulated it to their advantage operating in an
opportunistic manner
>
. The essence of the argument in is that the occurrence
and reoccurrence of such security scams and financial scandals can "e
attri"uted to a failure of corporate governance in finance
?
despite the
existence of an functioning regulatory authority empowered with the legal
sanctions.
! 'ecrit( 'ca): Introdction
4 security scam has the following features@
a+manipulation in share prices.
"+monopoly in dealing with a huge num"er of shares of a company.
c+money laundering-"orrowing money to trade in securities "ut using the
funds for unconnected purposes.
A
4ccording to the 5ecurities ;xchange
4ct3%,>?+5;4-BIt shall "e unlawful for any person to engage in any act,
practice or course of action which operates or would operate as a fraud or
deceit upon nay person in connection with the purchase or sale of a
security.B =hile understanding the causes or possi"le mechanisms "y which
>
(achira#u !.1. 8,Indian <inancial 5ystem9 3%,,7+
?
5anyal. 5ree#ata, 1egulation of 5ecurities (arkets in India9%,,7, Ph.*.
A
B5ecurities and ;xchange .ommission@ 5ecurities fraud and insider tradingB, Palgraves9 *ictionary &f (oney 4nd
<inance 3%,,?+
a security scam takes places we can on a parallel plane understand the
motives for financial market regulation otherwise called the economics of
financial market regulation. There is a certain systemic risk involved if
"rokers or "anks get into settlement pro"lems during the process of
transacting in securities. If so, it results in a domino effect, which could
create pro"lems for other "anks and "rokers in the system. 4 systemic risk
also can occur when there is not enough li'uidity in the system due to very
few "rokers, monopolizing in the transaction of a security. 4lso insider
trading is another pro"lem when traders who are insiders to an organization
trade when they have superior knowledge which is considered unfair and an
extension of asymmetric information. 4lso concentration tendencies of
traders towards dealing in one security only should "e avoided. There is also
a consumer protection to ensure that the price formation process is efficient
as possi"le and also to ensure sufficient competition among traders, "rokers
and other market participants.
Ta$le 1:'ca)s in India
@ear Aicti) Per8etrator Mec"anis) Econo)ics O&
Financial Market
Re2lation
Misde)eanor
%,,% Pu"lic "uyers
of shares of
companies
dealt with "y
manipulators,
Cational
!ousing
Dank3C!D+
5tate Dank
&f
5aurashtra
5DI .apital
(arkets
2td35DI
.aps+
5tandard
.hartered
Dank
!arshad
(ehta,!iten
*alal, Datliwala
E Farani
,(Gs 6.D. *esai
, C.F.
4ggarwala E
.o., (ukesh
Da"u etc.
Dorrow money from "anks
on a ready forward "asis
thus violating 1DI
guidelines and dealing in
security transactions with
"anks where issue of "ank
receipts and 5/2 forms
were not supported "y
genuine holding of
securities
H
.learing and
settlements
pro"lem35ystemic
1isk+,(oney
2aundering
)--% Pu"lic,Duyer
s of shares of
companies
dealt with "y
manipulators,
:TI,((.D,
.alcutta
5tock
;xchange
Fetan Parekh 5ame as a"ove "ut in this
case much of the
transactions had taken place
through companies owned
"y Fetan
Parekh,<IIIs3<oreign
Institutional
Investors,Danks ,0nit
Trst O& India
7
.learing and
5ettlement
Pro"lem,(oney
2aundering
!.1 'ecrit( 'ca) In India-1,,1
In 4pril %,,), press reports indicated that there was a shortfall in the
/overnment 5ecurities held "y the 5tate Dank of India. Investigations
H
Ta"le ? and A34ppendix+
7
Ta"le H34ppendix+
uncovered the tip of an ice"erg, later called the securities scam, involving
misappropriation of funds to the tune of over 1s. >A-- .rores
J
. The scam
engulfed top executives of large nationalized "anks, foreign "anks and
financial institutions, "rokers, "ureaucrats and politicians@ The functioning
of the money market and the stock market was thrown in disarray. The
tainted shares were worthless as they could not "e sold. This created a panic
among investors and "rokers and led to a prolonged closure of the stock
exchanges along with a precipitous drop in the price of shares. 5oon after the
discovery of the scam, the stock prices dropped "y over ?-K, wiping out
market value to the tune of 1s. %--,--- crores. The normal settlement
process in government securities was that the transacting "anks made
payments and delivered the securities directly to each other. The "rokerIs
only function was to "ring the "uyer and seller together. *uring the scam,
however, the "anks or at least some "anks adopted an alternative settlement
process similar to settlement of stock market transactions. The deliveries of
securities and payments were made through the "roker. That is, the seller
handed over the securities to the "roker who passed them on to the "uyer,
while the "uyer gave the che'ue to the "roker who then made the payment to
the seller. There were two important reasons why the "roker intermediated
settlement "egan to "e used in the government securities markets@
L The "rokers instead of merely "ringing "uyers and sellers together started
taking positions in the market. They in a sense imparted greater li'uidity to
the markets.
L =hen a "ank wanted to conceal the fact that it was doing an
,
1eady
<orward deal, the "roker came in handy. The "roker provided contract notes
J
5tock market 5cam in India of %,,%@The 0anakiraman .ommittee 1eport
,
/lossary3*efinition+
for this purpose with fictitious counterparties, "ut arranged for the actual
settlement to take place with the correct counterparty. This allowed the
"roker to lay his hands on the che'ue as it went from one "ank to another
through him. The hurdle now was to find a way of crediting the che'ue to
his account though it was drawn in favour of a "ank and was crossed
account payee. It is purely a matter of "anking custom that an account payee
che'ue is paid only to the payee mentioned on the che'ue. In fact, privileged
3corporate+ customers were routinely allowed to credit account payee
che'ues in favour of a "ank into their own accounts to avoid clearing delays,
there"y reducing the interest lost on the amount. The "rokers thus found a
way of getting hold of the che'ues as they went from one "ank to another
and crediting the amounts to their accounts. This effectively transformed an
1< into a loan to a "roker rather than to a "ank. Dut this, "y itself, would not
have led to the scam "ecause the 1< after all is a secured loan, and a secured
loan to a "roker is still secured. =hat was necessary now was to find a way
of eliminating the security itself.
Three routes adopted for this purpose were@
L 5ome "anks 3or rather their officials+ were persuaded to part with che'ues
without actually receiving securities in return. 4 simple explanation of this is
that the officials concerned were "ri"ed andGor negligent. 4lternatively, as
long as the scam lasted, the "anks "enefited from such an arrangement. The
management of "anks might have "een sorely tempted to adopt this route to
higher profita"ility.
L The second route was to replace the actual securities "y a worthless piece
of paper $ a fake
%-
Dank 1eceipt 3D1+. 4 D1 like an I&: has only the
%-
/lossary3*efinition+
"orrowerIs assurance that the "orrower has the securities which canGwill "e
delivered ifGwhen the need arises.
L The third method was simply to forge the securities themselves. In many
cases, P5: "onds were represented only "y allotment letters rather than
certificates on security paper. !owever, it accounted for only a very small
part of the total funds misappropriated. *uring the scam, the "rokers
perfected the art of using fake D1s to o"tain unsecured loans from the
"anking system. They persuaded some small and little known "anks $ the
Dank of Farad 3D&F+ and the (etropolitan .ooperative Dank 3(.D+ - to
issue D1s as and when re'uired. These D1s could then "e used to do 1<
deals with other "anks. The che'ues in favour of D&F were, of course,
credited into the "rokersI accounts. In effect, several large "anks made huge
unsecured loans to the D&FG(.D which in turn made the money availa"le
to the "rokers.
!.! 'ecrit( 'ca) in India-!//1
In 5pite of the recommendations made "y the 0anakiraman .ommittee
1eport in %,,) to prevent security scams from happening in the future
another security market took place in )--%. This involved the actions of one
ma#or player "y the name of Fetan Parekh. !e manipulated a large amount
of funds in the capital market though a num"er of his own companies which
is pro"a"ly why the scam remained a mystery for 'uite some time the
1DI,5;DI and *.43*epartment &f .ompany affairs+ had gone slack in
their regulatory operations.*uring %,,, and )--- the 5;C5;M reached a
high and after than the stock market crashed in )--%.5ome of the ma#or
companies he invested in were
%%
Cirma, 4dani /roup, ;ssel /roup,*5N and
%%
4ppendix@/raphical ;vidence &f 5ecurity 5cam in India In )--%
Oee .adila.Fetan Parekh manipulated the stock market through <IIIs
3<oreign Institutional Investors+, &.DIs 3&verseas .ommercial
Dorrowings+,Danks and (utual <unds3:nit Trust &f India+. In fact an
important extension of this scam remains the :nit Trust &f India 5cam.
!.3 0TI 'ca)
&f all the recent encounters of the Indian pu"lic with the much-cele"rated
forces of the market, the :nit Trust9s :5-H? de"acle is the worst
%)
. Its
gravity far exceeds the stock market downswing of the mid-%,,-s, which
wiped out 1s. )-,--- crores in savings.
%>
The de"acle is part of the recent
economic slowdown which has eliminated one million #o"s and also "urst
the information technology 3IT+ "u""le. This has tragically led to suicides "y
investors. 4nd then suspension of trading in :5-H?made the hapless
investors more de#ected at the sinking of this Bsuper-safeB pu"lic sector
instrument that had delivered a regular return since %,H?. There is a larger
lesson in the :5-H? de"acle for policies towards pu"lic savings and pu"lic
sector undertakings 3P5:s+. The :5-H? crisis is rooted in plain
mismanagement. :5-H? was launched as a steady income fund. 2ogically, it
should have invested in de"t, especially low-risk fixed-income government
"onds. Instead, its managers increasingly invested in e'uities, with high-risk
speculative returns.In the late %,J-s :TI was BpoliticisedB with other
financial institutions 3<Is+ such as 2I. and /I., and made to invest in
certain favoured scrips. Dy the mid-%,,-s, e'uities exceeded de"t in its
portfolio. The <Is were also used to B"oost the marketB artificially as an
BendorsementB of controversial economic policies. In the past couple of
%)
0oint Parliamentary .ommittee 1eport3)--%+
%>
www.hinduonnet,com
years, :TI made downright imprudent "ut heavy investments in stocks from
Fetan Parekh9s favourite F-%- portfolio, such as !imachal <uturistic, /lo"al
Tele and *5N. These BtechnologyB investments took place despite
indications that the Btechnology "oomB had ended. :5-H? lost half its 1s.
>-,--- crore portfolio value within a year. :TI sank 1s. >,?-- crores in #ust
six out of a portfolio of ?? scrips. This eroded "y H- percent. ;arly this year,
:5-H?9s net asset value plunged "elow par 31s.%-+. Dut it was re-purchasing
:5-H? a"ove 1s. %?P Today, its C46 stands at 1s. J.>- - a massive loss for
%> million unit-holders.It is inconceiva"le that :TI made these fateful
investment decisions on its own. 4ccording to insiders, the <inance (inistry
su"stantially influenced them@ all ma#or decisions need high-level political
approval. Indeed, collusion "etween the <Is, and shady operators like
!arshad (ehta, was central to the 5ecurities 5cam of %,,). The 0oint
Parliamentary .ommittee9s report documents this. In recent months, the
<inance (inistry "ecame desperate to reverse the post-Dudget market
downturn. :TI9s misinvestment now coincided with the glo"al technology
Bmeltdown.B :5-H? crashed. :TI chairman resigned. 4lthough culpa"le, he
was pro"a"ly a scapegoat too. The (inistry has kept a close watch on :TI,
especially since %,,,.The :5-H? de"acle, then, is not #ust a :TI scam. It is a
governance scam involving mismanagement "y a government frustrated at
the failure of its macroeconomic calculations. This should have ensured the
<inance (inister9s exit in any democracy which respects parliamentary
norms. There are larger lessons in the :TI de"acle. If a well-esta"lished, and
until recently well-managed, institution like :TI cannot safeguard pu"lic
savings, then we should not allow the most precious of such savings -
pensions - to "e put at risk. 5uch risky investment is "anned in many self-
avowedly capitalist ;uropean economies. In India, the argument ac'uires
greater force given the poorly regulated, extremely volatile, stock marketQ
where a dozen "rokers control ,- percent of trade. Ret, there is a proposal "y
the <inance (inistry to privatize pensions and provident funds. Dasically,
the government, deplora"ly, wants to get rid of its annual pension o"ligation
of 1s. )),--- crores.
Ta$le !:'ecrit( 'ca)s in so)e 9e%elo8ed Contries
@ear Contr( Aicti) Per8etrator Mec"anis) Misde)eanor in
Econo)ics o&
&inancial
re2lation?
%,,A :.F. Darings
Dank
Cick 2eeson ;xcessive ar"itraging
in futures trading
"etween the 5ingapore
(onetary
;xchange35I(;M+
and &saka 5tock
;xchange3&5;+
5ystemic
1isk,5ettlements
Pro"lem
)--% :.5.4. ;nron ;nron
;xecutives
(anufacture losses "y
mismanagement of
capital structure
through 5P;s 35pecial
Purpose
;ntities+,hiding losses,
keeping de"t off "ooks
Insider
Trading,Dad
4ccounta"ility
%,,- 2uxem"urg D..I
and
5heikh
Oayid of
4"u
*ha"i

The owner
4gha !asan
4"edi and two
shipping
magnates from
Pakistan The
/okal Drothers
Inflating loans from
the "ank "y the two
"rothers for their
shipping "usness,
ar"itraging in
derivatives market of
/ulf through The
D..I-/ulf Transport
/roup consortium
which lead to huge
losses
(oney
2aundering,,
5ystemic 1isk
!.* 1arin2s 1ank
The aftermath of the "ankruptcy of Darings Dank provides an excellent case
study of
%?
systemic risk. 1epresentative Those who cite Darings as an
example of derivatives causing market failures point to the fact that the
authorities in 5hanghai temporarily closed its "ond-futures market and told
investors to wind down positions in an attempt to limit damage from a
trading scandal. In addition, they argue that Bif anything, the Darings name
may have contri"uted to its undoing, if it turns out to have "een the "ankIs
familiarity that "linded the authorities at 5ingaporeIs futures exchange to the
enormous wrong-way "et its trader made on the future direction of 0apanIs
Cikkei average.B 4 closer look at the reaction of market participants and
volatility after the fall may provide insight into the magnitude of the
contagion effect. DaringsI young trader Cicholas 2eeson was supposed to "e
%?
I;conomics &f <inancial (arket 1egulationI-.hapter >.) Ciemeyer,0onas, =here to /o after
the 2amfalussy 1eportS4n ;conomic 4nalysis of 5ecurities (arket 1egulation and
5upervision3)--%+
Bar"itragingB, seeking to profit from differences in the prices of Cikkei-))A
futures contracts listed on the &saka 5ecurities ;xchange 3&5;+ in 0apan
and 5ingapore (onetary ;xchange 35I(;M+. 5uch ar"itrage involves
"uying futures contracts on one market and selling them on another. 5ince
the margins on this are small, the volumes traded "y ar"itrageurs tend to "e
large. !owever, this strategy is not very risky@ a long position in one market
3"etting on a rise+ is offset "y a short position 3"etting on a fall+ in the other+.
!owever, in addition to ar"itraging the &saka ;xchange and the 5I(;M, as
far "ack as 5eptem"er %,,?, 2eeson "egan to simultaneously sell put options
and call options on Cikkei-))A futures. This type of deal is known as a
Bstraddle.B If the market is less volatile than the options prices predict, the
seller makes a profit. !owever, as a result of the Fo"e earth'uake, the
Cikkei-))A fluctuated and 2eeson "egan to exponentially increase the size
of his open positions. Dy trading on a fraudulent account, num"ered JJJJJ,
2eeson "egan to "uy futures on a large scale in an attempt to almost single-
handedly push up the Cikkei ))A. This proved unsuccessful and eventually
2eesonIs losses were so large the "ank eventually collapsed. 4 life"oat "y
the Dank of ;ngland was not feasi"le due to the fact that many of the
derivatives were impossi"le to wind down immediately, as the options did
not expire for months. =hile this case has "een widely cited as providing
evidence of a market failure, others argue that the systemic risk from the loss
was minimal. &thers argue that in the event of a via"le threat of systemic
risk, the Dank of ;ngland would have "ailed out Darings Dank, "ut the
precise magnitude of the systemic risk is not known. 1eports in the =all
5treet 0ournal immediately following the collapse of Darings express that the
markets were BshakenB "ut provide no 'uantifia"le estimate of the effect of
the collapse.
!.+ T"e 1CCI 3T"e 1ank O& Credit and Co))erce International4
A&&air
The perpetrators in this case were two "rothers,the /okal "rothers, who were
shipping magnates. The fraudulent "rothers and D..IIs founder 4gha !asan
4"edi, shared the confidence of a new world "alance of power centered on
the massive (iddle ;ast oil deposits. 4gha !asan 4"edi went as far as to
fund a very reada"le "usiness magazine called 5&:T! which was a
welcome relief from the :54 propaganda to "e found in TI(; and
C;=5=;;F. D..IIs loans through 4gha !asan 4"edi to the "rothers
shipping "usiness were inflated, and their 'uality was upgraded "y forgery.
The fraud went on for over a decade.. The D..I-/ulf Transport /roup
consortium wanted to dip their fingers into the coffers of one of their "est
sponsors, 5heikh Oayid of 4"u *ha"i. The reason for this was the financial
hole left "y huge losses suffered "y /ulf on the derivatives market. It is
certainly true that 5heikh Oayid started to pick up the losses in %,,-. This
leaves open the argument of many muslims that the "ank did not have to fail.
There is also deception in the way that one of the perpetrators was "rought
to #ustice. !e was flying to the :54 in order to clear himself of lia"ility for
a""etting in the production of a Pakistani nuclear "om". 4lmost any high-
tech metallurgy going to a third world country is suspect. In the same way
developments of high tech chemical refining processes or pharmaceutical
products in the Third =orld are accused of forwarding chemical warfare or
illicit drug refining ventures. The perpetrator took the plane from Farachi to
Cew Rork in l,,?. Dritish police arrested him during a refuelling stop at
<rankfurt.
!.- T"e Enron Case
4t the heart of ;nronIs demise was the creation of partnerships with shell
companies, these shell companies, run "y ;nron executives who profited
richly from them, allowed ;nron to keep hundreds of millions of dollars in
de"t off its "ooks. Dut once stock analysts and financial #ournalists heard
a"out these arrangements, investors "egan to lose confidence in the
companyIs finances. The results@ a run on the stock, lowered credit ratings
and insolvency. 4ccording to claims and counter-claims filed in *elaware
court hearings3of the ;nron .ase+T many of the most prominent names in
world finance - including .itigroup, 0P (organ .hase, .ID., *eutsche
Dank and *resdner Dank - were still involved in the partnership, directly or
indirectly, when ;nron filed for "ankruptcy. &riginally, it appears that
initially ;nron was using
%A
5P;Is35pecial Purpose ;ntities+ appropriately "y
placing non energy-related "usiness into separate legal entities. =hat they
did wrong was that they apparently tried to manufacture earnings "y
manipulating the capital structure of the 5P;sT hide their lossesT did not have
independent outside partners that prevented full disclosure and did not
disclose the risks in their financial statements. There should "e no
interlocking management@ The managers of the off "alance sheet entity
cannot "e the same as the parent company in order to avoid conflicts of
interest. The ownership percentage of the off "alance sheet entity should "e
higher than >K and the outside investors should not "e controlled or
affiliated with the parent@ This was clearly not the case at ;nron. ;nron, in
order to circumvent the outside ownership rules funneled money through a
series of partnerships that appeared to "e independent "usinesses, "ut which
%A
/lossary
were controlled "y ;nron management. The scope and importance of the off-
"alance sheet vehicles were not widely known among investors in ;nron
stock, "ut they were no secret to many =all 5treet firms. Dy the end of %,,,,
according to company estimates, it had moved U)7"n of its total UH-"n in
assets off "alance sheet.
These security scams and financial scandals examined in the section a"ove
involved the manipulation of huge amounts of money. The purpose of the
traders or investors was not genuine. The perpetrators had such a
comprehensive knowledge of how the system worked that they manipulated
it to their advantage operating in an opportunistic manner
%H
. The crux of the
argument in this work is that the occurrence and reoccurrence of such
security scams and financial scandals can "e attri"uted to a failure of
corporate governance in finance
%7
despite the existence of an functioning
regulatory authority empowered with the legal sanctions.
3 Financial Market Re2lation 3Rationale4
The nature of securities markets is such that they are inherently suscepti"le
to failures due to the existence of information asymmetries and existence of
high transaction costs 5anyal 3%,,7+. It needs to "e emphasized that when
securities markets come into existence, the interest of the mem"er "rokers
are taken care of through margin re'uirements, "arriers to entry of
%H
"Securities Exchange Commission:Securities Fraud and Insider Trading",Palgraves *ictionary &n
(oney 4nd <inance3%,,)+
%7
5anyal. 5ree#ata, 1egulation of 5ecurities (arkets in India9%,,7, Ph.*.
mem"ership, listing agreements. !owever the investorsGclients who "uy and
sell via their "rokers are not a"le to form an organization to safeguard their
interests due to the cost of creation of such organizations and free rider
pro"lems. The distinctive nature of the market can "e o"served with
reference to the commodity, its 'uality, the system of transactions and the
participants in the market, as follows@
3a+ the commodity3the security+has a life to perpetuity.
3"+ while the outcome of the contract say the redemption of de"t is certain,
in the case of the government, it is not always so in the case of a private de"t
instrument, hence uncertainty comes into focus.
3c+ the 'uality of private de"t instrument is uno"serva"le and hence, it is the
trust reposed on the trader or the issuer that is the decisive factor, here the
pro"lem of information comes into focus.
3d+ in any securities market in any transaction or deal there are at least four
participants, two clients and two "rokers. The "rokers negotiate deals with
each other on "ehalf of their clients and thus the pro"lem of transaction cost
comes into focus. =hen there is so much scope for failure and opportunism,
there appears to "e su"stantial ground for prescri"ing an institution that
oversees the market at different stages to ensure its relia"ility, efficiency and
itIs very existence.
3.1 O$#ecti%e o& Financial Market Re2lation
The o"#ective of regulation and supervision is to facilitate the efficient and
fair performance of economic functions, "ut a practical regulatory structure
must deal with 3and will influence+ the products and institutions through
which those functions are performed. This creates considera"le complexities
"ecause there is no uni'ue relationship "etween functions, products, and
institutions. 5everal products might perform the same function, some
functions might involve several products, institutions can provide a range of
products, and these relationships can "e changing over time, in response to
technological change and in ways influenced "y the existing regulatory
structure. &ne focus of financial regulation is upon the characteristics of
financial products, which are explicit or implicit contracts "etween parties,
entered into with certain expectations on the "asis of information held "y
those parties. <inancial regulation stems in large part from the undesira"le
conse'uences of participants entering contracts with inappropriate
expectations "ased on imperfect information. Participants may "e una"le to
o"tain information to appropriately evaluate the a"ility of a counter-party to
meet a contractual o"ligation 3such as payment of an insurance "enefit+, or
may "e given incorrect information which leads them to form inappropriate
expectations of performance 3such as of a managed fund+. :ltimately, the
focus of a regulatory structure must "e on the welfare of the end users.
<inancial products are contracts "etween two parties, issued under specific
legal arrangements. =hile there may "e an argument that individuals have a
BnaturalB right to enter into such contracts as deposit takers, there is no
BnaturalB right possessed "y institutions, which allows them to do so. That is
recognized internationally "y financial legislation of most nations, which
impose certain socially determined criteria upon institutions 3institutional
form, identity of owners, competence of managers, compliance with
prudential standards etc.+ if they are to "e allowed to undertake such
activities. 4lso they should "e a good incentive structure for providing
information in financial markets as information is very important to the
investor. &ften investors find it difficult to evaluate the 'uality of the
security or service offered which calls for an intermediary to disseminate
information and services that have to "e regulated. 1egulations also prevent
monopoly of capital markets which otherwise #eopardize the market
mechanism.
!ere is a ta"le indicating regulatory "odies of financial markets
around the world.
Ta$le 3:Financial Market Re2lation arond t"e ;orld
Contr( Re2lator( 1od(
India 1DI31eserve Dank &f India+,5;DI35ecurities ;xchange Doard of
India+
:nited Fingdom 5ID35ecurities Investment Doard+
Cetherlands 5ecurities Doard
:.5.4. 5;.35ecurities ;xchange .ommission+
4 security scam involves the manipulation of funds in the capital market
which could involve the usage of funds for highly speculative purposes
resulting in the monopolization of capital market, trading in shares with
money not used for their actual purpose etc.

3.! Financial Market Re2lation in India
3.2 (a) Gidelines Issed $( Reser%e 1ank o& India &or t"e Re2lation o&
Financial Markets
%+ (anagement oversight, policyGoperational guidelines
%J
- The
management of a Primary *ealer should "ear primary responsi"ility
for ensuring maintenance of appropriate standards of conduct and
adherence to proper procedures "y the entity. Primary *ealers 3P*+
should frame and implement suita"le policy guidelines on securities
transactions. &perational procedures and controls in relation to the
day-to-day "usiness operations should also "e worked out and put in
place to ensure that operations in securities are conducted in
accordance with sound and accepta"le "usiness practices. =ith the
approval of respective Doards, the P*s should clearly lay down the
"road o"#ectives to "e followed while undertaking transactions in
securities on their own account and on "ehalf of clients, clearly define
the authority to put through deals, procedure to "e followed while
putting through deals, and adhere to prudential exposure limits, policy
regarding dealings with "rokers, systems for management of various
risks, guidelines for valuation of the portfolio and the reporting
systems etc. =hile laying down such policy guidelines, the Primary
*ealers should strictly o"serve 1eserve Dank9s instructions on the
following@
%+ 1eady <orward deals
)+ Transactions through 5/2 4ccount
>+ Internal .ontrolsG1isk (anagement 5ystem
?+ *ealings through Drokers
A+ 4ccounting 5tandards
H+ 4udit, 1eview and 1eporting
%J
www.r"i.org.in
4ny other instructions issued from time to time The internal policy
guidelines on securities transactions framed "y the P*, duly certified "y its
management to the effect that they are in accordance with the 1DI
guidelines and that they have "een put in place, may "e perused "y the
5tatutory 4uditors and commented upon as to the conformity of the
guidelines with the instructionsGguidelines issued "y 1DI. The effectiveness
of the policy and operational guidelines should "e periodically evaluated.
)+ Prohi"ition of short selling of securities - The Primary *ealers should not
put through any sale transaction without actually holding the security in its
portfolio i.e. under no circumstances, a P* should hold a oversold position
in any security.
>+ .oncurrent audit of securities transactions - 5ecurities transactions should
"e separately su"#ected to a concurrent audit "y internalGexternal auditors to
the extent of %--K and the results of the audit should "e placed "efore the
.;&3.hief &perating &fficer+G .(*3.hief (anaging *irector+ of the P*
once every month. The compliance wing should monitor the compliance on
ongoing "asis, with the laid down policies and prescri"ed procedures, the
applica"le legal and regulatory re'uirements, the deficiencies pointed out in
the audits and report directly to the management.
?+ 4ll pro"lem exposures where security of dou"tful value, diminution of
value to "e provided for - 4ll pro"lem exposures, if any, which are not
"acked "y any security or "acked "y security of dou"tful value should "e
fully provided for.
A+ Provision also for suits under litigation - ;ven in cases where a P* has
filed suit against another party for recovery, such exposures should "e
evaluated and provisions should "e made to the satisfaction of auditors.
H+ .laims against the P* to "e taken note of and provisions made - 4ny
claim against the P* should also "e taken note of and provisions made to the
satisfaction of auditors.
7+ Pro"lem exposures to "e reflected clearly in Profit and 2oss 4ccount -
The profit and loss account should, reflect the pro"lem exposures, if any, as
also the effect of valuation of portfolio, as per the instructions issued "y the
1eserve Dank, if any, from time to time. The report of the statutory auditors
should contain a certification to this effect.
J+ Dusiness through "rokers and contract limits for approved "rokers - 4
disproportionate part of the "usiness should not "e transacted through only
one or a few "rokers. P*s should fix aggregate contract limits for each of the
approved "rokers. 4 limit of AK, of total transactions 3"oth purchase and
sales+ entered into "y a P* during a year should "e treated as the aggregate
upper contract limit for each of the approved "rokers. This limit should
cover "oth the "usiness initiated "y a P* and the "usiness offeredG"rought to
the P* "y a "roker. P*s should ensure that the transactions entered into
through individual "rokers during a year normally does not exceed this limit.
!owever, the norm would not "e applica"le to P*9s dealings through other
Primary *ealers.
,+ Investments in and :nderwriting of 5hares, *e"entures and P5: Donds
and Investments in :nits of (utual <unds-/uidelines. P*s should
formulate, within the a"ove parameters, their own internal guidelines, as
approved "y their Doard of *irectors, on securities transactions either "y
directly su"scri"ing or through secondary market with counter-party or
counter-party group, including norms to ensure that excessive exposure
against any single counter-party or group or product is avoided and that
due attention is given to the maturity structure and the 'uality of such
transactions. The P*s will also need to take into account the fact that
such securities are su"#ect to risk weight and necessary depreciation has
to "e fully provided for.
%-+ (aterial changes in circumstances - The P*s should report any material
changes in circumstances such as change in the ownership structure,
"usiness profile, organization etc. affecting the conditions of licensing as
P* to 1DI immediately.
3.! 3$4 Gidelines Issed $( 'ecrities and E6c"an2e 1oard o& India &or
t"e Re2lation o& 'ecrities Markets
14Pro"i$ition o& certain dealin2s in secrities
a+ Co person shall "uy, sell or otherwise deal in securities in a fraudulent
manner.
!4Pro"i$ition a2ainst Market Mani8lation
Co person shall -
3a+ effect, take part in, or enter into, either directly or indirectly,
transactions in securities, with the intention of artificially raising or
depressing the prices of securities and there"y inducing the sale or
purchase of securities "y any personT
3"+ indulge in any act, which is calculated to create a false or
misleading appearance of trading on the securities marketT
3c+ indulge in any act which results in reflection of prices of securities
"ased on transactions that are not genuine trade transactionsT
3d+ enter into a purchase or sale of any securities, not intended to
effect transfer of "eneficial ownership "ut intended to operate only as
a device to inflate, depress, or cause fluctuations in the market price of
securitiesT
3e+ pay, offer or agree to pay or offer, directly or indirectly, to any
person any money or moneyIs worth for inducing another person to
purchase or sell any security with the sole o"#ect of inflating,
depressing, or causing fluctuations in the market price of securities
%,
.
34 Pro"i$ition o& )isleadin2 state)ents to indce sale or 8rc"ase o&
secrities
Co person shall make any statement, or disseminate any information which -
3a+ is misleading in a material particularT and
3"+ is likely to induce the sale or purchase of securities "y any other
person or is likely to have the effect of increasing or depressing the
market price of securities, if when he makes the statement or
disseminates the information-
%,
http@GGwww. se"i.gov.in
3i+ he does not care whether the statement or information is true
or falseT or
3ii+ he knows, or ought reasona"ly to have known that the
statement or information is misleading in any material
particular.
Cothing in this su"-regulation shall apply to any general comments made in
good faith in regard to -
3a+ the economic policy of the /overnment,
3"+ the economic situation in the country,
3c+ trends in the securities markets, or
3d+ any other matter of a similar nature, whether such comments "e made
in pu"lic or in private.
*4 Pro"i$ition on n&air trade 8ractice relatin2 to secrities
Co person shall -
3a+ in the course of his "usiness, knowingly engage in any act, or
practice which would operate as a fraud upon any person in
connection with the purchase or sale of, or any other dealing in, any
securitiesT
3"+ on his own "ehalf or on "ehalf of any person, knowingly "uy, sell
or otherwise deal in securities, pending the execution of any order of
his client relating to the same security for purchase, sale or other
dealings in respect of securities.
Cothing contained in this clause shall apply where according to the
clients instruction, the transaction for the client is to "e effected only
under specified conditions or in specified circumstancesT
3c+ intentionally and in contravention of any law for the time "eing in
force delays the transfer of securities in the name of the transferee or
the dispatch of securities or connected documents to any transfereeT
3d+ Indulge in falsification of the "ooks, accounts and records
3whether maintained manually or in computer or in any other form+T
3e+ =hen acting as an agent, execute a transaction with a client at a
price other than the price at which the transaction was executed "y
him, whether on a stock exchange or otherwise, or at a price other
than the price at which it was offset against the transaction of another
client
3.3 Econo)ics o& Financial Market Re2lation
This section includes the motives "ehind financial market regulation. There
are several factors which motivate financial market regulation. &ne
if them is the systemic risk .Individual agents take into
consideration only the private cost and often forget the social cost
involved in their transactions.If one trader finds difficulty in
delivering the proposed security under consideration it could set a
chain or reactions which could affect several other traders in the
system.5o will "e the case if "anks get into settlement pro"lems or
failures.It could affect several other "anks and traders in the
system.4lso it should "e ensured that there is enough li'uidity in
the system. This can "e allowed "y making sure that there is perfect
competition and removing "arriers to entry-the more traders in the
system, more li'uidity. 4lso insider trading should "e prohi"ited-i.e
when some traders possess superior information than other which
cause the latter to get su"optimal returns in transactions. This can
"e corrected "y having an investment "anker to mediate "etween
traders and ensuring an ade'uate supply of information. Insider
trading allows people to manipulate with prices and cause
monopolised holding of shares. 4s more and more traders access
the system it leads to "enefits3positive externalities+ to all as
opposed to monopoly. 5uch a monopoly condition is more a
characteristic of security markets "ecause of the associated low
transaction costs and greater regulation which raise the "arriers to
entry. 4lso these is need for consumer protection to ensure that the
price formation process is as efficient as possi"le. .onsumers are
"etter off in a more efficient market than a less efficient one. 4
more efficient market can "e ensured "y reducing asymmetric
information. Principal agent relationships are common in securities
markets. 1etail investors typically invest in different funds and
other financial services firms. !ere the former are principals and
the latter agents. It is essentially than in all transactions agents do
not deviate from what they are "ound to so as mentioned in the
contract. 4lso money which is used for the transaction of securities
should not "e used for any king of personal "enefit of traders nor
should drug traders or criminals "e allowed to trade in securities
there"y allowing themselves to perpetuate their evil deeds.
3.3 a4T"e '(ste)ic Risk Moti%e
The prime o"#ective of most existing financial regulation and supervision is
to ensure that no systemic risks will threaten the financial system.
)-
In
principle, there are two assumptions underlying the concept of systemic risk.
The first assumption is the existence of a market failure, often in terms of an
externality. The individual agents only take the private costs into account
and any potential social cost Vor "enefitW is not incorporated in the decision
making of the agents. <or instance, if one trader encounters pro"lems in
delivering the securities after a trade, pro"lems may easily spread to other
agents through the settlement system. The existence of an externality is
however not enough to create a systemic risk. The scope of the effect is also
at hand. The second assumption is "ased on the notion that if pro"lems
occur, they would damage the financial system to such an extent that
economic activity in the wider economy would suffer. The traditional
example of systemic risks is when financial pro"lems in one "ank lead to a
)-
Ciemeyer,0onas, =here to /o after the 2amfalussy 1eportS4n ;conomic 4nalysis of 5ecurities (arket
1egulation and 5upervision3)--%+
"ank run which in turn undermines the confidence in the whole "anking
system, makes the payment system collapse, the money supply contract and
potentially results in a recession or even depression. In this case, the effects
on other "anks and economic agents, let alone the social costs of a general
depression, are not taken into account in the risk analysis of the "ank or the
agent. In this paper, the focus is not on "anking issues "ut on the pro"lems
related to the securities markets. In terms of systemic risks resulting from
activities in financial markets, there are two main concerns , a+ the
settlement systems and "+ the li'uidity of the markets. ;ven though the
focus of the paper is not on "anking issues, in practice the "anks play such
an important role in the payment and therefore in the settlement of financial
securities that "anks and other financial intermediaries cannot "e completely
ignored in a discussion of securities regulation.

3.3 $4Clearin2 and 'ettle)ent
The clearing and settlement of financial securities entails several pro"lems.
<irst, if a seller of a financial security is not a"le to deliver, it may cause
delivery pro"lems in other transactions, i.e. have domino effects on many
other traders. If one trader is una"le to fulfill her o"ligations, all her
counterparts could run into pro"lems, thus spreading the financial insta"ility.
The netting, used in most settlement systems, makes many transactions
dependent on each other and therefore amplifies this pro"lem. 5econd, a
dominating and increasing part of the daily flows in the payment system
emanates form the securities markets and the payment system is a vital part
of the financial infrastructure. (ost other activities rely on a well-
functioning payment system. If the payment system would collapse all other
economic activity would run into serious pro"lems. It is difficult to imaging
any economic activity, which does not involve payments. Therefore, a
disruption in the settlement of financial securities may have far reaching
conse'uences for the entire economy. <urthermore, clearing and settlement
organizations have features similar to natural monopolies. There are
su"stantial economies of scale. 4s a conse'uence, most countries only have
one settlement organization, at least for the same type of financial securities.
If such an organization would default due to technical pro"lems or fraud,
settlement may "e difficult and the risk of ma#or macroeconomic
distur"ances is not negligi"le. There are however not only operational
reasons for systemic risks. 5uch risks are also present if financial pro"lems
for one agent involved in the system spread to other agents. The typical way
to deal with this systemic pro"lem is to set up different forms of prudential
regulation, including stringent supervision standards. Cormally the central
"ank assumes responsi"ility of the payment system, while the clearing and
settlement organizations often fall under the #urisdiction of the general
financial supervision. /iven the special status and importance of the clearing
and settlement organizations, it has even "een argued that they should "e
governed more like pu"lic utilities than as privately held companies. In any
case, "y imposing regulations on the clearing and settlement as well as the
payment systems, there is clearly a risk of inducing moral hazard, "y
increasing the agents9 propensity to take risks, and thus raising the
pro"a"ility of systemic pro"lems.
3.3 c4Market Li7idit(
4nother type of systemic risks emanates from the fact that li'uidity in the
securities markets has externality features. Investors want three things from
markets@ li'uidity, li'uidity and li'uidity. 4s a conse'uence, most investors
will prefer to trade when li'uidity is as high as possi"le, i.e. when and where
most other investors trade. 4lso, if one agent supplies more li'uidity,
every"ody gains, since the service provided "y the li'uidity supplier is
availa"le to every"ody in the market. Thus, as more traders access a certain
trading system, the "enefits for every"ody in the trading system will rise.
4lso, while trading in a market, or supplying li'uidity, agents are not likely
to take the aggregated "enefit to all other agents of the increased li'uidity
into account, i.e. li'uidity has a positive externality. Thus, market li'uidity
feeds market li'uidity. !owever, there is a "ackside of the coin as well. If
li'uidity falls it may also disappear fast. Thus, there is a su"stantial risk that
li'uidity will dry up if a crisis occurs, in ways similar to what happened at
the stock market crash of %,J7. In a crisis the cost of supplying li'uidity is
likely to increase. Thus, when li'uidity is most needed, it may "ecome
increasingly scarce. In this sense the first re'uirement for a systemic risk is
fulfilled, i.e. there is a potential market failure. 4s a conse'uence, many
agents, especially financial intermediaries, are increasingly dependent on the
securities markets for funding and risk management. 2i'uidity pro"lems in
the securities markets could easily spread to the "anking sector. 5erious
distur"ances in the securities markets could severely affect the funding of a
"ank. 4lso, sale of assets to cover funding needs may itself depress the
value of other holdings, or "e impossi"le due to the market-li'uidity crisis,
with contagious effects for the entire "anking sector. If these "anks run into
pro"lems, it may #eopardize the payment system with severe effects on the
entire economy. Thus, the funding of and the risk management systems in
"anks have "ecome so dependent on the securities markets that systemic
risks may follow if li'uidity falls. 4s "anks are "ecoming increasingly active
in securities "usiness, including issuing, trading, underwriting and providing
"ack-up facilities the potential pro"lems are increasing.
3.3 d4Insider tradin2
Prohi"iting insiders from trading when they have superior knowledge, and
forcing them to disclose all their trades are measures aimed at reducing the
asymmetric information and restoring market confidence among market
participants and the general pu"lic. !ere, it is not o"vious that any market
solution, such as signaling or reputation, would solve the pro"lem.
Therefore, potentially rules and regulations to reduce the asymmetric
information may "e welfare increasing, given that a well-functioning market
can "e seen as a pu"lic good. There are four means through which insider
trading could potentially harm the company. <irst, insider trading may
reduce the efficiency of corporate decisions "y delaying the transmission of
information within the company. !owever, if a manager wants to trade on
price sensitive information "efore transmitting it to her superior $ a phone
call to her "roker would suffice and this would not take more than a few
minutes. Thus, the delay story is not convincing. 5econd, insider trading
may increase the individual manager9s incentives to choose high-risk
pro#ects, where the "enefits from insider trading are larger. !owever, this
may attenuate the conflict that managers are more risk averse than
shareholders. Third, managers may manipulate share prices, "y disclosure
policies etc, in order to maximize their insider trading profits and at
considera"le social costs. !owever, prohi"iting insider trading is also costly.
<ourth, insider trading may harm the company9s reputation. The main
pro"lem is that the insider information is the property of the corporation.
Therefore the insider trading is primarily a contractual dilemma and could "e
resolved through contracts "etween the corporation and the user of any
insider information. In practice, insider trading rules and regulations could
entail esta"lishing and verifying standards of information, supervising
disclosure re'uirements and enforcing o"ligations to include audit reports in
the annual statements of companies, etc.
3.3 e4E6ternalities
There are also other externality pro"lems. 4s more traders access a certain
trading system, the "enefits for every"ody in the trading system will rise.
Thus, there are clearly externalities involved in market li'uidity. &ne
pro"lem with this externality is that it results in a consolidation of trading to
a limited num"er of trading venues. These concentration tendencies are
likely to limit competition. Thus, financial markets have a certain num"er of
features in common with natural monopolies. <rom economic theory, we
know that monopolies charge prices that are higher than the socially optimal.
This results in a too low production of the services supplied "y the
monopolist and an economic loss to society and investors. ;conomic theory
indicates that the ideal situation is perfect competition on all markets. The
concentration tendencies descri"ed a"ove may "e seen as a market failure.
Put differently, if we let the market forces work, the competition "etween the
providers of the financial markets may "e limited and the level of financial
services production su"-optimal. The o"vious regulatory response is to
lower the "arriers to entry, in order to stimulate competition. The 'uestion
here is if the concentration tendencies are higher in the securities "usiness
than in other areas. There are surely also other industries with significant
concentration tendencies. !owever there may "e two reasons why securities
markets are more exposed to this pro"lem than other markets. <irstly,
financial securities have very low transaction costs, such as transportation
and legal costs. In many other markets, these costs make market integration
prohi"itively expensive. Therefore, concentrations tendencies in securities
market may "e large compared to other markets. 5econdly, securities
regulation imposed for other reasons $ may raise the "arriers-to-entry and
reduce competition. The traditional test of fit and proper is one example of
a regulation, which in this sense could "e counterproductive in terms of
efficiency. In defining securities regulations, $ motivated for other reasons$
it is therefore important to take the concentrations tendencies into account.
5till, the main 'uestion is whether these concentrations tendencies
necessitate regulation specific to the securities industry or whether the
general anti-trust laws and competition regulations are sufficient. There are
also other externalities. <or example, all market participants would "e "etter
off if every"ody followed high ethical standards, "ut market participants
often have strong incentives to "reak these standards as long as every"ody
else acts ethically. The result without rules and regulation may "e that many
participants "reak the ethical rules and every"ody is worse off. There is a
market failure if the incentives of the market participants 3"e it exchanges,
"rokers, ma#or investors, corporations etc+ are not aligned. The pro"lem is
that they cannot coordinate their actions. This is a classical prisoner9s
dilemma pro"lem and can "e generalized to many situations. 4nother
example of a coordination dilemma is the monitoring pro"lem, common to
securities markets. The "asic pro"lem is the com"ination of three features.
<irst, there is a principal agent pro"lem. Investors $ the principals $ supply
capital into corporations "ut delegate the decisions to the management $ the
agents. 5mall investors $ the principals $ "uy investment services from
professional investors $ the agents. 5econd, contracts cannot specify all
contingencies, and thus leave the agents with some freedom to deviate from
what is optimal for the principals. Third in securities markets, the principals
are typically small. /iven these features, the competitive situation is likely
to result in low levels of monitoring, due to free riding. .ontracts that align
the incentives of the agents and the principals could potentially "e difficult
to o"tain. 4n aggregated low level of monitoring could therefore harm
efficiency and appropriate regulation inducing coordination of the
monitoring efforts could enhance efficiency.
3.3 3&4T"e Cons)er Protection Moti%e
&ne fre'uently used argument for securities regulation and supervision is t
that the consumers need protection. /enerally speaking, an efficient way to
protect consumers in the securities markets is to ensure, a+ that the price
formation process is as efficient as possi"le, and "+ that there is sufficient
competition "etween the traders, "rokers and other market participants.
Thus, if a large num"er of professional traders compete in assem"ling and
interpreting new information, securities market prices will reflect that
information and unsophisticated traders do not need any additional
information and analysis. In this case, the o"served prices are sufficient.
/iven that rules and regulations are needed for some other reason, effective
ways to protect uniformed traders are therefore to enact measures to reduce
transaction costs, to guarantee efficient trading mechanisms, to introduce
antitrust policies, to lower "arriers to entry and to improve competition. If
the markets are efficient, all trades will "e performed at correct prices and
the need to protect consumers will in principle vanish. Thus, one "asic
conclusion is that consumers are "etter protected in an efficient market than
in a less efficient market. Thus, an effective way of protecting the consumers
is to ensure an efficient market. !owever, securities markets cannot always
"e perfectly efficient in an informational sense. &ne of the reasons is that
there is asymmetric information. The consumer protection argument for
regulation is typically "ased on the existence of asymmetric information.
Price sensitive information is not immediately spread to all traders. 5ome
investors, especially small investors, normally have less access to
information than other traders. 4s a conse'uence, securities regulations are
often aimed at either reducing the asymmetric information "etween different
agents, or limiting the perceived damage of asymmetric information.
!owever, reducing the asymmetric information may also have significant
adverse effects. If the regulation prohi"its agents from taking advantage of
superior information, this information will not "e incorporated into the
securities prices. It is exactly the search for information, not yet reflected in
the prices, which makes prices informationally efficient. This search, which
is costly, has to "e profita"le otherwise prices will not "e as informative.
Therefore, accepting a certain limited level of asymmetric information may
"e the price we have to pay to get informative prices on a well-functioning
market. There are also other pro"lems. The main reason for investor
protection is "ased on a free-riding pro"lem, com"ined with a principal
agent conflict and incomplete contracts. Principal agent relationships are
common in securities markets. 1etail investors typically invest in different
funds and other financial services firms. !ere the former are principals and
the latter agents. These investment funds, trusts and financial services firms
invest in stocks, "ond etc and then act as principals towards the management
of the issuing companies 3agents+. /iven that complete contracts are not
feasi"le or enforcea"le, that all contingencies cannot "e foreseen, and that it
is not o"vious that contracts that align the incentives are always availa"le,
there is a potential economic pro"lem. :nder these circumstances, the free
market may yield a. socially su"-optimal solution, and thus there may "e
scope for regulations "ased on the consumer protection motive. socially su"-
optimal solution, and thus there may "e scope for regulations "ased on the
consumer protection motive. The overall conclusion is therefore that the
main consumer protection argument for the regulation of investment services
is "ased a+ on the principal agent pro"lem "etween the retail investor and the
investment service provider, "+ on the difficulty of the retail investor to
monitor the performance of the service provider, even ex post, c+ on the long
term aspect of many investment services, and d+ all under the assumption
that the pu"lic se-ctor has a responsi"ility for some minimum living
standards. 4nother 'uestion is then how these pro"lems can "e solved. &ther
(otives &ccasionally other motives for separate securities regulations are
presented, such as competitiveness and money laundering. !istorically, a
num"er of other politically motivated arguments have "een made, including
the need to channel funds to politically favored sectors of the economy, or to
help financing pu"lic deficits. !owever after the deregulation of securities
markets, the latter argument have more or less disappeared.

3.3 324Mone( Landerin2
=ith the exploding volume of international financial transactions and the
lifted regulation on these transactions, it has "ecome easier also for drug
traders and organized crime to use the financial system to hide criminal
revenue and transform them into legitimate financial positions. Therefore a
num"er of countries have imposed reporting re'uirements for ma#or
currency transactions. 4s long as it is only a 'uestion of re'uirements to
report, the costs are likely to "e small and not to influence legitimate
transactions in any ma#or way. !owever, if additional restrictions are
imposed, even for 8good9 causes such as in the com"at against terrorism, It
may severely affect the efficiency of international securities markets. (oney
mo"ilized in security markets "y monopoly "rokers used for their own
personal "enefit3luxuries+ is also considered as money laundering.
* Cor8orate Go%ernance3de&ined4
.orporate /overnance deals with the ways in which suppliers of finance to
corporations assure themselves of getting a return on their investments
)%
.(ost advanced market economies attempted to solve the pro"lem of
corporate governance to the extent that they have assured the flows of
enormous amounts of capital to firms, and actual repatriation of profits to
)%
.aprio, /erard 0r. and 1oss 2evine, .orporate /overnance In <inance@ .oncepts and International
&"servations3)--)+
the providers of finance. Dut this does not imply that they have solved the
corporate governance pro"lem perfectly, or that the corporate governance
mechanisms cannot "e improved. .orporate governance mechanisms are
economic and legal mechanisms that can "e altered through the political
process. .orporate governance is a straightforward agency perspective
sometimes referred to as separation of ownership and control.
*.1Cor8orate Go%ernance in Finance
.orporate governance influences the efficiency of firm production at the
corporate level, so that the effectiveness of a nation9s corporate governance
system shapes economic performance at a country level
))
. 5tandard agency
theory defines the corporate governance pro"lem in terms how e'uity and
de"t holders influence managers to act in the "est interests of the providers
of capital. To the extent that shareholders and creditors induce managers to
maximize firm value, this will improve the efficiency with which firms
allocate resources. These mechanisms, however, do not work well around
the world. 5mall investors have a difficult time exercising corporate
governance "ecause of informational asymmetries and poor legal,
"ankruptcy, and regulatory systems. If the world is to rely on "anks $ and
other financial intermediaries $ to exert effective corporate governance, then
the managers of financial institutions must themselves face sound corporate
governance. If "ank managers face sound incentives, they will "e more
likely to allocate capital efficiently and then implement effective corporate
governance over the firms in which they invest. If "ank managers, however,
have enormous
))
4nderei 5heleifer and 1o"ert 6ishny 3%,,7+ 84 5urvey of .orporate /overnance9

discretion to act in their own interests rather than the interests of the "ank9s
e'uity and de"t holders, then this will adversely affect corporate governance.
In particular, "anks will allocate capital less efficiently and "ank managers
may actually induce firm managers to "ehave in ways that favor the interests
of "ank managers and firms "ut hurt overall firm performance. Thus, the
corporate governance of "anks and other financial intermediaries is crucial
for shaping capital allocation at the firm level and at the country level.
Cevertheless, the financial sector has generally received far less attention in
the corporate governance literature than seems warranted "y their central
role in a nation9s corporate governance system. !ow do the suppliers of
capital influence managers to act in the "est interests of capitalistsS
<irst, governments construct the "asic legal system underpinning corporate
governance. 5econd, governments may influence the flow of corporate
finance "y restricting corporate activities and insuring corporate finance in
the case of "anks and occasionally other intermediaries. =e consider each
of these stakeholders and also discuss the market for corporate control.
*.! Pro$le)s o& Cor8orate Go%ernance in Finance
In particular, we examine three interrelated characteristics of financial
intermediaries and how these traits affect corporate governance. <irst, "anks
and other intermediaries are more opa'ue, which fundamentally intensifies
the agency pro"lem. *ue to greater information asymmetries "etween
insiders and outside investors in "anking, it is 3i+ more difficult for e'uity
and de"t holders to monitor managers and use incentive contracts, 3ii+ easier
for managers and large investors to exploit the private "enefits of control,
rather than maximize value, 3iii+ unlikely that potential outside "idders with
poor information will generate a sufficiently effective takeover threat to
improve governance su"stantially, and 3iv+ likely that a more monopolistic
sector will ensue and will generate less corporate governance through
product market competition, compared with an industry with less
informational asymmetries. 5econd, "anks, like most intermediaries, are
heavily regulated and this fre'uently impedes natural corporate governance
mechanisms. <or instance, 3i+ deposit insurance reduces monitoring "y
insured depositors, reduces the desira"ility of "anks to raise capital from
large, uninsured creditors with incentives to monitor, and increases
incentives for shifting "ank assets to more risky investments, 3ii+ regulatory
restrictions on the concentration of ownership interfere with one of the main
mechanisms for exerting corporate governance around the world@
concentrated ownership, 3iii+ regulatory restrictions on entry, takeovers, and
"ank activities reduce competition, which reduce market pressures on
managers to maximize profits, and 3iv+ "ank regulators and supervisors
fre'uently have their own incentives in influencing "ank managers that do
not coincide with value maximization. <inally, government ownership of
"anks fundamentally alters the corporate governance e'uation. 5ince state
ownership of "anks remains large in many countries, this makes corporate
governance of the "anking industry very different from other industries.
*.3 'trate2( &or i)8ro%in2 Cor8orate Go%ernance
)>
;xisting research shows that countries in which the government supports
the a"ility of private sector entities to monitor "anks, permits "anks to
)>
.aprio, /erard 0r. and 1oss 2evine, Corporate Governance In Finance: Concepts and
International Observations3)--)+
engage in a wide-range of activities, in "anking. 4s a first step, it is critical
that governments recognize and cur" any of their own "ehaviors that thwarts
the private sector9s a"ility and incentive to monitor "anks. Thus, for
example, in countries in which government ownership is pronounced,
private sector monitoring cannot "e expected, and competitive forces clearly
are "locked. (oreover, as argued a"ove, government supervision of
government "anks also cannot "e expected to "e thorough and independent
as we o"serve in India. In these cases, em"arking on a program to reduce
government ownership where it is pronounced would seem to "e essentialT
without this step it is difficult to conceive of the success of other efforts to
ameliorate the governance pro"lem. .ountries with "lanket deposit
insurance, or extremely generous deposit insurance coverage 3certainly the
levels of %- to %A times per capita /*P that are found in very low income
countries+ also are sure to "e those in which private sector monitoring is
virtually nonexistent. 1educing such coverage to much lower levels also
would "e essential in order to enhance private sector monitoring. 4 second
step in improving governance in "anking involves directly reducing the
opacity of "anks "y improving the flow of information. 4lthough
transparency of "anking information in emerging markets is receiving
increased attention in the wake of the ;ast 4sian crisis 3and perhaps more so
in the aftermath of the ;nron collapse+, the likely reinforcement of opacity
"y existing ownership patterns in emerging markets suggests that this task is
even more important and yet more difficult than has "een recognized. In
effect, authorities will need to engage in the unpopular task of shaking-up
cozy relationships among powerful interest groups in their society. This task
is not as simple as superficial adherence to international standardsT rather, it
is a process that will re'uire sustained commitment over a period of time in
order to effect. In addition to much greater attention to improving
accounting and auditing, improvements to credit information will facilitate
the expansion of "anking "y those interested in providing finance to groups
that were previously excluded. ;nhancing corporate finance reporting in the
media, and education as to the importance of this issue in a wide swath of
civil society, will help make a lasting contri"ution to "etter corporate
governance. This is not easy@ the same family groups that control "anks may
also control the media, so "roader antitrust activity may "e necessary in
order to make this work. (oreover, it is worth stressing again that these
changes will not happen to the extent that governments underwrite risk.
Third, although "etter information may indirectly enhance the contesta"ility
of the "anking market and invigorate the market for corporate control in
"anking, opening to foreign "anks offers a direct mechanism for creating
competitive pressures in "anking. It was not so much the presence of foreign
"anks as the contesta"ility of markets 3associated with relative openness to
foreign entry+ that contri"uted to the development and sta"ility of emerging
market "anking. <oreign "anks, and indeed foreign entry in other markets,
will serve to increase the competitiveness of the economy in general and
lessen the reliance on family or conglomerates relationships. Increased
foreign presence in emerging market "anking has the attractive "enefit of
improving access to credit, even "y small and medium-sized enterprises. The
resulting increase in competition in the economy can pay dividends in the
long-term to the corporate governance pro"lems discussed here. .learly the
same should apply to foreign competition in insurance and pension
management. <ourth and most importantly, the potential monitors of "anks $
owners, markets 3large creditors in particular+ and supervisors $ need clear
and strong incentives to do their #o"s well. 4s stressed a"ove, the legal and
"ankruptcy systems do not operate well in many countries. Thus, "ank
managers can control "anks with little to fear from outsider investors, or
even from "ankruptcy as is clearly evident from 0apan9s ten-year "anking
crisis. &wners, particularly controlling shareholders, will have the incentive
to monitor their "anks well 3meaning in accordance with society9s goals+,
only to the extent that their own resources are really at risk and to the extent
that there are healthy profits in return for safe and sound "anking.
:nfortunately, ensuring that capital is real and that weak lending practices
have not eroded is not simple in practice. The incentives facing insider
owners and managers can "e enhanced in a num"er of ways. The a"ility of
authorities to influence inside owners and managers is enhanced if regulators
can impose penalties when there is evidence of fraud or of improper
conduct. 5imilarly, the incentives of inside owners and managers will clearly
"e enhanced if small shareholders and de"tors can confidently use an
efficient court system that supports their rights.(ore generally, regulation
has not focused much attention on the compensation of senior managers. <or
example, an attempt to vary capital re'uirements in line with the extent to
which "anks9 compensation policies encourage or discourage excessive risk
taking is a promising area for new research. The supervisory process in some
countries is getting close to this issue when supervisors examine the systems
that "anks have in place for managing their risks. =e suspect that as
important as risk management is as a process, the incentives inside the
individual "anks for taking risk will determine the efficacy of any processes
that are written down. .ertainly, the threat of legal recourse for those who
suffer losses when directors do not fulfill their fiduciary duties would
improve the incentives for this group, and it might also encourage them to
support reforms in compensation policies for senior "ank officers.
.ompensation policies of directors themselves also demand greater attention
and further research into the extent to which "ank and corporate
performance is a function of differences in this area would "e highly useful.
To improve corporate governance of financial intermediaries, policy makers
must seek to enhance the a"ility and incentives of creditors and other market
participants to monitor "anks. 1ecently, su"ordinated de"t proposals have
received increased attention. It should "e clear that the governance pro"lem
in finance is severe, "ut it is not hopeless. 1ecognition of the difficulty of
the process, and the need to get governments focused on. Detter-governed
"anks, in the sense of those a"le to contri"ute to development yet also ro"ust
to macro distur"ances, used to "e more common. Cotwithstanding, waves of
failure "y small :.5. "anks in the nineteenth century, depositor losses in the
now industrialized countries were minor and taxpayers9 losses nil. This state
of affairs resulted from clear incentives for the various actors reviewed here,
not least of which was the practice for "onds to "e posted "y "ankers and
even deferred compensation for supervisors. =e can only hope that the scale
of losses in emerging market "anking and the conse'uent increased attention
to this topic will help promote reform efforts.
*.* Cor8orate Go%ernance in India
)?
In India recently ,(arch )-->, a committee has "een formed "y 'E1I to
discuss the scope of Cor8orate Go%ernance in India which is headed "y
the CEO o& In&os(s=Nara(ana Mrt"(.
;xcerpts from the .ommittee report@
4 corporation is a congregation of various stakeholders, namely, customers,
)?
B1eport &f The .ommittee &n .orporate /overnanceB3)-->+,5;DI .omittee 1eport,www.se"i.gov.in
employees, investors, vendor partners, government and society. 4
corporation should "e fair and transparent to its stakeholders in all its
transactions. This has "ecome imperative in today9s glo"alized "usiness
world where corporations need to access glo"al pools of capital, need to
attract and retain the "est human capital from various parts of the world,
need to partner with vendors on mega colla"orations and need to live in
harmony with the community. :nless a corporation em"races and
demonstrates ethical conduct, it will not "e a"le to succeed.
.orporate governance is a"out ethical conduct in "usiness. ;thics is
concerned with the code of values and principles that ena"les a person to
choose "etween right and wrong, and therefore, select from alternative
courses of action. <urther, ethical dilemmas arise from conflicting interests
of the parties involved. In this regard, managers make decisions "ased on a
set of principles influenced "y the values, context and culture of the
organization. ;thical leadership is good for "usiness as the organization is
seen to conduct its "usiness in line with the expectations of all stakeholders.
.orporate governance is "eyond the realm of law. It stems from the culture
and mindset of management, and cannot "e regulated "y legislation alone.
.orporate governance deals with conducting the affairs of a company such
that there is fairness to all stakeholders and that its actions "enefit the
greatest num"er of stakeholders. It is a"out openness, integrity and
accounta"ility. =hat legislation can and should do is to lay down a common
framework $ the form to ensure standards. The su"stance will ultimately
determine the credi"ility and integrity of the process. 5u"stance is
inexora"ly linked to the mindset and ethical standards of management
.orporations need to recognize that their growth re'uires the cooperation of
all the stakeholdersT and such cooperation is enhanced "y the corporation
adhering to the "est corporate governance practices. In this regard, the
management needs to act as trustees of the shareholders at large and prevent
asymmetry of "enefits "etween various sections of shareholders, especially
"etween the owner-managers and the rest of the shareholders.
.orporate governance is a key element in improving the economic
efficiency of a firm. /ood corporate governance also helps ensure that
corporations take into account the interests of a wide range of constituencies,
as well as of the communities within which they operate. <urther, it ensures
that their Doards are accounta"le to the shareholders. This, in turn, helps
assure that corporations operate for the "enefit of society as a whole. =hile
large profits can "e made taking advantage of the asymmetry "etween
stakeholders in the short run, "alancing the interests of all stakeholders alone
will ensure survival and growth in the long run. This includes, for instance,
taking into account societal concerns a"out la"or and the environment.
&ften, increased attention on corporate governance is a result of financial
crisis. <or instance, the 4sian financial crisis "rought the su"#ect of
corporate governance to the surface in 4sia. <urther, recent scandals
distur"ed the otherwise placid and complacent corporate landscape in the
:5. These scandals, in a sense, proved to "e serendipitous. They spawned a
new set of initiatives in corporate governance in the :5 and triggered fresh
de"ate in the ;uropean :nion as well as in 4sia. The many instances of
corporate misdemeanours have also shifted the emphasis on compliance
with su"stance, rather than form, and "rought to sharper focus the need for
intellectual honesty and integrity. This is "ecause financial and non-financial
disclosures made "y any firm are only as good and honest as the people
"ehind them. Dy this very principle, only those industrialists whose
corporations are governed properly should "e allowed to "e a part of
committees. This includes the Prime (inister and <inance (inister9s
advisory councils, committees set up "y the .onfederation of Indian
Industry 3.II+, the 5ecurities and ;xchange Doard of India 35;DI+, the
*epartment of .ompany 4ffairs, ministries, and the "oards of large "anks
and financial institutions.
+ Conclsion
Findin2s and Reco))endations
The security scams and financial scandals discussed here involved the
manipulation of huge amounts of money. The purpose of the so called
traders or investors was not genuine. The perpetrators had such a
comprehensive knowledge of how the system worked that they manipulated
it. It is clearly evident that the occurrence and reoccurrence of such security
scams and financial scandals as some point in time "e attri"uted to a failure
of corporate governance in finance and that of financial regulation.
.orporate /overnance vs <inancial 1egulation is more a personal thing
which involves the adherence to rules regulations and ethics "y officials
3management+.It is more self enforced as a ethical "ehavior or a matter of
pursuing codes of conduct without an outside agent monitoring , "ut
financial market regulation in exercised more "y an external organization
either a regulatory "ody authorized to monitor and impose a surveillance
mechanism to ensure frauds or misdemeanors are not perpetuated and so
that the market functions efficiently to over see the functions of the market
participants and impose fines and other penalty for non-compliance.
)A
Though standard corporate governance theory states that corporate
governance includes the role that e'uity and de"t holders have to play in
influencing managers to act in the "est interests of suppliers of capital it
should not "e forgotten that it also includes the role that creditors, owners
and government in the same capacity. =hile corporate governance
mechanisms are decided "y economic and legal institutions and are
influenced "y politics itIs success depends a great deal on the principles,
diligence and sincerity of management when it comes to the adherence to
rules and regulation. 4lso they must have a concern for the welfare of
shareholders3investors+ and other suppliers of capital to ensure that they get
a fair and regular return for their investments. =hile corporate governance
ensures a regular supply of capital and fair share of profit to investors itIs
role does not end there. .orporate /overnance at that level does not mean
that it is entirely solved "ut definitely can "e improved on. 5hareholders and
other parties find difficulty in exercising corporate governance "ecause of
poor legal systems, corruption and "ankruptcy. 4lso managers have the
incentive to act in their own interests rather than the interests of e'uity and
de"t holders which could definitely affect corporate governance. 4lso
)A
.aprio, /erard 0r. and 1oss 2evine, Corporate Governance In Finance: Concepts and
International Observations3)--)+
informational asymmetries in the system make it difficult for e'uity and de"t
holders to monitor mangers. It also induces "ank mangers to act according to
their own incentives and not according to value maximization. 4lso heavy
regulation induces "ankers to invest in high risk ventures rather than
"orrowing from uninsured "orrowers who have a greater incentive
monitor .4lso regulations and prohi"itions of entry of foreign "anks reduces
competition and market pressures on managers to earn profits. .orporate
/overnance pro"lem can "e improved "y increasing private monitoring and
reducing government ownership when it interferes with private monitoring.
The opacity of "anking processes should "e removed and a proper
information flow should ensue. 4 lack of this can "e attri"uted to the 4sian
.risis and collapse of ;nron. ;ntry of foreign "anks should induce
competition and make mangers do their #o" well without relying on family
conglomerates and politicians. 4lso managers in "anks should "e given
strong incentives to do their #o"s well and their good efforts should "e
rewarded and mistakes corrected. They should "e remunerated well. In India
corporate governance revolves around ethical "ehavior on part of
management, knowing to make right decisions and also knowing to choose
"etween right and wrong.. It also calls for the managers to "ehave in the
interests of economics efficiency of the firm and shareholders. (anagement
should "e made more accounta"le for their actions in terms of deployment of
funds , making decisions and also transmitting information. !owever though
standard corporate governance theory states that itIs realms of control
include assuring a fair return to suppliers of capital itIs scope has changed in
recent years. &ften, increased attention on corporate governance is a result
of financial crisis. <or instance, the 4sian financial crisis "rought the su"#ect
of corporate governance to the surface in 4sia. <urther, recent scandals
distur"ed the otherwise placid and complacent corporate landscape in the
)H
:5. These scandals, in a sense, proved to "e serendipitous. They spawned a
new set of initiatives in corporate governance in the :5 and triggered fresh
de"ate in the ;uropean :nion as well as in 4sia.
)7
&ne cannot forget the
security scams in India. The many instances of corporate misdemeanors
have also shifted the emphasis on compliance with su"stance, rather than
form, and "rought to sharper focus the need for intellectual honesty and
integrity. This is "ecause financial and non-financial disclosures made "y
any firm are only as good and honest as the people "ehind them. Dy this
very principle, only those industrialists whose corporations are governed
properly should "e allowed to "e a part of committees.
)J
This includes the
Prime (inister and <inance (inister9s advisory councils, committees set up
"y the .onfederation of Indian Industry 3.II+, the 5ecurities and ;xchange
Doard of India 35;DI+, the *epartment of .ompany 4ffairs, ministries,
and the "oards of large "anks and financial institutions
)H
Ta"le )
)7
Ta"le %
)J
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4"use@a Perspective from the Cetherlands
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/overnance, 0ournal of <inance,6ol A),3%,,7+
www.hinduonnet.com,The !indu
www.iimcal.ac.in,Indian Institute &f (anagement3.alcutta+
www.nseindia.com,Cational 5tock ;xchange &f India
www.se"i.gov.in
5 Glossar(
1ank Recei8t @Dank 1eceipts are issued "y the selling "ank, signifying that
it has received money and is holding the securities in trust for the "uyer.
Dank 1eceipts are supposed to "e non-transfera"le and to "e discharged after
the securities are delivered.
P$lic 9e$t O&&ice3P9O4-In ledgers earmarked for each "ank , the P*& of
1DI records transactions "etween "anks in government securities .;ach kind
of security transaction is recorded separately.
'$sidiar( General Led2er 3'GL4-The 5u"sidiary /eneral 2edger
maintained "y the P*& in which government security transactions are
recorded. The 5/2 will show "alance standing in the name of a particular
"ank in a particular security.
Read( &or<ard 9eal-Fnown worldwide as repurchase options or repos.
The 1eserve Dank &f IndiaIs records refer to it as "uy"ack .It involves
selling securities with the purpose of "uying them "ack after a short period
of time, usually at a slightly higher price. The seller there"y creates
temporary li'uidity for himself for which he pays the higher price.
9o$le Read( For<ard-5imultaneous "uying and selling of two sets of
securities with the "uy"ack options created "y "oth the parties. The sellerIs
o"#ective could "e to create li'uidity "y selling one kind of
security3normally ready forward+and at the same time "uying some other
kind for the portfolio.
'8ecial Pr8ose Entities3'PEs4-4 "usiness interest formed solely in order
to accomplish some specific task or tasks. 4 "usiness may utilize a special
purpose entity for accounting purposes, "ut these transactions must still
adhere to certain regulations.
.4 A88endi6
A4'tock Market 'ca) in India o& 1,,1:T"e Banakira)an Co))ittee
Re8ort
&n the "asis of the information received that some "anks -Cational !ousing
Dank3C!D+,5tate Dank &f 5aurashtra,5DI .apital (arkets 2td 35DI
.aps+,5tandard .hartered Dank,.anfina etc -were undertaking large-
scale transactions in /overnment securities through the medium of
"rokers in the course of which they were violating the 1eserve Dank &f
India 31DI9s+ detailed guidelines issued to them in 0uly %,,%,1DI had
started making en'uiries into the securities transactions of some of the
"anks since 0anuary %,,).Towards the end of (arch %,,) ,information
was also received that 5tate Dank &f India 35DI+ had purchased a large
'uantity of /overnment securities on a ready forward "asis one day prior
to the date on which the coupon rate of /ovt of India securities was
raised. Therefore the securities transactions of 5DI were also taken up
for scrutiny immediately.The "ank was advised on ) 4pril %,,) to
furnish to 1DI a statement of as on >% (arch %,,) as soon as the
statement was compiled. It was o"served that the "ank was una"le to
furnish the statement as it had not reconciled the "alance of securities
held "y it as shown with the actual "alance held in the
),
5u"sidary
/eneral 2edger 35/2+ 4ccount with the 1DI "eyond Covem"er %,,%.

3%+The following "anks, su"sidiaries of "anks and institutions have made
payments for purchase of investments for which they do not hold either
securities, 5/2 forms or D1s to the extent indicated "elow@
),
/lossary3*efinition+
Ta$le *: Pa()ents &or 8rc"ase o& in%est)ents &or <"ic" '$sidiar(
General Led2ers and 1ank Recei8ts are not "eld drin2 secrit( sca)
1,,1 in India
Na)e o& 1ank Rs in crores
Cational !ousing
Dank3C!D+
%%,,.>,
5tate Dank &f
5aurashtra
%7A.-?
5DI .apital (arkets
2td35DI .aps+
%)%.)>
5tandard .hartered
Dank
>--.--
Total %7,A.HH

3)+Danks ,su"sidiaries of "anks and institutions are holding D1sG5/2s
issued "y the Dank &f Farad 2td and the (etropolitan .o-operative Dank
for which the issuing "anks do not appear to have sufficient "acking to the
extent indicated "elow@
Ta$le +:1anks=s$sidiaries o& $anks and instittions "oldin2 1ank
Reci8ts and '$sidiar( General Led2ers &or <"ic" t"ere a88ears to $e
no s&&icient $ackin2 drin2 secrit( sca) o& 1,,1 in India

Na)e O& 1ank
Rs in crores
5tandard .hartered Dank 7AA.--
.an"ank <inancial 5ervices
2td3.anfina+
?)A.--
.an"ank (utual <und %-).,7
Total %)J).,7
A14 Reco))endations
Dased on the committee9s preliminary findings it made the following
recommendations
3%+The diversion of funds has "een largely facilitated "y the practice of
"anks executing a large num"er of ready forward and dou"le ready
forward transactions . 5ince there is no permanent sale of transfer of
investments in such cases ,there is no real need to effect transfer of actual
scrips of 5/2 forms or to deposit 5/2 forms when issued with the
>-
P*&3Pu"lic *e"t &ffice-that which records all the "anks transactions in
government securities+. These transactions have, therefore, presuma"ly "een
supported "y D1s or 5/23ledger accounts maintained "y the P*& which
records all the "anks transactions in government securities with
"alances+forms not intended to "e deposited with the P*&.4s the
transactions effectively get reversed on the due date, it is also possi"le that
the transactions were effected without the sale of D1s ,5/2 forms "y the
issue of unauthorized D1s or 5/2 forms. 4 ready forward transaction in
su"stance could also "e a mere lending of funds for the period of the
contract in the guise of a purchaseGsale of investments. The .ommittee
recommended that-
3a+ the practice of "anks entering in to ready forward and dou"le ready
forward deals with other "anks "e restricted to /overnment
securities only 3as permitted "y the 1DI+ and guidelines "e laid down
specifying the circumstances in which such transactions would "e
permitted.
>-
/lossary3*efinition+
3"+ Danks "e prohi"ited from entering into ready forward and dou"le
ready forward deals in other securities including P5: "onds , units
and sharesT
3c+ The prohi"ition regarding "anks entering into "uy "ack deals with
non-"ank clients 3already imposed "y the 1DI+ "e strictly enforced
and action "e taken against "anks which have violated this directionT
3d+ Danks "e prohi"ited from entering into ready forward and dou"le
ready forward deals on "ehalf of customers under portfolio
management scheme 3P(5+.
)+The internal control procedures of "anks regarding their treasury
functions "e immediately reviewed "y the 1DI,inter alia,with regard to-
3a+the segregation of duties "etween
3a%+ persons responsi"le for entering into deals
3a)+persons having custody of investments and
3a>+ persons responsi"le for recording the transactions in the "ooks of
accounts and other records
3"+the periodic reconciliation of investment account and the independent
verification thereofT
3c+ controls over the issue of 5/2 forms and D1s and record keeping in
respect thereofT
3d+ controls for verification of the authenticity of D1s and 5/2 forms
and confirmation of authorized signaturesT
3e+procedures for confirmation with counterparties of "rokers9 contracts
as also of overdue D1sT
3f+the segregation of responsi"ilities of persons handling the "ank9s
own investment and those deleing on client9s accounts.
3>+ Danks should "e re'uired to formulate and get approved internal
exposure limits which ensure that there is no undue reliance on a few
"rokers. These limits should also cover the maximum amount of outstanding
D1s or 5/2s issued "y other "anks which can "e accepted "y the "ank.
3?+Drokers9 contract notes should "e re'uired to indicate the
counterparty so that direct communication with such parties is possi"le.The
notes should also indicate separately the "rokerage charged on the
transactions.
3A+=hen "anks act as custodian of "rokers9 or other parties9
securities ,all transactions effected for such customers 3including all
documentation+must clearly disclose that the "ank is acting as a custodian
and not as a principal.
3H+The existing prohi"ition on "anks issuing che'ues drawn on their
account with the 1DI for third party transactions should "e strictly enforced.
5uch payments should "e made through normal instruments like "ankers9
che'ues, drafts or a transfer advice which clearly discloses the identity of the
person on whose "ehalf the transfer is made.
37+=hen "anks exercise custodial functions on "ehalf of their
merchant "anking su"sidiaries these functions should "e su"#ect to the same
procedures and safeguards as would "e applica"le to other constituents.
Therefore, full details should "e availa"le with the su"sidiaries of the
manner in which the transactions have "een executed.
3J+ the issuance of a large num"er of D1s in respect of transactions in
P5: "onds may have "een #ustified "y the "anks on the ground that there
has "een undue delay in the issue of scrips "y the P5:s and therefore trading
in such "onds has "een possi"le only through D1s. The issue of a large
num"er of D1s in respect of units may also have "een #ustified "y the "anks
on the ground that the transfer of the units in the name of the "uyer involves
stamp duty and therefore transfers need to "e effected only when the units
need to "e lodged with the :TI payment of dividend. These are no dou"t
valid assertions "ut the practice of issuance of D1s in respect of these
instruments have "een largely responsi"le for the diversion of funds to the
"rokersT
3,+The issuance of D1s in respect of /overnment securities as also the
apparent short-trading has "een sought to "e #ustified "y the "anks on
grounds of the ina"ility of the P*&s in the 1DI to record speedily the
transactions effected and to communicate the credit advices in time to "anks.
Danks, therefore do not know the fate of 5/2 forms lodged when they in
turn issue 5/2 forms. The .ommittee is not convinced that this #ustification
is valid particularly since o"#ection memos have generally "een
communicated in time. !owever ,the work of the P*&s needs to "e
considera"ly speeded up and more relevant information furnished to "anks.
This information should includeT
3a+ immediate advice of all o"#ection memos. :nless a "ank makes
arrangements on a regular "asis to collect o"#ection memos over the
P*& counter the advices should "e "y courier for which
acknowledgement would "e de"ited to the account of the concerned
"ankT
3"+ a weekly statement of all transactions in individual ledger accounts
together with the "alance thereof.
It is also necessary that there is a daily verification of all securities held in
the 5/2 accounts of all "anks in the aggregate and that on a weekly "asis
the P*& su"mit to the *epartment of Danking &perations and *evelopment
3*D&*+ of the 1DI a report giving "ank-wise details of all 5/2s returned
for want of sufficient "alance.The .ommittee "elieves that given the large
num"er of accounts the large num"er of individual securities and the num"er
of transactions, the work of the P*& cannot "e done manually and needs to
"e immediately computerized.
3%-+The .ommittee recognizes that with J- "anks having over
H---- "ranches it is virtually impossi"le for the 1DIs inspection
procedures to examine individual transactions of "anks. 4t present the
1DI carries out an annual financial review34<1+ and a financial
inspection once in four years. ;ven the financial inspection is largely
concerned with the advances portfolio of the "anks and the ade'uacy of
provisions. The committee understands that the inspection system and
procedures of the *D&* have "een recently reviewed "y a committee
appointed "y the 1DI governor and its recommendations are in the
process of "eing implemented. !owever the primary responsi"ility in this
regard must remain with the "ank managements which must remain with
the "ank managements which must ensure that there are ade'uate internal
control 3including internal audit+ procedures. The committee would
,therefore recommend that@
3a+ &n-site inspection "y the 1DI should "e supplemented "y reporting of
compliance "y "anks with prudential and other guidelines. To lend
authenticity to this compliance reporting, "anks should "e re'uired to
get compliance in key areas certified "y statutory auditors of the
"anks.
3"+ The scope of the 1DI inspection should "e widened to include greater
emphasis on the treasury function
3c+ The 1DI should review the ade'uacy of the internal audit departments
of the "anks and the scope of their operations.
3d+ The portfolio management operations of "anks should "e su"#ected to
a separate audit "y the "anks9statutory auditors as these operations are
in the nature of trusteeship functions.
3e+ The 1DI should strengthen it9s organization responsi"le fro market
intelligence so that early action can "e taken when there are market
rumours of irregularities.
%%+1eady Purchase &perations
It would "e counter productive to "an 1;P& transactions as they serve a
useful purpose as money market instrument for e'uili"rating li'uidity and
for covering the needs of "anks and "ulk investors for short-term funds at
varying points of time. =hile continuation of 1;P&s even in P5: "onds
and units could "e allowed. It is important that the transactions should "e
covered "y prudential guidelines to "e stipulated "y 1DI, limiting overall
maximum position as also portfolio turn over ratios per player and
stipulating that all transactions are put through a centralized clearance
system, which can inter alia make the necessary information availa"le to the
authorities.&nly "anks, mutual funds and financial institutions may "e
allowed to participate in the 1;P& operations .These also would necessarily
"e the mem"ers of the centralized clearing agency. The need of some of the
P5:s who have large stocks of existing P5: "onds also has to "e recognized
and they should "e allowed to participate in 1;P& transactions with
"anksGmutual fundsGfinancial institutions for a limited period of say ,two
years.1DI may look into the manner in which "anks and financial
institutions account in their "ooks their investments in P5: "onds and units
and ensure that these are valued at market prices rather than at prices
nominated in 1;P& transactions.
%)+1ole of Drokers
4s regards role of "rokers the committee recommends that the firms dealing
in the money market transactions should "e segregated from those dealing in
shares. 1DI would "e the right authority to regulate such firms with regard
to ade'uacy of their capital, extent f transactions etc. These "rokers should
"e allowed to take positions, "ut they should cat as genuine intermediaries.
%>+Phased ;lectronic .learance, 5ettlement and *epository
3;.5*+
4ll the transactions should "e routed through a centralized agency which
will operate an electronic "ook-entry clearance and settlement system and
would also act as depository 3;.5*+.1DI should ensure that all the "ulk
investors 3i.e. "anks, mutual funds ,financial institutions and P5:s + "ecome
mem"ers of the ;.5* and all their transactions in P5:Gunits irrespective of
whether they are traded on stock exchanges or outside on spot "asis are
reported cleared and settled through ;.5*.There "e only one ;.5* in
Dom"ayGCew Dom"ay as the setting up to many smaller organizations may
not "e cost effective and may create pro"lems in monitoring and control.To
give a legal standing to the depository legal changes would also "e re'uired
for registration of P5: "onds and units in the name of the depository .2egal
changes will also "e re'uired for exemption of revenue stamp duty in respect
of P5: "ondsGunits whilst registering in the name of the depository.;.5*
should "e formed and "ecome operative straightaway even in a limited
fashion so that it can act as a centralized agency fro monitoring the
transactions and making the data availa"le for monetary and regulatory
authorities.
14 'ecrit( Market 'ca) o& !//1:Boint Parlia)entar( Co))ittee
3BPC4 Re8ort
The terms of reference of the .ommittee were as follows@Q
%. To go into the irregularities and manipulations in all their ramifications in
all transactions,
including insiders trading, relating to shares and other financial instruments
and the
role of "anks, "rokers and promoters, stock exchanges, financial institutions,
corporate
entities and regulatory authorities.
). To fix the responsi"ility of the persons, institutions or authorities in
respect of such
transactions.
>. To identify the misuse, if any, of and failuresGinade'uacies in the control
and the
supervisory mechanisms.
?. To make recommendations for safeguards and improvements in the
system to prevent
rec urrence of such failures.
A. To suggest measures to protect small investors.
H. To suggest deterrent measures against those found guilty of violating the
regulations.
114 O%er%ie<

Parliament, through a motion in the 2ok 5a"ha on )H.?.)--%, mandated this
0P.30oint Parliamentary .ommittee+ to en'uire into the stock market scam.
This scam was distinct and different from the scam en'uired into "y a 0oint
Parliamentary .ommittee in %,,)-,>. =hile the en'uiry into the earlier
scam related to 8irregularities in securities and "anking transactions9, the
present scam mainly relates to financial misconduct in the stock market.
Doth the scam en'uired into in %,,)-,> and the present one have some
common features like the failure of some "anks as also high volatility in the
stock market.The .ommittee were given an additional task after they had
"een constituted and started functioning. 4s announced "y the 5peaker, 2ok
5a"ha on >.J.)--%, the .ommittee were further asked to look into all
matters relating to the :nit Trust of India 3:TI+. This additional task to the
.ommittee was necessitated "y the freeze on resale of :5-H? units "y :TI
in 0uly )--%. 4ccordingly, the .ommittee enlarged their en'uiry to include
:TI in addition to the 5tock (arket 5cam.*uring the working of this
.ommittee, simultaneous actions pertaining to the en'uiry were initiated "y
the 1egulatory agencies like 5;DI35ecurities 4nd ;xchange Doard &f
India+,1DI31eserve Dank &f India+ and *.4 3*epartment &f .ompany
4ffairs+.Information was gathered "y the .ommittee from all these agencies
through written 'uestions, perusal of relevant departmental documents
including files and depositions in person "y headsGrepresentatives of Danks,
1egulatory "odies, 5tock ;xchanges, :TI3:nit Trust &f India+ and officials
of /overnment departments. The .ommittee were also assisted "y the
present <inance (inister and his three immediate predecessors. <lowing
from the terms of reference were some of the 'uestions that were discussed
in-house "y the 0P.@ =hy do scams occur fre'uentlyS 4re the rules and
regulations o"solete or inade'uateS *o regulatory authorities lack ade'uate
power, or, are they deficient in implementation and vigilanceS *o the stock
exchanges follow laid-down guidelines and proceduresS 4re the managem
ents of "anks following the norms of accounta"ility and corporate
governance and are they running them according to guidelines laid down "y
the regulatorS 5hould the stock market "e self-disciplined and self-regulating
or, should the regulators and the /overnment keep a close watch all the
timeS !ave /overnment shown themselves alert to emerging pro"lemsS
1!4 T"e Mec"anics o& t"e 'tock Market 'ca) o& !//1
The period of the scam, the main players involved, and its intensity have
"een examined "y the .ommittee. The present scam includes the role of
"anks, stock exchanges, "rokers, the :nit Trust of India 3:TI+, corporate
"odies and chartered accountants. 1egulatory authorities like 5;DI, 1DI and
the *epartment of .ompany 4ffairs 3*.4+ should have "een a"le to lay
down and implement guidelines and procedures that could prevent such a
scam or at least activate red alerts that could lead to early detection,
investigation and action against fraud as well as the rectification of any
systemic deficiencies discovered. (oreover, the (inistry of <inance, the
1egulators and all others concerned had the "enefit of the voluminous and
detailed 4ction Taken 1eports 34T1s+ su"mitted "y /overnment to
Parliament on the numerous recommendations of the %,,> 1eport of the
0oint .ommittee on irregularities in securities and "anking transactions.
.oncerted mutual interaction "etween /overnment and the 1egulators,
especially through the institutional mechanism of !2.., could have
signally contri"uted to effective pre-emptive and corrective action to
forestall or moderate the scam "y the early detection of wrong-doing.
Investigations were undertaken "y 5;DI against the manipulator9s entities
in the wake of allegations that manipulator9s entities were involved in
market manipulation in some scrips. The manipulator was operating through
a large num"er of entities which facilitated hiding the nexus "etween the
source of fund flows to him from corporate houses, "anks, financial
institutions and foreign institutional investors and the ultimatedeployment of
these funds in the stock market. It was o"served that funds received "y
certain entities from "anks as loans and overdrafts were diverted to other
entities for ac'uiring sharesGmeeting other o"ligations. It also appeared that,
transactions for purchase and sale of shares were done in the name of a large
num"er of entities so that concentration of positionsGtransactions in a
particular scrip could not "e readily detected. Thus, various layers were
created so that it "ecame difficult to link the source of fund with the actual
users to which these fund were put. !e used a net working of various <II su"
accounts, &.Ds, institutions and mutual funds for large transactions there"y
creating an impression of market interest in certain select scrips.To "egin
with, he normally identified companies with relatively low floating
stocks,ac'uired su"stantial holdings in these companies either directly or
through associates including <II su" accounts, &.Ds etc.!e also used the
presence of a num"er of exchanges and different settlement cyclesto
systemically shift positions from one ;xchange to the other ;xchange.
=hile "eing interested in increasing or maintaining the prices of select
scrips, he appears at various point of time to have systematically soldGoff-
loaded his holdings to "ook profits and take further positions therefrom to
further increase the prices.. 5ome of the corporate groups which had given
funds to the manipulators entities during 0anuary )----4pril )--% are
4dani, !<.2, *5N, .adila, ;ssel,Fopran and Cirma and the amount
outstanding from the manipulator to these entities is over 1s. %)7> crore. !is
entities received around 1s. J- crore from 6idyut Investments, a su"sidiary
of 1an"axy. (ost of the companies have claimed that the funds given "y
them to the manipulator9s entities were in the nature of Inter .orporate
*eposits3I.*s+ under the .ompanies 4ct. They also claim that they have
given some money to "uy the shares of other companies "ut not their own.
3i+ 5hares of *5N Diotech, *5N Industries were given "y entities associated
with promoters to the manipulator9s entities who sold these shares through
.5<D and *resdner Fleinwort Denson 3*FD+ and availed of immediate
funding. 3ii+ 5hares of !<.2 were reportedly given "y promoter group
entities to the manipulators entities for selling to strategic investors. 4gainst
the sanctioned limit of 1s. )-A crore, there is an outstanding "alance of1s.
JJJ.)A crore against the manipulators company /roup towards (adhavpura
(ercantile.o-operative Dank 3((.D+. 4s, against a limit of 1s. ,) crore,
an amount of 1s. ))A.H> crore is outstanding to ((.D from the (ukesh
Da"u /roup. 5hri (ukesh Da"u has stated under oath that 1s. A7 crores was
used for entities connected with the manipulators and 1s. %%A crores has
"een utilized for transactions made for (adhur 5hares which is controlled
"y a son of (r. 1amesh Parekh, .hairman of ((.D. There are close knit
relations "etween the manipulator and (adhur 5hares. 2arge funds have
flowed from the manipulators account to the (adhur 5hares account. It is
suspected that dealings for (adhur 5hares as well as through (anniar are
for the manipulators entities mainly. The amount outstanding to /lo"al Trust
Dank from the manipulator9s entities as on )>.->.-% was 1s. )HH.J7 crore.
The manipulator9s .ompany /roup had also received funds from .enturion
Dank, I.I.I Dank and Dank of Pun#a" against which a total amount of 1s.
HA.?7 crore was outstanding. ((.D issued Pay &rders 3P&s+ in favour of
the manipulators entities from time to time even when there were no
sufficient creditsGsecurities to cover these loansGover drafts.The
manipulator9s entities would then discount these P&s with Dank of India
3D&I+. The 5tock ;xchange Dranch of D&I would present these Pay orders
for realisation to the clearing house in the normal course of their "usiness.
&n J.).)--- and ,.>.)--%, ((.D issued Pay &rders totaling 1s. %>7 crore
in favour of the manipulator9s entities, which were immediately discounted
with D&I and the proceeds received were utilized "y the manipulator9s
entities. Dut on this occasion when D&I presented these Pay &rders to the
clearing house for realisation , ((.D declared its ina"ility to pay, since
sufficient funds were not availa"le with the "ank. !ence, D&I was left with
a de"it "alance of 1s. %>7 crore against the three manipulator9s entities
concernedQ.lassic .redit 2td. Panther <incap and Panther Investrade
2td.Triumph /roup did not provide delivery to its &.D clients on several
occasions. ;uropean Investments 2td. 3;I2+ had lodged a complaint with
5;DI, Cational 5tock ;xchange 3C5;+ E 1DI against Triumph International
<inance India 2td. 3TI<I2+ regarding dishonouring of three che'ues issued
to ;I2 "y TI<I2 totaling 1s. 7-.7% crore toward sale proceeds. &n many
occasions Triumph /roup did not make payment to its &.D clients for sale
transactions made "y them. The amount of non-payment "y TI<I2 to four
&.Ds viz. Drentfield, Fensington, =akefield and *ossier for sales effected
from *ecem"er )--- to (arch )--% stood at 1s. %-A.,A crore. The amount
of non-payment from Triumph 5ecurities 2td. to =akefield was 1s. %H.7
crore. The .ommittee en'uired whether he and his associated entities "uilt
large concentrated position in some select scrips like !<.2, Oee Tele, *5N
5oftware, /lo"al Tele, etc. and whether these companies provided him large
funds to #ack up their prices. In reply, the witness conceded that they had
large investments in these companies and said 8=e did "uild huge positions
in the market in these companies, and pro"a"ly "ecause of that I suffered
that losses that I suffered.9 !e further said that , 8none of the corporates has
ever given us money to invest in their own shares or to "uy their own shares.
The moneys received from the corporates were for specific contracts - for
purchase of shares in the companies that they were interested in, either
which we were holding or to "uy them from the market. Parts of the
contracts were completed in time, part of the contracts are still pending
"ecause I got into pro"lems. The moneys that have come from these
corporates have come when the markets have, in fact, started going down
drastically and when the valuations thought "y them were right for investing
in the companies they wanted. In the whole rise of %,,,-)---, not a single
corporate has ever given us any money to invest in the shares. ;ven during
the down side also, there was no money fromany corporate given to us to
"uy their own shares or for #acking up the price. 1eferring to 5;DI reports,
the .ommittee pointed out that funds were availa"le to the manipulator from
!<.2 /roup, Oee group, (adhavpura Dank and &.Ds, the witness said that
8all these monies have come in from the period of 5eptem"er, )--- to (arch
)--%9 after the fall started. 4ccording to the manipulator, the "iggest rise in
the market was during the period %,,,-)--- and that his "orrowings during
that period was in the region of 1s. A- crore to %-- crore. &n the other hand
the money "orrowed "y him or his entities when the market started falling
was around 1s. %A-- crore.paya"le "y them to various institutions, "anks,
corporates, "rokers, &.Ds, etc. 4ccording to 5;DI,it appeared that the
manipulators entities suffered loss in range of 1s. >--- crores to 1s. ?---
crore.
The amount paya"le "y the manipulator9s entities is stated to "e as follows @
Ta$le -:A)ont 8a(a$le $( >etan Parek"?s Entities to $anks and
co)8anies drin2 secrit( sca) o& !//1 in India
Na)e o& t"e entit(
A)ont 3Rs. in crore4 a88ro6
(adhavpura (ercantile .o-operative "ank JJJ.--
!<.2 AA-.--
;ssel /roup ?A-.--
4dani /roup %>).--
*5N /roup 7A.--
5honkh Technologies >7.--
Fopran )J.--
/lo"al Trust Dank )H7.--
I.I.I DankG.enturionGDank of Pun#a", etc HH.--
&.D5 3delivery of shares not given and
sale proceeds not paid+
?J-.--
Total >>)>
The .ommittee find that the manipulator was a key person involved in all
dimensions of the stock market scam which surfaced in (arch )--%, as also
in payments pro"lem in the .alcutta 5tock ;xchange 3.5;+ and the crash of
(adhavpura (ercantile .ooperative Dank 3((.D+. !e was operating
through a large num"er of entities which facilitated hiding the nexus
"etween source of funds flow and their ultimate use. 6arious layers were
created in his transactions so that it "ecame difficult to link the source of
fund with the actual user of fund. 5;DI9s investigations after the scam have
revealed that the amount outstanding from the manipulators entities to
certain corporate houses at the end of 4pril, )--% was over 1s. %,)7> crore.
*ues of the manipulators entities to ((.D were around 1s. JJJ crore and
to /lo"al Trust Dank over 1s. )HH crore. There were also dues to other
entities. The funds received from corporate houses and "anks have gone to
three ma#or "roker groups in .5; and "een utilized in capital market
operations. The manipulators entities appear to have chosen .5; mainly to
exploit the known weaknesses of the ;Mchange. They also used a
networking of various &verseas .orporate Dodies, <oreign Institutional
Investor su"-accounts and mutual funds for large transactions. Cot till the
((.D crash occurred did the regulatory authorities even "egin looking in
the manipulators directions although this was "eing underlined in Parliament
and the media. It is difficult to "elieve that the 5tock ;xchanges or 5;DI
were 'uite unaware of what was going on in the market when the
manipulators entities were manipulating the market using their network. Cor
did the !igh 2evel .oordination .ommittee 3!2..+ or the 5;DI seek a
check on where the mnaipulator was getting his funds from or his methods
of manipulating the market. This is all the more distur"ing in the context of
the previous 0P.9s findings against the manipulator. The main regulator of
5tock ;xchanges, 5;DI, has "een in place since %,JJ and has "een working
under an 4ct of Parliament since %,,) and should have "een a"le to regulate
the li"eralized market more efficiently. The .ommittee found that 5;DI has
still a long way to go "efore "ecoming a mature and effective regulator. If
5;DI had continued to improve its procedures, vigilance, enforcement and
control mechanisms, it could have "een more effective in a situation where
the stock market "ecame unusually volatile, leading to an unprecedented
surge and su"se'uent depression in the capital markets. It was also clear that
the capitalmarket in India is neither deep nor wide enough to moderate
volatility and, therefore, a fewplayers could attempt to manipulate the stock
markets. .learly, the various regulatory authorities were not a"le to foresee
the situation leading to the scam and prevent it. Cor was ade'uate attention
paid in government circles particularly the (inistry of <inance as the
custodian of the financial health of the economy.=rong doing "y "anks have
also contri"uted significantly towards the scam although the num"er of
"anks involved in committing irregularities in comparison to the total
num"er of "anks functioning in our country is small. Cota"ly, ma#or "anks
were nationalized in %,H, "ut pursuant to economic li"eralization, new
private "anks including foreign "anks were allowed into "anking sector.
Pu"lic sector "anks were in general not involved in the scam and have fared
well "ut private sector "anks need to "e closely watched, especially in the
area of risk management and stricter regulation. .ooperative "anks have
tended to ignore rules, procedures and risk management. This should set the
1DI and the /overnment thinking. There is need to have more effective
regulation in the "anking sector as a whole with particular emphasis on
cooperative "anks.&ne of the ma#or concerns of the .ommittee was to look
at the trading practices and procedures adopted in the stock market. 5tock
;xchanges, "rokers and regulators play a very important role in determining
the transparency of procedures and practices in the stock markets. The
.ommittee went into the functioning of these entities and generally found
that the 'uality of governance and the practices followed in the stock
exchanges were different from exchange to exchange, having evolved from
different local economic, social and historical conditions. 5;DI, as a
regulator, had made some attempts at standardizing the practices in these
exchanges and had also instituted arrangements where"y the happening in
the stock exchanges would come to its notice. Dut, in practice, the system
did not function efficiently or in a transparent manner. =hen stock markets
were rising, there was general lack of concern to see that such a rise should
"e in consonance with the integrity of the market and not the conse'uence of
manipulation or other malpractice. &n the other hand, when the markets
went into a steep fall, there was concern all over. 5uch dissonance in the
approach to issues of regulation and good governance needs to "e replaced
with effective regulation which concentrates on market integrity and investor
protection whether at any given point of time the market is "uoyant or not.
This .ommittee did not concern itself with either the rise or fall of the
market "ut specifically with manipulations or irregularities that caused
unusual rise and fall. The procedures, adherence to rules and the concern for
common investor appear to have "een 'uite loose in the .5;. The payment
pro"lem that surfaced in .alcutta 5tock ;xchange "rought to light many ills
of the institution. =orse, those ills such as unofficial "adla could have "een
recognized and corrected well in time. The .ommittee discussed the period
in which the present 5cam surfaced, resulting ultimately in the crash of the
stock market in (arch )--% onwards. *uring the year %,,, and early )---,
the market, particularly I.; stocks, rose sharply. Thereafter, from 0une )---
onwards it showed a decline which was gradual "ut consistent. <rom (arch
)--% onwards the decline in the 5;C5;M was sharp and could "e termed a
crash. There are a num"er of factors that contri"uted to this crash, one of
which is over-reaching "y one particular "roker and his ina"ility to sustain
his position. In addition, during the month of 0anuary-<e"ruary )--% the
.ommittee have found indications of large funds "eing withdrawn from the
stock market. =hether withdrawal of large sums from the stock market was
responsi"le for the crash or the large players withdrew the money "ecause
they knew that the 5;C5;M was likely to take a "eating was another aspect
the .ommittee deli"erated upon. The .ommittee note that the manipulator
who emerged as a key player in this scam received large sums of money
from the "anks as well as from the .orporate "odies during the period when
5;C5;M was falling rapidly. This led the .ommittee to "elieve that there
was a nexus "etween the manipulator, "anks and the corporate houses. The
.ommittee recommend that this nexus "e further investigated "y 5;DI or
*ept. of .ompany 4ffairs expeditiously. The process of li"eralization of the
economy has continued apace and it is market forces that will increasingly
determine economic trends in the country. =ith li"eralization, the role of the
/overnment as a direct player in the financial market will diminish. This
makes it all the more necessary that the procedures and guidelines laid down
for the creation and perpetuation of fair and transparent financial markets
and institutions like stock exchanges and "anks have to "e more specific,
and effective mechanisms have to "e put in place to ensure that they are
regularly followed. That #o" will have to "e done "y the regulatory
authoritiesT viz., 5;DI, 1DI and *.4 in liaison with investigative agencies
like the Income Tax *epartment, ;nforcement *irectorate and the .entral
Dureau of Investigation. .oordination with /overnment on policy issues
will, however, continue to "e central to good governance as there can "e no
escaping /overnment9s responsi"ility to Parliament and the country.
Therefore, /overnment must recognize that transactions in the market will
"e insulated from scams only if the relin'uishment of /overnment control
over the economy is accompanied "y strong and effective regulatory "odies.
This point had also "een underlined "y the earlier 0P. 1eport, %,,> on
Irregularities in 5ecurities and Danking Transactions.The proceedings "efore
the .ommittee themselves acted as a catalyst for many reforms in the
system, which were put in place during the .ommittee9s pendancy. These
actions "y regulators like 5;DI and 1DI and "y the (inistry of <inance
have "een touched upon in various chapters. The .ommittee feel that after
the presentation to Parliament in 4ugust and *ecem"er %,,? of the 4ction
Taken 1eports 34T1s+ on the scam relating to irregularities in securities and
"anking transactions, the will to implement various suggestions of the
previous .ommittee petered out. Dut, as soon as this .ommittee "egan its
sittings and searching 'uestions were asked, 5;DI,1DI and other regulatory
authorities including (inistry of <inance, went into active mode. !ad this
state of affairs prevailed after the 4ction Taken 1eport, the pro"a"ility of the
present 5cam would have "een negligi"le.
134 Reasons &or t"e Reoccrrence o& 'ecrit( 'ca) in !//1 Ins8ite o&
Gidelines Issed $( R1I in 1,,!
The .ommittee did not have the "enefit of a report on the lines of the
0anakiraman .ommittee 1eport which was made availa"le to the previous
0P. on the scam in securities and "anking transactions. 1elia"le evidence
was difficult to find and took much time to cull. The .ommittee had to rely
on a num"er of reports that dealt with specific and limited su"#ects. The
en'uiry reports of the regulators also displayed many gaps which had to "e
filled "y securing answers to a very large num"er of 'uestions asked "y the
.ommittee. The 5pecial .ell constituted "y the (inistry of <inance in 0une,
%,,? to investigate the nexus "etween "rokers and industrial houses in
pursuance of the recommendation of the earlier0P. having gone defunct
since (ay )), %,,A, without coming out with any tangi"le findings or
recommendations for remedial action, is one of the examples of apathy on
the part of different agencies and departments concerned. The .ommittee
were informed "y the .entral Doard of *irect Taxes that on (ay %,, %,,A
the */IT 3Investigation+, Dom"ay, who headed the 5pecial .ell, had sought
from .D*T ade'uate empowerment and administrative support for the .ell
in the a"sence of which the .ell was unlikely to reach to any firm
conclusions a"out the role of any one or more industrial houses in
comprehensive manner "ut the .hairman, .D*T, in his response thereto had
suggested that due to limited scope of task of the 5pecial .ell no additional
manpower was re'uired. 4lso in the minutes of the last meeting of the
5pecial .ell held on (ay )), %,,A, the mem"ers recorded that principal
o"stacle in unearthing the exact role of the industrial houses in the scam was
due to the scope of the .ell was limited only to Dom"ay region due to which
investigation into the activities of the suspects outside Dom"ay was not
within the #urisdictional authority. Thus, the 5pecial .ell was virtually
rendered a still-"orn "a"y. The lack of concern of /overnment demonstrated
in this casual approach to such an important issue is regretta"le. This 5cam
is "asically the manipulation of the capital market to "enefit market
operators, "rokers, corporate entities and their promoters and managements.
.ertain "anks, nota"ly private and co-operative "anks, stock exchanges,
overseas corporate "odies and financial institutions were willing facilitators
in this exercise. The scam lies not in the rise and fall of prices in the stock
market, "ut in large scale manipulations like the diversion of funds,
fraudulent use of "anks funds, use of pu"lic funds "y institutions like the
:nit Trust of India 3:TI+, violation of risk norms on the stock exchanges
and "anks, and use of funds coming through overseas corporate "odies to
transfer stock holdings and stock market profits out of the country. These
activities went largely unnoticed. =hile the stock market was rising, there
was inade'uate attempt to ensure that this was not due to manipulations and
malpractices. In contrast, during the precipitous fall in (arch )--% the
regulators showed greater concern. 4nother aspect of concern has "een the
emergence of a practice of non-accounta"ility in our financial system. The
effectiveness of regulations and their implementation, the role of the
regulatory "odies and the continuing decline in the "anking systems have
"een critically examined, for which the regulators, financial institutions,
"anks, 1egistrars of .o-operative 5ocieties, perhaps corporate entities and
their promoters and managements, "rokers, auditors and stock exchanges are
responsi"le in varying degrees. The parameters of governmental
responsi"ility have also "een taken into account.
It is the considered view of the .ommittee that the lack of progress in
implementing the recommendations of the last 0oint Parliamentary
.ommittee set up in %,,) to en'uire into Irregularities in 5ecurities and
Danking Transactions em"oldened wrong-doers and unscrupulous elements
to indulge in financial misconduct. The 5pecial .ell constituted "y the
(inistry of <inance in 0une %,,? to investigate the nexus "etween "rokers
and industrial houses in pursuance of the recommendation of the previous
.ommittee having gone defunct since )) (ay %,,A, without coming out
with anytangi"le findings or recommendations for remedial action, is one of
the examples of apathy on the part of different agencies and departments
concerned. The .ommittee express their concern at the way the supervisory
authorities have "een performing their role and the regulators have "een
exercising their regulatory responsi"ilities. That the regulatory "odies failed
in exercising prudent supervision on the activities of the stock market and
"anking transactions, "ecame evident during the course of evidence taken "y
the .ommittee and this has "een detailed in the succeeding chapters. In the
.ommittee9s view no financial system can work efficiently even if
innumera"le regulations are put in place, unless there is a system of
accounta"ility, cohesion and close cooperation in the working of different
agencies of the government and the regulators. In 4ugust )--%, after the
freeze "y :TI in :5-H? unit repurchases, the .ommittee were additionally
mandated "y Parliament to en'uire into :TI matters. The .ommittee find
that weaknesses in management and regulations of stock exchanges was
compounded "y serious management deficiencies in the :TI and financial
institutions.
1*4Mr R Banakira)anCs 3E6 9e8t( Go%ernor o& R1I4 %ie<s on t"e
Reoccrrence o& a 'ecrit( 'ca) in India and Cor8orate Go%ernance in
t"is re2ard.
BCew "rains are out to circumvent rules in the system. Politicians and
politics have a ma#or role to play. They is a pressure in P5:s to hire every
M, R and O and hence overstaffing and inefficiency. They have "ecome more
commercial in operations. These workers are also inefficient and have no
incentive to work hard. 4s much as how good work is not rewarded so are
mistakes not found out and corrected. =hile people in ma#or "anks are paid
less they have no initiative to work hard. In order to prevent another scam
from happening a more comprehensive set of guidelines have to "e prepared.
(aster .irculars have to "e made availa"le to "ankers so that they work
honestly and efficiently. In India #ustice is so much delayed and people often
fall into old ways without following guidelines.B