Ilp Set 4 Block 3 Part 3

ILP Value Add SET 4 Block 3 2017
INDIAN FINANCIAL SYSTEM
The financial system of India refers to the institutions of borrowing and lending of funds or
demand for and the supply of funds of all individuals, institutions, and companies and of the
government.
INDIAN FINANCIAL SYSTEM
Money Capital
Market Market
We will first deal with Money Market then in Next section we will look into Capital Market
MONEY MARKET
The Money Market is the market for borrowing and lending of short – term funds say up to 3 yrs.
The commercial banks, Regional Rural banks, Bill markets form money market.
Money Market
Organised Unorganised
Money
Banking SubMarkets Merchents
Lenders
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Both Banking and Sub Markets have further classification which are as follows.
We will look into each and every topic in detail one by one.
ORGANISED SECTOR
Organised sector consists of banking and sub markets as mentioned earlier. Banking sector
carries out both, deposit taking and lending operations. The sub markets do the money
transaction among banks and generate necessary capital for banking sector and commercial
sector.
BA
NKI
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Banking Sector SEC

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R
Cla
Regional ssif
Cooperative Commercial Rural icat
Banks ion
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ba
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Rural Urban Public Private ng
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tor.
RBI
It is the apex regulatory body of Indian banking system. It keeps the cash reserves of all
scheduled banks and hence is known as the “Reserve Bank”. It is also called the central bank. It
was established in 1935 under RBI Act 1934. It was owned by Private with Government share. It
was nationalised in 1949. General Superintendence and direction are carried by Central Board
of directors. Apart from central board, RBI has four local Boards (Chennai, Mumbai, Calcutta,
and New Delhi).
FUNCTIONS OF RBI
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:
“ ...to regulate the issue of Bank Notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of the
country to its advantage.”
The functions of RBI can be classified as
Functions
Monetary General
MONETARY FUNCTIONS
Monetary functions
Banker’s Bank are those concerned
Monetary Function
duly with money like

Banker and debt manager to issue of money,
government
quantity of money,
control of money
Bank of Issue
supply etc. The
following are the
Custodian and manager of Foreign
exchange monetary functions.
Quantiative
Controller of Credit
Qualitative
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We are not going into the details of the functions. That part has been covered under the
Monetary system related section.
RESERVE BANK OF INDIA: SUBSIDIARIES
1.DEPOSIT INSURANCE AND CREDIT GUARANTEE CORPORATION (DICGC)
With a view to integrating the functions of deposit insurance and credit guarantee, the Deposit
Insurance Corporation and Credit Guarantee Corporation of India were merged and the present
Deposit Insurance and Credit Guarantee Corporation (DICGC) came into existence on July 15,
1978. Deposit Insurance and Credit Guarantee Corporation (DICGC), established under the
DICGC Act 1961, is one of the wholly owned subsidiaries of the Reserve Bank. The DICGC
insures all deposits (such as savings, fixed, current, and recurring deposits) with eligible banks
except the following:
 Deposits of foreign Governments;

 Deposits of Central/State Governments;
 Inter-bank deposits;
 Deposits of the State Land Development Banks with the State cooperative bank;
 Any amount due on account of any deposit received outside India;
 Any amount, which has been specifically exempted by the corporation with the previous
approval of Reserve Bank of India.
Every eligible bank depositor is insured up to a maximum of `1,00,000 (Rupees One
Lakh) for both principal and interest amount held by him.
2. NATIONAL HOUSING BANK (NHB)
National Housing Bank was set up on July 9, 1988 under the National Housing Bank Act, 1987 as
a wholly-owned subsidiary of the Reserve Bank to act as an apex level institution for housing.
Some of the primary objectives were:
 To promote a sound, healthy, viable and cost effective housing finance system to all
segments of the population and to integrate the housing finance system with the overall
financial system.
 To promote a network of dedicated housing finance institutions to adequately serve
various regions and different income groups.
 To augment resources for the sector and channelise them for housing.
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 To make housing credit more affordable.

 To regulate the activities of housing finance companies based on regulatory and
supervisory authority derived under the Act.
 To encourage augmentation of supply of buildable land and also building materials for
housing and to upgrade the housing stock in the country.
 To encourage public agencies to emerge as facilitators and suppliers of serviced land for
housing.
3. BHARATIYA RESERVE BANK NOTE MUDRAN PRIVATE LIMITED (BRBNMPL)
The Reserve Bank established BRBNMPL in February 1995 as a wholly-owned subsidiary

to augment the production of bank notes in India and to enable bridging of the gap
between supply and demand for bank notes in the country. The BRBNMPL has been
registered as a Public Limited Company under the Companies Act, 1956 with its
Registered and Corporate Office situated at Bengaluru. The company manages two
Presses, one at Mysore in Karnataka and the other at Salboni in West Bengal.
4. NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT (NABARD)
In NABARD the majority stake is held by the Reserve Bank. NABARD is an apex
Development Bank with a mandate for facilitating credit flow for promotion and
development of agriculture, small-scale industries, cottage and village industries,
handicrafts and other rural crafts. It also has the mandate to support all other allied
economic activities in rural areas, promote integrated and sustainable rural
development and secure prosperity of rural areas
CLASSIFICATION OF BANKS
Banks are classified into scheduled and non-scheduled banks. All commercial banks, regional
rural banks, and state cooperative banks are classified like this.
SCHEDULED BANKS OF INDIA
Scheduled Banks in India constitute those banks which have been included in the Second
Schedule of Reserve Bank of India(RBI) Act, 1934. RBI in turn includes only those banks in this
schedule which satisfy the criteria laid down vide section 42 (6) (a) of the Act. The banks
included in this schedule list should fulfil two conditions.
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• The paid capital and collected funds of bank should not be less than Rs. 5 Lakh
• Any activity of the bank will not adversely affect the interests of depositors.
Every Scheduled bank enjoys the following facilities.
• Such bank becomes eligible for debts/loans on bank rate from the RBI
• Such banks automatically acquire the membership of clearing house.
Scheduled Banks have been classified as follows
NON SCHEDULED BANKS
The banks which are not included in the second schedule are called nonscheduled banks. Like
scheduled banks, these banks also have to follow the conditions regarding Cash Reserve Ratio
(CRR) but can keep it with itself. These banks are not eligible for loan from RBI. but become
eligible under emergency conditions.
THE REGIONAL RURAL B ANKS (RRB)
These banks were established since 1975. under RRBs Act 1976. RRBs were set up in all states
except Sikkim and Goa. Totally 196 Banks were set up. These banks were set up by public sector
banks. The public sector bank which set up a particular RRB is called sponsor bank of that RRB.
For example, Pandian Gram bank, a RRB was set up by Indian Overseas Bank. Indian Overseas
Bank is called sponsor bank of Pandian Gram bank. The purpose is to further increase credit
flow to rural areas. RRBs were established to lend to weaker section called target group like
landless labour, artisan and craftsmen at concessional rate. From 1997, RRBs were freed to lend
outside the target group.
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Since April 1987, no new RRBs have been opened due to the Kelkar committee’s
recommendations. Many of the RRBs became unviable or less profitable. To solve the problem,
weak banks are being merged with the efficient banks. The merging of RRBs is going on. Now,
they gain more autonomous power also.
CO-OPERATIVE BANKS
Cooperative banks are established by State laws. These banks are called as cooperative banks
because these have cooperation of stake holders as motive. If some individuals come together.
they can establish a cooperative bank. Cooperative banks are established with the aim of
funding agriculture and allied sectors and to finance village and cottage industries.
Along with lending, cooperative banks accept deposits. They operate on the principle “one
person one vote" in decision making. NABARD (National Bank for Agriculture and Rural
Development) is the apex body of cooperative sector in India.
THE COMPOSITION OF COOPERATIVE BANKS
The cooperative banks are divided into urban and rural. Further, they are divided into short
term and long term structure.
SHORT TERM STRUCTURES
Short term structures lend up to one year. They lend for cultivation activities and provide
working capital to buy seeds, fertilisers etc. The short term structure cooperative banks have a
3 tiered set up.
They are:
a. State Co-operative Bank

b. Central or District Co-operative Bank
c. Primary Agricultural Credit Societies
STATE CO-OPERATIVE BANK (SCB)
Each state has its own State Co-operative Bank. It is the Apex body for cooperative banks in a
particular state. They act as a mediator or as an intermediary between RBI and NABARD on the
one side and Central or District Co-operative Bank and Primary Agricultural Credit Societies on
the other side. They get loan from RBI at concessional rate. It gives grants to cooperative banks
in the state. Now, the intermediation of these banks is abolished by a memorandum of
understanding between RBI and these banks. Now, RBI has direct dealing with low tier
cooperative banks
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CENTRAL (OR DISTRICT) CO-OPERATIVE BANK
This cooperative bank operates at district level. Its operational area is limited to onedistrict.
There are two types of Central (or District ) Co-op Banks.
They are:
a. Co-operative Banking Union

b. Mixed Central Co-operative Bank
The membership of Co-operative Banking Union is open only to co-operative societies. But, the
membership of Mixed Central Co-operative Bank is open both to co-operative societies and
individuals.
The Central (or District) Co-operative Banks get loan from SCBs (State Cooperative Bank). They
grant loans to PACs (Primary Agricultural Credit Societies) and individuals.
PRIMARY AGRICULTURAL CREDIT SOCIETIES
These cooperative banks operate at village level. They provide short term loan to agriculture ( 1
year sometimes 3 years). PACs give loans to its members that are individuals.
LONG TERM STRUCTURES
Long term structures lend to meet medium and long term fund requirements. It ranges from
one and a half years to twenty-five years. They lend for land development, construction of
wells, purchase of pump sets, redemption of old debts etc. These banks initially were called as
mortgage banks. Earlier they were called Land development banks. Now they are called
Cooperative Agricultural and Rural Development Banks (CARDBs).
It is a two tiered structure. They are;
1. State Cooperative Agricultural and Rural Development Banks

2. Primary Cooperative Agricultural and Rural Development Banks
URBAN CO-OPERATIVE CREDIT INSTITUTIONS
The co-operative banks set up in the urban and semi urban areas are called Urban co-operative
credit institutions. They mainly lend to small borrowers and businesses.
SUB MARKETS
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Government, financial institutions and industries need resources for investment

and to meet shortage if any in the money for regular activities. Sub markets are markets to
generate resources needed to meet these needs.
COMPOSITION OF SUB M ARKETS
The sub market is divided into various segments. It is based on the financial instruments used in
this market. It is diagrammatically shown in figure below
Sub Market
Commercial Certificate
Call Money bill Market
paper of deposits
Commercial Treasury
bills bills
CALL MONEY MARKET
It is also known as money at call and short notice market. It deals in loans for a period ranging
from one to fourteen days. It is an inter-bank borrowing and lending market. One bank
demands money from another bank to cover its cash reserve requirements with RBI every
fortnight and to gain from foreign exchange market. The rate at which funds are borrowed in
these markets
is called call money rate.
COMMERCIAL DEPOSITS
A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by
commercial banks but they can be bought through brokerages. They bear a specific maturity
date (from three months to five years), a specified interest rate, and can be issued in any
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denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on
demand like those in a checking account.
COMMERCIAL PAPERS
Commercial paper is an unsecured, short-term loan issued by a corporation, typically for

financing accounts receivable and inventories. It is usually issued at a discount, reflecting
current market interest rates. Maturities on commercial paper are usually no longer than nine
months, with maturities of between one and two months being the average.
BILL MARKET (OR) DISCOUNT MARKET
In bill market, short term funds (usually 90 days) are bought and sold. The bill market consists
of two markets, one is commercial bill market and another is Treasury bill market
COMMERCIAL BILL MARKET
Commercial bills are bills other than treasury bills. They are issued by industries and traders.
TREASURY BILL
Treasury bills are securities issued by Government treasury. They are of short term in nature. In
this regard, they differ from market loans. They are non-interest bearing (zero interest/ zero
coupon). These kinds of bonds are called Zero coupon bonds. They are issued at a discount rate.
For example, a security worth of Rs. 1,000 may be issued against receipt of amount lower than
Rs. 1000. The purchaser of security can redeem the full Rs. 1,000 at a particular date (maturity
date). This is called redemption at par (original value).
UNORGANISED SECTOR
The unorganised sector banking is not a registered and regulated one. They do not maintain
proper account. The unorganized sector has two types of participants i.e. Money lenders and
Merchants.
The interest rate is usually high in unorganised sector.The lending and borrowing operation is
less cumbersome because many of the procedures followed by banks are not followed in
unorganised sector.
MONEY LENDERS
The money lenders are exclusively engaged in money lending operations. It is their source of
livelihood.
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MERCHANT CUM MONEY LENDERS
The merchant cum money lenders are engaged in merchandising and money lending. They lend
to producers of the product in which they merchandise. The producers have to sell their
products only to the lender. In this case merchant cum money lenders usually purchase
products at low price.
BANKING SCHEMES IN INDIA
Many schemes were launched in Banking Sector after nationalization of bank. These schemes
were launched to enhance spread of banking services to all the regions of the country and to
increase banking habit among people.
LEAD BANK SCHEME
In this scheme, any one public sector bank is selected in a district. That bank is designated as
Lead bank of the district. It co-ordinates the activities of all banks in that district to avoid
duplication of banking works, to ensure same person does not get loan from different banks,
and to ensure the banking benefit to all sections of people.
SERVICE AREA APPROACH (1988)
It operated under Lead Bank Scheme. Each semi urban & rural branch allotted a specific area
(cluster of village) to implement banking scheme.
DIFFERENTIAL RATE OF INTEREST SCHEME (1972)
Public Sector banks were directed to grant at least I% of their total deposits of previous year to
weaker sections of society at a concessional rate of 4%. At least 40% loan under this scheme to
SC/ST people is made compulsory.
SOCIAL BANKING
Financing of poverty reduction and employment programme of government by banks is called

social banking. Under this scheme beneficiaries of government’s self-employment programme
and those who got training from government programme are provided with loan.
PRIORITY SECTOR LENDING
First of all, in 1974, the banks were given a target of 33.33 % as share of the priority sector in
the total bank credit. This was later revised on the recommendation of the Dr. K S
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Krishnaswamy to 40%. This is the current target given to banks to disburse the loans to priority
sector.
Broadly, priority sector includes the Agriculture Finance, Small Enterprises, Retail Trade, Micro
Credit, Education Loans and housing loans. As per Reserve Bank of India, Priority sector includes
the sectors shown in the below figure.
Agriculture
Renewable
MSME
Energy
Priority
Sectors
Social
Education
Infrastructure
Housing
 At present the domestic banks have to disburse 40% of the Net Bank Credit to Total
Priority sector, out of which 18% should be total agricultural advances.
 The Foreign banks with less than 20 branches have been given a target of 40% of the
Net Bank Credit to priority sector, however, there is no lower limit fixed for agriculture.
 Target Credit to women beneficiaries is 5%.
(for further details check: https://www.rbi.org.in/scripts/FAQView.aspx?Id=87)
The basic objective of setting priority sector targets has been to ensure greater
flow of credit to certain sectors where credit would normally not flow to the
desired extent.
Earlier, there was a demand from various stake holders of the society that banks should be
given a higher than current 40% target of the Priority sector. As of now the targets have not
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been revised. The reason is that out of total deposits, banks have to keep certain amount to
maintain Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) and from the remaining
disposable amount 40 per cent is dedicated for the priority sector, so increasing the amount
reserved for priority sector lending from present 40 per cent is not possible.
FINANCIAL INCLUSION
Financial Inclusion is the delivery of financial services (Not only Banking) at an affordable cost to
the vast sections of the disadvantaged and low profile groups of the society. It helps the
vulnerable groups such as low income groups, weaker sections, etc., to increase incomes,
acquire capital, manage risk and work their way out of poverty through secure savings,
appropriately priced credit and insurance products, and payment services.
The inclusion is to be done on both supplying end (saving account) and receiving end (loans
from
financial institutions) Towards this end the RBI started “No-frills account” drive. The
banks were requested to open “No-frills account” with low or minimum balance
No- frills means including only the basic features without anything unnecessary especially
things added to make something more attractive or comfortable/ No-frills account means
accounts without premium services that are charged some amount. This reduces the cost of
holding account. It enables even poor people to hold bank account.
In place of No-frill account Basic Savings Bank Deposit Account (BSBDA) was
introduced. This account shall not have the requirement of any minimum balance. No
charge will be levied for non-operation/activation of in-operative ‘Basic Savings
Bank Deposit Account/ These accounts are now opened under Prime Minister Jan
Dhan Yojana with the aim of opening at least two accounts per family.
PROMOTION OF MICRO CREDIT
Micro Credit is defined as provision of thrift, credit and other financial services and
products of very small amount to the poor in rural, semi-urban and urban areas for
enabling them to raise their income levels and improve their living standards. Micro
credit Institutions are those which provide these facilities. The self-help group and bank
linkage is a medium to promote micro credit
NACHIKET MOR COMMITTEE ON FINANCIAL INCLUSION
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(Committee on Comprehensive Financial Services for Small Businesses and Low-Income

Households), 2014
The Reserve Bank of India (RBI) appointment a Committee on Comprehensive Financial Services
for Small Businesses and Low-Income Households under the Chairmanship of Shri Nachiket
Mor,
member on the Central Board of Directors, RBI in the month of Sep 2013.
Its prime object was to frame a clear and detailed vision for financial inclusion and financial
deepening in India and designing principles for achievement of financial inclusion and financial
deepening across the country and also development of comprehensive framework to monitor
the progress of financial inclusion. Committee’s recommendations are that in order to achieve
the task of financial inclusion in a manner that enhances both financial inclusion and stability,
there is need to move away from an exclusive focus on any one model to an approach where
multiple models and partnerships are allowed to thrive, particularly between national full-
service banks, regional banks of various types, NBFCs, and financial markets. The common
theme of all the recommendations made by the Committee is that instead of focusing only on
large generalist institutions, specialization and partnerships between specialists must be
encouraged.
Some of the key recommendations of the CCFS include:
I. Universal Electronic Bank Account for every resident to be made available at the time
of issuing the Aadhaar number.
II. Licensing, with lowered entry barriers but otherwise equivalent treatment, more
functionally focused banks, including payment banks, wholesale consumer banks, and
wholesale investment banks.
III. Developing risk-based supervision processes for regional banks and strengthening
existing ones before creating new regional banks.
IV. Reorienting the focus of NABARD, SIDBI, and NHB to be market-makers and providers
of risk-based credit enhancements.
V. Consolidating NBFC definitions into two categories: Core investment companies and
other NBFCs. Restore permission of NBFCs-ND to act as business correspondents.
VI. On priority sector lending, while the Committee acknowledged that the current focus of
the policy, on small farmers, small businesses, and weaker sections, was well placed, it
recommended an approach that incentivizes each provider to specialize in one or more
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sectors of the economy and regions of the country. It recommends raising priority sector
lending cap for banks to 50 per cent from the current 40 per cent.
VII. Government subsidies to be channeled as direct benefit transfers (DBTs) rather than as
subventions or waivers.
VIII. It also proposed for creation of a Payment Bank (PB) to provide payments services
including credit, insurance and risk management products.
IX. All financial firms regulated by the RBI be required to have an internal process to assess
suitability of products prior to advising clients with regard to them.
X. It recommends unified Financial Redress Agency under Finance Ministry for customer
grievances.
XI. Statutory liquidity ratio has outlived its utility for both Banks and NBFCs. So, it needs to
be scrapped
SMALL BANKS AND PAYMENT BANKS
The payment banks will be allowed to perform money transactions and open saving account
but
without giving loans. This will be helpful to the migrant work force which has to frequently
transfer money. The payment banks can also be used as banking correspondence. Thus it will
be
helpful in the creation of a mechanism which will allow the banking to percolate to the 60% of
the population who have no access to the formal banking sector. In the purview of scams like
Sharda and Sahara, where people are duped by the unscrupulous financial institutions, a move
towards institutionalization small transactions is a commendable step. Further if the initiative is
able to bring the millions of the poor under the formal banking institution, it will be given a
huge
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impetus to the reforms like direct cash transfers and may become a game changer in the public
delivery system existing in the country.
Its major criticisms are –
I. Timeframe it has set for financial inclusion is too short – just 24 months which is highly
unrealistic
II. It is also argued that there is no need for a new category of banks – Payment Banks –
and existing RRBs can be utilized for this purpose as RRBs themselves have not been
fully utilized.
III. Further, it pays too much attention on Aadhar and sees it as panacea to all challenges in
financial inclusion
BASEL NORMS
Basel norms are fixed by Bank for International Settlements(BIS). It is located in Basel,
Switzerland. It acts as a coordinating agency for Central Banks of various countries. It is
necessitated by globalization. Many banks operate internationally. These norms are for
individual banks and Systemically Important Financial Institutions (SIFT). Its implementation is
done by Central Banks of the respective countries. In India it is by RBI.
SIFTs are whose “failure may trigger a relatively large number of simultaneous failures within
the financial sector, and as a result, large losses to the entire economy”.'' It defines these
institutions from the point of failure.
Does it mean we can identify these institutions only after failure? The answer is yes and no.
There is no pre known definition. At the same time there are few indicators to
identify them. The financial institutions which are big in size, receiving short term
funds and lending for long term purpose are prone to failure. These are few
indicators based on which it can be identified. But these are not exhaustive
indicators.
These norms are developed by Basel committee on Banking Supervision (BCBS). So lar three set
of norms were developed. They are called Basel I, Basel II and Basel III. Basel I and II were
implemented. the Basel III is on implementation. but before coming to that we have to
understand following terms-
 CAR/CRAR- Capital Adequacy Ratio/ Capital

to Risk Weighted Asset Ratio
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 RWA- Risk Weighted Assets
- Formulae for CAR=Total Capital/RWA*100

- Now here, Total Capital= Tier1+ Tier2 capital
Tier 1 - The Tier-I Capital is the core capital
For example - Paid up Capital, Statutory Reserves, Other disclosed free reserves, Capital
Reserves which represent surplus arising out of the sale proceeds of the assets, other intangible
assets are belongs from the category of Tier1 capital.
Tier 2 - Tier-II capital can be said to be subordinate capitals.
For example - Undisclosed reserves, Revaluation Reserves, General Provisions and loss reserves,
Hybrid debt capital instruments such as bonds, Long term unsecured loans, Debt Capital
Instruments etc. are belongs from the category of Tier2 capital.
RISK WEIGHTED ASSETS -
RWA means assets with different risk profiles; it means that we all know that is much larger risk
in personal loans in comparison to the housing loan, so with different types of loans the risk
percentage on these loans also varies.
Leverage Ratio = Capital measure / Exposure measure
Capital measure means Tier 1 capital. Exposure measure means the assets created by banks
and financial institutions. The total assets are adjusted to take care of some unusual exposures
and after adjustments this exposure measure is arrived for this purpose. The banks are
expected to maintain a leverage ratio of at least 3%
BASEL III
 In 2010, Basel III guidelines were released. These guidelines were introduced in
response to the financial crisis of 2008.
 A need was felt to further strengthen the system as banks in the developed economies
were under-capitalized, over-leveraged and had a greater reliance on short-term
funding. Too much short-term funding makes the banks prone to risks. Banks generally
rely on short-term funding because it is profitable.
 Also the quantity and quality of capital under Basel II were deemed insufficient to
contain any further risk. This was because the banking system was growing. The world
economy was growing too. Hence, what is sufficient earlier was not sufficient now.
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 Basel III norms aim at making most banking activities such as their trading book
activities more capital-intensive.
 3 Most Important pillar of Basel III
The guidelines aim to promote a more resilient banking system by focusing on four vital
banking parameters viz. capital, leverage, funding and liquidity. We will not go into details here
and will just try to understand the concepts.
Capital
The capital requirement (as weighed for risky assets) for Banks was more than doubled. (e.g.
4.5% from 2% in Basel-II accord for common equity)
Leverage
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Leverage basically means buying assets with borrowed money to multiply the gain. The
underlying belief is that the asset will return the investor more than the interest he has to pay
on the loan. Obviously doing so is risky business. Thus the Basel III puts a limit on the banks for
doing this.
Funding and liquidity
Banks can be subjected to a lot of risk if all depositors come and ask all their money at the
same time. This is a hypothetical situation but it has happened in real with Lehman Brothers –
the bank whose collapse gave us the 2008 recession.
So, Basel III puts a requirement for the banks to maintain some liquid assets all the time. Liquid
assets are those which can be easily converted to cash. In India, this practice can be correlated
with that of maintaining CRR and SLR.
Implementation of Basel III norms in India
- The RBI has postponed the implementation of these norms to 2019.
It is important to note that it is not easy to implement these norms as it requires several
changes in the present banking system like higher capital requirement for banks, more
technological deployment, liquidity crunch etc.
From here we will move on to our next part of financial system – the capital Market.
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CAPITAL MARKET
The capital market is a vital of the financial system. Capital market concerned with the
industrial security market, government securities markets, and long term loan market. Capital
market deals with long term loan market. It supplies long-term and medium term funds. It deals
with shares, stocks debentures and bonds. Security dealt in capital markets are long-term
securities. It provides a market mechanism for those who have saving and to those who have
saving and to those who need funds for productive investments. The capital market aids
economic growth by mobilizing the savings of the economic sector and directing the same
towards channels of productive uses. Companies turn to them to raise funds needed to finance
for the infrastructure facilities and corporate activities. The capital market is source of income
for investors. When stock of other financial assets rises in value, investors become wealthier,
often they spend some of this additional wealth boost sales and promoting economic growth.
Stock value reflects investor reactions to government policy as well, if the government adopts
policies that investors believe will hurt the economy and company profits, vice-versa.
Here in this chapter we will look into the composition and Function of capital market in detail.
CAPITAL MARKET
Capital market deals with medium term and long term funds. It refers to all facilities and the
institutional arrangements for borrowing and lending term funds (medium term and long term). The
demand for long term funds comes from private business corporations, public corporations and the
government. The supply of funds comes largely from individual and institutional investors, banks and
special industrial financial institutions and Government.
NBFC
The institutions in the capital market are called Non-Banking Financial Companies. This is
evident from RBI's observation which runs as: “Housing Finance Companies, Merchant Banking
Companies. Stock Exchanges, Companies engaged in the business of stock-broking/ sub-
broking. Venture Capital Fund Companies, Nidhi Companies, Insurance companies and Chit
Fund Companies are NBFCs”. All the institutions listed in this observation are capital market
institutions. But it is not necessary that all NBFCs are capital market institutions
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COMPOSITION AND FUNC TIONS OF CAPITAL MAR KET
Capital Market
Developmental Financial
Securities Market
Financial Institution intermediaries
Government
Securities
Industrial Securities
SECURITIES MARKE T
Securities market deals with shares (equity shares, preference shares, derivatives) and debt
instruments (bonds, debentures etc.) Both shares and debt instruments are instruments of fund
raising. But, there is a difference between them.
SHARES VS DEBT INSTRUMENTS
In case of shares, the investors have a share in the capital and profit. In
case of debt instruments, the investors do not have any share in the
capital. They just lend to the company. The company is liable to pay
interest on capital borrowed through bonds. Regardless of profit or loss,
the debt instrument holders are entitled to receive interest income.
DEBENTURE VS BOND
Debenture is also like bond but there is a slight difference. Bonds are unsecured one. It means
there is no surety for bonds. The lender lends money to companies without any surety. In the
case of debentures there is some surety. It may be plant, machinery or building etc.
SHARES
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Shares are of two types. One is Equity share and the other is Preference share.
Equity shares are shares that has claim over capital, profit and loss. It means, the equity share-
holders have right to receive profit if the company earns profit and have to forego capital to the
extent of loss in case the company incurs loss.
Preference shares are shares that have entitlement to a fixed amount of dividend or dividend at
a fixed rate like that of interest on bonds. In the case of winding up (closing up) of company,
these shares have the preferential right to get back the capital paid. They have the right to get
back capital next to bond holders.
GOVERNMENT AND INDUSTRIAL SECURITIES MARKET
Based on the fund raiser, we can classify securities market into two types. One is Government
securities market and the other is Industrial Securities market.
GOVERNMENT SECURITIES MARKET
It is a market for Government and semi government securities backed by RBI. It is also known as
Gilt Edged Market. Gilt edged means “of the best quality”. The government securities are more
reliable. That is why they are called Gilt edged securities.
INDUSTRIAL SECURITIES MARKET
It is a market for securities of industrial and commercial organisations. Both the Government
securities and industrial securities are traded in primary as well as secondary market.
NEW AND OLD ISSUE MA RKET
Further, based on the nature of issue (in lay man’s language issue means selling) the securities
market can be classified as New issue market and Old issue market. The New issue market is
also known as Primary market. The Old issue market also known as Secondary Market.
In new issue market, the securities issued by issuer are purchased by investors that
are public. To put in another way, sale and purchase of new (fresh/ first time issued)
securities is carried out. In old issue market the sale and purchase of securities that were
already issued in the New issue market is carried out. In India, both New issue and Old issue
markets are regulated by Securities and Exchange Board of India (SEBI)
SEBI ACT, 1992:
SEBI was established and empowered statutory powers for
(a) protecting the interests of investors in securities,
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(b) promoting the development of the securities market, and
(c) regulating the securities market.
Jurisdiction of SEBI extends over corporates in the issuance of capital and transfer of securities,
in addition to all intermediaries and persons associated with securities market. It can conduct
enquiries, audits and inspection of all concerned and adjudicate offences under the Act. It has
powers to register and regulate all market intermediaries and also to penalise them in case of
violations of the provisions of the Act, Rules and Regulations
made there under. SEBI has full autonomy and authority to regulate and develop an orderly
securities market.
MEANS OF RAISING FUNDS BY FIRM IN PRIMAR Y MARKET
IPO: INITIAL PUBLIC OFFERING
Unlisted company offers its new or existing securities to the investors of the 1st time through
the issue of prospectus.
RED HERRING PROSPECTUS
It is the prospectus which is submitted with the regulator (e.g. SEBI) for the approval
FPO: FOLLOW ON PUBLIC OFFER
if any company or corporation that has already issued shares, issues share again, to raise
additional fund it is called as Follow on Public Offering (FPO).
RIGHTS ISSUE
A company offers its new shares only to the existing shareholders in proportion of their
shareholding. Usually shares are issued at discount.
PREFERENTIAL ISSUE
Under this a company offers its new security only to a selected group/ class of shareholders.
BONUS ISSUE
Under this a company offer/ allot new shares only to existing shareholders in proportion of
their shareholding, in lieu of distribution of dividend.
PRIVATE PLACEMENTS
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Under this a company raise funds from few big investors through personal contacts or through
a FI. Here SEBI permission is not compulsory.
TYPES OF CAPITAL
NAME DESCRIPTION
AUTHORISED MAXIMUM SHARE CAPITAL WHICH A COMPANY CAN RAISE

CAPITAL
ISSUED CAPITAL IT IS THAT PART OF AUTHORISED CAPITAL THAT IS OFFERED TO PUBLIC FOR SUBSCRIPTION
SUBSCRIBED CAPITAL WHICH IS SUBSCRIBED THE INVESTOR

CAPITAL
CALLED UP CAPITAL PART OF SUBSCRIBED CAPITAL WHICH SHAREHOLDERS HAVE TO PAY OR WHICH IS
DEMANDED BY THE COMPANY.
PAID UP CAPITAL CAPITAL WHICH IS ACTUALLY PROVIDED SHAREHOLDERS
SECONDARY MARKET
Secondary market is a medium for buying and selling of securities issued in the New issue
market. Stock exchange is synonymously used for Old issue market. But it is wider than that.
SECONDARY
MARKET
OVER THE COUNTER

STOCK EXCHANGE
EXCHANGES
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OVER THE COUNTER EXCHANGES
Over the counter exchange is a platform for trading in securities that are not ‘listed' on a
recognised Stock exchange. Ex. NASDAQ etc.
STOCK EXCHANGE
Stock exchange is an institution for orderly buying and selling of listed securities. Listed
securities means the securities accepted to be traded in stock exchanges. Ex. BSE, NSE
NSE: NATIONAL STOCK EXCHANGE
 Established: 1993 on recommendation of Pherwani committee.

 Industrial Development Bank of India (IDBI) is the main promoter of this exchange.
Other leading Financial Institutions are also promoters of it alone with IDBI.
 Head Quarter: Mumbai
 Companies listed > 1600
 Nifty stands for National Index for fifty. This and Nifty Junior are indices of National
stock exchange. NIFTY measures price movement of top fifty companies. Nifty Junior is
an index of next 50 top companies.
BSE: BOMBAY STOCK EXCHANGE
 Established: 1887
 lt is Asia’s oldest Stock Exchange. It was known as The Native Share and Stock Brokers
Association’. It was owned by stock brokers. Now it is demutualised.
Demutualised means the stock brokers owned organisation made public owned
organisation. The shares in the hands of brokers were transferred to public. This
process is called Demutualisation.
 Sensex stands for Sensitive index. This is an index of Bombay stock exchange. This
measures the price movement of top 30 company shares. The top 30 companies are
called Blue chip companies.
HOW TOP COMPANIES BE SELECTED FOR INDEXING PURPOSES?
The top companies are selected on the basis of total value of all shares that
are traded in the stock exchange.
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value of traded shares = Price of one share x Number of shares traded

This value is called free float market capitalisation. The value of all {both traded and non-
traded (the shares that are kept for a long time)} shares is called market capitalisation.
 Market capitalisation is the value of shares that were sold to public which are called
outstanding shares.
In formulaic form:
 Market capitalisation = Price x Total outstanding share
For example, if the price of a share is Rs.500 and the total outstanding share of that
company is 2000 then market capitalization is 500 x 2000 = Rs. 1000000. The price
mentioned here is not actual price but price estimated on the basis of future prospects of
the company and economic condition etc.
DEVELOPMENT FINANCIAL INSTITUTIONS
Development financial institutions provide long term loan (even more than
25 years) and entrepreneurial assistance to industries. The entrepreneurial assistance
is in the form of technical advice, helping in feasibility study etc. In India IDBI, Industrial
Financial Corporation of India (IFCJ), Exim Bank etc. are some of the development financial
institutions to be named.
FINANCIAL INTERMEDIA RIES
The capital market institutions other than stock exchanges and development
Financial Intermediaries
Department
of
NHB
Corporate
RBI Regulated SEBI Regulated Regulated
affaris
NBFC
regulated
NBFC.
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Asset
loan investment Venture
Merchant stock
Finance banking broking Page 26
company company Capital Fund
company companies companies
financial institutions can be called as Financial Intermediaries.
We will discuss only few of them as all the details are not important for the examination
purpose.
ASSET FINANCE COMPANY
The RBI website defines AFCs as follows:
“AFC would be defined as any company which is a financial institution carrying on as its
principal business the financing of physical assets supporting productive/ economic
activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and
material handling equipment, moving on own power and general purpose industrial
machines. Principal business for this purpose is defined as aggregate of financing real/
physical assets supporting economic activity and income arising there from is not less
than 60% of its total assets and total income respectively”.
VENTURE CAPITAL COMPANIES
Usually the financial institutions are hesitant to finance new products because the
profitability of new products is uncertain and involve risks. So, to finance such products,
separate type of financial companies who venture to finance them are established. They are
called Venture capital companies. The venture capital companies provide capital to
companies that produce new products based on innovations and to new industries.
DERIVATIVE INSTRUMEN TS & DERIVATIVE MARKETS
Market
Spot Forward
Forwards Futures options Warrants
call put
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SPOT MARKET
Spot Markets are those markets in which commodity or securities are bought and sold @
prevailing prices. Transactions are completed on the spot.
FORWARD MARKET
In this market, contracts are made to buy or sell a commodity or security @ a predetermined
price in future.
E.g. Farmer: I will sell 10kg wheat @ Rs.14/kg
Miller: I will buy 10 kg wheat after 2 months on the above price.
These transactions / contracts in forward market called as derivatives.
DERIVATIVES
Derivatives are products whose value is derived from the value of one or more basic variables,
which are called Underlying Assets. The underlying asset can be equity, index, foreign exchange
(Forex), commodity or any other asset. This means that any instrument that derives its value on
its underlying equity, index, foreign exchange (Forex), commodity or any other asset, is a
Derivative Instrument.
TYPES OF DERIVATIVES
The derivatives can be Forwards or Futures or Options or Warrants.
FORWARD CONTRACT
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified future time at a price agreed upon today.
FUTURE CONTRACT
Futures contracts are special types of forward contracts in the sense that they are standardized
exchange-traded contracts, such as futures of the Nifty index.
OPTIONS
An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying
at a stated date and at a stated price. While a buyer of an option pays the premium and buys
the right to exercise his option, the writer of an option is the one who receives the option
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premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options.
 ‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given future date.
 ‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of
underlying asset at a given price on or before a given future date. Please note that
options generally have lives of up to one year. The majority of options traded on
exchanges have maximum maturity of nine months. Longer dated options are called
Warrants and are generally traded over-the counter.
Let’s Understand these with an example.

We suppose that A wants to buy a house in next year June. At the same
time, B has a house worth Rs. 15 Lakh and he plans to sell it in June next
year. Since the current price is Rs. 15 Lakh, A and B enter into an
agreement via which A will buy that house in June 2017 in Rs. 17 Lakh. This
would be called
a Forward Contract. The price agreed upon would be called Delivery price.
Since A is buying it, for him, it
would be called Long Forward Contract. On the other side, B is selling it; it would be
called Short Forward Contract.
Now, we suppose that in next year June, instead of Rs. 17 Lakh, the market price of that
house becomes Rs. 20 Lakh. Since B is already in contract with A to sell him the house in
Rs. 17 Lakh, A would earn a profit of Rs. 3 lakh. B would lose Rs. 3 Lakh. Here we note
that forward contract is in contrast with the Spot contract. Spot contract is an
agreement to buy or sell an asset today.
There is one more term related to Forward Contracts called NDF or Non-Deliverable
Forward. Non-deliverable forwards are over-the-counter transactions settled not by
delivery but by exchange of the difference between the
contracted rate and some reference rate such as the one fixed by the Reserve Bank of
India. For example, if B pays A Rs. 3 Lakh without
delivering the actual house, it would be called NDF. The
same is basic funda for commodity forward contracts and TYPES of Goods - Exchanged
currency forward contracts. AGRICULTURAL PRODUCTS
GOLD & SILVER

MAJOR COMMODITIES EXCHANGE IN INDIA
FUELS
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1. MCX – Multi Commodity Exchange (Established: 2003)

2. NMCX – National Multi Commodity Exchange.
3. NCDEX – National commodities & derivatives exchange
4. ICEX – Indian commodities exchange.
ELECTRONIC SPOT EXCH ANGE
It facilitates spot trading in commodities through electronic medium. It creates direct linkages
between farmers, industrial producers, exporters and consumers.
 NSEL: National Spot exchange ltd.

 NSPOT: NCDEX spot exchange ltd.
 NAPMC: National agriculture Produce market company ltd.
FEW IMPORTANT TERMS
FACE VALUE AND ISSUE PRICE
Face value is the actual value of shares. Issue price means price of share including
share premium. Premium means extra price a share claims in the market due to high demand
for it. For example, the face value of share may be Rs.10 but due to high demand the share can
be issued at say Rs.600. Here the share premium is Rs. 590. The thing to be noted is the
companies announce dividend only on face value. In this case, if a company says dividend is
23% it means 23% of Rs.10.
SHORT SELLING
In short selling, the seller sells the securities without owning the securities. He borrows
the securities and sells it.
BULL AND BEAR TRADING
In bull trading, buyers buy more shares in the expectation that the securities price will rise in
the future with a plan to sell at that time and earn profit. In bear trading the sellers sell the
securities,
with the intention to avoid loss, in the expectation that the security prices will fall.
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SECURITISATION
Securitisation is the method of converting existing assets into securities. lake the
case of banks, their unrecovered loans are considered as Non- performing assets (NPA). These
assets are sold to Asset Reconstruction Companies (ARCs). The asset reconstruction company
divides the total assets into equal parts and sells to investors. The investors are entitled to flow
of interest income from these assets and principal amount when repaid.
MUTUAL FUNDS (MFS)
While merchant banker primarily helps issuer, the Mutual funds help investors. The mutual
funds mobilise the savings of the people and invest in securities. The
individuals lack expertise in stock market and have very small amount to invest. So the mutual
funds collect money from public and create a large pool of money and with their expertise they
invest in securities. They invest in product called Units. Units are made up of more number of
securities. The shares of various companies are pooled together.
For example, 10 shares often companies (totally 100 shares) are pooled together.
The value of share of each company may be different. Assume that the total value
of 100 shares is Rs. 7000. This may be divided into units of Rs. 10 each. So, totally
700 units are available. It means each unit has a small portion of all the 100 shares.
The investor money is invested in these units. Their return depends on growth of
all the 100 shares. In this way investment, the small amount of money gets invested in many
shares and not in single share. So the risk is spread out.
HEDGE FUNDS
Hedge funds are similar to Mutual Funds. But in the case of Mutual Funds the fund is collected
from public and invested by Mutual fund which is created by somebody else whereas in case of
Hedge Funds it is not public but a hand full of investors join together and form fund of their
own and invest in different securities and use different investment strategies. These investors
are financially well and are sophisticated investors. So, they do not need protection of SEBI and
they are unregistered and unregulated.
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Copyright © by IASbaba
All rights are reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted
in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior
permission of IASbaba.
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INDIAN FINANCIAL SYSTEM

INDIAN FINANCIAL SYSTEM

Banking Sector SEC

duly with money like

RESERVE BANK OF INDIA: SUBSIDIARIES

1.DEPOSIT INSURANCE AND CREDIT GUARANTEE CORPORATION (DICGC)

 Deposits of foreign Governments;

2. NATIONAL HOUSING BANK (NHB)

 To make housing credit more affordable.

3. BHARATIYA RESERVE BANK NOTE MUDRAN PRIVATE LIMITED (BRBNMPL)

The Reserve Bank established BRBNMPL in February 1995 as a wholly-owned subsidiary

4. NATIONAL BANK FOR AGRICULTURE AND RURAL DEVELOPMENT (NABARD)

SCHEDULED BANKS OF INDIA

• Such banks automatically acquire the membership of clearing house.

Scheduled Banks have been classified as follows

NON SCHEDULED BANKS

THE REGIONAL RURAL B ANKS (RRB)

THE COMPOSITION OF COOPERATIVE BANKS

SHORT TERM STRUCTURES

a. State Co-operative Bank

STATE CO-OPERATIVE BANK (SCB)

a. Co-operative Banking Union

PRIMARY AGRICULTURAL CREDIT SOCIETIES

LONG TERM STRUCTURES

It is a two tiered structure. They are;

1. State Cooperative Agricultural and Rural Development Banks

URBAN CO-OPERATIVE CREDIT INSTITUTIONS

Government, financial institutions and industries need resources for investment

COMPOSITION OF SUB M ARKETS

CALL MONEY MARKET

Commercial paper is an unsecured, short-term loan issued by a corporation, typically for

BILL MARKET (OR) DISCOUNT MARKET

COMMERCIAL BILL MARKET

MERCHANT CUM MONEY LENDERS

BANKING SCHEMES IN INDIA

LEAD BANK SCHEME

SERVICE AREA APPROACH (1988)

DIFFERENTIAL RATE OF INTEREST SCHEME (1972)

Financing of poverty reduction and employment programme of government by banks is called

PRIORITY SECTOR LENDING

(for further details check: https://www.rbi.org.in/scripts/FAQView.aspx?Id=87)

PROMOTION OF MICRO CREDIT

NACHIKET MOR COMMITTEE ON FINANCIAL INCLUSION

(Committee on Comprehensive Financial Services for Small Businesses and Low-Income

SMALL BANKS AND PAYMENT BANKS

Its major criticisms are –

 CAR/CRAR- Capital Adequacy Ratio/ Capital

 RWA- Risk Weighted Assets

- Formulae for CAR=Total Capital/RWA*100

Tier 1 - The Tier-I Capital is the core capital

Tier 2 - Tier-II capital can be said to be subordinate capitals.

RISK WEIGHTED ASSETS -

Leverage Ratio = Capital measure / Exposure measure

Funding and liquidity

Implementation of Basel III norms in India

- The RBI has postponed the implementation of these norms to 2019.

COMPOSITION AND FUNC TIONS OF CAPITAL MAR KET

SHARES VS DEBT INSTRUMENTS

GOVERNMENT AND INDUSTRIAL SECURITIES MARKET

GOVERNMENT SECURITIES MARKET

INDUSTRIAL SECURITIES MARKET

NEW AND OLD ISSUE MA RKET

SEBI ACT, 1992: