Indian Financial System2

7/30/2019 Indian Financial System2

1/42

UNIT II

ELEMENTS OF THE FINANCIAL SYSTEM

The Indian Financial System Consists of:

The Financial Markets

The Financial Intermediaries

The Financial Instruments

Financial Markets:

The Indian Financial Markets can be divided into two components:

a) Money Marketb) Capital Market

The Indian Money market is unorganized or we can say that India has an

under developed money market. Therefore, it needs measures to

strengthen it.

Indian Money market can broadly be divided into two parts:a) Organized money market

b) Unorganized money market

Financial Intermediaries:

Banking and Non-banking financial Institutions.

The Reserve Bank of India which was set up in 1935, is the apex

organization or institution in the Indian money market (It is theCentral Bank of our country).

The Reserve Bank of India set up many institutions which are

supposed to help it in achieving its objectives. In April 1988, set upthe Discount and Finance House of India to perform the function of

stabilizing the money market.

The following diagrams can be used in order to notice the evolution andthe current structure of the financial system in India.


2/42

ORGANISAITON OF THE FINANCIAL

SYSTEM (1951 to 1985)

FINANCIAL

INTERMEDIARIE

S

FINANCIAL

MARKETS

FINANCIAL

ASSETS/

INSTRUMENTS

BANKS NBFCsMUTUAL

FUNDS

INSURANCE

ORGANISATION

S

ASSET FINANCE COMPANIES

HOUSING FINANCE COMPANIES

VENTURE CAPITAL FUNDS

MERCHANT BANKING ORGANISATIONS

CREDIT RATING AGENCIES

FACTORING AND FORFAITING ORGANISATIONS

STOCKBROKING FIRMS

CUSTODIAL SERVICES

DEPOSITORIES

ORGANISAITON OF THE

FINANCIAL SYSTEM (1951 to 1985)

FINANCIAL

INTERMEDIARIES

FINANCIAL

MARKETS

FINANCIAL

ASSETS/

INSTRUMENTS

MONEY

MARKET

CAPITAL/

SECURITIES

MARKET

PRIMARY/NEW

ISSUEMARKET

SECONDARY/

STOCK

MARKET/

EXCHANGE

CALL MARKET

T-BILLS MARKET

BILLS MARKETCP MARKET

CD MARKET

REPO MARKET


3/42

ORGANISAITON OF THE

FINANCIAL SYSTEM (1951 to 1985)

FINANCIAL

INTERMEDIARIES

FINANCIAL

MARKETS

FINANCIAL

ASSETS/INSTRUMENTS

PRIMARY/

DIRECT

INDIRECT DERIVATIVES

EQUITY/

ORDINARY

SHARES

PREFERENCE

SHARES

DEBENTURES

INNOVATIVE

DEBT

INSTRUMENTS

MUTUAL FUNDS UNITS

SECURITY RECEIPTS

SCRUTINISED DEBT

INSTRUMENTS

FORWARD

FUTURES

OPTIONS

CONVERTIBLE DEBENTURES

NON-CONVERTIBLE

DEBENTURESSECURED PREMIUM NOTES

WARRANTS

ORGANISATION OF THE INDIAN FINANCIAL SYSTEM (Post 1991)

PRIVATISATION OF

FINANCIAL

INSTITUTIONS:

BANKS

MUTUAL FUNDS

INSURANCE

COMPANIES

REORGANISATION

OF STRUCTURE

FINANCIAL

MARKETS

INVESTOR

PROTECTION

SEBI

DFIs/PFIsBANKS

NBFCs

MUTUAL

FUNDS

CAPITAL

MARKET

MONEY

MARKET

PRIMARY

MARKETSTOCK

EXCHANGE

PRUDENTIAL

NORMS:

CREDIT/ADVANCE

PORTFOLIO

INVESTMENT

PORTFOLIO

CAPITAL

ADEQUACY

MANAGEMENT OF

NON-PERFORMING

ASSETS:

DEBT RECOVERY

TRIBUNALS

CORPORATE DEBT

RESTRUCTURING

SECURITISATION,

RECONSTRUCTION

OF FINANCIAL ASSETS

AND ENFORCEMENT

OF SECURITY

INTEREST

RISK

MANAGEMENT

ASSET

LIABILITY

MANAGEMENT

CREDIT

RISK

MANAGEMENT

OPERATIONAL

RISK

MANAGEMENT


4/42

FUNCTIONS OF FINANCIAL SYSTEM:Savings function:

As already stated, public savings find their way into the hands of those inproduction through the financial system. Financial claims are issued in the

money and capital markets, which promise future income flows. The funds,

in the hands of the producers, result in the production of better goods andservices and an increase societys living standards. When saving flows

decline, however, the growth of investment and living standard begins tofall.

Liquidity function:Money in the form of deposits offers the least risk of all financial

instruments. But its value is mostly eroded by inflation. That is why onealways prefers to store funds in financial instruments like stocks, bonds,

debentures, etc. However, in such investments (1) a greater level of risk is

involved, (2) and the degree of liquidity (i.e., conversion of the claims intomoney) is less. The financial markets provides the investor with the

opportunity to liquidate the investments.

Payment function:The financial system offers a very convenient mode of payment for goods

and services. The cheque system, credit card systems et al are the easiest

methods of payment in the economy; they also drastically reduce the costand time of transactions. In India, the cheque system of payment is widely

practiced. The credit card system has entered only urban India and iswidely used in these areas for payment of consumption expenditure.

Risk function:The financial markets provide protection against life, health and income

risks. These are accomplished through the sale of life, health and propertyinsurance policies. The financial markets provide immense opportunities for

the investor to hedge himself against or reduce the possible risks involved

in various investments.

Policy function:India has a mixed economy. The government intervenes in the financial

system to influence macroeconomic variables like interest rates or inflation.In 1996-97, by bringing about several cuts in the CRR from 12% to 10%the government, the RBI tried to force the interest rates down and increase

the availability of credit-at cheaper rates to the corporate sector.

Modern day economies require huge sums of money for investment incapital assets (land, equipment, factory, etc.), which are then used for

providing goods and services. The funds required are so huge that it is not

possible for a single government/firm to meet the requirement. By sellingfinancial claims like stocks, bonds etc., the required can be quickly raised

from a variety of investors. The business firm/government issuing such a

financial claim then hopes to return the borrowed funds from expectedfuture inflows. Indeed, we see that the financial markets within the

financial system have made possible the exchange of current income forfuture income and transformation of savings into investments, so that

production and income grow.

INDIAN MONEY MARKET:

Money market refers to a mechanism whereby on the one hand borrowers

manage to obtain short-term loanable funds and on the other, lenders

succeed in getting creditworthy borrowers for their money. In any moneymarket, commercial banks are the most important lenders. These banks


5/42

are, however, not merely the lenders of money, they also create credit.The central banks role is important as the controller of credit. The money

market as it existed in India during the pre-independence period was farmore undeveloped than what it is today. Now the Indian money market in

spite of all its limitations and defects is perhaps one of the most organized

money markets in a Third World country.

Here we will discuss the following issues:1. The nature of the unorganized sector of the Indian money market.

2. Organised sector of the Indian money market and its various

constituents.3. Characteristics of Indian money market.

4. Measures introduced to strengthen the money market in India.

THE INDIAN MONEY MARKET:

The Indian money market is not an integrated unit. It is broadly dividedinto two parts, viz., the unorganized and the organized. There is

compartmentalization between the two markets and as such the rates ofinterest differ in the unorganized sector from those in the organized sector.

The unorganized sector of the money market comprises the indigenousbankers and the moneylenders. This, in fact, is not a homogeneous sector.

The organized sector, on the other hand, is fairly integrated. Both

nationalized and the private sector commercial banks constitute the core ofthe organized sector. The foreign banks, co-operative banks, Reserve Bank

of India, Discount and Finance House of India, development financeinstitutions like IDBI and IFCI and investment finance companies like the

LIC, GIC and UTI and Mutual Funds are the other institutions which operatein the organized sector of the Indian market. The Reserve Bank of India isthe apex organization in the Indian money market. Since it is the leader

and controller of the money market, it has great responsibility in respect ofsmooth functioning of the financial system. In April 1988, the Reserve

Bank of India set up the Discount and Finance House of India to perform

the function of stabilizing the money market.

UNORGANIZED SECTOR OF THE INDIAN MONEY MARKET:Although some indigenous bankers and moneylenders exist even in big

cities, the fact is that their banking activities, or to be more specific,lending activities are mostly confined to small towns and villages wheremodern banking facilities are still inadequate. Farmers, artisans and other

small scale producers and traders, who do not have access to modernbanks borrow from them. Lendings of the moneylenders are rather small,

but some indigenous bankers do a considerable amount of business. Theypursue banking business on traditional lines and combine it with other

businesses.

The unorganized sector of the Money Market Consists of:

Unregulated non-bank financial intermediaries

Indigenous bankers and

Money lenders

1. Unregulated non-bank financial intermediaries. In India,there are several types of unregulated non-bank financial

intermediaries. Among these the most prominent are (i) finance

companies, (ii) chit funds and (iii) nidhis. Finance companies arefound in all parts of the country. The exact number of finance

companies is not known. Finance companies generally give loans toretailers, wholesale traders, artisans and other self-employed persons.

Since finance companies charge high rates of interest varying from 36 to


6/42

48 per cent, normally corporate firms do not borrow from thesecompanies. The chit funds are savings institutions. They are of

various types lacking any standardized form. A chit fund has regularmembers who make periodical subscriptions to the fund. The periodic

collection is given to some member of the chit fund selected on the basis

of previously agreed criterion. The chit fund business is now done inalmost all the States but Kerala and Tamil Nadu account for the

major part of total chit fund business. Estimates of depositsreceived by the chit fund companies and their annual turnover are not

available. The RBI has absolutely no control over the lending activities

of the chit funds. The nidhis operate particularly in South India.In their character they are like some kind of mutual benefit funds as

their dealings are restricted only to the members. Since the nidhisoperate in the unregulated credit market, there is hardly any information

available about the amount of lending business done by them.

2. Indigenous bankers. Indigenous bankers are individuals or

private firms which receive deposits and give loans and thereby operateas banks. Since their activities are not regulated, they belong to the

unorganized segment of the money market. Indigenous bankers do notconstitute a homogeneous group. Broadly they may be classified under

four main sub-groups: Gujarati Shroffs, Multani or Shikarpuri Shroffs,

Chettiars and Marwari Kayas. The Gujarati Shroffs operate in Mumbai,Kolkata, and the industrial and trading cities of Gujarat. The Marwari

Shroffs are active in Kolkata, Mumbai, tea-gardens of Assam and otherparts of North-East India. The Multani or Shikarpuri Shroffs are to be

found mainly in Mumbai and Chennai and the Chettiars are concentratedin the South. Of the four main such groups of the indigenousbankers, the Gujarati indigenous bankers are the most important

in terms of the volume of the business. Over the past threedecades the indigenous bankers have faced stiff competition from the

commercial and cooperative banks, yet they have survived.

3. Money lenders. Moneylenders do not constitute one

homogeneous category. Broadly they are of three types: (1)professional moneylenders whose main activity is money lending; (2)

itinerant moneylenders, like Pathans and Kabulis, and (3) non-professional moneylenders whose main source of income is not moneylending. The methods of operation of the moneylenders are not

uniform. Their activities are generally localized.

ORGANIZED SECTOR OF THE INDIAN MONEY MARKET:

The modern sector of the Indian money market is reasonably well

organized and integrated. Leaving aside some highly developed financialcentres, the organized sector of the Indian money market is far more

organized and developed than the money markets in most of the countries.

The organized sector of the Indian money market comprises the ReserveBank of India, commercial banks, foreign banks, cooperative banks, finance

corporations, Mutual Funds and the Discount and Finance House of IndiaLimited (DFHI).

Mumbai, Kolkata, Delhi, Chennai, Ahmedabad and Bangalore are the

principal centres of the organized sector of the Indian money market, of

which Mumbai is the most prominent. The Mumbai money market has nowbecome synonymous with the Indian money market. At present the

Mumbai money market occupies the same position in India as the London

money market in England and the New York money market in the USA.The presence of the head offices of the RBI and various commercial banks,


7/42

the leading stock exchange, well organized market of the governmentsecurities; the billion exchange and the cotton exchange have made

Mumbai the most prominent financial centre of the country.

No doubt the organized sector of the Indian money market is fairly

developed and organized, yet it is not comparable to the New York or theLondon money market. Broadly, the principal constituents of the Indian

money market are: (i) The Call Money Market, (ii) The Treasury Bill Market,

(iii) The Repo Market, (iv) The Commercial Bill Market, (v) the Certificate ofDeposits Market, (vi) The Commercial Paper Market and (vii) Money Market

Mutual Funds.

FINANCIAL INSTITUTIONS:Financial institutions are vital to the economic well-being and future growth

of a market-oriented economy. In most industrialized economies today,

the liabilities of financial institutions are the principal means for makingpayments for goods and services, and their loans are the chief source of

credit for all economic units in society-business, households, and

governments. Moreover, the financial institutions sector, along with theservices sector as a whole, has been one of the most rapidly growing

ORGANIZED SECTOR OF THE INDIAN MONEY MARKET

SUB MARKETS

Call Money Market

Treasury Bill Market

The Repo Market

Commercial and

Trade Bills MarketCertificate of Deposits

Market

Commercial Paper

Market

Money Market Mutual

Funds

PARTICIPATING

INSTITUTIONS

Reserve Bank of India

Discount and Finance

House of India

Banks

Development Financial

Institutions

Investment Finance

Companies

Mutual Funds

INSTRUMENTS

Treasury Bills

Repos

Inter Bank Call Money

Commercial and Trade

Bills

Commercial Paper

Certificates of

DepositsParticipation

Certificates


8/42

components of the global economy, creating challenging businesses andcareer opportunities for the future. For all of these reasons, an

understanding of the lending and borrowing activities, the portfoliobehaviour, the management policies and the regulatory environment of the

financial institutions is essential.

Financial Institutions & Environment in India :

Thanks to the initiatives taken by the government, a large number of otherfinancial institutions have also come up in the post Independence period.

The wide variety of financial institutions existing in India can be broadly

classified into all-India financial institutions, State level institutions andother institutions. The financial institutions within these groups can be

further categorized according to their main activities/functions into:

1. All India Development Financial Institutions (DFIs): Industrial

Finance Corporation of India Ltd (IFCI), Industrial Development ofIndia (IDBI), Small Industries Development Bank of India (SIDBI)

and Industrial Investment Bank of India (IIBI). Industrial Credit andInvestment Corporation of India Ltd. (ICICI Ltd) has ceased to be a

development bank after its merger with ICICI Bank with effect fromMarch 30, 2002.

2. Specialized Financial Institutions: Export-Import Bank (EXIM

Bank), IFCI Venture Capital Funds (IVCF, formerly RCTC) Ltd., ICICIVenture Ltd. (formerly TDICI Ltd), Tourism Finance Corporation of

India (TFCI) Ltd., and Infrastructure Development Finance Company(IDFC) Ltd.

3. Investment Institutions: Life Insurance Corporation of India (LIC),Unit Trust of India (UTI), and General Insurance Corporation of India(GIC) and its four erstwhile subsidiaries.

4. Refinance Institutions: National Housing Bank (NHB) and NationalBank for Agriculture and Rural Development (NABARD).

5. State level Institutions: State Financial Corporations (SFCs) and

State Industrial Development Corporations (SIDCs).6. Other Financial Institutions: Some other financial institutions are

Export Credit and Guarantee Corporation of India Ltd. (ECGC) andDeposit Insurance and Credit Guarantee Corporation (DICGC).

Of all the above financial institutions, only nine (IDBI, IFCI, EXIM Bank,NABARD, SIDBI, IDFC, IFCI, IIBI and NHB) fall within the regulatory and

supervisory domain of Reserve Bank of India.

FINANCIAL INSTITUTIONS

FINANCIAL INTERMEDIARIES

COMMERCIAL BANKS

CREDIT UNIONS

SAVING BANKS

SAVINGS AND LOAN

ASSOCIATIONS

LIFE INSURANCE COMPANIES

INVESTMENT COMPANIES

FINANCE COMPANIES

PENSION FUNDS

REAL ESTATE INVESTMENT

TRUSTSLEASING COMPANIES

OTHER FINANCIALINSTITUTIONSSECURITIES BROKERS

AND DEALERS

INVESTMENT BANKERS

MORTGAGE BANKERS

MISCELLANEOUS

INSTITUTIONS


9/42

The all-India financial institutions have been fast losing ground in recentyears. This situation has come about as a result of the distinction

between development and commercial banking getting blurred, high

cost of funds and asset-liability mismatches. With reforms in the financialsector, the facility of low cost funds under long-term operations funds,

funds from bilateral and multilateral agencies and bond issues understatutory liquidity ratio is no more available. Now the financial institutions

are raising funds at market rates of interest. The Narasimham Committee

II had recommended that with the convergence of activities between banksand development financial institutions, the development financial

institutions should, over a period of time, convert themselves into bankspaving the way for only two forms of intermediaries, viz., banking

companies and non-banking financial institutions. The Reserve Bank of

India had advised financial institutions to chart a path for their evolutioninto universal banks. The merger ofICICI had accounted for a substantial

part of the sanctions and disbursements of all India financial institutions.With its merger with ICICI Bank, the role of all-India financial

institutions has subsided further. Similarly, in order to pave the wayfor conversion into a universal bank, IDBI had approached the government

to corporatize it by repealing the IDBI Act. Accordingly the government

announced the proposal for corporatizing IDBI by introducing the necessarylegislative changes.

The Call Money Market:

The call money market consists of overnight and money at short notice forperiods upto 14 days. It is meant to balance the short-term needs ofbanks. The call money market exists in almost all developed money

markets. It is generally the most sensitive part of the financial system.Any change in flow of funds and the demand for them is clearly reflected in

it. The response is generally quick. In India, the call money market is

centred at Mumbai, Kolkata and Chennai. Among these, the market atMumbai is the most important. During the 1980s the call money rate was

an administered one. Its ceiling at 10 per cent was fixed by the IndianBanks Association. This was the time when there were a few large lenders

and a large number of borrowers in the call money market. Since in thisperiod there were not many participants who alternated as both lendersand borrowers, the call money market failed to develop adequately. The

UTI and the LIC were large lenders. They were not allowed to operate asborrowers. These investment institutions had a sizeable short-term float

which they could profitably deploy in the call money market. Thecommercial banks were usually the borrowers. Their needs for short-term

funds often coincided. Among the banks the State Bank of India was

sometimes on the lenders side of the market on account of its strongliquidity position.

On the recommendations of the Vaghul Committee the Discount andFinance House of India (DFHI) was set up in April 1988. In July 1988

the DFHI was allowed to operate both as lender and borrower in the callmoney market. The operations of the DFHI were exempted from the

ceiling rate set by the Indian Banks Association. These measureshelped in the development of the call money market as they corrected

imbalances in the supply and demand for funds in the market. With the

participation of DFHI in the call money market there was a significantincrease in its annual turnover.

In May 1989, the ceiling on the call money rate was withdrawn. In May1990, the Reserve Bank of India allowed IDBI, GIC and NABARD to


10/42

participate in the call money market as lenders. In October 1993, theparticipating development banks and the financial institutions were allowed

to borrow up to an aggregate limit of Rs.1,000 crore with individual limitsto be fixed for borrowing from time to time.

Since the withdrawal of ceiling on the call money rate there have beensharp fluctuations in it due to imbalances in the demand and supply of bank

reserves. The imbalances in the demand and supply of bank reservesarose on account of several factors. The most important of these has been

a branching up of the banks needs for short-term funds in order to meet

cash reserve ratio (CRR) requirements. Another contributing factor hasbeen the unsound policy of some large banks to invest in medium and long-

term assets by borrowing from the call money market. Finally, theoccasional withdrawal of liquidity from the banking system by the

government led to imbalances in the demand and supply of bank reserves.

According to Kunal Sen and Rajendera R. Vaidya, instability in the call

money rates in the post-1990 period notwithstanding, with thederegulation of the interest rate and the widening of the market through

the participation of more non-bank financial institutions as both lenders andborrowers, the call money market has been playing an increasingly

important role in equilibrating the banking systems demand and the supply

of the short-term funds. Clearly, with the growth in the size of the callmoney market (as evident by the increase in DFHIs annual turnover), the

need for commercial banks to hold on to excess reserves to meet anyunanticipated deposit withdrawals by bank customers has been greatly

reduced thereby lowering bank intermediation costs. The setting up ofDFHI in 1988 and its emergence as a major force in the call money markethave also contributed to the development of the market.

Call money rates were stable during the first-half of 2004-05, reflecting the

substantial overhang of liquidity in the system. The scenario began

changing in October 2004 and the call money market once again stabilizedin November 2004. However, the average call rate had risen to 5.62 per

cent as against below 4.5 per cent in the first-half of 2004-05.

The Treasury Bill MarketThe market which deals in treasury bills is known as the treasury billmarket. In India, treasury bills are short-term liability of the Central

government. Theoretically treasury bills should be issued for meetingtemporary deficits which a government faces due to its excess of

expenditure over revenue at some point of time. However, in India tillrecently they were a permanent source of funds for the Central

government, as every year more new bills were issued than those retired.

Further, every year a part of treasury bills held by the Reserve Bank ofIndia was converted into long-term bonds.

The treasury bill market in India is very much undeveloped. Except theRBI, there are no major holders of treasury bills. In fact, even the RBI is a

passive or captive holder of these bills which implies that it is under anobligation to purchase all the treasury bills which are being offered to it by

the government. It is also required to rediscount whatever treasury billsare presented to it by banks and others for this purpose. This has resulted

in the monetization of public debt and has become a major source of

inflationary expansion of money supply. At present the RBI holds mostof the outstanding treasury bills. Other holders, such as commercial

banks, State governments and semi-government bodies do not hold

them in large quantities. Non-bank financial intermediaries, such as theLIC and the UTI and corporate and non-corporate firms do not hold


11/42

treasury bills. In contrast, in the U.S.A. and the U.K., treasury bills arethe most important money market instrument, and as a result the open

market operations of the central bank in these countries are quite effective.Since April 1, 1997, ad hoc and on-tap treasury bills have been replaced by

Ways and Means Advances for financing the Central governments

temporary deficits. It is hoped that this measure would preventmonetization of public debt and inflationary expansion of money supply.

At present the following types of treasury bills are in use:14-Day Intermediate Treasury Bills: With the discontinuance of tap

treasury bills, the Central government had introduced the scheme of 14-day treasury bills to provide the State governments, foreign central banks

and specified bodies with an alternative arrangement to invest their surplus

funds. These treasury bills were to be sold only to the State governments,

foreign central banks and other specified bodies with whom the RBI has anagreement for investing their temporary surplus funds. Auction of thesetreasury bills was discontinued from May 14, 2001.

14-Day Auction Treasury Bills: The Reserve Bank of India introduced14-day auction treasury bills on a weekly basis with effect from June 6,

1997. The dual purpose of introducing these treasury bills was to facilitatethe cash management requirements of various segments of the economy

and to help in forming a complete yield curve for aiding in the pricing of

debt instruments. The 14-day auction treasury bills did not devolve on theReserve Bank unlike the 91-day treasury bills. Auction of these treasury

bills was discontinued from May 14, 2001.91-Day Treasury Bills: Earlier there were two types of 91-day treasury

bills ordinary and ad hoc. With effect from April 1, 1997 ad hoc treasurybills were discontinued. On this day 91-day ad hoc treasury bills

amounting to Rs.38,130crore were converted into special securities without

any specific maturity. The interest on these securities was fixed at 4.6 percent per annum.

In 1992-93 a scheme for the issue of 91-day treasury bills with the RBI of

India participation was introduced. The cut off yields on these treasury bills

were higher than the fixed discount rate of 4.6 per cent per annum on 91-day treasury bills sold on tap.

182-Day Treasury Bills: 182-day treasury bills were reintroduced with

effect from May 26, 1999. As per the calendar, notified amount for 182-

day treasury bills remained constant at Rs.100 at the fortnightly auctionsheld on Wednesdays preceding non-reporting Fridays. Auction of these

treasury bills was discontinued from May 14, 2001.

364-Day Treasury Bills: 364-day treasury bills were introduced in April

1992. Since then these treasury bills are auctioned on a fortnightly basis in

a regular manner. These treasury bills are not rediscountable with the RBI.However, they offer short-term investment opportunities to banks andother financial institutions. Since 364-day treasury bills constitute a safe

avenue for investment, the auction of these treasury bills have evokedgood response.

The Repo MarketRepo is a money market instrument which helps in collateralized short-term

borrowing and lending through sale/purchase operations in debtinstruments. Under a repo transaction, securities are sold by their holder

to an investor with an agreement to repurchase them at a predeterminedrate and date. Under reverse repo transaction, securities are purchased


12/42

with a simultaneous commitment to resell at a predetermined rate anddate.

Initially repos were allowed in the Central government treasury bills and

dated securities created by converting some of the treasury bills. In order

to make the repos market in equilibrating force between the money marketand the government securities market, the Reserve Bank of India generally

allowed repo transactions in all government securities and treasury bills ofall maturities. Lately State government securities, public sector

undertakings bonds and private corporate securities have been made

eligible for repos to broaden the repo market.

Explaining the usefulness of repos, Report on Currency and Finance 1999-2000 notes that repos help to manage liquidity conditions at the short-end

of the market spectrum. Repos have been used to provide banks an

avenue to park funds generated by capital inflows to provide a floor to thecall money market. During time of foreign exchange volatility, repos have

been used to prevent speculative activity as the funds tend to flow from themoney market to the foreign exchange market.

The Commercial Bill Market:

The commercial bill market is the sub-market in which the trade bills or the

commercial bills are handled. The commercial bill is a bill drawn by onemerchant firm on the other. Generally commercial bills arise out of

domestic transactions. The legitimate purpose of a commercial bill is toreimburse the seller while the buyer delays payment. In India, the

commercial bill market is highly undeveloped. The two major factorswhich have arrested the growth of a bill market are: (i) popularity of cashcredit system in bank lending, and (ii) the unwillingness of the larger buyer

to bind himself to payment discipline associated with the commercial bill.Among other factors that have prevented growth of genuine bill market

are, lack of uniformity in drawing bills, high stamp duty on usance or time

bills and the practice of sales on credit without specified time limit.

Commercial bills as instruments of credit are useful to bothbusiness firms and banks. In addition, since the drawees of the bill

generally manage to recover the cost of goods from their resale orprocessing and sale during the time it matures, the bill acquires a selfliquidating character. Finally, it is easier for the central bank to regulate

bill finance. Keeping in view these considerations, the Reserve Bank ofIndia has made efforts to develop a bill market in this country and

popularize the use of bills. Its two specific bill market schemes,however, had limited success. The old bill market scheme introduced in

January 1952 was not correctly designed to develop a bill market. It

merely provided for further accommodation to banks in addition to facilitiesthey had already enjoyed. The scheme had, in fact, provided for obtaining

loans on the security of bills rather than for their rediscount. In order to

encourage use of bills the RBI offered loans at a concessional rate ofinterest and met half the cost of stamp duty incurred by banks on

converting demand bills into usance bills. This scheme, however, failed tomake any impact.

Not satisfied with the old scheme, the RBI introduced a new bill market

scheme in November 1970. It has been modified from time to time. The

two noteworthy features of the new scheme are: (i) the bills covered underthe scheme are genuine trade bills; and (ii) the scheme provides for their

rediscounting. Even this scheme which really aimed at developing a bill

market in the country has not been very successful. The major obstacle tothe development of bill finance in this country is the dominant cash credit


13/42

system of credit delivery where the onus of cash management rests withbanks. The outstanding amount of commercial bills rediscounted by the

banks with various financial institutions stay often below Rs.1,000crore.

The Certificate of Deposit Market:

A Certificate of Deposit (CD) is a certificate issued by a bank to depositorsof funds that remain on deposit at the bank for a specified period. Thus

CDs are similar to the traditional term deposits but are negotiable ortradeable in the short-term money markets. In the mid-eighties, the short-

term bank deposit rates were much lower than older comparable interest

rates. The Vaghul Committee thus felt that the CD as a money marketinstrument could not be developed in this country until the situation

remained unchanged. The Committee stressed that it was necessary forthe introduction of the CD that the short-term bank deposit rates were

aligned with the other interest rates. In 1988-89, the RBI, as a corrective

measure, revised the rate of interest upward on term deposits of 46 to 90days. Once this was done in March 1989, the RBI introduced CDs with the

objective of widening the range of money market instruments andproviding investors greater flexibility in the deployment of their short-term

surplus funds.

The CDs could initially be issued only by scheduled commercial banks in

multiples of Rs.25lakh (later lowered to Rs.10lakh) subject to the minimumsize of an issue being Rs.1crore. Their maturity varied between three

months and one year. In 1993 six financial institutions, viz., IndustrialDevelopment Bank of India (IDBI), Industrial Credit and

Investment Corporation of India (ICICI), Industrial FinanceCorporation of India (IFCI), the Industrial Reconstruction Bank ofIndia, Small Industries Development Bank of India (SIDBI) and

Export-Import Bank of India were permitted to issue CDs with amaturity period of more than one year and upto three years. CDs are

issued at discount to face value and the discount rate is market

determined. They are further freely transferable by endorsement anddelivery. Banks pay a high interest rate on CDs. Hence, holders of CDs

prefer to hold them till maturity and thus secondary activity in CDs hasbeen non-existent. To begin with there was a lack of interest among banks

in issuing fresh CDs. The stringent conditions in the money market,however, induced banks to mobilize resources on a large scale throughCDs. The outstanding amount of CDs issued by the banks rose from

Rs.4,485 crore as at end April 2003 to Rs.4,460 crore on March 31, 2004and further to Rs.5,425 crore as on November 12, 2004. Due to the tight

money market conditions, the discount rates on CDs increased sharplyduring 1995-96. However, since July 1996 the average discount rate on

CDs has steadily declined. By early November 2004 typical discount rate

was 4.0 per cent per annum. To bring CDs at par with other instrumentssuch as CPs and term deposits, the minimum maturity of this instrument

was reduced to 15 days in April 2003 from 3 months earlier.

Commercial Paper:

Commercial Paper (CP) is a short-term instrument of raising funds bycorporates. It is essentially a sort of unsecured promissory note sold by

the issuer to the investor or via some agent like a merchant banker or asecurity house. The issuance of commercial paper is not related to any

underlying self-liquidating trade. Therefore, maturity of this instrument is

flexible. Usually borrowers and lenders adopt a maturity of a CP to theirneeds. Highly rated corporates which can obtain funds at a cost lower

than the cost of borrowing from banks are particularly interested in issuing

CPs. Institutional investors also find CPs an attractive outlet for the short-term funds. The Vaghul Committee had strongly recommended the


14/42

introduction of CPs in the Indian money market. In its observations on thisinstrument, the Committee had stated the issue of commercial paper

imparts a degree of financial stability to the system as the issuing companyhas an incentive to remain financially strong. The possibility of raising

short-term finance at relatively cheaper cost would provide an adequate

incentive for the corporate clients to improve the financial position and inthe process the financial health of the corporate sector should show visible

improvement.

Following the recommendations of the Vaghul Committee, the CP was

introduced in the Indian money market in January 1990. The CP can beissued by a listed company which has a working capital of not less than

Rs.5 crore. With maturity ranging from three months to six months theycould be issued in multiples of Rs.25 lakh (later reduced to Rs.5 lakh)

subject to the minimum size of an issue being Rs.1crore (later reduced to

Rs.25 lakh). The company wanting to issue CP would have to obtain everysix months a specified rating form an agency approved by the RBI. CP

would be freely transferable by endorsement and delivery. According tothe RBIs guidelines for the issue of CP, a company will have to obtain P2

rating from Credit Rating Information Services of India Ltd. (CRISIL) or A2rating from Investment Information and Credit Rating Agency of India Ltd.

(ICRA). Minimum maturity period of CP was reduced to 7 days. The

effective interest rates were in the range of 9.35 to 20.9 per cent perannum. Easy liquidity conditions gave fillip to the issue of CPs since 1998-

99 and the outstanding stocks of CPs rose from a low level of Rs.1,030crore in April 1998 to Rs.10,848 crore as on July 31, 2004. The discount

rate on commercial paper remained in the range of 4.61-5.50 per cent perannum during April 2004.

Money Market Mutual Funds:A scheme of Money Market Mutual Funds (MMMFs) was introduced by the

RBI in April 1992. The objective of the scheme was to provide an

additional short-term avenue to the individual investors. As the initialguidelines were not attractive, the scheme did not receive a favourable

response. Hence, with a view to making the scheme more flexible, the RBIpermitted certain relaxations in November 1995. The new guidelines allow

banks, public financial institutions and also the institutions in the privatesector to set up MMMFs. The ceiling of Rs.50 crore on the size of MMMFsstipulated earlier, was withdrawn. The prescription of limits on investment

in individual instruments by MMMFs was also deregulated. Since April1996, MMMFs are allowed to issue units to corporate enterprises and

others.

During 1996-97 the scheme of MMMFs was made more flexible by bringing

it on par with all other mutual funds by allowing investment by corporatesand others. The scheme was later on made more attractive to investors by

reducing the lock-in period from 45 days to 15 days. The scheme was

further liberalized in 1997-98 and the MMMFs were permitted to makeinvestments in rated corporate bonds and debentures with residual

maturity of up to one year.

Resources mobilized by the MMMFs could earlier be invested exclusively incall/notice money, treasury bills, CDs, CPs, commercial bills arising out of

genuine trade/commercial transactions and government securities having

an unexpired maturity up to one year. The prudential measure that theexposure of MMMFs to CPs issued by an individual company should not

exceed 3 per cent of the resources of the MMMFs has been retained. The

MMMFs have been brought under the purview of the SEBI regulations since


15/42

March 7, 2000. Banks are now allowed to set up MMMFs only as a separateentity in the form of a trust. Currently there are three MMMFs in operation.

HALLMARKS OF A DEVELOPED MONEY MARKET

The Characteristics of a developed money market are as

following:1. Existence of a well-developed and highly organized commercial

banking system.

2. Existence of a strong central bank as the money marketregulator.

3. Availability of a wide variety of financial instruments for both

borrowers and lenders.4. Existence of a number of highly developed and specialized sub-

markets, which are closely integrated.5. Existence of a large number of players in a competitive

environment.6. Prevalence of a developed information and communication

network.

7. Minimum government intervention and restrictions in themoney market.

CHARACTERISTICS OF INDIAN MONEY MARKET

In its organization and development, the Indian money market is not

comparable to either the London money market or the New York moneymarket. It suffers from a number of defects of which the following are

more prominent:

1. Lack of integration: As already stated, the Indian

money market is divided into two sections, viz., the unorganized sectorand the organized sector. As the two sectors are completely separate

from each other, their financial operations are quite independent, andwhatever goes on in one sector has little effect on the other. Some

financial operations are quite independent, and whatever goes on in one

sector has little effect on the other. Some experts assert that thecountry has no national money market. There are reasonably well

developed local money markets; the Mumbai and the Kolkata money

markets being the most prominent. The Mumbai money market,however, has been showing a tendency for quite some time to emergeas the national money market.

2. Lack of rational interest rates structure: For a long

time a major defect of the Indian money market was the lack of rationalinterest rates structure in it. This was particularly due to lack of

adequate co-ordination between different banking institutions. Lately,situation has improved somewhat due to the authority of the Reserve

Bank of India. Further, standardization of interest rates has also

introduced some rationality in the structure of interest rates. However,the system of administered interest rates suffered in the past from

various defects such as: (1) relatively low yield on governmentsecurities, (2) too many concessional rates of interest, and (3)

inappropriate deposit and lending rates of commercial banks. These

defects in administered interest rates has led to a situation in the past inwhich there had always been excess demand for credit and the Reserve

Bank of India had to rely often on cash reserve ratio (CRR) changes tocombat inflationary pressure. The number of administered rates on

bank advances was reduced to 2 from 20 in 1989-90. Further,

interest rate structure has now been deregulated.The RBIs efforts to introduce rationality in the interest rate structure

notwithstanding, the situation in the Indian money market is still not


16/42

comparable to that in the London money market where the discount rateis sufficiently effective and market rates immediately respond to

changes in it. In India not only the lending rates of the State Bank ofIndia and the commercial banks differ from those of the co-operative

banks and the indigenous bankers, but their bill finance rates also differ

from the Hundi rate.

4. Absence of an organized bill market: Though both inland and foreignbills are being purchased as well as discounted by the commercial

banks, yet it cannot be said that an organized bill market exists in the

country. Only a limited bill market that has been created by the RBIunder its schemes of 1952 and 1970 now exists but it has failed to

popularize bill finance in this country. Some experts contend that thepopularity of cash credit and lack of uniformity in commercial bills

proved to be serious obstacle in the development of a bill market.

Moreover, due to the presence of inter-bank call money market,commercial banks never felt the real necessity of an organized bill

market. Interestingly, the bill finance has fallen since the secondscheme was introduced.

5. Shortage of funds in the money market: The Indian money

market is characterized by shortage of funds. Invariably demand for

loanable funds in the money market far exceeds its supply. This isattributed to a variety of factors. In the first place, savings are small

due to low per capita income. Because of widespread poverty, a vastmultitude of population has virtually no ability to save. Those of the

people who have the ability to save often indulge in wastefulconsumption. Secondly, inadequate banking facilities, lack of bankinghabit among the people and absence of ample and diversified

investment opportunities had also contributed in the past to shortage offunds. As in the countryside banking facilities are still lacking, people

have little option but to hoard their savings. Failure to mobilize them is

a factor that must not be ignored, if the supply of loanable funds is to beaugmented. Finally, emergence of a parallel economy and vast amount

of black money in the country have also caused shortage of financialresources in the money market. In the recent past, the development of

banking, particularly the opening of branches of commercial banks in therural sector and expansion of co-operative banking have, however,improved the mobilization of funds. This has helped in overcoming the

stringency of funds to an extent, but no remedial measures are possibleto remove scarcity of loanable funds in the money market caused by the

acute poverty of the mass of population.

6. Seasonal stringency of funds and fluctuations in interest

rates: India being essentially an agricultural country, farm operationshave also some bearing on the demand as well as the supply of funds in

the money market. From October to June when farm operations and

trading in agricultural produce require additional finance, a monetarystringency is created in the money market. Had the money market been

sufficiently elastic and had it been possible to augment the supply offunds more or less automatically in response to the seasonal rise in

demand, interest rates would have been very much stable. But untilrecently this did not happen in this country.

7. Inadequate banking facilities: Though lately commercial bankshave opened their branches on an unprecedented scale, yet banking

facilities in the country are still somewhat inadequate. The coverage of

the rural sector by the modern banks leaves much scope for furtherdevelopment. Compared to the U.S.A. where per 1,00 persons there is


17/42

a branch of a commercial bank, in India, we have a branch on anaverage for roughly 15,000 persons. This difference is probably due to

the difference in the levels of development in the two countries. Anoverwhelming majority of the people in this country is either below the

poverty line or just at the subsistence level and does not require any

banking facility. At the same time lots of people, particularly those inthe countryside whose savings are small, have no access to banking

facilities. Mobilization of small savings is both difficult and uneconomic,but in an underdeveloped country like ours, where every bit of saving is

to be used for productive purposes, banking facilities have to be

expanded.

DEFECTS OF INDIAN MONEY MARKET

1. Unorganized Sector still beyond Control: Now we proceed to

take up the defects from which the Indian money market sufferstoday. We have earlier stated that the Indian money market suffers

mainly because of lack of relationship between its different segments.Although, prior to the establishment of the Reserve Bank of India, the

Indian money market was divided into various sections and units andall these units, say for example, the Imperial Bank of India, the

foreign exchange banks, the joint-stock banks, the co-operative

banks, etc. confined their activities to their own areas and to aparticular class of business, their relations were more competitive

then co-operative. After the establishment of the Reserve Bank,these separatists tendencies have no doubt, to a great extent

disappeared, more particularly after the passing of the BankingRegulation Act, 1949. The co-operative banks have now also comewithin the jurisdiction of the reserve Bank and so it can be said that

the organized sector of the money market is now under the effectivecontrol of the Reserve Bank. The reliance of the commercial banks

for rediscounting and borrowing facilities on the Reserve Bank has

considerably increased. The Reserve Bank also undertakes regularinspections of the books of these banks and issues guidelines for their

lending operations, from time to time. But the major drawback is theabsence of control of the Reserve Bank on the unorganized sector.

The indigenous bankers are even today outside the control of theReserve Bank, despite frantic efforts made by it. Very recently, signshave started developing for the increasing control of the Reserve

Bank of India on the indigenous bankers, since the bigger indigenousbankers have started forming themselves into joint-stock companies.

2. Competition within the Same Sector: Again, one finds that even

in these two sectors, there is tough competition among the members

of the same sector, e.g., the State Bank of India and othercommercial banks compete with each other. Similarly, the members

of the unorganized sector compete among themselves. This sort of

competition is not only wasteful but is also detrimental to theinterests of the poor agriculturists, specially small and marginal

farmers and also endangers the speedy economic development of thecountry.

3. Fragmentation: One also finds that the Indian money market

suffers from fragmentation. In other words, it would not be correct

to call the money market in India as an All India Market in the truesense of the term. There is hardly any contact between the money

markets in smaller towns and those in the bigger towns like Mumbai,

Kolkata, Delhi, Chennai, etc.


18/42

4. Large Variety of Money Rates: As a consequence of thiscompetition between the various constituents of the money market

and intrasectoral competition a large variety of money rates prevail inthe country. This creates confusion and chaos. The confusion is

worse confounded when one finds that there are different rates of

interest in bigger and smaller towns, in rural and urban areas, indifferent localities of the same town and in different seasons in the

country. Such sort of diversity in the rates of interest is hardly to beseen in any of the money markets of developed countries of the

West. Nearly 50 years ago, the Central Banking Enquiry Committee

had remarked: The fact that a call rate of .75 per cent, a hundi rateof 4 per cent, a bank rate of 4 per cent, a bazaar rate for bills of

small traders of 6.38 per cent and a Calcutta bazaar rate for bills ofsmall traders of 10 per cent can exist simultaneously indicates

extraordinary sluggishness of the movement of credit between the

various markets. And the situation has not changed much in theseyears. The result of such a situation is that changes in the bank rate

do not produce the desired result.

5. Undeveloped Bill Market: As stated already, the existence of anundeveloped and unorganized bill market is the greatest defect of the

Indian money market. In fact the Indian money market has not been

able to function properly and effectively only because of this reason.Although, hundies have been in use since time immemorial, there is a

general shortage of hundies in the market. That is why, thecommercial banks have not been able to invest more than 6 per cent

of their deposits in hundies. This can also be the reason forcompelling the businessmen and traders to conduct their business incash. Whatever may be the position, the absence of a developed bill

market has certainly marred the efficient functioning of the Indianmoney market. It is, therefore, essential that the Reserve Bank of

India should take steps to popularize the use of hundies among

Indian businessmen and offer facilities for rediscounting them. Theposition now stands very much improved in this respect butit cannot

be considered satisfactory at all.

6. Seasonal Variations in Interest Rates: Another defect from whichthe Indian money market suffers today is the lack of synchronizationbetween the demand for and supply of credit facilities during various

seasons of the year. As already stated, during the busy season thesupply of credit does not increase proportionately, while during the

slack season there is a general fall in the demand for credit facilities.The supply of money being generally elastic, there is a wide variation

in the rates of interest during these two parts of the year. Despite

sincere efforts of the Reserve Bank, it has not been possible toeliminate these seasonal variations in the rates of interest.

Ultimately, it affects the economic development of the country.

7. General Shortage of Capital: There is a general shortage of capital

in the Indian money market. Firstly, the per capita income of thepeople in the country is quite low and therefore, the saving capacity

of the people is rather limited. Secondly, the banking services in therural areas are hardly adequate and hence the rural savings are not

being mobilized, to the desired extent. Consequently, the rate of

capital formation is low and mobility of the capital is also at a lowebb.

8. Lopsided and Unbalanced: The Indian money market is ratherlopsided and unbalanced. The rural areas which cover the major


19/42

portion of the country are inadequately served by commercial banks.The indigenous bankers are, therefore, in a very large number and

they provide a large amount of credit to trade and business. It wouldnot be wrong to say that in certain parts of the country, they enjoy

monopoly in the moneylending business. On the other hand, one

finds that specialized banking institutions are conspicuous by theirabsence. These specialized institutions are the industrial banks,

discount houses, Indian-owned foreign exchange banks, etc.

The above defects have been considerably reduced during recent decades

by the Reserve Bank. The different parts of the money market stand todayvery much interlinked, the discrimination between foreign and Indian

commercial banks has virtually disappeared, the money rates indifferentparts of he country are not very much uniform; the seasonal monetary

stringency stands very much reduced and the bill market in the country is

now on its way to development. In this respect, the nationalization ofmajor commercial banks has no doubt been a great step in the direction.

REFORM MEASURES OF MONEY MARKET

1. Remitting the stamp duty: In August 1989, the

government remitted the stamp duty on usance bills which was

considered a major administrative constraint in the use of bill system.However, this measure has failed to induce use of commercial bills.

Experts assert that unless effective measures are undertaken todiscourage cash credit system, the governments decision to remit the

stamp duty alone would not alter the situation in the favour of the use ofbill system.

2. Deregulation of money market interest rates: Witheffect from May 1, 1989 the RBI deregulated money market interest

rates which proved to be a significant step towards the activation of the

money market. This was expected to make interest rates flexible andlend transparency to transactions in the money market. Earlier the

call/notice money was subject to interest rate ceiling of 10.0 per cent.Likewise interest rate on interbank term money was subject to a

ceiling of 10.5-11.5 per cent, and on rediscounting of commercial billsand inter-bank participations without risk was subject to a ceiling of 12.5per cent.

3. Introducing new money market instruments: Over

the past fifteen years four major money market instruments have beenintroduced. These are 182-day treasury bills, 364-day treasury bills,

Certificates of Deposits (CDs) and Commercial Paper (CP). 182-day

treasury bills were systematically promoted by the Discount and FinanceHouse of India and were the first security sold by auction for financing

the fiscal deficit of the Central government. The Discount and Finance

House of India also developed a secondary market in these bills andthey became popular with the banks. In 1992-93 it was decided to

introduce 364-day treasury bills and the auction for 182-day treasurybills were discontinued. 182-day treasury bills were, however,

reintroduced in May 1999. Like 182-day treasury bills, 364-day treasurybills can be held by the commercial banks for meeting Statutory

Liquidity Ratio.

CDs gained a considerable market in 1996-97. The volume ofoutstanding CDs rose from Rs.6,385crore on January 6, 1995 to

Rs.20,815crore on July 5, 1996. However, due to improvement in the

liquidity conditions later on, the outstanding amount of CDs issued bybanks increased in 2004-05 and amounted to Rs.5,438crore on June 25,


20/42

2004. Now private banks account for the largest share of outstandingCDs. An encouraging development is that the top banks get their CDs

rated for better access to the market.CPs as money market instrument are now more than ten years old. The

Indian CP market is driven by the demand for CP by scheduled

commercial banks which, in turn, is determined by bank liquidity. Thesecondary activity is subdued in the Indian CP market due to most

investors preference to hold the instrument on account of higher risk-adjusted return relative to those of other instruments.

4. Introduction of repos: An important development inthe government securities market is introduction of repos in December

1992. A repo is an instrument of repurchase agreement between theRBI and the commercial banks. This is an asset which banks use for

short-term liquidity management. The repo rates are market

determined and often fluctuate steeply. The period of repo hasstabilized since August 1993 at 14 days. The repo has now become

popular with banks. It can now also be effected between banks andfinancial institutions and banks themselves. To further develop and

widen repos, in April 1999. the RBI introduced regulatory safeguards.

5. Setting the Discount and Finance House of India:

The Discount and Finance House of India (DFHI) was set up on April 25,1998. Its major function is to bring into the fold of the Indian money

market the entire financial system comprising of the scheduledcommercial banks, foreign banks, co-operative banks and all-India

financial institutions in the public and private sectors, so that their short-term surpluses and deficits are equilibrated at market relatedrated/prices through inter-bank transactions in case of bank and through

money market instruments in the case of banks and others. In DFHIoperations, the emphasis is placed on a high turnover in the money

market instruments rather than on being their repository.

6. Introducing money market mutual funds: Money

market mutual funds (MMMFs) were introduced in India in April 1991.MMMFs provide an additional short-term avenue to investors and bring

money market instruments within the reach of individuals. The portfolioof MMMFs consists of short-term money market instruments.The growth of MMMFs has been far less than expected. While in

principle approvals have been granted to ten MMMFs, only there havebeen set up one each by the IDBI and UTI and one in the private

sector. It is hoped that with the growth of the money market in volumeand depth more MMMFs would be set up.

7. Developing call/notice money market: Thecall/notice money market was mainly an interbank market until 1990.

Only the Unit Trust of India and the Life Insurance Corporation were

allowed to operate as lenders since 1971. During the 1990s the RBIspolicy relating to entry into the call/notice money market was liberalized

to provide more liquidity despite the recommendation of the VaghulCommittee that the call money market should be restricted to banks. As

of now, broadly speaking banks and primary dealers (PDs) are operatingas both lenders and borrowers while a number of non-bank financial

institutions and mutual funds are operating only as lenders.

8. Removing constraints on development of the term

money market: The term money market in India has always been

dormant. Statutory pre-emptions on inter-bank liabilities, cash creditsystem of financing, the regulated interest rate structure, the high


21/42

degree of bolatility in the call money rates, availability of sector-specificrefinance, the scarcity of money market instruments of varying

maturities and the inadequate assets liability management (ALM)discipline among banks were the factors that inhibited the development

of the term money market. Most of these constraints have been

gradually removed by the RBI in recent years and, as a result, there issome activity in the term money market. However, despite the

foregoing reforms the volumes of operations still remain rather small.

9. Sector specific refinance facilities: Refinance is

used by central banks to meet liquidity shortage in the system, tocontrol monetary and credit conditions and direct credit to selective

sectors. The RBI has used in the past a number of sector specificrefinance facilities of which export credit refinance and food credit

refinance were the most prominent. Currently there are only two

refinance schemes in operation export credit refinance and generalrefinance. Lately with the emergence of the bank rate as the signaling

rate of monetary policy stance, the RBIs policy has been to keep therefinance rate linked to the bank rate.

The Indian money market has been characterized by ample liquiditysince 2002-03. Mirroring the comfortable liquidity conditions, the

interest rates softened across the various segments of the money

market. The RBI continued to appropriately manage liquidity conditionsthrough open market operations.

SUGGESTIONS FOR IMPROVING THE INDIAN MONEY MARKET:

The following suggestions are offered for improving the Indian moneymarket:

1. Control over Non-Bank Financing Companies: During recentmonths a number of cases have come to light where public limited

finance companies have cheated the general public by inviting

deposits to the tune of crores of rupees. The Reserve Bank of Indiahas not been able to protect the depositors from exploitation and

cheating of such finance companies. Similarly, a number of chitfunds have also been cheating the general public. The Reserve Bank

of India should, therefore, insist on a uniform legislation forregulating the activities of chit funds and financing companies. Thelegislation should specially incorporate a provision that at least 25 per

cent of deposits accepted from the public would be deposited by suchcompanies with the State Bank of India or the Reserve Bank of India;

and also that such companies will have to submit every quarterly astatement indicating the names of the depositors, the amounts of

deposit and the period of such deposits to the Reserve Bank of India.

2. Standard Forms of Hundies: The Banking Commission (1972)

recommended that standard forms of hundies should be prescribed

and the Negotiable Instruments Act be made to apply to suchhundies, but so far nothing in particular seems to have been done in

this regard. It is a well-known fact that in the organized sector of theIndian money market large transactions are performed by

discounting hundies by the indigenous bankers. The commercialbanks, however, do not accept these hundies. It is therefore

necessary, that suitable action may be taken immediately by the

Reserve Bank of India to implement the recommendation of theBanking Commission.

3. Regulation of the Activities of the Indigenous Bankers: Thesituation of the banking services now available in the rural areas is


22/42

far more improved than what it was in the early1960s of this century.A number of branches have been opened by commercial banks, lead

banks, regional rural banks and cooperative banks in the rural areasafter 1969. Despite the expansion of banking facilities in the rural

areas indigenous bankers continue to occupy an important position.

As early as 1972 the Banking Commission has recommended theregulation of the activities of indigenous bankers through commercial

banks but unfortunately no progress has been made in this directionso far.

4. Development of Bill Market: A developed bill market is veryessential for the growth of Indian money market. Despite the efforts

made in this direction by the Reserve Bank of India the situation doesnot appear to have improved to a satisfactory extent. The

government should, therefore, at least in its own departments and

public sector undertakings make it compulsory that payments for allcredit purchases should be in the form of bills which should be

honoured on due date. Besides, Reserve Bank of India should laydown simpler procedure for rediscounting of bills. These steps will go

a long way to develop bill culture in the country.

5. Development of Money Market in Other Centres: At present the

money market is confined to four major cities in the country. For theproper growth of the money market it is necessary that adequate

banking and clearing house facilities are provided on a large scale,discount and acceptance houses are established and cheap

remittance facilities are extended throughout the country to facilitatethe mobilization of funds.

6. Creation of Secondary Market: For imparting adequate linking inthe Indian money market it is essential that an active secondary

market is created by developing new sets of institutions. This step

will certainly improve the functioning and growth of the Indian moneymarket.

COMMERCIAL BANKING:TYPES OF BANKS1. Commercial Banks2. Industrial Banks

3. Agricultural Banks

4. Foreign Exchange Banks

On the basis of proprietorship5. Public sector and Private sector Banks

On the basis of ORGANIZATION

1. Branch Banking2. Unit Banking

The public sector bank is a Government of India undertaking while a privatesector bank is owned by the shareholders. Both these types of banks

perform the same functions, and their interest rate structure and salary

and allowance structure are the same except the non-scheduled banks.State Bank of India was the first public sector bank established on 1 July,

1995, after nationalization of Imperial Bank of India. It had 7 subsidiarieswhich were nationalized in 1959. These are State Bank of Hyderabad,

State Bank of Bikaner and Jaipur, State Bank of Travancore, State Bank ofMysore, State Bank of Patiala, State Bank of Indore and State Bank of


23/42

Saurashtra. 14 major scheduled banks were nationalized on 19 July, 1969.These were Allahabad Bank, Bank of Baroda, Bank of India, Bank of

Maharashtra, Canara Bank, Central Bank of India, Dena Bank, Indian Bank,Indian Overseas Bank, Punjab National Bank, Syndicate Bank, Union Bank

of India, United Bank of India and United Commercial Bank. On 15

April,1980, 6 more scheduled banks were nationalized. They were AndhraBank, Corporation Bank, New Bank of India, Oriental Bank of Commerce,

Punjab and Sind Bank and Vijaya Bank. Later on 4 September, 1993, NewBank of India was merged with Punjab National Bank.

The regional rural banks are also public sector banks and their number is196. Hence there are in all 223 public sector banks comprising State Bank

of India and its 7 subsidiaries, 19 nationalized banks and 196 regional ruralbanks.

FUNCTIONS OF COMMERCIAL BANKS:Prof. Sayers has described the functions of a modern bank in the following

words, Ordinary banking business consists of changing cash for bankdeposits and bank deposits for cash: transferring bank deposits from one

person or corporation to another, giving bank deposits in exchange for billsof exchange, government bonds, the secured promises of businessmen to

repay, and so forth. The modern bank performs a large variety of

functions and services. The fundamental functions performed by the bankare:

1. Acceptance of Deposits: The bank accepts three types of deposits

from the public.(i) Fixed Deposit Account: Money is this account is accepted

for a fixed period, say, one, two or five years. The money

so deposited cannot be withdrawn before the expiry of thefixed period. The rate of interest on this account is higher

than that on other accounts. The longer the period, the

higher is the rate of interest. In technical language, thistype of deposit is known as time or time deposit. It matures

at a definite date and entails an interest penalty if it iswithdrawn earlier due to some emergency by the depositor.

(ii) Current Account: The depositor can withdraw the moneyfrom his current account whenever he requires it. Generally

speaking, the bank grants no interest on this accountbecause it has to keep the cash ready at all times to meet

the requirements of the depositor. This account is generallyopened by businessmen who may have to withdraw money

several times a day. The bank, however, levies certain

incidental charges on the customer for the services renderedby it. In technical language, it is known as demand deposit

or checking deposit. The debtor (i.e., bank) has to pay off

the debt on demand either to the depositor himself or toanyone else whom he authorizes by writing a cheque. The

money represented by demand deposits is the debt of thebank. It is a liability for the bank but an asset for the

depositor.

(iii) Savings Bank Account: Some restrictions are imposed on

the depositor under this account. For example, he canwithdraw only a specified sum of money in a week. Of

course, the depositors are given cheque facility to withdraw

money from this account. The rate of interest allowed on this


24/42

account is rather low. This type of deposit accountencourages small savings in the country.

According to banking terminology, the bank deposits are divisible into

two categories:

(a) Demand Deposits or Demand Liabilities: Thesedeposits refer to those deposits which are repayable by

the banks on demand. These include current depositsand a major portion of the savings deposits.

(b) Time Deposits or Time Liabilities: Time deposits are

accepted by the banks for fixed time-periods and are notrepayable before the expiry of the stipulated period.

They include fixed deposits, recurring deposits and a partof the savings deposits.

Greater the volume of demand deposits, greater shall be theproportion of the liquid assets which the banks will be required to

keep with themselves to meet their liabilities. In addition to thecommercial banks, there are certain other institutions as well which

specialize in the acceptance of both time and savings deposits. Theyare savings and thrift associations, mutual savings banks and Credit

Unions etc.

2. Advancing of Loans: The deposits received by the bank are not

allowed to lie idle in the cash box of the bank. After keeping certaincash reserves, the balance is given by the bank to the needy

borrowers in the form of loans and advances. Before advancing loansto the borrowers, the bank satisfies itself fully about their credit-worthiness. The various types of loans and advances are as follows:

(i) Making Ordinary Loans: Here the bank gives a specified

sum of money to a person or a firm against some collateral

security. The loan money is credited to the account of theborrower and the borrower can withdraw the money from

the account according to his requirements. The bank canrecall such loans at its option.

(ii) Cash Credit: Under this account, the bank gives loans tothe borrowers against certain society. But the entire loan is

not given at one particular time. What the bank does is thatit opens the account in the name of the debtor and allows

him to withdraw the money from time to time up to a certainlimit determined by the value of the stocks kept in the

debtors godown. The godown remains in the possession of

the bank. The debtor continues to withdraw small sums ofmoney according to his requirements, but he cannot exceed

the credit limit allowed to him. The bank, however, charges

interest only on the amount withdrawn from the account.This type of loan is very popular with the Indian

businessmen.

(iii) Overdraft: Sometimes the bank grants overdraft facilitiesto its respectable and reliable customers. The bank allows

such customers to overdraw their accounts through cheques.

The customers, however, pay interest to the bank on theamount overdrawn by them.

(iv) Discounting of Bills of Exchange: This is another type oflending which is very popular with the modern banks. If the


25/42

holder of an exchange bill needs money immediately he canget it discounted by the bank. After deducting its

commission, the bank pays the present price of the bill tothe holder. When the exchange bill matures, the bank can

secure its payment from the party which had accepted the

bill.

3. Investment of Funds: Besides loans and advances, a moderncommercial bank also invests a part of its surplus funds in

government securities and earns interest on them. In India, the

commercial banks are requirement under statute to invest a part oftheir funds in government and other approved securities. Though the

return from such securities is not very attractive, the funds investedin them are not only near liquid, but also secure from the risk of loss.

4. Promote the Use of Cheques: The commercial banks render animportant service by providing to their customers a cheap medium of

exchange like cheques. It is found much more convenient to settledebts through cheques rather than through the use of cash. The

cheque is the most developed type of credit instrument in the moneymarket.

5. Agency Functions of the Bank: In addition to the above functions,the bank performs certain agency functions for its customers. For

these services, the bank charges a certain commission from itsclients. The various agency services rendered by the bank are as

follows:

(i) Transfer of Funds: The bank helps its customers in

transferring funds from one place to another. Theinstrument used for this purpose is known as the Bank

Draft. For this service rendered, the bank charges a small

commission from the customers.

(ii) Collecting Customers Funds: The bank collects the fundsof its customers from other banks and credits them to their

accounts.

(iii) Purchase and Sale of Shares and Securities for its

Customers: The bank buys and sells stocks and shares ofprivate companies as well as government securities on

behalf of its customers.

(iv) Collecting Dividends on the Shares of the Customers:

The bank collects dividends as well as interest on the sharesand debentures of its customers and credits them to their

accounts.

(v) Payment of Premia: The bank pays premia to the

insurance companies on behalf of its customers. It may alsopay certain bills of the customers as per their directives.

(vi) The Bank acts as the Trustee and the Executor: The

bank preserves the Wills of the customers and executes

them after their death.

(vii) Income-Tax consultant: The bank may also give advice to

its customers on income-tax matters. It may even prepare


26/42

the income-tax returns of its customers on payment of itsfee.

(viii) Acts as Correspondent: The bank may also act as a

correspondent, agent, or representative of its customers.

The bank may obtain passports, travellers tickets and evensecure air and sea passages for its customers.

6. Purchase and Sale of Foreign Exchange: The bank also carries on

the business of buying and selling foreign currencies. Ordinarily, the

sale and purchase of foreign currency is done by the ForeignExchange Banks. But in India, some commercial banks, in addition to

their other functions, also do business in foreign exchange.

7. Financing Internal and Foreign Trade: The bank finances internal

and foreign trade through discounting of exchange bills. Sometimes,the bank gives short-term loans to traders on the security of

commercial papers. This discounting business greatly facilitates themovement of internal and external trade.

8. Other Functions of the Bank: They are as follows:

(i) Safe Custody of Valuable Goods: The modern bank

provides locker facilities to its customers. The customerscan keep their valuables, such as, gold and silver

ornaments, important papers, shares and debentures inthese lockers. The bank charges an annual rental for this

service.

(ii) Issuing of Travellers Cheques: The bank also issues

travellers cheques or circular letters of credit for the benefitof its customers. The customers are saved the botheration

and the risk of carrying cash during their travels.

(iii) Giving Information about its Customers: Since the bank

is closely acquainted with its customers, it can pass onreliable information about their credit-worthiness to other

parties at other places. The businessmen often make use ofthis service to know about the credit-worthiness of otherparties at other places.

(iv) Collection of Statistics: The modern bank collects

statistics about money, banking, trade and commerce, andpublishes them in the form of pamphlets and hand-outs. This

helps the banks customers in acquiring knowledge about the

latest economic situation on the basis of which they canformulate their business policy.

(v) Underwriting of Company Debentures: Sometimesprivate companies issue debentures for public sale. But the

public may hesitate in buying these debentures unless theyare underwritten by the banks. The public has full

confidence in the banks. If the debentures carry thesignatures of a bank, the public would not hesitate in buying

them. For under-writing these debentures, the bankers

charge a small underwriting commission from thecompanies.

(vi) Accepting Bills of Exchange on behalf of Customers:Sometimes, the banks accept exchange bills on behalf of


27/42

their trusted customers. This benefits the customersbecause when the bank signifies its acceptance on the

exchange bill, it becomes readily discountable in the moneymarket.

(vii) Giving Advice on Financial Matters: Since the bank isfully acquainted with the economic situation in the country,

it is in a position to render useful advice to its customers onfinancial matters.

9. Creation of Credit: As pointed out above, granting of loans andadvances is an important function of the bank. But the process by

which the bank grants loans and advances has special significance forthe modern economy. As is well-known, when the bank grants a loan

to its customers, it generally does not lend out cash, equal to the

amount of the loan, to the customer as an individual money-lenderdoes, but, on the contrary, opens an account in his (borrowers)

name and credits the amount of the loan to his account. Thus,whenever a bank grants a loan, it creates a deposit or a liability

against itself. Since the deposits of the bank circulate as money, thecreation of such deposits leads to a net increase in the money stock

of the economy. This is known as creation of money or creation of

credit by the bank. A modern bank, during its operations, createsquite a good deal of money which has a far-reaching influence on the

course of economic activity in the country.

10. Fulfillment of Socio-economic Objective: In recent years,commercial banks, particularly in developing countries, have beencalled upon to help achieve certain socio-economic objectives laid

down by the State. For example, the nationalized banks in India(representing 85 per cent of the total banking business in the

country) have framed special innovative schemes of credit to help

small agriculturists, village and cottage industries, retailers, artisans,the self-employed persons through loans and advances at

concessional rates of interest. Under the Differential Interest Scheme(D.I.S) the nationalized banks in India advance loans to persons

belonging to scheduled tribes, tailors, rickshaw-walas, shoe-makersat the concessional rate of 4 per cent per annum. This does notcover even the cost of the funds made available to these priority

sectors. Banking is, thus, being used to subserve the national policyobjectives of reducing inequalities of income and wealth, removal of

poverty and elimination of unemployment in the country.

From the above discussion, it is evident that a modern bank plays a very

vital role in the economic activity of the country. It plays the role of afinancial intermediary it accepts deposits, makes loans and advances and

buys negotiable securities. Without it, the individual saver-investor would

have to deal directly with individual borrowers. The modern bank actingas an intermediary enables the individual saver to secure reasonable

return without undergoing the botheration of confronting a borrower. It ison account of this that a well-developed banking system provides a firm

and durable foundation for the economic development of the country.

In addition to the above, the commercial banks have also started

performing a number of other functions during recent years, such asissuing credit cards, establishing mutual funds, engaging in merchant

banking, giving loans to priority sectors, consumption loans, education

loans, housing loans, etc.


28/42

CENTRAL BANKING (RBI)

Defining a Central Bank is not easy. There has been a great diversity

of opinions in regard to its definition. Each writer has defined it in his

own way emphasizing either on one or more functions performed byit.

According to Kent:

It is an institution which is charged with the responsibility of

managing and expanding and contracting of the general public

welfare. According to Verasmith:

The primary definition of Central Banking is a banking system in

which a single bank has either complete or residuing monopoly in thenote issue. It was out of monopoly in the note issue that were

derived the secondary functions and characteristics of are modern

central banking.

According to Shaw

A Central Bank is a bank which controls Credit and

According to Hawtrey:

a Central Bank is a lender of the last resort. According to M.H.de Kock:

A Central Bank is a bank which constitutes the apex of the monetary

and banking structure of its country which performs as best as it canin the national economic interest.

The Central Bank occupies a pivotal position in the monetary and banking

structure of the country. The Central Bank is the undisputed leader of themoney market. As such it supervises, controls and regulates the activities

of the commercial banks affiliated with it. The Central Bank is also the

highest monetary institution in the country charged with the duty andresponsibility of carrying out the monetary policy formulated by the

government.

NECESSITY OF CENTRAL BANK

The need for a Central Banking Institution in a country arises from thefollowing:

1. Control of Credit: As already pointed out, every commercial

bank creates credit during its daily operations. In fact, credit creation

is supposed to be the major function of the commercial banks. But

this credit creation sometimes poses serious dangers for the economyof the country. For example, if the commercial banks in the countryare creating excessive credit, it can be a source of serious danger for

the economy of the country. Hence, the need arises of some

institution which can exercise contr

Indian Financial System2

Documents

Transcript of Indian Financial System2