Financial Markets & Institutions

KARNATAKA STATE OPEN UNIVERSITY
MUKTHAGANGOTHRI, MYSURU- 570 006.
DEPARTMENT OF STUDIES AND RESEARCH IN MANAGEMENT
M.B.A III Semester
COURSE - 16 A
FINANCIAL MARKETS AND INSTISTUTIONS
BLOCK
1
OVERVIEW OF INDIAN FINANCIAL SYSTSEM
UNIT - 1
RESERVE BANK OF INDIA 1-17
UNIT - 2
COMMERCIAL BANKS IN INDIA 18-31
UNIT - 3
NON-BANKING FINANCIAL COMPANIES (NBFCs) 32-47
UNIT - 4
REGULATORY PRAME WORK OF BANKING SECTOR 48-61
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Course Design and Editorial Committee
Prof. D. Shivalingaiah Prof. T.D. Devegowda

Vice-Chancellor & Chairperson Dean (Academic) & Convenor
Karanataka State Open University Karanataka State Open University
Mukthagangothri, Mysuru - 570006 Mukthagangothri, Mysuru - 570006
Co- Editor & Subject Co-ordinator
Dr. C. Mahadevamurthy
Chairman
Department of Management
Karanataka State Open University
Mukthagangothri, Mysuru - 570006
Course Writers
Dr. C. Mahadevamurthy Block - 1 (Units 1 to 4)
Associate Professor and Chairman
KSOU, Mysuru
Publisher
Registrar
Mukthagangothri, Mysuru. - 570006
Developed by Academic Section, KSOU, Mysuru

Karanataka State Open University, 2016
All rights reserved. No part of this work may be reproduced in any form, by mimeograph or
any other means, without permission in writing from the Karnataka State Open University.
Further information may be obtained from the University’s office at Mukthagangothri,

Mysuru.-6.
Printed and Published on behalf of Karanataka State Open University, Mysuru.-6.
2
BLOCK -1 : OVERVIEW OF INDIAN FINANCIAL SYSTEMS
The financial system of a country is an important tool for economic development of

the country, as it helps in creation of wealth by linking savings with investments. It facilitates
the flow of funds from the households (savers) to business firms ( investors) to aid in wealth
creation and development of both the parties. A financial system consists of various financial
institutions, financial market, financial transactions, rules and regulations, liabilities and climes
etc.
The first block of this course overview of Indian financial system comprises of 04
units (01-04). Unit 01 discuss reserve bank of India introduction, historical background,
evolution, purpose of establishment, role in Indian financial system, the functions and minority
policy. Unit 02 explains commercial banks in India introduction, functions, structure of
scheduled and non-scheduled banks, resources and need for nationalization. Unit 03 elucidates
non-banking financial companies(NBFCs) Introduction growth, functions, types of services
rendered, features and regulation. Unit 04 exhibits regulatory framework of banking sector
introduction, role in credit control, and regulations over commercial banks.
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UNIT - 1 : RESERVE BANK OF INDIA
Structure :
1.0 Objectives
1.1 Introduction
1.2 Historical Background and Evolution of Central Bank in India
1.3 Purpose of establishment of Reserve Bank of India
1.4 Role of Reserve Bank of India in Indian Financial System
1.5 Functions of the Reserve Bank of India
1.6 The RBI and Monetary Policy
1.7 Notes
1.8 Summary
1.9 Self -Assessment Questions
1.10 Case Study
1.11 References
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1.0 OBJECTIVES
After reading this unit, you will be able to;
• The concept of Reserve Bank of India
• Historical background of Reserve Bank of India.
• The Functions of Reserve Bank of India
• The role of Reserve Bank of India in financial system.
• The Reserve Bank of India and monetary policy.
1.1 INTRODUCTION
The Reserve Bank of India is the Central Bank of our country. The Reserve Bank of
India is the apex financial institution of the country’s financial system entrusted with the task
of control, supervision, promotion, development and planning. Reserve Bank of India came
into existence on 1st April, 1935 as per the Reserve Bank of India act 1935. But the bank was
nationalized by the government after independence. It became the public sector bank from
1st January, 1949. Thus, Reserve Bank of India was established as per the Act 1935 and
empowerment took place in Banking Regulation Act 1949.
Reserve Bank of India is the queen bee of the Indian financial system which influences
the commercial banks’ management in more than one way. The Reserve Bank of India regulates
and monitors the functioning of commercial banks through its various policies, directions
and regulations. Its role in bank management is quite unique. In fact, the Reserve Bank of
India performs the four basic functions of management, viz., planning, organizing, directing
and controlling in laying a strong foundation for the functioning of commercial banks. Reserve
Bank of India has four local boards in North, South, East and West – located respectively in
four metro cities viz Delhi, Chennai, Calcutta, and Mumbai.
1.2 HISTORICAL BACKGROUND AND OF CENTRAL BANK IN INDIA

The genesis of Reserve Bank of India (RBI) started in 1926 when the Hilton-Young
Commission or the Royal Commission on Indian Currency and Finance made recommendation
to the British Government of India for creation of a central bank. The chief objectives of
such recommendations were twofold:
• To separate the control of currency and credit from the government
• To augment banking facilities throughout the country.
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To give effect to above recommendations, a bill was introduced in Legislative Assembly in
1927 but this bill was withdrawn because various sections of the people were not in agreement.
The recommendation to create a reserve bank was made by White Paper on Indian
Constitutional Reforms. Thus, a fresh bill was introduced and was enacted in 1935.
Thus, Reserve Bank of India was established via the RBI Act of 1934 as the banker to the
central government. RBI launched its operations from April 1, 1935. Its headquarters were
in Kolkata in the beginning, but it was shifted to ShahidBhagat Singh Marg, Mumbai in 1937.
Prior to establishment of RBI, the functions of a central bank were virtually being done by
the Imperial Bank of India, which was established in 1921 by merging three Presidency banks.
It was mainly a commercial bank but also served as banker to the government to some extent.
It’s worth note that RBI started as a privately owned bank. It started with a Share Capital
of Rs.5 Crore, divided into shares of Rs.100 each fully paid up. In the beginning, this entire
capital was owned by private shareholders. Out of this Rs.5 Crore, the amount of Rs.4,97,8000
was subscribed by the private shareholders while Rs.2 20,000 was subscribed by central
government.
After independence, the government passed Reserve Bank (Transfer to Public Ownership)
Act, 1948 and took over RBI from private shareholders after paying appropriate compensation.
Thus, nationalization of RBI took place in 1949 and from January 1, 1949, RBI started working
as a government owned Central Bank of India.
Key Landmarks in the journey of RBI:
In 1926, the Royal Commission on Indian Currency and Finance recommended creation of a
centralbank for India. In 1927, a bill to give effect to the above recommendation was introduced
in the Legislative Assembly, but was later withdrawn due to lack of agreement among various
sections of people.
In 1933, the White Paper on Indian Constitutional Reforms recommended the creation of a
Reserve Bank. A fresh bill was introduced in the Legislative Assembly.
In 1934, the Bill was passed and received the Governor General’s assent In 1935, Reserve
Bank commenced operations as India’s central bank on April 1 as a private shareholders’
bank with a paid up capital of rupees five crore. In 1942 Reserve Bank ceased to be the
currency issuing authority of Burma (now Myanmar).
In 1947, Reserve Bank stopped acting as banker to the Government of Burma.
In 1948, Reserve Bank stopped rendering central banking services to Pakistan.
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In 1949, the Government of India nationalized the Reserve Bank under the Reserve
Bank (Transfer of Public Ownership) Act, 1948.
In 1949, Banking Regulation Act was enacted. In 1951, India embarked in the Planning
Era. In 1966, the Cooperative Banks came within the regulations of the RBI. Rupee was
devaluated for the first time.
In 1969, Nationalization of 14 Banks was a Turning point in the history of Indian
Banking. In 1973, the Foreign Exchange Regulation act was amended and exchange control
was strengthened.
In 1974, the Priority Sector Advance Targets started getting fixed.
In 1975, Regional Rural Banks started In 1985, the Sukhamoy Chakravarty and Vaghul
Committee reports embarked the era of Financial Market Reforms in India.
In 1991, India came under the Balance of Payment crisis and RBI pledged Gold to
shore up reserves. Rupee was devaluated. In 1991-92, Economic Reforms started in India. In
1993, Exchange Rate became Market determined.
In 1994, Board for Financial Supervision was set up.
In 1997, the regulation of the Non-Banking Financial Companies (NBFC) got
strengthened.
In 1998, Multiple Indicator Approach for monetary policy was adopted for the first
time. In 2000, the Foreign Exchange Management Act (FEMA) replaced the erstwhile FERA.
In 2002, the Clearing Corporation of India Ltd started operation.
In 2003, Fiscal Responsibility and Budget Management Act (FRBMA) enacted.
In 2004, Liquidity Adjustment Facility (LAF) started working fully. In 2004, Market
Stabilization Scheme (MSS) was launched.
In 2004 Real Time Gross Settlement (RTGS) started working. In 2006, Reserve Bank
of India was empowered to regulate the money, forex, G-Sec and Gold related security
markets.
In 2007, Reserve bank of India was empowered to regulate the Payment systems.
1.3 PURPOSE OF ESTABLISHMENT OF RESERVE BANK OF INDIA

The Preamble to the Reserve Bank of India Act, 1934 spells out the objectives of the
Reserve Bank as: “to regulate the issue of Bank notes and the 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.”
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Prior to the establishment of the Reserve Bank, the Indian financial system was totally
inadequate on account of the inherent weakness of the dual control of currency by the Central
Government and of credit by the Imperial Bank of India. The Hilton-Young Commission,
therefore, recommended that the dichotomy of functions and division of responsibility for
control of currency and credit and the divergent policies in this respect must be ended by
setting-up of a central bank – called the Reserve Bank of India – which would regulate the
financial policy and develop banking facilities throughout the country. Hence, the Bank was
established with this primary object in view.
Another objective of the Reserve Bank has been to remain free from political influence
and be in successful operation for maintaining financial stability and credit. The fundamental
object of the Reserve Bank of India is to discharge purely central banking functions in the
Indian money market, i.e., to act as the note- issuing authority, bankers’ bank and banker to
government, and to promote the growth of the economy within the framework of the general
economic policy of the Government, consistent with the need of maintenance of price stability.
A significant object of the Reserve -Bank of India has also been to assist the planned
process of development of the Indian economy. Besides the traditional central banking
functions, with the launching of the five-year plans in the country, the Reserve Bank of India
has been moving ahead in performing a host of developmental and promotional functions,
which are normally beyond the purview of a traditional Central Bank.
1.4 ROLE OF RESERVE BANK OF INDIA IN INDIAN FINANCIAL

SYSTEM
In every country there is one organization which works as the central bank. The function
of the central bank of a country is to control and monitor the banking and financial system of
the country. In India, the Reserve Bank of India (RBI) is the Central Bank.
The RBI was established in 1935. It was nationalized in 1949. The RBI plays role of
regulator of the banking system in India. The Banking Regulation Act 1949 and the RBI Act
1953 has given the RBI the power to regulate the banking system.The RBI has different
functions in different roles. Below, we share and discuss some of the functions of the RBI.
 RBI is the Regulator of Financial System
The RBI regulates the Indian banking and financial system by issuing broad guidelines
and instructions. The objectives of these regulations include:
• Controlling money supply in the system,
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• Monitoring different key indicators like GDP and inflation,
• Maintaining people’s confidence in the banking and financial system, and
• Providing different tools for customers’ help, such as acting as the “Banking
Ombudsman.”
 RBI is the Issuer of Monetary Policy
The RBI formulates monetary policy twice a year. It reviews the policy every quarter
as well. The main objectives of monitoring monetary policy are:
• Inflation control
• Control on bank credit
• Interest rate control
The tools used for implementation of the objectives of monetary policy are:
• Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR),
• Open market operations,
• Different Rates such as repo rate, reverse repo rate, and bank rate.
 RBI is the Issuer of Currency
Section 22 of the RBI Act gives authority to the RBI to issue currency notes. The RBI
also takes action to control circulation of fake currency.
 RBI is the Controller and Supervisor of Banking Systems
The RBI has been assigned the role of controlling and supervising the bank system in
India. The RBI is responsible for controlling the overall operations of all banks in India.
These banks may be:
• Public sector banks
• Private sector banks
• Foreign banks
• Co-operative banks, or
• Regional rural banks
The control and supervisory roles of the Reserve Bank of India is done through the following:
• Issue of License: Under the Banking Regulation Act 1949, the RBI has been given
powers to grant licenses to commence new banking operations. The RBI also grants
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licenses to open new branches for existing banks. Under the licensing policy, the RBI
provides banking services in areas that do not have this facility.
• Prudential Norms: The RBI issues guidelines for credit control and management.
The RBI is a member of the Banking Committee on Banking Supervision (BCBS). As
such, they are responsible for implementation of international standards of capital
adequacy norms and asset classification.
• Corporate Governance: The RBI has power to control the appointment of the
chairman and directors of banks in India. The RBI has powers to appoint additional
directors in banks as well.
• KYC Norms: To curb money laundering and prevent the use of the banking system
for financial crimes, The RBI has issued “Know Your Customer” guidelines. Every
bank has to ensure KYC norms are applied before allowing someone to open an
account.
• Transparency Norms: This means that every bank has to disclose their charges for
providing services and customers have the right to know these charges.
• Risk Management: The RBI provides guidelines to banks for taking the steps that
are necessary to mitigate risk. They do this through risk management in Basel norms.
• Audit and Inspection: The procedure of audit and inspection is controlled by the
RBI through off-site and on-site monitoring system. On-site inspection is done by
the RBI on the basis of “CAMELS”. Capital adequacy; Asset quality; Management;
Earning; Liquidity; System and control.
• Foreign Exchange Control: The RBI plays a crucial role in foreign exchange
transactions. It does due diligence on every foreign transaction, including the inflow
and outflow of foreign exchange. It takes steps to stop the fall in value of the Indian
Rupee. The RBI also takes necessary steps to control the current account deficit.
They also give support to promote export and the RBI provides a variety of options
for NRIs.
• Development: Being the banker of the Government of India, the RBI is responsible
for implementation of the government’s policies related to agriculture and rural
development. The RBI also ensures the flow of credit to other priority sectors as
well. Section 54 of the RBI gives stress on giving specialized support for rural
development. Priority sector lending is also in key focus area of the RBI.
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Apart from the above, the RBI publishes periodical review and data related to banking.
The role and functions of the RBI cannot be described in a brief write up. The RBI plays a
very important role in every aspect related to banking and finance. Finally the control of
NBFCs and others in the financial world is also assigned with RBI.
1.5 FUNCTIONS OF THE RESERVE BANK OF INDIA
The Reserve Bank of India performs all the typical functions of a good Central Bank.
In addition, it carries out a variety of developmental and promotional functions which are
tuned to the course of economic planning in the country:
i) Issuing currency notes, i.e. to act as a currency authority.
ii) Serving as banker to the Government.
iii) Acting as bankers’ bank and supervisor.
iv) Regulatory and Supervisor Functions.
V) Controller of Credit.
Important functions of Reserve Bank of India are briefed below:
i) Monopoly in Note Issue: - Reserve Bank of India enjoys monopoly of Notes
issue since its establishment. The bank issues the currency notes of all denominations. Except
coins which are issued by the ministry of finance in the government of India. But these coins
are put into circulation only through the RBI. The Bank (RBI) issue currencies to a minimum
reserve system under which Rs 200\- crores worth of Gold and foreign exchange reserve
should be kept out of these 200 crores, 115 crores values should be in the form of Gold only.
To undertake this function RBI established two departments i.e.
a) Issue Department
b) Banking department
Issue department is involved in issue of currencies and manages currencies circulation.
ii) Banker to the Government: - Reserve Bank of India acts as a banker to the
central and state Government. As a banker it provides all the services like a commercial bank
to these Governments. It accepts deposits of the Government and allows them to withdrawal
of cheques. It makes payments and collect receipts on behalf of the government. It also
provides temporary advances for maximum period of 3 months to these governments. It is
known as “Ways” and “Means advances”. It is also the financial advisor to the central and
states. It also helps them in formulation of financial policies.
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iii) Bankers bank: - Reserve Bank of India is the apex financial institution acts as
banker to other bank. RBI accepts deposits, maintains cash reserves and lends loans to all the
banks operating under its preview. It is a banker’s bank in the following grounds: It provides
short-term loans to the banks for 3 months against (security) i.e. eligible securities.
It is known as lenders of last resort in the times of financial emergency. It also gives
loans at concessional rate of Interest for a specific purpose. It also offers refinance facilities
to all the eligible banks.
iv) Regulatory and Supervisor Functions: -The most significant provision of the
Banking regulation act is supervision and regulation of banks. Section 35 of the act say’s that
RBI can inspect any branch of Indian Bank located in or outside the country. Further, it issued
licensing for the banks and can establish new branches to maintain regional balance in the
country. It also arranges for training colleges to the banks employees and officers.
v) Controller of Credit: - Reserve Bank of India is an important controller of credit
in our credit. The credit created by bank leads to inflation or depression and disturbs the
smooth functioning of the economy. Therefore, to regulate credit Reserve Bank of India
uses qualitative as well as Quantitative credit control measures.
1.6 THE RBI AND MONETARY POLICY

The RBI formulates monetary policy twice a year. It reviews the policy every quarter
as well. The main objectives of monitoring monetary policy are:
 Inflation control
 Control on bank credit
 Interest rate control
The tools used for implementation of the objectives of monetary policy are:
 Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR),
 Open market operations,
 Different Rates such as repo rate, reverse repo rate, and bank rate.
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1.7 NOTES
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1.8 SUMMARY
In this unit historical background of Reserve Bank of India, Functions and Objectives
of Reserve Bank of India are discussed. The Reserve Bank of India is India’s central
banking institution, which controls the monetary policy of the Indian rupee. It was established
on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act; 1934.The
central office of the Reserve Bank was initially established in Calcutta but was permanently
moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies
are formulated. Though originally privately owned, since nationalization in 1949, the Reserve
Bank is fully owned by the Government of India. The central bank performs the functions of
issuing of notes, as bankers bank, as banker to the government, credit control etc. it uses
qualitative and quantitative measures to control the credit.
1.9 SELF-ASSESSMENT QUESTIONS

1. What do you mean by “Central Banking”. Explain in detail.
2. Discuss the organization of Reserve Bank of India?
3. What are the various functions of Reserve Bank of India?
4. Write short note on following:
(i) Ways and means advances
(ii) Banker’s Bank
5. Discuss various objectives of Reserve Bank of India?
6. “Central Bank is an apex financial institution of the country”. Elaborate
7. Examine the role played by Reserve Bank of India in our economy.
1.10 REFERENCES
1. Anthony Sauners, Megraw . Financial Markets and Institutions, Special Indian
edition, Bengaluru: MacGraw- Hill Education, 2009.
2. Mishkin. Financial Markets and Institution, Noida: Pearson education, 2011.
3. Bharati V. Pathak. The Indian Financial System : Markets, Institutions and Services
, Noida: Pearson Education, 2007.
4. Khan M.Y. Financial Service, Mumbai: Tata McGraw- Hill Education, 2015.
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5. Vijayesh Kumar. Financial Institutions and Capital Markets, New Delhi: Global
Vision Publishing House, 2012.
6. Chandan Sengupta, - Financial Analysis and Modelling using excel and VBA – 2011
7. Dr. S. Guruswamy. Merchant Banking and Financial Services, Bengaluru McGraw-
Hill Education, 2013.
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UNIT-II : COMMERCIAL BANKS IN INDIA
Structure :
2.0 Objectives
2.1 Introduction
2.2 Functions of Commercial Banks
2.3 Structure of Commercial Banks
2.3.1. Scheduled banks
2.3.1.1 Public Sector Banks
2.3.1.2 Private Sector Banks
2.3.1.3 Foreign Banks
2.3.1.4 Regional Rural Banks
2.3.2.Non- scheduled banks.
2.4 Resources of Commercial Banks
2.4.1 Paid-up Capital and Reserves
2.4.2 Deposits
2.4.3 Borrowings
2.5 Employment of Resources
2.6 Need for nationalization of Banks
2.7 Notes
2.8 Summary
2.9 Self-Assessment Questions
2.10 References
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2.0 OBJECTIVES
After reading this Unit, you will be able to;
• The structure of working of Commercial Banks in India,
• The functions of Commercial Banks
• The sources of funds for Commercial Banks and their utilization,
• The problem of non-performing assets of banks and its impact on banks
functioning.
2.1 INTRODUCTION
Commercial Banks are the oldest and the largest banking institutions in India. Some
of them are more than hundred years old. Their branches are spread all over the country and
have penetrated in the countryside as well. Commercial Banking has passed through three
distinct phases in India since Independence. The period 1955- 1970 witnessed the genesis of
public sector banking in India Commencing with the setting up of the State Bank of India in
1955 and ending with the nationalization 0f 14 major banks in 1969.
The two decades after nationalization of banks i.e. the seventies and eighties witnessed
the conversion of class banking into mass banking. During this Period branch expansion took
place on a large-scale, followed by recruitment of -large number of bank employees,
expansion in priority sector advances, especially for the poor and neglected sectors.
Loan Melas were the main features of this period. On the other hand, the Reserve
Bank of India’s regulatory control intensified over various facets of banking operations. The
post-nationalization era was not without its resultant problems. With poor training, employee
efficiency and productivity went down, problem of non-recovery of loans cropped up, and
pre-emption of funds in meeting statutory requirement went up, resulting in reduced
profitability of banks. It was such a situation in 1991 when the new economic policies were
launched by the Government.
A Committee on financial sector under the Chairmanship of Shri M, Narashimham
was appointed which suggested measures of far-reaching significance to improve efficiency,
productivity and profitability of banks. These measures have been largely implemented.
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2.2 FUNCTIONS OF COMMERCIAL BANKS
A Bank is a financial Institution whose main business is accepting deposits and lending
loans. A Banker is a dealer of money and credit. Banking is an evolutionary concept i.e.
expanding its network of operations. According to banking regulations act 1949, the word
Banking has been defined as “Accepting for the purpose of lending and investment of deposits
of money from the public repayable on demand or otherwise”.
The important functions of commercial banks are explained below:
I. Primary Functions
These are further classified into 2 categories
i) Accepting Deposits: -
Deposits are the capital of banker. Therefore, it is first Primary function of the banker.
He accepts deposits from those who can save and lend it to the needy borrowers. The size of
operation of every bank is determined by size and nature of Deposits. To attract the saving
from all sort (categories) of individuals, Commercial banks accepts various types of deposits
account they are:
a) Fixed Deposits
b) Current Deposits
c) Saving Bank account
d) Recurring Deposits
ii) Lending Loans: -
The 2nd important function of the commercial bank is advancing loans. Bank accepts
deposits to lend it at higher rate of interest. Every Commercial Bank keep the rate of interest
on its deposit at lower level or less that what he charges on its loans which is as NIM (Net
Interest Margin). The banker advances different types of loans to the individual and firms.
They are: -
a) Overdraft
b) Cash Credit
c) Term Loan
d) Discounting Bill
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II) Secondary Functions
i) Agency functions:
Bankers act as an agent to the customers it means he performs certain function son
behalf of the customers such services are called Agency Services. Example:
a) Bank pay electricity bill, water bill, Insurance Premium etc.
b) They guide the customer in Task Planning.
c) Bank provides safety locker facility.
d) Pay salaries of customer’s employees.
ii) General Utility Services: -
Bankers are the past of society. They offer: several services to general public they
are:-
a) It provides cheap remittance (transfer) facilities.
b) The banks issue traveler cheque for safe travelling to its customers.
c) Banks accepts and collects foreign Bills of Exchanges.
d) Other than these services the bankers also provide ATM services, Internet Banking,
Electronic fund transfer (EFT), E-Banking to provide quick and proper services to its
customers.
III) Credit Creation: -
It is a unique function of Commercial Banks. When a bank advances loan to its
customer if doesn’t lend cash but opens an account in the borrowers name and credits the
amount of loan to that account. Thus, whenever a bank grants loan, it creates an equal amount
of bank deposits. Creation of deposits is called Credit Creation. In simple words we can
define Credit creation as multiple expansions of deposits. Creation of such deposits will
results an increase in the stock deposits. Creation of such deposits will results an increase in
the stock of money in an economy.
2.3 STRUCTURE OF COMMERCIAL BANKS
Commercial banks are basically of two types.
2.3.1. Scheduled banks
2.3.2. Non- scheduled banks.
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2.3.1 Scheduled Banks are those which have been in II schedule of Reserve Banks of India
act, 1934 and following criteria should be satisfied.
1. Minimum paid up capital Rs. 5 lakh.
2. It must be a corporation as co-operative society.
3. Any activity of bank will not adversely affect the interest of depositors
Scheduled banks consists public sector banks, private sector banks, foreign banks,
and regional rural banks.
2.3.1.1 Public Sector Banks:
Public banks are those in which 50% of their capital is provided by central government,
15% by concerned state government and 35% by sponsored commercial banks. In India,
there are 27 public sector banks. They includes the state bank of India and its 6 associated
banks such as state bank of Hyderabad, state bank of Mysore etc. and 19 nationalized banks
and IDBI banks Ltd. Public sector banks mostly situated in rural area than urban area.
2.3.1.2 Private Sector Banks:
Private Banks are those in which majority of share capital kept by business house and
individual. After the nationalization, entry of private sector banks is restricted. But some of
private banks continued to operate such as Jammu & Kashmir bank Ltd. To increase the
competition spirit and improve the working of public sector banks, RBI permitted the entry
of private sector banks in July, 1993.
2.3.1.3 Foreign Banks:
Foreign banks are those which incorporated outside India and open their branches in
India. Foreign banks performed all the function like other commercial banks in India. Foreign
banks are superior in technology and management than India banks. They offer different
types of products and services such as offshore banking, online banking, personal banks etc.
They provide loans for automobiles, small and large businesses. Foreign banks also
providespecial types of credit card which are nationally and internationally accepted. These
banks earn lots of profit and create new ways of investments in the country.
2.3.1.4 Regional Rural Banks
Regional rural banks established 1975 with mandate to ensure sufficient credit for
agriculture and rural sector. RRB’s are jointly owned by government of India, concerned
state government and sponsor bank, the capital share being 50 %, 15% and 35% respectively.
Now these Days, there are 14,475 regional rural banks in India. NABARD control and prepare
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the policies for Regional Rural Banks. The basic objective of establishing RRB’s in India
was to provide the credit to rural sector especially the small and medium farmers, artisans,
agricultural labour and even small entrepreneurs.
2.3.2 Non Scheduled Banks:
Non Scheduled banks in India define in clause (C) of section 5 of Banks regulation
Act 1949. Non Scheduled banks are those which are not a schedule bank and their paid up
capital and reserves less than Rs.5 lakh and are not included in the 2nd schedule of the Reserve
Bank of India Act, 1934.
2.4 RESOURCES OF COMMERCIAL BANKS
Banking business essentially lies in the acceptable of deposits for the purpose of
lending and investment. Acceptance of deposits thus, constitutes the main source of funds
for them. Their own funds constitute a small percentage of their total resources. As we shall
see later, efforts are being made during recent years to increase the owned funds of the banks
also.
2.4.1 Paid Up Capital and Reserves
The authorized capital of nationalized banks is Rs. 1500 crore each. The Central
Government has subscribed to the 100% paid-up capital in case of some banks, while in
other cases; its percentage holding has declined with the issuance of shares to the public.
Banks transfer 20% (now 25%) of their net profits to a Statutory Reserve Fund every year.
Besides, they also maintain other Reserve Funds, e.g. Capital Reserves, Share premium, revenue
and other reserves and Investment Fluctuation Reserve.
2.4.2 Deposits
Deposits from the public, institutions, and organizations constitute the bulk of the
resources of commercial banks. They accept deposits under three types of deposit accounts:
i) Fixed Deposits: the minimum period of such deposits is 15 days
ii) Savings Deposits
iii) Current Deposits
No interest is payable on current deposits, while interest on savings bank accounts is
prescribed by Reserve Bank of India. Currently it is payable @ 4% p.a. Interest is calculated
on the minimum balance held in the savings accounts from 11th day of the month till the last
day of the month. Interest rates on fixed deposits were prescribed by Reserve Bank of India
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till a few years ago. Now, such interest rates are completely deregulated. Banks are permitted
to prescribe their own interest rates for fixed deposits of different maturities. At the stance
of the Reserve Bank of India, banks pay slightly higher rates on bulk deposits of Rs. 15 lakh
and above and on deposits held in the names of senior citizens (i.e. persons of age 60 years
and above).
Deposits with Commercial banks, as well as with Regional Rural Banks and Co-
operative banks are insured by Deposit Insurance and Credit Guarantee COMPANY of India
up to an amount of Rs. 1 lakh in each account. These banks pay the insurance premium @ 5
paise percent to the COMPANY for this insurance. Scheduled Commercial Banks also solicit
large deposits through certificates of deposits. The outstanding amount of CDs issued by
them stood at Rs. 1695 crore as on October 20, 2000, but declined to Rs. 823 crore as on
October 5, ‘ 2001.
2.4.3 Borrowings
Banks augment their resources by borrowings also. Sources of such borrowings are:
i) Reserve Bank of India
ii) Other Banks
iii) Other Institutions and Agencies.
Reserve Bank of India provides refinance for export credit and also provides short-
term funds under its Liquidity Adjustment Facility Moreover; banks get refinance from other
Apex Banks like Exim Bank, IDBI etc.
2.5 EMPLOYMENT OF RESOURCES

As you have keen, bulk of banks’ funds are raised in the form of deposits, which are
repayable on demand or after a specified period. Banks, therefore, employ these funds partly
in liquid assets like cash balances with themselves and other banks and money at call and
short notice and the rest of the amount is either invested in securities or given in the form of
loans and advances.
i) Cash and balance with other Banks
These are the most liquid assets of a bank and are called the first line of defence,
because banks can immediately repay the claims of the depositors with these balances. Banks
keep a reasonable amount of cash; say 10% or so of, deposits, in such balances.
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ii) Money at Call and Short Notice
The surplus money with the banks is lent to other banks which are in need of funds for
a day or a few days. Banks earn interest on-such amount lent to other banks. The interest rate
varies from day to ‘day on the basis of demand for and supply of funds.
iii) . Cash Reserves with Reserve Bank of India
Under Section 42 of the Reserve Bank of India Act, 1934, scheduled commercial
banks are required to maintain at least 3 % of their net demand and time liabilities with the
Reserve Bank of India. This is the statutory minimum limit; Reserve Bank of India is
empowered to raise it to a higher percentage of upto 20%.
With effect from June 1, 2002, the Cash Reserve Ratio ICRR) is required to be
maintained @ 5% (reduced from 5.5%). In recent years, Reserve Bank of India has gradually
reduced this rate. With every reduction in CRR, Commercial Banks’ balances with Reserve
Bank of India are released to them, thereby increasing their liquidity. Reserve Bank of India
pays interest at bank rate on eligible balances i.e. balances held in excess of statutory 3%
limit.
iv). Investments
Banks invest substantial portion of their deposit liabilities in investments. Primarily,
banks are under compulsion to invest in Government and other approved securities to meet
the Statutory Liquidity requirement under section 24 of the Banking regulation act, 1949.
Besides, Reserve Bank of India has also permitted the’ banks to invest in corporate securities,
i.e. equity shares, convertible bonds and debentures within the ceiling of 5% of their total
outstanding advances as on March 31 of the previous year. Thus, commercial banks do invest
in corporate securities, predominantly, bonds and debentures.
Investments of banks are shown under the following head in their Balance Sheets:
1) Government Securities
2) Other approved securities
3) Shares
4) Debentures and Bonds
5) Subsidiaries and Joint Ventures
6) Others (Commercial Paper, Indira Vikas Patras, Units of UTI and Mutual Funds)
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Though the Statutory Liquidity Requirement at present is 25% of net demand and
time liabilities, banks do invest more than this percentage, which is mainly due to their
investments in corporate bonds and debentures. The investment-deposit ratio of Scheduled
Commercial banks (on an outstanding basis) was 38.5% as on March 23, 2001.
v) Loans and Advances
Granting loans and advances is the principal business of commercial banks. There are
three forms in which such loans are granted:
a) Bills purchased and discounted,
b) Cash credits, overdrafts and loans repayable on demand, and
c) Term loans.
a) Bill of exchange arises out of genuine trade transactions. When the bills are payable at
sight or presentment, banks purchase them from customers (i.e. drawers’ of the bills).
In case of time bills or usance bills banks discount them.
b) Cash Credit is a running account wherein a cash credit limit is prescribed for a customer.
He is permitted to withdraw the amount any time he likes and may return the money
whenever he is able to do so. Interest is charged on the actual amount lent and for the
period of loan.
Overdraft is a temporary facility which is granted to account holders. They are
permitted to draw more than their deposits for some exigency or urgent work. Short-term
loans are granted- to the customers, which are repayable on demand.
c) Term loans are loans for medium to long periods. Such loans are granted by banks
either singly or jointly with term lending institutions. These loans are meant for
investment in futed assets or for expansion, modernization, etc.
2.6 NEED FOR NATIONALIZATION OF COMMERCIAL BANKS
Nationalization of Commercial Banks

The role of public sector banks increased after nationalization of commercial banks.
On I July 1955, the government of India took over imperial Bank of India and converted it
into the state Bank of India. In India, the major nationalization of commercial banks was done
in July 1969 by Prime Minister Mrs Indira Gandhi. 14 Commercial banks were nationalized
in July 1969. In April 1980, 7 more bank were nationalized.
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Need for Nationalization of Commercial Banks
The needs for nationalization of Commercial Banks are given below.
1. Commercial Banks were provide loans to large scale Industries and neglected priority
sectors.
2. Before the nationalization financially strong Bank ignored RBI Directives which
adversely effected RBI monetary policy.
3. To remove the fear of bank failures from the minds of people.
4. To keep means of generating wealth in public control.
5. To remove regional imbalances and ensure even distribution of banking facilities.
6. To prevent unfair credit distribution by commercial banks
Advantages of Nationalization of Commercial Banks
Some of the advantages of Nationalization of Commercial Banks are as follows:
1. To Check on Creation of Industrial Monopoly:
Before nationalization of commercial banks credit was concentrated to few hands
and this formed Industrial Monopoly. No person except big Industrialist could get loan and
advances. This neglected the other smaller industrialist. So, commercial banks were
nationalized to curb the monopolizing tendencies.
2. Credit Facility to Priority Sector:
Agriculture sector is backbone of India. This sector was neglected at that time. There
was no credit facility available to agriculture sector before nationalization.
3. Reduction of Regional Imbalance:
Regional imbalances had existed in India for a long time in area of banking facilities.
After nationalization, branches opened in backward states like Assam, Bihar, and Uttar Pradesh
than in developed states like Gujarat, Tamil Nadu etc. These banks reduced the Regional
Imbalances.
4. Collection of Saving:
Before the Nationalization, the banks did not attract more saving from public, because
people did not trust banking system. But After nationalization of commercial Banks, the
deposits were increased. Because public believed in public sector Banks then private sector
Banks.
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5. To check on Black Money:
In order to avoid income tax, people kept money with banks. For the solution of this
problem the banks were nationalized.
6. Economic Growth:
Before nationalization of banks, economy of country was not growing due to antisocial
practices, speculation and hoarding. The country’s economy suffered badly. In order to solve
this problem banks were nationalized.
7. Export Promotion:
Commercial Banks also promotes export. Because there is need to promote export
for earn Foreign exchange. So, Banks give Finance to Exporter at concessional rates.
8. Credit Card Facility:
Credit card facility is provided by these Banks which has made our life easy. People
can buy necessary things through credit card make payment later on.
9. Promote Small Scale Industry:
Nationalized commercial Banks encouraged small scale Industry by granting Loans.
These banks grant short term and long term loan to purchase machinery and equipment.
Disadvantages of Nationalization of Commercial Banks
1. Low performance:
The biggest problem of nationalized banks has been their low performance. Banks are
required to keep minimum capital to risk asset ratio which known as capital adequacy ratio.
It should be 9%.Most of public sector banks had negative ratio. Only four banks maintained
ratio during 1999-2000.
2. Favoritism:
Another limitation of commercial banks was favoritism in granting loan. They harass
certain small industrialist and same time banks grant loan to big industrialist on easy terms
and conditions. They follow the policy of partiality which affected the trust of client in banks
working.
3. Unbalanced Distribution of Credit:
In initial years, Agriculture sector got priority and other sector were neglected. Bank
do not advance loan to weaker section such as laborers, worker and small trader due to lack
of security.
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4. Financial Crisis:
After nationalization, some banks were operating under losses .This is because banks
advance loan without adequate security. Banks grant non-performing loans which interest
has not been received for 180 days. The recovery of loan was poor which lead to losses. This
is main reason for failure of banks.
5. Political Interference:
Another limitation of nationalized commercial banks was increasing the political
interference in granting loans, appointment of banks personnel, opening of new branches
etc.
6. Inadequate Facilities:
Nationalized commercial banks have failed to provide adequate facilities and services
to population living in rural and sub urban area. Banks failed to mobilize rural deposit.
2.7 NOTES
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2.8 SUMMARY
Major portion of commercial banking in 1ndia is undertaken in the public sector.
Within the public sector, the State Bank of India and its subsidiaries constitute State Bank
Group on the basis of their ownership pattern. New private sector bank, include ICICI Bank
Ltd, which is the second biggest bank after State Bank of India. Banks get the status of
Scheduled Banks on the fulfilment of prescribed conditions.
The main sources of banks’ funds are deposits. Interest Rates on deposits are now
completely deregulated (except savings). Borrowings from Reserve Bank and other
institutions also augment their funds.
Commercial Banks employ their funds in liquid assets, semi liquid assets and profit
earning assets like loans and advances. They are required to maintain a prescribed percentage
of deposits with Reserve Bank of India as CRR and also to maintain Statutory Liquidity Ratio
of 25%.
Funds are lent for diversified purposes-priority sector advances constitute over 40%
of total advances. They also lend for housing, consumer durables, real estate financing and
other personal purposes also.
2.9 SELF ASSESSMENT QUESTIONS

1. What do you mean by Commercial banks? Explain the functions of Commercial banks.
2. Discuss the structure of commercial banks in India.
3. Critically examines the need of nationalization of commercial banks.
2.10 REFERENCES
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UNIT –III : NON-BANKING FINANCIAL COMPANIES (NBFCs)
Structure :
3.0 Objectives
3.1 Introduction
3.2 Growth Of Non-Banking Financial Companies
3.3 Functions Of Non-Banking Financial Companies
3.4 Types Of Non-Banking Financial Companies (NBFCs)
3.5 Types Of Services Rendered By Non-Banking Finance Companies
3.6 Features Of Non-Banking Financial Companies
3.7 Regulations of (NBFCs)
3.8 Notes
3.9 Summary
3.10 Self Assessment Questions
3.11 Some Useful Books
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3.0 OBJECTIVES
After reading this unit, you will be able to;

• The concept of Non-Banking Financial Companies
• The difference between NBFCs and Banks
• The Functions of Non-Banking Financial Companies (NBFCs)
• The different kinds of services rendered by Non-Banking Finance Companies (NBFCs)
3.1 INTRODUCTION
Financial intermediaries are that institution which link lenders and borrows. The process
of transferring saving from savers to investors is known as financial intermediation.
Commercial banks and cooperative credit societies are called “finance Companies”, or
“finance companies”. These finance companies with very little capital have been mobilizing
deposits by offering attractive interest rates and incentives and advance loans to wholesale
and retail traders, small industries and self-employed persons. They grant unsecured loans at
very rates of interest. These are non-banking companies performing the functions of financial
intermediaries. They cannot be called banks. A Non-Banking Financial Company (NBFC) is
a company registered under the Companies Act, 1956 and is engaged in the business of loans
and advances, acquisition of shares, securities, leasing, hire-purchase, insurance business,
and chit business.
Number of Non-Banking Financial Companies
The number of Non-Banking Financial Companies continued to grow year after year
in the nineties. During 1996-97, the aggregate deposits of 13,970 Non- Banking Financial
Companies totalled up to Rs.3,57,150crores. As on March 31, 2012 the total number of
Non-Banking Financial Companies registered with RBI stood at 12,385 compared with
12,409 in 2011. The number of deposit taking Non-Banking Financial COMPANY’s (NBFC-
D), including residuary NBFCs (RNBC), also reduced from 297 at end-March 2011 to 271
as on end March 2012. The size of total assets of Non-Banking Financial Companies grew
from Rs 1,169 billion to Rs 1,244 billion as at end March 2012. Net owned funds of NBFCs
too grew 25% from Rs 180 billion in 2011 to Rs 225 billion at end- March 2012.The large
finance companies numbering 2,376 accounted for 63 per cent of deposits.
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3.2 GROWTH OF NON-BANKING FINANCIAL COMPANIES
NBFCs in India have existed since long. They came into limelight in the second half
of the 1980s and in the first half of the 1990s.
NBFCs flourished during the stock market boom of the early 1990s. In the initial
years of liberalization, they not only became prominent in a wide range of activities but they
outpaced banks in deposit raising owing to their customized services. They have backed many
small entrepreneurs. They have also lent small-ticket personal loans of size of Rs 25,000 to
customers and thereby fuelled the consumption boom.
Total assets/liabilities of NBFCs grew at an average annual rate of 36.7 percent during
the 1990s (1991-98) as compared to 20.9 percent during the 1980s (1981-91). The growing
importance of this segment and the surfacing of some scams compelled the RBI to increase
regulatory attention.
Almost all corporate houses have set up their own NBFCs. Big banks also floated
NBFCs to tap certain segments on which restrictions were imposed by the regulator. Banks
through the NBFCs could generously lend funds to promoters to raise his holdings through
a creeping acquisition. Citi Financial is one of the oldest foreign bank-owned NBFC and a
pioneer in this segment. There has been an increase in the number of NBFCs, especially
those floated by foreign banks as there are strictures on branch licensing. Reserve Bank of
tightened NBFC norms in November 2006 to reduce regulatory arbitrage between different
financial sector players. According to the new guidelines, non-deposit taking NBFCs which
have assets of over Rs. 100 crore will be subject to exposure and capital adequacy norms.
Banks will not be able to lend indiscriminately to them. Nor will they be allowed to hold
more than 10 percent equity stake in deposit taking NBFCs. Moreover, foreign banks with
NBFC subsidiaries will be required to include the activities of their NBFC arms in their
reporting to the Reserve Bank.
3.3 FUNCTIONS OF NON-BANKING FINANCIAL COMPANIES

The functions performed by Non-Banking Financial Companies may be described as under:
• They are able to attract deposits of huge amounts by offering attractive rates of interest
and other incentives. Half of the deposits are below two years time period.
• They provide loans to wholesale and retail merchants’ small industries, self employment
schemes.
• They provide loans without security also. Hence they are able to charge 24 to 36 per
cent interest rate.
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• They run Chit Funds, discount hundies, provide hire-purchase, leasing finance, merchant
banking activities.
• They ventures to provide loans to enterprises with high risks. So they are able to charge
high rate of interest. They renew short period loans from time to time. They therefore
become long period loans.
• They are able to attract deposits by offering very high rate of interest. In the process
many companies sustained losses and went into liquidation. The bankruptcy of many
companies adversely affected middle-class and lower income people. There is no
insurance protection for deposits as in the case of bank deposits.
• The finance companies are able to fill credit gaps by providing lease finance, hire purchase
and instalment buying. They provide loans to buy scooter, cars, TVs and other consumer
durables. Such extension of functions makes them almost commercial banks. The only
difference is that Non-Banking Financial Companies cannot introduce cheque system.
This is the difference b/w the two
 Difference between banks & Non-Banking Financial Companies:
Non-Banking Financial Companies are doing functions similar to that of banks;
however there are a few differences:
1) A Non-Banking Financial Companies cannot accept demand deposits,
2) It is not a part of the payment and settlement system and as such cannot issue cheques
to its customers,
3) Deposit insurance facility of DICGC is not available for Non-Banking Financial
Companies depositors unlike in case of banks
3.4 TYPES OF NBFCs

There are different categories of Non-Banking Financial Companies’ operating in
India under the supervisory control of RBI. They are:
1. Non-Banking Financial Companies (NBFCs)
2. Residuary Non-banking Finance companies (RNBCs).
3. Miscellaneous Non-Banking Finance Companies (MNBCs)
Residuary Non-Banking Company is a class of Non-Banking Financial Companies,
which is a company and has as its principal business the receiving of deposits, under any
35
scheme of arrangement or in any other manner and not being Investment, Leasing, Hire-
Purchase, Loan Company. These companies are required to maintain investments as per
directions of RBI, in addition to liquid assets. The functioning of these companies is different
from those of NBFCs in terms of method of mobilization of deposits and requirement of
deployment of depositors’ funds. Peerless Financial Company is the example of RNBCs.
Miscellaneous Non-Banking Financial Companies are another type of Non- Banking
Financial Companies and MNBC means a company carrying on all or any of the types of
business as collecting, managing, conducting or supervising as a promoter or in any other
capacity, conducting any other form of chit or kuri which is different from the type of business
mentioned above and any other business similar to the business as referred above. Type of
Services provided by Non-Banking Financial Companies: Non-Banking Financial Companies
provide range of financial services to their clients.
3.5 TYPES OF SERVICES PROVIDED BY NON-BANKING FINANCE

COMPANIES
Non-Banking Financial Companies provide range of financial services to their clients.
Types of services under non-banking finance services include the following:
1. Hire Purchase Services
2. Leasing Services
3. Housing Finance Services
4. Asset Management Services
5. Venture Capital Services
6. Mutual Benefit Finance Services (Nidhi) banks.
The above type of companies may be further classified into those accepting deposits
or those not accepting deposits.
Hire Purchase Services
Hire purchase is the legal term for a conditional sale contract with an intention to
finance consumers towards vehicles, white goods etc. If a buyer cannot afford to pay the
price as a lump sum but can afford to pay a percentage as a deposit, the contract allows the
buyer to hire the goods for a monthly rent. If the buyer defaults in paying the installments,
the owner can repossess the goods. Hire purchase is a different form of credit system among
other unsecured consumer credit systems and benefits. Hero Honda Motor Finance Co.,
Bajaj Auto Finance Company is some of the Hire purchase financing companies.
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Leasing Services
A lease or tenancy is a contract that transfers the right to possess specific property.
Leasing service includes the leasing of assets to other companies either on operating lease
or finance lease. An NBFC may obtain license to commence leasing services subject to, they
shall not hold, deal or trade in real estate business and shall not fix the period of lease for
less than 3 years in the case of any finance lease agreement except in case of computers and
other IT accessories. First Century Leasing Company Ltd., Sundaram Finance Ltd. is some
of the Leasing companies in India.
Housing Finance Services
Housing Finance Services means financial services related to development and
construction of residential and commercial properties. An Housing Finance Company
approved by the National Housing Bank may undertake the services /activities such as
Providing long term finance for the purpose of constructing, purchasing or renovating any
property, Managing public or private sector projects in the housing and urban development
sector and Financing against existing property by way of mortgage. ICICI Home Finance
Ltd., LIC Housing Finance Co. Ltd., HDFC is some of the housing finance companies in our
country.
Asset Management Company
Asset Management Company is managing and investing the pooled funds of retail
investors in securities in line with the stated investment objectives and provides more
diversification, liquidity, and professional management service to the individual investors.
Mutual Funds are comes under this category. Most of the financial institutions having their
subsidiaries as Asset Management Company like SBI, BOB, UTI and many others.
Venture Capital Companies
Venture capital Finance is a unique form of financing activity that is undertaken on the
belief of high-risk-high-return. Venture capitalists invest in those risky projects or companies
(ventures) that have success potential and could promise sufficient return to justify such
gamble. Venture capitalist not only provides finance but also often provides managerial or
technical expertise to venture projects. In India, venture capitals concentrate on seed capital
finance for high technology and for research & development.
Industrial Credit and Investment company ventures and Gujarat Venture are one of the
first venture capital organizations in India and SIDBI, Industrial development bank of India
and others also promoting venture capital finance activities.
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Mutual Benefit Finance Companies (MBFCs)
A mutual fund is a financial intermediary that allows a group of investors to pool their
money together with a predetermined investment objective. The mutual fund will have a fund
manager who is responsible for investing the pooled money into specific securities/bonds.
Mutual funds are one of the best investments ever created because they are very cost efficient
and very easy to invest in. By pooling money together in a mutual fund, investors can purchase
stocks or bonds with much lower trading costs than if they tried to do it on their own. But the
biggest advantage to mutual funds is diversification.
There are two main types of such funds, open-ended fund and close-ended mutual
funds. In case of open-ended fund, the fund manager continuously allows investors to join or
leave the fund. The fund is set up as a trust, with an independent trustee, who keeps custody
over the assets of the trust. Each share of the trust is called a Unit and the fund itself is called
a Mutual Fund. The portfolio of investments of the Mutual Fund is normally evaluated daily
by the fund manager on the basis of prevailing market prices of the securities in the portfolio
and this will be divided by the number of units issued to determine the Net Asset Value
(NAV) per unit. An investor can join or leave the fund on the basis of the NAV per unit.
In contrast, a close-end fund is similar to a listed company with respect to its share
capital. These shares are not redeemable and are traded in the stock exchange like any other
listed securities. Value of units of close-end funds is determined by market forces and is
available at 20-30% discount to their NAV.
3.6 FEATURES OF NON-BANKING FINANCIAL COMPANIES

1) Small size: NBFCs are small entities in terms of their size and scope. Some NBFCs are
larger in size like Provident Fund, Pension Fund etc., but mostly these are small size
institutions. Their structure is easy and simple and management cost is low.
2) Less Capital intensive: These entities have very low amount of owned capital. The
attractive returns offered help them to collect larger sum of money from the people. If
they do not offer attractive returns to the people, their existence will bein danger, as
they will find it difficult to collect deposits.
3) Easy availability of loans: Borrowers turned down by the commercial banks and
development banks, go to these NBFCs. Loans from NBFCs are easily available as very
little documentation is required. Handicraft and small industries, small businessmen,
sundry traders, often turn to NBFCs for loans.
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4) Unsafe loans: The loans offered by NBFCs involve more risk as the sear offered without
or with inadequate mortgage. The recovery of loans, therefore, becomes difficult.
5) Rescheduling of loans: Many a times, the loans offered for short and medium term are
not recovered and, therefore, converted into long term loans. As result, amount of loan,
term and rate of interest increase.
6) Lack of co-ordination: The number of NBFCs has increased rapidly. Up to 1996, there
were 39,450 NBFCs working in India. Most of the NBFCs were smallsize entities with
very few large ones. These smaller size NBFCs do not have anyco-ordination among
them. They act independently and focus on short-term profit and therefore, do not survive
in the long run.
7) Annual report and balance sheet: Except few, most NBFCs ignore auditing of their
accounts, publication of balance sheet and other relevant information. This is not good
from the point of view of depositors.
8) Fulfilment of several needs of the economy : People need loan assistance in several
activities like agriculture, industry, trade, service sector, and also for consumption,
education, home construction, purchase of vehicle, healthetc. NBFCs come forward to
provide loan assistance in all the areas where it is possible to earn maximum rate of
interest.
9) Independent Policy: NBFCs are required to follow the rules and orders of RBI. They
are registered under Company Act, but capital limitation, profit provisioning maintaining
reserves, auditing of accounts and publication of balance sheet etc., are not binding on
them. As a result, many NBFCs emerge and conduct their business independently.
10) Perfection in work: Some NBFCs conduct their business very efficiently. They always
strive for perfection in their work, which in turn benefits both the depositors and
borrowers. Other NBFCs either get into the problems or don’t survive.
3.7 REGULATIONS OVER NON-BANKING FINANCE COMPANIES

The Non-Banking Finance Companies perform very important financial inter mediation
function in India. They supplement the role of the banking institutions, as they cater to the
needs of those borrowers who remain beyond the purview of the banking institutions and
mobilize the savings from the depositors. Hire purchase finance and leasing companies,
loans and investment companies and housing finance companies are the important categories
of such Non-Banking Finance Companies (NBFCs).
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In the 1960s, the RBI made an attempt to regulate NBFCs by issuing directions relating
to the relating to the maximum amount of deposits, the period of deposits, and rate of interest
they could offer on the deposits accepted. Norms were laid down regarding maintenance of
certain percentage of liquid assets, creation of reserve funds, and transfer there to every year
a certain percentage of profit, and so on. These directions and norms were revised and amended
from time to time. And In view of the significant role played by NBFCs, regulatory framework
has been devised, particularly to safeguard the interests of the depositors. Chapter III(B) of
the Reserve Bank of India Act, 1934 provides for such regulatory framework over NBFCs.
Significant amendments to this Chapter were made in January, 1997, vesting more powers in
the Reserve Bank of India to regulate the activities of such companies. We shall first deal
with the provisions of Chapter 111 B, following by the important provisions of the directives
issued by the Reserve Bank of India in this regard.
1) Reserve Bank of India Act, 1834
The powers vested in the Reserve Bank of India Act under Chapter I11 B of Reserve
Bank of India Act, 1934 are as follows:
i) To regulate or prohibit issue of prospectus
In the public interest, the Reserve Bank of India may regulate or prohibit the issue by
any non-banking company of any prospectus or advertisement soliciting deposits of money
from the public. The Bank may also give directions to these companies as to the particulars
to be included in such advertisements.
ii) To collect information as to deposits and to give direction
The Reserve Bank of India is empowered to direct every non-banking institution to
furbish to it information or particulars relating to the deposits received by it. The Bank may
also issue directions in the public interest, to such institutions generally, or to any institution
in particular, or group of such institutions in particular, on any of the matter sconnected with
the receipt of deposits. If any such institution fails to comply with any direction, the Bank
may prohibit the acceptance of deposits by such institutions.
iii) To conduct inspection
The Reserve Bank of India may, at any time, causes an inspection to be made of any
non-banking institution to verify the correctness/completeness of the particulars furnished
to the Bank or to obtain any such particulars, if not submitted.
iv)The Reserve Bank of India (Amendment) Act, 1997, has conferred explicit powers
on the Reserve Bank of India as follows:
40
a) A new NBFC cannot operate unless it is registered with Reserve Bank of India and has
a minimum owned fund of Rs. 25 lakhs. Reserve Bank has been vested with the power of
enhancing the minimum Net Owned Funds (NOF) of NBFCs to Rs. 2 crore in case of
companies which are incorporated on or after April 20, 1999, and which seek registration
with Reserve Bank of India.
b) Every NBFC is required to create a Reserve Fund and transfer not less than 20% of its
net profit each year to such fund before declaring any dividend.
c) Reserve Bank of India is given the power to prescribe the minimum level of liquid assets,
as a percentage of the deposits, to be maintained in unencumbered approved securities
(i.e. government securities or guaranteed bonds).
d) The Company Law Board has been empowered to direct NBFCs to repay deposits that
have matured, if it finds that the company is unable or unwilling to repay the depositors.
e) Powers have been conferred upon the Reserve Bank of India to:
• give directions to the NBFCs regarding prudential norms,
• give directions to the NBFCs and their auditors on matters relating to balance sheets
and cause special audit as well as to impose penalty on erring auditors,
• prohibit NBFCs from accepting deposits for violation of the provisions of the RBI Act
and to direct NBFCs not to alienate their assets,
• file winding up petition against erring NBFCs,
• Impose penalty directly on the erring NBFCs.
2) NBFCs Acceptance of Public Deposits (Reserve Bank)Directions. In exercise of
the powers vested in it under Chapter 111 B, the Reserve Bank of India, issued these directions
to NBFC sregarding acceptance of deposits from the public. These directions were
substantially revised in January, 1998, to include prudential norms to be followed by NBFCs.
The salient features of RBI Directions, as further revised in December, 1998 are as follows:
i) For regulatory purposes, NBFCs have been classified in to three categories:
a) Those accepting public deposits,
b) Those not accepting public deposits, but engaged in financial business,
c) Core investment companies, with 90% of their total assets in investments in the
securities of their group/holding/subsidiary companies.
The thrust of RBI regulation is on companies accepting public deposits (category (a) above).
41
ii) Public deposits have been defined to include field/ recurring deposits received from public,
deposits received from relatives and friends, deposits from shareholders by a public
limited company and money raised by issue of unsecured debentures and bonds to
shareholders and the public. Public Deposits exclude money raised by way of issue of
secured debentures and bonds, borrowings from banks and financial institutions
(including by way of unsecured debentures), deposits from directors, inter-corporate
deposits, deposits from foreign citizens, deposits received by private limited companies
from their shareholders, security deposits from employees, advance receipt of lease
and hire purchase instalments.
iii) NBFCs with net owned funds (NOF) of less than Rs. 25 1 lakh (with or without credit
rating) are not allowed to accept public deposits.
iv) Ceilings on public deposits for NBFCs, with NOF of Rs. 25lakh and above, have been
prescribed as follows. These ceiling limits were enforced in December, 1998. Prior to
that, these limits were based on the credit rating (effective January, 1998).
A) Equipment Leasing and Hire Purchase Finance Companies
a) For unrated and under-rated (i.e. rating below the minimum investment grade) NBFCs-
1.5 times of their NOF or Rs. 10 crore, whichever is less (provided their CRAR is 15%,
or above, as per their last audited balance sheet).
b) for NBFCs with minimum investment grade creditrating-4 times of their NOF (provided
they have CRAR of not less than 10% as on 31.3.1998 and not less than12% as on 3
1.3.1999). They are required to increase CRAR to 15% as early as possible.
B) Loan and Investment Companies
a) Unrated and under-rated-not entitled to accept public deposits (irrespective of their
NOF and CRAR).
b) With minimum Investment Grade Credit Rating-1.5times of NOF (provided they have
CRAR of 15% or above).
Further, it has been stipulated that loan and investment companies which do not have
minimum CRAR of 15% as on
Date, but other-wise comply with all the prudential norms and
a) have credit rating of AAA may accept or renew public deposits up o the level
outstanding as on December 18,1998 or 1.5 times of the NOF whichever is more, subject to
the condition that they should attain CRAR or 15%by 31"’ March, 2000 and bring down the
excess deposits, if any, by December 3 1, 2000, and
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b) Have credit rating of AA/A may accept or renew public deposits as per the existing
provisions of Directions (i.e.0.5 or 1 time of their NOF), but they should attain the minimum
CRAR of 15% on or before 31stMarch, 2000 as per their audited balance sheet, failing which
they should regularize their position by repayment or otherwise by December 3 1, 200 1.
The above benefit will not be available to those companies whose CRAR is presently
15% and above but slips down below the minimum level of 15% subsequently.
v) The maximum permissible interest rate on public deposits has been fixed at 16%
per annum. NBFCs can pay uniform maximum brokerage of 2% on deposits for 1 year to 5
years. Brokers may also be reimbursed other expenses not exceeding 0.5% of the collected
deposits.
vi). only those NBFCs, which are accepting public deposits, are required to submit to
Reserve Bank annual statutory returns and financial statements. Other NBFCs are exempted
from this requirement.
3) Prudential Norms for NBFCs
Reserve Bank of India issued guidelines prescribing the prudential norms for NBFCs
in June, 1994. Companies
Accepting public d deposits have to comply with all the guidelines, while leasing, hire
purchase finance, loan and investment companies, not accepting public deposits, are required
to comply with prudential norms other norms on capital adequacy and credit investment
concentration. Similarly, investment companies holding not less than 90% of their assets
being securities of their group/holding/subsidiary companies and not accepting public
deposits are exempted from prudential norms, these guidelines are as follows:
i) Income Recognition
NBFCs are required not to take into books income due but not received within a
period of six months, till it is actually received.
ii) Classification of Assets
NBFCs are required to classify their assets as non-performingas sets if payment of
principal /instalment is due but not received within six months. For leasing, hire purchase
finance companies such assets are to be treated as NPAs, if lease rentals and hire purchase
instalments remain past due for 12 months. Guidelines regarding classification of assets
into4 categories and provisioning issued to commercial banks, are applicable to NBFCs
also.
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iii) .Capital Adequacy Norm
In January 1998, the capital adequacy requirement for NBFCs with net owned funds
of Rs. 25 lakhs and above and having public deposits had been raised from 8% to 10%(effective
3 1.3.1998), and further to 12% (effective31.3.1999).The composition of capital and risk
weights attached to assets and conversion of off Balance Sheet items are the same as applicable
to banks.
iv).Credit/ Investment Concentration Norms
Registered finance companies are required not to lend more than 15% of their net
owned funds to a single borrower and not more than 25% of their owned fund; to a group of
borrowers. These limits are also applicable to investment in a single company or a single
group of companies. Composite limits of credit to and investment in a single company or a
single group of companies have been prescribed at 25% and 40% respectively of its owned
funds. NBFCs are not permitted to lend on the security of their own shares. The ceiling on
investment in unquoted shares of companies other than their group/subsidiary companies
has been fixed at 10% of their owned funds for equipment leasing and hire purchase finance
companies and 20% of the owned funds for loan and investment companies. NBFCs are
advised not to invest more than 10% of their owned funds in land and building except for
their own use. NBFCs are required to dispose off excess of the assets over the indicated
ceilings within three years.
v) Liquid Assets
NBFCs are required to maintain certain percentage of their deposits in liquid assets
to ensure their liquidity and to safeguard the interests of the depositors. With effect from
January 2, 1998, the ratio of liquid assets is uniform for all NBFCs accepting public deposits.
It has been prescribed at12.5% with effect from April 1, 1998 and at 15% with effect from
April 1, 1999. The liquid assets are to be maintained with relation to public deposits only.
NBFCs are required to keep Government securities and Government guaranteed bonds
in the custody of a scheduled bank at the place of its head office. These securities are permitted
to be withdrawn for repayment to depositors or for replacing them by other securities or in
the case of reduction of deposits.
The above account shows that the Reserve Bank of India has instituted a comprehensive
regulatory framework for NBFCs. Out .of 8802 applications of NBFCs which were eligible
for registration on the basis of Minimum Net Owned Funds of Rs. 25 lakh, registration has
been granted to 7555 NBFCs. Out of them only 584 NBFCs have been permitted to accept
public deposits. Applications of 1030 companies have been rejected. 28676 companies with
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NOF below Rs. 25 lakh have been given time up to January 8, 2000 to achieve the minimum
NOF. Thus, an era of consolidating and strengthening the Non-Banking Financial Companies
has commenced and better results may be expected in future.
3.8 NOTES
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3.9 SUMMARY
A Non-Banking Financial Company (NBFC) is a company registered under the
Companies Act, 1956 and is engaged in the business of loans and advances, acquisition
of shares/stock/bonds/debentures/securities issued by Government or local authority or other
securities of like marketable nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture activity,
industrial activity, sale/purchase/construction of immovable property. A non-banking
institution which is a company and which has its principal business of receiving deposits
under any scheme of arrangement or any other manner, or lending in any manner is also an
on-banking financial company (Residuary non-banking company).NBFCs are doing functions
akin to that of banks; however there are a few differences:
(i) An NBFC cannot accept demand deposits;
(ii) An NBFC is not a part of the payment and settlement system and as such an NBFC
cannot issue cheques drawn on itself; and
(iii) Deposit insurance facility of Deposit Insurance and Credit Guarantee Company is not
available for NBFC depositors unlike in case of banks.

1. What do you mean by NBFCs? Classify them and provide brief information.
2. Distinguish between common bank and NBFC.
3. What are the NBFCs? Explain their features.
4. Highlight the various appropriate regulatory or statutory measures taken by the authorities
to oversee the operations of NBFCs.
3.11 REFERENCES
47
UNIT-IV : REGULATORY FRAMEWORK OF BANKING
SECTOR
Structure :
4.0 Objectives
4.1 Introduction
4.2 Role of Reserve Bank of India in Credit Control
4.3 Regulations over Commercial Banks
4.4 Notes
4.5 Summary
4.7 References
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4.0 OBJECTIVES
After going through this Unit, you will be able to;
• The principal regulatory authorities regulating banking sector.
• The main provisions of the Banking Regulation Act, 1949, which govern the
Commercial Banks.
• The powers vested with Reserve Bank of India under Reserve Bank of India
Act, 1934 to regulate Commercial Banks.
4.1 INTRODUCTION
Necessity of regulatory framework for the financial system has been universally felt,
primarily to safeguard the interests of a large number of savers/depositors and also to ensure
proper and efficient functioning of the institutions that are part and parcel of the financial
system. Financial institutions, financial markets, financial instruments and financial services
are all regulated by regulators like Ministry of Finance, the Company Law Board, RBI, SEBI,
IRDA, Dept. of Economic Affairs, Department of Company Affairs etc. The two major
Regulatory and Promotional Institutions in India are Reserve Bank of India (RBI) and
Securities Exchange Board of India (SEBI).
Both RBI and SEBI administer, legislate, supervise, monitor, control and discipline
the entire financial system. RBI is the apex of all financial institutions in India. All financial
institutions are under the control of RBI. The financial markets are under the control of
SEBI. Both RBI and SEBI have laid down several policies, procedures and guidelines. These
policies, procedures and guidelines are changed from time to time so as to set the financial
system in the right direction.
4.2 ROLE OF RESERVE BANK OF INDIA IN CREDIT CONTROL

The Reserve Bank of India adopts two methods to control credit in modern times for
regulating bank advances. They are as follows:
4.2.1 Quantitative or General Credit Control
This method aims to regulate the amount of bank advance.
a) Bank rate
It is the rate at which central bank discounts the securities of commercial banks or
advance loans to commercial banks. This rate is the minimum and it affects rate is the rate of
49
discount prevailing in the money market among other lending institutions. Generally bank
rate is higher than the market rate. If the bank rate is changed all the other rates normally
change at the same direction. A central bank control credit by manipulating the bank rate. If
the central bank raises the bank rate to control credit, the market discount rate and other
lending rates in the money will go up. The cost of credit goes up and demand for credit goes
down. As a result, the volume of bank loans and advances is curtailed. Thus raise in bank rate
will contract credit.
b) Open Market Operation:
It refers to buying and selling of Government securities by the central bank in the
open market. This method of credit control becomes very popular after the 1st World War.
During inflation, the banks will securities and during depression, it will purchase securities
from the public and financial institutions. The Reserve Bank of India is empowered to buy
and sell government securities from the public and financial institutions. The Reserve Bank
of India is empowered to buy and sell government securities, treasury bills and other approved
securities. The central bank uses the weapon to overcome seasonal stringency in funds during
the slack season.
When the central bank sells securities, they are purchased by the commercial banks
and private individuals. So money supply is reduced in the economy and there is contraction
in credit. When the securities are purchased by the central bank, money goes to the commercial
banks and the customers. SO money supply is increased in the economy and there is more
demand for credit.
c) Variable Reserve Ratio (VRR):
This is a new method of credit control adopted by central bank. Commercial banks
keep cash reserves with the central bank to maintain for the purpose of liquidity and also to
provide the means for credit control. The cash reserve is also called minimum legal reserve
requirement. The percentage of this ratio can be changed legally by the central bank. The
credit creation of commercial banks depends on the value of cash reserves. If the value of
reserve ratio increase and other things remain constant, the power of credit creation by the
commercial bank is decreased and vice versa. Thus by varying the reserve ratio, the lending
capacity of commercial banks can be affected.
4.2.2 Qualitative or Selective Control Method
It is also known as qualitative credit control. This method is used to control the flow
of credit to particular sectors of the economy. The direction of credit is regulated by the
central bank. This method is used as a complementary to quantitative credit control discourages
50
the flow of credit to unproductive sectors and speculative activities and also to attain price
stability. The main instruments used for this purpose are:
4.2.2.1 Varying margin requirements for certain bank
While lending commercial banks accept securities, deduct a certain margin from the
market value of the security. This margin is fixed by the central bank and adjusts according to
the requirements. This method affects the demand for credit rather than the quantity and cost
of credit. This method is very effective to control supply of credit for speculative dealing in
the stock exchange market. It also helps for checking inflation when the margin is raised. If
the margin is fixed as 30%, the commercial banks can lend up to 70% of the market value of
security. This method has been used by RBI since 1956 with suitable modifications from
time to time as per the demand and supply of commodities.
4.2.2.2 Regulation of consumer’s credit
Apart from trade and industry a great amount of credit is given to the consumers for
purchasing durable goods also. Reserve Bank of India seeks to control such credit in the
following ways:
(a) By regulating the minimum down payments on specific goods.
(b) By fixing the coverage of selective consumers’ durable goods.
(c) By regulating the maximum maturities on all instalment credit and
(d) By fixing exemption costs of instalment purchase of specific goods.
4.2.2.3 Control through Directives
Under this system, the central bank can issue directives for the credit control. There
may be a written or oral voluntary agreement between the central bank and commercial banks
in this regard. Sometimes the commercial banks do not follow these directives of the Reserve
Bank of India.
4.2.2.4 Rationing of credit
The amount of credit to be granted is fixed by the central bank. Credit is rationed by limiting
the amount available to each commercial bank. The Reserve Bank of India can also restrict
the discounting of bills. Credit can also be rationed by the fixation of ceiling for loans and
advances.
4.2.2.5 Direct Action
It is an extreme step taken by the Reserve Bank of India. It involves refusal by Reserve
Bank of India to extend credit facilities, denial of permission to open new branches etc.
51
Reserve Bank of India also gives wide publicity about the erring banks to create awareness
amongst the public.
4.2.2.6 Moral suasion
Reserve Bank of India uses persuasion to influence lending activities of banks. It
sends letters to banks periodically, advising them to follow sound principles of banking.
Discussions are held by the Reserve Bank of India with banks to control the flow of credit to
the desired sectors.
4.3 REGULATIONS OVER COMMERCIAL BANKS

Main provisions of the Banking Regulation Act, 1949, which govern the Commercial
Banks, are as follows:
4.3.1 Establishment
It is essential for every banking company-Indian or foreign, to acquire a license from
the Reserve Bank of India, before it commences its business in India. Reserve Bank of India
issues a license, if it is satisfied that the company fulfils the following conditions:
i) The company is/or will be in a position to pay its present or future depositors in full
as their claims accrue,
ii) The affairs of the company are not being, or are not likely to be conducted in a
manner detrimental to the interest of its present or future depositors,
iii) The general character of the proposed management of the company will not be
prejudicial to the public interest, or the interests, of its depositors,
iv). The company has adequate capital structure and earning prospects,
v) Public interest will be served by the grant of a license to the company to carry on
banking business in India,
vi) Any other condition to ensure that the carrying on of the banking business in India
by the company will not be prejudicial to the public interest or the interests of the
depositors.
A foreign bank must, in addition, satisfy the following conditions:
i) The carrying on of banking business by such company in India will be in the public
interest,
52
ii) The Government or the law of the country in which it is incorporated does not
discriminate in any way against banking companies in India, and
iii) The company complies with all the provisions of the Act applicable to such
companies.
4.3.2 Opening of Branches
Every banking company (Indian as well as foreign) is required to take Reserve Bank’s
prior permission for opening a new place of business in India or outside India, or to change
the location of an existing place of business in India or outside.
Reserve Bank, before granting its permission, takes into account -
i) The financial condition and history of the company,
ii) The general character of its management,
iii) The adequacy of its capital structure and earning prospects, and
iv) Whether public interest will be served by the opening/ change of location of the
place of business.
4.3.3 Business Permitted and Prohibited
Section 6 contains a list of businesses which may be undertaken by a banking company.
Under Clause ‘O’, any other business may also be specified by the Central Government as
the lawful business of a banking company. But, a banking company is prohibited from
undertaking, directly or indirectly, trading activities and trading risks (except for the realization
of the amount lent or in connection with the realization of bills for collection/ negotiations).
4.3.4 Subsidiary Company
A banking company may establish a subsidiary company for undertaking any business
permitted under Section 6, or for carrying on the business of banking exclusively outside
India, or for undertaking any other business, which in the opinion of Reserve Bank, would be
conducive to the spread of banking in India or to be useful in public interest.
4.3.5 Paid-up Capital
The Act stipulates the minimum aggregate value of its paid-up capital and reserves for
banks established before 1962. Minimum amount of capital was raised to Rs. 5 Lakhs for
banks set up after 1962. The revised guidelines issued by Reserve Bank for establishing new
private sector banks prescribed minimum paid-up capital for such bank: at Rs. 200 crore,
53
which shall be increased to Rs. 300 crore in the next three years, out of which promoter’s
contribution will be 25% (or 20% in case paid-up capital exceeds Rs. 100 crore). Non-
Resident .Indians may participate in the equity of a new bank to the extent of 40%. The
authorized capital of a nationalized bank is Rs. 1580 crore, which may be raised to Rs. 3000
crores. These banks are allowed to reduce the capital also but nor below Rs. 1500 crore.
These banks are permitted to issue shares to the public also, but the share of the Central
Government is not allowed to be less than 51% of the paid-up capital. The paid-up capital
may be reduced at any time so as to render it below 25% of the paid-up capital as on 1995.
4.3.6 Maintenance of Liquid Assets
Section 24 required every banking company to maintain in India in cash, gold or
unencumbered approved securities an amount which shall not, at the close of business on any
day, be less than 25% of the total of its net demand and time liabilities in India. Reserve Bank
of India is empowered to step up this ratio, called Statutory Liquid Ratio (SLR), upto 40%
of the net demand and time liabilities. When this ratio is raised, banks are compelled to keep
larger proportion of their deposits in these specified liquid assets.
SLR is to be maintained on a daily basis. The amount of SLR is calculated on the basis
of net demand and time liabilities as on the last Friday of the second preceding fortnight.
Reserve Bank also possesses the power to decide the mode of valuation of the securities
held by banks, i.e. valuation may be with reference to cost price, market price, and book
value or face value as may be decided by Reserve Bank of India from time to time.
Approved securities mean the securities in which the trustees may invest trust funds
under Section 20 of the Indian Trusts Act 1882. The securities should be unencumbered i.e.
free of charge in favour of any creditor. The Act also provides for penalties for default in
maintaining the liquid assets under Section 24. At present SLR is to be maintained @ 25%
of net demand and time liabilities (which excludes net interbank liabilities).
4.3.7 Maintenance of Assets in India
Section 25 requires that the assets of every banking company in India at the close of
business on the last Friday of every quarter shall not be less than 75% of its demand and time
liabilities.
4.3.8 Inspection by Reserve Bank
Under Section 35, the Reserve Bank may, either at its own initiative or at the instance
of the Central Government, cause an inspection to be made by one or more of the officers,
of any banking company and its books and accounts. If, on the basis of the inspection report
54
submitted by the Reserve Bank, the Central Government is of the opinion that the affairs of
the banking company are conducted to detriment the interests of its depositors, it may prohibit
the banking company from receiving fresh deposits or direct the Reserve Bank to apply for
the winding up of banking company.
4.3.9 Reserve Bank’s Power to Issue Directions
Reserve Bank of India is vested with wide powers under Section 35 A to issue direction
to banking companies generally, or to any banking company, in particular:
i) in the public interest or in the interest or banking policy, or
ii) To prevent the affairs of any banking company being conducted in a manner detrimental
to the interests of the depositors or in a manner prejudicial to the interests of the
banking company, or
iii) To secure proper management of ally banking company generally. The banking company
shall be bound to comply with such direction.
Section 36 empowers the Reserve Rank to caution or prohibit banking companies
against entering into any particular transaction or class of transactions and generally give
advice to the banking company. Reserve Bank also possesses the powers to ask the banking
company to call a meeting of Board of Directors, to depute its officers, to watch the
proceedings-of the meetings of the Board, to appoint its officers as observers and requires:
the banking company to make changes in the management on suggested lines.
4.3.10 Management of Banks
The constitution of the Board of Directors of the private sector commercial banks
must be in accordance with the provisions of the Banking Regulation Act, 1949. Section 10
(A)lays down the Board of Directors be constituted in such ri way that not less than 51% of
the total number of members shall consist of persons who satisfy the following two conditions:
i) They have special knowledge or practical experience in respect of accountancy,
agriculture, rural economy, banking, co-operation, economics, finance, law, small scale
industry, or any other related matter.
ii) They do not have substantial interest in, or be connected with any company or firm
which carries on any trading, commercial or industrial concern (this excludes those
connected with small-scale industries or companies registered under Section 25 of
the Companies Act).
55
Reserve Bank of India has conferred the power to direct a banking company to
reconstitute the Board, if it is not constituted as above. It may remove a Director and appoint
a suitable director also. A person cannot be a Director of two banking companies or a Director
of a banking company, if he is . A Director of companies which are entitled to exercises
voting rights in excess of 25% of the total voting rights of all shareholders of the banking
company.
The Act also requires that the Chairman of a banking company shall be a person who
has special knowledge and practical experience of the working of a bank or financial institution,
or that of financial, economic or business administration. But he shall not be a Director of a
company, partner in a firm or have substantial interest in any company. Firm If, the Reserve
Bank of India is of the opinion that a person appointed as Chairman is not a fit/proper person
hold such office, it may request the bank to elect another person. If it fails to do so, the
Reserve Bank of India is authorized to remove the said person and to appoint a suitable
person in his place.
Reserve Bank’s approval is also required to appoint, re-appoint, or terminate the
appointment of a Chairman, Director, or Chief Executive Officer. Reserve Bank has the power
to remove top managerial personnel of the banking companies, if the Bank feels it necessary
in the public interest, or for preventing the affairs of a banking company being conducted in
a manner detrimental to the interests of the depositors. Reserve Bank may appoint a suitable
person in place of the person so removed. Moreover, Reserve Bank is also empowered to
appoint Additional Directors not exceeding five or one third of the maximum strength of the
Board, whichever is less.
The Board of Directors of the nationalized banks are to be constituted in accordance
with the provisions of Section 9 of the Banking Companies (Acquisition and Transfer of
Undertakings) Act, 1970 or 1980. It provides for appointment as Directors or officials of
RBI, Central Government, other financial institutions and from amongst the officers and
workmen of the bank concerned. Moreover, six Directors are to be nominated by the Central
Government, and two to six directors are to be elected by shareholders other than Central
Government. These Directors are required to be experts in, or have practical experience in
the subjects enumerated above in case of private banks’ Directors. If the Reserve Bank is of
the opinion that any Director elected by the shareholders (other than Government) does not
fulfil the aforesaid requirement, it can remove such Director, and the Board of Directors
shall co-opt another person in his place.
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The nationalized banks are under an obligation to comply with the guidance given by
the Central Government. According to Section 8 of the (Nationalization) Act, “every
nationalized bank shall, in the discharge of its functions, be guided by such directions in
regard to matters of policy, involving public interest as the Central Government may, after
consultation with the Governor of the Reserve Bank,give”.
4.3.11 Control over Advances
Section 21 confers wide powers on the Reserve Bank of India to issue directive to the
banking companies with regard to the advances to be granted by the banking companies either
generally or by any of them in particular. These directions may relate to any or all of the
following:
a) The purposes for which advances may, or may not be, granted,
b) The margins to be maintained in respect of secured advances,
c) The maximum amount of advance to any one company, firm, individual or
association of persons,
d) The maximum amount up to which guarantees may be given by the banking
company on behalf of any company or firm, and
e) The rate of interest and other terms and conditions, on which advances may be
made or guarantees may be given.
The directive issued under this Section is called Selective Credit Control Directives,
if they relate to advances on the security of selected commodities. Banks are bound to comply
with these directives.
4.3.12 Restrictions on Loans and Advances
A banking company is prohibited from sanctioning loans and advances on the security
of its own shares. Restrictions are also imposed under Section 20 on the loans granted by
banks to the persons interested in the management of banks.
4.3.13 Maintenance of Cash Reserve with Reserve Bank Section 42 of the Reserve Bank
Act, 1934 requires every scheduled bank to maintain with the Reserve Bank of India an average
daily balance, the amount of which shall not be less than 3% of the net demand and time
liabilities of the bank in India. Reserve Bank of India is empowered to increase this rate up to
20% of the net demand and time liabilities. If a bank fails to maintain the cash balance as
required by the Reserve Bank, penalty may be imposed as prescribed in the Act. This provision
57
applies to all scheduled banks, commercial banks, state co-operative banks, and Regional
Rural Banks. With effect from December 29, 2001, commercial banks are required to maintain
Cash Reserve Ratio @ 5.5% of their net demand and time liabilities of the second preceding
fortnight. It was reduced by 2 percentage points from 7.5% to 5.5% with effect from that
date and further to 5% w.e.f. June 1, 2002. Reserve Bank of India pays interest on eligible
cash reserves as per the Bank Rate (6.5%).
4.4 NOTES
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4.5 SUMMARY
In this unit we have studied the regulatory framework under which the banks in India
function. There are two regulatory authorities in this field, viz. the Reserve Bank of India and
the Securities and Exchange Board of India. They have been entrusted with the responsibilities
of development and regulation of the money market and capital market respectively.
The Reserve Bank of India is the regulatory authority over the commercial banks, co-
operative banks, non-banking finance companies and the financial institutions. It derives its
powers from the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949,
exercising its discretionary powers, the Reserve Bank of India issues directives to these
institutions from time to time. In this Unit, we have studied institution-wise regulatory
framework.
Reserve Bank exercises control over the commercial banks through the provisions of
the Banking Regulation Act, 1949,relating to licensing of banks, opening of branches,
establishment of subsidiaries, paid-up capital, and maintenance of liquid assets. Reserve Bank
of India has the power to inspect the banks, to issue the directives, to exercise control over
the top management and advances granted by them. Cash Reserves are maintained by banks
with the Reserve Bank of India under Section 42 of the Reserve Bank of India Act, 1934.
Reserve Bank of India has also issued directives regarding priority sector advanced, capital
adequacy ratio, exposure norms, assets classification, provisioning, etc.

1. What do you mean by NBFCs? Classify them and provide brief information.
2. Distinguish between commercial bank and NBFC.
3. Explain the role of NBFCs in Indian financial system.
4.7 REFERENCES
60
61
M.B.A III Semester
COURSE - 16 A
BLOCK
2
CAPITAL MARKETS
UNIT - 5
OVERVIEW OF CAPITAL MARKET 1-25
UNIT - 6
THE STOCK EXCHANGE 26-49
UNIT - 7
FOREIGN DIRECT INVESTMENT AND FOREIGN PORTFOLIO
INVESTMENT 50-65
UNIT - 8
INVESTORS PROTECTION AND SEBI GUIDELINES 66-81
1

Chairman
Course Writers
Prof. Shivaraj Block - 2 (Units 5 to 8)
Professor
BIMS, University of Mysore
Mysuru
Publisher
Registrar

Mysuru.-6.
2
BLOCK -2 : CAPITAL MARKETS
Capital markets are markets for buying and selling equity and debt instruments in
which money is provided for periods longer than one year. A new era in capital market in
India was ushered in July, 1991, with starting of a process of financial and economic
deregulation.
Block 02 capital markets contain 04 units (05-08) Unit 05 specifies capital market
introduction, importance, primary and secondary market, listing of securities , issue
mechanism, functions of new issue primary and secondary market, and relationship between
new issue market and stock exchanges. Unit 06 on stock exchange introduction, functions,
BSE,NSE, functions and services, OTC need and objectives, features, benefits and securities
traded, reasons for the down fall of stock market. Unit 07 explains FDI and Foreign Portfolio
Investment(FPI). Introduction, meaning and definitions, advantages and disadvantages of
foreign direct investment. Meaning, introduction and definitions of PFI, difference between
FDI and FPI, and introduction, meaning and definitions of private equity. Last unit of this
block investors protection and SEBI guidelines introduction, need, factors affecting investor,
SEBI guidelines of primary market, secondary market, Foreign Institution Investors (FIIs),
types of issues, types of debentures, guidelines for the protection of debenture holders.
3
4
UNIT-5 : OVERVIEW OF CAPITAL MARKET
Structure:
5.0 Objectives
5.1 Introduction
5.2 Importance of Capital Market
5.3 Primary and Secondary Markets
5.4 Listing of Securities
5.5 Issue mechanism
5.6 Functions of New Issues Primary Market
5.7 Functions of Stock Market/ Secondary Market/exchanges
5.8 Relationship between new issue market and stock exchange
5.9 Check Your Progress
5.10 Notes
5.11 Summary
5.12 Key words
5.14 References
5
5.0 OBJECTIVES
After studying this unit, you will be able to;
• Give the meaning of capital market
• Explain the issue mechanism
• Describe the functions of stock market
• Bring out the importance of the capital market
• Identify the functions of primary market
• Highlight the primary and secondary market
5.1 INTRODUCTION
Capital Market It is a market for long-term funds. Its focus is on financing of fixed
investment in contrast to money market which is the institutional source of working capital
finance. The main participants in the capital market are mutual funds, insurance organisations,
foreign institutional investors, corporate and individuals. The capita/securities market has
two segments: (i) Primary new issue market and (ii) Secondary market/stock
exchange(s)market(s).
New Issue Market (NIM) Primary Market: The NIM deals in new securities, that
is, securities which were not previously available and are offered to the investors for the
first time. Capital formation occurs in the NIM as it supplies additional funds to the corporate
directly. It does not have any organisational setup located in any particular place and is
recognised only by the specialist institutional services that it tenders to the lenders/borrowers
(buyers/sellers) of capital funds at the time of any particular operation. It performs triple-
service/function, namely: (i) origination, that is, investigation and analysis and processing
of new issue proposals; (ji) underwriting in terms of guarantee that the issue would be sold
irrespective of public response and (iii) distribution of securities to the investors.
Secondary Stack Market/Exchange (SE) The SE is a market for old/existing
securities, that is, those already issued and granted SE quotation/listing. It plays only an
indirect role in industrial financing by providing liquidity to investments already made. It has
a physical existence and is located in a particular geographical area. The SE discharges three
vital functions in the orderly growth of capital formation: (i) Nexus between savings and
investments; (ii) Liquidity to investors by offering a place of transaction in securities and
(iii) Continuous price formation.
6
The behaviour of SEs as reflected in the prices of listed securities has a Significant bearing
on the level of activity in the NIM in terms of its response to issues of capital. Similarly, the
prices of new issues are generally influenced by the price movements in the stock markets.
5.2 IMPORTANCE OF CAPITAL MARKET

Absence of capital market acts as a deterrent factor to capital formation and economic
growth. Resources would remain idle if finances are not funnelled through the capital market.
The importance of capital market can be briefly summarised as follows:
(i) The capital market serves as an important source for the productive use of the
economy’s savings. It mobilizes the savings of the people for further investment and
thus, avoids their wastage in unproductive uses.
(ii) It provides incentives to saving and facilitates capital formation by offering suitable
rates of interest as the price of capital.
(iii) It provides an avenue for investors, particularly the household sector to invest in
financial assets which are more productive than physical assets.
(iv) It facilitates increase in production and productivity in the economy and thus, enhances
the economic welfare of the society. Thus, it facilitates ‘the movement of stream of
command over capital to the point of highest yield ‘ towards those who can apply
them productively and profitably to enhance the national income in the aggregate.
(v) The operations of different institutions in the capital market induce economic growth.
They give quantitative and qualitative directions to the flow of funds and bring about
rational allocation of scarce resources.
(vi) A healthy capital market consisting of expert intermediaries promotes stability in
values of securities representing capital funds.
(vii) Moreover, it serves as an important source for technological up gradation in the
industrial sector by utilizing the funds invested by the public.
Thus, a capital market serves as an important link between those who save and those
who aspire to invest their savings.
7
5.3 PRIMARY AND SECONDARY MARKETS
A primary market is a financial market in which new issues of a security, such as a
bond or a stock, are sold to initial buyers by the corporation or government agency borrowing
the funds. A secondary market is a financial market in which securities that have been
previously issued (and are thus second-hand) can be resold.
The primary markets for securities are not well known to the public because the selling
of securities to initial buyers often takes place behind closed doors. An important financial
institution that assists in the initial sale of securities in the primary market is the investment
bank. It does this by underwriting securities: It guarantees a price for a corporation’s securities
and then sells them to the public.
The New York and American stock exchanges, in which previously issued stocks are
traded, are the best-known examples of secondary markets, although the bond markets, in
which previously issued bonds of major corporations and the U.S. government are bought
and sold, actually have a larger trading volume. Other examples of secondary markets are
foreign exchange markets, futures markets, and options markets. Securities brokers and
dealers are crucial to a well-functioning secondary market. Brokers are agents of investors
who match buyers with sellers of securities; dealer’s link buyers and sellers by buying and
selling securities at stated prices.
When an individual buys a security in the secondary market, the person who has sold
the security receives money in exchange for the security, but the corporation that issued the
security acquires no new funds. A corporation acquires new funds only when its securities
are first sold in the primary market. Nonetheless, secondary markets serve two important
functions. First, they make it easier to sell these financial instruments to raise cash; that is,
they make the financial instruments more liquid. The increased liquidity of these instruments
then makes them more desirable and thus easier for the issuing firm to sell in the primary
market. Second, they determine the price of the security that the issuing firm sells in the
primary market. The firms that buy securities in the primary market will pay the issuing
corporation no more than the price that they think the secondary market will set for this
security. The higher the security’s price in the secondary market, the higher will be the price
that the issuing firm will receive for a new security in the primary market and hence the
greater the amount of capital it can raise. Conditions in the secondary market are therefore
the most relevant to corporations issuing securities. It is for this reason that books like this
one, which deal with financial markets, focus on the behaviour of secondary markets rather
than that of primary markets.
8
5.4 LISTING OF SECURITIES
Listing of securities mean the securities are admitted for trading on a recognised
stock exchange. Transactions in the securities of any company cannot be conducted on stock
exchanges unless they are listed by them. Hence, listing is the basis of stock exchange
operations. It is the green signal given to selected securities to get the trading privileges of
the stock exchange concerned. Securities become eligible for trading only through listing.
Listing is compulsory for those companies which intend to offer shares/ debentures
to the public for subscription by means of issuing a prospectus. Moreover, the SEBI insists
on listing for granting permission to a new issue by a public limited company. Again, financial
institutions do insist on listing for underwriting new issues. Thus, listing becomes an
unavoidable one today.
The companies which have got their shares/debentures listed in one or more recognised
stock exchanges must submit themselves to the various regulatory measures of the stock
exchange concerned as well as the SEBI. They must maintain necessary books, documents,
etc., and disclose any information which the stock exchange may call for.
Group A. group S and group C shares (BSE)
The listed shares are generally divided into two categories namely:
i. Group A shares (Specified shares or cleared securities).
ii. Group B shares (Non-specified shares or non-cleared securities).
Group A shares represent large and well established companies having a broad investor
base. These shares are actively traded. Naturally, these shares attract a lot of speculative
multiples. These facilities are not available to Group B shares. However, shares can be moved
from Group B to Group A and vice versa depending upon the criteria for shifting. For instance,
the Bombay Stock Exchange has laid down several criteria for shifting shares from Group B
to Group A, such as, an equity base of Rs 10 crore, a market capitalisation of Rs. 25-30
crore, a public holding of 35 to 40 per cent, a shareholding population of 15,000 to 20,000,
good dividend paying status etc. Group B2 shares are again divided into B1 and B shares on
the Bombay Stock Exchange. B1 shares represent well traded scrip’s among the B Group and
they have weekly settlement.
Apart from the above, there is another group called Group C shares. Under Group C,
only odd lots and permitted securities are included. A number of shares that are less than the
market lot are known as odd lots. Market lot refers to the minimum number of shares of a
particular security that must be transacted on a stock exchange. Odd lots have settlement
9
once in a fortnight or once on Saturdays. Permitted securities are those that are not listed on
a stock exchange but are listed on other stock exchanges in India. So, they are permitted to
be traded on this stock exchange. Odd lots cannot be easily transacted on the stock exchange
and so they are not liquid in. nature.
The market where existing securities are traded is referred to as the secondary market
or stock market. In a stock market, purchases and sales of securities whether of Government
or Semi-Government bodies or other public bodies and also shares and debentures issued by
joint-stock companies are affected. The securities of Government are traded in the stock
market as a separate component, called gilt-edged market. Government securities are traded
outside the trading wing in the form of over-the-counter sales or purchases. Another
component of the stock market deals with trading in shares and debentures of limited
companies.
Stock exchanges are the important ingredient of the capital market. They are the citadel
of capital and fortress of finance. They are the theatres of trading in securities and as such
they assist and control the buying and selling of securities. Thus, according to Husband and
Dockeray, ‘Securities or stock exchanges are privately organised markets which are used to
facilitate trading in securities’. However, at present, stock exchanges need not necessarily
be privately organised ones.
As per the Securities Contracts Regulation Act, 1956, a stock exchange has been
defined as follows: ‘It is an association, organisation or body of individuals whether
incorporated or not, established for the purpose of assisting, regulating and controlling
business in buying, selling and dealing in securities’. In brief, stock exchanges constitute a
market where securities issued by the Central and State Governments, public bodies and
joint-stock companies are traded.
5.5 ISSUE MECHANISM

The success of an issue depends, partly, on the issue mechanism. The methods by
which new issues are made are: (i) Public issue through prospectus, (ii) Tender/Book building,
(iii) Offer for sale (iv) Placement and (v) Rights issue.
Public Issue through Prospectus
A common method followed by corporate enterprises to raise capital through the
issue of securities is by means of a prospectus inviting subscription from the investing public.
Under this method, the issuing companies themselves offer directly to the general public a
fixed number of shares at a stated price, which in the case of new companies is invariably the
10
face value of the securities, and in the case of existing companies it may sometimes include
a premium amount, if any. Another feature of public issue method is that generally the issues
are underwritten to ensure success arising out of unsatisfactory public response.
The foundation of the public issue method is a prospectus, the minimum contents of
which are prescribed by the Companies Act, 1956. It also provides both civil and criminal
liability for any misstatement in the prospectus. Additional disclosure requirements are also
mandated by the SEBI. The contents of the prospectus, inter alia, include: (i) Name and
registered office of the issuing company; (ii) Existing and proposed activities; (iii) Board of
directors; (iv) Location of the industry; (v) Authorised, subscribed and proposed issue of
capital to public; (vi) Dates of opening and closing of subscription list; (vii) Name of broker,
underwriters, and others, from whom application forms along with copies of prospectus can
be obtained; (viii) Minimum subscription; ( ix) Names of underwriters, if any, along with a
statement that in the opinion of the directors, the resources of the underwriters are sufficient
to meet the underwriting obligations; and (x) A statement that the company will make an
application to stock exchange(s) for the permission to deal in or for a quotation of its shares
and so on.
The public issue method through prospectus has the advantage that the transaction is
carried on in the full light of publicity coupled with approach to the entire investing public.
Moreover, a fixed quantity of stock has to be allotted among applicants on a non-
discriminatory basis. The issues are, thus, widely distributed and the danger of an artificial
restriction on the quantity of shares available is avoided. It would ensure that the share
ownership is widely-diffused, thereby contributing to the prevention of concentration of
wealth and economic power.
A serious drawback of public issue, as a method to raise capital through the sale of
securities, is that it is a highly expensive method. The cost of flotation involves underwriting
expenses, brokerage, and other administrative expenses. The administrative cost includes
printing charges of prospectus, advertisement/publicity charges, accountancy charges, legal
charges, bank charges, stamp duty, listing fee, registration charges, travelling expenses, filling
of document charges, mortgage deed registration fee and postage and so on. In view of the
high cost involved in raising capital, the public issue method is suitable for large issues and
it cannot be availed of in case of small issues.
Tender/Book Building Method
The essence of the tender/book building method is that the pricing of the issues is
left to the investors. The issuing company incorporates all the details of the issue proposal
11
in the offer document on the lines of the public issue method including the reserve/ minimum
price. The investors are required to quote the number of securities and the price at which
they wish to acquire.
Offer for Sale
Another method by which securities can be issued is by means of an offer for sale.
Under this method, instead of the issuing company itself offering its shares directly to the
public, it offers through the intermediary of issue houses/merchant banks/ investment banks
or firms of stockbrokers. The modus operandi of the offer of sale is akin to the public issue
method in that the prospectus with strictly prescribed minimum contents which constitutes
the foundation for the sale of securities, and a known quantity of shares are distributed to the
applicants in a non-discriminatory manner. Moreover, the issues are underwritten to avoid
the possibility of the issue being left largely in the hands of the issuing houses. But the
mechanism adopted is different. The sale of securities with an offer for sale method is done
in two stages.
In the first stage, the issuing company sells the securities enbloc to the issuing houses
or stockbrokers at an agreed fixed price and the securities, thus acquired by the sponsoring
institutions, are resold, in the second stage, by the issuing houses to the ultimate investors.
The securities are offered to the public at a price higher than the price at which they were
acquired from the company. The difference between the sale and the purchase price, technically
called as turn, represents the remuneration of the issuing houses. In the case of public method,
the issuing houses receive a fee based upon the size and the complications involved in
supervision as they act as agents of the issuing companies. Although this is theoretically
possible, but usually the issuing houses’ remuneration in offer for sale is the turn’ out of
which they also meet subsidiary expenses such as underwriting commission, the cost of
advertisement and prospectus, and so on, whereas these are borne by the companies
themselves in the case of public issue method.
The offer for sale method shares the advantage available to public issue method. One
additional advantage of this method is that the issuing company is saved from the cost and
trouble of selling the shares to the public. Apart from being expensive, like the public issue
method, it suffers from another serious shortcoming. The securities are sold to the investing
public usually at a premium. The margin between the amount received by the company and
the price paid by the public does not become additional funds, but it is pocketed by the
issuing houses or the existing shareholders.
12
Placement Method
Yet another method to float new issues of capital is the placing method defined by
London Stock Exchange as “sale by an issue house or broker to their own clients of securities
which have been previously purchased or subscribed·, Under this method, securities are
acquired by the issue houses, as in offer for sale method, but instead of being subsequently
offered to the public, they are placed with the clients of the issue houses, both individual and
institutional investors. Each issue house has a list of large private and institutional investors
who are always prepared to subscribe to any securities which are issued in this manner. Thus,
the flotation of the securities involves two stages: In the first stage, shares are acquired by
the issuing houses and in the second stage; they are made available to their investor-clients.
The issue houses usually place the securities at a higher price than the price they pay and the
difference, that is, the turn is their remuneration. Alternatively, though rarely, they may arrange
the placing in return for a fee and act merely as an agent and not principal.
Another feature of placing is that the placing letter and the other documents, when
taken together, constitute a prospectus/offer document and the information concerning the
issue has to be published. In this method, no formal underwriting of the issue is required as
the placement itself amounts to underwriting since the issue houses agree to place the issue
with their clients. They endeavour to ensure the success of the issue by carefully vetting the
issuing company concerned and offering generous subscription terms.
Placing of securities that are unquoted is known as private placing. The securities are
usually in small companies but these may occasionally be in large companies. When the
securities to be placed are newly quoted, the method is officially known as stock exchange
placing.
The main advantage of placing, as a method of issuing new securities, is its relative
cheapness. This is partly because many of the items of expenses in public issue and offer for
sale methods like underwriting commission, expense relating to applications and allotment
of shares, and so on are avoided. Moreover, the stock exchange requirements relating to
contents of the prospectus and its advertisement are less onerous in the case of placing.
Its weakness arises from the point of view of distribution of securities. As the securities
are offered only to a select group of investors, it may lead to the concentration of shares into
a few hands who may create artificial scarcity of scrip’s in times of hectic dealings in such
shares in the market.
The placement method is advantageous to the issuing companies but it is not favourably
received by the investing public. The method is suitable in case of small issues which cannot
13
bear the high expenses entailed in a public Issue, and also in such issues which are unlikely to
arouse much
Interest among the general investing public. Thus with the placement method, new
issues can be floated by small companies, which suffer from a financial disadvantage in the
form of prohibitively high cost of capital in the case of other method of flotation as well as
at times when conditions in the market may not be favourable a, it doe, not depend for its
success on public response. This underscores the relevance of this method from the viewpoint
of the market.
Rights Issue
The methods discussed above can be used both by new companies as well as by
established companies. In the case of companies whose share, are already listed and widely-
held, shares can be offered the existing shareholders. This is called rights issue. Under this
method, the existing shareholders are offered the right to subscribe to new shares in proportion
10 the number of shares they already hold. This offer is made by circular to ‘existing
shareholders only.
In India Section 81 of the Companies Act 1956 provides that where a company
increases its subscribed capital by the issue of new shares. Either after two years of its
formation or after one year of first issue of shares whichever is earlier, these have to be first
offered to the existing shareholders with a right to renounce them in favour of a nominee. A
company can, however dispense with this requirement by passing a special resolution to the
same effect.
Rights issues are not normally underwritten hut to ensure full subscription and as a
measure of abundant precaution. a few companies have resorted to underwriting of rights
shares. The experience of these companies has been that underwriters were not called upon
to take up shares in terms of their obligations. It is, therefore, observed that such underwriting
serves little economically useful purpose in that “it represents insurance against a risk which
is (i) readily avoidable and (ii) of extremely rare occurrence even where no special steps are
taken to avoid it.” The chief merit of rights issue is that it is an inexpensive method. The
usual expenses like underwriting commission, brokerage and other administrative expenses
are either non-existent or are very small. Advertising expenses have to be incurred only for
sending a letter of rights to shareholders. The management of applications and allotment is
less cumbersome because the number is limited. As already mentioned, this method can be
used only by existing companies and the general investing public has no opportunity to
participate in the new companies. The pre-emptive right of existing shareholders may conflict
with the broader objective of wider diffusion of share-ownership.
14
The above discussion shows that the available methods of flotation of new issues are
suitable in different circumstances and for different types of enterprises. The issue mechanism
would vary from market to market.
5.6 FUNCTIONS OF NEW ISSUES/PRIMARY MARKET

The main function of NIM is to facilitate the transfer of resources from savers to
entrepreneurs seeking to establish new enterprise or to expand/diversify existing ones. Such
facilities are of crucial importance in the context of the dichotonomy of funds available for
capital uses from those in whose hands they accumulate, and those by whom they are applied
to productive uses. Conceptually, the NIM should not, however, be conceived as exclusively
serving the purpose of raising finance for new capital expenditure. In fact, the organisation
and facilities of the market are also utilized for selling concerns to the public as going
concerns through the conversion of existing proprietary enterprises or private companies
into public companies. The NIM is a complex of institutions through which funds can be
obtained directly or indirectly by those who require them from investors who have savings.
New issues can be classified in various ways. The first category of new issues is by
new companies and old companies. This classification was first suggested by R.F. Henderson.
The distinction between new also called initial and old also known as further, does not bear
any relation to the age of the company. The securities issued by companies for the first time
either after the incorporation or conversion from private to public companies are designated
as initial issues, while those issued by companies which already have stock, exchange
quotation, either by public issue or by rights to existing shareholders, are referred to as
further or old.
The new issues by corporate enterprise can also be classified on the basis of companies
seeking quotation, namely, new money issues and no new money issues. The term new money
issues refers to the issues of capital involving newly created shares; no new money issues
represent the sale of securities already in existence and sold by their holders. The new money
issues provide funds to enterprises for additional capital investment. According to Merrett
and others, new money refers to the sum of money equivalent to the number of newly created
shares multiplied by the price per share minus all the administrative cost associated with the
issue. This money may not be used for additional capital investment: it may be used wholly
or partly to repay debt. Henderson uses the term in a rather limited sense so that it is the net
of repayment of long-term debt and sums paid to vendors of existing securities. The
differences in the approaches by Merrett and others, on the one hand, and Henderson, on
the other, arise because of the fact that while the concern of the former is with both flow of
funds into the market as well as flow of money, Henderson was interested only in the latter.
15
However, two types of issues are excluded from the category of new issues. First,
bonus/capitalization issues which represent only book-keeping entries, and, second, exchange
issues by which shares in one company are exchanged for securities of another.
The general function of the NIM, namely, the channelling of investible funds into
industrial enterprises, can be split from the operational stand-point, into three services: 7 (i)
Origination, (ii) Underwriting, and (iii) Distribution. The institutional setup dealing with
these can be said to constitute the NIM organisation. In other words, the NIM facilitates the
transfer of resources by providing specialist institutional facilities to perform the triple-
service junction.
Origination
The term origination refers to the work of investigation and analysis and processing
of new proposals. These two functions are performed by the specialist agencies which act as
the sponsors of issues. One aspect is the preliminary investigation which entails a careful
study of technical, economic, financial, and legal aspects of the issuing companies. This is
to ensure that it warrants the backing of the issue houses in the sense of lending their name to
the company and, thus, give the issue the stamp of respectability, to satisfy themselves that
the company is strongly-based, has good market prospects, is well-managed and is worthy of
stock exchange quotation. In the process of registration the sponsoring institutions render,
as a second function, some services of an advisory nature which go to improve the quality of
capital issues. These services include advice on such aspects of capital issues as: (i)
determination of the class of security to be issued and price of the issues in the light of
market conditions, (ii) the timing and magnitude of issues, (iii) methods of flotation, and
(iv) Technique of selling, and so on. The importance of the specialised services provided by
the NIM organisation in this respect can hardly be overstressed in view of its pivotal position
in the process of flotation of capital in the NIM. On the thoroughness of investigation and
soundness of judgement of the sponsoring institutions depends, to a large extent, the allocative
efficiency of the market.
Underwriting
The origination howsoever thoroughly done, will not, by itself, guarantee the success
of an issue. To ensure success of an issue, therefore, the second specialist service—
underwriting-provided by the institutional setup of the NIM takes the form of a guarantee
that the issues would be sold by eliminating the risk arising from uncertainty of public response.
That adequate institutional arrangement for the provision of underwriting is of crucial
significance both to the issuing companies as well as the investing public cannot be
overstressed.
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Distribution
Underwriting, however, is only a stop-gap arrangement to guarantee the success of an
issue. The success of an issue, in the ultimate analysis, depends on the issues being acquired
by the investing public. The sale of securities to the ultimate investors is referred to as
distribution. It is a specialist job which can best be performed by brokers and dealers in
securities, who maintain regular and direct contact with the ultimate investors.
Thus, the NIM is a complex of institutions through which funds can be obtained by
those who require them from investors who have savings. The ability of the NIM to cope with
the growing requirements of the expanding corporate sector would depend on the presence
of specialist agencies to perform the triple-service junction, of origination, underwriting
and distribution. While the nature of the services provided by an organised NIM is the same
in all developed countries, the degree of development and specialisation of market
organisation, the type of institutions found and the actual procedures followed differ from
country to country, as they are determined partly by history and partly by the particular legal,
social, political, and economic environment.
5.7 FUNCTIONS OF STOCK/SECONDARY MARKETS/EXCHANGES

Stock exchanges discharge three vital functions in the orderly growth of capital
formation: (i) Nexus between savings and investments, (ii) Market place and (iii) Continuous
price formation.
Nexus between Savings and Investment
First and foremost, they are the nexus between the savings and the investments of the
community. The savings of the community are mobilised and channelled by stock exchanges
for investment into those sectors and units which are favoured by the community at large, on
the basis of such criteria as good return, appreciation of capital, and so on. It is the preference
of investors for individual units as well as industry groups, which is reflected in the share
price, that decides the mode of investment. Stock exchanges render this service by arranging
for the preliminary distribution of new issues of capital, offered through prospectus, as also
offers for sale of existing securities, in an orderly and systematic manner. They themselves
administer the same. by ensuring that the various requisites of listing (such as offering at
least the prescribed minimum percentage of capital to the public, keeping the subscription
list open for a minimum period of days, making provision for receiving applications at least
at the prescribed centres, allotting the shares against applications on a fair and unconditional
basis) are duly complied with. Members of stock exchanges also assist in the flotation of
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new issues by acting (i) as brokers, in which capacity they, inter alia, try to procure subscription
from investors spread all over the country, and (ii) as underwriters. This quite often results in
their being required to nurse new issues till a time when the new ventures start making profits
and reward their shareholders by declaring reasonable dividends when their shares command
premiums in the market. Stock companies also provide a forum for trading in rights shares
of companies already listed, thereby enabling a new class of investors to take up a part of the
rights in the place of existing shareholders who renounce their rights for monetary
considerations.
Market Place
The second important function discharged by stock markets/exchanges is that they
provide a market place for the purchase and sale of securities, thereby enabling their free
transferability through several successive stages from the original subscriber to the never
ending stream of buyers, who may be buying them today to sell them at a later date for a
variety of considerations like meeting their own needs of liquidity, shuffling their investment
portfolios to gear up for the ever changing market situations, and so on. Since the point of
aggregate sale and purchase is centralised, with a multiplicity of buyers and sellers at any
point of time, by and large, a seller has a ready purchaser and a purchaser has a ready seller at
a price which can be said to be competitive. This guarantees sale ability to one who has
already invested and surety of purchase to the other who desires to invest.
Continuous Price Formation
The third major function, closely related to the second, discharged by the stock
exchanges is the process of continuous price formation. The collective judgement of many
people operating simultaneously in the market, resulting in the emergence of a large number
of buyers and sellers at any point of time, has the effect of bringing about changes in the
levels of security prices in small graduations, thereby evening out wide swings in prices. The
ever changing demand and supply conditions result in a continuous revaluation of assets,
with today’s prices being yesterday’s prices, altered, corrected, and adjusted, and tomorrows
values being again today’s values altered, corrected and adjusted. The process is an unending
one. Stock exchanges thus act as a barometer of the stat” of health of the nation’s economy,
by constantly measuring its progress or otherwise. An investor can always have his eyes
turned towards the stock exchanges to know, at any point of time, the value of the investments
and plan his personal needs accordingly.
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5.8 RELATIONSHIP BETWEEN NEW ISSUE MARKETAND STOCK EXCHANGE
The industrial securities market is divided into two pans, namely, NIM and stock market.
The relationship between these pans of the market provides an insight into its organisation.
One aspect of their relationship is that they differ from each other organisationally as well
as in the nature of functions performed by them. They have some similarities also.
Differences
The differences between NIM and stock exchanges pertain to (i) Types of securities
dealt, (ii) Nature of financing, (iii) Organisation and (iv) Functions.
They are depicted in Exhibit (a)
Exhibit (a : Differences Between Stock Exchange and Primary Market
Exhibit (a : Differences Between Stock Exchange and Primary Market
New Issue Market Stock Exchange
1. Types of Security New Existing / old
2. Nature of Financing Direct Indirect
3. Organization Physical Existence Specialist Institutional

Triple-services
4. Functions  Nexus between savings  Organisation

and investments
 Market Place  Underwriting
 Continuous price  Distribution

formation
New vs. Old Securities: The NIM deals with new securities, that is, securities which
were not previously available and are, therefore, offered to the investing public for the first
time. The market. subscription. The stock market, on the other hand, is a market for old
securities which may be defined as securities which have been issued already and granted
stock exchange quotation. The stock exchanges, therefore, provide a regular and continuous
market for buying and selling of securities. The usual procedure is that when an enterprise is
in need of funds, it approaches the investing public, both individuals and institutions, to
subscribe to its issue of capital. The securities thus floated are subsequently purchased and
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sold among the individual and institutional investors. There are, in other words, two stages
involved in the purchase and sale of securities. In the first stage, the securities are acquired
from the issuing com parties themselves and these are, in the second stage, purchased and
sold continuously among the investors without any involvement of the companies whose
securities constitute the stock-in-trade except in the strictly limited sense of registering tile
transfer of ownership of the securities. The section of the industrial securities market dealing
with the first stage is referred to as the NIM, while secondary market covers the second
stage of the dealings in securities.
Nature of Financing Another aspect related to tile separate functions of these two
parts of the securities market is the nature of their contribution to industrial financing.
Since the primary market is concerned with new securities, it provides additional funds to
the issuing companies either for starting a new enterprise or for the expansion or
diversification of the existing one and, therefore, its contribution to company financing
is direct. In contrast, the secondary markets can in no circumstance supply additional funds
since the company is not involved in the transaction. This, however, does the stock markets
have no relevance in the process of transfer of resources from savers to investors.
Their role regarding the supply of capital is indirect. The usual course in the
development of industrial enterprise seems to be that those who bear the initial burden of
financing a new enterprise pass it on to others when the enterprise becomes well-established.
The existence of secondary markets which provide institutional facilities for the continuous
purchase and sale of securities and, to that extent, lend liquidity and marketability, play an
important part in the process.
Organisational Differences The two parts of the market have orgartisational
differences also. The stock exchanges have orgartisationally speaking, physical existence
and are located in a particular geographical area. The NIM is not rooted in any particular spot
and has no geographical existence. The NIM has neither any tangible form any administrative
organisational setup like that of stock exchanges, nor is it subjected to any centralised control
and administration for the consummation of its business. It is recognised only by the services
that it renders to the lenders and borrowers of capital funds at the time of any particular
operation. The precise nature of the specialised institutional facilities provided by the NIM
is described in a subsequent section.
Similarities
Nevertheless, in spite of organisational and functional differences, the NIM and the
stock exchanges are inseparably connected.
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Stock Exchange Listing One aspect of this inseparable conned ion between them is
that the securities issued in the NIM are invariably listed on a recognised stock exchange for
dealings in them. In India, for instance, one of the conditions to which a prospectus is to
conform is that it should contain a stipulation that the application has been made, or will be
made in due course for admitting the securities to dealings on tile stock exchange. The
practice of listing of new issues on the stock market is of immense utility to the potential
investors who can be sure that should they receive an allotment of new issues, they will
subsequently be able to dispose them off any time. The absence of such facilities would act
as some sort of psychological barrier to investments in new securities. The facilities provided
by the secondary markets, therefore, encourage holdings of new securities and, thus, widen
the initial/primary market for them.
Control The stock exchanges exercise considerable control over the organisation of
new issues. In terms of regulatory framework related to dealings in securities, the new issues
of securities which seek stock quotation/listing have to comply with statutory rules as well
as regulations framed by the stock exchanges with the object of ensuring fair dealings in
them. If the new issues do not conform to the prescribed stipulations, the stock exchanges
would refuse listing facilities to them. This requirement obviously enables the stock exchange
to exercise considerable control over the new issues market and is indicative of dose
relationship between the two.
Economic Interdependence The markets for new and old securities are, economically,
an integral part of a single market-the industrial securities market. Their mutual
interdependence from the economic point of view has two dimensions. One, the behaviour
of the stock exchanges has a significant bearing on the level of activity in the N1M and,
therefore, its responses to capital issues: Activity in the new issues market and the movement
in the prices of stock exchange securities are broadly related: new issues increase when
share values This is because the two parts of the industrial securities market are susceptible
to common influences and they act and react upon each other. The stock exchanges are usually
the first to feel a change in the economic outlook and the effect is quickly transmitted to the
new issue section of the market.
The second dimension of the mutual interdependence of the two parts of tile market
is that the prices of new issues are influenced by the price movements on the stock
market. The securities market represents an important case where the stock-demand-and-
supply curves, as distinguished from flow-demand-and-supply curves, exert a dominant
influence on price determination. The quantitative predominance of old securities in the
market usually ensures that it is these which set the tone of the market as a whole and govern
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the prices and acceptability of the new issues. Thus, the flow of new savings into new securities
is profoundly influenced by the conditions prevailing in the old securities market-the stock
exchange.
5.9 CHECK YOUR PROGRESS

1. The differences between NIM and stock exchanges pertain to
a) Types of securities dealt b) Nature of financing
c) Organisation and Functions d) RBI
2. Primary market and Secondary market is also known as
a) New issue and stock market b) Old issue and debt market
c) New and Old issue market c) Fresh issue and old market
3. Mention the methods by which new issues are made
a) Public issue through prospectus
b) Tender/Book building
c) Offer for sale
d) Rights issue
Answer to check your progress: 1) a, b, c, 2) a 3) a, b, c, d
5.10 NOTES
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5.11 SUMMARY
Capital market consists of primary markets and secondary markets. Primary markets
deal with trade of new issues of stocks and other securities, whereas secondary market deals
with the exchange of existing or previously-issued securities. Another important division in
the capital market is made on the basis of the nature of security traded, i.e. stock market and
bond market. An essential characteristic of Indian Capital Market is that it is developing and
making rapid strides by allowing the development of new financial institutions to happen. An
important one among them include venture capital firms, mutual firms, credit rating agencies,
factoring firms, etc. an innovative feature of the capital market in India is the introduction of
the new and innovative financial instruments used by firms for raising capital.
5.12 KEY WORDS

Capital Market: Capital market is a market where buyers and sellers engage in trade
of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants
such as individuals and institutions.
Capital markets help channelize surplus funds from savers to institutions which then
invest them into productive use. Generally, this market trades mostly in long-term securities.
Rights Issue: A rights offering (issue) is an issue of rights to a company’s existing
shareholders that entitles them to buy additional shares directly from the company in
proportion to their existing holdings, within a fixed time period.
Underwriter: An underwriter is a company or other entity that administers the public
issuance and distribution of securities from a corporation or other issuing body.
An underwriter works closely with the issuing body to determine the offering price
of the securities buys them from the issuer and sells them to investors via the underwriter’s
distribution network.
5.13 SELF ASSESMENT QUESTIONS

1. What do you mean issue mechanism?
2. Define the term capital market.
3. Explain the functions of stock market.
4. Identify the relationship between new issue market and stock exchange.
5. Discuss the importance of capital market.
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5.14 REFERENCES
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UNIT - 6 : THE STOCK EXCHANGE
Structure:
6.0 Objectives
6.1 Introduction
6.2 Functions of Stock Exchange
6.3 Bombay Stock Exchange
6.4 National Stock exchange
6.5 Functions and Services of Stock Exchange
6.6 Over the Counter
6.6.1 Need and Objectives
6.6.2 Features
6.6.3 Benefits
6.6.4 Benefits to Investors
6.6.5 Benefits to Financial System
6.6.6 Securities Traded
6.7 Reasons for the Downfall of Stock Market
6.9 Notes
6.10 Summary
6.11 Key words
6.13 References
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6.0 OBJECTIVES
After studying this unit, you sould be able to;
• Give the meaning of stock exchange
• Explain the various services provided by stock exchange
• Describe the functions of stock market
• Differentiate BSE and NSE
• Identify the services of stock exchange
• Highlight the various reasons for the downfall of stock exchange
6.1 INTRODUCTION
The Securities Contracts (Regulation) Act, 1956 has defined stock exchange as
an “association, organization or body of individuals, whether incorporated or not, established
for the purpose of assisting, regulating and controlling business of buying, selling and dealing
in Securities.”
According to Pyle, “security exchanges are market places where securities that have
been listed thereon may be bought and sold for either investment or speculation”.
K.L. Garg has described the stock exchange as “an association of persons engaged in
the buying and selling of stocks, bonds and shares for the public on commission and guided
by certain rules and conditions.”
The word “Stock Exchange” is made from two words ‘Stock’ and Exchange. Stock
means part or fraction of the capital of a company, and Exchange means a transferring the
ownership; representing a market for purchasing and selling. Thus, we can describe the stock
exchange as a market or a place where different types of securities are bought and sold.
Securities traded on a stock exchange include shares issued by companies, unit trusts,
derivatives, pooled investment products and bonds. As the stock exchange deals in all types
of securities, it is known as ‘securities market’ or ‘securities exchange’ also. A stock exchange
is a secondary market of securities because the trading happens only for the securities that
have already been issues to the public and now being allowed to be traded on the floor of a
stock exchange after getting listed with the stock exchange. The initial offering of stocks
and bonds to investors is by definition done in the primary market and subsequent trading is
done in the secondary market.
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A stock exchange is a body that deals with stocks shares, bonds and securities. It also
includes people who deal with stocks shares, bonds and securities. Those people are known
as traders or stock brokers. Their services include issue and also redemption of stocks,
securities and any other financial instruments. Stock exchange also facilitates payment of
dividend and other income in short the entire stock market is regulated by the stock exchange.
These securities and shares are issued by companies. One can however deal with the stocks
and shares of those companies that are listed in the stock exchange. All stocks and shares
cannot be dealt here. So to deal with a particular company’s share or stock it has to be listed.
The physical records of the stick exchange are located at a particular place but then trading
and other transactions can be done from anywhere. Internet has, to a great extent improved
the stock and shares business. Hence the speed of the transactions is increased and the cost
is minimized. Also such trading is possible only by the members of the stock exchange.
The stock exchange consists of:
• Primary market
• Secondary market
In the primary market the initial offering of the stock shares and securities are done.
The trading of these securities and bonds is done in the secondary market. In a stock market
the vital role is played by the stock exchange. The supply and the demand of the various
stocks and securities are however as result of lot of factors.
The stock exchange gives an option to deal with the securities without the stock
exchange. Such kind of trading is called as over the counter or off exchange trading. Normally
the bonds and derivatives are traded this way. In the global market also the stock exchanges
play a vital role.
6.2 FUNCTIONS OF STOCK EXCHANGE
The roles and responsibilities of stock exchange are detailed below:

• They help to raise the capital for a business for expansion: Such capital can be
raised by selling the stocks and shares. The common ways to raise capital with the help
of stock exchange is by going public, venture capital, partnerships and corporate partners.
• Organize the savings which can be invested: Stock exchange uses the funds of the
people for the best resource. Hence the funds are used effectively which will lead to
growth of the general economy and in turn that will lead to more returns for those who
are saving as well as investing.
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• They help the companies which want to and also have the potential to grow:
Expansion is possible with the help of capital raising option.
• The profits are shared by all. Right from the big investor to a small investor all of
them get dividend in relation to the amount that they have invested. So all are entitled
for the income and share in the profit.
• Stock exchange has an overall governance of the companies that deal in the stock
market. To deal in the stock exchange certain standards have to be met by the
companies.
• Even small investors can invest in the stock market. So it breaks the old rule that
only people with lot of money can invest in business. Even small investors have the
opportunity to invest.
• For infrastructure work the government needs funds: Water treatment, sewage
work are all infrastructure projects for which the government need funds. They get
these funds by selling security that is called bonds. The members of the stock exchange
can raise these funds. Which means people can give loan to the government. So
government will pay interest for the loan at regular intervals and also the principal will
be paid back at the maturity.
Stock exchange is an indicator of how the economy is performing. The prices of the
shares depend vastly on the market. In a stable economy the stock price is also stable and
there will also be growth. The prices will come down and the market will crash when the
economy is going through depression. Similarly the prices will increase when there is a
boom. In India we have the National Stock Exchange and the Bombay Stock exchange.
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6.3 BOMBAY STOCK EXCHANGE
Bombay Stock Exchange is also known as BSE. It is one of the oldest stock exchanges
that existed in whole of Asia. It was established 135 years ago in year 1875 under the name
of “The Native Share & Stock Brokers”. It is a podium where various and number of
transactions that takes place daily and has provided tremendous growth to various sectors
such as corporate sector. Bombay Stock Exchange (BSE).
In order to trade in Bombay Stock exchange one needs to be listed with the Bombay
Stock Exchange. As per the records, there are about 4900 companies which are listed with
the Bombay Stock Exchange and thus making it supreme through the world in terms of the
companies that are listed with any stock exchange. The trading that place in the Bombay
stock exchange is not only manual but there is a facility of electronic transaction that can be
made in the BSE. If ranked on the terms of the electronic transaction that takes place daily in
the Bombay Stock exchange, than the BSE become the fifth largest stock exchange in the
world.
When a stock exchange obtains an ISO 9001:2000 certificate, it is regarded as the
distinctive asset of that stock exchange. The Bombay Stock Exchange had all the capabilities
to acquire that certificate and thus it had become the second most stock exchanges in the
world to obtain the certificate. By obtaining the certificate it had become the India first
stock exchange to obtain the same.
The Stock exchange also had the facility of BOLT, which is known as BSE Online
Trading System. For this system, the stock exchange has received the Information Security
Management System Standard BS 7799-2-2002 Certificate and thus making it Second in the
world to obtain the same, and it had also become the first stock exchange to obtain the
certificate, thus making it a supreme stock exchange amongst all.
BSE Index
SENSEX is the Index on which the BSE works. It is the most distinctive and important
bench mark index in India.
Contribution of Bombay stock Exchange
Though every Stock Exchange in the world has its own distinctive features, but the
Bombay stock Exchange has contributed under various heads thus making it important. The
various contributions that are made by the Bombay Stock Exchange are:
 It has developed its In house technology by purchasing marketplace technology in 2009;
30
 It had purchased fifteen percentage of stick in the United Stock exchange. The purchase
has helped in the enhancement of the currency and the imitative markets for the interest
rates;
 BSE Sensex Mobile Streamer was launched by the Stock exchange;
 It has launched its websites in Gujarati, Hindi, Marathi;
 The stock exchange is providing enough support in the field of education, environment
by taking the Corporate social Responsibility;
 The exchange has also launched IPO and PSU websites.
Thus, these are some of the contributions which are made by the Bombay Stock
exchange. Though the contribution made by every stock exchange is a contribution which
can be never be replaced, but the contribution made by the Bombay stock Exchange is
something which the world will remember for the time to come.
6.4 NATIONAL STOCK EXCHANGE
Every Stock exchange is located at a particular place. For example, the Stock Exchange
which is located in Delhi is known as Delhi Stock exchange. The Stock Exchange which is
located in Mumbai (Maharashtra) earlier Bombay is known as Bombay Stock Exchange. But
National Stock Exchange is formed to aim whole nation. At the request of the Government
of India, the national Stock Exchange is endorsed by various Financial Institutions, Insurance
companies, banks etc.
Incorporation and Origin of NSE:
The National Stock Exchange was for the first time incorporated in 1992. It was
incorporated as a tax paying company. The Stock Exchange was under the provisions of the
Securities Contracts (Regulation) Act, 1956 was accepted as a recognized stock exchange.
Since then, the National stock exchange was growing with leaps and pounds. In 1994, the
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stock exchange started to deal in the Whole Sale Debt Market and has started to operate in
the Capital Market. However, it was not until 2000 when the stock exchange has for the first
time stated its operations in the derivatives.
The National Stock exchange is highly active in the field of market capitalization and
thus aiming it the ninth largest stock exchange in the said field. Similarly, the trading of the
stock exchange in equities and derivatives is so high that it has resulted in high turnovers and
thus making it the largest stock exchange in India.
National stock Exchange Index:
The Index of the National stock exchange is known as S&P CNX Nifty. It is popularly
known as NIFTY. The other indices which are contributed by the National Stock Exchange
are CNX Nifty Junior, CNX 100, S&P CNX 500 and CNX Midcap.
Contributions of the National stock Exchange
There are significant numbers of contributions which are provided by the National
Stock Exchange. Some of the contributions are listed herein below:
There is hardly ant stock exchange which uses the satellite communication technology
for trading. The National stock Exchange is a Stock exchange which was the first stock
exchange in the world to use such technology. The technology is basically a client server
based technology which is known as NEAT (National Exchange for Automated Trading);
 It is the first stock exchange in India which has started using the NSE model;
 It is the first stock exchange which has provided an innovation to the spot equity market.
This is done by the national stock exchange by establishing a NSCCL (National Securities
Clearing Corporation Ltd);
 It is the stock exchange which has established the first s\depository system in India by
establishing a National Securities Depository system;
 It has launched the S&P CNX Nifty;
 The facility of internet trading was established by the National Stock exchange for the
first time in year 2000;
 It has traded in GOLD ETFs and thus making it the first stock exchange in doing such
activity;
 A media centre known as NSE-CNBC-TV 18 was launched in co-operation with the
CNBC-TV 18;
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Thus, these are the some of the achievements which are honored to the National Stock
Exchange. The National stock Exchange has contributed mainly in all the fields and thus
making it distinctive and unique stock exchange in India.
The national Stock Exchange is dealing in capital market and the main section of the
capital market in which the National stock Exchange is dealing in are Equity, stock lending
and borrowing, currency futures, wholesale debt market etc.
Working Hours of the national Stock exchange
Every Stock Exchange has a fixed number of duration in a day in which the transaction
in that particular stock exchange takes place. The official timing of the national stock exchange
is 9:00 AM to 3:30 PM. It is working an all week days except Sundays. It also does not work
on all the official holidays that are affirmed by the National Stock exchange. All the official
holidays of the National stock Exchange are declared well in advance.
Though the National stock exchange was established in year 1992 but it was recognized
as the stock exchange only in year 1993. To safeguard the investors it has launched the Investor
Grievance cell in year 1995. Thus, in all it can be regarded that the contribution made by the
National stock exchange cannot be regarded and thus makes it a stock exchange which is not
only boosting the economy of India but also safeguarding the investor in every aspect.
6.5 FUNCTIONS /SERVICES OF STOCK EXCHANGES

The stock market occupies a pivotal position in the financial system. It performs
several economic functions and renders invaluable services to the investors, companies, and
to the economy as a whole. They may be summarised as follows:
(i) Liquidity and marketability of securities
Stock exchanges provide liquidity to securities since securities can be converted into
cash at any time according to the discretion of the investor by selling them at the listed
prices. They facilitate buying and selling of securities at listed prices by providing continuous
marketability to the investors in respect of securities they hold or intend to hold. Thus, they
create a ready outlet for dealing in securities.
(ii) Safety of funds
Stock exchanges ensure safety of funds invested because they have to function under
strict rules and regulations and the bye-laws are meant to ensure safety of investible funds.
Overtrading, illegitimate speculation, etc., are prevented through carefully designed set of
rules. This would strengthen the investor’s confidence and promote larger investment.
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(iii) Supply of long-term funds
The securities traded in the stock market are negotiable and transferable in character
and as such they can be transferred with minimum of formalities from one hand to another.
So, when a security is transacted, one investor is substituted by another, but the company is
assured of long-term availability of funds.
(iv) Flow of capital to profitable ventures
The profitability and popularity of companies are reflected in stock prices. The prices
quoted indicate the relative profitability and performance of companies. Funds tend to be
attracted towards securities of profitable companies and this facilitates the flow of capital
into profitable channels. In the words of Husband and Dockeray, ‘Stock exchanges function
like a traffic signal, indicating a green light when certain fields offer the necessary inducement
to attract capital and blazing a red light when the outlook for new investment is not attractive.
(v) Motivation for Improved performance
The performance of a company is reflected on the prices quoted in the stock market.
These prices are more visible in the eyes of the public. Stock market provides room for this
price quotation for those securities listed by it. This public exposure makes a company
conscious of its status in the market and it acts as a motivation to improve its performance
further.
(vi) Promotion of Investment
Stock exchanges mobilise the savings of the public and promote investment through
capital formation. But for these stock exchanges, surplus funds available with individuals and
institutions would not have gone for productive and remunerative ventures.
(vii) Reflection of business cycle
The changing business conditions in the economy are immediately reflected on the
stock exchanges. Booms and depressions can be identified through the dealings on the stock
exchanges and suitable monetary and fiscal policies can be taken by the government. Thus, a
stock market portrays the prevailing economic situation instantly to all concerned so that
suitable actions can be taken.
(viii) Marketing of new Issues
If the new issues are listed, they are readily acceptable to the public, since listing
presupposes their evaluation by concerned stock exchange authorities. Public response to
such new issues would be relatively high. Thus, a stock market helps in the marketing of new
issues also.
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(ix) Miscellaneous services
Stock exchange supplies securities of different kinds with different maturities and
yields. It enables the investors to diversify their risks by a wider portfolio of investment. It
also inculcates saving habits among the community and paves the way for capital formation.
It guides the investors in choosing securities by supplying the daily quotation of listed
securities and by disclosing the trends of dealings on the stock exchange. It enables companies
and the Government to raise resources by providing a ready market for their securities.
6.6 OVER-THE-COUNTER
The term over-the-counter is a way of trading securities otherwise than on an organized
stock exchange. Trading of securities is carried out by the brokers, dealers scattered over
different locations and regions, with the help of a communication network including telephone,
telegraphs, tele-typewriters, telex; fax and computers. Communication network links every
deafer-broker, helps arrive at the prices and allows investors to select among the competing
market-makers. A market-maker is one who offers two-way prices (a buy rate and a sell rate)
at which the member-dealer is willing to buy or sell a standard quantity of scrip’s that will be
continuously quoted for a specified period. Thus, over-the-counter (OTC) market is envisaged
as a floorless securities trading system equipped with electronic or computer network through
which nationally and internationally scattered buyers and sellers can conduct business more
efficiently and economically.
6.6.1 Need and Objectives
The setting up of the OTCEI was conceived as a method by which the ailments facing
the working of the traditional stock exchanges at present could be overcome. Stock exchanges
function as a single door market in which the securities of companies engaged in different
industries and trades of varied sizes are listed with identical qualifying criteria, and are traded
simultaneously in the same trading hall. This creates a situation where only the big and
in1portant companies receive all the attention, with the large bulk of companies, particularly
the new and small companies remaining unnoticed. This creates a situation of unlisted / on-
traded companies that greatly jeopardizes liquidity of small scrips.
Small investors allover the country are faced with the problems of access, liquidity,
delays in payment and delivery, and uncertainty regarding prices at which their shares are
bought or sold. Prohibitive issue costs restricted access to the markets and administered
pricing of their shares are the main’ problems faced by companies. This meant India lacked a
stock market option for small and medium companies given the BSE and NSE entry threshold
35
of Rs.l0 crores-equity base. Similarly small, start-up companies in India had the problems of
raising capital through a public issue. at exorbitant costs and delays in realization of proceeds.
Moreover. many companies, which are doing well, were unable to grow to their potential
because of their inhibition to go public to raise adequate capital. All such mid-cap companies
have benefited from the establishment of OTCEI. The OTC Exchange has been set up as an
answer to these problems of companies and investors, the two critical players in the cap ital
markets.
The OTCEI aims at creating a stock exchange that will:
1. Facilitate small companies to raise funds from the capital market in a cost-effective
manner. as it does not involve any flotation costs
2. Provide a convenient and an efficient avenue of capital market investments for small
investors
3. Strengthen investors’ confidence in the financial market by offering them the two-way
best prices to the investors
4. Ensure transparency, redress investors’ complaints and unify the country’s securities
market to cover even those places which do not have a stock exchange.
5. Provide liquidity advantage to the securities traded
6. Promote organized trading in Unlisted Securities
7. Broad base the existing informal market in order to make it more liquid
8. Provide a source of valuation for securities traded and
9. Act as a launch pad to an I PO
6.6.2 Features
The salient features of OTCEI are as follows:
Nation-wide Trading
OTCEI has a nation-wide network. By listing 011 the OTCEI, securities of a company
call be traded across the country through centers that are located in different cities. Counters
opened at different locations are interlinked by computer-based communication system. A
public notice is given as to the availability of counters where trading takes place. Facilities
for trading will be available at the counters of the sponsors and the market-makers who are
notified by the OTCEI. Companies have an unique benefit of nationwide listing and trading of
the scrips by simply listing at only one exchange, the OTC Exchange.
36
Compulsory Investor Registration
Every investor is expected to obtain ‘Invest OTC Card for buying and selling securities
on OTCEI by making an application at any of the counters of OTCEI. In fact, the share
application form includes the necessary details to be filled in for obtaining ‘Invest OTC
Card’. The purpose of the investor registration is to facilitate computerized trading. It also
provides greater safety of operations to the investors.
Ringless Trading
Trading does not take place on any specific floor of an exchange. The members and
dealers open counters at various, places, which offer investors to connect locations for the
purchase and sale of the listed securities. OTCEI does not have any trading ring/hall. Dealers
quote, query and transact business through a central OTC computer connected with computers
that are located at different centres/counters spread across the country.
The network of on-line computers allows market participants to execute trades from
their offices and provides all relevant information on their screens, creating a fair market.
Trading takes places through a network of computers (screen based) of OTC dealers located
at several places within the same city and even across cities. These computers allow dealers
to quote, query and transact through a central OTC computer using telecommunication links.
Investors can walk into any of the counters of members and dealers, and see the quote display
on the screen, decide to deal and conclude the transaction.
Transparent Computerized Trading
The entire trading at OTCEI is done in a transparent and speedy manner through
computers. This makes the market more disciplined. The confirmation that the investor
receives through the computer, gives the exact date, time, price of the deal and brokerage
charged. The system also ensures that transactions are done at the best prevailing quotes in
the market. The investors ‘ interest is fully protected in this regard.
Exclusive Listing
Companies listed at OTCEI are not listed on other stock exchanges. However, of late,
following the liberalized approach of the RBI, companies that have been already listed in
other stock exchanges are also allowed trading on the OTCEI. The companies sponsored by
members of OTCEI are listed.
Closeness to Investors
There are a large number of inter-connected counters throughout the country. Facility
for trading is available at the counters of the sponsors. The addresses of Additional Market-
37
makers and dealers are provided in the application attached to the offer for sale. This way,
OTCEI is considered to be closer to investors.
Authorized Dealers
Only those members and dealers who are authorized and approved by the OTCEI can
deal on it.
Price Display
In a traditional stock exchange, the investor has no means of verifying the price at
which the broker effected the transaction. Conversely, the OTCEI continuously displays
current security prices on the screens installed at each of the OTC Exchange counters. This
enables investors to make on-the-spot decisions on purchase or sale of securities.
Greater Liquidity
Since the sponsor and the Additional Market-maker offer two-way quotes, (i.e. buy
and sell quotes) within specified margin, securities can be purchased and sold at any time.
The compulsory market-making by the sponsor for every security ensures that buy and sell
quotes are available everyday for a period of 3 years after which another market-maker takes
over the price quotation. Unlike other stock exchanges, the OTC Exchange, through its
nationwide reach, facilitates widely dispersed trading across the country, thus enabling greater
liquidity.
Trading for Unlisted Companies
In pursuance of the recommendations of the Dave Committee, the SEBI has allowed
trading of equity shares of all unlisted companies on the OTCEI to boost-the business volume
of OTCEI. Such trading provides an opportunity to make the stocks liquid and tradable. In
addition, it also provides a source of valuation of mutual funds, facilitates inter-institutional
trades and enables placement of these shares with. Foreign institutional investors (FIIs) who
can now subscribe to the shares of unlisted companies.
Trading in Derivatives
Based on Dave Committee recommendations, instruments like futures and options,
forward contracts on stocks, other forms of forward transactions and stock lending are allowed
to be traded on OTCEI. This aims at improving OTCEI’s liquidity by providing greater depth.
Instant Execution of Orders
The investors’ orders are executed immediately. If there are no buyers or sellers on
the OTC Exchange, the market-maker deals with the investor. .
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Ready Information
The compulsory market-maker carries out research on the scrip sponsored by him
and, hence, all vital information pertaining to the company is readily available.
MoU with NASDAQ
OTCEI has signed a Memorandum of Understanding with NASDAQ, USA, the second
largest stock exchange in the world. The MoU entails mutual exchange of information, training
in various aspects of the capital market, access to the global market, etc Multi-product
Exchange
A lot of innovation has gone into the working of the OTCEI. For instance, OTCEI
introduces new products from time to time for the benefit of the investors, issuers and
intermediaries in the capital market and the nation at large. OTCEI has also created a national
market in its listed segment to facilitate large corporates to have simultaneous listing on the
exchange. It is pertinent to note that OTCEI currently offers trading in the following category
of securities viz., Listed Equity, Listed Debentures, GOI Securities. Permitted Equity.
Permitted Debentures, Mutual Funds and Bonds of public sector units.
Technology
OTCEI uses computers, telecommunications and other technologies. of the modern
information age in order to bring members/dealers together electronically, so as to enable
them to trade with one another electronically, rather than on a trading floor in a single location.
All the information needed for trading ‘is available on the OTCEI’s computer screen. To
enhance connectivity for its trading systems, OTCEI has shifted to VSATs (Very Small Aperture
Terminals). The use of modern technology ensures a more transparent. quick and disciplined
trading.
Faster Transfers
The investor has to submit counter receipt at any of the OTCEI counters for transfer
of shares. Shares are automatically transferred in the name of the investor. if the consolidated
holding of the shares is within the limit of 0.5 percent of the issued capital of the company.
OTC trading provides for transfer of shares by Registrars up to a certain percentage
per folio. This results in faster transfers. The concept of immediate settlement makes it
better for the investors. Investors will trade, not with share certificates but with a different
tradable document called Counter Receipt (CR). However, an investor can always exercise
his right of having the share certificate by surrendering the CR and again exchanging the
share certific.ate for CR when he wants to trade. A custodian provides this facility along with
39
a settler who will do the signature verification and CR validation (The Counter Receipt is no
longer a tradable document from 1st March, 1999).
Trading Services
An investor can buy and sell any listed scrip at any of the OTC exchange counter. The
investor can also make an application for services like transfer of shares, splitting and
consolidation of shares, nomination and revocation. of nomination, registering power of
attorney, transmission of shares and change of holder’s name, etc. The parties involved in
trading on OTC-are Investor, Counter, Settler, Registrar/Custodian, Company and Bank. The
trading documents mainly involved in OTC exchange transactions are: Temporary Counter
Receipt (TCR), Permanent Counter Receipt (PCR), Sales Confirmation Slip (SCS), Transfer
Deed (TD), Service Application Form (SAF), Application Acknowledgement Slip (AAS), and
Deal Form (DF).
6.6.3 Benefits
The OTCEI offers the following benefits:
Benefits to Listed Companies
The benefits that are offered to companies listed with OTCEI are as follows:
1. Negotiability The Company can negotiate the issue price with the sponsors who
have to market the issue. It provides an opportunity for fair pricing of an issue through
negotiation with the sponsors.
2. Fixation of premium In consultation with the sponsors, the company can fix an
optimum level of premium on issue with minimum risk of non-subscription of the issue.
3. Savings in costs Lots of costs associated with public issue of capital are saved
through this mode. It provides an opportunity to companies to raise funds through capital
market instruments at an extremely low cost as compared to a public issue. The method of
sponsors placing the scrip’s with members who in turn will offload the scrip’s to public will
obviate the need for a public issue and its associated costs.
4. No take-over threat OTCE lists scrip’s even with 40 percent of the capital offered
for public trading, limit has now been brought down to 20 percent in the case of closely held
companies and new companies. As a result, the present management of the companies are
saved of threats of takeover if they restrict public offer.
5. Large access Accessing a large pool of captive investor base through the OTCEI’s
computerized network is made possible for companies. Through nationwide network for
servicing of investors, companies listed on
40
OTC Exchange can have a larger investor base.
6. Other benefits
a) Helpful to small companies
b) Shares of all unlisted companies can now be traded on OTCEI
c) Platform for issuers and first-level investors like financial institutions, state level
financial corporations, Foreign Institutional Investors, etc.
d) System for defining benchmark for securities
e) Increasing business for the market constituents
f) Easier launch pad for an IPO
6.6.4 Benefits to Investors
The OTCEI offers the following benefits that are otherwise not available for investors
dealing in other stock exchanges. These are as follows:
1. Safety OTCEI’s ringless and scrip less electronic trading ensures safety of
transactions of the investor. For instance, every investor in a OTCEI is given an ‘Invest-OTC-
Card ‘ free. This code is allotted on a permanent basis and should be used in all OTC
transactions and applications of OTC issues. This card provides for the safety and security of
the investors ‘ investments. The mechanism offers greater security to investors as the sponsors
investigate into the company and the projects, before accepting sponsorship thus building up
much needed greater investor confidence. .
2. Transparency OTC screens at every OTC counter display the best buy/sell prices.
The exact trading prices are printed in the trading documents for confirmations. This protects
the investor interest and thereby minimizes disputes.
3. Liquidity A great advantage of the OTC is that the scrip’s traded are liquid. This is
because there are at least two market-makers who indulge in continuous buying and selling.
This enables investors to buy and sell the scrip’s any time. .
4. Appraisal OTC member’s sponsor each scrip listed in an OTC counter. The sponsor
makes an appraisal of the scrip’s for investor worthiness. This ensures quality of investments.
5. Access Every OTC counter serves as a single window to the entire OTC exchange
throughout the country and throughout the world too. Therefore, buying and selling may be
resorted to from any part of the world. It offers the facility of faster deal settlement for
investors across the counters spread over the entire country.
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6. Transfer: It is important that OTC shares are transferable within 7 days, where the
consolidated holdings of the scrip’s do not exceed 0.5 percent of the issued capital of the
company.
7. Allotment There is not much waiting for the investors when it comes to allotment
of scrip’s. Allotment is completed in all respects within a matter of 35 days and trading
begins immediately thereafter.
8. Other benefits:
a) Derivatives such as futures and options, forward contracts on stocks, and other forms
of forward transactions and stock lending are allowed on OTCEI
b) Scrip less trading makes dealings simpler and easier
c) Market-making system in OTC Exchange gives sufficient opportunities for the investor
to exit
d) Acts as a benchmark to value securities
e) Creating an exit option for illiquid stocks/venture capitalists
f) Shuffling portfolios for the investors
g) Organizing and broad-basing trading in the existing market
6.6.5 Benefits to Financial System
The OTCEI’s role has been laudable in as far as it helps contribute improving the
financial system of India in the
Following ways:
1. National network of OTCEI operations facilitates the integration of capital market in
the country
2. Boon to closely-held companies as they are encouraged to go public because scrips
can be listed even if only 40 percent of capital (now a minimum of 20 percent in case of
closely held and new companies) is offered for public trading
3. Facilitates wider dispersal of economic activities by encouraging small companies and
small investors
4. Promoting savings and investments by offering easier avenues for raising capital
5. Providing over-all stimulation to venture capital activities thereby promoting
entrepreneurship
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6. Market-making assistance by the sponsors on the OTCEI that helps in making an
appraised future projections in the issue documents which in turn helps prospective
investors in determining the
7. usefulness of the issues for investment purposes, promoting investment environment
in general
8. Those members of the OTCEI who did not have multiple memberships Can now have an
opportunity to trade in some of the large capital index stocks.
9. Encourage venture capital activities and boost entrepreneurship
10. Spread of stock exchange operations geographically all over India
6.6.6 Securities Traded
Following are the securities that are traded on the OTCEI:
1. Listed equity (exclusive) these are equity shares of the companies listed
exclusively on the OTCEI. The shares can be bought or so ld at any of the member/dealer’s
office all over India. The securities, which are listed exclusively on the OTCEI, cannot be
traded on other stock exchanges.
2. Listed debt These are the debentures/bonds that are issued through a public issue
or a private placement and are listed on OTCEI. Any entity holding the entire series of a
particular debt instrument can also offer them for trading on the OTCEI, by appointing an
OTCEI member/dealer to carry out compulsory market making in those securities.
3. Gills The securities issued by the Central arid State Governments are called ‘
gilts’. Government of India Dated Securities, Treasury Bills and special securities are traded
in this segment. Banks, Foreign Investors, Foreign Institutional Investors, NBFCs and
Provident Funds can trade in these securities through OTCEI designated members/dealers.
PSU Bonds, Commercial Paper, and Certificates of Deposit will also be traded in this segment.
4. Permitted securities These are the securities listed on other exchanges, which
are permitted for trading on OTCEI. Securities of Blue Chip companies like ACC, Reliance
Industries Ltd., State Bank of India, ITC etc are traded in this segment.
5. Listed mutual funds Listed mutual funds are units of mutual funds that are listed
on OTECI. Mutual fund units like units of Unit-64, Monthly Income Plan, and IISFUS 97 are
also listed under this category.
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6.7 REASONS FOR THE DOWNFALL OF STOCK MARKET
We all know about the unpredictable nature of stock market. There are several reasons
when the stock market go high and touch the sky, similarly there are reasons which make the
stocks market fall. The major fall in the stock market comes when there is an unnecessary
hike in prices of stocks in a very short span of time. Stock market falls generally when the
stocks listed in large cap index that is the index which has stocks of all the big companies.
When stock prices of the top companies which are included in large cap index start falling,
stock market as a whole will take the downward trend. It is very important that corrections
should take place in stock market at regular intervals because if the market will keep on
rising people will lose interest and the downfall is the time which attracts new investors to
participate in the investment of stock market.
a) Pressure of inflation always tends to move the stock markets down.
b) There is a fear of hike in prices which also provokes the stock market towards its downfall.
c) Weak growth of industry can also take stock market towards downfall.
d) Scandals and scams like the one done by Harshad Mehta in 1991-1992 can prove to be
one of the reasons.
e) Changing policies of government regarding tightening of domestic and foreign trade
can prove one of the reasons for the fall of stock process.
f) Introduction of new policies by Reserve Bank of India can also lead stock markets
towards its downfall.
g) Sometimes some new announcements made by SEBI i.e. Securities Exchange Board of
India make a noise in stock market in such a way that the prices of stock start falling
which ultimately lead to the fall of stock market.
h) Stock market tends to fall abruptly when foreign investors start selling their stocks in
our market due to political instability or any other new policy intervention.
i) Sometimes wrong news in the Market conveys wrong things to its investors due to
which they start selling their stock at a faster rate which lead towards a disastrous fall in
the stock market.
j) Sometimes Reserve Bank of India increase the value of Cash Reserve Ratio i.e. CRR
which can be responsible for the downfall in stock market.
k) Global economies also affect our Indian stock markets in one way or the other due to
which fall in any of the global economy can make our Indian stock market fall too.
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l) Interest rates movements can also be one of the reasons for the downfall of the market.
m) Sometimes due to natural disasters like droughts and heavy rain fall also have a bad
impact on markets which lead their way to the downfall?
n) In case of situations like wars, markets can fall as people feel insecure about their
money and start selling their stocks at a faster rate.
o) Terrorism is also one of the other factors which create fear in mind of people and there
is a state of terror in country which stops people in investing in stocks.
p) Increased rate of fraud and high rate of crime also pave the way to the downfall of the
stock market in India.
In conclusion we can say that, it is the best time for the investors who want to buy
stocks because when the markets are following the downward trend, prices of stocks go
down abruptly. At this point of time when the markets are following a downward trend sellers
want to sell their stocks at any price which they are getting in order to save themselves from
loses while the buyers wait for the lowest prices to buy the stock and they wait the stock to
reach its lowest point in order to buy that stock. Whenever there is a fall in stock market,
nobody can predict that whether this is due to minor fluctuations or major fluctuations and
this is a temporary downfall or going to last for some longer period of time. So an investor
should be careful while taking the investment decision when the stock markets are going
southward trend.

1. The full form of OTCEI is
a) Over-the-Counter Exchange of India
b) Over the Counter Exchange of India
c) Over the Stock Exchange of India
d) Over the Stock Exchange of India
2. The index of BSE and NSE is also known as
a) SENSEX and NIFTY b) NYSE and SENSEX
c) LSE and TSE c) NASDAQ and NYSE
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3. Mention the functions of stock market
a) Liquidity and marketability of securities
b) Supply of long term funds
c) Safety of funds
d) Promotion of Investment
Answer to check your progress: 1) a 2) a 3) a, b, c, d]
6.9 NOTES
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6.10 SUMMARY
The stock market is the market in which shares of publicly held companies are issued
and traded either through exchanges or over-the-counter markets. The stock market lets
investors participate in the financial achievements of the companies whose shares they hold.
National Stock Exchange of India or in short NSE happens to be India’s largest Stock Exchange
and World’s third largest stock exchange in terms of transactions. It is located in Mumbai
and was incorporated in November 1992 as a tax-paying company. It was in April 1993 that
NSE was recognized as stock exchange under the Securities Contract Act 1956.BSE or
Bombay Stock Exchange is the oldest stock exchange in Asia that was established in 1875. It
is also the biggest stock exchange in the world. BSE is located at Dalal Street, Mumbai.
Bombay Stock Exchange and National Stock Exchange are both major stock exchange in
India. But there is a difference between NSE and BSE. Investors put their money in the stock
market in order to reap huge benefits from their investment. But nobody can predict the
market. Also any stock market is decided by its country’s growth. But you should be aware
that it requires a lot of patience. The market tumbles down and this is the reason why investors
fear of investing their money.
6.11 KEY WORDS

Bombay Stock Exchange (BSE) and National Stock Exchange (NSE): are the
leading stock exchanges of India. BSE is the 4th largest stock exchange in Asia and the 11th
largest in the world. NSE is mutually-owned by a set of leading financial institutions, banks,
insurance companies and other financial intermediaries in India.
The over-the-counter exchange of India (OTCEI) is an electronic stock exchange
based in India that is comprised of small- and medium-sized firms looking to gain access to
the capital markets.

1. What do you mean by OTCEI?
2. Define the term stock exchange.
3. Explain the various reasons for the downfall of stock market.
4. Differentiate between BSE and NSE
5. Explain the various features of OTCEI.
6. Mention the functions and services of stock exchange.
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6.13 REFERENCES
49
UNIT - 7 : FOREIGN DIRECT INVESTMENT AND
FOREIGN PORTFOLIO INVESTMENT
Structure:
7.0 Objectives
7.1 Introduction to Foreign Direct Investment (FDI)
7.2 Meaning and Definition FDI
7.3 Advantages and Disadvantages of Foreign Direct Investment (FDI)
7.4 Introduction to Foreign Portfolio Investment
7.5 Meaning and Definition Of Foreign Portfolio Investment (FPI)
7.6 Difference between FDI and FPI
7.7 Introduction to Private Equity
7.8 Meaning and Definition Of Private Equity
7.10 Notes
7.11 Summary
7.12 Key Words
7.14 References
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7.0 OBJECTIVES
• Give the meaning of foreign direct investment
• Explain the meaning of FPI
• Describe the advantages of foreign direct investment
• Bring out the meaning of private equity
• Identify the difference between FDI and FPI
• Highlight the advantages and disadvantages of FDI
7.1 INTRODUCTION TO FOREIGN DIRECT INVESTMENT (FDC)

A foreign direct investment (FDI) is an investment made by a company or entity based
in one country, into a company or entity based in another country. Foreign direct investments
differ substantially from indirect investments such as portfolio flows, wherein overseas
institutions invest in equities listed on a nation’s stock exchange. Entities making direct
investments typically have a significant degree of influence and control over the company
into which the investment is made. Open economies with skilled workforces and good growth
prospects tend to attract larger amounts of foreign direct investment than closed, highly
regulated economies.
Foreign Direct Investment, or FDI, is a type of investment that involves the injection
of foreign funds into an enterprise that operates in a different country of origin from the
investor.
Investors are granted management and voting rights if the level of ownership is greater
than or equal to 10% of ordinary shares. Shares ownership amounting to less that the stated
amount is termed portfolio investment and is not categorized as FDI.
This does not include foreign investments in stock markets. Instead, FDI refers more
specifically to the investment of foreign assets into domestic goods and services. FDIs are
generally favoured over equity investments which tend to flow out of an economy at the first
sign of trouble which leaves countries more susceptible to shocks in their money markets.
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7.2 MEANING AND DEFINITION OF FOREIGN DIRECT INVESTMENT (FDI)
Foreign direct investment (FDI) is an investment in a business by an investor from

another country for which the foreign investor has control over the company purchased. The
Organization of Economic Cooperation and Development (OECD) defines control as
owning 10% or more of the business. Businesses that make foreign direct investments are
often called multinational corporations (MNCs) or multinational enterprises (MNEs).
A MNE may make a direct investment by creating a new foreign enterprise, which is called a
Greenfield investment, or by the acquisition of a foreign firm, either called an acquisition
or brown field investment.
Investment from one country into another (normally by companies rather than
governments) that involves establishing operations or acquiring tangible assets, including
stakes in other businesses. The purchase or establishment of income-generating assets in a
foreign country that entails the control of the operation or organisation.
FDI is distinguished from portfolio foreign investment (the purchase of one country’s
securities by nationals of another country) by the element of control. Standard definitions of
control use the internationally agreed 10 per cent threshold of voting shares, but this is a
grey area as often a smaller block of shares will give control in widely held companies.
Moreover, control of technology, management, even crucial inputs can confer de facto control.
FDI is not just a transfer of ownership as it usually involves the transfer of factors
complementary to capital, including management, technology and organisational skills.
Example:
Strategically FDI comes in three types:
Horizontal: where the company carries out the same activities abroad as at home
(for example, Toyota assembling cars in both Japan and the UK.
Vertical: when different stages of activities are added abroad. Forward vertical FDI
is where the FDI takes the firm nearer to the market (for example, Toyota acquiring a car
distributorship in America) and Backward Vertical FDI is where international integration
moves back towards raw materials (for example, Toyota acquiring a tyre manufacturer or a
rubber plantation).
Conglomerate: where an unrelated business is added abroad. This is the most unusual
form of FDI as it involves attempting to overcome two barriers simultaneously - entering a
foreign country and a new industry. This leads to the analytical solution that
internationalisation and diversification are often alternative strategies, not complements.
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In the below given diagram we can observe the foreign direct investment for the year
2015 for various months.
Source: Reserve Bank of India

7.3 ADVANTAGES AND DISADVANTAGES OF FOREIGN DIRECT
INVESTMENT
It is true that globalization has rapid expansion through national borders and several
industries. The foreign direct investment is considered as one of the most significant
economical figures and it is associated with business enterprise and benefits that will greatly
help you in attaining your business goals in just a short period of time. Today, most of the
countries are opening their borders and doors especially when it comes to foreign investment.
Foreign direct investment (FDI) is made into a business or a sector by an individual or a
company from another country. It is different from portfolio investment, which is made
more indirectly into another country’s economy by using financial instruments, such as bonds
and stocks.
There are various levels and forms of foreign direct investment, depending on the
type of companies involved and the reasons for investment. A foreign direct investor might
purchase a company in the target country by means of a merger or acquisition, setting up a
new venture or expanding the operations of an existing one. Other forms of FDI include the
acquisition of shares in an associated enterprise, the incorporation of a wholly owned company
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or subsidiary and participation in an equity joint venture across international boundaries. If a
business is planning to engage in this kind of venture, you should determine first if it provides
you and the society with maximum benefits. One good way to do this is evaluating its
advantages and disadvantages.
Various Advantages of Foreign Direct Investment is mentioned below:
1. Economic Development Stimulation.
Foreign direct investment can stimulate the target country’s economic development,
creating a more conducive environment for you as the investor and benefits for the local
industry.
2. Easy International Trade:
Commonly, a country has its own import tariff, and this is one of the reasons why
trading with it is quite difficult. Also, there are industries that usually require their presence
in the international markets to ensure their sales and goals will be completely met. With FDI,
all these will be made easier.
3. Employment and Economic Boost:
Foreign direct investment creates new jobs, as investors build new companies in the
target country, create new opportunities. This leads to an increase in income and more buying
power to the people, which in turn leads to an economic boost.
4. Development of Human Capital Resources:
One big advantage brought about by FDI is the development of human capital resources,
which is also often understated as it is not immediately apparent. Human capital is the
competence and knowledge of those able to perform labor, more known to us as the workforce.
The attributes gained by training and sharing experience would increase the education and
overall human capital of a country. Its resource is not a tangible asset that is owned by
companies, but instead something that is on loan. With this in mind, a country with FDI can
benefit greatly by developing its human resources while maintaining ownership.
5. Tax Incentives:
Parent enterprises would also provide foreign direct investment to get additional
expertise, technology and products. As the foreign investor, you can receive tax incentives
that will be highly useful in your selected field of business.
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6. Resource Transfer:
Foreign direct investment will allow resource transfer and other exchanges of
knowledge, where various countries are given access to new technologies and skills.
7. Reduced Disparity Between Revenues and Costs:
Foreign direct investment can reduce the disparity between revenues and costs. With
such, countries will be able to make sure that production costs will be the same and can be
sold easily.
8. Increased Productivity:
The facilities and equipment provided by foreign investors can increase a workforce’s
productivity in the target country.
9. Increment in Income:
Another big advantage of foreign direct investment is the increase of the target
country’s income. With more jobs and higher wages, the national income normally increases.
As a result, economic growth is spurred. Take note that larger corporations would usually
offer higher salary levels than what you would normally find in the target country, which can
lead to increment in income.
List of Disadvantages of Foreign Direct Investment
1. Hindrance to Domestic Investment.
As it focuses its resources elsewhere other than the investor’s home country, foreign
direct investment can sometimes hinder domestic investment.
2. Risk from Political Changes.
Because political issues in other countries can instantly change, foreign direct
investment is very risky. Plus, most of the risk factors that you are going to experience are
extremely high.
3. Negative Influence on Exchange Rates.
Foreign direct investments can occasionally affect exchange rates to the advantage of
one country and the detriment of another.
4. Higher Costs.
If you invest in some foreign countries, you might notice that it is more expensive
than when you export goods. So, it is very imperative to prepare sufficient money to set up
your operations.
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5. Economic Non-Viability.
Considering that foreign direct investments may be capital-intensive from the point
of view of the investor, it can sometimes be very risky or economically non-viable.
6. Expropriation.
Remember that political changes can also lead to expropriation, which is a scenario
where the government will have control over your property and assets.
7. Negative Impact on the Country’s Investment.
The rules that govern foreign exchange rates and direct investments might negatively
have an impact on the investing country. Investment may be banned in some foreign markets,
which means that it is impossible to pursue an inviting opportunity.
8. Modern-Day Economic Colonialism.
Many third-world countries, or at least those with history of colonialism, worry that
foreign direct investment would result in some kind of modern day economic colonialism,
which exposes host countries and leave them vulnerable to foreign companies’ exploitations.
Investing into another country’s economy, buying into a foreign company or otherwise
expanding your business abroad can be extremely financially rewarding and might provide
you with the boost needed to jump to a new level of success. However, foreign direct investment
also carries risks, and it is highly important for you to evaluate the economic climate
thoroughly before doing it. Also, it is essential to hire a financial expert who is accustomed
to working internationally, as he can give you a clear view of the prevailing economic
landscape in your target country. He can even help you monitor market stability and predict
future growth. Remember that we live in an increasingly globalized economy, so foreign
direct investment will become a more accessible option for you when it comes to business.
However, you should weigh down its advantages and disadvantages first to know if it is the
best road to take.
7.4 INTRODUCTION TO FOREIGN PORTFOLIO INVESTMENT

Foreign portfolio investment (FPI) consists of securities and other financial assets
passively held by foreign investors. Foreign portfolio investment (FPI) does not provide the
investor with direct ownership of financial assets, and thus no direct management of a company.
This type of investment is relatively liquid, depending on the volatility of the market invested
in. It is most commonly used by investors who do not want to manage a firm abroad.
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Foreign portfolio investment typically involves short-term positions in financial assets
of international markets, and is similar to investing in domestic securities. FPI allows investors
to take part in the profitability of firms operating abroad without having to directly manage
their operations. This is a similar concept to trading domestically: most investors do not
have the capital or expertise required to personally run the firms that they invest in.
Foreign portfolio investment differs from foreign direct investment (FDI), in which
a domestic company runs a foreign firm. While FDI allows a company to maintain better
control over the firm held abroad, it might make it more difficult to later sell the firm at a
premium price. This is due to information asymmetry: the company that owns the firm has
intimate knowledge of what might be wrong with the firm, while potential investors (especially
foreign investors) do not.
The share of FDI in foreign equity flows is greater than FPI in developing countries
compared to developed countries, but net FDI inflows tend to be more volatile in developing
countries because it is more difficult to sell a directly-owned firm than a passively owned
security.
7.5 MEANING AND DEFINITION OF FOREIGN PORTFOLIO
INVESTMENT
Foreign Portfolio Investment (FPI) is investment by non-residents in Indian securities
including shares, government bonds, corporate bonds, convertible securities, infrastructure
securities etc. The class of investors who make investment in these securities are known as
Foreign Portfolio Investors. The FPI is induced by differences in equity price scenario, bond
yield, growth prospects, interest rate, dividends or rate of return on capital in India’s financial
assets.
SEBI has recently stipulated the criteria for Foreign Portfolio Investment. According
to this, any equity investment by non-residents which is less than 10% of capital in a company
is portfolio investment. While above this the investment will be counted as Foreign Direct
Investment (FDI). Investment by a foreign portfolio investor cannot exceed 10 per cent of
the paid up capital of the Indian company. All FPI taken together cannot acquire more than 24
per cent of the paid up capital of an Indian Company.
Who are Foreign Portfolio Investors?
Foreign Portfolio Investors includes investment groups of Foreign Institutional
Investors (FIIs), Qualified Foreign Investors (QFIs) (Qualified Foreign Investors) and
subaccounts etc.
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After the new SEBI guidelines, the RBI stipulated that Foreign Portfolio Investors
include Asset Management Companies, Pension Funds, Mutual Funds, and Investment Trusts
as Nominee Companies, Incorporated / Institutional Portfolio Managers or their Power of
Attorney holders, University Funds, Endowment Foundations, Charitable Trusts and Charitable
Societies.
Who is a Foreign Institutional Investor?
FII is an institution like a mutual fund, insurance company, pension fund etc. According
to SEBI, “an FII is an institution established or incorporated outside India which proposes to
make investment in India in securities”. FII is an institution who is registered under the
Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995.
FIIs comprised of a pension fund, a mutual fund, investment trust, insurance company or a
reinsurance company.
Who is a Qualified Foreign Investor?
QFI is an individual, group or association which is a resident in a foreign country. The
QFI should compliant with the Financial Action Task Force standard and should be a signatory
to the International Organisation of Securities Commission.
The FIIs are big and hence they have the capacity to make large scale investment.
On the other hand, small investors and individuals under QFI category can’t match FIIs in
terms of business volume. So, often when we hear about foreign investment in the share
market, it is the FIIs who steal the attention.
7.6 DIFFERENCE BETWEEN FDI AND FPI

FDI is an acronym that stands for Foreign Direct Investment. It refers to the type of
investment carried out at international level where an investor will acquire a stake in an
enterprise in a foreign country with long term realization of goals in the enterprise. FPI
stands for Foreign Portfolio Investment where an international investor acquires stakes in a
foreign country in terms of stock, bonds and some other assets but with the investor having
an inert role in the management of those financial holdings.
FDI typically involves establishment of some physical entity such as a factory or an
enterprise in a foreign country. It may involve a relationship created between a parent company
in one country and an affiliate in another country which would together form a multinational
company. All kinds of capital contributions are included while calculating FDI, for instance
stock acquisitions, reinvestments of business profits by a parent company in its foreign
subsidiary or just direct lending by a subsidiary company. It is not easy to withdraw from FDI
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so it is common to have members with a direct interest in the investment committing to
managing the day to day affairs of their foreign interests or at least making major strategic
decisions.
FPI usually aims at short term benefits and typical target countries for this type of
foreign investment, given its transient nature, are developing countries. It offers easier escape
routes compared to FDI, where an investor can easily withdraw from a foreign portfolio
either when targets have been realized or when there’s an unexpected occurrence affecting
the economic standing of that country which may adversely affect foreign investments. Unlike
FPI, FDI requires more investment specific capital and so it’s harder to adjust this type of
investment in short term changing conditions whereas FPI can easily be adjusted as the
business conditions fluctuate.
7.7 INTRODUCTION: PRIVATE EQUITY

Private equity is equity capital that is not quoted on a public exchange. Private equity
consists of investors and funds that make investments directly into private companies or
conduct buyouts of public companies that result in a delisting of public equity. Capital for
private equity is raised from retail and institutional investors, and can be used to fund new
technologies, expand working capital within an owned company, make acquisitions, or to
strengthen a balance sheet. The majority of private equity consists of institutional investors
and accredited investors who can commit large sums of money for long periods of time.
Private equity investments often demand long holding periods to allow for a turnaround of a
distressed company or a liquidity event such as an IPO or sale to a public company.
Private equity refers to a type of investment aimed at gaining significant, or even
complete, control of a company in the hopes of earning a high return. As the name implies,
private equity funds invest in assets that either are not owned publicly or that are publicly
owned but the private equity buyer plans to take private. Though the money used to fund these
investments comes from private markets, private equity firms invest in both privately and
publicly held companies. The private equity industry has evolved substantially over the past
decade or so. The basic principle has remained constant: a group of investors buy out a
company and use that company’s earnings to pay themselves back. What has changed are the
sheer numbers of recent private equity deals. In the past ten years, the record for the most
expensive buyout has been broken and re-broken several times. Private equity firms have
been acquiring companies left and right, paying sometimes shockingly high premiums over
these companies’ market values. As a result, takeover targets are demanding exorbitant prices
for their outstanding shares; with the massive buyouts that have made headlines around the
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world, companies now expect a certain premium over their current value. One example is
Free-scale Semiconductor, who turned down a deal that paid a nearly 30% premium over its
market value, holding out for a sweeter package, which it received. The sheer number of
these high-priced deals that have occurred in recent years have led some to question whether
this pace is sustainable in the long run. This could turn out to be a self-fulfilling prophecy; as
concerns grow and people become less eager to invest in private equity deals, firms won’t be
able to raise the money to fund their acquisitions, essentially crippling the industry.
Private Equity is not very well known outside of the finance world, but it is one of the
key players in global business. Private Equity firms are part of the fabled ‘buy-side’ and
some of the largest firms (mega funds) are:
• Kohlberg, Kravis & Roberts (KKR)
• Blackstone
• Bain Capital
• Carlyle Group
The definition of private equity is simply money invested into a private company, or
the privatization of a company through the investment of outside money. Basically, what
private equity firms attempt to do is to invest into a company, take a majority stake, improve
the company and then exit their investment at a large profit. In order to magnify returns, PE
firms make use of leverage (borrowed money) to conduct Leveraged Buyouts (LBOs).
Private Equity firms can either focus on a specific sector (Energy, Technology,
Healthcare etc.) or operate across a broad spectrum. The larger the firm, the more likely it is
to cover more sectors.
7.8 MEANING AND DEFINITION OF PRIVATE EQUITY

It’s a source of investment capital from high net worth individuals with the goal of
investing and acquiring equity ownership in companies. The investment in those companies
will generally be made by a private equity firm, but also by a venture capital firm or an angel
investor.
In simpler terms, the idea behind private equity is to gather up funds from a number of
investors, take those funds and use them to acquire a controlling or substantial minority
position in a firm, and then get a return on that investment.
The targeted companies of private equity are not usually publicly traded on the stock
market— or if they are, are usually de-listed from the markets in order to make the private
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deal. The firms can be listed again, usually as a way to make money for the private equity
investors, as we’ll note in a bit.
A private equity fund typically refers to a general partnership formed by PE firms,
which are utilized to invest in private companies. The private equity fund may have general
investment criteria (meaning it invests in different industries) or have specific industry
criteria. However, private equity funds typically have an investment philosophy that it sticks
to throughout its term, which tends to be anywhere between 10 and 13 years. After this time
period elapses, the private equity fund is closed by having all funds distributed back to the
limited partners. Private equity funds may invest directly in equity securities of the target
investment, in the form of mezzanine debt, or in both equity and debt.
In general terms, private equity funds often focus on one of the following investment
philosophies:
 Venture capital - used to finance early stage companies that do not have access to
financial markets or conventional financing.
 Growth capital - used to fund the expansion of an established private company that is
“asset light,” and therefore may not be able to use its own assets to secure traditional
financing for such growth.
 Leveraged or management buyouts - used in combination with additional leverage placed
on a company to allow the existing management to take control of the target. The
company’s cash flow has to be sufficient to cover the carrying costs of the additional
debt.
 Distressed or turnaround situations - used when companies are unable to service their
existing debt, and the fund’s equity is used to recapitalize the balance sheet along with
management conducting a turnaround strategy.
How do private equity investors make money back?
They generally receive a return on their investments through one of the
following ways:
An initial public offering (IPO):
Shares of the company are offered to the public, typically providing an immediate
return on an investment through the sale of shares in the firm.
A merger or acquisition:
The company is sold for either cash or shares in another company.
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A recapitalization:
Cash is distributed to the shareholders — the investors — either from cash
flows generated by the company or through raising debt or other securities to fund
the distribution.

1. How is FDI strategically classified?
a) Conglomerate b) Vertical
c) diversified d) Horizontal
2. Mention some private equity firms
a) Bain Capital
b) Blackstone
c) Kohlberg, Kravis & Roberts (KKR)
d) Carlyle Group
3. What is the full form of MNE’S?
a) Multinational Equity
b) Multinational Enterprises
c) Multinational Company
d) Multinational Issue
Answer to check your progress: 1) a, b, d, 2) All options 3) b
7.10 NOTES
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7.11 SUMMARY
FDI tends to yield more returns on investment as a direct result of investors’ controlling
position in the investment but with FPI, although there’s a lot of flexibility to adjust to short
term environmental changes, there’s generally less returns realized, making this a favorite
investment route for smaller firms looking for flexibility and lower investment specific
costs other than bigger returns.FDI and FPI investment calculations are determined by the
amount of investments made in a single year, which is the ‘flow’, or as ‘stock’, which is the
amount of investment massed in a year. It is therefore harder to make estimates for FPI
portfolio flows especially if a FPI investment is made for one year or less as they contain
various instruments, so a definite value is hard to estimate. The difference between FDI and
FPI may be hard to establish, especially if it is a relatively big foreign investor considering
investing in stock options. The two models coincide in part with each other in this case and it
may go down to choosing between flexibility and returns on investment.
7.12 KEY WORDS

Foreign direct investment (FDI): Involves establishing a direct business interest
in a foreign country, such as buying or establishing a manufacturing business.
A portfolio investment: is an investment made by an investor who is not involved in
the management of a company. This is in contrast to direct investment, which allows an
investor to exercise a certain degree of managerial control over a company.
Foreign portfolio investment (FPI) is investing in financial assets, such as stocks
or bonds, in a foreign country.
7.13 QUESTIONS FOR SELF STUDY

1. What do you mean FDI and FPI?
2. Define the meaning of private equity.
3. Explain the advantages and disadvantages of FDI.
4. Differentiate between FDI and FPI.
5. Discuss the difference between FDI and FPI.
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7.14 REFERENCES
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UNIT - 8 : INVESTORS PROTECTION AND SEBI
GUIDELINES
Structure:
8.0 Objectives
8.1 Introduction
8.2 Need for Investor Protection
8.3 Factors Affecting Investors Interest
8.4 SEBI Guidelines
8.4.1 Primary market
8.4.2 Secondary market
8.4.3 Foreign Institutional Investors (FIIs)
8.4.4 Bonus Issue
8.4.5 Rights Issue
8.4.6 Debentures
8.4.7 Fully Convertible Debenture (FCD). Partly Convertible Debenture (PCD)
And Non-Convertible Debentures (NCDs)
8.4.8 Guidelines for the protection of debenture holders
8.4.9 Underwriters
8.4.10 Investor protection
8.6 Notes
8.7 Summary
8.8 Key words
8.9 Self assessment questions
8.10 References
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8.0 OBJECTIVES
• Give the meaning of Investor Protection
• Explain the factors affecting investors interest
• Describe the need for Investor Protection
• Identify the significance of SEBI Guidelines
• Highlight the guidelines of Investor Protection
8.1 INTRODUCTION
The peculiar nature of the company form of organisation is that there is diversity of
ownership and management. Though thousands of shareholders have invested their money in
a company, they don’t have any direct connection with the day-to-day running of the business.
They have invested their small means in the company through the share market to get ample
returns and also to get capital appreciation of their invested funds. At the same time, they
have to shoulder many risks of different kinds. Apart from the normal risks attached to every
business, there may be abnormal risks also in the form of dishonesty and improprietory of
all the counterparties with whom they come into contact while investing their funds. Hence,
there arises a necessity to protect them from all such risks so that their confidence in the
market may be built-up and they may actively participate in the market with boosted confidence.
It will go a long way in creating a healthy and vibrant capital market.
8.2 NEED FOR INVESTORS’ PROTECTION

The need for investors’ protection arises due to the following reasons:
(i) To instil confidence in investors’ minds
Investors’ confidence is very essential for the smooth and successful functioning of the
capital market. When their confidence is shaken or when they lose their confidence in the
market, there will be a severe jolt in the market. Many investors are tempted to invest with an
expectation of making good fortunes out of their investment. If it does not happen, they
come away from the market. Such a situation is not at all desirable. Therefore, it is vital to
build-up investors’ confidence by creating a conducive atmosphere for investment through
investors’ protection measure.
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(ii) To create a conducive atmosphere for investment
A proper and sound investment climate is very essential for industrial development.
The corporate customers would find it easy to raise capital at affordable minimum cost only
when there is efficient and secured investment climate. In fact, strong investors’ protection
measures would create a healthy investment climate.
(iii) To ensure transparency in dealing
The investors would be able to evaluate their prospective investments only when there
is transparency of dealings of companies and all the intermediaries connected with the stock
market. Investment decisions would be taken on the basis of full disclosures made by
companies in various areas. All investors’ protection measures aim at bringing the much
needed transparency and disclosures in all key areas.
(iv) To create a vibrant capital market
Investors would freely enter into the capital market in large numbers only when their
interest is fully protected from all angles. This increased participation would develop the
market and once the market gets developed, it would again attract more and more investors.
Thus, investors’ protection would indirectly promote a vibrant capital market.
(v) To regulate the market on sound lines
Investors’ protection measures in the form of regulations would make all market
players work within the ambit of regulations. It would lead to a smooth and stable functioning
of the market on desired lines.
(vi) To create discipline in the market
All investors’ protection measures aim at minimising the unhealthy practices, undue
speculation, unnecessary malpractices, etc., in the market. It would go a long way in creating
a good discipline among all market players.
(vii) To create accountability among market players
A sense of accountability is created among all players in the market by means of
laying down strict disclosure norms and taking stringent investors’ protection measures.
This accountability makes them comply with all requirements failing which they are
answerable to the regulatory bodies.
(viii) To create awareness among Investors
Above all, investors must be aware of their own rights and liabilities, grey areas of
frauds, the type of frauds that can take place, etc. Hence, investor protection measures also
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aim at educating the prospective and present investors on these aspects. This would enable
them to protect themselves from all unhealthy and fraudulent practices by becoming saviours
of their own protection.
8.3 FACTORS AFFECTING INVESTORS’ INTEREST

There are many factors that affect investors’ ‘interest and thereby cause dissatisfaction
among them. The prominent causes are:
(i) Price rigging
Price rigging is nothing but the artificial manipulation of prices of securities by forming
cartels by bulls and bears. They don’t allow the market forces of demand and supply to play
their due role. These artificial prices create a market wind in either direction to which innocent
investors fall as victims.
(ii) Insider trading
Insider trading refers to the purchase or sale of securities by persons who hold price-
sensitive information about the company due to their fiduciary relationship with that company.
In other words, insiders get regular profits at the expense of a majority of uninformed
investors.
(iii) Excessive speculation
Speculation, if it exceeds its limit, would affect the interest of investors to a greater
extent. If brokers, in order to earn more and more profits due to a probable rise in price, may
engage themselves in a buying spree far beyond their capacity. It would result in non-fulfilment
of their settlement promises which may lead to market crash. Ultimately, the innocent investors
suffer for no fault of theirs.
(iv) Lack of transparency
In order to attract investors, some companies may present a rosy picture of their
financial position by manipulating their system of accounting. The accounts are not at all
transparent in their disclosures. Again, the stock market dealings are not transparent.
(v) Short selling
Short selling refers to selling of scrip’s without owning them by bear cartels with the
anticipation that these shares could be purchased at a much lesser price in future when delivery
would be actually made. It leads to extreme volatility in the market.
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(vi) Restricted trading
One of the serious grievances of the investors is restricted trading in stock exchanges.
Though there is an increase in the turnover of stock exchanges, it is restricted to a few shares
only with the top 10 shares accounting for about 80 per cent of the turnover and top 100
shares for 99 per cent of the turnover.
(vii) Restricted trading hours and trading days
Another factor arises from the fact that the trading hours of stock exchanges are very
small and the market also remains closed on many days a week. This affects the marketability
and liquidity of securities.
(viii) Dominance of few stock exchanges
Though many stock exchanges are functioning in India, a lion’s share of the dealings
are held in BSE and NSE only. The regional stock exchanges are gradually losing their
importance.
(ix) Dominance of Institutional and foreign Institutional Investors
The institutional investors, particularly the foreign institutional investors dominate
the Indian capital market. They dictate the terms in the market. They account for nearly 80
per cent of the new issues. The ownership of equities by individuals and households is gradually
coming down.
(x) Excessive volatility
Due to the impact of IT revolution, LPG policies, introduction of innovative
instruments and adoption of flexible interest rate structure, the volatility in the capital market
has been greatly increased. The small investors are not able to face such a situation with
confidence.
(xi) Grievances against listed companies
Moreover, the investor’s complaints against listed companies are manifold.
Some of them are:
i. Non-receipt of share certificates.
ii. Non-receipt of refund orders.
iii. Non-receipt of duplicate securities.
iv. Non-receipt of certificates after consolidation.
v. Non-receipt of certificates after splitting.
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vi. Bad delivery of share certificates.
vii. Failure to affect transfers and delay in executing transfers.
viii. Non-receipt of interest on listed debentures.
ix. Non-receipt of redemption proceeds of listed debentures.
x. Non-receipt of allotment advice.
xi. Complaints regarding revalidations.
(xii) Grievances against members of stock exchanges are:
The nature of complaints against the members of the stock exchanges
i. Non-receipt of delivery of shares.
ii. Non-receipt of dividend.
iii. Non-receipt of rights shares.
iv. Non-receipt of bonus shares.
v. Non-receipt of sale proceeds.
vi. Disputes relating to non-settlement of accounts.
vii. Disputes regarding rate differences, etc.
(xiii) Miscellaneous grievances
Miscellaneous grievances arise due to:
i. Non-repayment of fixed deposits in financial companies.
ii. Non-repayment of deposits in manufacturing companies.
iii. Non-redemption of mutual funds and all complaints relating to mutual funds.
iv. Complaints relating to shares and debentures in unlisted companies.
8.4 SEBI GUIDELINES
SEBI has brought out a number of guidelines separately, from time-to-time, for primary
market, secondary market, mutual funds, merchant bankers, foreign institutional investors,
investor protection, etc. The guidelines are described below.
8.4.1 Guidelines for primary market
New company: A new company is one: (a) Which has not completed 12 months
commercial production and does not have audited results and (b) Where the promoters do
not have a track record.
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These companies will have to issue shares only at par.
New company set up by Existing company: When a new company is being set up
by existing companies with a five-year track record of consistent profitability and a
contribution of at least 50 per cent in the equity of new company, it will be free to price its
issue, i.e., it can issue its share at premium.
Private and closely Held companies: The private and closely held companies having
a track record of consistent profitability for at least three years shall be permitted to price
their issues freely. The issue price shall be determined only by the issues in consultation
with lead managers to the issue.
Existing listed companies: The existing listed companies will be allowed to raise
fresh capital by freely pricing expanded capital provided the promoter’s contribution is 50
per cent on first Rs. 100 crore of issue, 40 per cent on next Rs. 200 crore, 30 per cent on
next Rs.300 crore and 15 per cent on balance issue amount.
Reservation of Issues
Reservations under public subscription for various categories of persons are made in the
following manner:
1. Permanent Employees - 10%
2. Indian Mutual Funds - 20%
3. Foreign Institutional Investors - 15%
4. Development Financial Institutions - 20%
5. Shareholders of Group of Companies - 10%
Composite Issues
In the case of composite issue, i.e., right-cum-public issue by existing listed companies
differential pricing shall be allowed. In other words, issue to the public can be priced
differentially as compared to issue to rights shareholders. However, justification for the
price difference should be given in the offer document.
Lock-In period
Lock-in period is five years for promoter’s contribution from the date of allotment
or from the commencement of commercial production whichever is late. At present, the
lock-in period has been reduced to one year.
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Guidelines for public Issue
1. Abridged prospectus has to be attached with every application.
2. A company has to highlight the risk factors in the prospectus.
3. Objective of the issue and cost of project should be mentioned in the prospectus.
4. Company’s management, past history and present business of the firm should be
highlighted in the prospectus.
5. Particulars with regard to company and other listed companies under the same
management which made any capital issues during the last three years are to be stated in
the prospectus.
6. Justification for premium, in the case of premium is to be stated.
7. Subscription list for public issues should be kept open for a minimum of three days and
a maximum of 10 working days.
8. The collection centers should be at least 30 which include all centers with stock
exchanges.
9. Collection agents are not to collect application money in cash.
10. The quantum of issue, whether through a rights or public issue, shall not exceed the
amount specified in the prospectus. No retention of oversubscription is permissible
under any circumstances.
11. A compliance report in the prescribed form should be submitted to SEBI within 45 days
from the date of closure of issue.
12. Minimum number of shares per application has been fixed at 500 shares of face value of
Rs. 100.
13. The allotments have to be made in multiples of tradable lot of 100 shares of Rs. 10 each.
14. Issues by way of bonus, rights, etc., to be made in appropriate lots to minimize odd lots.
15. If minimum subscription of 90 per cent has not been received, the entire amount is to be
refunded to investors within 120 days.
16. The capital issue should be fully paid-up within 120 days.
17. Underwriting has been made mandatory.
18. Limit of listing of companies issue in the stock exchange has been increased from Rs. 3
crore to Rs. 5 crore.
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19. The gap between the closure dates of various issues, viz., rights and public should not
exceed 30 days.
20. Issues should make adequate disclosure regarding the terms and conditions of redemption,
security conversion and other relevant features of the new instrument so that an investor
can make reasonable determination of risks, returns, safety and liquidity of the instrument.
The disclosure shall be vetted by SEBI in this regard.
21. SEBI has made grading of all IPO mandatory for which draft documents are filled with it
after April 30, 2007.
It shall be mandatory to obtain grading from at least one credit rating agency.
The issues shall be required to disclose all grades obtained by it in the prospectus,
abridged prospectus, issue advertisements and others places where the issues is advertising
for the IPO.
SEBI has announced on 5th August, 2008 that an alternate payment mode would be
launched for public issues that would ensure that the funds of retail investors are not locked
until the actual allotment of shares. On 10th September, 2008, five banks have agreed to debit
application money only when it was required and not 21 days in advance and the registrar to
give instruction to block the amount only when it was required.
8.4.2 Secondary market
Stock exchange
i. Board of Directors of stock exchange has to be reconstituted so as to include non-
members, public representatives, and government representatives to the extent of 50
per cent of total number of members.
ii. Capital adequacy norms have been laid down for members of various stock exchanges
depending upon their turnover of trade and other factors.
iii. Working hours for all stock exchanges have been fixed uniformly.
iv. All the recognized stock exchanges will have to inform about the transaction within 24
hours.
v. Guidelines have been issued for introducing the system of market making in less liquid
scrip’s in a phased manner in all stock exchanges.
Brokers
i. Registration of brokers and sub-brokers is made compulsory.
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ii. In order to ensure that brokers are professionally qualified and financially solvent, capital
adequacy norms for registration of brokers have been evolved.
iii. Compulsory audit of broker’s book and filing of audit report with SEBI have been made
mandatory.
iv. To bring about greater transparency and accountability in the broker client relationship,
SEBI has made it mandatory for brokers to disclose transaction price and brokerage
separately in the contract notes issued to client.
v. No broker is allowed to underwrite more than 5 per cent of public issue.
8.4.3 Foreign Institutional Investors (FIIs)
i. Foreign institutional investors have been allowed to invest in all securities traded in
primary and secondary markets.
ii. There would be no restriction on the volume of investment for the purpose of entry of
FIIs.
iii. The holding of single FIT in a company will not exceed the ceiling of 5 per cent of the
equity capital of a company.
iv. Disinvestment will be allowed only through stock exchanges in India.
v. FIIs have to pay a concessional tax rate of 10 per cent on large capital gain (more than
one year) and 30 per cent on short-term capital gains. A tax rate of 20 per cent on dividend
and interest is prescribed.
8.4.4 Bonus Issue
The guidelines relating to the issue of bonus shares have undergone several changes
since 1969. The latest set of guidelines announced by SEBI was made effective from April
13, 1994. At present, there are in all 10 guidelines laid down for bonus shares.
(i) There should be a provision in the Articles of Association of the company for issue of
bonus shares. If not, the company should pass a resolution at the General Body Meeting,
making provision for capitalization of profits. The proposal for bonus issues is
recommended by the Board of Directors and then approved in the General Body Meeting.
(ii) The bonus is made out of free reserves built out of the genuine profits or share premiums
collected in cash only.
(iii) Reserves created by revaluation of fixed assets are not permitted to be capitalized.
(iv) The declaration of bonus issue in lieu of dividend is not to be made.
75
(v) Bonus issues are not permitted unless the partly paid shares existing are fully paid-up.
(vi) No bonus issue will be permitted if there are sufficient reasons to believe that the
company has defaulted in respect of payment of statutory dues to the employees such as
provident fund, gratuity, bonus, etc. Further, no bonus issue is permitted if the company
defaults in payment of principal or interest on fixed deposits or on debentures.
(vii)No bonus issue can be made within 12 months of any public issue/ rights issue.
(viii) A company which announces bonus issue after the approval of the Board of Directors
must implement the proposals within a period of six months from the date of such
proposal and shall not have the option of changing the decision.
(ix) Consequent to the issue of bonus shares, if the subscribed and paid-up capital exceeds
the authorized share capital, a resolution shall be passed by the company at its general
body meeting for increasing the authorized capital.
(x) Issue of bonus shares after any public/ rights issue is subject to the condition that no
bonus shall be made which will dilute the value or rights of holders of debenture,
convertible fully or partly.
The company shall forward a certificate duly signed by the issuer and duly
countersigned by its statutory auditor or by a company secretary in practice to the effect that
the terms and conditions for the issue of bonus shares as laid down in these guidelines have
been complied with.
8.4.5 Rights Issue
Section 81 of the Companies Act specifies the conditions to be satisfied by a public
company for issuing rights shares. SEBI has issued the following guidelines for the issue of
rights share.
(i) Composite issue: A public and rights issue can be made at different prices where
these two kinds of issues are made as a composite issue by existing listed companies.
There is no restriction in charging lower premium on rights issue than on public issues.
The premium must be fixed by the Board of Directors in consultation with lead manager
to the issue. Differential pricing in a composite issue is not permitted in the case of
existing unlisted companies making public issue for the first time.
(ii) Appointment of merchant banker: Appointment of merchant banker is not mandatory,
if the size of rights issue by a listed company does not exceed Rs. 50 lakh. For issues
of listed companies exceeding Rs. 50 lakh, the issue is to be managed by an authorized
merchant banker.
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(iii) Minimum subscription: If the company does not receive minimum subscription of
90 per cent of the issue amount including devolvement of underwriters within 120
days from the date of opening of issue, the company has to refund the entire subscriptions
within 128 days with interest at 15 per cent p.a. for delay beyond 78 days from the date
of closure of the issue.
(iv) Preferential allotment: No preferential allotment shall be made along with the rights
issue. If a company wants to make preferential allotment, it should be made independent
of rights issue by complying the provisions of the Companies Act, 1956.
(v) Underwriting: Underwriting of rights issue is not mandatory but as per SEBI
(Underwriter’s) Rules and Regulations, 1993, rights issue can be underwritten.
(vi) Rights of FCD/PCD holders: The proposed rights issue should not dilute the value
or rights of fully or partly convertible debenture holders. If the conversion of FCDs/
PCDs is due within a period of 12 months from the date of rights issue, reservation of
shares out of rights issue is to be made for them in proportion to the convertible part
of FCDs/PCDs.
(vii) Oversubscription not to be retained: The quantum rights issue should not exceed
as specified in the letter of offer. The companies are not allowed to retain
oversubscription under any circumstances through rights issue.
(viii) Promoter’s contribution: If the promoter’s shareholding in the equity at the time of
the rights issue is more than 20 per cent of the issued capital, the promoters have to
ensure that their equity holding do not fall below 20 per cent of the expanded capital.
If the promoter’s holdings are less than 20 per cent of the issued capital, they shall
take up the unsubscribed portion of the rights issue so that their holdings amount to 20 per
cent of the expanded capital.
The lock-in period is two years for the share holdings prior to the rights issue from
the date of allotment in the rights issue.
(ix) Vetting of letter of offer by SEBI: The letter of offer pertaining to rights issue has
to be vetted by SEBI and the concerned lead manager has to obtain SEBI clearance for
the draft letter of offer before approaching stock exchange for fixing the record date
for the proposed issue. A copy of letter of offer is forwarded to SEBI for information
if the rights issue is less than Rs. 5lakh. The responsibility of vetting the rights issue
is passed on to merchant bankers in 1995. Rights issue not accompanied by public
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issue, if made three months prior to or three months after the public issue, will not
have to be vetted by SEBI.
(x) Disclosure in the letter of offer: The letter of offer like the prospectus should
conform to the disclosure prescribed in Form 2A under Section 56(3) of the
Companies Act, 1956. Full justification and parameters used for issue price should
clearly be mentioned in the letter of offer.
(xi) Advertisement in newspaper: All listed companies making rights issue shall
invariably issue an advertisement in at least two all India newspapers about the dispatch
of letters of offer, opening date, closing date, etc. Such advertisement should be at
least one week before the date of opening of the subscription list.
(xii) Compliance report: Within 45 days of closure of rights issue, a report in the
prescribed form along with the compliance certificate from statutory auditor /
practicing chartered accountant/ company secretary should be forwarded to SEBI by
lead managers.
(xiii) Applicability of SEBI guidelines: The above guidelines with regard to rights issue
apply only to rights issue made by existing listed companies.
(xiv) Revised disclosure norms for listed companies: To enable the listed companies
to raise funds easily from the primary market, the SEBI has amended its Disclosure
and Investor Protection Guidelines in March 2006. These guidelines are applicable
to those listed companies that are regular in filing periodic returns with stock
exchanges and have comprehensive investor grievances mechanism. The following
are the important guidelines:
(a) Listed companies going in for a rights issue can now fix and disclose the issue price any
time prior to fixing the record date in consultation with the designated stock exchange.
(b) In the case of fixed price route, for public issues of such companies, the price can be
fixed before filing of the prospectus with the Registrar of companies. .
(c) Further, companies making rights issues are now permitted to dispatch an abridged letter
of offer, containing disclosures as required in the abridged prospectus. However, such
companies may provide the detailed letter of offer to any shareholder upon request.
(d) Again, companies that have filed a draft offer document with full disclosures can now
come out with further capital issues even before the shares pertaining to the document
are listed on the bourses.
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These guidelines do not apply to rights issue by existing private companies/ closely
held or other unlisted companies. They have to comply with the requirements as laid down in
the Companies Act.
SEBI, on 13th August, 2008, reduced the time duration for a rights issue from 109
days to 43 days.
Reduction in timeline approved includes:
1. The number of days for the notice period for a board meeting will be reduced from 7
working days to 2 working days.
2. The notice period for record date will be reduced to 7 working days.
3. The issued period will be reduced from a minimum of 30 days with a minimum of 15
days with a maximum of 30 days.
4. The period for completion of post-issue activity will be reduced from 42 days to 15
days.
8.4.6 Debentures
i. The amount of working capital debenture should not exceed 20 percent of the gross
current assets.
ii. The debt-equity ratio should not exceed 2: 1.
iii. The rate of interest can be decided by the company.
iv. Credit rating is compulsory for all debentures except debentures issued by public sector
companies, private placement of Non-Convertible Debentures (NCDs) with financial
institutions and banks.
v. Debentures are to be redeemed after the expiry of seven years from the date of allotment.
NCD is permitted to be redeemed at 5 per cent premium.
vi. Normally, debentures above seven years cannot be issued.
vii. Debentures issued to public have to be secured and registered.
viii. A Debenture Redemption Reserve is to be set up out of profits of the company.
ix. Debenture Trustee and Debenture Trust Deed are to be finalized within six months of
the public offer.
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8.4.7 Fully Convertible Debenture (FCD). Partly Convertible Debenture (PCD)
and Non-Convertible Debentures (NCDs)
(i) FCD/PCD/NCD issued for a period of more than 18 months are to be compulsorily
credit rated.
(ii) The debentures converted within 18 months are treated as equity.
(iii) FCDs having conversion period more than 36 months will not be permitted.
(iv) The terms of issue should be predetermined and stated in the prospectus.
(v) The interest rate can be determined by the issuer.
(vi) Conversion after 18 months from the date of allotment but before 36 months will be
optional at the hand of the debenture holders.
(vii) Appointment of Debenture Trustees and Creation of Debenture Redemption Reserve
are not necessary if the maturity period is 18 months or less.
(viii) The Debenture Trust Deed should be executed within six months of the closure of the
issue.
(ix) The offer document should specify existing and future equity, long term debt-equity
ratio, servicing of existing debentures, payment of interest on existing loans and
debentures.
(x) No objection for second or participation charge.
(xi) In the case of rollover of NCO portion of debentures, the following conditions are ‘to
be complied with:
(a) Six months before the date of redemption, fresh credit rating should be obtained and
it should be communicated to debenture holders.
(b) The company must have obtained the positive consent of debenture holders.
(c) SEBI should vet the roll over and its terms and conditions.
8.4.7 Guidelines for protection of the debenture holders

(i) Servicing of debentures
A Debenture Redemption Reserve shall be created by companies issuing debentures
on the following basis:
Existing companies need not create ORR up to the date of commercial production.
ORR shall be created in equal instalments for the remaining period.
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For new companies, creation of ORR will commence from the year the company
earns profit and it should be created in equal or in one or more instalments for the remaining
life of debentures.
In the case of PCOs, ORR should be created only for NCO portion. ORR should be
created up to 50 per cent of the amount before redemption commences.
Withdrawal from ORR will be permitted only after 10 per cent of the liability is
actually redeemed.
DRR will be treated as a part of general reserve for the purpose of bon US issue.
In the case of new companies, distribution of dividend shall require approval of trustees
to the debenture issue and the lead institution, if any.
In the case of existing companies, prior permission of the lead institution for declaring
dividend exceeding 20 per cent or as per the loan covenants is necessary if the company does
not comply with institutional conditions regarding interest and debt service coverage ratio.
(ii) Protection of Interest of debenture holders
Trustees to the debenture issue shall be vested with the requisite powers for protecting
the interest of debenture holders including a right to appoint a nominee director on the Board
of the Company in consultation with institutional debenture holders.
Lead institution / investment institutions will monitor the progress in respect of
debentures for project finance, modernisation, diversification, etc. The lead bank for the
company will monitor debentures raised for working capital funds.
The company shall file with SEBI, a certificate from their bankers that the assets on
which security is to be created are free from encumbrances and necessary permissions to
mortgage the assets have been obtained or a no objection certificate from the financial
institutions or banks for a second or pari passu charge in case where assets are encumbered.
The security should be created within six months from the date of issue of debentures.
It can be created within 12 months provided 2 per cent penal interest is paid to debenture
holders.
If the security is not created even after 18 months, a meeting of the debenture holders
shall be called within 21 days to explain the reasons thereof and the date by which the security
would be created.
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The trustees to the debenture holders will supervise the implementation of the
conditions regarding creation of security for the debenture and debenture redemption reserve.
The trustees and institutional debenture holders should obtain a certificate from the
company’s auditors in respect of utilisation of funds during the implementation of period of
projects and at the end of each accounting year in the case of debentures for working capital.
8.4.8 Underwriters
(i) No person can act as underwriter unless he holds certificate of registration granted by
SEBI.
(ii) The certificate of registration is valid for a period of three years from the date of issue.
(iii) The total underwriting obligations should not exceed 20 times of his net worth.
(iv) In the case of devolvement, the underwriter should subscribe to such securities within
30 days of the receipt of the intimation from the company.
(v) The underwriter should furnish within a period of six months from the end of the financial
year a copy of the balance sheet, profit and loss account, the statement of capital adequacy
requirements ·and such other documents as required by SEBI.
(vi) The books of accounts should be maintained for a period of five years.
10 . Investor protection
Investor protection is the major responsibility of the SEBI. SEBI has taken
various measures to protect the interests of investors.
New Issues
The issuing company should provide fair and correct information. Allotment process
should be transparent and not tainted by any bias. The draft prospectus of the companies is
scrutinised for full and fair disclosure.
• No delay in refunds or despatch of share certificates.
• Underwriting ·obligations is necessary to inspire confidence of investors.
• Risk factors and highlights should be fairly stated without any bias in the prospectus.
• Listing should be timely and transferability is ensured.
• Both stock exchange and companies are responsible for investor protection in respect
of free trading and transferability of shares.
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The investor protection is to be ensured by not only the Director / Secretary of the
company but by all the parties in the new issue process namely merchant bankers, Registrars,
collecting banks, stock exchange and SEBI.
Recently, SEBI has instituted the system of appointing its representatives to supervise
the allotment process to ensure that no malpractices take place in allotment process.
1. According to SEBI guidelines debt equity ratio should not exceed

a) 3:1 b) 2:1
c) 1:3 d) 1:2
2. Mention the role of merchant banker
a) Combination of banking and consultancy services b) Underwriter
c) Stock exchange d) Primary Market
3. Define the need for investor protection
a) To ensure transparency in dealing
b) To instil confidence in investors’ minds
c) To create vibrant capital market
d) To create discipline in the market
Answer to check your progress: 1) b 2) a 3) all options
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8.7 SUMMARY
Investors, especially small investors who constitute an important segment of the Indian
stock market need all the support and protection so as to enable them to trade on the stock
exchange fearlessly and truthfully. It is interesting to know that several factors were responsible
for the loss of confidence of the investor on the activities of stock exchange. The unsuccessful
and failing mutual fund is one of the chief reasons for the loss of investor interest on the
stock market activities. Investors basically command certain rights such as the right to receive
all the benefits/material information declared for the investors by the company, the right to
obtain prompt services from the company such as transfers, sub-divisions and consolidation
of holdings in the company. The Bombay stock exchange is providing lot of benefits to the
investors in order to protect the interest of the investors.
8.8 KEY WORDS

Investor Protection: Actions to encourage honest advertising of financial products,
and to prevent fraud to make sure that investors do not lose money if their investments
default (are not repaid).
Bonus Issue: A bonus issue is an offer of free additional shares to existing
shareholders. A company may decide to distribute further shares as an alternative to increasing
the dividend payout. Also known as a “scrip issue” or “capitalization issue”.
Bonus shares are additional shares given to the current shareholders without any
additional cost, based upon the number of shares that a shareholder owns.
Rights Issue: A rights offering (issue) is an issue of rights to a company’s existing
shareholders that entitles them to buy additional shares directly from the company in
proportion to their existing holdings, within a fixed time period.
8.9 SELF ASSESMENT QUESTIONS

1. What you mean by investor protection?
2. Define the term rights issue.
3. Explain the need for investor protection.
4. Discuss the guidelines of SEBI pertaining to secondary market and primary market.
5. Discuss the guidelines of SEBI for investor protection.
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8.10 REFERENCES
86
M.B.A III Semester
COURSE - 16 A
BLOCK
3
MONEY MARKET
UNIT - 9
OVERVIEW OF MONEY MARKET 1-21
UNIT - 10
MONEY MARKET INSTRUMENTS 22-34
UNIT - 11
RECENT DEVELOPMENTS IN MONEY MARKET 35-49
UNIT - 12
PREVENTION OF MONEY LAUNDERING 50-72
1

Chairman
Course Writers
Dr. T. Manjunath Block - 3 (Units 9 to 12)
Principal
UBDT, Davanagere
Publisher
Registrar

Mysuru.-6.
2
BLOCK -3 : MONEY MARKET
Money market is a segment of financial markets where borrowing and lending of the
short term funds takes place. The maturity of the money market instruments in one day to
one year. In our country money markets are regulated by both RBI and SEBI.
This block money market exhibits 04 units (09-12) . Unit 09 tells about introduction
to money market meaning, constituents, functions and government security market. Unit 10
takes you to money market instruments introduction, money market instruments, participants
and regulations of the money market in India. Unit 11 explains recent development in money
market introduction, MIBOR, recent development and chit funds and their regulations. The
last unit 12 of this block elucidates prevention of money laundering introduction, prevention,
global money market, integration of domestic and global money market.
3
4
BLOCK - 3
MONEY MARKET
UNIT- 9: OVERVIEW OF MONEY MARKET
Structure:
9.0 Objectives
9.1 Introduction
9.2 Constituents and Functions
9.3 Government Security Market
9.4 Notes
9.5 Summary
9.6 Key Words
9.10 References
5
9.0 OBJECTIVES
After studying this unit, you should be able to ;
• Concept of money market
• Difference between money market and capital market
• Call money market and Short-term Deposit market
• Various money market instruments
• Types & features of Government Securities
• Bill Rediscounting
• Money Market Mutual funds
• Concept & features of Treasury bills
• Guidelines for issuance of Commercial Paper.
9.1 INTRODUCTION
Money market is a very important segment of the Indian financial system. It is the
market for dealing in monetary assets of short-term nature. Short-term funds up to one year
and financial assets that are close substitutes for money are dealt in the money market. Money
market instruments have the characteristics of liquidity (quick conversion into money),
minimum transaction cost and no loss in value. Excess funds are deployed in the money
market, which in turn are availed of to meet temporary shortages of cash and other obligations.
Money market provides access to providers and users of short-term funds to fulfill their
borrowings and investment requirements at an efficient market clearing price. It performs
the crucial role of providing an equilibrating mechanism to even out short-term liquidity and
in the process, facilitating the conduct of monetary policy. Short-term surpluses and deficits
are evened out. The money market is the major mechanism through which the Reserve Bank
influences liquidity and the general level of interest rates. The Bank’s interventions to
influence liquidity serve as a signaling-device for other segments of the financial system.
The money market is a wholesale debt market for low-risk, highly liquid, short term
instruments. Funds are available in this market for periods ranging from a single day up to a
year. Mostly government, banks and financial institutions dominate this market. It is a formal
financial market that deals with short-term fund management. Though there are a few types
of players in money market, the role and the level of participation by each type of player
differs greatly. Government is an active player in the money market and in most economies,
it constitutes the biggest borrower of this market. Both, Government Securities or G-Secs
and Treasury-Bills or T-Bills are securities issued by RBI on behalf of the Government of
6
India to meet the latter’s borrowing for financing fiscal deficit. Apart from functioning as a
merchant banker to the government, the central bank also regulates the money market and
issues guidelines to govern the money market operations.
Another dominant player in the money market is the banking industry. Banks mobilize
deposits and utilize the same for credit accommodation. However, banks are not allowed to
use the entire amount for extending credit. In order to promote certain prudential norms for
healthy banking practices, most of the developed economies require all banks to maintain
minimum liquid and cash reserves. As such, banks are required to ensure that these reserve
requirements are met before directing on their credit plans. If banks fall short of these statutory
reserve requirements, they can raise the same from the money market since it is a short-
term deficit.
Moreover, financial institutions also undertake lending and borrowing of short-term
funds. Due to the large volumes these FIs transact in, they do have a significant impact on the
money market. Corporates also transact in the money market mostly to raise short-term
funds for meeting their working capital requirements.
 Features of Money Market
The money market is a wholesale market. The volumes are very large and generally
transactions are settled on a daily basis. Trading in the money market is conducted over the
telephone, followed by written confirmation from both the borrowers and lenders.
There are a large number of participants in the money market: commercial banks,
mutual funds, investment institutions, financial institutions and finally the Reserve Bank of
India. The bank’s operations ensure that the liquidity and short-term interest rates are
maintained at levels consistent with the objective of maintaining price and exchange rate
stability. The Central bank occupies a strategic position in the money market. The money
market can obtain funds from the central bank either by borrowing or through sale of securities.
The bank influences liquidity and interest rates by open market operations, REPO transactions
changes in Bank Rate, Cash Reserve Requirements and by regulating access to its
accommodation. A well-developed money market contributes to an effective implementation
of the monetary policy. It provides:
1. A balancing mechanism for short-term surpluses and deficiencies.
2. A focal point of central bank intervention for influencing liquidity in the economy and
3. A reasonable access to the users of short-term funds to meet their requirements at
realistic/reasonable price or cost.
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 Money Market Vs. Capital Market
The money market possesses different operational features as compared other
institutional players like mutual funds (MFs), Foreign institutional investors (FIIs) etc. also
transact in money market. However, the level of participation of these players varies largely
depending on the regulations. For instance, the level of participation of the FIIs in the Indian
money market is restricted to investment in government securities only to capital market. It
deals with raising and deployment of funds for short duration while the capital market deals
with long-term funding. The money market provides the institutional source for providing
working capital to the industry, while the capital market offers long-term capital for financing
fixed assets. The money market operates as a wholesale market and has a number of inter-
related sub-markets such as the call market, the bill market, the Treasury bill market, the
commercial paper market, the certificate of deposits market etc. The volume of transaction
in money market is very large and varied and skilled professional operators are required to
ensure successful operations. Due to its flexibility, money market trading is mostly done on
telephone with written confirmation from both borrowers and lenders being sent immediately
thereafter. The transactions are supposed to be on “same day settlement” basis. As stated
earlier, commercial banks, financial intermediaries, large corporates and the Reserve Bank
of India (RBI) are the major constituents of Indian Money Market. RBI as the residual source
of funds in the country plays a key role and holds strategic importance in the money market.
RBI is able to expand or contract the liquidity in the market through different instruments
such as Statutory Liquidity Ratio (SLR), Current Liquidity Ratio(CLR) etc. Thus RBI policy
controls the availability and the cost of credit in the economy.
 Growth of Money Market
The organisation and structure of the money market has undergone a sea change in the
last decade in India. This was accompanied by a growth in quantitative terms also.
1. Call Money Market;
2. Inter Bank Term Deposit/Loan Market;
3. The Participation Certificate Market;
4. Commercial Bills Market;
5. Treasury Bills Market; and
6. Inter-corporate Market
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The market had 3 main deficiencies:
1. It had a very narrow base with RBI, Banks, LIC and UTI as the only participants lending
funds while the borrowers were large in number.
2. There were few money market instruments. The participation certificate became extinct
during 1980s;
3. The interest rates were not market determined but were controlled by either RBI or by
a voluntary agreement between the participants through the Indian Banks Association
(IBA).
To set right these deficiencies the Chakravarthy Committee (1985) and the Vaghul
Committee (1987) offered many useful suggestions and their implementation has widened
and deepened the market considerably by increasing the number of participants and instruments
and introducing market determined rates as compared to the then existing administered interest
rates.
An additional feature was the creation of an active secondary market for money market
instrument to have greater liquidity. For this purpose the Discount and Finance House of
India Limited (DFHI) was formed as an autonomous financial intermediary in April, 1988 to
smoothen the short-term liquidity imbalances and to develop an active secondary market for
the instruments of the money market. The DFHI plays the role of a market maker in money
market instruments. In the relaxation of the regulatory framework and the arrival of the new
instruments and the new players, DFHI occupies a key role in ushering in a more active de-
regulated money market.
9.2 CONSTITUENTS AND FUNCTIONS

1. Constituents of Money Market:
A money market is a mechanism which makes possible for borrowers and lenders to
come together. Essentially it refers to a market of short-term funds. It meets the short-term
requirements of the borrowers and provides liquidity of cash to the lenders. In the words of
Crowther, money market is the name given to the various firms and institutions that deal with
various grade of money.
According to Madden and Nadler, “a money market is a mechanism through which
short-term loans are loaned and borrowed and through which a large part of the financial
transactions of a particular country or of the world are cleared”.
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The importance of the money market for the nation does not solely lie on its size; it
lies rather in its liquidity in its capacity for furnishing cash to any part of the country at a few
hours’ notice. What a bank balance is to the individual, the money market is to the country’s
credit system.
The term “money market” is used at least in three senses to be judged by the context.
In its narrowest and most specific sense it appears as “the London Money Market” when it
signifies the market in short--term, secured loans, most of them “at call” in which the
borrowers are the London Discount Houses and a small number of money brokers and jobbers
and the lenders are principally the commercial banks, though they include other financial
institutions and some companies.
In London the term money even in narrow sense the money market is to be regarded
as embracing the market in bills in which the discount houses are predominant. Secondly, the
term is used to denote any market in highly liquid assets which is supported by an identifiable
and active set of operators.
In London it embraces the group includes the Inter-bank, Inter-company and Local
Authority Markets and the market in Sterling Certificates of deposit. Finally, the term is
occasionally met in the literature of Monetary Theory where it may refer simply to the
market in loanable funds in the most general and undifferentiated sense.
The term “Money Market” does not refer to any specific place where money is lent
or borrowed. Money market is a mechanism through which a large part of the financial
transactions of a particular country or of the world are cleared.
Although money market does not refer to any specific place, it may be located in or
associated with a particular place or geographical locality where short-term funds from an
entire region or country or countries are attracted.
Mumbai Money Market in India, is a typical example. There are also a few money
markets which are international in character e.g. London Money Market, New York Money
Market etc. These serve not only specific areas or countries but several countries in the
world.
A money market is not homogeneous in character. It consists of several sectors or
sub-markets such as call loan markets, bills market or discount market, acceptance market,
collateral loan market etc. That is why, Crowther describes, “a money market as the various
firms and institutions that deal in various grades of near money.
The money market is a wholesale market. The volume of business is very large and
generally transactions are settled on a daily basis. There are a large number of participants in
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the money market commercial banks, mutual funds, investment institutions, financial
institutions and finally the central bank.
The central bank occupies a strategic and pivotal position in the money market. The
money market can obtain funds from the central banks either by borrowing or through sales
of securities.
By varying the liquidity and regulating accession to the accommodation, the central
bank influences the cost and availability of credit. A well-developed money market contributes
to an effective implementation of monetary policy.
The Constituents of the Money Market:
A money market consists of several sectors or sub- markets; each specialising in a
particular type of lending.
The important sectors are:
(a) Call Money Market:
This is a sub-market specialising in call loans which are sometimes referred to as
“loans to call and short notice”. Call money refers to funds borrowed by the discount houses
from the clearing and other banks and which they employ in holding portfolio assets.
A large portion of the funds are borrowed literally “at call” that is they can be withdrawn,
“called” without notice on a day’s basis. Some, however, are lent at seven days’ notice or for
even longer periods. For the clearing banks call money represents their most liquid asset
after cash and balances at the central bank and is used for the adjustment of day-to-day changes
in their total reserves.
In UK such loans are provided by the banks to bill brokers and discount houses. In
USA call money is interest-bearing deposits and foreign banks that can be withdrawn within
24 hours’ notice. Many Euro currency take this form. In India this sector provides facilities
for inter-bank lending.
(b) Acceptance Market:
This sub-market specialises in the acceptance of bills of exchange on behalf of the
customers. Acceptance Houses in the London Money Market provide an example of
institutions specialising in this business.
Commercial banks also accept bills of exchange on behalf of their customers. Although
both inland and foreign bills are accepted, the service rendered by the acceptance market is
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especially important in the case of foreign bills. Once the bill is accepted in this manner, it is
easier for the same to be discounted.
(c) Bill Market (Discount Market):
This is another sub-market specialising in the discounting of short-term commercial
bills and treasury bills. In the London Money Market, the Discount Houses specialise in this
field. English commercial banks do not undertake the discounting of commercial bills; instead
they get these bills from the discount houses according to their needs.
With the decline in the volume of commercial bills, the Discount Houses turned their
attention to the Treasury Bills and short- dated government securities also. In other countries
the discounting of commercial bills is considered to be a subsidiary function of the
commercial banks. In India, the establishment of Discount and Finance House of India Ltd.
in 1988 has been an important step towards the development of an active discount market.
The discount market provides valuable services to the commercial banks by imparting
greater flexibility to them in their funds management, to the trading community by facilitating
the financing of home and foreign trade and to the government by creating a market in Treasury
Bills and short-dated government securities.
(d) Collateral Loan Market:
This sector specialises in the granting of short-term loans against collateral securities.
Such loans are usually granted by the commercial banks to stock exchange dealers and brokers.
Business houses also avail of short-term loans; against the security of goods, documents of
title to goods, stock exchange securities, bullion etc.
2. Functions of Money Market:
Money markets serve five functions—to finance trade, finance industry, invest
profitably, enhance commercial banks’ self-sufficiency, and lubricate central bank policies.
1. Financing trade:
The money market plays crucial role in financing domestic and international trade.
Commercial finance is made available to the traders through bills of exchange, which are
discounted by the bill market. The acceptance houses and discount markets help in financing
foreign trade.
2. Financing industry:
The money market contributes to the growth of industries in two ways:
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 They help industries secure short-term loans to meet their working capital requirements
through the system of finance bills, commercial papers, etc.
 Industries generally need long-term loans, which are provided in the capital market.
However, the capital market depends upon the nature of and the conditions in the money
market. The short-term interest rates of the money market influence the long-term
interest rates of the capital market. Thus, money market indirectly helps the industries
through its link with and influence on long-term capital market.
3. Profitable investment:
The Money Market enables the commercial banks to use their excess reserves in
profitable investment. The main objective of the commercial banks is to earn income from
its reserves as well as maintain liquidity to meet the uncertain cash demand of the depositors.
In the money market, the excess reserves of the commercial banks are invested in assets
(e.g., short-term bills of exchange) which are highly liquid and can be easily converted into
cash. Thus, the commercial banks earn profits without sacrificing liquidity.
4. Self-sufficiency of commercial bank:
Developed money markets help the commercial banks to become self-sufficient. In
the situation of emergency, when the commercial banks have scarcity of funds, they need not
approach the central bank and borrow at a higher interest rate. On the other hand, they can
meet their requirements by recalling their old short-run loans from the money market.
5. Help to central bank:
Though the central bank can function and influence the banking system in the absence
of a money market, the existence of a developed money market smoothens the functioning
and increases the efficiency of the central bank.
Money markets help central banks in two ways:
 Short-run interest rates serve as an indicator of the monetary and banking conditions
in the country and, in this way, guide the central bank to adopt an appropriate banking
policy,
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 Sensitive and integrated money markets help the central bank secure quick and
widespread influence on the sub-markets, thus facilitating effective policy
implementation.
9.3 GOVERNMENT SECURITY MARKET

A Government security is a tradable security issued by the Central Government or the
State Governments, acknowledging the Government’s debt obligation. Such securities can
be short term (usually called Treasury Bills, with original maturities of less than 1 year) or
long term (usually called Government bonds or dated securities with original maturity of
one year or more). In India, the 7 Central Government issues both Treasury Bills and bonds
or dated securities while the State Governments issue only bonds or dated securities, which
are called the State Development Loans (SDLs). Government securities carry practically no
risk of default and, hence, are called risk-free instruments. Government of India also issue
savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special
securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not
fully tradable and are not eligible for meeting the SLR requirement.
a. Treasury Bills (T-Bills):
Treasury Bills, which are money market instruments, are short term debt instruments
issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182
day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are
issued at a discount and redeemed at the face value at maturity. For example, a 91 day Treasury
Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and
redeemed at the face value of Rs.100/-. The return to the investors is, therefore, the difference
between the maturity value or face value (i.e., Rs.100) and the issue price (please see answer
to Question No. 21 on calculation of yield on Treasury Bills). Treasury Bills are issued
through auctions conducted by the Reserve Bank of India usually every Wednesday and
payments for the Treasury Bills purchased have to be made on the following Friday. The
Treasury Bills of 182 days and 364 days’ tenure are issued on alternate Wednesdays, that is,
Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday
while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting
Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is
Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at
Rs.1000 crore. Government, at its discretion, can also decide to issue additional amounts of
the Treasury Bills by giving prior notice. An annual calendar of T-Bill issuances for the
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following financial year is released by the Reserve Bank 8 of India in the last week of March.
The Reserve Bank of India also announces the issue details of Treasury bills by way of press
release every week.
b. Dated Government Securities:
Dated Government securities are longer term securities and carry a fixed or floating
coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-
yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO)
of the RBI acts as the registry / depository of Government securities and deals with the
issue, interest payment and repayment of principal at maturity. Most of the dated securities
are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government
security has the following features - coupon, name of the issuer, maturity and face value. For
example, 7.49% GOI 2017 would have the following features. Date of Issue : April 16, 2007
Date of Maturity : April 16, 2017 Coupon : 7.49% paid on face value Coupon Payment Dates
: Half-yearly (October16 and April 16) every year Minimum Amount of issue/ sale : Rs.10,000.
The details of all the dated securities issued by the Government of India are made
available on the RBI website at http://rbi.org.in/ Scripts/ financialmarketswatch.aspx. Just as
in the case of Treasury Bills, dated securities of both Government of India and State
Governments are issued by RBI through auctions which are announced by the RBI a week in
advance through Press Releases and paid advertisements in major dailies (for dated securities).
The investors are thus given adequate time to plan for the purchase of government securities
through such auctions. A specimen of a dated security in physical form is given at Annex 1.
Dated securities may be of the following types:
i) Fixed Rate Bonds: These are bonds on which the coupon rate is fixed for the
entire life of the bond. Most Government bonds are issued as fixed rate bonds. For example
– 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing on April 22,
2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly payment being
the half of the annual coupon 8.24%) of the face value on October 22 and April 22 of each
year.
ii) Floating Rate Bonds: Floating Rate bonds are securities which do not have a
fixed coupon rate and the coupon is re-set at pre-announced intervals based on a specified
methodology. The coupon is re-set at predetermined intervals (say, every six months or one
year) by adding a spread over a base rate. In the case of most floating rate bonds issued by the
Government of India, the base rate is the weighted average cutoff yields of the last three 364
day Treasury Bill auction preceding the coupon re-set date. Floating Rate Bonds were first
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issued in September 1995 in India. For example, a Floating Rate Bond was issued on July 2,
2002 for a tenor of 15 years, maturing on July 2, 2017. The base rate on the bond for the
coupon payments was fixed at 6.50% being the weighted average rate of implicit yield on
364 day Treasury Bills during the preceding six auctions. Further, in the bond auction, a cut-
off spread (markup over the benchmark rate) of 34 basis points (0.34%) was decided. Hence
the coupon for the first six months was fixed at 6.84%. At the next reset date after six months,
assuming that the average cutoff yield in the preceding six auctions of 364 day Treasury Bill
is 6.60%, coupon applicable for the next half year would be 6.94%.
iii) Zero Coupon Bonds: Zero coupon bonds are bonds with no coupon payments.
Like Treasury Bills, they are issued at a discount to face value. Such securities were issued
by the Government of India in the 1990s, but no issue was made thereafter.
iv) Capital Indexed Bonds: These are bonds, the principal of which is linked to an
accepted index of inflation with a view to protecting the holder from inflation. A capital
indexed bond, with the principal hedged against inflation, was issued in December 1997.
These bonds matured in 2002. Steps are now being taken to revive the issuance of the Inflation
Indexed Bonds wherein payment of both the coupon and principal payments on the bonds
will be linked to an Inflation Index (Wholesale Price Index).
v) Bonds with Call/ Put Options: Bonds can also be issued with features of
optionality wherein the issuer can have the option to buyback (call option) or the investor
can have the option to sell the bond (put option) to the issuer during the currency of the bond.
A bond (viz., 6.72%GS2012) with call / put option was issued in India in the year 2002 which
will mature in 2012. 6.72%GS2012 was issued on July 18, 2002 for a maturity of 10 years
maturing on July 18, 2012. The optionality on the bond could be exercised after completion
of five years tenure from the date of issuance on any coupon date falling thereafter. The
Government has the right to buyback the bond (call option) at par value (equal to the face
value) while the investor has the right to sell the bond (put option) to the Government at par
value at the time of any of the half-yearly coupon dates starting from July 18, 2007.
vi) Special Securities: In addition to Treasury Bills and dated securities issued by
the Government of India under the market borrowing programme, the Government of India
also issues, from time to time, special securities to entities like Oil Marketing Companies,
Fertilizer Companies, the Food Corporation of India, etc. as compensation to these companies
in lieu of cash subsidies. These securities are usually long dated securities carrying coupon
with a spread of about 20-25 basis points over the yield of the dated securities of comparable
maturity. These securities are, however, not eligible SLR securities but are approved securities
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and are eligible as collateral for market repo transactions. The beneficiary oil marketing
companies may divest these 11 securities in the secondary market to banks, insurance
companies / Primary Dealers, etc., for raising cash.
vii) Steps are being taken to introduce new types of instruments like STRIPS
(Separate Trading of Registered Interest and Principal of Securities). STRIPS are instruments
wherein each cash flow of the fixed coupon security is converted into a separate tradable
Zero Coupon Bond and traded. For example, when Rs.100 of the 8.24%GS2018 is stripped,
each cash flow of coupon (Rs.4.12 each half year) will become coupon STRIP and the principal
payment (Rs.100 at maturity) will become a principal STRIP. These cash flows are traded
separately as independent securities in the secondary market.
C. State Development Loans (SDLs)
State Governments also raise loans from the market. SDLs are dated securities issued
through an auction similar to the auctions conducted for dated securities issued by the Central
Government (see question 3 below). Interest is serviced at half-yearly intervals and the
principal is repaid on the maturity date. Like dated securities issued by the Central
Government, SDLs issued by the State Governments qualify for SLR. They are also eligible
as collaterals for borrowing through market repo as well as borrowing by eligible entities
from the RBI under the Liquidity Adjustment Facility (LAF).
c. How are the Government Securities issued?
Government securities are issued through auctions conducted by the RBI. Auctions
are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing
System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers
(a list of Primary Dealers with their contact details is given in Annex 2), insurance companies
and provident funds, who maintain funds account (current account) and securities accounts
(SGL account) with RBI, are members of this electronic platform. All members of PDO-
NDS can place their bids in the auction through this electronic platform. All non-NDS 12
members including non-scheduled urban co-operative banks can participate in the primary
auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban
co-operative banks need to open a securities account with a bank / Primary Dealer – such an
account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a
scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled
urban co-operative bank).
The RBI, in consultation with the Government of India, issues an indicative half-yearly
auction calendar which contains information about the amount of borrowing, the tenor of
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security and the likely period during which auctions will be held. A Notification and a Press
Communique giving exact particulars of the securities, viz., name, amount, and type of issue
and procedure of auction are issued by the Government of India about a week prior to the
actual date of auction. RBI places the notification and a Press Release on its website
(www.rbi.org.in) and also issues an advertisement in leading English and Hindi newspapers.
Information about auctions is also available with the select branches of public and private
sector banks and the Primary Dealers.
9.4 NOTES
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19
9.5 SUMMARY
Money market is a very important segment of the Indian financialsystem. It is the
market for dealing in monetary assets of short-term nature. There are a large number of
participants in the money market: commercial banks, mutual funds, investment institutions,
financial institutions and the Regulatory Authority. The money market possesses different
operational features as compared to capital market. It deals with raising and deployment of
funds for short duration while the capital market deals with long-term funding.
The money market operates as a wholesale market and has a number of inter- related
sub-markets such as the call market, the bill market, the Treasury bill market, the commercial
paper market, the certificate of deposits market etc. Money market instruments mainly include
Government securities, securities issued by banking sector and securities issued by private
sector. All funds raised by the government from the money market are through the issue of
securities by the RBI.
9.6 KEY WORDS

Money market, Short-term funds, financial institutions, Treasury-Bills or T-Bills, short-
term funds, working capital requirements, participants in the money market, REPO
transactions, Bank Rate, Cash Reserve Requirements, Statutory Liquidity Ratio, Current
Liquidity Ratio, Chakravarthy Committee, Vaghul Committee.

1. What is money market?
2. What steps have been taken to develop the Indian money market?
3. What is CRR?
4. Write short notes on:
a. Certificate of Deposits
b. Commercial Paper and Treasury bills.
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9.8 REFERENCES
3. Bharati V. Pathak. The Indian Financial System : Markets, Institutions and Services,
Noida: Pearson Education, 2007.
21
UNIT - 10 : MONEY MARKET INSTRUMENTS
Structure:
10.0 Objectives
10.1 Introduction
10.2 Money Market Instruments
10.3 Regulations of the Money Market in India.
10.4 Participants in Money Market.
10.5 Notes
10.6 Summary
10.7 Key Words
10.9 References
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10.0 OBJECTIVES
After studying this lesson, you will be able to;
• State the nature and importance of money market;
• Money Market Instruments;
• Regulations of the Money Market in India.
• Participants in Money Market
• State the advantages of money market from the points of view of companies, investors
and society as a whole;
10.1 INTRODUCTION
The Money Market is a market for short term funds with maturity ranging from
overnight to one year and includes instruments that are deemed to be close substitutes of
money. The Money Market is a key component of the financial system as it is the fulcrum of
the monetary operations conducted by the RBI in its pursuit of monetary policy objectives.
As the Central Bank, RBI regulates the Money Market in India and injects liquidity in the
banking system. Important institutions operating in the money market are central banks,
commercial banks, acceptance house, non-banking financial institutions, bill brokers etc.
The objective of this lesson is to provide the students with basic understanding of Money
Market, its distinct features, various instruments available in the Money Market, .difference
between Money Market and Capital Market, instruments used in financing import and export
etc.,
10.2 MONEY MARKET INSTRUMENTS

Money market instruments are generally characterized by a high degree of safety of
principal and are most commonly issued in units of $1 million or more. Maturities range
from one day to one year; the most common are three months or less. Active secondary
markets for most of the instruments allow them to be sold prior to maturity. Unlike organized
securities or commodities exchanges, the money market has no specific location. Available
from financial institutions, money markets give the smaller investor the opportunity to get
in on treasury securities. The institution buys a variety of treasury securities with the money
you invest. The rate of return changes daily, and services such as check writing may be offered.
The major participants in the money market are commercial banks, governments,
corporations, government-sponsored enterprises, money market mutual funds; futures market
exchanges, brokers and dealers. Some of the money market instruments are:
23
1. Treasury Bills
These are issued by the Reserve Bank usually a period of 91 days. The Reserve Bank
uses these bills to take money out of the market. This will reduce a bank’s ability to lend to
its clients leading to a contraction of the money supply. The bill consists of an obligation to
pay the bearer the face value of the bill upon a given date. A bank buying such a bill will not
pay face value for it but would instead buy it at a discount. The bill is tradable so the purchaser
does not have to hold it until the due date. If interest rates decrease during the term of the
bill, the holder can sell the bill at a profit before the due date.
Advantages of investing in Treasury Bills:
 No Tax Deducted at Source (TDS)
 Zero default risk as these are the liabilities of GOI
 Liquid money Market Instrument
 Active secondary market thereby enabling holder to meet immediate fund
requirement.
1. Bankers’ Acceptance
Although BA’s, as they are known, have their origin in trade bills issued by merchants,
today they are an important money market instrument. A banker’s acceptance is simply a bill
of exchange drawn by a person and accepted by a bank. The person drawing the bill must have
a good credit rating otherwise the BA will not be tradable. The drawer promises to make
payment of the face value upon a given future date. The most common term for these
instruments is 90 days. They can vary from 30 days to180 days. The BA has the advantage of
locking the borrower in to a fixed rate over the term of the bill. This can be important if a rise
in short-term rates is expected.
2. Negotiable Certificates of Deposit (NCD)
NCD’s are like fixed deposits except them are bearer documents. They offer a market
related rate of interest and are completely liquid because they can be negotiated during the
term of the deposit. Most NCD’s have a term of less than one year. They usually offer a rate
of return slightly higher than banker’s acceptances which makes them extremely popular
instruments.
3. Money Market at Call and Short Notice
Next in liquidity after cash, money at call is a loan that is repayable on demand, and
money at short notice is repayable within 14 days of serving a notice. The participants are
banks & all other Indian Financial Institutions as permitted by RBI.
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The market is over the telephone market, non-bank participants act as lender only.
Banks borrow for a variety of reasons to maintain their CRR, to meet their heavy payments,
to adjust their maturity mismatch etc.
4. Repo/ Reverse Repo
A repo agreement is the sale of a security with a commitment to repurchase the same
security as a specified price and on specified date while a reverse repo is purchase of security
with a commitment to sell at predetermined price and date. A repo transaction for party
would mean reverse repo for the second party. In lieu of the loan, the borrower pays a contracted
rate to the lender, which is called the repo rate. As against the call money market where the
lending is totally unsecured, the lending in the repo is backed by a simultaneous transfer of
securities. The main players in this market are all institutional players like banks, primary
dealers like PNB Gilts Limited, financial institutions, mutual funds, insurance companies
etc. allowed to operate a SGL with the Reserve Bank of India. Further RBI also operates daily
repo/ reverse repo auctions to provide a benchmark rates in the markets as well as managing
in the liquidity in the system. RBI sucks or injects liquidity in the banking system by daily
repo/ reverse operations.
5. Commercial Bills
Commercial bill is a short term, negotiable, and self-liquidating instrument with low
risk. It enhances the liability to make payment within a fixed date when goods are bought on
credit. Bills of exchange are negotiable instruments drawn by the seller (drawer) on the
buyer (drawer) or the value of the goods delivered to him. Such bills are called trade bills.
When trade bills are accepted by commercial banks, they are called commercial bills. The
bank discount this bill by keeping a certain margin and credits the proceeds. Banks can also
get such bills rediscounted by financial institutions such as LIC, UTI, GIC, ICICI and IRBI.
The maturity period of the bills varies from 30 days, 60 days or 90 days, depending on the
credit extended in the industry.
Commercial bill is an important tool finance credit sales. It may be a demand bill or
a nuisance bill; clean bills or documentary bills. Inland bills or foreign bills.
6. Commercial Paper
Commercial Paper is a money-market security issued (sold) by large banks and
corporations to get money to meet short term debt obligations , and is only backed by an
issuing bank or corporation’s promise to pay the face amount on the maturity date specified
on the note. Since it is not backed by collateral, only firms with excellent credit ratings from
25
a recognized rating agency will be able to sell their commercial paper at a reasonable price.
Commercial paper is usually sold at a discount from face value, and carries shorter repayment
dates than bonds. The longer the maturity on a note, the higher the interest rate the issuing
institution must pay. Interest rates fluctuate with market conditions, but are typically lower
than banks’ rates. Corporate Borrowers, especially the large and financially sound, can diversify
their short term borrowing by the issue of Commercial Paper. Commercial Paper is especially
attractive for companies with cyclical cash flows and for cash rich companies during periods
of greater cash inflows than overdraft or cash credit since monitoring is more convenient.
Maturity: 7days -1 year Preconditions for issue of Commercial paper:
• Tangible net worth (paid-up capital plus free reserves) is not less than Rs 4 crores has
been sanctioned working capital limit by banks or FIs
• Borrowable account of the company is classified as a Standard Asset by Banks/FIs
• Specified Credit Rating of P2 is obtained from CRISIL, A2 from ICRA and PR2 from
CARE Commercial Paper is issued in denominations of Rs. 5 lakhs. But the minimum
lot or investment is Rs 25 lakhs (face value) per investor.
The secondary market transactions can be for Rs. 5 lakhs or multiples thereof.
Commercial Paper may be issued to any person, bank, company or other registered (in India)
corporate body and incorporated body. Issue to NRI can only be on non-repatriable basis and
is not transferable. The paper issued to NRI should state that it is non-repatriable and non-
endorsable.
Procedure for Issue:
Commercial Paper is issued only through the bankers who have sanctioned working
capital limits to the company. It is counted as a part of working capital. Unlike public deposit,
commercial paper really cannot augment working capital resources. There is no increase in
the overall short term borrowing facilities.
Every company proposing to issue commercial paper should submit the proposal in
the form prescribed by the RBI to the bank which provides working capital along with the
credit rating of the company. The bank scrutinizes the application and on being satisfied that
eligibility criteria are met and conditions stipulated are met will has to be privately place the
issue within two weeks by the company or through the good offices of a merchant banker.
The initial investor pays the discounted value of the paper to the account of the issuing company
with the bank in writing. The working capital limit is correspondingly reduced by the bank.
The company must advise RBI, through the bank, of the amount of commercial paper issued
within three days.
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7. Certificates of Deposit (CD’s)
Money in a CD is tied up from a few months to six years or more depending on the
terms of the specific CD you buy. A notice of withdrawal is required and a penalty imposed if
you withdraw money before the CD matures. Interest earned is higher than paid on insured
savings accounts. The longer you tie up money in a CD, the higher the interest rate earned.
Interest is paid either at time of purchase or at maturity, depending on the policy of
the financial institution. In most cases, the more money you invest, the higher the rate of
interest earned. All earnings are subject to income tax. CD’s are available from banks, savings
and loans and credit unions. No purchase fees are charged.
8. Gilt Edged Government Securities
These are issued by governments such as Central Government, State Government,
Semi Government authorities, City Corporations, Municipalities, Port trust, State Electricity
Board,
Housing boards etc. The gilt-edged market refers to the market for Government and
semi-government securities, backed by the Reserve Bank of India(RBI). Government
securities are tradable debt instruments issued by the Government for meeting its financial
requirements. The term gilt-edged means ‘of the best quality’. This is because the Government
securities do not suffer from risk of default and are highly liquid (as they can be easily sold
in the market at their current price). The open market operations of the RBI are also conducted
in such securities.
9. Money Market Mutual Funds (MMMFs)
A money market fund is a mutual fund that invests solely in money market instruments.
Money market instruments are forms of debt that mature in less than one year and are very
liquid. Treasury bills make up the bulk of the money market instruments. Securities in the
money market are relatively risk-free. Money market funds are generally the safest and most
secure of mutual fund investments. The goal of a money-market fund is to preserve principal
while yielding a modest return by investing in safe and stable instruments issued by
governments, banks and corporations etc.
10. Tax-Exempt Bonds
Often referred to as municipal bonds, tax-exempt bonds represent state and local
government debt. A City, town, or a village and also states, territories, and housing authorities,
port authorities, and local government agencies may issue these bonds. Interest earned is
exempt from income taxes and from state and local income taxes if bonds issued are from
27
your state or city. Interest rates are determined by the general level of interest rates and by
the credit rating of the issuer. The seller of these bonds has tables showing you what the tax-
exempt yields of these bonds are equivalent to in taxable yield for your tax bracket. As little
as $1,000 may be invested in these bonds, available from a broker or a financial institution.
Type 3 investments include corporate bonds and corporate stocks. Higher investment
risk and lower purchasing power risk are represented by these investment alternatives.
10.3 REGULATIONS OF THE MONEY MARKET IN INDIA

Reserve Bank of India is the biggest regulator of the Indian markets. It controls the
monetary policy of India. Its control is however limited to the organised part of economy
and the unorganised sector which has a significant presence is largely unregulated. RBI
frequently introduces many reforms to bolster the Indian economy which is in a state of
constant flux and is continuously evolving. The major money market reforms came after the
recommendations of S. Chakravarty Committee and Narsimham Committee. These were
major changes which helped unfold the banking potential of India and shape our financial
institutions to world class standards. It was soundness of these reforms which helped our
economy to easily tide over the economic crisis which had gripped the world in 2008. These
are discussed below:
1. Deregulation of Interest Rates
2. Reforms in Call and Term money market
3. Introduction of new money market instruments
4. Setting up Discount and Finance House of India
5. Introducing Liquidity Adjustment Facility
6. Refinance by RBI
7. Regulation of Non-Banking Financial Companies
8. Debt Recovery
1. Deregulation of Interest Rates
Interest rates are now subject to market conditions as the ceiling limit on them have
been removed by RBI after 1989.The important interest rates in India are-Bank rate, Medium-
term lending rate, Prime Lending rate, Bank Deposit rate, Call rate, Certificate of Deposit
rate, Commercial paper rate etc. This deregulation got a major push after the economic
liberalisation of 1991. Chakravarty Committee was a strong proponent of free and flexible
interest rates to promote savings, investments, government financial system and stability.
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RBI removed the upper ceiling of 16.5% and instead fixed a minimum of 16% per annum.
The rates were further relaxed after the Narasimhan Committee report in 1991.
2. Reforms in Call and Term money market
The reforms in call and term money market were done to infuse more liquidity into
the system and enable price discovery. RBI undertook several important steps to check the
constraints and remove them systematically. It was in October 1998, RBI announced that
non-banking financial institutions should not participate in call/term money market operations
and it should purely be an interbank operating segment and encouraged other participants to
migrate to collateralised segments to improve stability. Also, reporting of all call/notice
money market transactions through negotiated dealing system within 15 minutes of
conclusion of transaction was made mandatory. The volume of operations in this segment
was not increased much even after the reforms.
3. Introduction of new money market instruments
RBI introduced many new market instruments to diversify the market. These were
certificates of deposit in 1989, commercial papers in 1990 and interbank participation
certificates with/without risk in 1988.
4. Setting up Discount and Finance House of India
Discount and Finance House of India was set up in 1988 to impart more liquidity and
also further develop the secondary market instruments. However, maturities of existing
instruments like CDs and CPs were gradually shortened to encourage wider participation.
Likewise ad hoc treasury bills were abolished in 1997 to stop automatic monetisation of
fiscal deficit.
5. Introducing Liquidity Adjustment Facility
RBI introduced a Liquidity Adjustment Facility in June 2000 which was operated
through fixed repo and reverse repo rates. This helped establishment of interest rate as an
important monetary instrument and granted greater flexibility to RBI to respond to market
needs and suitably adjust liquidity in the market. Repo and Reverse Repo rates were introduced
in 1992 and 1996 respectively.
6. Refinance by RBI
This is a potent tool by RBI to meet the any liquidity shortages and for credit control
to select sectors. The export credit refinance facility to banks is provided under Section
17(3) of RBI Act 1934. It is available to all scheduled commercial banks who are authorised
to deal in foreign exchange and have extended export credit. The SCBs are prvided export
29
credit to the tune of 50% of the outstanding export credit. The concept of directed credit
was also changed as the Narasimhan Committee recommended reduction of directed credit
from 40 to 10%. It also suggested narrowing of priority sector and realigning focus to small
farmers and low income target groups. The refinance rate is linked to bank rate.
7. Regulation of Non-Banking Financial Companies
RBI Act was amended in 1997 to bring the NBFCs under its regulatory framework. A
NBFC is a company registered under Companies Act, 1956 and is involved in making loans
and advances, acquisition of shares, stocks, bonds, securities issued by government etc.
They are similar to banks but are different from the latter as they cannot accept demand
deposits and cannot issue cheques. They have to be registered with RBI to operate within
India. There are a host of regulations which NBFCs have to follow to smoothly operate
within India like accept deposit for a minimum period, cannot accept interest rate beyond the
prescribed rate given by RBI.
8. Debt Recovery
RBI has set up special Recovery Tribunals which provide legal assistance to banks
for recovery of dues.
10.4 PARTICIPANTS IN MONEY MARKET

The following are the players in the Indian money market:
1. Govt.
2. RBI
3. Commercial banks
4. Financial institutions like IFCI, IDBI, ICICI, SIDBI, UTI, LIC etc.
5. Discount and Finance House of India.
6. Brokers
7. Mutual funds
8. Public sector undertakings
9. Corporate units
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10.5 NOTES
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10.6 SUMMARY
To sum up, the money market is a key component of the financial system as it is the
fulcrum of monetary operations conducted by the central bank in its pursuit of monetary
policy objectives. It is a market for short-term funds with maturity ranging from overnight to
one year and includes financial instruments that are deemed to be close substitutes of money.
The money market performs three broad functions. Firstly, it provides an equilibrating
mechanism for demand and supply of short-term funds. Secondly, it enables borrowers and
lenders of short-term funds to fulfil their borrowing and investment requirements at an
efficient market clearing price. Three, it provides an avenue for central bank intervention in
influencing both quantum and cost of liquidity in the financial system, thereby transmitting
monetary policy impulses to the real economy. The objective of monetary management by
the central bank is to align money market rates with the key policy rate. As excessive money
market volatility could deliver confusing signals about the stance of monetary policy, it is
critical to ensure orderly market behavior, from the point of view of both monetary and
financial stability. Thus, efficient functioning of the money market is important for the
effectiveness of monetary policy.
10.7 KEY WORDS

Money Market, Treasury Bills, Bankers’ Acceptance, Negotiable Certificates Of Deposit,
Money Market, Call and Short Notice, Repo/ Reverse Repo, Commercial Bills, Commercial
Paper, Certificates Of Deposit, Gilt Edged Government Securities, Money Market Mutual
Funds, Tax-Exempt Bonds, Reserve Bank of India, Deregulation of Interest Rates, Non-
Banking Financial Companies, Debt Recovery, Commercial Banks, Brokers, Public Sector
Undertakings, Corporate Units.

1. Briefly discuss about Call money and Notice Money Market.
2. Explain Treasury Bills as an effective Cash Management product and state how yield
of Treasury Bill is calculated.
3. What is Banker’s Acceptance? Discuss.
4. Explain briefly about Money Market Mutual funds.
5. How credit transaction takes place in a Letter of Credit? Explain with step wise
description.
33
10.9 REFERENCES
34
UNIT- 11 : RECENT DEVELOPMENTS IN MONEY MARKET
Structure:
11.0. Objectives
11.1 Introduction
11.2 Recent Developments in Money Market
11.3 MIBOR
11.4 Chit Funds and their regulations
11.5 Notes
11.6 Summary
11.7 Key Words
11.9 References
35
11.0 OBJECTIVES
After studying this unit, you should be able to;
• Define the recent development in Money Market
• State the chit bund and that regulations
11.1 INTRODUCTION
Banks and primary dealers in government securities may soon have more flexibility
in borrowing and lending in the call money market. The Reserve Bank of India said that banks
may be allowed to borrow and lend in the interbank call money market based on their assets
and liability match rather than prudential limits.
In the call money market, banks can currently borrow not beyond 100 % of their
capital funds on a fortnightly average basis and on daily basis it cannot exceed 125 %they can
lend up to 25 % of their capital fund on a fortnightly average basis and 50 % on daily basis.
With the rising credit demand, the RBI will also review the Inter-bank participation certificates
scheme to improve assets liability management and liquidity management. The debt market
would require more investor if the statutory liquidity ratio of banks is cut, the RBI said. With
respect to SLR, the central bank said,” The investor base needs to be widened in the views of
possibilities of reduction in the captive investor base resulting from the scaling down of the
SLR from the present level”.
11.2 RECENT DEVELOPMENTS IN MONEY MARKET

Indian Government appointed a committee under the chairmanship of Sukhamoy
Chakravarty in 1984 to review the Indian monetary system. Later, Narayanan Vaghul working
group and Narasimham Committee was also set up. As per the recommendations of these
study groups and with the financial sector reforms initiated in the early 1990s, the government
has adopted following major reforms in the Indian money market.
Reforms made in the Indian Money Market are:-
1. Deregulation of the Interest Rate :
In recent period the government has adopted an interest rate policy of liberal nature.
It lifted the ceiling rates of the call money market, short-term deposits, bills re-discounting,
etc. Commercial banks are advised to see the interest rate change that takes place within the
limit. There was a further deregulation of interest rates during the economic reforms.
Currently interest rates are determined by the working of market forces except for a few
regulations.
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2. Money Market Mutual Fund (MMMFs):
In order to provide additional short-term investment revenue, the RBI encouraged
and established the Money Market Mutual Funds (MMMFs) in April 1992. MMMFs are
allowed to sell units to corporate and individuals. The upper limit of 50 crore investments
has also been lifted. Financial institutions such as the IDBI and the UTI have set up such
funds.
3. Establishment of the DFI :
The Discount and Finance House of India (DFHI) was set up in April 1988 to impart
liquidity in the money market. It was set up jointly by the RBI, Public sector Banks and
Financial Institutions. DFHI has played an important role in stabilizing the Indian money
market.
4. Liquidity Adjustment Facility (LAF):
Through the LAF, the RBI remains in the money market on a continue basis through
the repo transaction. LAF adjusts liquidity in the market through absorption and or injection
of financial resources.
5. Electronic Transactions:
In order to impart transparency and efficiency in the money market transaction the
electronic dealing system has been started. It covers all deals in the money market. Similarly
it is useful for the RBI to watchdog the money market.
6. Establishment of the CCIL:
The Clearing Corporation of India limited (CCIL) was set up in April 2001. The CCIL
clears all transactions in government securities, and repose reported on the Negotiated Dealing
System.
7. Development of New Market Instruments:
The government has consistently tried to introduce new short-term investment
instruments. Examples: Treasury Bills of various duration, Commercial papers, Certificates
of Deposits, MMMFs, etc. have been introduced in the Indian Money Market.
These are major reforms undertaken in the money market in India. Apart from these,
the stamp duty reforms, floating rate bonds, etc. are some other prominent reforms in the
money market in India. Thus, at the end we can conclude that the Indian money market is
developing at a good speed.
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11.3 MIBOR
Mumbai Inter-Bank Offer Rate (MIBOR) and Mumbai Inter-Bank Bid Rate (MIBID)
are the benchmark rates at which Indian banks lend and borrow money to each other. The bid is
the price at which the market would buy and the offer (or ask) is the price at which the market
would sell. These rates reflect the short term funding costs of major banks. In other words,
MIBOR reflects the price at which short term funds are made available to participating banks.
MIBID is the rate at which banks would like to borrow from other banks and MIBOR
is the rate at which banks are willing to lend to other banks. Contrary to general perception,
MIBID is not the rate at which banks attract deposits from other banks.
MIBOR is the Indian version of London Interbank Offer Rate (LIBOR). MIBOR is
fixed for overnight to 3 month long funds and these rates are published every day at a
designated time. Of the above tenors, the overnight MIBOR is the most widely used one
which is used for pricing and settlement of Overnight Index Swaps (OIS). Corporates use the
OIS for hedging their interest rate risks[1]. The MIBID/MIBOR rate is also used as a bench
mark rate for majority of deals struck for Interest Rate Swaps (IRS), Forward Rate
Agreements (FRA), Floating Rate Debentures and Term Deposits. The aggregate amount of
outstanding interbank/Primary Dealers (PD) notional principal referenced to MIBOR
remained at INR 16,847.6 billion as on October 31, 2013[2].
Financial Benchmarks
MIBOR, MIBID etc. are all financial benchmarks. Financial benchmarks are mainly
used for pricing, settlement, and valuation of financial contracts. The IOSCO’s Report on
Principles for Financial Benchmarks describes financial benchmarks as:
“Prices, estimates, rates, indices or values that are:
 Made available to users, whether free of charge or for payment;
 Calculated periodically, entirely or partially by the application of a formula or
another method of calculation to, or an assessment of the value of one or more
underlying Interests;
 Used for reference for purposes that includes one or more of the following:
 Determining the interest payable, or other sums due, under loan agreements or
under other financial contracts or instruments;
 Determining the price at which a financial instrument may be bought or sold or
traded or redeemed, or the value of a financial instrument; and/or
 Measuring the performance of a financial instrument.”
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MIBOR is the interest rate at which banks can borrow funds, in marketable size, from
other banks in the Indian interbank market. MIBOR is calculated everyday by the National
Stock Exchange of India (NSEIL) as a weighted average of lending rates of a group of banks,
on funds lent to first-class borrowers. The MIBOR was launched on June 15, 1998 by the
Committee for the Development of the Debt Market, as an overnight rate.
The NSEIL launched the 14-day MIBOR on November 10, 1998, and the one month
and three month MIBORs on December 1, 1998. Further, the exchange introduced a 3 Day
FIMMDA-NSE MIBID-MIBOR on all Fridays with effect from June 6, 2008 in addition to
existing overnight rate. Thus, we can say that MIBOR is is arrived now a days by FIMMDA
and NSE, based on inputs from PS Banks, Private Sector Banks, Primary Dealers and Foreign
Banks.
Evolution of MIBOR- How MIBOR is fixed?
An Internal Committee at NSE for the Development of the Debt Market had studied
and recommended the modalities for the development for a benchmark rate for the call money
market. Accordingly,National Stock Exchange (NSE) developed and launched the NSE
Mumbai Inter-bank Bid Rate (MIBID) and NSE Mumbai Inter-bank Offer Rate (MIBOR) for
the overnight call money market on June 15, 1998. The success of the Overnight NSE MIBID-
MIBOR encouraged the Exchange to develop a benchmark rate for the term money market.
Thus, NSE launched the 14-day NSE MIBID- MIBOR on November 10, 1998 and the longer
term money market benchmark rates for 1 month and 3 months on December 1, 1998. Fixed
Income Money Market and Derivative Association of India (FIMMDA) became a partner to
NSE in co-branding the dissemination of MIBID-MIBOR rates for the overnight and term
segments on March 4, 2002 and the product thereafter was rechristened as FIMMDA-NSE
MIBID/MIBOR. Later, NSE introduced a 3 Day FIMMDA-NSE MIBID-MIBOR on all Fridays
with effect from June 6, 2008 in addition to existing overnight rate.
FIMMDA-NSE MIBID MIBOR was based on rates polled by NSE from a
representative panel of 30 banks/ primary dealers. That is, participating banks are asked at
what rate they would be borrowing/lending funds of a reasonable market size at the scheduled
time of reference. Extreme values are avoided while calculating the reference rates and the
mean or average benchmark rate is calculated with “Bootstrapping” scores (i.e., computing
the reference rate from a sample with replacement, as an average of the polled rates after an
appropriate amount of trimming to minimize noise (outliers) and then computing a measure
of dispersion i.e. the confidence intervals for the trimmed means/average).
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Every day the FIMMDA-NSE MIBID MIBOR along with their respective standard
deviations (probability that the estimated trimmed mean obtained after avoiding extreme
values, lies in a given range) were disseminated to the market at 9.40 (IST) for overnight
rates (3 day on all Fridays) and at 11.30 PM for the three term rates, viz. 14-day, 1-month and
3-month. The structure of the reporting is given below.
FIMMDA-NSE MIBID MIBOR for the Day
Category Time MIBOR Standard Deviation of MIBOR MIBID Standard Deviation of MIBID
OVERNIGHT 9:40 a.m.
3 DAY 9:40 a.m.
14 DAY 11:30 a.m.
1 MONTH 11:30 a.m.
3 MONTH 11:30 a.m.
Source: http://www.arthapedia.in/index.php?title=MIBOR_and_MIBID
11.4 CHIT FUNDS AND THEIR REGULATIONS

A Chit fund is a kind of savings scheme practiced in India. A chit fund company is a
company that manages, conducts, or supervises such a chit fund, as defined in Section of the
Chit Funds Act, 1982.
According to Section 2(b) of the Chit Fund Act, 1982 “Chit means a transaction
whether called chit, chit fund, chitty, kuree or by any other name by or under which a person
enters into an agreement with a specified number of persons that every one of them shall
subscribe a certain sum of money (or a certain quantity of grain instead) by way of periodical
installments over a definite period and that each such subscriber shall, in his turn, as determined
by lot or by auction or by tender or in such other manner as may be specified in the chit
agreement, be entitled to the prize amount”.
Such chit fund schemes may be conducted by organized financial institutions, or may
be unorganized schemes conducted between friends or relatives. In some variations of chit
funds, the savings are for a specific purpose. Chit funds also played an important role in the
financial development of people of south Indian state of Kerala, by providing easier access
to credit. In Kerala, chitty (chit fund) is a common phenomenon practiced by all sections of
the society. A company named Kerala State Financial Enterprise exists under the Kerala
State Government, whose main business activity is the chitty.Chit fund concept came into
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the eyes of people in 1800’s when Raja Rama Varma, ruler of erstwhile Cochin state gave a
loan to a Syrian Christian trader, by keeping a certain portion of it to himself for other expenses
and later he drew that money for the principle of equity.
How it works: An example
Chit funds operate in different ways, and this may lead to many fraudulent tactics
practiced by private firms. The basic necessity of conducting a ‘Chitty’ is a group needy
people called subscribers. The foreman — the company or person conducting the chitty —
brings these people together and conducts the chitty. The foreman is also responsible for
collecting the money from subscribers, presiding over the auctions, and keeping subscriber
records. He is compensated by a fixed amount (generally 5% of gross chitty amount) monthly
for his efforts. Other than that, the foreman has no specific privileges, she is just a chitty
subscriber. A simple formula depicts the pattern of the chitty:
Monthly Premium × Duration in Months = Gross Amount
E.g., 1000 * 50 = 50,000/- Where 1000 is the maximum monthly contribution needed
from a subscriber, 50 is the duration of the chitty in months and 50,000 is the maximum sum
assured. The duration also equals the number of subscribers, as there must be (not more or
less) one subscriber to receive the prize money every month.
The chitty starts on an announced date, every subscriber come together for the auction/
lot. As per Kerala chit act, the minimum prize money of an auction is limited to 70% of the
gross sum assured that is 35,000 in the above example. When there are more than one person
willing to take this minimum sum, lots are conducted and the ‘Lucky subscriber’ gets the
prize money for the month. If there is no person willing to take the minimum sum, then a
reverse auction is conducted where subscribers open-bid for lower amounts; that is from
50,000 >> 49,000 >> 48,000, and so on. The person bidding the lowest sum will get the bid
amount.
In both the cases the auction discount, that is the difference between the gross sum
and auction amount, is equally distributed among subscribers or is deducted from their monthly
premium. For example, if the auction is settled on a sum of 40,000, then the auction discount
of 10,000 (50,000 - 40,000) is divided by 50 (the total number of subscribers) and every
one gets a discount of 200. The same practice is repeated every month and every subscriber
gets a chance of receiving some money.
Chit funds are considered microfinance organizations.
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Contribution of Thrissur:
According to All Kerala Kuri Foremen’s Association, Kerala has around 5,000 chit
companies, with Thrissur district accounting for the maximum of 3,000. These chit companies
provide employment to about 35,000 persons directly and an equal number indirectly.
Acts:
Chit funds in India are governed by various state or central laws. Organised chit fund
schemes are required to register with the Registrar or Firms, Societies and Chits.
1. Union Government - Chit Funds Act 1982 (Except the State of Jammu and Kashmir)
2. Kerala: Kerala Chitties Act 1975
3. Tamil Nadu: Tamil Nadu Chit Funds Act, 1961
4. Karnataka: The Chit Funds (Karnataka) Rules, 1983
5. Andhra Pradesh: The Andhra Pradesh Chit Funds Act, 1971
6. New Delhi: The Chit Funds Act,1982 and Delhi Chit Funds Rules, 2007
7. Maharashtra: Maharashtra Chit Fund Act 1975
 Organised chit funds:
In North India, a common type of chit fund uses small paper slips with each member’s
name, gathered in a box. When all members are at a monthly or weekly meeting, the one in
charge in front of the other members picks a slip from the box. The member so selected gets
that day’s collection. Afterwards, that person’s name slip is discarded. Thereafter, he comes
to the meetings and pays his share, but his name isn’t selected again.
 Special purpose funds
Some chit funds are conducted as a savings scheme for a specific purpose. An example
is the Deepavali sweets fund, which has a specific end date about a week before Deepavali.
Neighborhood ladies pool their savings each week. They use this fund to buy and prepare
sweets in bulk just before the Deepavali festival, and they distribute sweets to all members.
Preparation of Deepavali sweets may be a time consuming and costly activity for individuals.
Such a chit reduces costs, and relieves members from extra work in a busy festival season.
Nowadays, such special purpose chits are conducted by jeweler shops, kitchenware shops,
etc. to promote their products.
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 Online Chit Funds:
With the advent of ecommerce in India, Chit funds have also started going online.
Online chit funds conduct auctions online and subscribers can pay their monthly dues and
receive prize amount online through online transactions including electronic fund transfers.
Each member has an online account to manage their chit funds.
Guidelines for Chit Fund Companies:
1. How To Get a Registration Certificate:
Chit fund Companies operating in Delhi (for example) as a practice, first obtain a
certificate of incorporation from the Registrar of Companies. The office of the Registrar of
Companies (Delhi & Haryana) is at Paryavaran Bhawan, C.G.O. Complex, Lodhi Road, New
Delhi.
(A) Requirements for registration of New Co. with Registrar of Chit Fund, New Delhi:
After getting this certificate, you can apply for registration of first Bye-laws of the
company with Chit Fund Department., Govt. of N.C.T. of Delhi, 13th floor, Bikri Kar Bhawan,
I.P. Estate, New Delhi 110 002 (Tel. No. 331 8992)
a) Memorandum and Articles of Association.
b) Incorporation Certificate.
c) Form No. 2 regarding shares allotment.
d) Form No. 18 regarding registered office.
e) Form No. 32 regarding appointment of Directors.
f) R.O.C. Receipt for filing of form No. 2, 18, 32.
g) Bank certificate for deposit of Rs. 1,00,000/- as paid-up capital.
h) Resolution for appointment of foreman of the company.
I) Affidavits of the Directors regarding:
1. Age, good health and sound mind.
2. Insolvency.,
3. Non-conviction.
4. Membership/Directorship in other chit fund company.
j) Proof of ownership of the office premises.
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k) No objection certificate from the landlord.
l) Rent Receipt of premises.
m) Lay out plan of premises.
n) Photo-copies of Ration Cards of the Directors.
o) Photographs of all the Directors duly attested.
p) Papers regarding financial soundness of the Directors.
1. Proof of property, if any.
2. Assessment order, if any.
3. Balance sheet(s) of the company whether partnership or proprietorship.
4. Other financial documents.
q) Form CF-1 in duplicate (application for registration).
r) Bye-laws in duplicate.
s) Cash Voucher for Rs.50/- (Bye-laws fee).
(B) Basic requirements for approval of First Bye-laws:
i) All Directors/Partners should be adults, possess good health and sound mind, should
not have been convicted in any case and should be financially sound. Preferably, the
Directors should not be related to each other.
ii) The Company should have at least an amount of Rs.1,00,000/- in the bank as paid-up
capital.
Documents to be submitted at the time of approval of Bye-laws:
a. Form CF-1.
b. Bye-laws (in duplicate).
c. Form regarding details of company’s business and deposit of fee.
d. Certificate of Registration in Form CF-II (in duplicate).
e. Bye-laws fee amounting to Rs. 50/- for each Bye-law to be deposited in cash with the
Cashier.
f. Residential proof of Directors/Foreman in the shape of ration card, election I-Card, or
passport.
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(C) Inspection of the Registered Office:
After all the prescribed requirements are fulfilled, spot inspection of the proposed
registered office of the company will be made by the Chit Fund Department through an
Inspecting Officer.
For this purpose, the registered office should be:
i) Havingat least 150 square feet of office area.
ii) Well-furnished to conduct chit fund business.
iii) Having an Auction Hall.
iv) A sign board displayed on the front side of the premises.
Preferably, the company should also display the registered groups with it showing
tickets and monthly subscription and the chit value. In case any vacancy is likely to come up
in a group, this may also be displayed.
(D) Framing of Bye-Laws:
The Bye-Laws submitted for registration shall contain the following particulars:
i) The full name of foreman conducting chit business.
ii) The complete address of the foreman, registered address, in the case of a company
being a foreman.
iii) The name under which chit business is done or is proposed to be done.
iv) The full details of the working of the chit.
v) The area of operation of the chit.
vi) The circumstances under which withdrawals of subscriber shall be permitted.
vii) The procedure to be followed for returning the money of the subscribers in case
withdrawal, ineligibility or death of the subscriber.
viii) The condition under which the transfer of a chit or the interest of a subscriber shall
be permitted.
ix) The full name and designation of the officer entitled to sign documents on behalf of
the foreman.
x) The rate of commission to which the foreman is entitled.
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xi) The language in which the accounts shall be kept.
xii) The mode of custody and investment of money.
xiii) The settlement of disputes touching or concerning the chit.
On receipt of application, the Registrar shall examine the application and Bye-laws in
order to satisfy himself that the bye-laws are:
a) In conformity with the Act and Rules.
b) Suitable for carrying out the object of the chit.
c) Suitable for carrying safe and fair conduct of the business and shall grant a certificate of
registration in Form CF-II.
(E) Amendment of Bye-laws:
After the Bye-laws have been registered, the chit fund company can apply for the
amendment of these bye-laws, if necessary.
Documents required for amendment of Bye-laws:
i) Application alongwith a Court fee stamp of Rs.5/-.
ii) Approved Bye-laws (in original).
iii) Proposed Bye-laws (in duplicate).
When the proposed amendments in Bye-laws are approved, one copy of Bye-Laws
duly endorsed for registration of amendment will be issued to the company. No application
for amendment of Bye-laws will be entertained, if the chit group of such Bye-laws has
commenced. Under prevailing practice of the department amendment of bye-laws is allowed
only once.
(F)After the Registrar, Chit Funds Delhi is satisfied that all the requirements are fulfilled,
a certificate for registration of first Bye-laws will be issued to the company.
11.5 NOTES
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11.6 SUMMARY
Deepak Mohanty of RBI gives really good speeches.
In his recent speech, he explains how India’s money markets have evolved and
developed over the years. It also has some basics about money market and its role in an
economy.
He makes three suggestions towards the end:
First, there has been a swift transmission of policy rate at the short-end of money
market, partly due to the prevalence of market liquidity in deficit mode. However, ensuring
market liquidity in a deficit mode of desired level on a sustained basis is contingent on
Reserve Bank’s ability to effectively conduct OMOs and the market appetite for such
operations. Hence, there is a need to develop the market micro-structure and further
enhance secondary market transactions in government securities to facilitate smooth
conduct of OMOs.
Second, the LAF is not the appropriate instrument for managing the liquidity of
more enduring nature. As the system is expected to be in deficit, there is a need to develop
term repo to minimise daily requirement of liquidity.
Third, notwithstanding significant advances in developing the market, the term
structure in the money market is incomplete. It is, therefore, desirable to extend the yield
curve beyond the overnight rate by developing a term-money market.
Second and third are interlinked..Term repo will help in both the tasks of providing
term market liquidity and extending the yield curve beyond the overnight rate..
The first one is more interesting. As my report shows, RBI has been relying extensively
on forex assets to create liquidity since 2004-05 onwards. Share of Rupee securities in RBI
Balance sheet declined significantly. Since last year, as forex flows slowed and RBI intervened
to prevent rupee depreciation, RBI relied more on rupee securities via LAF repo and OMO
purchases.
As forex assets are beyond RBI’s control, it does not have a choice but to look at
Rupee securities to keep liquidity in deficit mode. It will be interesting to see what RBI does
in future. Will it announce OMOs as it does now or does more secondary market OMO
actions as Fed does.
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11. 7 KEY WORDS
Reserve Bank Of India , Recent Development, Sukhamoy Chakravarty , Narayanan
Vaghul, Narasimham Committee, Deregulation Of The Interest Rate, Establishment Of The
DFI, Electronic Transactions, Establishment Of The CCIL, Mumbai Inter-Bank Offer Rate
(MIBOR), Mumbai Inter-Bank Bid Rate (MIBID), Financial Benchmarks, CHIT FUNDS.

1. Explain the recent development in money market.
2. Explain briefly chit funds.
3. Briefly explain the amendments and regulations of chit funds in India.
11.9 REFERENCES
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UNIT- 12 : PREVENTION OF MONEY LAUNDERING
Structure:
12.0. Objectives
12.1 Introduction
12.2 Prevention of money laundering
12.3 Global money market
12.4 Integration of domestic and global money market
12.5 Notes
12.6 Summary
12.7 Key Words
12.9 References
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12.0 OBJECTIVES
• Prevention of money Laundering, its impact on the country
• how global money market is interlinked with the domestic money market.
• extent of various instruments available internationally so as to avail benefits by cross
border businesses.
12.1 INTRODUCTION
India is extensively gripped under crime of money laundering. Money laundering is
usually used by criminals to hide money made through illegal act. It is the process by which
huge amount of money obtained unlawfully, from drug trafficking, terrorist activity or other
severe crimes. Money laundering has an unfavorable impact on economy and political
steadiness of nation. It is necessary that all nations of the world must jointly device policies
and adopt measures to curb act of money laundering by resorting to forceful enforcement of
law.
Generally people consider Money laundering is the conversion of black money into
white money. This takes one back to cleaning the huge piles of cash. If it is done successfully,
it allows the criminals to maintain control over their proceeds and ultimately to provide an
authentic cover for their source of income. Money laundering fulfils the ambitions of the
drug trafficker, the terrorist, the organized criminal, the insider dealer, the tax evader as well
as the many other groups who need to avoid the kind of attention from the authorities that
unexpected prosperity comes from illegal acts. These criminal tries to get money and power
through criminal activities and then attempt to penetrate the legitimate society, thereby
misrepresenting the terms of the compact. They create huge amount of money for the members
of the enterprise and permit their associates to live extravagant lifestyles.
12.2 PREVENTION OF MONEY LAUNDERING

1. Concept of Money Laundering :
Money laundering is designated as the source of illegally obtained funds covered
through a series of transfers and deals in order that those same funds can eventually be made
to appear as legitimate income (Robinson). According to Interpol General Secretariat
Assembly in 1995, money laundering is any act or attempted act to conceal or disguise the
identity of illegally obtained proceeds so that they appear to have originated from legitimate
sources.
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Money Laundering is an expression that has recent origin. Money laundering is a
cultured crime that is not to be taken seriously by society. When comparing with street
crimes, it is a modern crime. Some experts refer to it as a victimless crime but in reality, it
is not a crime against a particular individual, but it is a crime against nations, economies
government, rule of law and world at large. Money laundering has become a worldwide threat.
The objective of a huge number of criminal acts is to get profit for the individual or group
that performed the act and then hide either the source or the purpose of cash. Money laundering
is the processing of these criminal proceeds to cover their illegal origin. This process is
very crucial for government and other responsible authorities as it enables the criminal to
enjoy money obtained from illegal source. Some of the crimes such as illegal arms sales,
smuggling, corruption, drug trafficking and the activities of organized crime including tax
evasion produce huge money.
Insider trading, corruption and computer fraud schemes also generate more profits
and create the incentive to legitimize the illegal gains through money laundering. When a
criminal activity produces large profits, the individual or group involved must find a way to
control the funds without attracting attention to the original activity or the persons involved.
Criminals perform this by disguising the sources, changing the form, or transferring money
to a place where they are less likely to attract attention. Otherwise, they will not be able to
use the money because it would connect them to the criminal action, and law enforcement
authorities would grab it. If criminals perform this process successfully, it allows the
criminals to maintain control over their proceeds and eventually to provide a legitimate cover
for their source of income. Where criminals are allowed to use the proceeds of crime, the
ability to launder such proceeds makes crime more attractive.
2. Significance of Money Laundering :
Money laundering is an important criminal issue for policy makers and government
authorities that gained increasing significance after the occurrence of heart throbbing indents
of 9/11 attack on the twin towers in the U.S. After that all nations has focused its attention on
the notion of money laundering and has recognized it as a source of the funding of terrorist
actions. The process of globalization and advancements of the communications have made
crime increasingly international in scope, and the financial aspects of crime have become
more complex due to technology enhancement. The huge expansion of international banks
all over the world has facilitated the transmission and the disguising of the origin of funds.
This may have shocking social consequences and poses a threat to the security of any
nation at large or small scale. It offers immense facilities for drug dealers, terrorists, illegal
arms dealers, corrupt public officials and all types of criminals to operate and increase their
52
criminal activities. Laundering enables criminal activity to continue. Money laundering causes
an alteration of resources to less productive areas of the economy which in turn decreases
economic development. If security authorities and government ignore this crime, there will
be serious consequences on social and political development of nation. The economic and
political influence of criminal organizations can deteriorate the social fabric, collective
ethical standards, and eventually the democratic institutions of civilization.
3. The Oretical Review of Money Laundering :
It has been demonstrated in academic reports that financial institutions have made
efforts to detect and prevent money laundering since last many years, but the main feature of
money laundering are its processes in which it is carried out. Many experts have argued that
money laundering does not take a singular act but takes a more complex operation, which is
completed in three basic steps which include placement, layering and integration (Anon,
2006). The International Monetary Fund (IMF) (2001: 7-8) defined money laundering as
being the “transferring (of) illegally obtained money or investments through an outside party
to conceal the true source”. In South Africa, the Public Accountants and Auditors Board
(2003), stated that money laundering is defined in local legislation as being “virtually every
act or transaction that involves the proceeds of crimes, including the spending of funds that
were obtained illegally”. There are variation in views of different authorities to explain the
notion of money laundering.
4. Processes of Money Laundering :
i. Placement stage:
First step is the Placement stage in the money laundering cycle. Money laundering
activities is usually generated from cash intensive business, large amount of cash or hard
currency and grown from illegal activities such as sale of drugs, illegal firearms, prostitution
or human trafficking. Currencies gained from this cycle need to be disposed of immediately
by the launderer, so they go as far as depositing it back in financial institutions, spending in
retail economy, and involvement in a business or acquisition of an expensive property/asset
or smuggled out of the country. The launderer’s intention in this stage is to eliminate the
cash from the place of possession so as to escape any form of detection from the authorities
and to transform it to other form of assets such as travellers’ cheques.
ii. Layering:
In this stage, the launderer tries to hide or disguise the origin of the funds by creating
complicated layers of financial transactions designed to cover the audit trail and conceal it.
It stated that layering serves to hide the source and ownership of the funds. Others suggested
53
the methods used to accomplish layering such as the use of offset accounts by dealers, online
electronic fund transfers between certain tax havens, and doubtful gold transactions in which
large purchases of gold in countries with low VAT rates and then (there is an) exporting (of)
the bullion back to the country of origin”.
The aim of layering is to separate the illegal duties from the source of the crime,
layers upon layers of transactions are created, moving illegal funds between accounts or
business, or buying and selling assets on a local and international basis until the original
source of the money is undetectable. It has been designated that there are other methods that
can be adopted to allow, layering to take place that involve the over-invoicing and false
invoicing of imports and exports.
iii. Integration:
After the layering stage, illegal funds are taken back into the financial system as
payments for services rendered. Making the launderer feel fulfilled by making the funds
appear to be legally earned. Illegal funds is returned to the economy and disguised as genuine
income. The techniques adopted to successfully integrate funds from a criminal enterprise
would very often be similar to that of practices adopted by legitimate business.
Basic steps of money laundering: (Source: Georgios Boustras, 2012)
5. Impact of Money Laundering on Nation :

There are many dangerous impact of money laundering on country as well as whole
world. The following key effects of money laundering are as follows:
i. Undermining of the legitimate private sector:
The use of front companies by money launderers undermines the legitimate private
sector, as the motive of money launderers is not necessarily to make a profit out of operations
of the front company.
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ii. Undermining of the integrity of financial markets:
The succeeding reputational loss by financial institutions results in a loss of confidence
by consumers in these affected financial institutions who may be perceived to be involved in
fraudulent activities. This could also affect the reputation of a country and force investors to
invest in economies that are perceived to be less exposed to the risk of money laundering.
Money laundering can deleteriously impact on the truthfulness of financial markets, and
also weaken the reputation of a nation.
iii. Loss of control of economic policy:
Reports of IMF (2003) signified that the size of the funds being laundered, and the
fact that money launderers would want to launder their funds through developing economies
to reduce possible detection of their schemes, can affect the inflow and outflow of funds in
these countries.
iv. Economic distortion and instability:
Money laundering may also misrepresent capital flows, and thus destabilise the
effective functioning of the world-wide economy. Researchers argued that money launderers
would not look at where to best invest their money based on economic principles, but rather
at where it would be easier to avoid being caught or based on where the cost of avoidance was
lower.
v. Loss of revenue:
Many theorists stated that money laundering decreases the tax funds available for
collection in the economy and by implication government’s revenues. Consequently,
governments may have to levy higher taxes in order to obtain the funds necessary to fulfill
their responsibilities towards their citizens.
vi. Security threats to privatization efforts:
Money launderers who are able to obtain previous government entities that are being
privatized, can attempt to establish a legitimate front to launder funds. This can weaken
economic reforms as money launders are not interested in operating these entities as going
concerns, but rather as a channel for laundering money.
vii. Reputation risk:
The nations that are competing as destinations for legitimate investments may face
difficulty to do so if there is a perception that the country has a poor track record of dealing
with money laundering or is seen to be a centre for money laundering. This is because
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legitimate investors are wary of being associated with any country that has a negative
reputation.
Other impacts of money laundering are as follows:
i. Increased criminality:
The increase in criminality is serious effect and a matter of concern in money
laundering. The triumph of money launderers is the distance they create between themselves
and the criminal activity producing profit. So that they can live lavish life could through this
crime without attracting attention and could also go to the extent of reinvesting their profits
to finance other crimes. Therefore, government, legislative act and other enforcing laws
must implement policies in legal procedure to curb the crime.
ii. Social effect:
Committing crime of money laundering, transfers the economic power from the right
people to the wrong. The good citizens and the government are dispossessed from their
right, making the criminals take the benefit to flourish in their criminality. Money laundering
damages the financial institution which is an important factor in the economic development
of nation.
In developing countries where there is no strict control, the governments have to
seek further contribution from good citizens, making people suffer more and continue to be
subject to poverty. Companies cannot compete with operators financed by illegal funding,
labours then become jobless and the high rate of unemployment result in an increase in
criminality, dissatisfaction and insecurity. The burden on the government would then increase
with the need to provide security therefore reallocating resources from more productive
enterprise to other areas. This reduces productivity in the real sector of the economy by
diverting resources from productive areas to social sectors; crime and corruption which are
on the increase would then slow down economic growth and decrease human development.
iii. Microeconomics effect:
Money launderers generate and make use of companies that front for them. These
companies are not interested in and but pretend to be involved in them. Usually the companies
are not doing any serious business. The income generated from the company is not usually
from the business but from their criminal activities. Their decisions are not usually based on
economic considerations and would offer products at prices below cost price making the
front companies have an unjustified competitive advantage. Legitimate businesses lose when
competing, as there is no fair competition involved and results in business closures due to
crowding out effect of private sector business by criminal organizations.
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iv. Macroeconomic effect:
There are numerous impacts of money laundering on the macroeconomic situations.
These include volatility in exchange rates and interest rates due to unanticipated transfers of
funds; fall in asset price due to the disposition of laundered funds; misallocation of resources
in relative asset commodity prices arising from money laundering activities; loss of
confidence in markets caused by insider trading, fraud and embezzlement. When businesses
make less revenue and pay fewer taxes, people become unemployed and dependent on social
assistance which is most times difficult to get in developing countries. When criminals use
financial institution for laundering funds, this creates negative promotional and it’s enough
to scare banks into striving to keep criminals away from their terrain. Also banks have a risk
of performing a balancing act between attracting new business and complying with the
regulations and legislations.
The securities markets (especially derivatives) have become the attention of money
launderers and are posing an added risk to financial systems. Other indirect economic effects
are higher insurance premiums for those who do not make fraudulent claims and higher
costs to businesses therefore generating fewer profits which make it difficult to break even.
Financial institutions are not the only target the launderers use in their various schemes but
they are accountable for financial dealings and for reporting any doubtful transactions.
It has been cleared that the Money laundering has negative consequences on monetary
development. Money laundering constitutes a serious risk to national economies and
respective governments. The penetration and sometimes saturation of illicit money into
legitimate financial sectors and nations accounts can intimidate economic and political
constancy. Economic crimes have a disturbing effect on a national economy since potential
victims of such crimes are far more numerous than those in other forms of crime. Economic
crimes also have the potential of unfavourably affecting people who do not prima-facie,
seem to be the victims of the crime. For example, tax evasion results in forfeiture of
government income and in turn affecting the potential of the government to spend on
development schemes thereby affecting a large section of the population who could have
benefited from such government expenditure.
A company fraud not only results in cheating of the people who have invested in that
company but may also adversely affects investors’ confidence and eventually the development
of the economy. Legislature body has difficulty to quantify the negative economic effects of
money laundering on economic development. Such activity damages the financial-sector
institutions that are critical to economic growth, reduces productivity in the economy’s real
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sector by diverting resources and encouraging crime and corruption, which slow economic
growth, and can distort the economy’s external sector international trade and capital flows to
the detriment of long-term economic development.
v. The Financial Sector:
Financial sector may get negative effects of money laundering particularly financial
institutions including banking and non-banking financial institutions and equity markets, may
directly or indirectly be affected. Basically, these institutions facilitate concentration of
capital resources from domestic savings and funds from overseas. These institutions provide
impetus to furtherance of investment prospects by providing conducive environment and
efficient allocation of these resources to investment projects which contributes substantially
to long run economic growth.
Reports signify that Money Laundering weakens the sustainability and development
of financial institutions in two ways.
Firstly, the financial institutions are debilitated directly through money laundering
as there seems to be an association between money laundering and fraudulent activities
undertaken by employees of the institutions. Likewise, with the rise in money laundering
acts, major parts of financial institutions of a state are susceptible to crime by criminal
elements. This strengthens the criminals of money laundering channels. This may lead to the
removal of less equipped competitors and giving rise to domination.
Secondly, customer trust is important to the development of comprehensive financial
institutions, and the perceived risk to the growth of sound financial institutions, and the
perceived risk to depositors and investors from institutional fraud and corruption. The Real
Sector Money laundering harmfully affects economic development through the real sector
by diverting resources to less productive activities and by facilitating domestic corruption
and crime.
Money laundering also performed through the channels other than financial institutions
that include more sterile investments such as real estate, art, antiques, jewellery and luxury
automobiles, or investments of the type that gives lower marginal productivity in an economy.
These sub optimal allocations of resource give lower level of economic growth which is a
serious disadvantage to economic progress for developing countries. Criminals invest their
proceeds in companies and real estate in order to make further profits, legal or illegal. Most
of these investments are in sectors that are familiar to the criminal, such as bar, restaurant,
prostitution.
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The real estate sector is the largest and most susceptible sector for money laundering.
Real estate is important for money laundering, because it is a non-transparent market where
the values of the objects are often difficult for approximation and it is an efficient way to
place large amounts of money. The price increase in real estate is lucrative and the annual
profits on real business create a legal basis for income. The real estate has the following
characteristics for criminal money:
a. A safe investment
b. The objective value is difficult to assess.
c. It allows to realize “white” returns.
vi. The External Sector:
Money laundering activities may weaken the financial growth of any nation through
the trade and international capital flows. Excessive illegal capital flight from a state may be
facilitated by either domestic financial institutions or by foreign financial institutions. That
illicit capital flight drains scarce resources specially from developing economies. In this
way, economic growth of corresponding economy is adversely affected. Money laundering
negatively affects trust of local citizens in their own domestic financial institutions as well
as trust of foreign investors and financial institutions in a state’s financial institution which
ultimately contributes to economic growth. Money laundering channels may also be related
with distortions of a country’s’ imports and exports.
As with the participation of criminal elements on the import side, they may use illegal
proceeds to purchase imported luxury goods, either with laundered funds or as part of the
process of laundering such funds. Such imports do not produce domestic economic activity
or employment, and in some cases can theatrically reduce domestic prices, thus reducing
the productivity of domestic enterprises. The reliability of the banking and financial services
market place depends mainly on the perception that it functions within a framework of high
legal, professional and ethical standards.
A reputation for integrity is most valuable assets of a financial institution. Dangers
for the reputation can happen when a country purposely declares to want to attract ‘criminal
money. If funds from criminal activity can be easily processed through a particular institution,
either because its employees have been bribed or because the institution do not pay attention
to the criminal nature of such funds, the institution could be drawn into active complicity
with criminals and become part of the criminal system itself. Such network will damage the
attitudes of other financial intermediaries and of regulatory authorities as well as ordinary
customers.
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Money laundering has other dangerous consequences also. It not only impends the
financial system of nation by taking away command of the economic policy from the
government, but also declines the moral and social position of the society by exposing it to
activities such as drug trafficking, smuggling, corruption and other criminal activities. The
Global Sector Money Laundering has become a world-wide problem. Criminals target foreign
authority with liberal bank secrecy laws and feeble anti-money laundering regulatory
governments as they transfer illegal funds through domestic and international financial
institutions often with the speed and internet transactions. This huge penetration of criminal
proceeds into world market can destabilize and can have a debasing effect on those who work
within the market system. The infiltration of criminals into the genuine markets can also
change the balance of economic power from responsible and responsive entities to scoundrel
agents who have no political or social responsibility.
6. Prevention and Combat of Money Laundering :
Legislators around the world have realized that concentrated efforts are required to
deal with illegal funding and control money laundering. India has different laws to tackle
smuggling, narcotics, foreign trade violations, foreign exchange manipulations and also
special legal provisions for preventive detention and forfeiture of property, which were enacted
over a period of time to deal with such severe crimes. Some of these were considered to be
strong measures, but may not now match the post-Sept.11 measures initiated in the US and
the EU. In India, there were old age practices for prevention of Money laundering in the
sense of seizure and repossession of proceeds of crime. The statutes predominant before
the Prevention of Money Laundering Act, 2002 (Money Laundering Act of 2002) are:
i. Criminal Law Amendment Ordinance (XXXVIII of 1944).
ii. The Smugglers and Foreign Exchange Manipulators (Forfeiture of Property) Act, 1976.
iii. Narcotic Drugs and Psychotropic Substances Act, 1985.
i. Criminal Law Amendment Ordinance (XXXVIII of 1944):
Under this law, police can get the proceeds of crime relating to bribe, breach of trust
and cheating confiscated by an order of attachment and on completion of the criminal
prosecution can get an order from court forfeiting the proceeds. This ordinance was modified
in 1946 and responsibility of proof to the accused. In the event of crime under Prevention of
Corruption Act, the implementation rests with the CBI. However this law covers proceeds of
only certain crimes such corruption, breach of trust and cheating and not all the crimes under
the Indian Penal Code.
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ii. The Smugglers and Foreign Exchange Manipulators (Forfeiture of Property)
Act, 1976:
According to this law, there is a penalty of illegally acquired properties of smugglers
and foreign exchange manipulators and for matters connected therewith and incidental thereto.
The application of this law is restricted to the persons convicted under the Customs Act,
1962 or Sea Customs Act, 1878 or other foreign exchange laws. Under this Act, no person
shall hold any unlawfully acquired property either by himself or through any other person on
his behalf. The word ‘illegally acquired property’ has been well defined under section 3(c) of
the act.
There is very broad legislation in India on money laundering which includes all kinds
of laundering of money relating to all crimes and offences under laws of India except offences
relating to drug trafficking or offences under Indian Penal Code. As far as drug offences are
concerned, prevention of money laundering is taken care of by Narcotic and Psychotropic
Substances Act, 1985.
iii. Narcotic Drugs and Psychotropic Substances Act, 1985:
Narcotic Drugs and Psychotropic Substances Act, 1985 provide for the penalty of
property derived from, or used in illegal traffic in narcotic drugs. Sections 68A to 68Y of
Chapter VA of the Act provides for forfeiture of assets derived from or used in unlawful
traffic. The provisions are so broad that the authorities administering the law have huge powers
including the power to trace the source of drug related money or property and afterward to
proceed with freezing of accounts and seizure of property and forfeiting it to the government.
Other analogous statutes:
Besides these legislations, there is a law of Foreign Contribution (Regulation) Act,
1976 under which the Central government regulates flow of funds to various organizations.
If the Central government thinks any organization is acting against national interest, it can
block its funds. Further to that Reserve Bank of India, which administers Foreign Exchange
Management Act, 1999 has powers under section 11 of the Act to give appropriate directions
to the authorized dealers to prevent violation of any laws. In addition to above Section 102
and Sections 451to 459 of the Code of Criminal Procedure, 1973 enables seizure and
confiscation of the proceeds of crime.
The purpose of the Prevention of Money-laundering Act, 2002 (PMLA) is to combat
money laundering in India in order to prevent and control money laundering, to confiscate
and seize the property obtained from laundered money, and to deal with any other issue
connected with money laundering in India. It came into force from 1st July, 2015. The Act
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provides that whosoever directly or indirectly attempts to pamper or knowingly assists or
knowingly is a party or is actually involved in any process or activity connected with the
proceeds of crime and projecting it as untainted property, shall be guilty of offences of
money-laundering. For the purpose of money-laundering, the PMLA identifies certain
offences under the Indian Penal Code, the Narcotic Drugs and Psychotropic Substances Act,
the Arms Act, the Wild Life (Protection) Act, the Immoral Traffic (Prevention) Act and the
Prevention of Corruption Act, the proceeds of which would be covered under this Act.
International initiatives are also taken to fight against drug trafficking, terrorism and
other organized and serious crimes have concluded that financial institutions including
securities market intermediaries must establish procedures of internal control aimed at
preventing and impeding money laundering and terrorist financing. In other nations such as
US, The US Congress passed the USA Patriot Act of 2001 within 43 days of Sept.11, October
26, 2001. This Act made as many as 52 amendments to the existing Bank Secrecy Act of
1970 (BSA). The range of these new provisions touched every financial institution and business
not only in the US, but also in many countries of the world. One of the changes made in the
BSA requires every financial institution to establish anti-money laundering programmes.
Moreover, the list of businesses defined as financial institutions is wide ranging and
includes banks, brokers and dealers in securities or commodities, currency exchanges,
insurance companies, credit card operators, dealers in precious metals, stones and jewels,
travel agencies, businesses engaged in the sale of vehicles including automobiles, air planes
and boats, casinos and gaming establishments, and even telegraph companies and US postal
service. It also adds secretive banking systems, such as ‘hawala’, to the description of financial
institutions. It creates customer documentation and due diligence duties. Simultaneously, it
grants immunity to financial institutions and their personnel for sharing reports of doubtful
activities with any government agency or with each other. It also makes it a crime to conceal
more than US $ 10,000 in money or monetary instruments while entering or leaving the US.
Consequently, huge number of financial institutions and businesses, who were not earlier
concerned about money laundering, now have to maintain anti-money laundering programmes
requiring them to “develop internal policies, procedures and controls”, “elect a compliance
officer”, conduct “ongoing employee training programmes” and perform “independent audit
functions”.
Currently, the US intelligence agencies can have access to reports and records of
financial institutions and businesses including suspicious activity reports filed by them. One
of the major changes is ban of correspondent accounts for foreign shell banks, which have
no physical presence anywhere. A foreign bank must have a fixed address, employ at least
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one full-time employee, maintain operating records and be inspected by a banking authority
to qualify for a correspondent account. Besides amending the BSA, the USA Patriot Act of
2001 also modified in the Money Laundering Control Act of 1986.
It now acquires extra-territorial jurisdiction to combat terrorist funding and criminal
proceeds. The law covered funds representing proceeds of nearly 200 specified unlawful
activities such as fraud, kidnapping, gambling, espionage, drug trafficking, etc. It now covers
bribing of a foreign public official, embezzlement of public funds, smuggling or export
control violations involving items covered by the Arms Export Control Act as well as crimes
of violence. The new law requires the financial institutions to provide information regarding
customers within 120 days if the account is in the US and within seven days if the records are
maintained outside the US in respect of correspondence accounts. The new law also supports
forfeiture powers over funds of foreign persons and institutions. The US authorities now
have vast power to track and grab laundered money that runs terrorist activities and to penalise
the criminals involved. The USA Patriot Act of 2001 has also seen a jump in filing SARs. The
US Finance Crimes Enforcement Network reported an increase in SARs by over 40 per cent
in the year 2002 compared to the preceding year. The compliance costs for the financial
institutions have also gone up but many think that this may be a small price to pay to be able
to live in a world with reduced risks of terrorist assaults.
7. Procedures for Anti Money Laundering :
Each registered intermediary must implement written procedures to implement the
Anti-Money Laundering provisions as envisaged under the Prevention of Money laundering
Act, 2002. Such procedures should include inter alia, the following three specific parameters
which are related to the overall ‘Client Due Diligence Process:
i. Policy for acceptance of clients
ii. Procedure for identifying the clients
iii. Transaction monitoring and reporting especially Suspicious
In India, to combat the threat of offences of money laundering, the Government is
entrusting the work relating to investigation, attachment of property/proceeds of crime relating
to the scheduled offences under the Act and filing of complaints etc. to the Directorate of
Enforcement, which currently deals with offences under the Foreign Exchange Management
Act.
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12.3 GLOBAL MONEY MARKET
The global money market consists of financial institutions and dealers in money or
credit who wish to either borrow or lend. Participants borrow and lend for short periods,
typically up to thirteen months. Global money market trades in short-term financial
instruments commonly called “paper”. This contrasts with the capital market for longer-term
funding, which is supplied by bonds and equity.
The core of the money market consists of interbank lending banks borrowing and
lending to each other using commercial paper, repurchase agreements and similar instruments.
These instruments are often benchmarked to (i.e., priced by reference to) the London
Interbank Offered Rate (LIBOR) for the appropriate term and currency.
Finance companies typically fund themselves by issuing large amounts of asset-backed
commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP
conduit.
Examples of eligible assets include auto loans, credit card receivables, residential/
commercial mortgage loans, mortgage-backed securities and similar financial assets. Some
large corporations with strong credit ratings, such as General Electric, issue commercial
paper on their own credit. Other large corporations arrange for banks to issue commercial
paper on their behalf.
In the United States, federal, state and local governments all issue paper to meet
funding needs. States and local governments issue municipal paper, while theU.S.
Treasury issues Treasury bills to fund the U.S. public debt:
1. Trading companies often purchase bankers’ acceptances to be tendered for payment
to overseas suppliers.
2. Retail and institutional money market funds
3. Banks
4. Central banks
5. Cash management programs
6. Merchant banks
1. Functions of the Global Money Market :
Money markets serve five functions—to finance trade, finance industry, invest
profitably, enhance commercial banks’ self-sufficiency, and lubricate central bank policies.
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i. Financing trade:
The global money market plays crucial role in financing domestic and international
trade. Commercial finance is made available to the traders through bills of exchange, which
are discounted by the bill market. The acceptance houses and discount markets help in
financing foreign trade.
ii. Financing industry:
The global money market contributes to the growth of industries in two ways:
a. They help industries secure short-term loans to meet their working capital requirements
through the system of finance bills, commercial papers, etc.
b. Industries generally need long-term loans, which are provided in the capital market.
However, the capital market depends upon the nature of and the conditions in the money
market. The short-term interest rates of the money market influence the long-term
interest rates of the capital market. Thus, money market indirectly helps the industries
through its link with and influence on long-term capital market.
iii. Profitable investment:
The Global Money Market enables the commercial banks to use their excess reserves
in profitable investment. The main objective of the commercial banks is to earn income
from its reserves as well as maintain liquidity to meet the uncertain cash demand of the
depositors. In the money market, the excess reserves of the commercial banks are invested
in near-money assets (e.g., short-term bills of exchange) which are highly liquid and can be
easily converted into cash. Thus, the commercial banks earn profits without sacrificing
liquidity.
iv. Self-sufficiency of commercial bank:
Developed money markets help the commercial banks to become self-sufficient. In
the situation of emergency, when the commercial banks have scarcity of funds, they need not
approach the central bank and borrow at a higher interest rate. On the other hand, they can
meet their requirements by recalling their old short-run loans from the money market.
v. Help to central bank:
Though the central bank can function and influence the banking system in the absence
of a global money market, the existence of a developed global money market smoothens the
functioning and increases the efficiency of the central bank.
Global money markets help central banks in two ways:
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a. Short-run interest rates serve as an indicator of the monetary and banking conditions
in the country and, in this way, guide the central bank to adopt an appropriate banking
policy,
b. Sensitive and integrated money markets help the central bank secure quick and
widespread influence on the sub-markets, thus facilitating effective policy
implementation.
1. Global Money Market Instruments :
i. Certificate of deposit: Time deposit, commonly offered to consumers by banks,
thrift institutions, and credit unions.
ii. Repurchase agreements: Short-term loans normally for less than two weeks and
frequently for one day arranged by selling securities to an investor with an
agreement to repurchase them at a fixed price on a fixed date.
iii. Commercial paper: Short term usage promissory notes issued by company at
discount to face value and redeemed at face value
iv. Eurodollar deposit: Deposits made in U.S. dollars at a bank or bank branch located
outside the United States.
v. Federal agency short-term securities: In the U.S., short-term securities issued
by government sponsored enterprises such as the Farm Credit System, the Federal
Home Loan Banks and the Federal National Mortgage Association.
vi. Federal funds: In the U.S., interest-bearing deposits held by banks and other
depository institutions at the Federal Reserve; these are immediately available
funds that institutions borrow or lend, usually on an overnight basis. They are lent
for the federal funds rate.
vii. Municipal notes: In the U.S., short-term notes issued by municipalities in
anticipation of tax receipts or other revenues.
viii. Treasury bills: Short-term debt obligations of a national government that are issued
to mature in three to twelve months.
ix. Money funds: Pooled short-maturity, high-quality investments which buy money
market securities on behalf of retail or institutional investors.
x. Foreign exchange swaps: Exchanging a set of currencies in spot date and the
reversal of the exchange of currencies at a predetermined time in the future.
xi. Short lived mortgage and asset-backed securities
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2. Discount and accrual instruments
There are two types of instruments in the fixed income market that pay interest at
maturity, instead of as coupons discount instruments and accrual instruments. Discount
instruments, like repurchase agreements, are issued at a discount of face value, and their
maturity value is the face value. Accrual instruments are issued at face value and mature at
face value plus interest short terms investment.
12.4 INTEGARTION OF DOMESTIC AND GLOBAL MONEY MARKET

Global and domestic money market is a phenomenon in which financial markets in
neighboring, regional and/or global economies are closely linked together. Various forms of
actual global and domestic money market include: Information sharing among financial
institutions; sharing of best practices among financial institutions; sharing of cutting edge
technologies (through licensing) among financial institutions; firms borrow and raise funds
directly in the international capital markets; investors directly invest in the international
capital markets; newly engineered financial products are domestically innovated and originated
then sold and bought in the international capital markets; rapid adaption/copycat of newly
engineered financial products among financial institutions in different economies; cross-
border capital flows; and foreign participation in the domestic financial markets.
Because of financial market imperfections, global and domestic money market in
neighboring, regional and/or global economies is therefore imperfect. For example, the
imperfect global and domestic money market can stem from the inequality of the marginal
rate of substitutions of different agents. In addition to financial market imperfections, legal
restrictions can also hinder global and domestic money market. Therefore, global and domestic
money market can also be achieved from the elimination of restrictions pertaining to cross-
border financial operations to allow
i. financial institutions to operate freely,
ii. permit businesses to directly raise funds or borrow and
iii. equity and bond investors to invest across the state line with fewer [or without imposing
any restrictions.
However, it is important to note that many of the legal restrictions exist because of
the market imperfections that hinder global and domestic money market. Legal restrictions
are sometimes second-best devices for dealing with the market imperfections that limit
global and domestic money market. Consequently, removing the legal restrictions can make
the world economy become worse off. In addition, global and domestic money market of
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neighboring, regional and/or global economies can take place through a formal international
treaty which the governing bodies of these economies agree to cooperate to address regional
and/or global financial disturbances through regulatory and policy responses.
The extent to which global and domestic money market is measured includes gross
capital flows, stocks of foreign assets and liabilities, degree of co-movement of stock returns,
degree of dispersion of world-wide real interest rates, and financial openness.
Benefits:
Benefits of global and domestic money market include efficient capital allocation,
better governance, higher investment and growth, and risk-sharing. Global and domestic money
market helps strengthen domestic financial sector allowing for more efficient capital
allocation and greater investment and growth opportunities. As a result of global and domestic
money market, efficiency gains can also be generated among domestics firms because they
have to compete directly with foreign rivals; this competition can lead to better corporate
governance. If having access to a broader base of capital is a major engine for economic
growth, then global and domestic money market is one of the solutions because it facilitates
flows of capital from developed economies with rich capital to developing economies with
limited capital. These capital inflows can significantly reduce the cost of capital in capital-
poor economies leading to higher investment.
Likewise, global and domestic money market can help capital-poor countries diversify
away from their production bases that mostly depend on agricultural activities or extractions
of natural resources; this diversification should reduce macroeconomic volatility. Global
and domestic money market can also help predict consumption volatility because consumers
are risk-averse who have a desire to use financial markets as the insurance for their income
risk, so the impact of temporary idiosyncratic shocks to income growth on consumption
growth can be softened.
Adverse effects:
Global and domestic money market can also have adverse effects. For example, a
higher degree of global and domestic money market can generate a severe financial contagion
in neighboring, regional and/or global economies. In addition, the capital outflows can journey
from capital-poor countries with weak institutions and policies to capital-rich countries with
higher institutional quality and sound policies. Consequently, global and domestic money
market actually hurts capital-scarce countries with poor institutional quality and lousy policies.
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Recent development:
During the past two decades, there has been a significant increase in global and domestic
money market; this increased global and domestic money market generates a great deal of
cross-border capital flows among industrial nations and between industrial and developing
countries. In addition, this increase in global and domestic money market pulls global financial
markets closer together and escalates the presence of foreign financial institutions across
the globe. With rapid capital flows around the world, the currency and financial crises in the
late 1980s and 1990s were inevitable. Consequently, developing countries that welcomed
excessive capital flows were more vulnerable to these financial disturbances than industrial
nations. It is widely believed that these developing economies were much more adversely
impacted as well. Because of these recent financial crises, there has been a heated debate
among both academics and practitioners concerning the costs and benefits of global and
domestic money market.
12.5 NOTES
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12.6 SUMMARY
To summarize, money Laundering is spreading at speedy rate at global level and it is a
serious matter for legislature authorities that must be curbed for smooth functioning of
society and economic enhancement of all nations. All nations have to work together to combat
such devastating criminal activity. Money Laundering is fundamentally, the process of
transforming, through a series of stages, the proceeds of illegal or criminal activity, into
apparently legitimately acquired funds. Today, due to technical modernization, the criminals
are very clever and cheat the enforcing agencies through deploying a team of experts like
chartered accountants, attorneys, banker’s mafia, to cover their illicit money and pretence it
as legal income. These professionals charge fee between 10 to 15% of the sum involved.
The connection between white-collared criminals, politicians, enforcing agencies and gangs
are so strong that it is difficult to break.
Bankers also has vital role and without their involvement, the operation cannot be
successful. There numerous payment option such wire transfer of funds has further aggravated
the difficulties to identify the movement of sludge funds. The international type of money
laundering requires international law enforcement cooperation to effectively examine and
accuse those that initiate these complex criminal organizations. Money laundering must be
combated mainly by penal ways and within the frameworks of international cooperation among
judicial and law enforcement authorities. It can be said that simply enactment of Anti-Money
Laundering Laws will not resolve such serious crime instead the Law enforcement Community
must keep bound with the ever changing dynamics of money Launderers who continually
evolves advanced techniques which helps them to implement strict law to curb money
laundering.
12.7 KEY WORDS

Money laundering, Insider trading, The International Monetary Fund, Legislators,
Central government, Global money market, London Interbank Offered Rate.

1. What do you mean by money laundering?
2. Explain the impact of money laundering on nation.
3. Briefly explain the process of money laundering.
4. Strategies to Prevent money laundering in India.
71
5. What is global money market?
6. Integrate and explain domestic and global money market.
12.9 REFERENCES
72
M.B.A III Semester
COURSE - 16 A
BLOCK
4
FINANCIAL AND BANKING INSTITUTIONS
UNIT - 13
FINANCIAL INSTITUTIONS 1-25
UNIT -14
FUNDS FLOW ANALYSIS 26-44
UNIT - 15
MANAGEMENT OF COMMERCIAL BANKS 45-75
UNIT - 16
REFORMS IN BANKING SECTOR 76-101
1

Chairman
Course Writers
Prof. Shiral Shetty Module - 4 (Units 13 to 16)
Associate Professor
Department of Commerce,
Karnatak University,
Dharwad.
Publisher
Registrar


Mysuru.-6.
2
BLOCK -4 : FINANCIAL AND BANKING INSTITUTIONS
A financial institution is an establishment that conducts financial transactions, such

as investments, loans and deposits. Almost everyone deals with financial institutions on a
regular basis. Every thing from depositing money to taking out loans and exchanging currencies
must be done through financial institutions.
Block 04 exhibits financial and banking institutions comprises 04 units (13-16). Unit
13 financial institutions explains introduction, Indian financial system, constituent of financial
system , financial instruments, financial instruments and institutions , non-banking financial
intuitions and economic growth . Unit 14 on fund flow analysis meaning difference between
fund flow and income statement and fund flow and balance sheet, benefits, preparation of
fund flow statements . Unit 15 clarifies management of commercial banks, Introduction.
The banking system, functional and roles of commercial banks, gap analysis, credit rating
and methods of lending. Unit 16 explains reforms in banking sector, Narasimhan committee
report, NPAS, Asset classification, capital adequacy, provision for substandard assets.
3
4
BLOCK – 4
FINANCIAL AND BANKING INSTITUTIONS
UNIT- 13 : FINANCIAL INSTITUTIONS
Structure :
13.0 Objectives
13.1 Introduction
13.2 Indian Financial System
13.3 Constituents of Financial System
13.4 Financial Instruments
13.5 Financial Institutions
13.6 Non – Banking Financial Institutions
13.7 Financial Institutions and Economic Growth
13.8 Important Factors in Building Stable Financial System
13.9 Case Study
13.10 Notes
13.11 Summary
13.12 Key Words
13.13 Questions for Self Assessment
13.14 References
5
13.0 OBJECTIVES
• constituents of financial system
• instruments in financial system
• role of financial system in economic development of India
• important factors in building stable financial system
• capital adequacy, compliance and convergence, co-operation.
13.1 INTRODUCTION
Financial System of any country consists of financial markets, financial intermediaries
and financial instruments or financial products. The term “finance” in simple understanding
is perceived as equivalent to ‘money’. But finance exactly is not money; it is the source of
providing funds for a particular activity. Finance may be classified as personal finance,
corporate finance and public finance. Further, the public finance does not mean the money
with the Government, but it refers to sources of raising revenue for the activities and functions
of a government and use of funds for capital and revenue purposes. Here, some of the
definitions of the word ‘finance’, both as a source and as an activity (i.e. as a noun and a verb.)
are as follows;
The American Heritage® Dictionary of the English Language, Fourth Edition defines
the term (noun) finance as under;
1: The science of the management of money and other assets.
2: The management of money, banking, investments, and credit.
3: Finance monetary resources; Funds, especially those of a government or
corporate body.
4: The supplying of funds or capital.
Finance as a function (i.e. verb) is defined by the same dictionary as under;
1: To provide or raise the funds or capital for: financing a new car
2: To supply funds to finance a daughter through law school.
3: To furnish credit to.
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Another English Dictionary, “WorldNet ® 1.6, © 1997 Princeton University” defines
the term finance as under;
1: the commercial activity of providing funds and capital.
2: the branch of economics that studies the management of money and other assets.
3: the management of money and credit and banking and investments.
All definitions listed above refer to finance as a source of funding an activity. In this
respect, providing or securing finance by itself is a distinct activity or function, which results
in Financial Management, Financial Services and Financial Institutions. Finance therefore,
represents the resources by way of funds needed for a particular activity. We thus speak of
‘finance’ only in relation to a proposed activity. Finance goes with commerce, business,
banking, etc. Finance is also referred as “Funds” or “Capital”, when referring to the financial
needs of a corporate body. When we study finance as a subject for generalising its profile
and attributes, we distinguish between ‘personal finance” and “corporate finance” i.e. resources
needed personally by an individual for his family and individual needs and resources needed
by a business organization to carry on its functions intended for the achievement of its
corporate goals.
13.2 INDIAN FINANCIAL SYSTEM

The economic development of a nation is reflected by the progress of the various
economic units; broadly classified into corporate sector, government and household sector.
While performing their activities, these units will be placed in surplus/deficit/balanced
budgetary situations. There are areas or people with surplus funds and there are those with a
deficit. A financial system or financial sector functions as an intermediary and facilitates
the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a
composition of various institutions, markets, regulations and laws, practices, money manager,
analysts, transactions and claims and liabilities.
FINANCIAL SYSTEM;
The word “system”, in the term “financial system”, implies a set of complex and closely
connected or interlined institutions, agents, practices, markets, transactions, claims, and
liabilities in the economy. The financial system is concerned about money, credit and finance
and these three terms are intimately related yet are somewhat different from each other.
Indian financial system consists of financial market, financial instruments and financial
intermediation. These are briefly discussed below;
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FINANCIAL MARKET:
A Financial Market can be defined as the market in which financial assets are created
or transferred. As against a real transaction that involves exchange of money for real goods
or services, a financial transaction involves creation or transfer of a financial asset. Financial
Assets or Financial Instruments represents a claim to the payment of a sum of money
sometime in the future and /or periodic payment in the form of interest or dividend.
Money Market; The money market is a wholesale debt market for low-risk, highly
liquid, short-term instrument. Funds are available in this market for periods ranging from a
single day up to a year. This market is dominated mostly by government, banks and financial
institutions.
Capital Market; The capital market is a market designed to finance the long-term
investments. The transactions taking place in this market will be for periods over a year.
Forex Market; The Forex market deals with the multicurrency requirements which
are met by the exchange of currencies. Depending on the exchange rate that is applicable,
the transfer of funds takes place in this market. This is one of the most developed and
integrated market across the globe.
Credit Market; Credit market is a place where banks, FIs and NBFCs purvey short,
medium and long-term loans to corporate and individuals.
13.3 CONSTITUENTS OF FINANCIAL SYSTEM

Financial Intermediation
Having designed the instrument, the issuer should then ensure that these financial
assets should reach the ultimate investors in order to mobilise the requisite amount. When
the borrower of funds approaches the financial market to raise funds, mere issue of securities
will not suffice. Adequate information of the issue, issuer and the security should be passed
on to the borrower. There should be a proper channel within the financial system to ensure
such transfer. To serve this purpose, financial intermediaries came into existence. Financial
intermediation in the organized sector is conducted by a wide range of institutions functioning
under the overall surveillance of the Reserve Bank of India. In the initial stages, the role of
the intermediary was mostly related to ensure transfer of funds from the lenders to the
borrowers. This service was offered by banks, FIs, brokers, and dealers. However, as the
financial system widened along with the developments taking place in the financial markets,
the scope of its operations also widened. Some of the important intermediaries operating in
the financial markets include; investment bankers, underwriters, stock exchanges, registrars,
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depositories, custodians, portfolio managers, mutual funds, financial advisers financial
consultants, primary dealers, satellite dealers, self regulatory organizations, etc. Though the
markets are different, there may be a few intermediaries offering their services in more than
one market e.g. underwriter. However, the services offered by them vary from one market to
another.
13.4 FINANCIAL INSTRUMENTS

Money Market Instruments
The money market can be defined as a market for short-term money and financial
assets that are near substitutes for money. The term short-term means generally a period up
to one year and near substitutes to money is used to denote any financial asset which can be
quickly converted into money with minimum transaction cost.
Some of the important money market instruments are briefly discussed below;
1. Call/Notice Money
2. Inter Bank Term Money
3. Treasury Bills
4. Term Money
5. Certificate of Deposit
6. Commercial Papers
1. Call /Notice-Money Market
Call/Notice money is the money borrowed or lent on demand for a very short period.
When money is borrowed or lent for a day, it is known as Call (Overnight) Money. Intervening
holidays and/or Sunday are excluded for this purpose. Thus money, borrowed on a day and
repaid on the next working day, (irrespective of the number of intervening holidays) is “Call
Money”. When money is borrowed or lent for more than a day and up to 14 days, it is “Notice
Money”. No collateral security is required to cover these transactions.
2. Inter-Bank Term Money
Inter-bank market for deposits of maturity beyond 14 days is referred to as inter-bank
term money market. The entry restrictions are the same as those for call/notice money except
that, as per existing regulations, the specified entities are not allowed to lend beyond 14
days.
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3. Treasury Bills
Treasury Bills are short term (up to one year) borrowing instruments of the central
government. It is an IOU of the Government. It is a promise by the Government to pay a
stated sum after expiry of the stated period from the date of issue (14/91/182/364 days i.e.
less than one year). They are issued at a discount to the face value, and on maturity, the face
value is paid to the holder. The rate of discount and the corresponding issue price are
determined at each auction.
4. Certificate of Deposits
The Certificates of Deposit (CDs) is a negotiable money market instrument and issued
in dematerialised form or as a Usance Promissory Note, for funds deposited at a bank or
other eligible financial institution for a specified time period. Guidelines for issue of CDs
are presently governed by various directives issued by the Reserve Bank of India, as amended
from time to time. The CDs can be issued by (i) scheduled commercial banks excluding
Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial
Institutions that have been permitted by the RBI to raise short-term resources within the
umbrella limit fixed by the RBI. Banks have the freedom to issue CDs depending on their
requirements. Any FIs may issue CDs within the overall umbrella limit fixed by the RBI( i.e.,
issue of CD together with other instruments viz., term money, term deposits, commercial
papers and inter corporate deposits) should not exceed 100 per cent of its net owned funds,
as per the latest audited balance sheet.
5. Commercial Paper
The CP is a note in evidence of the debt obligation of the issuer. On issuing commercial
paper, the debt obligation is transformed into an instrument. The CP is thus an unsecured
promissory note privately placed with investors at a discount rate to face value determined
by market forces. The CP is freely negotiable by endorsement and delivery. A company shall
be eligible to issue CP provided; (a) the tangible net worth of the company, as per the latest
audited balance sheet, is not less than Rs. 4 crore; (b) the working capital (fund-based) limit
of the company from the banking system is not less than Rs.4 crore and (c) the borrower
account of the company is classified as a Standard Asset by the financing bank/s. The minimum
maturity period of CP is 7 days. The minimum credit rating shall be P-2 of CRISIL or such
equivalent rating by other agencies.
Capital Market Instruments
The capital market generally consists of the long term period (i.e., more than one
year period) financial instruments. In the equity segment, equity shares, preference shares,
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convertible preference shares, non-convertible preference shares, etc, and in the debt segment
debentures, zero coupon bonds, deep discount bonds, etc.
Hybrid Instruments
Hybrid instruments have both the features of equity and debenture. This kind of
instruments is called as hybrid instruments. For example convertible debentures, warrants,
etc.
13.5 FINANCIAL INSTITUTIONS

A financial institution is an establishment that conducts financial transactions such as
investments, loans and deposits. Almost everyone deals with financial institutions on a regular
basis. Everything from depositing money to taking loans and exchanging currencies must be
done through financial institutions. The following are the some of the major categories of
financial institutions.
13.5.1 Commercial Banks
Commercial banks accept deposits and provide security and convenience to their
customers. The original purpose of banks was to offer customers safe keeping for their
money. By keeping physical cash at home or in a wallet, there has risk of loss due to theft and
accidents, not to mention the loss of possible income from interest. With banks, consumers
no longer need to keep large amounts of currency on hand; transactions can be handled with
cheques, debit cards or credit cards.
Commercial banks lend loans to individuals and businesses to buy goods or expand
business operations, which in turn lead to more deposited funds that make their way to banks.
Usually, banks lend money at a higher interest rate than the rate of interest on deposits and
operating costs to earn profit for their growth and survival. Banks also serve, often under-
appreciated role, as payment agents within a country and between nations. Not only do banks
issue debit cards that allow account holders to pay for goods with the swipe and they can also
arrange wire transfers with other institutions. Banks essentially underwrite financial
transactions by lending their reputation and credibility to the transaction. A cheque is basically
just a promissory note between two people, but without a bank’s name and information on
that note, no merchant would accept it. As payment agents, banks make commercial
transactions much more convenient; it is not necessary to carry around large amounts of
physical currency when merchants will accept the cheques, debit cards or credit cards of
banks.
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13.5.2 Investment Banks
The stock market crash of 1929 and Great Depression caused the United States
Government to increase financial market regulations. The Glass-Steagall Act of 1933 resulted
in the separation of investment banking from commercial banking. Investment banks may
also be called “banks,” but their operations are far different than deposit-gathering commercial
banks. An investment bank is a financial intermediary that performs variety of services for
businesses and governments. These service include underwriting debt and equity offerings,
acting as an intermediary between an issuer of securities and the investing public, making
markets, facilitating mergers and other corporate reorganizations, and acting as a broker for
institutional clients. They may also provide research and financial advisory services to
companies. As a general rule, investment banks focus on initial public offerings (IPO’s) and
large public and private share offerings. Traditionally, investment banks do not deal with the
general public. However, some of the big names in investment banking, such as JP Morgan
Chase, Bank of America and Citigroup, also operate commercial banks. Other past and present
investment banks you may have heard of include Morgan Stanley, Goldman Sachs, Lehman
Brothers and First Boston.
Generally speaking, investment banks are subject to less regulation than commercial
banks. While investment banks operate under the supervision of regulatory bodies, like the
Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer
restrictions when it comes to maintaining capital ratios or introducing new products.
13.5.3 Insurance Companies
Insurance companies pool risk by collecting premiums from a large group of people
who want to protect themselves and/or their loved ones against a particular loss, such as a
fire, accident, illness, lawsuit, disability or death. Insurance helps individuals and companies
manage risk and preserve wealth. By insuring a large number of people, insurance companies
operate profitably and at the same time pay claims that may arise. Insurance companies use
statistical analysis to project what their actual losses will be within a given class. They know
that not all insured individuals will suffer losses at the same time or at all.
13.5.4 Brokerage Company
A brokerage Company acts as an intermediary between buyers and sellers to facilitate
securities transactions. Brokerage companies are compensated via commission after the
transaction has been successfully completed. For example, when a trade order for a stock is
carried out, an individual often pays a transaction fee for the brokerage company’s efforts to
execute the trade.
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A brokerage company can be either full service or discount. A full service brokerage
company provides investment advice, portfolio management and trade execution. In exchange
for this high level of services, customers pay significant commissions on each trade. Discount
brokers allow investors to perform their own investment research and make their own
decisions. The brokerage still executes the investor’s trades, but since it doesn’t provide the
other services of a full-service brokerage, its trade commissions are much smaller.
13.5.5 Investment Companies
An investment company is a corporation or a trust through which individuals invest in
diversified, professionally managed portfolios of securities by pooling their funds with those
of other investors. Rather than purchasing combinations of individual stocks and bonds for a
portfolio, an investor can purchase securities indirectly through package products like a
mutual fund.
There are three fundamental types of investment companies: unit investment trusts
(UITs), face amount certificate companies and managed investment companies. All three
types have the following things in common;
• An undivided interest in the fund proportional to the number of shares held
• Diversification in a large number of securities
• Professional management
• Specific investment objectives
Let’s take a closer look at each type of Investment Company.
13.5.6 Unit Investment Trusts (UITs)
A unit investment trust, or UIT, is a company established under an indenture or similar
agreement. It has the following characteristics;
• The management of the trust is supervised by a trustee.
• Unit investment trusts sell a fixed number of shares to unit holders, who receive a
proportionate share of net income from the underlying trust.
• The UIT security is redeemable and represents an undivided interest in a specific portfolio
of securities.
• The portfolio is merely supervised, not managed, as it remains fixed for the life of the
trust. In other words, there is no day-to-day management of the portfolio.
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13.5.7 Face Amount Certificate Company
A face amount certificate company issues debt certificates at a predetermined rate of
interest. Additional characteristics include:
• Certificate holders may redeem their certificates for a fixed amount on a specified
date, or for a specific surrender value, before maturity.
• Certificates can be purchased either in periodic instalments or all at once with a lump-
sum payment.
• Face amount certificate companies are almost nonexistent today.
13.5.8 Management Investment Companies
The most common type of Investment Company is the management investment
company, which actively manages a portfolio of securities to achieve its investment objective.
There are two types of management investment company, viz, closed-end and open-end. The
primary differences between the two come down to where investors buy and sell their shares
in the primary or secondary markets and the type of securities the investment company sells.
• Closed-End Investment Companies: A closed-end investment company issues shares in
one-time public offering. It does not continually offer new shares, nor does it redeem its
shares like an open-end investment company. Once shares are issued, an investor may
purchase them on the open market and sell them in the same way. The market value of the
closed-end fund’s shares will be based on supply and demand, much like other securities.
Instead of selling at net asset value, the shares can sell at a premium or at a discount to
the net asset value.
• Open-End Investment Companies: Open-end investment companies are also known as
mutual funds that issues new shares continuously. These shares are purchased from the
investment company and sold back to the investment company.
13.6 NON-BANK FINANCIAL INSTITUTIONS

The following institutions are not technically banks but provide some of the same
services as banks.
13.6.1 Savings and Loans Association
Savings and Loan Associations, also known as S&Ls or thrifts, resemble banks in
many respects. Most consumers don’t know the differences between commercial banks and
S&Ls. By law, savings and loan companies must have 65 per cent or more of their lending in
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residential mortgages, though other types of lending is allowed. S&Ls emerged largely in
response to the exclusivity of commercial banks. There was a time when banks would only
accept deposits from people of relatively high wealth, with references, and would not lend to
ordinary workers. Savings and loans typically offered lower rates than commercial banks and
higher interest rates on deposits; the narrower profit margin was a by-product of such S&Ls.
13.6.2 Credit Unions
Credit unions are another alternative to regular commercial banks. Credit unions are
almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions
can be chartered at the federal or state level. Like S&Ls, credit unions typically offer higher
rates on deposits and charge lower rates on loans in comparison to commercial banks. The
main problem in credit union is that the membership is not open to the public, but rather
restricted to a particular membership group. In the past, this has meant that employees of
certain companies, members of certain churches, and so on, were the only allowed joining a
credit union. In recent years, though, these restrictions have been eased considerably, there
has very much over the objections of banks.
13.6.3 Shadow Banks
The housing bubble and subsequent credit crisis brought attention to what is commonly
called “the shadow banking system.” This is a collection of investment banks, hedge funds,
insurers and other non-bank financial institutions that replicate some of the activities of
regulated banks, but do not operate in the same regulatory environment. The shadow banking
system funnelled a great deal of money into the U.S. residential mortgage market during the
bubble. Insurance companies would buy mortgage bonds from investment banks, which would
then use the proceeds to buy more mortgages, so that they could issue more mortgage bonds.
The banks would use the money obtained from selling mortgages to write still more mortgages.
Many estimates of the size of the shadow banking system suggest that it had grown to match
the size of the traditional U.S. banking system by 2008.
Apart from the absence of regulation and reporting requirements, the nature of the
operations within the shadow banking system created several problems. Specifically, many
of these institutions “borrowed short” to “lend long.” In other words, they financed long-
term commitments with short-term debt. This left these institutions very vulnerable to increase
in short-term rates and when those rates rose, it forced many institutions to rush to liquidate
investments and make margin calls. Moreover, as these institutions were not a part of the
formal banking system, they did not have access to the same emergency funding facilities.
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13.7 FINANCIAL INSTITUTIONS AND ECONOMIC GROWTH
A large body of academic research across many countries have demonstrated the
important role played by the highly developed banking sector and capital market in facilitating
economic growth. Well developed financial system allows economies to reach their potential
since they allow firms which have successfully identified profitable opportunities to exploit
these opportunities as intermediaries by channelling investment funds from those in the
economy who are willing to defer their consumption plans into the future.
In general, economic growth depends on the accumulation of input factors in the
production process and on technical progress. Seeing capital and capital accumulation as an
important input factor, financial development is linked most clearly to this source of growth.
Financial development may also help to realise faster technical progress, embedded in the
capital stock, to achieve higher economic growth.
More specifically, financial development can affect growth through three main channels:
i) It can raise the proportion of savings channelled to investment, thereby reducing the
costs of financial intermediation
ii) It may improve the allocation of resources across investment projects, thus increasing
the social marginal productivity of capital and
iii) It can influence the savings rates of households, for example, if it induces a higher
degree of risk sharing and specialisation, which as a result stimulates higher growth.
There is clear evidence of stronger growth in those countries which are characterised
by a good legal structure. This may lower both information costs (e.g., through verifying the
quality of disclosure of companies’ accounts) as well as transaction costs (e.g., through the
better legal enforcement of contracts) for a supplier of funds, such as banks. Furthermore,
when banks are allowed to be active in a wide range of activities, such as in the securities,
insurance, or real estate markets, and when banks can own or control non-financial firms, or
vice-versa, credit may be better allocated and/or more credit may be available to entrepreneurs.
In the EU context, the financial structure has seen a remarkable transformation and
elements such as the provision of risk capital and the strengthening of market-based elements
have become more important in recent years. The clearest transformation of the financial
sector has been the tendency towards integration, which is leading to positive scale and scope
effects and to increased competitive pressures on financial intermediaries. This is eliminating
quasi-rents, improving the allocation of capital, and offering the highest possible returns and
the lowest possible cost of capital. Moreover, enhanced competition among intermediaries
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has provided greater scope for financial innovation. However, considerable differences among
Member States do still exist. Even in the EU, there is evidence that differences in the degree
of financial sector development and the proportion of activity on financial markets is related
to differences in creditor protection and accounting standards.
13.8 IMPORTANT FACTORS IN BUILDING STABLE FINANCIAL

SYSTEM
Generally, a stable financial system can be described as a financial system that is able
to withstand shocks without giving way to cumulative processes which could impair the
allocation of savings to investments and the processing of payments in the economy. How do
we get there?
1. Financial system architecture should be carefully planned. Different stages of financial
development require adequate institutional processes to be in place. Here, one can
refer to the sequencing laid out by IMF in recent years and to the European experience
with opening and gradually liberalising the financial sector during 1980s and 1990s.
2. A solid micro supervision of the financial sector and individual institutions should be
in place.
3. A close co-operation and exchange of information between the central bank and
supervisory authorities is warranted at all times and especially in periods of financial
stress. There are several, complementary public policies that are typically needed to
sustain or build up confidence in financial institutions.
Let me mention:
 Fiscal policy; If fiscal authorities are restricted in their ability to run deficits or
accumulate large debts, an important source of financial market stress and financial
instability is removed.
 Monetary policy; The monetary authorities should try to guarantee price stability while
developing monetary policy of the country. Indirectly, this should also be conducive to
support financial stability, as the economy will have less macro uncertainties to deal
with, when allocating resources. However, it goes without saying that the central bank
should take an active interest in monitoring financial sector developments, given the
importance of the sector, also from a monetary policy (transmission) perspective, and
given its importance in the economic system (intermediation between lenders and
borrowers). In some cases, when financial stability is threatened, monetary policy may
be used as a tool to support the financial sector. This support may come not only
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through interest rate policy, but also and most powerfully through the central bank’s
role as a lender of last resort, that is, in providing final liquidity when solvent
commercial banks suffer liquidity strains.
 Financial supervision. An adequate supervisory framework helps to enhance financial
stability and maintain overall confidence in the financial system.
 A financial safety net is in place in most countries with a view to protect small
depositors in case of a bank failure. This system seems to work relatively well in
maintaining confidence in financial institutions.
Of course, a stable financial system cannot operate without market discipline of the
financial sector. In order to avoid costly bank runs and bank failures, the sector must show
some self-discipline, to meet acceptable standards and expectations of shareholders. Banks
should be able to show good performance, adopt a sound risk management system and adhere
to adequate corporate governance rules. In case of deteriorating results, prompt corrective
actions should be taken and announced to the public, in order not to lose its credibility. As an
external watchdog, rating agencies provide a valuable service by monitoring the financial
sector and designing a rating system, which reflect the institution’s capacity to service its
debts. This has, at times, proven to be a valuable tool to distinguish sound from unhealthy
institutions.
4. Strengthening the supervisory framework; It is a key to enhance financial stability and
overall confidence in the financial system. It is essential to ensure that the supervisory
structure is effective in safeguarding financial stability. In the EU, given the increased
cross-border activity, the infrastructures for large-value payment systems and the use
of sophisticated financial instruments, systemic risk is no longer confined to any one
Member State but is an EU and euro area-wide concern. In addition, consistent
implementation of the common EU regulatory framework and convergence of
supervisory practices across Member States are being increasingly pursued, with a
view to promoting a level playing field and to favouring the integration of financial
markets. Hence, within the EU co-operation among national authorities is increasingly
called for to ensure an effective monitoring of risks and to remove regulatory and
supervisory obstacles to integrated markets.
Indeed, in open and competitive financial markets a strong supervisory framework
can be characterised as encompassing three equally important features: Capital adequacy,
Compliance and Convergence, and Co-operation.
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13.8.1 Capital Adequacy
It is in simple words, rules and regulations which require banks to hold sufficient
capital to cover the risks they undertake. Capital requirements are now generally acknowledged
as a major foundation of a stable banking system and have become inherent part of the Financial
Sector Assessment Programs conducted by International Financial Institutions. A global
benchmark for such rules is the Basel Accord which, although is a product of G-10 Committee,
the Basel Committee on Banking Supervision, has undoubtedly achieved a global reach. The
New Basel Capital Accord (Basel II) is intended to better align regulatory capital requirements
to underlying risks and to provide banks and supervisors with a more flexible capital adequacy
framework.
Although Basel II may be seen as a major challenge for both banks and supervisors
given its complexity and sophistication, it represents at the same time a ‘golden opportunity’
for strengthening the quantity and quality of resources devoted to the management and
supervision of risks at financial institutions. Specialised training and strengthening of
resources, possibly including staff, will be an important component of this process, which
will improve the overall quality of the supervisory framework and, ultimately, lead to a more
resilient financial system.
13.8.2 Compliance and Convergence
The existence of rules is a necessary but not sufficient condition. In order to enhance
credibility and confidence, it is essential that markets perceive the rules to be effectively
implemented and enforced in a harmonised manner across countries. This requires
convergence in supervisory practices, which is essential in ensuring a level playing field and
in limiting compliance costs for financial groups with substantial cross-border business.
The activities of large and complex financial groups span across different jurisdictions,
significant differences in the implementation and enforcement of prudential rules may drive
to allocate business lines to minimise the regulatory burden, then exploiting intra group
transactions to ensure an optimal use of funds. But this can create complex dynamics in
times of stress. It is essential that competent authorities have full access to the relevant
information and are able in good times to fully understand the factors driving the organisation
of business within international groups. Towards this aim, enhanced flows of information
between banks and their supervisors and frequent exchanges of information between
supervisors in different jurisdictions are considered critical to successful implementation.
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13.8.3 Co-operation
Co-operation is essential on three main levels. The co-operation (entailing also
exchange of information) between supervisory authorities and central bank, irrespective of
the function that the latter have in the national supervisory in macro-prudential and structural
monitoring of financial market developments, and in the area of financial crisis management.
The cross-sector co-operation is important given the increasingly indistinct boundaries
between traditional banking, securities and insurance sectors from the integration of financial
products, markets and intermediaries across sectors. The cross-border co-operation will be
required namely regarding the supervision of large and complex banking groups. In this context,
it has been recognised that home-country supervisor may not have the ability to alone gather
all relevant information necessary for effective supervision. The principle of “mutual
recognition” for internationally active banks is a key basis for international supervisory co-
operation. The Basel Committee has published a set of principles to facilitate closer practical
co-operation and information exchange among supervisors.
As a specific aspect of international co-operation, it is necessary to stress the
relevance of host supervision, namely in light of Basel II. In Argentinean market, indeed
many subsidiaries of foreign banks are present and it should be noted that Basel II acknowledges
the increased importance of host supervision given the increased complexity of supervising
large complex banking groups or conglomerates and given the increased complexity in the
regulatory regime. Hence, home supervisors will have to rely more and enhance co-operation
with the host supervisors.
Here are some examples of how co-operation was indeed enhanced in the EU. Closer
co-operation between central banks and supervisors has been formally addressed through
the signing of three Memorandums of Understanding in the first part of 2003 for which the
ECB has played a catalytic role. The first addressed co-operation between banking supervisors
and payment system overseers, the second on co-operation between central banks and
supervisory authorities in crisis situations and the third focused on co-operation between
seven EU central banks managing credit registers.
The need to enhance co-operation between regulatory and supervisory authorities in
the EU is gaining political momentum. In the banking sector, the European Banking
Committee, which is the successor of the Banking Advisory Committee that is responsible
for maintaining a robust and flexible EU secondary legislation, which can be easily adapted
to fast changing financial markets. Also, a new supervisory committee, the Committee of
European Banking Supervisors has set up for providing technical advice and pursuing consistent
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implementation of the new framework and convergence in supervisory practices. Such
committees have been established for all financial sectors. Also, the strengthening of cross-
sectoral co-operation has addressed by the newly established Financial Services Committee,
which has succeeded the Financial Services Policy Group and is mandated to provide strategic
guidance on financial sector policies.
13.9 CASE STUDY

A Commercial Paper (CP) is a short term money market instrument used by Financial
Institutions and Corporations to source funds from the public. It is a negotiable instrument
transferable by endorsement and delivery. The CP market in India changed tremendously
after July 1, 2010. This case presents the salient features of CPs issued in India and abroad,
the legal framework related to the issue, the market position after July 1, 2010, the RBI
guidelines on the issue of CPs in India, etc. It gives the reader a comprehensive idea of the
instrument.
a) Discuss the usefulness of this instrument to the issuing agency.
b) Analyze the Yield to Maturity (YTM) to an investor.
c) Explain the guidelines issued by the RBI.
d) Discuss and debate the pros and cons of this instrument in comparison to other money
market instruments.
Case study:
Recently many countries around the globe have under gone financial sector reforms
due to global economic crisis such as restructuring or privatizing state owned banks and
establishment of capital markets. In Indian economy consists of many rigorous problems in
the smooth functioning of the capital markets? It has been made to bring out the phase-wise
development in respect of the capital markets in India. While this development was taking
place, there may have been some barriers causing hindrance to the development of capital
market. These problems or barriers may be political, socio-economic or administrative in
nature.
While the capital market playing vital role of developmental activity in the economy,
to know the many hindrances involved in their activity and also India is developing country,
how it helps to develop?
Find out
a) Problems involved in capital market.
b) Factors affecting to capital market.
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13.11 SUMMARY
The term “financial system”, implies a set of complex and closely connected or
interlined institutions, agents, practices, markets, transactions, claims, and liabilities in the
economy. A Financial Market can be defined as the market in which financial assets are
created or transferred. The money market is a wholesale debt market for low-risk, highly
liquid, short-term instrument. The capital market is a market designed to finance the long-
term investments. The Forex market deals with the multicurrency requirements which are
met by the exchange of currencies. Credit market is a place where banks, FIs and NBFCs
purvey short, medium and long-term loans to corporate and individuals
Important money market instruments are;
1. Call/Notice Money
2. Inter Bank Term Money
3. Treasury Bills
4. Term Money
5. Certificate of Deposit
6. Commercial Papers
Major categories of financial system are; commercial banks, investment banks,
investment company, insurance company, unit trust, etc.
Capital adequacy; rules and regulations which require banks to hold sufficient capital
to cover the risks they undertake.
13.12 KEY WORDS

Finance
Capital Market
Money Market
Financial Instruments
Financial Institutions
Economic growth
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1. Distinguish between money market and capital market.
2. Briefly highlight the constituents of financial system.
3. What are the instruments of money market? Explain
4. “Financial system is must for economic growth of India”. Discuss
5. Briefly explain the various factors in building stable financial system.
13.14 REFERENCES
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UNIT- 14 : FUNDS FLOW ANALYSIS
Structure :
14.0 Objectives
14.1 Introduction
14.2 Meaning of Fund
14.3 Difference between Fund Flow and Income Statement
14.4 Difference between Fund Flow Statement and Balance Sheet
14.5 Benefits of Fund Flow Analysis
14.6 Preparation of Fund Flow Statements
14.7 Fund Flow Statements
14.8 Inters Rate Analysis
14.9 Inflation and Risk
14.10 Case Study
14.11 Notes
14.12 Summary
14.13 Self Assessments Questions
14.16 Key Words
14.17 References
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14.0 OBJECTIVES
After study in this unit, you should be able to;
• meaning and definition of fund flow analysis,
• sources and application of funds,
• differences between fund flow statement and income statement,
• fund flow statement and balance sheet,
• benefits and drawbacks of funds flow statement,
• the procedure in preparation of funds flow statement,
• interest rate and its determinants, yield curve,
• inflation and risk, types of risk.
14.1 INTRODUCTION
The balance sheet and profit and loss account are the two important financial statements
usually prepared by all the companies irrespective of their nature and type to know the
operational and financial results at regular intervals. These two statements are also prepared
to meet the regulatory and stakeholders requirements. The balance sheet provides information
on sources of funds and application of funds. It gives summary of both assets and liabilities
on a specified date. The liquidity and solvency position can be examined by analysis of the
balance sheet. However, the balance sheet is static statement. In other words, it is just a
statement of assets and liabilities. The balance sheet does not disclose the details of assets
purchased and funds raised and repayment of liabilities.
The profit and loss account is prepared to know the operational results like gross
profit and net profit of a company on a particular date. This statement is also prepared to
meet the regulatory requirement. It portrays the summary of incomes realised and expenditures
incurred during the operating the period. This statement shows the change in position of the
owner on specific date. However, this is also a statement of income and expenditure. This
statement involves adjustments which do not have any cash outflow and inflow. However,
these two statements do no tell anything about flow of funds. Therefore, there is a need of
fund flow analysis.
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14.2 MEANING OF FUND
It is essential to understand the concept of fund to provide better understanding the
significance of fund flow analysis. The fund has defined by different experts in the field of
management accounting differently. In narrow sense, fund refers to cash only. In broader
sense, it refers to all financial resources of the company. However, the most acceptable
meaning of the term is working capital. The working capital may be defined as the difference
between current assets and current liabilities.
14.2.1 Meaning of Flow of Fund
The flow of funds refers to movement of funds involving inflow and outflow in working
capital of the company. A flow of fund takes place if there has a transaction between current
accounts and non current accounts are involved. In other words, transaction which involves
current account and non current account results into flow of funds. The following transactions
result into flow of funds;
1. Transaction between current assets and capital.
2. Transaction between current assets and long term liabilities.
3. Transaction between current liabilities and fixed assets.
4. Transaction between current liabilities and capital.
5. Transaction between current liabilities and long term liabilities.
6. Transaction between current assets and fixed assets.
14.2.2 Meaning of Fund Flow Statement
The fund flow statement which is popularly known as “statement of sources and
application of funds”. The fund flow statement is a report on movement of funds explaining
where working capital originates and where working capital goes during an accounting period.
It is financial statement which shows the manner in which the financial resources have been
generated and used during accounting period. This statement consists of sources and application
of funds. The transactions that increase the amount of working capital are known as sources
of funds and those that decrease the amount of working capital are known as application of
funds. The difference between the sources and application of funds is known as net funds.
The statement which depicts the sources of funds and application of funds is known as fund
flow statement. This is statement used to assess the change in financial position of a firm
between two dates. The fund flow statement is called by variety of names such as;
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1. Statement of sources and application of funds.
2. Statement of funds supplied and applied.
3. Statement of where got and where gone.
4. Statement of funds received and disbursed.
5. Statement of fund movement.
6. Statement of inflow of fund and outflow of fund.
14.2.3 Sources of Funds
1. Income from operations
2. Income from investments
3. Sale of fixed assets
4. Sale of long term investments
5. Issue of share capital
6. Issues of debentures
7. Rising of loans.
8. Dividend received
9. Gifts and damages awarded in legal suits.
14.2.4 Application of Funds
1. Operating losses
2. Redemption of preference share capital and debentures
3. Repayment of long term loans
4. Purchase of fixed assets
5. Purchase of long term investments
6. Non trading payments
7. Payment of dividend
8. Payment of taxes
Losses through embezzlements, payments of damages awarded.
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14.3 DIFFERENCE BETWEEN FUND FLOW AND INCOME
STATEMENT
Fund flow statement Income statement

Main objective is to ascertain the funds Main objective is to ascertain the
generated and used. operating results from business
operations
Prepared based on the financial Prepared based on the nominal accounts
statements of two consecutive years of particular accounting year
Takes into consideration the funds Takes into consideration income and
available from business operations and expenditure transactions relating to
other sources business operations of a particular
period.
It is not a statutory obligation on the part It is statutory obligation on the part of
of management to prepare fund flow management to prepare income
statement statement
Income statement act as a source Fund flow statement is not necessary in
document in preparation of this statement preparation of this statement
It can be prepared at any time at the It is usually prepared at the end of
desire of the management particular period of time
It is prepared on cash basis It is prepared both on cash and accrual
basis
Difficult to manipulate by the It is subject to manipulation by the
management management
It act as an instrument for planning and It does not act as an instrument for
control planning and control
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14.4 DIFFERENCE BETWEEN FUND FLOW STATEMENT AND
BALANCE SHEET
Fund flow statement Balance sheet

Main objective is to know the sources and Main objective is to know the financial
application of funds. position of the company on particular
date
Prepared based on the balance sheets of Prepared based on the ledger accounts of
two consecutive years particular accounting year
It is a dynamic statement It is a static statement
It is not a statutory obligation on the part It is statutory obligation on the part of
of management to prepare fund flow management to prepare income
statement statement
It shows change in the value of fixed It is a summary of assets and liabilities
assets and their effect on flow of funds on particular date.
It can be prepared at any time at the It is usually prepared at the end of
desire of the management particular period of time
It is prepared for internal purposes It is prepared to meet both internal and
external purposes
Difficult to manipulate by the It is subject to manipulation by the
management management
14.5 BENEFITS OF FUND FLOW ANALYSIS
1. It helps to determine financial consequences of operations.

2. It assists in formulating financial policies of a firm.
3. Optimum utilisation of working capital
4. It depicts the surplus and deficit of working capital
5. Useful to the bankers and lenders while lending the loans
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6. It is useful in effective allocation of scarce financial resources among different
projects on priority basis
7. It gives the reasons for change in the amount of working capital.
8. It provides the information on financial position of the company.
9. It gives information regarding trends in sources and application of funds
10. It acts as tool for effective planning and control.
14.6.1 Draw backs of Fund Flow Analysis
1. It is prepared based on the data appearing in account books and therefore it a
rearrangement of data of account books.
2. It is historical nature.
3. A study of cash flow is more relevant.
4. All the drawbacks of income statement and balance sheet are the draw backs
5. It is useful only when there has transaction between current and non current
accounts
6. It does not deal with various changes that are taking place continuously.
7. It ignores the non fund transactions
8. It deals with only external transactions.
14.7 PREPARATION OF FUND FLOW STATEMENT

The funds flow analysis requires preparation of two statements. They are;
1. Statement of changes in working capital
2. Funds flow statement
1. Statement of changes in working capital;
Working capital is the difference between total of current assets and current liabilities.
Current assets are those assets which are converted into cash within a period of one year.
Similarly, current liabilities are those liabilities which are converted into cash in one year.
The amount of working capital does not remain constant and it goes on changing from one
period to another. In other words, working capital at two periods is not same. In order to
know the change in working capital, it is necessary to prepare a statement of change in working
capital. This statement is prepared based on the amount of current assets and current liabilities
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appearing in the balance sheets. This statement shows change in current assets and current
liabilities and their effect on working capital. Total increase and decrease at the end of the
period is compared to calculate net increase and decrease in working capital. The statement
of change in working capital is also known as schedule of change in working capital. The
basic rules in preparation of schedule of working capital are;
1. Increase in current assets results in increase in working capital.
2. Decrease in current assets results in decrease in working capital.
3. Increase in current liabilities results in decrease in working capital.
4. Decrease in current liabilities results in increase in working capital.
14.7.1 Steps in preparation of schedule/statement of change in working capital
1. The amount of each item of current asset of the current year is compared with the
amount of the same of corresponding previous year. If the amount of current assets of
current year is more than its amount of previous year, the excess is recorded as increase
in working capital otherwise decrease in working capital.
2. The amount of each item of current liabilities of the current year is compared with the
amount of the same of corresponding previous year. If the amount of current liabilities
of current year is more than its amount of previous year, the excess is recorded as
decrease in working capital otherwise increase in working capital.
3. Make sure that all items of current assets and current liabilities appearing in the two
balance sheets are gone through and the difference is properly recorded.
4. Find the total of all increased and decreased amount.
5. Make comparison between the total of increased and decreased amount to find out the
difference in both to ascertain the increase and or decrease in the amount of working
capital.
14.8 FUNDS FLOW STATEMENT

The statement of change in working capital covers only current account items only.
This statement takes into consideration the change in working capital area. There are other
items in the balance sheet which are not covered in the statement of change in working
capital. Therefore, it is necessary to prepare fund flow statement to cover the items of balance
sheet which have no place in schedule of change in working capital to know the sources and
application of working capital. The fund flow statement covers all non current assets and all
non current liabilities of the balance sheets of two periods and additional information relating
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to balance sheets. The preparation of fund flow statement involves ascertainment of increase
or decrease in the various items of non current assets and non current liabilities and share
capital. The items those increase the amount of working capital are considered as sources of
funds and those decrease the amount of working capital are considered as application of
funds. The transactions that do not affect the amount of working capital are not in the purview
of fund flow statement. It is necessary to calculate the funds from operation to prepare fund
flow statement. The fund from operation is calculated by preparing funds from operation or
by preparing adjusted profit and loss account. The fund from operation is the difference
between the revenues generated from sales proceeds and cost paid. However, the fund from
business operation is quite different than fund from trading operations. To ascertain the funds
from operations, it is necessary to add non fund items debited to profit and loss account and
deduct non fund items credited to profit and loss account to the closing balance of profit/
retained earnings and deduct the opening balance of profit or retained earning and vice versa.
14.9 INTEREST RATE ANALYSIS

Rate of interest prevailing in any economy occupy an important place in the modern
world. All investors are interested in knowing the rate of return expected to receive from
investment whether it is from bank deposits, equity shares or debentures. The rate of interest
motivates the people to save money from their incomes and provide the same for productive
purposes.
14.9.1 Meaning of interest
Interest is the payment made for borrowed funds or the price paid for the use of
money. Interest is always expressed as a rate percent per annum or per month. i.e. 10% p.a, 5
% p.a.
In the words of Marshall, interest is the price paid for the use of capital in any market.
Keynes defined it as premium offered to induce people to hold their savings in some form
other than hoarded money. Interest is the cost paid by the borrower for the use of money as
well as for the risk involved in lending. The interest may be classified as gross interest and
net interest. Gross interest includes not only the payment made for use of capital but also for
the risk undertaken by the lender. Net interest includes the payment made exclusively for the
use of money.
14.9.2 Determinants of interest rates
The rate of interest is determined by the forces of demand and supply in financial
market. But the problem is to identify the demand and supply for what? Numbers of theories
have been developed to answer this question differently. They are as follows;
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1. Classical theory
2. Loanable fund theory
3. Liquidity preference theory
4. Modern theory
1. Classical theory;
This theory was given by classical economists such as Marshall, Ricardo, Pigiou,
Fisher and others. According to them, interest is a real phenomenon and is therefore
determined by supply of and demand for capital under condition of perfect competition. The
supply of savings depends on the willingness to save and ability to save. The demand for
investment depends on cost of investment.
Assumptions of this theory are;
1. Perfect competition.
2. Constant income and price level.
3. Rate of interest is flexible.
4. Full employment of resources
5. Rational behaviour of investors.
2. Loanable fund theory;
This theory is given Wickshell, Myrdal and Robertson. According to them, the rate
of interest is determined by demand for and supply of loanable funds; interest is the reward
for the use of loanable funds.
Assumptions of this theory are;
1. Perfect competition.
2. Funds are perfectly movable and market is fully integrated.
3. Rate of interest is flexible.
4. Full employment of resources
Supply of loanable funds comes from savings, dishoarded money, credit advanced by
banks and money from disinvestment. Demand from loanable funds comes from investment,
consumption and hoarding purpose.
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3. Liquidity preference theory
This theory is given by Keynes, a renowned economist. According to him, rate of
interest is determined by the intersection between the supply of and demand for money. He
defined interest as the reward for parting with liquidity for specified period. Interest is the
reward offered to people to induce them to hold securities or income yielding assets instead
of cash. According to this theory, people’s desire for liquidity can be reduced by offering
them high rate of interest. Thus, interest is the reward for inducing people to part with liquidity
and hold the same in the form of securities. Demand to hold money is called the liquidity
preference. The people have the following three motives to hold money as liquid asset. They
are transaction motive, precautionary motive and speculative motive. The supply of money is
determined and controlled by the monetary authorities.
4 Modern theory;
This theory suggests for consideration of both real and monetary factors to determine
the rate of interest. The theory suggests four determinants of rate of interest;
1. Saving function
2. Investment function
3. Liquidity preference function and quantum of money
5 Yield Curves;
The term yield is synonymous with interest rate. The structure of interest rate when
present graphically, takes the form of yield curve. Yield curve may be defined as curve
depicting relation between yield and term to maturity. Yield curve is a name given to the
functional relation between yield and the term to maturity. Yield to maturity includes nominal
coupon interest payment plus the capital gain or loss arising from sale of security.
A line that plots the interest rates, at a set point in time, of bonds having equal credit
quality, but differing maturity dates. The most frequently reported yield curve compares the
three-month, two-year, five-years and 30-year U.S. Treasury debt. This yield curve is used as
a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The
curve is also used to predict changes in economic output and growth.
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BREAKING DOWN ‘YIELD CURVE’
The shape of the yield curve is closely scrutinized because it helps to give an idea of
future interest rate change and economic activity. There are three main types of yield curve
shapes: normal, inverted and flat (or humped). A normal yield curve (pictured here) is one in
which longer maturity bonds have a higher yield compared to short-term bonds due to the
risks associated with time. An inverted yield curve is one in which the short-term yields are
higher than the long-term yields, which can be a sign of upcoming recession. A flat (or humped)
yield curve is one in which the short and long-term yields are very close to each other, which
is also a predictor of an economic transition. The slope of the yield curve is also seen as
important: the greater the slope, the greater the gap between short and long-term rates.
14.10 INFLATION AND RISK

Inflation is a fairly new phenomenon for world economic market during pre-twentieth
century. There had little upward pressure on prices due to gold and other metallic standards.
At the end of the gold standard, strong political pressures often caused governments to issue
more money caused increased supply of money supply and therefore the price level.
Inflation reflects a situation where the demand for goods and services exceeds their
supply in the economy. Its causes could be triggered by the private sector and the government
spending more than their revenues, or by shortfalls in output. Price increases could also be
triggered by increases in costs of production. For instance, increase in prices of imported
raw materials will cause inflation if not managed. Whatever the initial cause, inflation will
not persist unless accompanied by sustained increase in money supply. In this sense, inflation
is a monetary phenomenon
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But what effect does inflation have on the economy and on investment in particular?
Inflation causes many distortions in the economy. It hurts people who are retired and living
on a fixed income. When prices rise these consumers cannot buy as much as they could
previously. This discourages savings due to the fact that the money is worth more presently
than in the future. This expectation reduces economic growth because the economy needs a
certain level of savings to finance investments which boosts economic growth. Also, inflation
makes it harder for businesses to plan for the future. It is very difficult to decide how much
to produce, because businesses cannot predict the demand for their product at the higher
prices they will have to charge in order to cover their costs. High inflation not only disrupts
the operation of a nation’s financial institutions and markets, it also discourages their
integration with the rest of the worlds markets. Inflation causes uncertainty about future
prices, interest rates, and exchange rates, and this in turn increases the risks among potential
trade partners, discouraging trade. As far as commercial banking is concerned, it erodes the
value of the depositor’s savings as well as that of the bank’s loans. The uncertainty associated
with inflation increases the risk associated with the investment and production activity of
firms and markets.
The impact of inflation has on a portfolio depends on the type of securities held
there. Investing only in stocks one may not have to worry about inflation. In the long run, a
company’s revenue and earnings should increase at the same pace as inflation. But inflation
can discourage investors by reducing their confidence in investments that take a long time to
mature. The main problem with stocks and inflation is that a company’s returns can be
overstated. When there is high inflation, a company may look like it’s doing a great job,
when really inflation is the reason behind the growth. In addition to this, when analysing the
earnings of a firm, inflation can be problematic depending on what technique, the company
uses to value its inventory.
The effect of inflation on investment occurs directly and indirectly. Inflation increases
transactions and information costs, which directly inhibits economic development. For
example, when inflation makes nominal values uncertain, investment planning becomes
difficult. Individuals may be reluctant to enter into contracts when inflation cannot be
predicted making relative prices uncertain. This reluctance to enter into contracts over time
will inhibit investment which will affect economic growth.
1. Credit Risk:
Credit risk is arguably the most obvious risk to a bank. A bank’s business model is
basically predicated on the idea that the large majority of lenders will repay their loans on
time, but a certain percentage will not. So long as the bank’s estimates of repayment rates are
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accurate, or conservative, there are few problems. When a bank fails to adequately estimate
and price the rate of losses, or when economic conditions change significantly, banks may
face higher levels of bad loans which can shrink the bank’s capital reserves to an unacceptable
level. Taken to the extreme, if a bank underestimates the amount of credit losses it will incur,
the bank can fail altogether.
2. Concentration risk;
The risk of having too much money lent out to certain categories of borrowers. If all
of a bank’s mortgage lending was confined to a particular neighbourhood of a city, or a
particular company’s employees, there would be major risks to the bank’s capital if some
sort of disaster where to hit that neighbourhood, or if that company ran into financial
difficulties and laid-off many of those employees. More practically, concentration risk for
most commercial banks is measured by the type of lending (residential mortgage, multifamily
residential, construction, etc.) and the region of the borrowers.
3. Liquidity Risk:
Banks lend out the vast majority of the funds they receive as deposits, therefore,
there is always a risk that the bank will face a sudden rush of withdrawals that it cannot meet,
with the cash it has on hand. Banks cannot call in loans on demand and cannot legally forbid
depositors from withdrawing funds. Banks can call upon lending facilities with other banks
or the Federal Reserve. While capital is usually available for healthy banks, a sudden
simultaneous rush from multiple banks can increase short-term borrowing costs significantly.
The failure of a bank to properly administer its liquidity needs can significantly harm its
profitability.
4. Market Risk:
As banks frequently hold investment securities on their balance sheet, they are
vulnerable to changes in the market value of those investments. As many banks hold significant
percentages of their reserves in debt instruments widely thought of as “safe,” (including U.S.
government bonds), a sudden market decline in those securities could force banks to raise
capital or spare back on lending, to say nothing of the loss in shareholder equity from the
investment losses.
5. Operating Risk:
Banks are also vulnerable to the same sort of operating risk as any competitive
enterprise. Management may make mistakes regarding acquisitions, expansion, marketing
or other policies, and lose ground to rivals. In the case of banking, operating risk can have a
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longer tail than in other industries. Banks may be tempted to underprice loans to garner
market share, but underpriced mortgage loans can hurt a bank for many years, and over-
aggressive lending (lending to poor credit risks) can threaten the survival of the bank itself.
6. Interest Rate Risk;
The profitability of banks is determined by the interest rates they charge and pay out
and they are highly exposed to changes in interest rates. Banks must always be making
predictions and estimates of future interest rate movements and positioning their balance
sheet accordingly. Unexpected rate changes can significantly impair profitability, as the bank
repositions its balance sheet.
7. Legal Risk:
The banking industry also faces certain legal risks that are not very common outside
the financial services industries. In addition to the aforementioned laws concerning fair and
honest lending, banks are also compelled to play a role in monitoring potential illegal activities
on the part of customers. In particular, banks are required to be on the lookout for signs of
money laundering. There are strict “know your customer” rules in place and banks are
compelled to maintain customers profile as per the directions of the RBI.
Banks are also subject to legal risks pertaining to their lending activities. Banks are required
to be fair and unbiased in their lending, and are also required to disclose a range of information
to prospective borrowers, including the annual percentage rates, terms and total cost to the
borrowers. Likewise, banks are subject to laws on usury and predatory lending. While the
definitions of usury and predatory lending arguably seem fairly clear, in practice they can be
subjective; what banks may consider a fair rate to compensate for the elevated risk of default,
regulators or citizens groups may deem excessive and predatory.
14.11 CASE STUDY

As a partner in the asset management practice of Mumbai based law firm Malhotra
and Rathod has advised around 40 fund managers and trust companies on the creation of
products including equity funds, bond funds, monetary market funds and ETFs. With a client
base evenly split between foreign joint ventures and domestic companies, their role includes
advising on and drafting contractual arrangements for the establishment of new funds, helping
in negotiations in the formation of new JVs, and assistance in obtaining regulatory approvals.
Mr.Rathod has also advised a number of international investment banks which are
acting as advisors to domestic funds with FDI quotas to invest in international markets. “The
international institutions have a useful role to play here, because there are so many funds
40
globally for Indian funds to choose from. It can be daunting trying to decide which will be the
most suitable to invest in,” he says.
One unique feature of the Indian market is that an institution may have to deal with
one of three possible regulatory bodies. “The asset management market in India is still highly
regulated, so foreign firms need to understand the restrictions, guidelines and legal risks,”
he explains. “It is a bit more complicated than in Hong Kong or the US, where you would
only have one regulator to deal.”
A related point is that with the relaxation of approval processes, a greater number of
products are now on the market and Mr.Rathod believes this has stimulated competition and
also helped the market evolve. “In the past, marketing was very important to attract investors.
But now, the products speak for themselves. With more products available, people can see
clearly which have superior performance and that means the marketing element has become
less important.”
Questions;
1. Discuss the advice made by the various fund managers.
2. Explain the role of regulatory bodies in fund management.
14.12 NOTES
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14.13 SUMMARY
In narrow sense, fund refers to cash only. In broader sense, it refers to all financial
resources of the company.
The flow of funds refers to movement of funds involving inflow and outflow in working
capital of the company.
The following transactions result into flow of funds; Transaction between current
assets and capital, Transaction between current assets and long term liabilities, Transaction
between current liabilities and fixed assets, Transaction between current liabilities and capital,
Transaction between current liabilities and long term liabilities and Transaction between
current assets and fixed assets.
The fund flow statement which is popularly known as “statement of sources and
application of funds”.
Sources of Funds; Income from operations, Income from investments, Sale of fixed
assets, Sale of long term investments, Issue of share capital, Issues of debentures, Rising of
loans, Dividend received, Gifts and damages awarded in legal suits.
Application of Funds; Operating losses, Redemption of preference share capital
and debentures, Repayment of long term loans, Purchase of fixed assets, Purchase of long
term investments, Non trading payments, Payment of dividend, Payment of taxes.
Working capital is the difference between total of current assets and current liabilities.
The statement showing change in current assets and current liabilities is known as
schedule of change in working capital
Interest is the payment made for borrowed funds or the price paid for the use of
money.
Theories of interest are; Classical theory, Loanable fund theory, Liquidity preference
theory and Modern theory.
Yield curve may be defined as curve depicting relation between yield and term to
maturity.
Inflation reflects a situation where the demand for goods and services exceeds their
supply in the economy.
Risk is the amount of variability in actuals as compared with the estimates.
The main types risk are; credit risk, market risk, concentration risk, liquidity risk,
operating risk, interest rate risk, legal risk, etc.
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1. What is flow of fund? Explain with example the type transactions that results in flow of
funds.
2. What do you mean by fund flow statement? Explain the sources and application of
funds.
3. Differentiate fund flow and income statement and fund flow statement and balance
sheet.
4. What are the merits and demerits of fund flow statement? Explain.
5. Elucidate the statement required to prepare funds flow statement.
6. Define interest rate. What are the determinants of interest rate?
7. Explain the various types of risk in financial market.
8. What is yield curve? Discuss its significance in interest rate determination.
14.15 KEYWORDS
Funds
Fund flow statements
Income statements
Balance sheet
Interest rate
Inflation and risk
14.16 REFERENCES
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UNIT- 15 : MANAGEMENT OF COMMERCIAL BANKS
Structure :
15.0 Objective
15.1 Introduction
15.2 The Banking System
15.3 Functions Of Commercial Banking In India
15.4 Role Of Commercial Banks
15.5 Gap Analysis
15.6 What Is Consortium
15.7 Credit Rating
15.8 Tandon Committee
15.9 Methods Of Lending
15.10 Case Study
15.11 Notes
15.12 Summary
15.14 Key Words
15.15 References
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15.0 OBJECTIVES
• indian banking system, functions of commercial banks
• types of deposits in banks, agency services
• role of commercial banks in Indian economy
• credit gap analysis, consortium lending
• role of lead bank in consortium
• role of consortium, credit rating
• methods of lending.
15.1 INTRODUCTION
Commercial banks are considered not merely as dealers in money but also the leaders
in economic development. They are not only the store houses of the country’s wealth but
also the reservoirs of resources necessary for economic development.
Many of us share fairly basic views of banks. They are places to store money, make
basic investments like term deposits, sign up for a credit card or get a loan. Behind this
mundane view, however, is a highly regulated system that ties our day-to-day banking back
into the wider financial system.
A Commercial Bank is a type of bank/financial institution that provides services
such as accepting deposits, making business loans, and offering basic investment products.
“Commercial bank” can also refer to a bank, or a division of a large bank, which more
specifically deals with deposits and loan services provided to corporations or large/middle-
sized business as opposed to individual members of the public/small business.
A financial institution that provides services, such as accepting deposits, giving
business loans and auto loans, mortgage lending, and basic investment products like savings
account and certificate of deposits. The traditional commercial bank is a brick and mortar
system with tellers, safe deposit boxes, vaults and ATMs. However, some commercial banks
do not have any physical branches and require consumers to complete all transactions by
phone or Internet. In exchange, they generally pay higher interest rates on investments and
deposits, and charge lower fees.
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15.2 THE BANKING SYSTEM
A commercial bank is basically a collection of investment capital in search of a good
return. The bank, the building, people, processes and services is a mechanism for drawing in
more capital and allocating in a way that the management and board believe will offer the
best return. By allocating capital efficiently, the bank will be more profitable and the share
price will increase. From this view, a bank provides a service to the consumers. But it also
provides a service to investors by rendering investment services. Banks that do both jobs will
be on successes. Banks that don’t do one or either of these jobs may eventually fail. In case
of failure, the FDIC swoops in, protects depositors and sees that the bank’s assets end up in
the hands of a more successful bank.
15.3 FUNCTIONS OF COMMERCIAL BANKS IN INDIA

Commercial banks provide banking services to businesses and consumers through a
network of branches. These banks are in business to make a profit for their owners and they
are usually public limited companies managed by shareholders. In India, however, most of
the top commercial banks are owned by the government. But many private commercial banks
have been established in recent years. Commercial banks are all-purpose banks that perform
wide range of functions such as accepting demand deposits, issuing cheques against saving
and fixed deposits, making short-term business and consumer loans, providing brokerage
services, buying and selling foreign exchange and so on.
The primary functions of commercial bank are accepting deposits from the public
and granting credit to all sectors of the economy after making provisions for reserves as per
the RBI regulations. Apart from receiving and lending functions, commercial banks undertake
various secondary or incidental functions such as agency services and general utility services.
The functions of commercial banks are mainly classified in to two types and they are-
1. Primary functions
2. Secondary functions
15.3.1 Primary functions
Collection of deposits, Making loans and advances
Collection of Deposits: The Collection of deposits from the public is a primary
function of commercial banks. There are mainly three types of deposits: current, savings and
fixed.
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Current account is usually opened by the business community to make business
related receipts and payments. A customer can deposit and withdraw money from the current
account subject to a minimum required balance. If the customer overdraws the account, he/
she may be required to pay interest to the bank. Cash credit facility is allowed in the current
account.
Savings account is an interest yielding account. Deposits in savings account are used
for saving money. Savings bank account-holder is required to maintain a minimum balance in
his account to avail cheque facilities.
Fixed or term deposits are used by the customers to save money for a specific
period of time, ranging from 7 days to 3 years or more. The rate of interest is related to the
period of deposit. For example, a fixed deposit with a maturity period of 3 years will give a
higher rate of return than a deposit with a maturity period of 1 year. But money cannot be
usually withdrawn before the due date. Some banks also impose penalty if the fixed deposits
are withdrawn before the due date. However, the customer can obtain a loan from the bank
against the fixed deposit receipt.
Loans and Advances: Commercial banks have to keep a certain portion of their
deposits as legal reserves. The balance is used to make loans and advances to the borrowers.
Individuals and firms can borrow this money and banks make profits by charging interest on
these loans. Commercial banks make various types of loans such as: Loan to a person or to a
firm against some collateral security; Cash credit (loan in instalments against certain security);
Overdraft facilities (i.e. allowing the customers to withdraw more money than what their
deposits permit); and Loan by discounting bills of exchange.
15.3.2 Secondary functions
Agency services and General utility service
Agency Services; The customers may give standing instructions to the banks to accept
or make payments on their behalf. The relationship between the banker and customer is that
of principal and agent. The following agency services are provided by the bankers:
1. Payment of rent, insurance premium, telephone bills, instalments on hire purchase,
etc. The payments are obviously made from the customer’s account. The banks
may also collect such receipts on behalf of the customer.
2. The bank collects cheques, drafts, and bills on behalf of the customer.
3. The banks can exchange domestic currency for foreign currencies as per the
regulations.
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3. The banks can act as trustees / executors to their customers. For example, banks
can execute the will after the death of their clients, if so instructed by the latter.
4. General Utility Services
General Utility Services: The commercial banks also provide various general utility
services to their customers. Some of these services are discussed below:
1. Safeguarding money and valuables: People feel safe and secured by depositing their
money and valuables in the safe custody of commercial banks. Many banks look after
valuable documents like house deeds and property, and jewellery items.
2. Transferring money: Money can be transferred from one place to another. In the same
way, banks collect funds of their customers from other banks and credit the same in the
customer’s account.
3. Merchant banking: Many commercial banks provide merchant banking services to the
investors and the firms. The merchant banking activity covers project advisory services
and loan syndication, corporate advisory services such as advice on mergers and
acquisitions, equity valuation, disinvestment, identification of joint venture partners and
so on.
4. Automatic Teller Machines (ATM): The ATMs are machines for quick withdrawal of
cash. In the last 10 years, most banks have introduced ATM facilities in metropolitan and
semi-urban areas. The account holders as well as credit card holders can withdraw cash
from ATMs.
5. Traveller’s cheque: A traveller’s cheque is a printed cheque of a specific denomination.
The cheque may be purchased by a person from the bank after making the necessary
payments. The customer may carry the traveller’s cheque while travelling. The traveller’s
cheques are accepted in banks, hotels and other establishments.
6. Credit Cards: Credit cards are another important means of making payments. The Visa
and Master Cards are operated by the commercial banks. A person can use a credit card
to withdraw cash from ATMs as well as make payments to trade establishments.
In developing countries like India commercial banks perform certain promotional
(developmental) activities. For example, nationalized banks in India provide credit to the top
priority sectors of the economy such as agriculture, and small-scale and cottage industries.
In this way commercial banks help to promote the socio-economic development of the
country.
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15.4 ROLE OF COMMERCIAL BANKS
Besides performing the usual commercial banking functions, banks in developing
countries play an effective role in their economic development. The majority of people in
such countries are poor, unemployed and engaged in traditional agriculture. There is acute
shortage of capital. People lack initiative and enterprise. Means of transport are undeveloped.
Industry is depressed. The commercial banks help in overcoming these obstacles and
promoting economic development. The role of a commercial bank in a developing country is
discussed as under;.
1. Mobilising Saving for Capital Formation:
The commercial banks help in mobilising savings through network of branch banking.
People in developing countries have low incomes but the banks induce them to save by
introducing variety of deposit schemes to suit the needs of individual depositors. They also
mobilise idle savings of the few rich. By mobilising savings, the bank channelizes them into
productive investments. Thus they help in the capital formation of a developing country.
2. Financing Industry:
The commercial banks finance the industrial sector in a number of ways. They provide
short-term, medium-term and long-term loans to industry. In India, they provide short-term
loans. Income of the Latin American countries like Guatemala, they advance medium-term
loans for one to three years. But in Korea, the commercial banks also advance long-term
loans to industry. In India, the commercial banks undertake short-term and medium-term
financing to small scale industries and also provide hire purchase finance. Besides, they
underwrite the shares and debentures of large scale industries. Thus they not only provide
finance for industry but also help in developing the capital market which is undeveloped in
such countries.
3. Financing Trade:
The commercial banks help in financing both internal and external trade. The banks
provide loans to retailers and wholesalers to stock goods in which they deal. They also help
in the movement of goods from one place to another by providing all types of facilities such
as discounting and accepting bills of exchange, providing overdraft facilities, issuing drafts,
etc. Moreover, they finance both exports and imports of developing countries by providing
foreign exchange facilities to importers and exporters of goods.
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4. Financing Agriculture:
The commercial banks help the large agricultural sector in developing countries in a
number of ways. They provide loans to traders in agricultural commodities. They open a
network of branches in rural areas to provide agricultural credit. They provide finance directly
to agriculturists for the marketing of their produce, for modernisation and mechanisation of
their farms, for providing irrigation facilities, for developing land, etc. They also provide
financial assistance for animal husbandry, dairy farming, sheep breeding, poultry farming,
and horticulture. The small and marginal farmers and landless agricultural workers, artisans
and petty shopkeepers in rural areas are provided financial assistance through the regional
rural banks in India. These regional rural banks operate under a commercial bank. Thus the
commercial banks meet the credit requirements of all types of rural people.
5. Financing Consumer Activities:
People in underdeveloped countries being poor and having low incomes do not possess
sufficient financial resources to buy durable consumer goods. The commercial banks advance
loans to consumers for the purchase of such items as houses, scooters, fans, refrigerators,
etc. In this way, they also help in raising the standard of living of the people in developing
countries by providing loans for consumptive activities.
6. Financing Employment Generating Activities:
The commercial banks finance employment generating activities in developing
countries. They provide loans for the education of young person’s studying in engineering,
medical and other vocational institutes of higher learning. They advance loans to young
entrepreneurs, medical and engineering graduates, and other technically trained persons in
establishing their own business. Such loan facilities are being provided by a number of
commercial banks in India. Thus the banks not only help in human capital formation but also
in increasing entrepreneurial activities in developing countries.
7. Help in Monetary Policy:
The commercial banks help the economic development of a country by faithfully
following the monetary policy of the central bank. In fact, the central bank depends upon the
commercial banks for the success of its policy of monetary management in keeping with
requirements of a developing economy. Thus the commercial banks contribute much to the
growth of a developing economy by granting loans to agriculture, trade and industry, by helping
in physical and human capital formation and by following the monetary policy of the country.
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8. Credit Gap Analysis
Gap analysis is one of the traditional methodologies in asset/liability management
for credit unions. It should not be confused with GAAP, the acronym for “Generally Accepted
Accounting Principles.” Instead, it will focus on how interest rate risk can be managed using
gap analysis and also describe the limitations of this risk management technique.
People have very different views about the usefulness of gap analysis. At a recent
financial institutions’ conference, one speaker commented that gap analysis was a valuable
foundation but the other participant from a credit union said “gap is crap!”.
15.5 GAP ANALYSIS

Gap measurements can be obtained by calculating the difference between rate-sensitive
assets and rate-sensitive liabilities at different time periods (or “time buckets”). If there are
more rate-sensitive assets than rate sensitive liabilities, the financial institution has a “positive
gap” position. If there are more rate-sensitive liabilities than rate-sensitive assets, it has a
“negative gap.”
In a rising interest rate environment, the financial institution with the negative gap
would suffer from lower net interest income. This is because there are more rate sensitive
liabilities being re-priced at a rising rate than the assets being re-priced. This would lead to a
squeeze in net interest margin as the increase in interest expense from the re-priced liabilities
(share accounts and borrowings) would be higher than the increase in interest income derived
from the re-priced assets (loans and investments) in that time bucket.
OR
Credit gap analysis is a method of asset-liability management that can be used to
assess interest rate risk or liquidity excluding credit risk. Gap analysis is a simple IRR
measurement method that conveys the difference between rate sensitive assets and rate
sensitive liabilities over a given period of time. This type of analysis works well if assets and
liabilities are compromised of fixed cash flows. Because of this a significant shortcoming
of gap analysis is that it cannot handle options, as options have uncertain cash flows.
Breaking Down ‘Gap Analysis’
1) Conducting a gap analysis can help a company re-examine its goals to determine whether
it is on the right path to be able to accomplish them. A company will list the factors that
define its current state, outline the factors that are required to reach the target state,
and then determine how to fill the “gaps” between the two states.
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2) Gap analysis was widely used in the 1980’s typically in tandem with duration analysis.
It was found to be harder to use and less widely implemented than duration analysis but
it can still be used to assess exposure to a variety of term structure
The maturity gap shows the maturity mismatch by comparing assets and liabilities
based on the contractual maturity time period. Very often this maturity gap does not reflect
true interest rate risks. Some assets and liabilities in a credit union’s balance sheet are re-
priced very differently from the contractual maturity date.
For example, a one-year floating rate CD can have a maturity term at the end of one
year. While the CD maturity is one year, the interest rate can be floating and re-priced every
month based on an index such as LIBOR, federal funds, prime, or U.S. treasury bills.ýÿ The
contractual maturity term is 1-year but the re-pricing term is monthly.
If a “5/1” Adjustable Rate Mortgage (the interest rate is fixed for the first five years
and then the interest rate is subject to adjustment annually afterwards) with a contractual
maturity of 10 years originated in 2001, after five years, the final maturity would be five
more years later. But the interest rate is re-priced every year starting 2006.
When interest rates rise by 1 percent, the net effect on interest income is negative
when the financial institution is negatively gapped. The opposite occurs for a positive gap
period.
Traditional advocates for gap analysis think that by matching the re-pricing gap between
rate-sensitive assets with rate-sensitive liabilities, interest rate risk can be minimized. The
cumulative gap at the one-year level is often used to determine the amount of net interest
income at risk.
15.6 WHAT IS CONSORTIUM

Consortium is a group of Independent Companies participating in a Joint Venture for
mutual benefits. Companies in a Consortium co-operate with one another, often sharing
technology as needed. A Consortium allows the Companies to conduct operations that they
would not be able to do individually. It is important to note, however, that a Consortium is not
a merger and the Companies remain independent. Further, it is a group of organizations that
participate in a Joint Venture. Airbus Industries, a European Airplane manufacturer, is a
Consortium of four Public and Private Corporations in Britain, France, Spain and Germany.
A group of organizations, sharing the same goals, which combines their resources and risks,
are known as consortium banking. Consortium Banking was popular in the late 1970s, when
a number of major banks would combine to form a Merchant Banking or Finance Company
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offshoot. Many of Australia’s Merchant Banks were formed as consortia with European,
Asian and US Banks teaming with Australian Banks. Consortium is a coalition of organizations,
such as Banks and Corporations, set up to fund ventures requiring large capital resources. A
Consortium is an association of two or more Individuals, Companies, Organizations or
Governments (or any combination of these entities) with the objective of participating in a
common activity or pooling their resources for achieving a common goal. Consortium is a
Latin word, meaning ‘partnership, association or society’.
15.6.1 Consortium of Bank
A Subsidiary Bank owned by several different banks. Each Owner Bank has an equal
share so that no bank is the majority shareholder. The owner banks are often in different
countries. A Consortium Bank is created to finance a specific project; once the project is
completed, the Consortium Bank dissolves itself. While they are not as common as they
once were, they are useful when a project involves multiple currencies.
15.6.2 Definition of ‘Consortium Bank
A subsidiary bank created by numerous banks. A consortium bank is created to fund a
specific project (such as providing affordable homeownership for low- and moderate-income
home buyers) or to execute a specific deal (such as selling loans in the loan
syndication market).
The consortium leverages individual banks’ assets to achieve its objectives. All
member banks have equal ownership shares – no one member has a controlling interest. After
the bank’s objective is met the consortium typically dissolves.
15.6.3 Definition
A Banking Syndicate formed by multiple banks, often from different countries, for
the single purpose of financing a specific project that is too large for any individual bank to
finance on its own. Under this arrangement participating banks on completion of the project,
the Consortium Bank is disbanded. That means Consortium Bank itself is a community of
interest and member brings resources in certain percentage in common pool. And therefore,
it shares the security interest in common.
Consortium banks originated in early 1960s and are predominantly found in Europe.
They were originally created to enable smaller banks to participate in international banking
activities. Consortium banks are not as active as in the past; however, examples can still be
found both in U.S. and overseas. Member banks can be headquartered in different countries.
54
15.6.4 Rbi’s Role In Consortium Finance:-
Large Lending is usually done under Consortiums as per the guidelines issued by
DBOD of RBI. That DBOD of RBI as such issues circulars and guidelines from time to time
including documentation. Consortium Bank itself is a community of interest and member
brings resources in certain percentage in the common pool formed under statutory directives
and documents are obtained as per the IBA formats strictly devised as per directions of RBI.
Those in terms of the guidelines which have statutory force, the Consortium of Banks have a
force of community of interest.
Now the question springs up for my opinion whether a deed of hypothecation or
mortgage created by a borrower in consortium lending shall be treated as one instrument or
separate instruments for the purpose of section 5, 6 of Bombay Stamp Act. Whether it is a
multifarious instrument covering several distinct matters? We will have to refer the provisions
of Bombay Stamp Act. Where several distinct matters and transactions are embodied in a
single Instrument, the Instrument is called the multifarious instrument.
15.6.5 What is the difference between loan syndication and a consortium?
In a very general sense, a consortium is any group of individuals or entities that decides
to pool resources towards a given objective. A consortium is usually governed by a legal
contract that delegates responsibilities among its members. In the financial world, a consortium
refers to several lending institutions that group together to jointly finance a single borrower.
These multiple banking arrangements are very similar to loan syndication, although there are
structural and operational differences between the two.
15.6.6 Loan Syndication
While loan syndication also involves multiple lenders and a single borrower, the term
is generally reserved for loans that involve international transactions, different currencies
and a necessary banking cooperation to guarantee payments and reduce exposure. Loan
syndication is headed by a managing bank that is approached by the borrower to arrange
credit. The managing bank is generally responsible for negotiating conditions and arranging
the syndicate. In return, the borrower generally pays the bank a fee.
The managing bank in loan syndication is not necessarily the majority lender, or “lead”
bank. Any of the participating banks may act as lead or assume the responsibilities of the
managing bank depending on how the credit agreement is drawn up.
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Consortium
Like loan syndication, consortium financing occurs for transactions that might not
take place with a single lender. Several banks may agree to jointly supervise a single borrower
with a common appraisal, documentation and follow-up. Consortiums are not built to handle
international transactions such as a syndication loan; instead, a consortium may arise because
the size of the project at hand is simply too large or too risky for any single lender to assume.
Sometimes the participating banks form a new consortium bank that functions by leveraging
assets from each institution and disbands after the project is complete.
15.6.7 Role of Lead Bank in Consortium
The lead bank performs the following functions in consortium;
1. Convening of consortium meetings
2. Obtaining of necessary documents, clarification etc. from the borrowing unit.
3. Making arrangements for joint appraisal of loan proposal by all member banks.
Preparation of joint appraisal report and sending the same to all member banks and
finalization of decision after discussions.
4. Fixation of loan limit.
5. Finalization of loan documents to be obtained from borrower
6. Convening of Consortium meeting for execution of documents and registration
of charge on the assets of the loanee.
7. Custody of documents, securities etc., on behalf of itself and consortium banks.
8. Verification of documents/securities pledged by itself or jointly with
consortium banks.
9. To maintain mutual interest between consortium banks and term loan lending
institutions, making correspondence with National/State level Financial
Institutions.
10. Obtaining stock statement every month and ensuring maintenance of adequate
stock for the loan.
11. Obtaining insurance coverage for the entire stock and ensuring renewal of
insurance coverage from time to time.
56
12. Passing on recoveries on pro rata basis to the entire consortium banks.
13. Ensuring of all transactions by borrower through Cash Credit A/c maintained
with the Lead Bank.
14. Ensuring of utilisation of working capital sanctioned limit only for production
activities.
15.6.8 Role of Consortium Banks
1. Participating in consortium meetings and using their expertise in the general
interest of consortium.
2. The consortium members should authorize the Lead Bank to take decision in
the interest of consortium Banks.
3. Consortium Banks should give firm decision regarding their share in the
consortium.
4. The Consortium Banks are not supposed to change their lending share without
obtaining prior approval from the consortium members.
5. The consortium Banks should not demand the refund of loans by taking own
decision.
6. Verification of stock pledged and submitting of verification report to lead bank
and other consortium banks.
7. If any adverse points observed in respect of the loanee, the same should be
brought to the notice of Lead Bank and other consortium members.
8. Annual or ad hoc share should be taken on the basis of original ratio in
consortium.
9. A Senior Officer, who is authorized to take spot decision, in the event of
necessity, should be deputed to the consortium meeting.
15.6.9 Role of Loanee under Consortium;
1. Furnishing of necessary documents, financial statements to the entire member
banks so as to enable them to make quick processing of loan proposals.
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2. Assisting Lead Bank in conducting consortium meetings and preparation of
proceedings and ensuring the delivery of the same to all consortium banks.
3. Ensuring registration of charge on the assets mortgaged before Registrar of
Companies/competent authority.
4. Sending of prescribed stock statement, quarterly statements etc. to all the
Consortium Banks within stipulated time.
5. Assisting the Consortium Banks/Lead Bank in the verification of stocks and
securities pledged for availing loan.
6. Should deposit the entire sale proceeds to Loan Account maintained at Lead
Bank and all the transactions should be routed through Account maintained at Lead
Bank.
7. Should submit the working capital renewal proposal well in advance i.e. 2 months earlier
to the date of expiry of the limit.
8. If there are any adverse developments in the transactions of the borrower, the same
should be informed all the consortium Banks and borrower should abide by the decision
taken in the Consortium Banks.
15.7 CREDIT RATING

After 1990, Indian capital market lot of companies entering the capital market with
the intention of raising the funds by issuing the shares and/or debentures. It expected that
before an investor makes the investment in the instruments issued by the company, he should
satisfy himself about the financial credentials of the company. While investing in the equity
shares of a company, the investor is assumed to know about the risk involved with the
investment. However, in case of the debt instruments, the investor are expected to make the
investment in the instruments after making the study of the various factors relating to the
investment. However, a small investor is not sufficiently equipped to make such a study. As
such, the financial service in the form of credit rating has emerged as a tool to help the
investors to evaluate their investment portfolio.
15.7.1 Meaning of credit rating
The credit rating is the expression of opinion, with the help of symbols, given by an
independent credit rating agency, about the ability of the issuer of a debt instruments to make
timely payments of principal and interest at the specified dates.
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The credit ratings are an important tool for borrowers to gain access to loans and
debt. Good credit ratings allow borrowers to easily borrow money from financial institutions
or public debt markets. At the consumer level, banks will usually base the terms of a loan as
a function of your credit rating, so the better your credit rating, the better the terms of the
loan typically are. If your credit rating is poor, the bank may even reject you for a loan.
The above description of credit rating reveals the following features;
a) Credit ratings with respect to a particular instruments issued by the company.
In other words, credit rating indicates the safety associated with the particular instrument
issued by the company. It does not indicate the financial health of the company as a
whole.
b) Credit rating is not a recommendation for buying, selling or holding a security.
Actual investment made by the investor depends upon the other important factors like
expectation of returns, risk taking capacity of the investor, etc.
c) For the purpose of deciding the rating about the particular instruments, the rating agency
may use of various types of information. This information may be made available to the
rating agency either by company itself or it may be available to the agency from any
other source. However, the rating agency does not perform audit function. In the sense,
the rating agency does not certify that the information available to it is true and correct.
d) Credit rating does not create any legal relationship between the rating agency and investor.
If an investor invests in particular security on the basis of high credit rating given by
rating agency and the investment turns out to be bad investment subsequently, the investor
cannot hold rating agency responsible for the bad investment.
e) The credit rating once given is not a one-time phenomenon applicable during the entire
tenure of the security. With the changing risk characteristics of the company, the credit
rating should be reviewed and upgraded or downgraded accordingly.
15.7.2 Is Credit Rating Obligation?

In the Indian circumstances, credit rating is not obligatory in case of the equity shares.
It is obligatory only in case of the debt instruments. To be more precise, credit rating is
obligatory in case of the following debt instruments:
a) Convertible or Non-convertible Debentures/ Bonds irrespective of the period of maturity
or redemption.
b) Fixed deposit issued by non-banking financial companies.
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c) Commercial paper.
Recently amended SEBI guidelines provide that if the size of the issue is more than
Rs. 100 crores, the issue is required to be rated by at least two credit rating agencies.
It should be noted that the requirements of credit rating in respect of the above
instrument is not a part of any particular law of statute. It is included in the various guidelines
applicable for the issue of above instruments.
15.7.3 Who can do the Credit Rating?
Presently, there are four approved credit rating agencies that can do the credit rating
of the various instruments. These agencies are:
a) Credit Rating and Information Services of India Ltd. (CRISIL)
b) Investment Information and Credit Rating Agency (IICRA)
c) Credit Analysis and Research Limited (CARL)
d) Fitch Rating India Private Ltd.
15.7.4 Advantages of Credit Rating;
I. Advantages to Investors
1. Safeguards against bankruptcy:
Credit rating of an instrument done by credit rating agency, gives an idea to the investors
about degree of financial strength of the issuer company which enables him to decide about
the investment. Highly rated instrument of a company gives an assurance to the investors of
safety of instrument and minimum risk of bankruptcy.
2. Recognition of risk:
Credit rating provides investors with rating symbols which carry information in easily
recognisable manner for the benefit of investors to perceive risk involved in investments. It
becomes easier for the investors by looking at the symbol to understand the worth of the
issuer company because the instrument is backed by the financial strength of the company
which in detail cannot be provided at the minimum cost to each and every one and at the same
time they cannot also analyse or understand such information for taking any investment
decisions. Rating symbol gives them the idea about the risk involved or the expected advantages
from the investment.
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3. Credibility of issuer:
Rating gives a clue to the credibility of the issuer company. The rating agency is quite
independent of the issuer company and has no “business connections or otherwise any
relationship with it or its Board of Directors, etc. Absence of business links between the
rater and the rated firm establishes ground for credibility and attract investors.
4. Easy understand of investment proposal:
Rating symbol can be understood by an investor which needs no analytical knowledge
on his part. Investor can take quick decisions about the investments to be made in any particular
rated security of a company.
5. Saving of resources:
Investors rely upon credit rating. This relieves investors from knowing about the
fundamentals of a company, its actual strength, financial standing, management details, etc.
The quality of credit rating done by professional experts of the credit rating agency, reposes
confidence in him to rely upon the rating for taking investment decisions.
6. Independence of investment decisions:
For making investment decisions, investors have to seek advice of financial
intermediaries, the stock brokers, merchant bankers, the portfolio managers, etc. about the
good investment proposal, but for rated instruments, investors need not depend upon the
advice of these financial intermediaries as the rating symbol assigned to a particular instrument
suggests the credit worthiness of the instrument and indicates the degree of risk involved in
it.
7. Choice of investments:
Several alternative credit rating instruments are available at a particular point of time
for making investment in the capital market and the investors can make choice depending
upon their own risk profile and diversification plan. In addition to above, investors have other
advantages like, Quick understanding of the credit instruments and weigh the ratings with
advantages from instruments; quick decision making for investment and also selling or buying
securities to take advantages of market conditions, or perceiving of default risk by the company.
II. Advantages to Company
1. Improves Corporate Image :
Credit rating helps to improve the corporate image of a company. High credit rating
creates confidence and trust in the minds of the investors about the company. Therefore, the
company enjoys a good corporate image in the market.
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2. Lowers Cost of Borrowing :
Companies that have high credit rating for their debt instruments will get funds at
lower costs from the market. High rating will enable the company to offer low interest rates
on fixed deposits, debentures and other debt securities. The investors will accept low interest
rates because they prefer low risk instruments. A company with high rating for its instruments
can reduce the cost of public issue to raise funds, because it need not spend heavily on
advertising for attracting investors.
3. Wider Audience for Borrowing :
A company with high rating for its instruments can get a wider audience for borrowing.
It can approach financial institutions, banks, investing companies. This is because the credit
ratings are easily understood not only by the financial institutions and banks, but also by the
general public.
4. Good for Non-Popular Companies :
Credit rating is beneficial to the non-popular companies, such as closely held
companies. If the credit rating is good, the public will invest in these companies, even if they
do not know these companies.
5. Act as a Marketing Tool :
Credit rating not only helps to develop a good image of the company among the
investors, but also among the customers, dealers, suppliers, etc. High credit rating can act as
a marketing tool to develop confidence in the minds of customers, dealers, suppliers, etc.
6. Helps in Growth and Expansion :
Rating provides motivation to the company for growth as the promoters feel confident
in their own efforts and encouraged to undertake expansion of their operations or new projects.
With better image created though higher credit rating, the company can mobilise funds from
public and investors or banks from self assessment of its own status which is subject to self-
discipline and self-improvement, it can perceive and avoid sickness.
7. Reduction of cost in public issues:
A company with higher rated instrument is able to attract the investors and with least
efforts can raise funds. Thus, the rated company can economise and minimise cost of public
issues by controlling expenses on media coverage, conferences and other publicity stunts
and gimmicks. Rating facilitates best pricing and timing of issues.
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8. Unknown issuer:
Credit rating provides recognition to a relatively unknown issuer while entering into
the market through wider investor base who rely on rating grade rather than on ‘name
recognition’.
9. Benefits to brokers and financial intermediaries:
Highly rated instruments put the brokers at an advantage to make fewer efforts in
studying the company’s credit position to convince their clients to select an investment
proposal. This enables brokers and other financial intermediaries to save time, energy, costs
and manpower in convincing their clients about investments in any particular instrument.
15.7.5 Methodology of Credit Rating
For this purpose we will take into consideration the rating methodology followed by
CRISIL.
The Rating procedure followed by CRISIL may be based upon the information available
either directly from company or any other sources. During this process, CRISIL consider
the following aspects about the company.
A) Business Analysing
1) Industry Risk:
This indicates the overall demand/supply position in the industry as a whole, the exiting
as well as the potential competitors in the industry, various government policies affecting
the industry, etc.
2) Market Position:
This indicates the market position of the company vis-à-vis that of the competitors in
the industry in terms of the market share, competitive advantages and disadvantages, selling
and distribution arrangements etc.
3) Operating Efficiency:
This involves the consideration of manufacturing process and operating efficiency of
the company in relation to those of the competitors, availability of various infrastructural
facilities, modernisation/expansion/diversification plans etc.
B) Financial Analysis
This involves the consideration of the various factors like accounting polices followed
by the company, analysis of the financial statement, adequacy of cash flows for fixed capital
needs, ability to raise funds from the market etc.
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C) Management Evaluation
This involves the consideration of the various factors like track record of the
management, capacity to overcome the adverse business conditions, management targets/
objectives/strategies, etc.
Credit Rating Symbols
Long term (Debentures/ bonds)
CRISIL IICRA CARE
Highest safety AAA LAAA CARE AAA
High safety AA LAA CARE AA
Adequate safety A LA CARE A
Moderate safety BBB LBBB CARE BBB
Inadequate safety BB LBB CARE BB
High risk B LB CARE B
Substantial risk C LC CARE C
Default D LD CARE D
Medium term (fixed deposits)
Highest safety FAAA MAAA CARE AAA (FD)
High safety FAA MAA CARE AA (FD)
Adequate safety FA MA CARE A (FD)
Inadequate safety FB MB CARE B (FD)
High risk FC MC CARE C (FD)
Default FD MD CARE D (FD)
Short term (commercial paper)
Highest safety P1 A1 PR1
High safety P2 A2 PR2
Adequate safety P3 A3 PR3
Inadequate safety P4 A4 PR4
Default P5 A5 PR5
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Note:
a) The above table indicates the comparison between the symbols used by the various
rating agencies. The basic description for the use of symbols is used by CRISIL. The
exact description used by the remaining true rating agencies varies slightly from the
description used by CRISIL.
b) The rating agencies may add + or – signs to indicate the degree of variation.
The credit rating symbols used by Fitch Rating India Pvt. Ltd., are as below:
For long term (12 months and more)

AAA (ind) High credit quality
AA+(ind), AA (ind), AA-(ind) High credit quality
A+(ind), A (ind), A-(ind) Adequate credit quality
BBB+(ind), BBB (ind), BBB-(ind) Moderate credit quality
BB+(ind), BB (ind), BB-(ind) Speculative
B+(ind), B (ind), B-(ind) Highly Speculative
C (ind) High default risk
D (ind) Default
Public deposits
tAAA (ind) High credit quality
tAA+(ind), tAA (ind), tAA-(ind) High credit quality
tA+(ind), tA (ind), tA-(ind) Adequate credit quality
tBBB+(ind), tBBB (ind), tBBB-(ind) Moderate credit quality
tBB+(ind), tBB (ind), tBB-(ind) Speculative
tB+(ind), tB (ind), tB-(ind) Highly Speculative
tC (ind) High default risk
tD (ind) Default
For short term (less than12 months)
F1+(ind), F1(ind) Highest credit quality
F2+(ind), F2(ind) Good credit quality
F3 (ind) Fair credit quality
F4 (ind) Speculative
F5 (ind) Default
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15.7.6 Limitations of Credit Rating
a) Credit rating is based upon the evaluation made by the agencies which is essentially a
subjective evaluation which may vary depending upon the experience, knowledge and
the individual opinion of the raters which may be biased in some cases.
b) The various guidelines issued for regulating the various types of instruments for which
credit rating is required to the companies to get the credit rating done. However, these
guidelines do not require the companies to publish these ratings. As such, in certain
cases the companies may not publish the ratings, particularly when the rating is not
favourable to the companies. This defeats the basic purpose of credit rating.
c) The approved credit rating agencies prevailing in the country are promoted by the
government controlled organisations. This may involves its own consequences.
d) It is usually observed that the rating given by the credit rating agencies is primarily
based upon the past performance of the companies. Whereas the future prospective of
the companies should be given more importance while deciding credit rating. Moreover,
if a particular company or a particular industry is passing though the temporary adverse
conditions, it may get a low credit rating if judged on temporary basis.
e) Multiplicity of the rating agencies can be considered to be the limitations of the credit
rating. If a company is not satisfied with the rating given by one agency, the company
can approach another rating agency with the hope to get better rating form that agency.
The recently introduced guidelines issued by the SEBI provide that if the company has
approached more than one rating agency, it is required that the ratings given by all
agencies are made known to the investors. If there is a vast difference between the
ratings awarded by the different agencies, it may be a point of concern for the investors.
f) In the recent past, some cases were observed that rating given by the agencies were
either upgraded or downgraded within comparatively a very short span of time. The
question arises what went wrong to such an extent that the rating were required to be
upgraded or downgraded to such an extract. In the whole process, the basic rating given
by the agencies gets challenged effectively, the credibility of the agencies become at
stake.
Maximum Permissible Banking Finance (Tandon Committee)
MPBF stands for Maximum Permissible Banking Finance in Indian Banking Sector.
As per the recommendations of Tandon Committee, the corporate are discouraged from
accumulating too much of stocks of current assets and are recommended to move towards
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very lean inventories and receivable levels. Depending on the size of credit required, two
methods are in practice to fund the working capital needs of the corporate.
15.8 TANDON COMMITTEE

Till mid-1970, the principle of commercial bank lending in India was predominantly
security oriented. It was more or less net worth based, collateralized financing. Major Banks
were nationalized in 1969 and with that the approach to lending is also changed. In 1974, a
study group under the chairmanship of P.L.Tandon was formed to examine the existing methods
of lending and suggest changes. The group submitted its report in August 1975, which came
to be popularly known as Tandon Committee Report. It was a landmark in the history of bank
lending in India. With the acceptance of major recommendations by the Reserve Bank of
India, a new era of lending began in India.
15.8.1 Tandon Committee’s Recommendations
Breaking away from the traditional methods of security oriented lending, the
committee enjoined upon the banks to move towards need-based lending. The committee
pointed out that the best security of bank loan is a well functioning of the committee which
are as follows;
1. Assessment of the need-based credit of the borrower on a rational basis of their
business plans.
2. Bank credit would only supplementary to the borrower’s resources and not a
replacement of them (i.e. bank would not finance cent percent) of borrower’s
working capital requirement.
3. Bank should ensure proper end-use of bank credit by keeping a closer watch on
the borrower’s business, and impose financial discipline on them.
4. Working capital finance would be available to borrower on the basis of
industry wise norms (prescribed first by the Tandon Committee and Reserve bank of
India) for holding different current assets, viz.
5. Raw material including stores and other items used in the manufacturing
process, Stocks- in –process, Finished goods, Accounts receivable and Spares
6. Credit would be made available to the borrower in different components like cash credit;
bills purchased and discounted working capital term loan, etc. depending upon the nature
of holding of various current assets.
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7. In order to facilitate a close watch on the operation of the borrowers, bank would
require them to submit, at regular intervals, data regarding their business and financial
operations, for both the past and future periods.
15.8.2 Norms of Tandon Committee
Tandon Committee had initially suggested norms for holding various current assets
for fifteen different industries. Many of these norms were revised and the list extended to
cover almost all major industries of the country. The norms for holding different current
assets were expressed as follows:
1. Raw materials, as so many months’ consumption. They include stores and other items
used in the process of the manufacture.
2. Stocks-in-process of manufacture.
3. Finished goods and accounts receivable, as so many months’ cost of sales and sales
respectively.
4. Stocks of spares were not included in the norms. In financial terms, these were considered
to be small part of total operation expenditure and hence, did not merit the development
of general norms for them. Banks were expected to ascertain the requirement of spares
on case-by-case basis. However, they should keep a watchful eye if spares exceed 5 per
cent of total inventories.
The norms were based on average level of holding of a particular current asset, not on
the individual items of the group. For example, if the receivables holding norms of an industry
was two months and an unit has satisfied this norm, calculated by dividing annual sales with
the average receivables, then the unit would not be asked to delete some of the accounts
receivable, which were being held for more than two months. Tandon Committee while laying
down the norms for holding various current assets made it very clear that it was against any
rigidity and straight-jacking. On the other hand, the committee said that norms were to be
regarded as the outer limits for holding different current assets but these were not to be
considered as entitlement to hold current assets up to this level. If borrower had managed
with less in the past, he should continue to do so. On the other hand, the committee held that
allowance must be made for some flexibility under circumstances justifying a need for re-
examination. The committee itself visualized that there might be deviation from norms in
the following circumstances.
1. Bunched receipt of raw materials included imports.
2. Interruption of production due to power-cuts, strikes or other unavoidable
circumstances.
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3. Transport delay or bottlenecks.
4. Accumulation of finished goods due to non-availability of shipping space for exports,
or other disruptions in sales.
5. Building up of stocks of finished goods, such as machinery, due to failure on the part
of the purchasers for whom these were specifically designed and manufactured.
6. Need to cover full or substantial requirements of raw materials for specific export
contract of short duration.
While allowing the above exception, the committee observed that the deviation should
be for known and specific circumstances and situations, and allowed only for a limited period
to tide over the temporary difficulty of a borrowing unit. Return to norms would be automatic
when condition returned to normal.
15.9 METHODS OF LENDING

Like many other activities of the banks, method and quantum of short-term finance
that can be granted to a corporate was mandated by the Reserve Bank of India till 1994. This
control was exercised on the lines suggested by the recommendations of a study group headed
by Shri Prakash Tandon.
The study group headed by Shri Prakash Tandon, the then Chairman of Punjab National
Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading
banks, financial institutions and a wide cross-section of the Industry with a view to study the
entire gamut of banks finance for working capital and suggest ways for optimum utilisation
of bank credit. This was the first elaborate attempt by the central bank to organise the bank
credit. The report of this group is widely known as Tandon Committee report. Most banks in
India even today continue to look at the needs of the corporate in the light of methodology
recommended by the group.
As per the recommendations of Tandon Committee, the corporate should be
discouraged from accumulating too much of stocks of current assets and should move towards
very lean inventories and receivable levels. The committee even suggested the maximum
levels of raw material, stock-in-process and finished goods which a corporate operating in
an industry should be allowed to accumulate. These levels were termed as inventory and
receivable norms. Depending on the size of credit required, the funding of these current
assets (working capital needs) of the corporate could be met by one of the following methods;
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 First Method of Lending:
Banks can work out the working capital gap, i.e. total current assets less current liabilities
other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and
finance a maximum of 75 per cent of the gap; the balance come out of long-term funds, i.e.,
owned funds and term borrowings. This approach was considered suitable only for very small
borrowers i.e. where the requirements of credit were less than Rs.10 lakhs
 Second Method of Lending:
Under this method, it was thought that the borrower should provide for a minimum of
25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A
certain level of credit for purchases and other current liabilities will be available to fund the
build up of current assets and the bank will provide the balance (MPBF). Consequently, total
current liabilities inclusive of bank borrowings could not exceed 75% of current assets. The
RBI stipulated that the working capital needs of all borrowers enjoying fund based credit
facilities of more than Rs. 10 lakhs should be appraised (calculated) under this method.
 Third Method of Lending:
Under this method, the borrower’s contribution from long term funds will be to the
extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group
as representing the absolute minimum level of raw materials, process stock, finished goods
and stores which are in the pipeline to ensure continuity of production and a minimum of
25% of the balance current assets should be financed out of the long term funds plus term
borrowings.
For the purpose of calculating MPBF of a borrowing unit, all the three methods
adopted equation 2 as the basis, which is translated arithmetically as follows:
Gross current assets Rs………………
Less: Current liabilities
Other than bank borrowings Rs………………
_________________
Working capital gap Rs………………..
Under the first Method, 75 percent of this working capital gap (WCG) would
be financed by the bank, and the remaining 25 percent would be financed by the borrowing
unit from its long-term sources. Under the second method, 25 percent of gross current
assets (GCA), the borrowing unit would require to finance from its long-term sources. In
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third method, permissible bank finance would be calculated in the same manner as in the
second method, but-only after deducting core current asset (CCA) from the gross current
assets. It was envisaged that CCA would be financed by the borrower from long-term sources.
Action Taken by the RBI:
According to the notification of the RBI dated 21st August, 1975, it accepted some of
the main recommendation of the committee and they are as follows;
a. Norms for inventories and receivables: Norms suggested by the committee were
accepted and banks were instructed to apply them in case of existing and new borrowers. If
the level of inventories and receivables are found to be excessive than the suggested norms,
the matters should be discussed with the borrower. If excessive levels continue without
justification, after giving reasonable notice to the borrowers, banks may charge excess interest
on that position which is considered as excessive.
b. Coverage : Initially, all the industrial borrowers including small scale industries having
aggregate banking limits of more than Rs.10 lakhs should be covered, but it should be extended
to all borrowers progressively.
c. Methods of Borrowing: The RBI instructed the banks that all covered borrowers
should be placed in method I as recommended by the committee. However, all those borrowers
who are already complying with requirements of method II should not slip back to method I.
As for as method III is concerned, the RBI has not taken any view. However, in case of the
borrowers already in method II, matter of application of method III may be decided on use to
use basis.
d. Style of Credit: As suggested by the committee, instead of granting entire facility by
way of cash credit, banks may divide the limit as term loan to take care of permanent
requirement and fluctuating cash credit within the overall limit, bill limits may also be
considered.
e. Information system: Suggestions added by the committee regarding the information
system were accepted by the RBI and were made applicable to all the borrowers having the
overall banking limits of more than Rs.1crore.
15.10 CASE STUDY

Assume that you manage the interest rate risk position for your bank. Your bank
currently has a positive cumulative GAP for all time intervals through 1 year. You expect that
interest rates will fall sharply during the year and want to reduce your banks risk position.
The current yield curve is inverted with long term rates below short term rates.
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a) To reduce risk would you recommend issuing a 3 months’ time deposit and investing the
proceeds in 1 year T-bills? Will you profit if rate fall during the year?
b) To reduce risk would you recommend issuing a 3 months’ time deposit and making a 2
year commercial loan priced at prime plus 1 per cent?
15.11 NOTES
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15.12 SUMMARY
A Commercial Bank is a type of bank/financial institution that provides services such
as accepting deposits, making business loans, and offering basic investment products.
The functions of commercial banks are ;-
1. Primary functions; Collection of deposits, Making loans and advances
2. Secondary functions; Agency services and General utility service
Bank finance for the growth all sectors of Indian economy.
Gap analysis is one of the traditional methodologies in asset/liability management
for credit unions.
Gap measurements can be obtained by calculating the difference between rate-sensitive
assets and rate-sensitive liabilities at different time periods.
Consortium is a group of Independent Companies participating in a Joint Venture for
mutual benefits.
Consortium Bank itself is a community of interest and member brings resources in
certain percentage in common pool.
The credit rating is the expression of opinion, with the help of symbols, given by an
independent credit rating agency, about the ability of the issuer of a debt instruments to make
timely payments of principal and interest at the specified dates.

1. What are the functions of commercial banks? Explain
2. Elucidate the role of commercial banks in development of Indian economy.
3. What is credit gap analysis? Explain the uses of credit gap analysis.
4. Explain the role of RBI in consortium lending.
5. What is credit rating? What are its merits and demerits of credit rating?
6. Explain the recommendations of Tandon Committee on maximum permissible
finance
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15.14 KEY WORDS
Commercial Banks
Credit Gap Analysis
Consortium
Credit Rating
Lending
Tandon Committee
15.15 REFERENCES
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UNIT - 16 : REFORMS IN BANKING SECTOR
Structure :
16.0 Objective
16.1 Narasimham Committee Report
16.2 Non – Performing Assets
16.3 Assets Classifications
16.4 Capital Adequacy
16.5 Provisions For Substandard Assets
16.6 Guidelines For Provision Under Special Circumstances
16.7 Case Study
16.8 Notes
16.9 Summary
16.10 Self Assessments Questions
16.11 Key Words
16.12 References
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16.0 OBJECTIVES
• banking sector,
• Narasimham Committee
• NPA, causes, asset classification
• assets classification, measures to solve NPA,
• capital adequacy, provisioning norms,
• disinvestment
16.1 NARASIMHAM COMMITTEE REPORT
India has accepted the policy of LPG from 1991 as a part of WTO agreement and
thereafter its economy has been growing significantly. There has lot of progress in banking
sector. During this period, recognizing the evolving needs of the banking sector, the Ministry
of Finance, Government of India (GOI) set up various Committees with the task of analysing
India’s banking sector and recommending legislation and regulations to make it more effective,
competitive and efficient. Two such expert Committees were set up under the Chairmanship
of M.Narasimham. The Committee submitted its report in 1990s which is widely known as
the Narasimham Committee-I (1991) Report and the Narasimham Committee-II (1998)
Report. These recommendations not only helped unleash the potentials of banking in India
but also recognized as a factor towards minimizing the impact of global financial crisis starting
from 2007. Unlike the socialist-democratic era of the 1960s to 1980s, India is no longer
insulated from the global economy and yet its banks survived the 2008 financial crisis relatively
unscathed, a feat due in part to these Narasimham Committees.
Background
The Government of India nationalized 14 commercial banks in 1969 and 6 more
Commercial banks in 1980. Many other developments have taken in banking sector during
pre liberalization period. However, India faced great set back in its economy resulting to the
balance of payment crisis that necessitates transfer of gold reserve from the RBI to
International Monetary Fund (IMF) to borrow loan to meet its short term financial obligations.
This event called into question the previous banking policies and triggered the era of economic
liberalization in India in 1991. These rigidities and weaknesses had made serious inroads
into the Indian banking system by late 1980s, the Government of India (GOI), during post
economic crisis, took several steps to remodel the country’s financial system. (Some claims
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that these reforms were influenced by the IMF and the World Bank as a part of their loan
conditions to India in 1991). The banking sector, handling 80% of the flow of money in the
economy, needed serious reforms to make it internationally reputable, accelerate the pace
of reforms and develop it into a constructive usher of an efficient, vibrant and competitive
economy by adequately supporting the country’s financial needs. In the light of these
requirements, two expert Committees were set up in 1990s under the Chairmanship of M.
Narasimham (an ex- Governor, Reserve Bank of India,) which are widely credited for
spearheading the financial sector reforms in India. The first Narasimhan Committee
(Committee on the Financial System–CFS) was appointed by Dr.Manmohan Singh, then
Finance Minister, Government of India on 14th August 1991, and the second Committee on
Banking Sector Reforms was appointed by P.Chidambaram as Finance Minister in December
1997. Subsequently, the first one widely came to be known as Narasimham Committee-I
(1991) and the second one is known as Narasimham Committee -II (1998). The purpose of
Narasimham-I Committee was to study all aspects relating to the structure, organization,
functions and procedures of the financial systems and to recommend improvements in their
efficiency and productivity. The Committee submitted its report to the Finance Minister in
November 1991 which was tabled in Parliament on 17th December, 1991.
The Narasimham-II Committee was asked to review the progress of implementation
of the banking reforms since 1992 with the aim of further strengthening the financial
institutions of India. It focused on issues like size of banks and capital adequacy ratio among
other things. M. Narasimham, Chairman, submitted the report of the Committee on Banking
Sector Reforms (Committee-II) to, Yashwant Sinha, the Finance Minister, Government of
India in April 1998.
.Narasimham Committee Report I - 1991
The Narasimham Committee was set up in order to study the problems of the Indian
financial system and to suggest some recommendations for improvement in the efficiency
and productivity of the financial institutions.
The Committee has made the following major recommendations;
1. Reduction in SLR and CRR: The committee recommended the reduction of the
higher proportion of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR).
Both of these ratios were very high at that time. The SLR then was 38.5 per cent and CRR was
15 per cent. This high amount of SLR and CRR meant locking the bank resources for
government uses. It was hindrance in the productivity of the bank thus the committee
recommended their gradual reduction. The Committee recommended reducing SLR from
38.5 per cent to 25 per cent and CRR from 15 per cent to 3 per cent to 5 per cent.
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2. Phasing out Directed Credit Programme: In India, since nationalization, directed
credit programmes were adopted by the government. The committee recommended phasing
out of this programme. This programme compelled banks to earmark their financial resources
for the needy and poor sectors at concession rate of interest. It was reducing the profitability
of banks and accordingly the committee recommended phasing out directed credit programme.
3. Interest Rate Determination: The committee felt that the interest rates in India are
regulated and controlled by the authorities. The determination of interest rate should be on
the grounds of market forces such as the demand for and supply of fund. Hence, the committee
recommended eliminating government controls on interest rate and phasing out the concession
interest rates for the priority sector.
4. Structural Reorganizations of the Banking Sector: The committee recommended
that the actual numbers of public sector banks need to be reduced. Three to four big banks
including SBI should be developed as international banks. Eight to Ten Banks having nationwide
presence should concentrate on the national and universal banking services. Local banks
should concentrate on region specific banking. Regarding the RRBs (Regional Rural Banks),
it recommended that they should focus on agriculture and rural financing. They recommended
that the government should assure that henceforth there won’t be any nationalization and
private and foreign banks should be allowed liberal entry in India.
5. Establishment of the ARF Tribunal: The proportion of bad debts and Non-performing
asset (NPA) of the Public Sector Banks and Development Financial Institutions was very
alarming in those days. The committee recommended the establishment of an Asset
Reconstruction Fund (ARF). This fund will take over the proportion of bad and doubtful
debts from the banks and financial institutions. It would help banks to get rid of bad debts.
6. Removal of Dual Control: The banks were under the dual control of the Reserve
Bank of India (RBI) and the Banking Division of the Ministry of Finance, the Government of
India. The committee recommended for removal of dual control system on banking sector. It
considered and recommended to the RBI to regulate banking sector as a regulating authority
in India.
7. Banking Autonomy: The committee recommended that the public sector banks should
be free and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy
autonomy so that they can reform the work culture and banking technology up gradation.
Some of these recommendations were later accepted by the Government of India and became
banking reforms.
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Narasimham Committee Report II - 1998
In 1998, the Government of India, appointed another Committee under the
Chairmanship of Mr. Narasimham. It is better known as the Banking Sector Committee. It
was asked to review the progress of banking reforms and design a programme for further
strengthening the financial system of India. The Committee focused on various areas of
banking sector reforms such as capital adequacy, bank mergers, bank legislation, etc.
It submitted its report to the Government in April 1998 with the following
recommendations.
1. Strengthening Banks in India: The committee considered the stronger banking
system in the context of the Current Account Convertibility (CAC). It thought that Indian
banks must be capable of handling problems regarding domestic liquidity and exchange rate
management in the light of CAC. Thus, it recommended the merger of strong banks which
will have ‘multiplier effect’ on the industry.
2. Narrow Banking: Many public sector banks were facing a problem of Non-performing
assets (NPAs). Some of them had high NPA about 20 per cent of their assets. Thus for
successful rehabilitation of these banks, it recommended ‘Narrow Banking Concept’ where
weak banks will be allowed to place their funds only in short term and risk free assets.
3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian
banking system, the Committee recommended that the Government should raise the prescribed
capital adequacy norms. This will further improve their absorption capacity also. Currently,
the capital adequacy ratio for Indian banks is at 9 per cent.
4. Bank Ownership: The banks need freedom in their working and autonomy, and
accordingly, it felt that the government control over the banks in the form of management
and ownership and bank autonomy does not go hand in hand. The Committee recommended
reviewing the functions of boards and enabling them to adopt professional corporate strategy.
5. Review of Banking Laws: The Committee considered that there was an urgent need
for reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking
Regulation Act, State Bank of India Act, Bank Nationalization Act, etc. This up gradation will
bring them in line with the present needs of the banking sector in India.
6. Autonomy in Banking: Greater autonomy was proposed for the public sector banks
in order to function with equivalent professionalism as their international counterparts. For
this, the panel recommended that recruitment procedures, training and remuneration policies
of public sector banks be brought in line with the best-market-practices of professional bank
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management. The committee recommended GOI equity in nationalized banks is reduced to
33 per cent for increased autonomy. It also recommended to the RBI to relinquish its seats
on the board of directors of these banks. The committee further added that the government
nominees to the board of banks are often members of parliament, politicians, bureaucrats,
etc. They often interfere in the day-to-day operations of the bank in the form of behest-
lending. As such, the committee recommended a review of functions of banks boards with a
view to make them responsible for enhancing shareholders value through formulation of
corporate strategy and reduction of government equity. To implement this, criteria for
autonomous status was identified by March 1999 (among other implementation measures)
and 17 banks were considered eligible for autonomy. But some recommendations like
reduction in Government’s equity to 33 per cent, the issue of greater professionalism and
independence of the board of directors of public sector banks is still awaiting.
7. Entry of Foreign Banks: The committee suggested that the foreign banks seeking
to set up business in India should have a minimum start-up capital of $25 million as against
the existing requirement of $10 million. It said that foreign banks can be allowed to set up
subsidiaries and joint ventures that should be treated on par with private banks.
8. Reform in the Role of RBI: The committee recommended that the RBI withdraw
from the 91-day treasury bills market and interbank call money and term money markets and
be restricted to banks and primary dealers. Further, the Committee proposed a segregation
of the roles of RBI as a regulator of banks and owner of bank. It observed that the Reserve
Bank as a regulator of the monetary system should not be the owner of a bank in view of a
possible conflict of interest. As such, it highlighted that RBI’s role of effective supervision
was not adequate and wanted it to divest its holdings in banks and financial institutions. Pursuant
to the recommendations, the RBI introduced a Liquidity Adjustment Facility (LAF) operated
through repo and reverse repos to set a corridor for money market interest rates. To begin
with, in April 1999, an Interim Liquidity Adjustment Facility (ILAF) was introduced pending
further up gradation in technology and legal/procedural changes to facilitate electronic transfer.
As per the second recommendation, the RBI decided to transfer its respective shareholdings
of public sector banks like State Bank of India (SBI), National Housing Bank (NHB) and
National Bank for Agriculture and Rural Development (NABARD) to GOI. Subsequently, in
2007–08, GOI decided to acquire entire stake of RBI in SBI, NHB and NABARD. Of these,
the terms of sale for SBI were finalized in 2007–08.
9. Stronger Banking System: The Committee recommended for merger of large Indian
banks to make them strong enough for supporting international trade. It recommended a
three tier banking structure in India through establishment of three large banks with
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international presence, eight to ten national banks and a large number of regional and local
banks. This proposal had been severely criticized by the RBI employees union. The Committee
recommended the use of mergers to build the size and strength of operations for each bank.
However, it cautioned that large banks should merge only with banks of equivalent size and
not with weaker banks, which should be closed down if unable to revitalize themselves. Given
the large percentage of non-performing assets for weaker banks, some as high as 20 per cent
of their total assets, the concept of “narrow banking” was proposed to assist in their
rehabilitation. There were a string of mergers in banks of India during late 90s and early
2000s, encouraged strongly by the Government of India|GOI in line with the Committee’s
recommendations. However, the recommended degree of consolidation is still awaiting
sufficient government impetus. Apart from these major recommendations, the committee
has also recommended faster computerization, technology up gradation, training of staff,
depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc.
As per recommendations made by the committee, on the Financial System, the Reserve
Bank of India has introduced, in a phased manner, prudential norms for income recognition,
asset classification and provisioning for the advances portfolio of the banks. These norms
were in line with the international practices, to move towards greater consistency and
transparency in the published accounts.
16.1.1 Actions on Recommendations of Narasimham Committee:
To implement the recommendations made by Narasimham Committee, the RBI in
October 1998, initiated the second phase of financial sector reforms by raising the banks’
capital adequacy ratio by 1 per cent and tightening the prudential norms for provisioning and
asset classification in a phased manner on lines of Narasimham Committee-II report. The
RBI targeted to bring the capital adequacy ratio to 9 per cent by March 2001. The mid-term
Review of the Monetary and Credit Policy, the RBI announced another series of reforms, in
line with the recommendations of the Committee, in October 1999. In 1998, the RBI’s
Governor, Bimal Jalan informed the banks that the RBI had a three to four-year perspective
on the implementation of the Committee recommendations. Based on other recommendations
of the committee, the concept of a universal bank was discussed by the RBI and finally ICICI
bank became the first universal bank of India. The RBI published an Actions Taken on the
Recommendations report on 31st October 2001 on its own website.
Many of the recommendations of the committee were accepted by the government.
The SLR, which was around 38.5 per cent in 1991-92, was brought down to some 28 per cent
in five years. The CRR was also brought down from 14 per cent to 10 per cent by 1997.
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The RBI introduced the CRAR or Capital to Risk Weighted Asset ratio in 1992 for
the soundness of the banking industry. The RBI also included new prudential reforms for
classification of assets and provisioning of non-performing assets.
Some strong banks (such as SBI) were allowed to seek access to capital markets. The
banks which were relatively weaker were recapitalized by the government via budgetary
support. More private banks were allowed and more freedom was given to banks to open
branches. The RBIs supervision system was strengthened. Rapid computerization of the banks
was adopted. The RBI started helping the commercial banks to improve the quality of their
performance.
16.2 NON-PERFORMING ASSETS

Non-performing assets had been the single largest cause of irritation of the banking
sector of India. Earlier, the Narasimham Committee-I had broadly concluded that the main
reason for the reduced profitability of the commercial banks in India was the priority sector
lending. The committee had highlighted that ‘priority sector lending’ was leading to the build-
up of non-performing assets of the banks and thus it recommended it to be phased out.
Subsequently, the Narasimham Committee-II also highlighted the need for ‘zero’ non-
performing assets for all Indian banks with International presence. The 1998 report further
blamed poor credit decisions, behest-lending and cyclical economic factors among other
reasons for the build-up of non-performing assets of these banks to uncomfortably high
levels. The Committee recommended creation of Asset Reconstruction Funds or Asset
Reconstruction Companies to take over the bad debts of banks, allowing them to start on a
clean-slate. The option of recapitalization through budgetary provisions was ruled out. Overall,
the committee wanted a proper system to identify and classify NPAs and NPAs to be brought
down to 3 per cent by 2002 and for an independent loan review mechanism for improved
management of loan portfolios. The committee’s recommendations leads to the introduction
of a new legislation which was subsequently implemented as the Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and the
same came into force with effect from 21st June, 2002.
16.2.1 Definition
A non-performing asset (NPA) is a loan or advance for which the principal or interest
payment remained overdue for a period of 90 days.
Thus, a Non- Performing Asset (NPA) is a loan or an advance where:
1. Interest and /or installment of principal remain overdue for a period of more than 90
days in respect of term loan
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2. The account remains ‘out of order’ below, in respect of an overdraft/cash credit
3. The bill remains overdue for a period more than 90 days in case of bills purchase or
discounted
4. The installment of principal or interest thereon remains overdue for two crop seasons
for short duration crops.
16.2.2 Causes of NPA
 Speculation: Investing in high risk assets to earn high income.
 Default: Willful default by the borrowers.
 Fraudulent practices: Fraudulent practices like advancing loans to ineligible persons,
advances without security or reference, etc.
 Diversion of funds: Most of the funds are diverted for unnecessary expansion and
diversion of business.
 Internal reasons: Many international reasons like inefficient management, inappropriate
technology, labour problems, marketing failure, etc. resulting in poor performance of
the bank.
 External reasons: External reasons like a recession in the economy, infrastructural
problem, delay in release of sanctioned limits by banks, delays in settlement of payments
by government, natural calamities, etc.
16.3 ASSETS CLASSIFICATIONS

Banks are required to classify non-performing assets into the following three
categories based on the period for which the asset remained non- performing and the reliability
of the dues:
1. Substandard Assets
2. Doubtful Assets
3. Loss Assets
1. Substandard Assets: With effect from March 31, 2005, sub standard asset would be
one, which has remained NPA for a period less than or equal to 12 months. Such an asset will
have well defined credit weaknesses that jeopardize the liquidation of the debt and are
characterized by the distinct possibility that the banks will sustain some loss, if deficiencies
are not corrected.
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2. Doubtful Assets: With effect from March 31, 2005, asset would be classified as
doubtful if it has remained in the substandard category for a period of 12 months. A loan
classified as doubtful has all the weaknesses inherent in assets that were classified as sub
standard, with the added characteristic that the weaknesses make collection or liquidation in
full, on the basis of currently known facts, conditions and values highly questionable and
improbable.
3. Loss Assets: A loss asset is one where loss has been identified by the bank or internal
or external auditors or the RBI inspection but the amount has not been written off wholly. In
other words, such an asset is considered uncollectible and of such little value that its
continuance as a bankable asset is not warranted although there may be some salvage or
recovery value.
16.3.1 Guidelines for Classification of Assets
Take into account the degree of well-defined credit weakness and the extent of
dependence on collateral security for realization of dues.
Banks should establish appropriate internal systems to eliminate the tendency to delay
or postpone the identification of NPAs, especially in respect of high value accounts the
classification of asset as NPA should be based on the record of recovery.
Banks should not classify an advance account as NPA merely due to the existence of
some deficiencies which are temporarily in nature such as non-availability of adequate drawing
power based on the latest available stock statement.
16.3.2 Up gradation of Loan Accounts Classified as NPAs
If arrears of interest and principal are paid by the borrower in the case of loan accounts
classified as NPAs, the account should be treated as performing and may be classified as
standard account.
16.3.3 Asset Classification to be borrower-wise and not facility-wise
All the facilities granted by a bank to a borrower and investment in all the securities
issued by the borrower will have to be treated as NPA/NPI and not the particular facility/
investment or part thereof which has become irregular.
16.3.4 Accounts where there is erosion in the value of security/frauds committed by
borrowers:
In respect of accounts where there are potential threats for recovery, such accounts
should go through various stages of asset classification.
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In case of such serious credit impairment the asset should be straightway classified
as doubtful or loss asset as appropriate.
The realizable value of the security is less than 50 per cent of outstanding in the
borrowed accounts such NPAs may be straightway classified under doubtful category.
The realizable value of the security, as assessed by the bank is less than 10 per cent of
the outstanding in the borrowed accounts; the asset should be straightway classified as loss
asset
16.3.4 Advances against Term Deposits, NSC, KVP/IVP, etc
Advances against term Deposits, NSCs eligible for surrender, IVPs, KVPs and life
policies need not be treated as NPAs, provided adequate margin is available in the accounts.
Loans with moratorium for payment of interest:
In the case of bank finance given for industrial projects or for agricultural plantations
etc. where moratorium is available for payment of interest, payment of interest becomes due
only after the moratorium or gestation period is over.
In case of loans granted to staff members where interest is payable after recovery of
principal, interest need not be considered as overdue from the first quarter onwards. NPA
only when there is a default in repayment of instalment of principal or payment of interest on
the respective due dates.
16.3.5 Government Guaranteed Advances
The credit facilities backed by guarantee of the Central Government though overdue
may be treated as NPA only when the Government repudiates the guarantee when invoked.
Projects under Implementation:
For all projects financed by the FIs/banks, the ‘Date of Completion’ and the ‘Date of
Commencement of Commercial Operations’ (DCCO), of the project should be clearly spelt
out at the time of financial closure of the project and the same should be formally documented.
These should also be documented in the appraisal note by the bank during sanction of loan.
16.3.6 Measures to Solve Problems of NPA
1. Debt Recovery Tribunals (DRTs): Narasimham Committee Report I (1991)
recommended the setting up of Special Tribunals to reduce the time required for settling
cases. Accepting the recommendations, Debt Recovery Tribunals (DRTs) were established.
There are 22 DRTs and 5 Debt Recovery Appellate Tribunals. This is insufficient to solve the
problem all over the country (India).
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2. Securitization Act, 2002: Securitization and Reconstruction of Financial Assets and
Enforcement of Security Interest Act 2002, popularly known as Securitization Act, enables
the banks to issue notices to defaulters who have to pay the debts within 60 days. Once the
notice is issued, the borrower cannot sell or dispose the assets without the consent of the
lender. The Securitization Act further empowers the banks to take over the possession of the
assets and management of the company. The lenders can recover the dues by selling the
assets or changing the management of the firm. The Act also enables the establishment of
Asset Reconstruction Company for acquiring NPA. According to the provisions of the Act,
Asset Reconstruction Company of India Ltd. with eight shareholders and an initial capital of
Rs.10 crores has been set up. The eight shareholders are HDFC, HDFC Bank, IDBI, IDBI
Bank, SBI, ICICI, Federal Bank and South Indian Bank.
3. Lok Adalats: Lok Adalats have been found suitable for the recovery of small loans.
According to RBI guidelines issued in 2001, they cover NPA up to Rs.5 lakhs, both suit filed
and non-suit filed are covered. Lok Adalats avoid the legal process. The Public Sector Banks
have recovered Rs.40 crores at the end of September 2001.
4. Compromise Settlement: Compromise Settlement Scheme provides a simple
mechanism for recovery of NPA. Compromise Settlement Scheme is applied to advances
below Rs. 10 crores. It covers suit filed cases and cases pending with courts and DRTs (Debt
Recovery Tribunals). Cases of wilful default and fraud were excluded.
5. Credit Information Bureau:A good information system is required to prevent loans
from turning into a NPA. If a borrower is a defaulter to one bank, this information should be
available to all banks so that they may avoid lending to him. A Credit Information Bureau can
help by maintaining a data bank which can be assessed by all lending institutions.
16.4 CAPITAL ADEQUACY

Along with profitability and safety, banks also give importance to solvency. Solvency
refers to the situation where assets are equal to or more than liabilities. A bank should select
its assets in such a way that the interest of shareholders and depositors is protected. The
capital is life blood of any productive activities. This is very much applicable to banking
sector due to its nature of business transaction. They are involved in buying and selling of
money. In other words, their main job is to accept deposits and lend the same to borrowers.
It also gives the bank the ability to absorb shocks and thereby, avoid the likelihood of
bankruptcy. Along with profitability and safety, banks also give importance to solvency. A
bank should select its assets in such a way that the shareholders and depositors’ interest is
protected.
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16.4.1 Definition of Capital Adequacy Ratio
Capital Adequacy Ratio (CAR) is defined as the ratio of bank’s capital to its risk
assets. Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets
Ratio (CRAR). Basel Committee appointed by BIS, formulated rules and regulations for
effective supervision of the central banks. For this, it also prescribed international norms to
be followed by the central banks. This committee prescribed Capital Adequacy Norms in
order to protect the interests of the customers. Narasimham Committee recommended that
all banks are required to have a minimum capital of 8% to the risk weighted assets. The ratio
is known as Capital to Risk Assets Ratio (CRAR). All 27 Public Sector Banks in India (except
UCO and Indian Bank) have achieved the Capital Adequacy Norm of 8% by March 1997.
The Second Report of Narasimham Committee was submitted in 1998-99 and it
recommended for raising the CRAR to 10 per cent in a phased manner. It also recommended
an intermediate minimum target of 9 per cent to be achieved by 2000 and 10 per cent by
2002.
The concept of capital adequacy ratio relates to risk weights assigned to an asset
raised by the banks in the process of conducting business and to the proportion of capital to
be maintained on such aggregate risk weighted assets. Capital adequacy ratio is calculated on
the basis of risk weightages on assets in the books of banks. Each business transaction carries
a specific risk and a portion of capital has to be earmarked for this risk. Capital adequacy
enables banks to expand their balance sheet and strengthen their fundamentals, which in turn,
help the banks to mobilize capital at reasonable cost. The RBI stipulates a capital adequacy
ratio of 9 per cent for all banks and a capital adequacy ratio below this stipulation indicates
the inadequacy of a bank’s capital, compared to its assets (largely loans advanced and
investments) weighted against the risk they carry.
Capital Adequacy Norms included in different concepts are explained as follows;
1. Tier-I Capital
Capital which is first readily available to protect the unexpected losses is called as
Tier-I Capital. It is also termed as Core Capital. Tier-I Capital consists of Paid-Up Capital,
Statutory Reserves, Other Disclosed Free Reserves (Reserves which are not kept side for
meeting any specific liability) and Capital Reserves (Surplus generated from sale of Capital
Assets)
2. Tier-II Capital
Capital which is second readily available to protect the unexpected losses is called as
Tier-II Capital. Tier-II Capital Consists of Undisclosed Reserves and Paid-Up Capital,
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Perpetual Preference Shares, Revaluation Reserves (at discount of 55%), Hybrid (Debt /
Equity) Capital, Subordinated Debt, General Provisions and Loss Reserves. There is an
important condition that Tier II Capital cannot exceed 50 per cent of Tier-I Capital for arriving
at the prescribed Capital Adequacy Ratio.
16.4.2 Risk Weighted Assets
Capital Adequacy Ratio is calculated based on the assets of the bank. The values of
bank’s assets are not taken according to the book value but they are taken according to the
risk factor involved. The value of each asset is assigned with a risk factor in percentage
terms. Suppose CRAR at 10 per cent on Rs.150 crores is to be maintained. This means the
bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier
II Capital items subject to a condition that Tier II capital should not exceed 50 per cent of
Tier I Capital. Suppose the total value of items under Tier I Capital is Rs.5 crore and total
value of items under Tier II capital is Rs.10 crore, the bank will not have requisite CRAR of
Rs.15 crore. This is because a maximum of only Rs.2.5 crore under Tier II will be eligible
for computation.
16.4.3 Subordinated Debt
These are bonds issued by the banks for raising Tier II Capital.
They are as follows:
1. They should be fully paid up instruments.
2. They should be unsecured debt.
3. They should be subordinated to the claims of other creditors. This means that the bank’s
holder’s claims for their money will be paid at last in order of preference as compared
with the claims of other creditors of the bank.
4. The bonds should not be redeemable at the option of the holders. This means the
repayment of bond value will be decided only by the issuing bank.
Formula:
Tier 1 Capital + Tier 2 Capital
Capital Adequacy Ratio = –––––––––––––––––––––––––––
Risk-weighted Exposures
Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1
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Total Capital = Tier 1 Capital + Tier 2 Capital
Risk-weighted exposures include weighted sum of the bank’s credit exposures
(including those appearing on the bank’s balance sheet and those not appearing). The weights
are determined in accordance with the Basel Committee guidance for assets of each credit
rating slab.
Example:
Calculate capital adequacy ratio i.e. total capital to risk weighted exposures ratio for
Small Bank Inc. using the following information:
Exposure Risk Weight
Government Treasury held as asset 15,00,000 0%
Loans to Corporate 1,50,00,000 10%
Loans to Small Businesses 80,00,000 20%
Guarantees and other non-balance sheet exposures 60,00,000 10%
The bank’s Tier 1 Capital and Tier 2 Capital are Rs 200000 and Rs 300000 respectively.
Solution:
Bank’s total capital = 200000 + 300000 = Rs500000
Risk-weighted exposures = 1.500000×0% + 15000000×10% + 8000000×20% +
6000000×10% = 3700000
500000
Capital Adequacy Ratio =–––––––––––––––= 13.51%
3700000
If the national regulator requires a capital adequacy ratio of 9 per cent, the bank is safe.
Income Recognition:
(i) Banks may recognize income on accrual basis in respect of the projects under
implementation, which are classified as ‘standard’.
(ii) Banks should not recognize income on accrual basis in respect of the projects
under implementation which are classified as a ‘substandard’ asset. Banks may recognize
income in such accounts only on realization on cash basis.
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(iii) Banks which have wrongly recognized income in the past should reverse the interest if
it was recognized as income during the current year or make a provision for an equivalent
amount if it was recognized as income in the previous year(s). As regards the regulatory
treatment of ‘funded interest’ recognized as income and ‘conversion into equity,
debentures or any other instrument’ banks should adopt the following:
a) Funded Interest: Income recognition in respect of the NPAs, regardless of whether
these are or are not subjected to restructuring/rescheduling/renegotiation of terms of the
loan agreement, should be done strictly on cash basis, only on realization and not if the
amount of interest overdue has been funded. If, however, the amount of funded interest is
recognized as income, a provision for an equal amount should also be made simultaneously.
In other words, any funding of interest in respect of NPAs, if recognized as income, should
be fully provided for.
b) Conversion into equity, debentures or any other instrument: The amount
outstanding converted into other instruments would normally comprise principal and the
interest components. If the amount of interest dues is converted into equity or any other
instrument, and income is recognized in consequence, full provision should be made for the
amount of income so recognized to offset the effect of such income recognition. Such
provision would be in addition to the amount of provision that may be necessary for the
depreciation in the value of the equity or other instruments, as per the investment valuation
norms. However, if the conversion of interest is into equity which is quoted, interest income
can be recognized at market value of equity, as on the date of conversion, not exceeding the
amount of interest converted to equity. Such equity must thereafter be classified in the
“available for sale” category and valued at lower of cost or market value. In case of conversion
of principal and /or interest in respect of NPAs into debentures, such debentures should be
treated as NPA, in the same asset classification as was applicable to loan just before conversion
and provision made as per norms. This norm would also apply to zero coupon bonds or other
instruments which seek to defer the liability of the issuer. On such debentures, income should
be recognized only on realization basis. The income in respect of unrealized interest which
is converted into debentures or any other fixed maturity instrument should be recognized
only on redemption of such instrument. Subject to the above, the equity shares or other
instruments arising from conversion of the principal amount of loan would also be subject to
the usual prudential valuation norms as applicable to such instruments
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Provisioning Norms:
General
The bank managements and the statutory auditors are responsible for making adequate
provisions for any diminution in the value of loan assets, investment or other assets.
The bank management and the statutory auditors before taking decision in regard to
making adequate and necessary provisions in terms of prudential guidelines use the assessment
made by the inspecting officer of the RBI.
Provisioning for Loss Assets:
Loss assets should be written off.
If loss assets are permitted to remain in the books for any reason, 100 per cent of the
outstanding should be provided for.
Provisioning for Doubtful Assets:
1. 100 per cent of the extent to which the advance is not covered by the realizable value of
the security to which the bank has a valid recourse and the realizable value is estimated
on a realistic basis.
2. With regard to secured portion, provision may be made on the following basis, at the
rates ranging from 25 per cent to 100 per cent of the secured portion depending upon
the period for which the asset has remained doubtful.
Period for which the advance Provision requirement

has (%)
remained in ‘doubtful’ category
Up to one year 25
One to three years 40
More than three years 100
Note: Valuation of Security for provisioning purposes. With a view to bringing down
divergence arising out of difference in assessment of the value of security, in cases of NPAs
with balance of Rs. 5 crore and above stock audit at annual intervals by external agencies
appointed as per the guidelines approved by the Board would be mandatory in order to enhance
the reliability on stock valuation. Collaterals such as immovable properties charged in favor
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of the bank should be got valued once in three years by values appointed as per the guidelines
approved by the Board of Directors.
16.5 PROVISION FOR SUBSTANDARD ASSETS

A general provision of 10 per cent on total outstanding should be made.
The ‘unsecured exposure’ which are identified as ‘substandard’ would attract additional
provision of 10 per cent.
The provisioning requirement for unsecured ‘doubtful’ assets is 100 per cent.
Provision for Standard Assets:
Banks are required to make general provision for standard assets at the following
rates for the funded outstanding on global loan portfolio basis:
1. Direct advances to agricultural and SME sectors at 0.25%
2. Advances to Commercial Real Estate(CRE) sectors at 1.00%
3. All other loans and advances not included in a) and b) above at 0.40%
Prudential Norms on Creation and Utilization of Floating Provisions:
Principle for creation of floating provisions by banks
The bank’s board of directors should lay down approved policy regarding the level to
which the floating provisions can be created. The bank should hold floating provisions for
‘advances’ and ‘investments’ separately and the guidelines prescribed will be applicable to
floating provisions held for both ‘advances’ & ‘investment.
Principle for utilization of floating provisions by banks
The floating provisions should not be used for making specific provisions as per the
extant prudential guidelines in respect of non- performing assets or for making regulatory
provisions for standard assets. The floating provisions can be used only for contingencies
under extraordinary circumstances for making specific provisions in impaired accounts after
obtaining board’s approval and with prior permission of RBI. The boards of the banks should
lay down an approved policy as to what circumstances would be considered extraordinary.
To facilitate banks’ boards to evolve suitable policies in this regard, it is clarified that
the extra-ordinary circumstances refer to losses which do not arise in the normal course of
business and are exceptional and non-recurring in nature. These extra-ordinary circumstances
could broadly fall under three categories viz. General, Market and Credit. Under general
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category, there can be situations where bank is put unexpectedly to loss due to events such as
civil unrest or collapse of currency in a country. Natural calamities and pandemics may also
be included in the general category. Market category would include events such as a general
melt down in the markets, which affects the entire financial system. Among the credit category,
only exceptional credit losses would be considered as an extra-ordinary circumstance.
Accounting:
Floating provisions cannot be reversed by credit to the profit and loss account. They
can only be utilized for making specific provisions in extraordinary circumstances as
mentioned above. Until such utilization, these provisions can be netted off from gross NPAs
to arrive at disclosure of net NPAs. Alternatively, they can be treated as part of Tier II capital
within the overall ceiling of 1.25 % of total risk weighted assets
Disclosures :
Banks should make comprehensive disclosures on floating provisions in the “notes
on accounts” to the balance sheet on (a) opening balance in the floating provisions account,
(b) the quantum of floating provisions made in the accounting year, (c) purpose and amount
of draw down made during the accounting year, and (d) closing balance in the floating
provisions account.
Additional Provisions for NPAs higher than prescribed rates:
A bank may voluntarily make specific provisions for advances at rates which are higher
than the prescribed under existing regulations, to provide for estimated actual loss in
collectible amount. Such higher rates are approved by the Board of Directors and consistently
adopted from year to year.
Provision on Leased Assets:
Substandard Assets:
10 percent of the sum of the net investment in the lease and the realized portion of
finance income net finance charge component.
Unsecured lease exposure, which are identified as ‘substandard’ would attract additional
provision of 10%, i.e., a total of 20%.
Doubtful Assets:
100 percent of the extent to which, the finance is not secured by the realizable value
of the leased asset.
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Loss Assets:
The entire asset is required to be written off.
16.6 GUIDELINES FOR PROVISION UNDER SPECIAL

CIRCUMSTANCES
Advances granted under rehabilitation packages approved by BIFR/term
lending institutions
For advances under rehabilitation package approved by BIFR/Term lending institutions,
the provision should continue to be made in respect of dues to the bank on the existing credit
facilities as per their classification as substandard or doubtful asset. As regards the additional
facilities sanctioned as per package finalized by BIFR/or term lending institutions, provision
on additional facilities sanctioned need not be made for a period of one year from the date of
disbursement.
16.6.1 Disinvestment
At the very basic level, disinvestment can be explained as follows:
“Investment refers to the conversion of money or cash into securities, debentures,
bonds or any other claims on money. As follows, disinvestment involves the conversion of
money claims or securities into money or cash.”
Disinvestment can also be defined as the action of an organization (or government)
selling or liquidating an asset or subsidiary. It is also referred to as ‘divestment’ or ‘divestiture.’
In most contexts, disinvestment typically refers to sale from the government, partly
or fully, of a government-owned enterprise.
A company or a government organization will typically disinvest an asset either as a
strategic move for the company, or for raising resources to meet general/specific needs.
16.6.2 Objectives of Disinvestment
The new economic policy initiated in July 1991 clearly indicated that PSUs had shown
a very negative rate of return on capital employed. Inefficient PSUs had become and were
continuing to be a drag on the Government’s resources turning to be more of liabilities to the
Government than being assets. Many undertakings traditionally established as pillars of growth
had become a burden on the economy. The national gross domestic product and gross national
savings were also getting adversely affected by low returns from PSUs. About 10 to 15 % of
the total gross domestic savings were getting reduced on account of low savings from PSUs.
In relation to the capital employed, the levels of profits were too low. Of the various factors
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responsible for low profits in the PSUs, the following were identified as particularly
important:
 Price policy of public sector undertakings
 Under–utilization of capacity
 Problems related to planning and construction of projects
 Problems of labour, personnel and management
 Lack of autonomy
Hence, the need for the Government to get rid of these units and to concentrate on
core activities was identified. The Government also took a view that it should move out of
non-core businesses, especially the ones where the private sector had now entered in a
significant way. Finally, disinvestment was also seen by the Government to raise funds for
meeting general/specific needs.
In this direction, the Government adopted the ‘Disinvestment Policy’. This was
identified as an active tool to reduce the burden of financing the PSUs. The following main
objectives of disinvestment were outlined:
 To reduce the financial burden on the Government
 To improve public finances
 To introduce, competition and market discipline
 To fund growth
 To encourage wider share of ownership
 To depoliticize non-essential services
16.6.3 Importance of Disinvestment
Presently, the Government has about Rs. 2 lakh crore locked up in PSUs. Disinvestment
of the Government stake is, thus, far too significant. The importance of disinvestment lies in
utilization of funds for:
 Financing the increasing fiscal deficit
 Financing large-scale infrastructure development
 For investing in the economy to encourage spending
 For retiring Government debt- Almost 40-45% of the Centre’s revenue receipts go
towards repaying public debt/interest.
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 For social programs like health and education
Disinvestment also assumes significance due to the prevalence of an increasingly
competitive environment, which makes it difficult for many PSUs to operate profitably. This
leads to a rapid erosion of value of the public assets making it critical to disinvest early to
realize a high value. The operational functioning and managerial decision-making should be
minimal.
16.7 CASE STUDY

The banking sector reforms in India were started as a follow up measures of the
economic liberalization and financial sector reforms in the country. The banking sector being
the life line of the economy was treated with utmost importance in the financial sector reforms.
The reforms were aimed at to make the Indian banking industry more competitive, versatile,
efficient, productive, to follow international accounting standard and to free from the
government’s control. The reforms in the banking industry started in the early 1990s have
been continued till now. The paper makes an effort to first gather the major reforms measures
and policies regarding the banking industry by the govt. of India and the Central Bank of India
(i.,e. Reserve Bank of India) during the last fifteen years. Secondly, the paper will try to study
the major impacts of those reforms upon the banking industry. A positive responds is seen in
the field of enhancing the role of market forces, regarding prudential regulations norms,
introduction of CAMELS supervisory rating system, reduction of NPAs and regarding the up
gradation of technology. But at the same time the reform has failed to bring up a banking
system which is at par with the international level and still the Indian banking sector is mainly
controlled by the govt. as public sector banks being the leader in all the spheres of the banking
network in the country.
Questions;
1. Discuss the various reforms under taken in Indian banking sector.
2. Explain pros and cons of implementing CAMEL model.
3. What are the causes and remedies for NPA in Indian banks.
16.8 NOTES
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16.9 SUMMARY
The Government of India nationalized 14 commercial banks in 1969 and 6 more
Commercial banks in 1980.
The Narasimham Committee I was set up in order to study the problems of the Indian
financial system and to suggest some recommendations for improvement in the efficiency
and productivity of the financial institutions.
The Narasimham Committee II was asked to review the progress of banking reforms
and design a programme for further strengthening the financial system of India.
A non-performing asset (NPA) is a loan or advance for which the principal or interest
payment remained overdue for a period of 90 days.
Causes of NPA: recession in the economy, infrastructural problem, delay in release of
sanctioned limits by banks, delays in settlement of payments by government, natural calamities,
etc.
Banks are required to classify non-performing assets into the following three
categories based on the period for which the asset remained non- performing and the reliability
of the dues:
1. Substandard Assets
2. Doubtful Assets
3. Loss Assets
Measures to Solve Problems of NPA are; Debt Recovery Tribunals (DRTs),
Securitization Act, 2002, Lok Adalats, Compromise Settlement, Credit Information Bureau.
Capital Adequacy Ratio (CAR) is defined as the ratio of bank’s capital to its risk
assets.
Tier-I Capital consists of Paid-Up Capital, Statutory Reserves, Other Disclosed Free
Reserves (Reserves which are not kept side for meeting any specific liability) and Capital
Reserves (Surplus generated from sale of Capital Assets)
Tier-II Capital Consists of Undisclosed Reserves and Paid-Up Capital, Perpetual
Preference Shares, Revaluation Reserves (at discount of 55%), Hybrid (Debt / Equity) Capital,
Subordinated Debt, General Provisions and Loss Reserves.
Disinvestment can also be defined as the action of an organization (or government)
selling or liquidating an asset or subsidiary.
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The following main objectives of disinvestment were outlined:
 To reduce the financial burden on the Government
 To improve public finances
 To introduce, competition and market discipline
 To fund growth
 To encourage wider share of ownership
 To depoliticize non-essential services

1. Briefly explain M.Narasimham Committee Reports on Banking Sector Reform.
2. WHAT do you mean by NPA? What are it causes?
3. Explain the guidelines of assets classification in banks.
4. Discuss the measures to minimise NPA.
5. Explain the provisioning norms for NPA.
6. What is disinvestment? What are its objectives? Explain.
16.11 KEY WORDS

Narasimham Committee
Non-performing assets
Capital adequacy
Disinvestment
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16.12 REFERENCES
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M.B.A III Semester
COURSE - 16 A
BLOCK
5
MARCHANT BANKING
UNIT - 17
AN OVER VIEW OF MERCHANT BANKING 1-15
UNIT -18
MERCHANT BANKING AND MARKETING OF NEW ISSUES 16-34
UNIT - 19
CREDIT CARDS 35-49
UNIT - 20
MERCHANT BANKING IN INDIA 50-65
1

Chairman
Course Writers
Prof. Jayanna Block - 5 (Units 17 to 20)

Professor
Department of Commerce
Vijayanagara Sri Krishnandevaraya University
Bellary
Publisher
Registrar

Mysuru.-6.
2
BLOCK -4 : FINANCIAL AND BANKING INSTITUTIONS
The increase in the numbers of issues and amount raised the number of merchant
bankers. Therefore, the field become highly competitive market, where it require a specialized
skill in handling the situation. The merchant bankers have a social responsibility to in building
an industrial structure in India.
The last block of this course discuss merchant banking consist of 04 units (17-20).
Unit 17 explains an overview of merchant banking, meaning, definitions, origin, nature, scope,
structure. Functions of merchant banking, industry and bankers, difference between merchant
banks and investment banks and qualities. Unit18 elucidates merchant banking and marketing
of new issues introduction , new issues, pure prospectus method, offer for sale method,
private placement, initial public offer, right issue, bonus issues, book building, brought out
deals method. Unit 19 tells credit card introduction, meaning, types, operational cycle, parties
in, global players, and emerging trend in payment system. Last unit of this block explains
merchant banking in India meaning , post independence, under SEBI regulations in India.
3
4
BLOCK - 5
MARCHANT BANKING
UNIT - 17 : AN OVERVIEW OF MERCHANT BANKING
Structure:
17.0 Objectives
17.1 Introduction
17.2 Meaning and Definitions
17.3 Origin, Nature and Scope of Merchant Banking
17.4 Structure of Merchant Banking Industry
17.5 Functions of Merchant Banker
17.6 Difference between Merchant Banks and Investment Banks
17.7 Qualities of a Merchant Banker
17.8 Notes
17.9 Summary
17.10 Key Words
17.12 References
5
17.0 OBJECTIVES
• concept of Merchant Banking
• Describe the scope of merchant banker and structure of merchant banking industry
• Explain the functions and qualities of merchant banker
• Differentiate between merchant banks and investment banks
17.1 INTRODUCTION
In this hyper competitive financial environment, merchant banking emerged as an
indispensable service that transfers the funds from surplus spending units to deficit spending
units through its various activities. The first merchant bank was set up in 1969 by Grind lays
Bank. Initially they were issue mangers looking after the issue of shares and raising capital
for the company. But subsequently they expanded their activities such as working capital
management; syndication of project finance, global loans, mergers, capital restructuring,
etc., initially the merchant banker in India was in the form of management of public issue and
providing financial consultancy for foreign banks. In 1973, SBI started the merchant banking
and it was followed by ICICI. SBI capital market was set up in August 1986 as a fully fledged
merchant banker. Between 1974 and 1985, the merchant banker has promoted lot of
companies. However they were brought under the control of SEBI in 1992.
17.2 MEANING AND DEFINITIONS

Securities and Exchange Board of India (Merchant Bankers) Rules, 1992 -A
merchant banker has been defined as any person who is engaged in the business of issue
management either by making arrangements regarding selling, buying or subscribing to
securities or acting as manager, consultant, adviser or rendering corporate advisory services
in relation to such issue management.
Random House Dictionary -Merchant banker is an organization that underwrites
securities for corporations, advices such clients on mergers and is involved in the ownership
of commercial ventures. These organizations are sometime banks which are not merchants
and sometimes merchants who are not banks and sometimes houses which are neither
merchants nor banks.
Charles P. Kindleberger -Merchant banking is the development of banking from
commerce which frequently encountered a prolonged intermediate stage known in England
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originally as merchant banking. The Notification of the Ministry of finance defines A
merchant banker as any person who is engaged in the business of issue management either by
making arrangements regarding selling, buying or subscribing to the securities as manager,
consultant, adviser or rendering corporate advisory service in relation to such issue
management.
17.3 ORIGIN, NATURE AND SCOPE OF MERCHANT BANKING

The origin of merchant banking is traceable to the developments of foreign trade and
finance during the 13th century. During this period, a few firms engaged in coastal trade and
finance spread throughout the European continent were engaged both in commercial activities
and banking activities. These firms also acted as the bankers to the Kings of the European
States, financial coastal trade among European nations, bore exchange risk and security risk
in financing the Kings, Monarchs and Governments engaged in continental wars. The main
centre for world trade and finance at that time was Amsterdam, where the Dutch traders
relied upon the expertise of merchant bankers (then known as commission agents) for
financing of trade. During the seventeenth and eighteenth century, the Italian grain merchants
also started merchant banking activities in Italy and France. It comprised of merchant bankers
who intermediated in financing the transactions of the traders and their own trade also. The
Italian merchant bankers introduced into England not only the bill of exchange, but also all
the institutions and techniques connected with the organized money market. Thus, the modern
merchant banking started from London where the merchants started to finance the foreign
trade through acceptance of bill of exchange. The industrial revolution in England gave further
boost to the merchant banking due to the growth of the home industry.
In India, prior to the enactment of Indian Companies Act, 1956, managing agents acted
as issue houses for securities, evaluated project reports, planned capital structure and to
some extent provided venture capital for new firms. Few share broking firms also functioned
as merchant bankers.
The need for specialized merchant banking service was felt in India with the rapid
growth in the number and size of the issues made in the primary market. The merchant banking
services were started by foreign banks, namely the National Grindlays bank in 1967 and the
City Bank in 1970. The banking commission in its report in 1972 recommended the setting
up of merchant banking institutions by commercial banks and financial institutions. This
marked the beginning of specialized merchant banking in India.
To begin with, merchant banking services were offered along with other traditional
banking services. In the mid-eighties, the Banking Regulations Act was amended permitting
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commercial banks to offer a wide range of financial services through the subsidiary rule. The
state bank of India was the first Indian Bank to set up Merchant Banking division in 1972.
Later ICICI set up its merchant banking division followed by Bank of India, Bank of Baroda,
Canara Bank, UCO bank.
17.4 STRUCTURE OF MERCHANT BANKING INDUSTRY

Initially Merchant Bankers were classified into 4 categories with regard to their nature
and range of activities and their responsibilities to SEBI, investors and issuers of securities.
Since September 1997 only a single category exists. The requirements are as under: There
are four different categories of merchant bankers. Only category 1 merchant bankers are
allowed to act as lead managers to the issue: Category 1: Those merchant bankers who can
conduct all above mentioned activities, relating to management of issues. They may, if they
so choose, act only in an advisory capacity or as co-manager, underwriter or as portfolio
manager. Category 2: Those merchant bankers who can act as consultant, advisor, portfolio
manager and co-manager. Category 3: Those merchant bankers who can act as underwriter,
advisor and consultant. Category 4: Those merchant bankers who can act only as advisor or
consultant to an issue. Different types of organizations in India which provide merchant
baking services: i. Commercial Banks ii. All India Financial Institutions iii. Private Consultancy
Firms iv. Technical Consultancy Organizations.
17.5 FUNCTIONS OF MERCHANT BANKER

Merchant bankers carry out a variety of functions and offer diverse range of services.
Some of the most important functions carried out by merchant bankers in India are :-
a) Corporate counseling
b) Project Counseling
c) Capital Structuring
d) Portfolio Management
e) Issue Management
f) Credit Syndication
g) Working capital
h) Venture Capital
i) Fixed Deposits
j) Other functions
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(i) Corporate counseling: Corporate counseling covers counseling in the form of
project counseling, capital restructuring, project management, public issue management,
loan syndication, working capital fixed deposit, lease financing, acceptance credit etc., The
scope of corporate counseling is limited to giving suggestions and opinions to the client and
help taking actions to solve their problems. It is provided to a corporate unit with a view to
ensure better performance, maintain steady growth and create better image among investors.
(ii) Project counseling Project counseling is a part of corporate counseling and
relates to project finance. It broadly covers the study of the project, offering advisory
assistance on the viability and procedural steps for its implementation.
a. Identification of potential investment avenues.
b. A general view of the project ideas or project profiles.
c. Advising on procedural aspects of project implementation
d. Reviewing the technical feasibility of the project
e. Assisting in the selection of TCO s (Technical Consultancy Organizations) for
preparing project reports
f. Assisting in the preparation of project report
g. Assisting in obtaining approvals, licenses, grants, foreign collaboration etc., from
government
h. Capital structuring
i. Arranging and negotiating foreign collaborations, amalgamations, mergers and
takeovers.
j. Assisting clients in preparing applications for financial assistance to various national
and state level institutions banks etc.,
k. Providing assistance to entrepreneurs coming to India in seeking approvals from the
Government of India.
(iii) Capital Structure Here the Capital Structure is worked out i.e., the capital
required, raising of the capital, debt-equity ratio, issue of shares and debentures, working
capital, fixed capital requirements, etc.,
(iv) Portfolio Management It refers to the effective management of Securities i.e.,
the merchant banker helps the investor in matters pertaining to investment decisions. Taxation
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and inflation are taken into account while advising on investment in different securities. The
merchant banker also undertakes the function of buying and selling of securities on behalf of
their client companies. Investments are done in such a way that it ensures maximum returns
and minimum risks.
(v) Issue Management: Management of issues refers to effective marketing of
corporate securities viz., equity shares, preference shares and debentures or bonds by offering
them to public. Merchant banks act as intermediary whose main job is to transfer capital
from those who own it to those who need it. The issue function may be broadly divided in to
pre issue and post issue management.
a. Issue through prospectus, offer for sale and private placement.
b. Marketing and underwriting
c. pricing of issues
(vi) Credit Syndication: Credit Syndication refers to obtaining of loans from single
development finance institution or a syndicate or consortium. Merchant Banks help corporate
clients to raise syndicated loans from commercials banks. Merchant banks helps in identifying
which financial institution should be approached for term loans. The merchant bankers follow
certain steps before assisting the clients approach the appropriate financial institutions.
a. Merchant banker first makes an appraisal of the project to satisfy that it is viable
b. He ensures that the project adheres to the guidelines for financing industrial projects.
c. It helps in designing capital structure, determining the promoters contribution and
arriving at a figure of approximate amount of term loan to be raised.
d. After verifications of the project, the Merchant Banker arranges for a preliminary
meeting with financial institution.
e. If the financial institution agrees to consider the proposal, the application is filled and
submitted along with other documents.
(vii) Working Capital: The Companies are given Working Capital finance, depending
upon their earning capacities in relation to the interest rate prevailing in the market.
(viii)Venture Capital: Venture Capital is a kind of capital requirement which carries
more risks and hence only few institutions come forward to finance. The merchant banker
looks in to the technical competency of the entrepreneur for venture capital finance.
10
(ix). Fixed Deposit: Merchant bankers assist the companies to raise finance by way
of fixed deposits from the public. However such companies should fulfill credit rating
requirements.
(x) Other Functions
• Treasury Management- Management of short term fund requirements by client
companies.
• Stock broking- helping the investors through a network of service units
• Servicing of issues- servicing the shareholders and debenture holders in distributing
dividends, debenture interest.
• Small Scale industry counseling- counseling SSI units on marketing and finance
• Equity research and investment counseling – merchant banker plays an important
role in providing equity research and investment counseling because the investor is not
in a position to take appropriate investment decision.
• Assistance to NRI investors - the NRI investors are brought to the notice of the various
investment opportunities in the country.
• Foreign Collaboration: Foreign collaboration arrangements are made by the Merchant
bankers.
17.6 DIFFERENCE BETWEEN MERCHANT BANKS AND

INVESTMENT BANKS
Merchant banks and investment banks, in their purest forms, are different kinds of
financial institutions that perform different services. In practice, the fine lines that separate
the functions of merchant banks and investment banks tend to blur. Traditional merchant
banks often expand into the field of securities underwriting, while many investment banks
participate in trade financing activities. In theory, investment banks and merchant banks
perform different functions.
Pure investment banks raise funds for businesses and some governments by registering
and issuing debt or equity and selling it on a market. Traditionally, investment banks only
participated in underwriting and selling securities in large blocks. Investment banks facilitate
mergers and acquisitions through share sales and provide research and financial consulting
to companies. Traditionally, investment banks did not deal with the general public.
11
Traditional merchant banks primarily perform international financing activities such
as foreign corporate investing, foreign real estate investment, trade finance and international
transaction facilitation. Some of the activities that a pure merchant bank is involved in may
include issuing letters of credit, transferring funds internationally, trade consulting and co-
investment in projects involving trade of one form or another.
The current offerings of investment banks and merchant banks varies by the institution
offering the services, but there are a few characteristics that most companies that offer both
investment and merchant banking share.
As a general rule, investment banks focus on initial public offerings (IPOs) and large
public and private share offerings. Merchant banks tend to operate on small-scale companies
and offer creative equity financing, bridge financing, mezzanine financing and a number of
corporate credit products. While investment banks tend to focus on larger companies,
merchant banks offer their services to companies that are too big for venture capital firms to
serve properly, but are still too small to make a compelling public share offering on a large
exchange. In order to bridge the gap between venture capital and a public offering, larger
merchant banks tend to privately place equity with other financial institutions, often taking
on large portions of ownership in companies that are believed to have strong growth potential.
Merchant banks still offer trade financing products to their clients. Investment banks
rarely offer trade financing because most investment banking clients have already outgrown
the need for trade financing and the various credit products linked to it.
17.7 QUALITIES OFA MERCHANT BANKER
Merchant Bankers are individual’s experts who organize and manage the merchant
banks. The operations of merchant banks are influenced by the personality, traits and nature
of merchant bankers. Some of the important qualities that a merchant banker should possess
are highlighted below
a. Proactive and Leading
b. Aggressive
c. Cooperation and Friendly
d. Networking and Liasioning skills
e. Problem Solving skills
f. Inquisitiveness for acquiring new knowledge
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17.8 NOTES
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17.9 SUMMARY
Merchant Banking services are gaining a lot of momentum in this century with wide
variety of services being offered such as Corporate counseling, Project Counseling, Capital
Structuring, Portfolio Management, Issue Management, Credit Syndication, Working capital,
Venture Capital, Fixed Deposits and Other functions namely treasury management, stock
broking, foreign collaboration, assistance to NRI investors etc. The role of merchant bankers
has become an integral part of our day to day activities in business.
17.10 KEY WORDS

Corporate Counseling
Portfolio Management
Credit Syndication
NRI
Venture Capital
Lease Finance
Issue Management
1. Define Merchant Banking
2. Discuss briefly the origin and growth of merchant banking
3. Write an explanatory note on structure of merchant banking
4. Critically evaluate the services rendered by merchant bankers
17.12 REFERENCE S
15
UNIT- 18 : MERCHANT BANKING AND MARKETING
OF NEW ISSUES
Structure:
18.0 Objectives
18.1 Introduction
18.2 Marketing of new Issues
18.3 Pure Prospectus Method
18.4 Offer for Sale Method
18.5 Private Placement Method
18.6 Initial Public Offer (IPO) Method
18.7 Rights Issue Method
18.8 Bonus Issue Method
18.9 Book-building Method
18.10 Stock Option of Employees Stock Option Plan (ESOP)
18.11 Bought-out Deals Method
18.12 Notes
18.13 Summary
18.14 Key Words
18.16 References
16
18.0 OBJECTIVES

• Steps involved in marketing of issue of securities
• Explain different methods available for marketing the securities in the new Issues
Market State the pros and cons of each of the methods
18.1 INTRODUCTION
Issue management by merchant bankers mainly focuses on three basic functions viz,
origination, underwriting and distribution of securities. Distribution services of lead managers
include the activities and cost incurred in selling and delivering the securities to the investors.
Along with performing the function as a bridge between the issuing company and the investors,
merchant bankers also have to generate interest and build the confidence of the investors in
the capital market. So distribution is a function of sale of securities to the ultimate investors.
This service, managed by lead manager, is performed by brokers and dealers in securities
who maintain regular direct contact with the ultimate investors. Merchant bankers make efforts
for the promotion and marketing of the issue. They plan, co-ordinate and control the entire
activities relating to public issues and direct different agencies to contribute to the successful
marketing of securities. In India, lead managers do not own an issue before its distribution to
general public. They simply underwrite and arrange the distribution through the underwriters.
Advancement of technology in communication and data processing has posed a new challenge
for the merchant bankers in the area of marketing of public issues. Today, merchant bankers
need top care about being in the centre of ‘information flow’ rather than in the centre of
‘capital flow’.
18.2 MARKETING OF NEW ISSUES

Following are the steps involved in the marketing of the issue of securities to be
undertaken by the lead manager:
1. Target market: The first step towards the successful marketing of securities is the
identification of a target market segment where the securities can be offered for sale.
This ensures smooth marketing of the issue. Further, it is possible to identify whether
the market comprises of retail investors, wholesale investors or institutional investors.
2. Target concentration: After having chosen the target market for selling the securities,
steps are to be taken to assess the maximum number of subscriptions that can be expected
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from the market. It would work to the advantage of the company if it concentrates on the
regions where it is popular among prospective investors.
3. Pricing: After assessing market expectations, the kind and level of price to be charged
for the security must be decided. Pricing of the issue also influences the design of
capital structure. The offer has to be made more attractive by including some unique
features such as safety net, multiple options for conversion, attaching warrants, etc.
4. Mobilizing intermediaries: For successful marketing of public issues, it is important
that efforts are made to enter into contracts with financial intermediaries such as an
underwriter, broker/sub-broker, fund arranger, etc.
5. Information contents: Every effort should be mad3e to ensure that the offer document
for issue is educative and contains maximum relevant information. Institutional investors
and high net worth investors should also be provided with detailed research on the project,
specifying its uniqueness and its advantage over other existing or upcoming projects in
a similar field.
6. Launching advertisement campaign: In order to push the public issue, the lead manager
should undertake a high voltage advertisement campaign. The advertising agency must
be carefully selected for this purpose. The task of advertising the issue shall be entrusted
to those agencies that specialize in launching capital offerings. The theme of the
advertisement should be finalized keeping in view SEBI guidelines. An ideal mix of
different advertisement vehicles such as the press, the radio and the television, the
hoarding, etc. should be used. Press meets, brokers and investor s conference, etc. shall
be arranged by the lead manager at targeted in carrying out opinion polls. These services
would useful in collecting data on investors opinion and reactions relating to the public
issue of the company, such a task would help develop an appropriate marketing strategy.
This is because; there are vast numbers of potential investors in semi-urban and rural
areas. This calls for sustained efforts on the part of the company to educate them about
the various avenues available for investment.
7. Brokers and investors conferences: As part of the issue campaign, the lead manager
should arrange for brokers‘ and investors‘ conferences in the metropolitan cities and
other important centre which have sufficient investor population. In order to make such
endeavors more successful, advance planning is required. It is important that conference
materials such as banners, brochures, application forms, posters, etc. reach the
conference venue in time. In addition, invitation to all the important people, underwriters,
bankers at the respective places, investors‘ associations should also be sent.
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8. A critical factor that could make or break the proposed pu8blic issue is its timing. The
market conditions should be favorable. Otherwise, even issues from a company with an
excellent track record, and whose shares are highly priced, might flop. Similarly, the
number and frequency of issues should also be kept to a minimum to ensure success of
the public issue.
Methods used for marketing of new issues
Following are the various methods being adopted by corporate entities for marketing
the securities in the new Issues Market:
1. Pure Prospectus Method
2. Offer for Sale Method
3. Private Placement Method
4. Initial Public Offers Method
5. Rights Issue Method
6. Bonus Issue
7. Book-building Method
8. Stock Option Method and
9. Bought-out Deals Method
18.3 PURE PROSPECTUS METHOD

The method whereby a corporate enterprise mops up capital funds from the general
public by means of an issue of a prospectus, is called Pure Prospectus Method. It is the most
popular method of making public issue of securities by corporate enterprises.
The features of this method are
a. Exclusive subscription: Under this method, the new issues of a company are offered
for exclusive subscription of the general public. According to the SEBI norms, a minimum
of 49 percent of the total issue at a time is to be offered to public.
b. Issue price: Direct offer is made by the issuing company to the general public to
subscribe to the securities at a staged price. The securities may be issued either at par,
of at a discount or at a premium.
c. Underwriting: Public issue through the pure prospectus method‘s usually underwritten.
This is to safeguard the interest of the issuer in the event of an unsatisfactory response
from the public.
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d. Prospectus: A document that information relating to the various aspects of the Issuing
company, besides other details of the issue is called a Prospectus. The document is
circulated to the public. The general details include the company’s name and address of
the registered office, the names and addresses of the company’s promoters, manager,
managing director, directors, company secretary, legal adviser, auditors, bankers, brokers,
etc. the date of opening and closing of subscription list, contents of Articles, the names
and addresses of underwriters, the amount underwritten and the underwriting commission,
material details regarding the project, i.e. Location, plant and machinery, technology,
collaboration, performance guarantee, infrastructure facilities etc. nature of products,
marketing set-up, export potentials and obligations, past performance and future
prospects, managements perception regarding risk factor, credit rating obtained from
any other recognized rating agency, a statement regarding the fact that the company will
make an application to specified stock exchange(s) for listing its securities and so on.
Advantages
a. Benefits to Investors: The pure prospectus method of marketing the securities serves
as an excellent mode of disclosure of all the information pertaining to the issue. Besides,
it also facilitates satisfactory compliance with the legal requirements of transparency
etc. It also allows for good publicity for the issue. The method promotes confidence of
investors through transparency and non-discriminatory basis of allotment. It prevents
artificial packing up of prices as the issue is made public.
b. Benefits to Issuers: The pure prospectus method is the most popular method among
the large issuers. In addition, it provides for wide diffusion of ownership of securities
contributing to reduction in the concentration of economic and social power.
Draw Backs
a. High Issue Costs: A major drawback of this method is that it is an expensive mode of
raising funds from the capital market. Costs of various hues are incurred in mobilizing
capital. Such costs as underwriting expenses, brokerage, administrative costs, publicity
costs, legal costs and other costs are incurred for raising funds. Due to the high cost
structure, this type of marketing of securities is followed only for large issues.
b. Time consuming: The issue of securities through prospectus takes more time, as it
requires the due compliance with various formalities before an issue could take place.
For instance, a lot of work such as underwriting, etc. should be formalized before the
printing and the issue of a prospectus.
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18.4 OFFER FOR SALE METHOD
Where the marketing of securities takes place through intermediaries, such as issue
houses, stockbrokers and others, it is a case of Offer for Sale Method. Under this method,
the sale of securities takes place in two stages. Accordingly, in the first stage, the issuer
company makes an end-block sale of securities to intermediaries such as the issue houses
and share brokers at an agreed price. Under the second stage, the securities are re-sold to
ultimate investors at a market-related price. The difference between the purchase price and
the issue price constitutes profit for the intermediaries. The intermediaries are responsible
for meeting various expenses such as underwriting commission, prospectus cost,
advertisement expenses, etc. The issue is also underwritten to ensure total subscription of
the issue. The biggest advantage of this method is that it saves the issuing company the hassles
involved in selling the shares to the public directly through prospectus. This method is, however,
expensive for the investor as it involves the offer of securities by issue houses at very high
prices.
18.5 PRIVATE PLACEMENT METHOD

A method of marketing of securities whereby the issuer makes the offer of sale to
individuals and institutions privately without the issue of a prospectus is known as Private
Placement Method. This is the most popular method gaining momentum in recent times
among the corporate enterprises. Under this method, securities are offered directly to large
buyers with the help of shares brokers. This method works in a manner similar to the Offer
for Sale Method whereby securities are first sold to intermediaries such as issues houses,
etc. They are in turn placed at higher prices to individuals and institutions. Institutional investors
play a significant role in the realm of private placing. The expenses relating to placement are
borne by such investors.
Advantages
1. Less expensive as various types of costs associated with the issue are borne by the issue
houses and other intermediaries.
2. Less troublesome for the issuer as there is not much of stock exchange requirements
connecting contents of prospectus and its publicity etc. to be complied with.
3. Placement of securities suits the requirements of small companies.
4. The method is also resorted to when the stock market is dull and the public response to
the issue is doubtful.
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Disadvantages
1. Concentration of securities in a few hands. 2. Creating artificial scarcity for the
securities thus jacking up the prices temporarily and misleading general public. 3. Depriving
the common investors of an opportunity to subscribe to the issue, thus affecting their
confidence levels.
18.6 INTIAL PUBLIC OFFER (IPO) METHOD

The public issue made by a corporate entity for the first time in its life is called Initial
Public Offer (IPO). Under this method of marketing, securities are issued to successful
applicants on the basis of the orders placed by them, through their brokers. When a company
whose stock is not publicly traded wants to offer that stock to the general public, it takes the
form of Initial Public Offer. The job of selling the stock is entrusted to a popular intermediary,
the underwriter.
An underwriter is invariably an investment banking company. He agrees to pay the
issuer a certain price for a minimum number of shares, and then resells those shares to
buyers, who are often the clients of the underwriting firm. The underwriters charge a fee for
their services. Stocks are issued to the underwriter after the issue of prospectus which provides
details of financial and business information as regards the issuer. Stocks are then released
to the underwriter and the underwriter releases the stock to the public. The issuer and the
underwriting syndicate jointly determine the price of a new issue. The approximate price
listed in the red herring (the preliminary prospectus – often with words in red letters which
say this is preliminary and the price is not yet set) may or may not be close to the final issue
price. IPO stock at the release price is usually not available to most of the public. Good
relationship between the broker and the investor is a prerequisite for the stock being acquired.
Full disclosure of all material information in connection with the offering of new securities
must be made as part of the new offerings. A statement and preliminary prospectus (also
known as a red herring) containing the following information is to be filed with the Registrar
of Companies:
1. A description of the issuer s business
2. The names and addresses of the key company offers, with salary and a 5 year business
history on each
3. The amount of ownership of the key officers
4. The company’s capitalization and description of how the proceeds from the offering
will be used and
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5. Any legal proceedings that the company is involved in. Applications are made by the
investors on the advice of their brokers who are intimated of the share allocation by the
issuer. The amount becomes payable to the issuer through the broker only on final
allocation. The allotment is credited and share certificates delivered to the depository
account of the successful investor.
The essential steps involved in this method of marketing of securities are as follows:
a. Order Broker receives order from the client and places orders on behalf of the client
with the issuer.
b. Share allocation: The issuer finalizes share allocation and informs the broker regarding
the same.
c. The client: The broker advises the successful clients of his share allocation Clients then
submit the application forms for shares and make payment to the issuer through the
broker.
d. Primary issue account: The issuer opens a separate escrow account (primary issue
account) for the primary market issue. The clearing house of the exchange debits the
primary issue account of the broker and credits the issuer s account.
e. Certificates: Certificates are then delivered to investors. Otherwise depository account
may be credited. The biggest advantage of this method of marketing of securities is that
there is no need for the investors to part with the money even before the shares are
allotted in his favor. Further, the method allows for elimination of unnecessary hassles
involved in making a public issue.
Under the regulations of the SEBI, IPOS can be carried out through the secondary
market and the existing infrastructure of stock exchanges can be used for this purpose.
18.7 RIGHTS ISSUE METHOD

Where the shares of an existing company are offered to its existing shareholders, it
takes the form of rights issue. Under this method, the existing company issues shares to its
existing shareholders in proportion to the number of shares already held by them. The relevant
guidelines issued by the SEBI in this regard are as follows;
1. Shall be issued only by listed companies
2. Announcement regarding rights issue once made, shall not be withdrawn and where
withdrawn, no security shall be eligible for listing up to 12 months
3. Underwriting as to rights issue is optional and appointment of Registrar is compulsory
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4. Appointment of category I Merchant Bankers holding a certificate of registration issued
by SEBI shall be compulsory
5. Rights shares shall be issued only in respect of fully paid shares
6. Letter of Offer shall contain disclosures as per SEBI requirements
7. Agreement shall be entered into with the depository for materialization of securities to
be issued
8. Issue shall be kept open for a minimum period of 30 days and for a maximum period of
60 days
9. A minimum subscription of 90 percent of the issue shall be received
10. No reservation is allowed for rights issue as regards FCDs and PCDs
11. A No Complaints Certificate‘s to be filed by the Lead Merchant Banker‘ with the SEBI
after 21 days from the date of issue of offer document
12. Obligatory for a company where increase in subscribed capital is necessary after two
years of its formation or after one year of its first issue of shares, whichever is earlier?
Advantages
Rights issue offers the following advantages:
1. Economy: Rights issue constitutes the most economical method of raising fresh capital,
as it involves no underwriting and brokerage costs. Further, the expenses by way of
advertisement and administration, etc. are less.
2. Easy: The issue management procedures connected with the rights issue are easier as
only a limited number of applications are to be handled.
3. Advantage of shareholders: Issue of rights shares does not involve any dilution of
ownership of existing shareholders. Further, it offers freedom to shareholders to
subscribe or not to subscribe the issue.
Drawbacks
The method suffers from the following limitations:
1. Restrictive: The facility of rights issue is available only to existing companies and not
to new companies.
2. Against society : The issue of rights shares runs counter to the overall societal
considerations of diffusion of shares ownership for promoting dispersal of wealth and
economic power.
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18.8 BONUS ISSUE METHOD
Where the accumulated reserves and surplus of profits of a company are converted
into paid up capital, it takes the form of issue of bonus shares . It merely implies capitalization
of exiting reserves and surplus of a company. The issue of bonus shares is subject to certain
rules and regulations. The issue does not in any way affect the resources base of the enterprise.
It saves the company enormously of the hassles of capital issue. Issued under Section 205
(3) of the Companies Act, such shares are governed by the guidelines issued by the SEBI
(applicable to listed companies only) as follows:
1. Reservation - In respect of FCDs and PCDs, bonus shares must be reserved in
proportion to such convertible part of FCDs and PCDs. The shares so reserved may be issued
at the time of conversion(s) of such debentures on the same terms on which the bonus issues
were made.
2. Reserves - The bonus issue shall be made out of free reserves built out of the
genuine profits or share premium collected in cash only. Reserves created by revaluation of
fixed assets are not capitalized.
3. Dividend mode - The declaration of bonus issue, in lieu of dividend, is not made
4. Fully paid - The bonus issue is not made unless the partly paid shares, if any are
made fully paid-up.
5. No default - The Company has not defaulted in payment of interest or principal in
respect of fixed deposits and interest on existing debentures or principal on redemption
thereof and has sufficient reason to believe that it has not defaulted in respect of the payment
of statutory dues of the employees such as contribution to provident fund, gratuity, bonus
etc.
6. Implementation - A company that announces its bonus issue after the approval of
the Board of Directors must implement the proposal within a period of 6 months from the
date of such approval and shall not have the option of changing the decision.
7. The articles- The articles of Association of the company shall contain a provision
for capitalization of reserves, etc. If there is no such provision in the Articles, the company
shall pass a resolution at its general body meeting making provisions in the Articles of
Associations for capitalization.
8. Resolution - Consequent to the issue of bonus shares if the subscribed and paid-
up capital exceeds the authorized share capital, the company at its general body meeting for
increasing the authorized capital shall pass a resolution.
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18.9 BOOK BUILDING METHOD
A method of marketing the shares of a company whereby the quantum and the price of
the securities to be issued will be decided on the basis of the bids received from the
prospective shareholders by the lead merchant bankers is known as book-building method.
Under the book-building method, share prices are determined on the basis of real demand
for the shares at various price levels in the market. For discovering the price at which issue
should be made, bids are invited from prospective investors from which the demand at various
price levels is noted. The merchant bankers undertake full responsibility for the same. The
option of book building is available to all body corporate, which are otherwise eligible to
make an issue of capital to the public. The initial minimum size of issue through book-
building route was fixed at Rs.100 crores. However, beginning from December 9, 1996
issues of any size will be allowed through the book-building route. Book-building facility is
available as an alternative to firm allotment. Accordingly, a company can opt for book-building
route for the sale of shares to the extent of the percentage of the issue that can be reserved
for firm allotment as per the prevailing SEBI guidelines. It is therefore possible either to
reserve securities for firm allotment or issue them through the book-building process. The
book-building process involves the following steps:
1. Appointment of book-runners:
The first step in the book-building process is the appointment by the issuer company,
of the book-runner, chosen from one of the lead merchant bankers. The book-runner in turn
forms a syndicate for the book-building. A syndicate member should be a member of National
Stock Exchange (NSE) or Over-the-Counter Exchange of India (OTCEI). Offers of bids‘ are
to be made by investors to the syndicate members, who register the demands of investors.
The bid indicates the number of shares demanded and the prices offered. This information,
which is stored in the computer, is accessible to the company management or to the book-
runner. The name of the book-runner is to be mentioned in the draft prospectus submitted to
SEBI.
2. Drafting prospectus:
The draft prospectus containing all the information except the information regarding
the price at which the securities are offered is to be filed with SEBI as per the prevailing
SEBI guidelines. The offer of securities through this process must separately be disclosed
in the prospectus, under the caption placement portion category . Similarly, the extent of
shares offered to the public shall be separately shown under the caption net offer to the
public . According to the latest SEBI guidelines issued in October 1999, the earlier stipulation
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that at least 25 percent of the securities were to be issued to the public has been done away
with. This is aimed at enabling companies to offer the entire public issue through the book-
building route.
3. Circulating draft prospectus
A copy of the draft prospectus filed with SEBI is to be circulated by the book-runner
to the prospective institutional buyers who are eligible for firm allotment and also to the
intermediaries who are eligible to act as underwriters. The objective is to invite offers for
subscribing to the securities. The draft prospectus to be circulated must indicate the price
band within which the securities are being offered for subscription.
4. Maintaining offer records:
The book-runner maintains a record of the offers received. Details such as the name
and the number of securities ordered together with the price at which each institutional buyer
or underwriter is willing to sub scribe to securities under the placement portion must find
place in the record. SEBI has the right to inspect such records.
5. Intimation about aggregate orders:
The underwriters and the institutional investors shall give intimation on the aggregate
of the offers received to the book-runner.
6. Bid analysis:
The bid analysis is carried out by the book-runner immediately after the closure of
the bid offer date. An appropriate final price is arrived at after a careful evaluation of demands
at various prices and the quantity. The final price is generally fixed reasonably lower than the
possible offer price. This way, the success of the issue is ensured. The issuer company
announce the pay-indate at eh expiry of which shares are allotted.
7. Mandatory Underwriting:
Where it has been decided to make offer of shares to public under the category of
Net Offer to the Public; it is incumbent that the entire portion offered to the public is fully
underwritten. In case an issue is made through book-building route, it is mandatory that the
portion of the issue offered to the public be underwritten. This is the purpose, an agreement
has to be entered into with the underwriter by the issuer. The agreement shall specify the
number of securities as well as the price at which the underwriter would subscribe to the
securities. The book-runner may require the underwriter of the net offer to the public to pay
in advance all moneys required to be paid in respect of their underwriting commitment.
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8. Filling with ROC:
A copy of the prospectus as certified by the SEBI shall be filed with the Registrar of
Companies within two days of the receipt of the acknowledgement card from the SEBI.
9. Bank accounts:
The issuer company has to open two separate accounts for collection of application
money, one for the private placement portion and the other for the public subscription.
10. Collection of Completed Applications:
The book-runner collects from the institutional buyers and the underwriters the
application forms along with the application money to the extent of the securities proposed
to be allotted to them or subscribed by them. This is to be done one day before the opening
of the issue to the public.
11. Allotment of securities:
Allotment for the private placement portion may be made on the second day from the
closure of the issue. The issuer company, however, has the option to choose one date for
both the placement portion and the public portion. The said date shall be considered to be the
date of allotment for the issue of securities through the book-building process. The issuer
company is permitted to pay interest on the application moneys till the date of allotment or
the deemed date of allotment provided that payment of interest is uniformly given to all the
applicants.
12. Payment schedule and listing:
The book-runner may require the underwriters to the net offer to the public to pay in
advance all moneys required to be paid in respect of their underwriting commitment by the
eleventh day of the closure of the issue. In that case, the shares allotted as per the private
placement category will become eligible for being listed. Allotment of securities under the
public category is to be made as per the prevailing statutory requirements.
13. Under-subscription:
In the case of under-subscription in the net offer to the public‘ category, any spillover
to the extent of under-subscription is to be permitted from the placement portion category
subject to the condition that preference is given to the individual investors. In the case of
under subscription in the placement portion, spillover is to be permitted from the net offer
to the public to the placement portion.
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Advantages of Book Building
Book-building process is of immense use in the following ways: 1. Reduction in the
duration between allotment and listing 2. Reliable allotment procedure 3. Quick listing in
stock exchanges possible 4. No price manipulation as the price is determined on the basis of
the bids received.
18.10 STOCK OPTION OF EMPLOYEES STOCK OPTION PLAN (ESOP)

A method of marketing the securities of a company whereby its employees are
encouraged to take up shares and subscribe to it is known as stock option. It is a voluntary
scheme on the part of the company to encourage employees‘ participation in the company.
The scheme also offers an incentive to the employees to stay in the company. The scheme is
particularly useful in the case of companies whose business activity is dominantly based on
the talent of the employees, as in the case of software industry. The scheme helps retain their
most productive employees in an industry, which is known for its constant churning of
personnel.
SEBI Guidelines Company whose securities are listed on any stock exchange can
introduce the scheme of employees‘ stock option. The offer can be made subject to the
conditions specified below:
1. Issue at discount - Issue of stock option at a discount to the market price would be
regarded as another form of employee compensation and would be treated as such in the
financial statements of the company regardless the quantum of discount on the exercise
price of the options.
2. Approval - The issue of ESOPs is subject to the approval by the shareholders through a
special resolution.
3. Maximum limit - There would be no restriction on the maximum number of shares to
be issued to a single employee. However, in case of employees being offered more than
1 percent shares, a specific disclosure and approval would be necessary in the AGM.
4. Minimum period - A minimum period of one year between grant of options and its
vesting has been prescribed. After one year, the company would determine the period
during which the option can be exercised.
5. Superintendence - The operation of the ESOP Scheme would have to be under the
superintendence and direction of a Compensation Committee of the Board of Directors
in which there would be a majority of independent directors.
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6. Eligibility - ESOP scheme is open to all permanent employees and to the directors of
the company but not to promoters and large shareholders. The scheme would be applicable
to the employees of the subsidiary or a holding company with the express approval of
the shareholders.
7. Director’s report - The Director’s report shall make a disclosure of the following : a.
Total number of shares as approved by the shareholders b. The pricing formula adopted
c. Details as to options granted, options vested, options exercised and options forfeited,
extinguishments or modification of options, money realized by exercise of options,
total number of options in force, employee-wise details of options granted to senior
managerial personnel and to any other employee who receive a grant in any one year of
options amounting to 5 percent or more of options granted during that year d. Fully
diluted EPS computed in accordance with the IAS IPO
SEBI’s stipulations prohibiting initial public offerings by companies having outstanding
options should not apply to ESOP. If any ESOPs are outstanding at the time of an IPO issue
by an unlisted company, the promoters‘ contribution shall be calculated with reference to
the enlarged capital that would arise if all vested options were exercised.
18.11 BOUGHT OUT DEALS METHOD

A method of marketing of securities of a body corporate whereby the promoters of
an unlisted company make an outright sale of a chunk of equity shares to a single sponsor or
the lead sponsor is known as bought-out deals .
The following are the characteristics of Bought out deals
1. Parties: There are three parties involved in the bought-out deals. They are promoters
of the company, sponsors and co-sponsors who are generally merchant bankers and
investors.
2. Outright sale: Under this arrangement, there is an outright sale of a chunk of equity
shares to a single sponsor or the lead sponsor.
3. Syndicate: Sponsor forms syndicate with other merchant bankers for meeting the
resource requirements and for distributing the risk.
4. Sale price: The s ale price is finalized through negotiations between the issuing
company and the purchaser, the sale being influenced by such factors as project
evaluation, promoters image and reputation, current market sentiments, prospects of
off-loading these shares at a future date, etc.
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5. Fund-based: Bought-out deals are in the nature of fund-based activity where the funds
of the merchant bankers get locked in for at least the prescribed minimum period.
6. Listing: The investor-sponsors make a profit, when at a future date, the shares get
listed and higher prices prevail. Listing generally takes place at a time when the company
is performing well in terms of higher profits and larger cash generations from projects.
7. OTCEI: Sale of these shares at Over-the-Counter Exchange of India (OTCEI) or at a
recognized stock exchanges, the time of listing these securities and off loading them
simultaneously are being generally decided in advance.
18.12 NOTES
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18.13 SUMMARY
The process of marketing of securities by merchant bankers in primary market starts
with the preparation of prospectus. The success of public issue depends upon the excellent
marketing techniques worked out by the lead manager/merchant banker. It covers the
institutional and retail distribution capacity, equity research capability, retail distribution
network, advertising strategies and international distribution capability. A general standardized
methodology of marketing may not be ideal for all issues. It may be worked out on a case to
case basis depending on the nature of public issues in hand.
18.14 KEY WORDS

Private Placement
ROC
Book Building
Subscription
ESOP
OTCEI
Rights Issue
IPOs

1. Explain briefly the steps involved in marketing of new issues
2. Write a note on pure prospectus method of issuing new issues, highlighting the features,
advantages and disadvantages of this method
3. Write an explanatory note on book building process
4. What are ESOPs? Explain the conditions under which ESOPs can be issued
5. Bring out the difference between offer for sale method and brought out deal method
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18.16 REFERENCES
34
UNIT –19 : CREDIT CARDS
Structure :
19.0 Objectives
19.1 Introduction
19.2 Meaning
19.3 Types of Credit Cards
19.4 Credit Card Operation Cycle
19.5 Parties In Credit Cards
19.6 Global Player in Credit Card Market
19.7 Emerging Trends in Payment System
19.8 Summary
19.9 Notes
19.10 Key Words
19.12 References
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19.0 OBJECTIVES
After studying this unit, you should be able to ;
• To explain the concept of credit cards
• To identify the types, parties involved and global players of credit cards
• To study the operating cycle of credit cards
• To understand the emerging trends in the payment system
19.1 INTRODUCTION
The credit card business got momentum in the sixties and a number of banks entered
the field in a big way. Credit card culture is an old hat in western countries. In India, it is
relatively a new concept that is fast catching on. The present trend indicates that the coming
years will witness a burgeoning growth of credit cards which will lead to a cashless society.
Credit has become an important vehicle of trade promotion. Credit cards provide convenience
and safety to the buying process. One of the important reasons for the popularity of credit
cards is the sea change witnessed in consumer behaviour. Credit cards enable an individual to
purchase products or services without paying immediately. The buyer only needs to present
the credit cards at the cash counter and sign the bill. Credit card can, therefore, be considered
as a good substitute for cash or cheques.
19.2 MEANING
A Credit card is a card/mechanism that enables cardholders to purchase, travel and
dine without making immediate payments. The holders can use the cards to get credit from
banks up to 50 days free of cost. The credit card relieves the consumers from immediate
payment of cash and ensures safety. It is a convenience of extended credit without formality.
Thus credit card is a passport to, “safety, convenience, prestige and credit.” A credit card is
a plastic card having a magnetic strip, issued by a bank or business authorizing the holder to
buy goods or services on credit. Any card, plate or coupon book that may be used repeatedly
to borrow money or buy goods and services on credit is called credit card.
A credit card is a card establishing the privilege of the person to whom it is issued to
charge bills. Most retail firms accept credit cards. Credit cards allow consumers to make
purchases without paying cash immediately or establishing credit with individual stores. They
eliminate the need to check credit ratings and to collect cash from individual customers. The
issuing institution establishes the card’s terms, including the interest rate, annual fees,
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penalties, the grace period, and other features. Credit card debt is typically an unsecured
debt. Repossession is not easily accomplished by the lender to ensure payment. Banks have
often priced the product assuming maximum risk exposure.
19.3 TYPES OF CREDIT CARD

Catering to different types of consumer needs, credit card companies issue several
types of credit cards. Each type has its own benefits. They can be classified as follows:-
Based on Franchise / Tie-up
1. Proprietary Card: Cards that are issued by the banks themselves without any tie-up, are
called proprietary cards. A bank issues such cards under its own brand. Examples include
SBI Card, CanCard of Canara Bank, Citicard.
2. Master Card: This is a type of credit card issued under the umbrella of MasterCard
International. The issuing bank has to obtain a franchise from the MasterCard Corporation
of the USA. The franchised cards will be honoured in the MasterCard network.
3. VISA Card: This type of credit card can be issued by any bank having tie-up with VISA
International Corporation, USA. The banks that issue such cards are said to have a franchise
of VISA International. The advantage of a VISA franchise is that one can avail the facility
of the VISA network for transactions.
4. Domestic tie-up Card: These cards are issued by a bank having a tie-up with domestic
card brands such as CanCard and Indcard are called ‘Domestic cards’
Based on geographical validity
1. Domestic Card: Cards that are valid only in India and Nepal are called ‘domestic cards’.
They are issued by most of the banks in India all transactions will be in rupees.
2. International and Global Card: Credit cards with international validity are called
‘international cards’. They are issued to people who travel abroad frequently. They are
honoured in every part of the world except India and Nepal. The cardholder can make
purchases in foreign currencies subject to RBI sanction and FERA rules and regulations.
Based on the issuer category.
1. Individual Card: These are the non-corporate credit cards that are issued to individuals.
Generally, all brands of credit cards are issued to individuals.
2. Corporate Card: They are credit cards issued to corporate and business firms. The
executives and top officials of the firms use them. They bear the names of the firms, and
the bills are paid by the firms.
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Based on mode of credit recovery
1. Revolving Card: This type of credit card is based on the revolving credit principle. A
credit limit is fixed on the amount of money one can spend on the card for a particular
period. The cardholder has to pay a minimum percentage of the outstanding credit which
may vary from 5 to 10 percent at the end of a particular period. Interest varying from 30
to 36 percent per annum is charged on the outstanding amount.
2. Charge Card: A charge card is not a credit instrument, it is a convenient mode of making
payment. This facility gives a consolidated for a specific periods and bills are payable in
full on presentation. There is neither interest liability nor no per-set spending limits.
Based on status of Card
1. Standard Card: Credit cards that are regularly issued by all card-issuing banks are called
‘standard cards’. With these cards, it is possible for a cardholder to make purchases
without having to pay cash immediately. They however, offer only limited privileges to
cardholders. Some banks issue standard cards under the Brand name “Classic” cards,
which are generally issued to salaried people.
2. Business Card: Business cards also known as ‘Executive cards’, are issued to small
partnership firms, solicitors, firms of chartered accountants, tax consultants and others,
for use by executives on their business trips. They enjoy higher credit limits and more
privileges than the standard cards.
3. Gold Card: The gold card offers high value credit for elite. It offers many additional
benefits and facilities such as higher credit limits, more cash advance limits that are not
available with the standard or the executive cards.
Other types of credit card
1. Special purpose Card: The eighties saw the development of special purpose cards. A host
of special purpose cards were issued by departmental stores, airlines, oil companies.
For instance, the International Bank of Asia in Hong Kong launched the first ‘women
only’ card, ‘My card’ in the year 1988. A highly encouraging membership and increasing
potential of such special purpose cards are called “Lady’s card” in Malaysia. In 1990, the
Green card was launched in the U.K and Europe to promote contributions towards the
protection of the environment. HDFC issued ‘My City’ credit cards used in particular
city with special discount offer for oil and petrol and also an offer for cash back. AXIS
Bank also offers special purpose credit cards like Gift card, Travel currency card and
Remittance card.
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2. Add-on card: An add-on card is more of an additional Credit card that the customer can
apply in the name of their family members (father, mother, sister, brother, spouse,
children), within the overall credit limit. Family members applying for Add-on cards
have to be 18 years and above. All the payments for the services made from Add-on
card(s) is done by the original cardholders. Most banks allow for at least two Add-on
cards.
3. Photo card: If a card comes with the imprinted photo, then it is a Photo card. This type of
card is considered safer as it is easier to identify the credit card user. It also serves as
more identity card.
4. Power card: It is a comprehensive credit card product that enables banks and financial
industry to enter into issuing and acquiring business of Credit Cards. The basic advantage
of this efficient tool is to improve productivity and control the risks involved in day-to-
day activities of any financial institutions in credit cards. The product is 24 × 7, multi
language, multi currency, multi-bank and multi country.
5. Regular credit card: This is the most basic type of credit card. It has a low credit limit and
the most basic status among various credit cards. Credit card companies can club various
other reward programs like travel rewards, cash back offers to enhance its value and
appeal to customers.
6. Silver credit card: Silver credit cards have higher eligibility criteria than regular credit
cards. They bring more benefits to the customers, and have higher credit limits than
regular credit cards.
7. Gold credit card: Gold credit cards have a higher status and credit limits than silver credit
cards. Needless to say these types of credit cards have higher income requirements as
their eligibility criteria. In addition to the regular benefits, banks extend special privileges
to their gold credit card holders.
8. Platinum or Titanium credit card: These types of credit cards bring more benefits to
credit card holders than regular, silver or gold card. These credit cards generally have
platinum or titanium hue and are issued to a select class of clients who have excellent
financial background and good income levels. Platinum credit cards have personal
concierge services, in addition to exclusive platinum benefits.
9. Signature credit card: A league of its own, the Signature Credit Cards usually have no pre-
set spending limits, personal concierge service, signature travel, and lounge and
membership benefits. Offered to a very elite group these credit cards, requires an excellent
financial status. On June 9, 2007 ICICI bank introduced the Visa Signature Card and
39
became the first credit card issuer in India to launch a premium credit card. This has a
joining fee of Rs.25,000/- and an annual fee of Rs.2,500/-. The exclusivity of this signature
card is exemplified by the statement.
10. Credit cards by invitation only: The earliest of the elite, no one can apply for these card.
For example, the American Express Black Credit Card, popularly called the Centurion
Card, is issued by invitation to the most exclusive and elite, to those who spend a certain
minimum amount (which can run into crores of rupees). These cards have huge annual
fees and minimum spending levels. In fact, these credit cards are so exclusive, that they
have an aura of mystery surrounding them and are considered status symbols.
11. Reward card: There are cards which offer rewards for specific kinds of purchases. For
example, the Airline Reward Card offer rewards on air travel, Cash back card offer cash
rewards on every card purchases, Fuel Reward Card offer rebates on petroleum and other
fuel purchases from specified outlets and preferred partners. Similarly, Hotel Reward
Card give rebates on hotel stay and related expenses and Health Rewards Card give benefits
on medical expenses, health treatments and related activities. The rewards offered by
credit card companies in alliance with various brands and stores, make them more attractive
for the credit card holders.
12. Student credit card: As the name implies, these credit cards are especially designed for
students and help them start their credit card journey. These bring lots of rewards
especially suited for students, which help them save time, money and enjoy their student
life. They are a first step towards building credit history. A good credit history goes a
long way in creating a relationship with banks helping to secure much needed loans and
credit in the future.
13. Special feature credit card: Credit cards can also be grouped on the basis of their features.
For example, based on their introductory interest rates, credit cards can be low
introductory interest credit cards, or 0 (zero) Interest credit cards. The Zero introductory
interest credit cards provide interest free credit (0%) for a specified time period, which
is called the introductory period. Similar is the case with credit cards that come without
any annual fee what so ever and are called ‘no annual fee’ credit cards.
14. Balance transfer credit card: Credit card companies provide lucrative offers with 0 per
cent introductory interest or low introductory interest charges on balance transfers. This
allows credit card holders to transfer the outstanding balances on their existing credit
cards to a credit card with low or zero interest on balance transfers. This brings them a
40
lot of savings in the interest rates. The balance transfer credit cards may charge a balance
transfer fees for every such operation.
15. Kisan Credit Card (KCC): The Kisan Credit Card Scheme aims at providing need based
and timely credit support to the farmers for their cultivation needs as well as non-farm
activities and cost effective manner to bring about flexibility and operational freedom in
credit utilization. The Kisan Card is for a period of 3 years subject to an annual review. It
was launched in 1998-99 by the Government of India in consultation with the Reserve
Bank of India and National Bank for Agricultural and Rural Development is a huge hit
with the farmers in India. According to the RBI, presently there are about 66.56 million
Kisan Credit Cards in use across India, which have been issued by various banks.
16. Secured credit card: Secured credit card is a type of credit card secured by a deposit
account owned by the cardholder. This deposit is held in a special savings account. The
cardholder of a secured credit card is still expected to make regular payments, as with a
regular card, but should they default on a payment, the card issuer has the option of
recovering the cost of the purchases paid to the merchants out of the deposit. The advantage
of the secured card for an individual with negative or no credit history is that most
companies report regularly to the major credit bureaus. This allows for building of positive
credit history.
19.4 CREDIT CARD OPERATION CYCLE

The credit card operation comprises the following steps as follows:
i. Credit purchases: A Cardholder purchases goods/services and gives the credit card.
ii. Processing of credit card: A Merchant establishment delivers goods after taking an
authenticated credit card and noting the number and taking signatures on certain
forms.
iii. Raising of bill: The Merchant establishment raises the bill for the purchase and sends
it to the credit card issuing bank for payment.
iv. Marking payment: The issuing bank pays the amount to the merchant establishment.
v. Bill to cardholder: The issuing bank raises bill on the credit cardholder and sends it for
payment.
vi. Card Payment: The credit cardholder makes the payment to the issuing bank.
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19.5 PARTIES IN CREDIT CARDS
The following important parties involved in the operation of credit cards are:
Credit cardholders: The person named on the card. This may be customer of a bank
to whom the card has been issued or any such person to whom the bank has issued a card
authorized by the customer of the bank to hold and use the card. This individual is also
responsible for payment of all charges made to that card. The holder of the credit card who
uses to make a purchase is called the consumer.
Card-issuing bank: The financial institution or other organization that issued the
credit card and also responsible for billing the cardholders for charges. The bank bills the
consumer for repayment and bears the risk that the card is used fraudulently. The issuing
bank extends a line of credit to the consumer. Liability for non-payment is then shared by the
issuing bank and acquiring bank.
Merchant Establishments: The individual or business accepting credit cards for
sold products or services to the cardholders.
Acquiring bank: The financial institution accepts payment for the products or
services on behalf of the merchant establishments.
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Independent sales organization: Resellers (to merchants) of the services of the
acquiring bank. i.e outside services providers for marketing of cards .
Merchant account: This could refer to the acquiring bank or the independent sales
organization, but in general is the organization that the merchant deals with.
Credit card association: An association of card-issuing banks such as Visa,
MasterCard, Discover, American Express that set transaction terms for merchants, card-
issuing banks, and acquiring banks.
Transaction network: The system that implements the mechanics of the electronic
transactions. May be operated by an independent company, and one company may operate
multiple networks. Transaction processing networks include Cardnet, Nabanco, Omaha,
Paymentech, NDC Atlanta, Nova, Vital, Concord EFSnet, and Visa Net.
Affinity partner: Some institutions lend their names to an issuer to attract customers
that have a strong relationship with that institution, and get paid a fee or a percentage of the
balance for each card issued using their name. Examples of typical affinity partners are sports
teams, universities, charities, professional organizations, and major retailers.
19.6 GLOBAL PLAYER IN CREDIT CARD MARKET

1. MasterCard: MasterCard is a product of MasterCard International and along with VISA is
distributed by financial institutions around the world. Cardholders borrow money against
a line of credit and pay it back with interest if the balance is carried over from month to
month. Its products are issued by 25,000 financial institutions in 220 countries and
territories. In 1998, it had almost 700 million cards in circulation, whose users spent
$650 billion in more than 16.2 million locations. The company, which had been organized
as a cooperative of banks, had an initial public offering on May 25, 2006 at $39.00 USD.
The stock is traded on the NYSE under the symbol MA.
2. VISA card: A VISA card is a product of VISA USA and along with Master Card is distributed
by financial institutions around the world. Visa Inc. commonly referred to as VISA, is a
multinational corporation based in San Francisco, California, USA. The company operates
the world’s largest retail electronic payment network, managing payments among financial
institutions, merchants, consumers, businesses and government entities. Before Visa
Inc’s IPO in early 2008, it was operated as a cooperative of some 21,000 financial
institutions that issued and marketed Visa products including credit and debit cards. A
VISA cardholder borrows money against a credit line and repays the money with interest
if the balance is carried over from month to month in a revolving line of credit. Nearly
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600 million cards carry one of the VISA brands and more than 14 million locations
accept them. In 2006, according to The Nilson Report, Visa held 44 per cent of the
credit card market share and 48 per cent of the debit card market share in the United
States. Visa Inc. is the world’s largest payments company, with more than US$ 4.0 trillion
of total volume as of March 31, 2008.
3. American Express: The world’s favourite card is American Express Credit Card. More
than 57 million cards are in circulation and growing and it is still growing further. Around
US $ 123 billion was spent last year through American Express Cards and it is poised to
be the world’s no.1 card in the near future. In a regressive US economy last year, the
total amount spent on American Express cards rose by 4 percent. They are very popular
in the U.S., Canada, Europe and Asia and are used widely in the retail and everyday
expenses segment.
4. Diners Club International: Diners Club International, originally founded as Diners Club,
is a charge card company formed in 1950 by Frank X. McNamara, Ralph Schneider and
Casey R. Taylor. When it first emerged, it became the first independent credit card
company in the world. Diners Club is the world’s no.1
5. Charge Card. Diners Club cardholders reside all over the world and the Diners Card is a
all time favourite for corporate. There are more than 8 million Diners Club cardholders
around the world. They are affluent and are frequent travelers in premier businesses and
institutions, including Fortune 500 companies and leading global corporations. In April
2008, Discover Card and Citibank announced that Discover would purchase the Diners
Club Network from Citi for $165 million. Discover Bank has no plans on issuing Diners
Club branded cards. Discover purchased the network, but not the licensees issuing the
cards. The deal was completed on July 1, 2008.141
6. Discover Card: The Discover Card was originally introduced by Sears in 1985, and was
a unit of Dean Witter, which merged with Morgan Stanley in 1997. In 2007, the unit was
spunoff as an independent, publicly traded company. To-day, Discover is headquartered
in the Chicago suburb of Riverwoods, IIinois. Discover Financial Services is an American
financial services company, which issues the Discover Card and operates the Discover
and Pulse networks. Discover Card is the third largest credit card brand in the United
States, when measured by cards in force, with nearly 50 million cardholder.142
7. JCB Card (Japan Credit Bureau): Japan Credit Bureau, usually abbreviated as JCB, is a
credit card company based in Tokyo, Japan. Founded in 1961, it established dominance
over the Japanese credit card market when it purchased Osaka Credit Bureau in 1968
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and its cards are now issued in 20 different countries. Fifty-nine million JCB card
members worldwide use their cards to purchase over US$62.7 billion of goods and
services annually in 190 countries worldwide. JCB also operates a network of membership
lounges targeting Japanese, Chinese, and Korean travelers in Europe, Asia, and North
America. The JCB philosophy of “identify the customer’s needs and please the customer
with service from the Heart” is paying rich dividends as their customers spend US$ 43
billion annually on their JCB cards.
19.7 EMERGING TRENDS IN PAYMENT SYSTEM

In addition, credit cards which have evolved into a variety of innovative cards over the
years are also issued by banks.
1. ATM Card: ATM cards allow customers to access their accounts at any time-24 hours a
day, every day of the year, through Automated Teller Machines. Customers can withdraw
cash, transfer funds, find out their account balance and perform other banking and financial
transactions with the help of ATMs.
2. Debit Card: A debit card, like an ATM card, directly accesses a customer’s account. It is
a hybrid of ATM and credit card. The card directly debits a designated savings bank account.
Whereas in the case of credit cards, a grace credit period of 20 to 50 days for making the
payment is available, no such credit period is allowed under debit cards. These cards can
be used either at merchant locations who have this facility to buy goods and services or
at ATMs. Presently, ATM-Cum Debit cards issued by Indian banks are in use.
3. Prepaid Card: Prepaid cards are also known as ‘Stored Value Cards’. These cards are
with stored value paid in advance by the holder. The card issuer and the service provider
are identical. They are also called Limited Purpose Prepaid Cards which can be used for
a limited number of well –defined purposes. Its use is often restricted to a number of
identified points of sales within a specified location
4. Private Label Card: These cards are uniquely tied to the retailer issuing the card and can
be used only in that retailer’s stores. A bank, on the basis of a contractual agreement with
the retailer extends credit under this type of card.
5. Affinity Group Card: These are credit cards designed for a collection of individuals with
some form of common interest or relationship, such as professional, alumni, retired
persons’ organizations, sports teams, schools, or service organizations. This credit card
carries the logo of the affiliated organization on the card design and brings special benefits
and discounts on products from that company. In case the affiliated company is a charity
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or non-profit organization, a part of the credit card expenses go into the affiliate
organization’s account. For example: The Help Age India Credit Card issued by ICICI
bank
6. Smart Card: A smart card is a credit card sized plastic card with an embedded computer
chip. The chip allows the card to carry a much greater amount of information than a
magnetic strip card. The telecom industry, was perhaps the pioneer in smart cards, the
most prominent being Subscriber Identity Module (SIM) cards in the GMS digital cellular
network. Using special terminals designated to interact with the embedded chip, the card
can perform special functions. This is essentially a prepaid card.
7. Chip Card: A chip card is a plastic card with an embedded integrated circuit or as
microchip as opposed to magnetic strips on a conventional card. The chip can be used on
existing debit and credit cards as well as on emerging products like stored value cards.
Inserting the card in a pin-pad effects the transaction, and the value on it reduces
accordingly. It is re-loadable and disposable. The idea is to do away with the trouble of
carrying cash. The chip card also scores over the magnetic card, in that it can retain 50 to
60 of the latest transactions, which can be produced on demand. It is also considered
more durable and secure since the cardholder alone can access it through a Personal
Identification Number (PIN).
8. Co-branded card: The Times Card, a co-branded credit card, is the first of its kind, from
a publishing house in the Asian subcontinent. This is a cobranded credit card of Times of
India Group and Citibank MasterCard. The co-branding concept caught the credit card
industry the world over during the last five years
19.8 SUMMARY
The market for credit cards is growing very fast. Cards are now tailor made to cater to
diverse segments of the society be it professionals, business men, entrepreneurs, households
etc. Credit cards can be used for multiple purposes such as emergency cash withdrawal, fuel
facility, medical advance facility, hotel and online discount facility etc.
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19.9 NOTES
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19.10 KEY WORDS
Plastic Money
Franchiser
ATM
VISA
Merchant Establishments

1. What is a credit card? Highlight its features
2. Explain the cycle of credit card
3. Classify the cards based on its utility
4. Explain various benefits that are available to credit card holders
5. Name a few global players in the credit card markets
19.12 REFERENCES
49
UNIT - 20: MERCHANT BANKING IN INDIA
Structure :
20.0 Objectives
20.1 Introduction
20.2 Merchant Banking in India
20.3 Merchant Banking in Post Independence Period
20.4 Merchant Banking under SEBI Regulations
20.5 SEBI (Merchant Bankers) Regulations, 1992
20.6 SEBI (Merchant Bankers) (Amendment) Regulations, 1997
20.7 Notes
20.8 Summary
20.9 Key Words
20.11 References
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20.0 OBJECTIVES
After study this unit, you should be able to;
• To understand the growth of merchant banking in India
• To familiarize with SEBI regulations on merchant banking
20.1 INTRODUCTION
SEBI, in exercise of the powers conferred under section 30 of the SEBI Act, 1992
has made the different regulations for almost all aspects of capital market. For regulating the
activities of merchant bankers, the Board has enacted SEBI (Merchant Bankers) Regulations,
1992. The objectives of the merchant banking regulations are to regulate the raising of funds
in the primary market would assure for the issuer a market for raising resources at low cost,
effectively and easily, ensure a high degree of protection of the interest of the investors and
provide for the merchant bankers dynamic and competitive market with high standard of
professional competence, honesty, integrity and solvency. The regulations would promote a
primary market which is fair, efficient, flexible and inspire confidence.
20.2 MERCHANT BANKING IN INDIA

Agency houses were the traditional name given to the merchant trading in India and
Far East. During 1813, trade and commerce developed in India through the ‘agency houses’
based in London. John Palmer & Co. was the leading agency house during this period and it
operated the banking activities from Calcutta. These agency houses had employed their
growing capital in trade and commerce. Thomas Skinner’s annual directories ‘London Banks’
(1880) traces the origin and growth of merchant banking activities in India and Far East. An
Anglo-American merchant bank (Baring Brothers) moved into the financing of India and Far
Eastern trade during 1830. When the First World War broke out, there were as many as
twenty one financial firms with considerable commitment in Central Europe and at least
eighteen firms with major interest in India and Far East.
Crooper Benson & Co, the premier cotton importer of Europe was operating in India
during 1820s and conducted major trade for about three generations through Calcutta. They
were followed by Ogilvy Gillanden & Co. in 1824 and Hong-Kong & Shanghai Bank in 1864.
The foreign merchant bankers operated in India through an agency house which was known as
‘East India House’. It was representing a group that produced several merchant bankers during
the 19th century; two of them, that is, Gladstone and the Arbuthnot remained in East India
trade. But the merchant bankers had to face stiff competition from Persian Finance House
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and ultimately failed. In the late 1860s, East India merchants had enough capital to invest in
trade and they floated joint stock banks with their own investments. Despite the opposition
from East India Company, some new banks were founded which included: Orient Bank in
1845, Chartered Bank of India and Chartered bank of Asia in 1853, Chartered Mercantile
Bank of India, London; and Agra & United Provinces Bank in 1857. These banks were operating
not only in the area of banking, but were also financing trade transactions. London based
merchant bankers had full control over the management of these banks through their Managing
Agents. The managing agency system devised by these merchant bankers gave major fillip to
trading and banking activities of foreign merchants in India. The managing agency system
enabled a single firm to look after a number of firms in complimentary industries. As a
result, the banking industry developed in India on the full support of London based merchant
bankers.
20.3 MERCHANT BANKING IN POST INDEPENDENCE PERIOD

India inherited an underdeveloped capital market from the British rulers. Managing
agency system was more driven by their personal gains rather than being helpful in the
development of capital market in the economy. After independence, Government of India
adopted the model of planned economic development for the country and a need was felt to
have a strong industrial base in the economy. Growth of Indian capital market was considered
as one of the key areas for accelerating the pace of economic development by mobilising
savings from household and business sector into the channel of investment for trade and
industry. Drastic amendments were made in the legislative framework relating to growth of
corporate sector, viz, Companies Act, Capital Issues (Control) Act, Banking Companies Act
etc. The managing agency system was sought to be abolished. Post independence period up
to the year 1969 saw the emergence of All India financial institutions like IFCI, ICICI, IDBI,
LIC, UTI and commercial banks playing, in one way or other, the role of merchant banking in
the Indian financial system. They had a significant role in underwriting the capital issues
besides lending support to 7 broking houses for placing the issue through prospectus before
the public for subscription. But the growth of the capital market remained limited during this
period. So the need for broad based merchant banking services was felt to meet the growing
need for capital. The formal merchant banking service in Indian capital market was initiated
in 1967, when Reserve Bank of India (RBI) granted licence to ‘The National Grindlays Bank’
to perform the services relating to issue management. The Bank started merchant banking
services by opening merchant banking Division within the bank in 1969. The First National
City Bank followed the Grindlays Bank by opening a ‘Management Consultant Division in
1970. Both these banks acted as ‘managers to the issues’. In 1971, Stock Exchange Division
52
under the Ministry of Finance examined the merchant banking role of these foreign banks
vis-à-vis the old existing organization of stock brokers. It came to the conclusion that the
services rendered by these foreign merchant bankers were not different from those what the
Indian investment broking firms have been extending to new issues. These banks did not
handle any issue promoted by new entrepreneurs or any small issues during this period. Also,
they could not provide any new skill and expertise in the area of merchant banking activities.
With a view to end monopoly of these foreign banks in merchant banking activities, the Govt.
traced out the possibility of commercial banks to undertake the management and underwriting
of public issues. Banking Commission 1972, in its report considered the need for specialized
financial institutions and banks which could provide facilities like backing the issue,
underwriting and distribution of capital issues. The Commission suggested not only the
commercial banks, but also other institutions may also be allowed to set up merchant banking
institutions subject to proper safeguards to ensure integrity to the operations. On the
recommendations of Banking Commission, State Bank of India (SBI) became the first Indian
bank to start with the merchant banking activities in 1972-73 by opening ‘Merchant Banking
Division’ at its head office in Bombay and sub offices as ‘ management banking bureau’ at the
other major cities. The other commercial banks that followed the SBI were Central Bank of
India, Bank of India and Syndicate Bank who started merchant banking services in 1977;
Bank of Baroda, Chartered Bank and Mercantile Bank in 1978; Union Bank of India, UCO
Bank, Punjab 8 National Bank, Canara Bank and Indian Overseas Bank undertook merchant
banking activities in late 1970s and the early 1980s. Among the development banks, ICICI
started merchant banking activities in 1973, followed by IFCI (1986) and IDBI (1991).
Merchant banking divisions of commercial banks have been active in a narrow range of
traditional merchant banking services, which mainly included issue management, underwriting
and syndication of loans and provision of advisory services to corporate clients on fund
raising and other financial aspects. Corresponding to the growth of capital market, the
development of merchant bank scenario has been significant. Following the notification under
section 6(1) (o) of the Banking Regulation Act, 1949, commercial banks were permitted
during 1984 to set up subsidiaries for undertaking equipment leasing or investments in shares
within the limits specified in section 19(2) of the above Act. The notification provided the
real impetus to commercial banks and consequently a number of subsidiaries were established
by them to undertake merchant banking activities. On August 1, 1986, State Bank of India
established a wholly owned subsidiary namely, SBI Capital Market Ltd. to handle the merchant
banking activities of the bank hitherto handled by its merchant banking division. The lead
taken by SBI in launching a subsidiary exclusively for performing the merchant banking
services has attracted the attention of other leading commercial banks in India. At the end of
53
June 1992, there were nine merchant banking subsidiaries set up by commercial banks with
prior approval of RBI.
20.4 MERCHANT BANKING UNDER SEBI REGULATIONS

SEBI, in exercise of the powers conferred under section 30 of the SEBI Act, 1992
has made the different regulations for almost all aspects of capital market. For regulating the
activities of merchant bankers, the Board has enacted SEBI (Merchant Bankers) Regulations,
1992. The objectives of the merchant banking regulations has been stated by H.R.Machiraju
as follows:
“The merchant bankers regulations which seek to regulate the raising of funds in the
primary market would assure for the issuer a market for raising resources at low cost,
effectively and easily, ensure a high degree of protection of the interest of the investors and
provide for the merchant bankers dynamic and competitive market with high standard of
professional competence, honesty, integrity and solvency. The 9 regulations would promote
a primary market which is fair, efficient, flexible and inspire confidence.”
Recognition by SEBI on merchant bankers
SEBI will grant recognition a merchant banker after taking into account the following
aspects.
1. Professional competence of merchant bankers.
2. Their capital adequacy.
3. Track record, experience and general reputation of merchant bankers.
4. Adequacy and quality of personal employed by them and also the available infrastructure.
After considering the above aspects, SEBI will grant permission for the merchant banker
to start functioning.
Conditions laid down by SEBI for merchant bankers
SEBI the following conditions on the merchant bankers, for conducting their
operations. They are:
a. SEBI will give authorization for a merchant banker to operate for 3 years only. Without
SEBI’s authorization, merchant bankers cannot operate.
b. The minimum net worth of merchant banker should be Rs. 1 crore.
c. Merchant banker has to pay authorization fee, annual fee and renewal fee.
54
d. All issue of shares must be managed by one authorized merchant banker. It should be the
lead manager.
e. The responsibility of the lead manager will be clearly indicated by SEBI.
f. Lead managers are responsible for allotment of securities, refunds, etc.,
g. Merchant banker will submit to SEBI all returns and send reposrts regarding the issue of
shares.
h. A code of conduct for merchant bankers will be given by SEBI which has to be followed
by them.
i. Any violation by the merchant banker will lead to the revocation of authorization by
SEBI.
Conditions by SEBI pertaining to pre issue obligations:
Recent regulations by SEBI on Merchant bankers with regard to pre issue obligations
involve the following;
• Registration
• Capital structure decision
• Public issue
• Rights issue
• Prospectus
Registration:
All merchant bankers must compulsorily register themselves with SEBI. SEBI will
grant certificate of registration to merchant bankers under following conditions;
1. Merchant bankers should be a body corporate and should not be a NBFC.
2. They must have necessary infrastructure for maintaining an office.
3. They must have employed a minimum of two persons with experience in merchant banking
business.
4. They should not be connected with any company directly or indirectly.
5. They should not have involved in any litigation connected with Stock Exchanges.
6. They must have a professional qualification in finance, law or business management.
7. Their registration must be in public interest.
55
Capital structure decision:
According to SEBI, they must have a minimum net worth (paid up capital + Free
reserves) of Rs. 5 crores. But this will vary according to the category Rs. 5 crores for first
category and none for the fourth category.
Registration fee to be paid to SEBI:
1. For category, 1 Rs. 2.5 crores per annum for the first 2 years and Rs. 1 lakh for the third
year have to paid to SEBI towards registration fee.
2. For category 2. Rs.1.5 lajhs for the first 2 years per annum and Rs. 50,000 for the third
year.
3. For category 3 Rs. 1 lakh per annum for the first 2 years and Rs. 25,000 for the third
year.
4. From 1999 onwards, Rs.2.5 lakhs for every year, failing which the registration will be
suspended for all categories.
Role of Merchant banker in public issue:
While acting as a banker to an issue, a merchant banker has to disclose full detail to
SEBI. The details should contain the following.
1. Furnishing information:
a. Number of issues for which the merchant banker is engaged axis banker to issue.
b. Number of applications received and details of application money received.
c. Dates on which applications from investors were forwarded to issuing company.
d. Details of amount as refund to investors.
2. Books to be maintained:
a. Books of accounts for a minimum period of 3 years.
b. Records regarding the company.
c. Documents such as company applications, names of investors, etc.,
3. Agreement with issuing company:
a. Number of collection centers.
b. Application money received.
c. Daily statement by each branch which is a collecting centre.
56
4. Action by RBI:
Any action by RBI on Merchant banker should be informed to SEBI by the Merchant
banker concerned.
5. Code of Conduct:
a. Having high integration in dealing with clients.
b. Disclosure of all details to the authorities concerned. Avoid making exaggerated
statements.
c. Disclosing all the facts to its customers.
d. Not disclosing any confidential matter of the clients to third parties.
Responsibilities of Merchant Banker in Right Issue:
1. The merchant banker will ensure that when Rights issues are taken by a company, the
merchant banker who is responsible for the right issue shall see that an advertisement
regarding the same is published in an English national daily, in an Hindi national daily and
in a regional daily. These newspapers should be in circulation in the city/town where the
registered office of the company is located.
2. It is the duty of the merchant banker to ensure that the application forms for Rights issue
should be made available to the shareholders and if they are not available, a duplicate
composite application form is made available to them within a reasonable time.
3. If the shareholders are not able to obtain neither the original not the duplicate application
for Rights shares, they can apply on a plain paper through the merchant banker.
4. The details that should be furnished in the plain paper , while applying for rights shares
shoul be provided by the merchant banker.
5. The merchant banker should mention in the advertisement, the company official to whom
the shareholders should apply for Rights shares.
6. The merchant banker should also inform that no individual can apply twice, in standard
form as well as in plain paper.
Role of Merchant banker in the issue of prospectus:
It is the duty of the lead merchant banker to ensure that the prospectus are properly
made and should not contain any false information. The merchant banker will also ensure
that
57
a. The application form issued will be accompanies by abridged prospectus by the issuer
company.
b. In the abridged prospectus, application form may be inked as a perforated part.
c. Unconnected matters should not be furnished in the prospectus.
Disclosure to SEBI:
Action can be taken against a merchant banker when he is found guilty of non
compliance of regulations. The defaults committed by the merchant banker can be categorized
into
a. General
b. Minor
c. Major
d. Serious defaults.
General default: The general default may be the failure to submit the diligence
certificate in the prescribed manner to SEBI or failure to despath refund orders, etc.,
Minor default: May consist of advertisements not being n conformity with
prospectus, delay in allotment of securities, etc.,
Major default: When underwriting is not properly taken up or when there are excess
metabers of merchant bankers for an issue that the permissible limit.
Serious default: Unethical practice or non cooperation with SEBI.
Furnishing details on capital structure of the company: - A merchant banker
should provide details of the capital structure of the company in the following manner.
1. Authorized, Issued, Subscribed and paid up capital.
2. Size of the present issue including contribution by promoters.
3. Paid up capital after the issue
4. Share premium account.
58
The merchant banker should also provide details regarding lock-in-period nature of
allotments rights, bonus and face value of securities and issue price of securities etc.
20.5 SEBI (MERCHANT BANKERS) REGULATIONS, 1992

SEBI (Merchant Bankers) Regulations, 1992 have provided five chapters. Chapter
first states the definitions relating to the subject, chapter II contains the provisions for
compulsory registration of merchant bankers with SEBI, capital adequacy requirements,
renewal of certificate and fee payable to SEBI. Chapter III deals with the general obligations
and responsibilities of merchant bankers including code of conduct to be observed while
performing merchant banking activities. In chapter IV, procedure for inspection of books of
accounts, records and documents of the merchant bankers by SEBI has been specified. Chapter
V states the procedure for action against merchant bankers in case of default: suspension or
cancellation of registration of merchant bankers by SEBI. Important provisions of the above
regulations have been explained below:-
(i) Classification of Merchant Bankers
The SEBI has classified merchant bankers under four categories for the purpose of
registration. Category-I can act as issue manager, advisor, consultant, underwriter and portfolio
manager. Category-II can act as advisor, consultant, underwriter and portfolio manager.
Category-III can act as underwriter, advisor and consultant only.
Category-IV can act as consultant or advisor to the issue of capital.
Thus, only Category-I merchant bankers could act as lead managers to an issue.
However, with effect from December 9, 1997, different categories of merchant bankers
were abolished and only Category-I merchant bankers are registered by the SEBI.
(ii) Capital Adequacy Norms
For registration of merchant bankers of various categories, SEBI has prescribed capital
adequacy norms. Minimum ‘net worth’ of category I was fixed at Rs. 1.00 crore which was
further raised to Rs. 5.00 crore by an amendment in the regulations in 1995. For category II,
the minimum net worth was fixed as Rs. 50.00 lakhs, while for category III, this amount was
Rs. 20.00 lakhs. Category IV was not required to have any capital or net worth. 10
(iii) Restriction on Appointment of Lead Managers
The regulations state that the number of lead merchant bankers (issue manager to the
issue) may not exceed in the case of any issue of :
59
Size of the issue No. of lead managers
(a) Less than Rs. 50 crore Two
(b) Rs. 50 crore but less than Rs. 100 crore Three
(c) Rs. Rs. 100 crore but less than Rs. 200 crore Four
(d) Rs. 200 crore but less than Rs. 400 crore Five
(e) Above Rs. 400 crore five or more as may be agreed by the board.
This restriction on the number of lead managers for an issue was omitted by an
amendment in regulations on April 19, 2006.
(iv) Responsibilities of Lead Managers
The Regulations state that no lead manager shall agree to manage or be associated
with any issue unless his responsibilities relating to issue mainly those of disclosures,
allotment and refund are clearly defined, allocated and determined and a statement specifying
such responsibilities is furnished to the Board at least one month before the opening of the
issue for subscription: Provided that where there are more than one lead merchant bankers
to the issue, the responsibilities of each of such lead merchant banker shall clearly be
demarcated and a statement specifying such responsibilities shall be furnished to the Board
at least one month before opening of the issue for subscription.
(v) Underwriting Obligations
In respect of every issue to be managed, the lead merchant banker holding a certificate
under category I shall accept a minimum underwriting obligation of five percent of the total
underwriting commitment or rupees twenty five lakhs, whichever is less: Provided that, if
the lead merchant banker is unable to accept the minimum underwriting bligation, that lead
merchant banker shall make arrangement for having the issue underwritten to that extent by a
merchant banker associated with the issue, shall keep the Board informed of such arrangement.
(vi) Appointment of Compliance Officer
(a) Every merchant banker shall appoint a compliance officer who shall be responsible for
monitoring the compliance of the Act, rules and regulations, notifications, guidelines,
instructions etc., issued by SEBI or the Central Government and for redressal of
investors’ grievances.
(b) The compliance officer shall immediately and independently report to SEBI any non-
compliance observed by him and ensure that the observations made or deficiencies
pointed out by SEBI on/in the draft prospectus or the letter of offer as the case may be,
60
do not recur. However, during the period from 1992-97, there was mushrooming of
merchant bankers registered with SEBI. This was due to low entry barriers (i.e. minimum
net worth of Rs. 1.00 crore for category I merchant bankers up to 1995). The number
of merchant bankers in 1992-93 was only 74. However, the number of merchant bankers
registered with SEBI rose to 422 in 1993-94, 790 in 1994-95, 1012 in 1995-96 and
1163 at the end of 1996-97. Out of the total 1163 merchant bankers at the end of
1996-97, as many as 720 did not handle any assignment in any capacity and only 234
category I merchant bankers out of 435, were active in business of issue management.
130 merchant bankers were also issued show cause notice for their failure to meet
underwriting commitments during 1996-97. During this period, merchant bankers in
India were involved in many malpractices and they did not bother about the quality of
issue, connived with promoters in floating bad issues and also in cheating investors
through price rigging. Due to intense competition, merchant bankers vied with one
another to attract issuing companies by assuring a good public response to even
overpriced issues. There was a lack of proper appraisal of the issues by the merchant
bankers.
20.6 SEBI (MERCHANT BANKERS) (AMENDMENT) REGULATIONS,

1997
CRB Scam in the capital market in 1997 led to the amendment in the SEBI (Merchant
Bankers) Regulations, 1992. CRB Capital Market, which was registered with SEBI as category-
I merchant banker and had also obtained licence to act as nonbanking financial company
from RBI collapsed in May 1997 due to bouncing of cheques issued by the company in
favour of its fixed deposit investors. Then came the end of CRB group, which had floated
around 133 subsidiaries and unlisted companies and had managed to raise around Rs. 900
crore from the public. Then came to light the various irregularities on the part of RBI and
loopholes in the regulatory frame work in context of merchant bankers functioning as a non
banking financial institutions also. There was a lack of co-ordination between RBI and SEBI
as in case of Non banking financial company performing fund based activities (Leasing,
hire-purchase etc.) are controlled by RBI and their fee based activities ( merchant banking
activities and underwriting) are regulated by SEBI. Consequently, SEBI (Merchant bankers)
Amendment Regulations, 1997 was enacted w.e.f. 9th December, 1997. Under this
amendment, only body corporate was allowed to function as merchant bankers and multiple
categories of merchant bankers were abolished. The new entity (merchant banker) was allowed
to undertake only those activities which were related to securities market including issue
61
management activities and was prohibited from carrying on fund based activities other than
those related exclusively to the capital market. The SEBI regulations required that the applicant
for the regulations of merchant banker should be a fit and proper person.
In USA, The Glass-Steagall Act, 1933 separated commercial banking (i.e. deposit
taking and loan granting functions) from investment banking (i.e. underwriting and trading
functions). It prohibited any institution from having both the business. The main purpose
behind the segregation was to prevent commercial banks from taking an extra-ordinary risk.
However, this Act was repealed in November, 1999.
With the enactment of SEBI ( Merchant Bankers) Amendment Regulation in 1997,
the number of merchant bankers registered with SEBI also declined due to segregation of
fund based and fee based activities, tightening regulations, increase in the requirement of net
worth to rupees five crore and eligibility of only body corporate to be the merchant bankers.
The number of merchant bankers declined from 802 in 1997-98 to 415 in 1998-99 and
further to 186 in 1999-2000. From 2001-02 onward, the number of SEBI registered merchant
bankers varied from 145 to 150. On March 31, 2008, their number stood at 155 which
increased to 164 at the end of March 2010. As a result, there has been a quantitative and
qualitative change in merchant banking scenario in India and only professional merchant
bankers, committed to the profession remained in the field due to tight control of SEBI.
After the above amendments, measures like more transparency in disclosure
requirements in offer documents, submission of prospectus to SEBI for approval, size of
the issue, its firm allotment to different categories of investors, free pricing through book
building process and mandatory underwriting by lead managers have been introduced.
20.7 NOTES
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20.8 SUMMARY
The formal merchant banking services in Indian capital market started with the setting
up of the merchant banking division by Grindlays Bank in 1969. Further, on the
recommendation of Banking Commission, 1972, public sector banks and financial institutions
entered in this field. With the abolition of CCI and the setting up of SEBI in 1992, the role of
merchant banking in India has become more diverse. Inspite of diverse nature of merchant
banking services and the responsibilities involved therein, issue management remains the
major function performed by merchant bankers.
20.9 KEY WORDS

IPO
Rights Issue
Prospectus
SEBI
Book Building
Lead Manager
Broker
Underwriter

1. Briefly explain the state of merchant banking in India
2. Highlight the developments that occurred in merchant banking services post
independence period
3. Write a note on SEBI regulations on merchant bankers
20.11 REFERENCES
64
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KARNATAKA STATE OPEN UNIVERSITY

MUKTHAGANGOTHRI, MYSURU- 570 006.

DEPARTMENT OF STUDIES AND RESEARCH IN MANAGEMENT

M.B.A III Semester

FINANCIAL MARKETS AND INSTISTUTIONS

Prof. D. Shivalingaiah Prof. T.D. Devegowda

Mukthagangothri, Mysuru. - 570006

Developed by Academic Section, KSOU, Mysuru

Further information may be obtained from the University’s office at Mukthagangothri,

The financial system of a country is an important tool for economic development of

1.2 HISTORICAL BACKGROUND AND OF CENTRAL BANK IN INDIA

1.3 PURPOSE OF ESTABLISHMENT OF RESERVE BANK OF INDIA

1.4 ROLE OF RESERVE BANK OF INDIA IN INDIAN FINANCIAL

1.6 THE RBI AND MONETARY POLICY

1.9 SELF-ASSESSMENT QUESTIONS

2.4 RESOURCES OF COMMERCIAL BANKS

2.5 EMPLOYMENT OF RESOURCES

2.6 NEED FOR NATIONALIZATION OF COMMERCIAL BANKS

Nationalization of Commercial Banks

2.9 SELF ASSESSMENT QUESTIONS

After reading this unit, you will be able to;

3.3 FUNCTIONS OF NON-BANKING FINANCIAL COMPANIES

3.4 TYPES OF NBFCs

3.5 TYPES OF SERVICES PROVIDED BY NON-BANKING FINANCE

3.6 FEATURES OF NON-BANKING FINANCIAL COMPANIES

3.7 REGULATIONS OVER NON-BANKING FINANCE COMPANIES

3.10 SELF ASSESSMENT QUESTIONS

4.2 ROLE OF RESERVE BANK OF INDIA IN CREDIT CONTROL

4.3 REGULATIONS OVER COMMERCIAL BANKS

4.6 SELF ASSESSMENT QUESTIONS

DEPARTMENT OF STUDIES AND RESEARCH IN MANAGEMENT

M.B.A III Semester

FINANCIAL MARKETS AND INSTISTUTIONS

Prof. D. Shivalingaiah Prof. T.D. Devegowda

Mukthagangothri, Mysuru. - 570006

Developed by Academic Section, KSOU, Mysuru

5.2 IMPORTANCE OF CAPITAL MARKET

5.5 ISSUE MECHANISM

5.6 FUNCTIONS OF NEW ISSUES/PRIMARY MARKET

5.7 FUNCTIONS OF STOCK/SECONDARY MARKETS/EXCHANGES

Exhibit (a : Differences Between Stock Exchange and Primary Market

New Issue Market Stock Exchange

1. Types of Security New Existing / old

2. Nature of Financing Direct Indirect

3. Organization Physical Existence Specialist Institutional

4. Functions  Nexus between savings  Organisation

 Continuous price  Distribution

5.9 CHECK YOUR PROGRESS

5.12 KEY WORDS

5.13 SELF ASSESMENT QUESTIONS

6.2 FUNCTIONS OF STOCK EXCHANGE

The roles and responsibilities of stock exchange are detailed below:

6.4 NATIONAL STOCK EXCHANGE

6.5 FUNCTIONS /SERVICES OF STOCK EXCHANGES

6.8 CHECK YOUR PROGRESS

6.11 KEY WORDS

6.12 SELF ASSESSMENT QUESTIONS

7.1 INTRODUCTION TO FOREIGN DIRECT INVESTMENT (FDC)

Foreign direct investment (FDI) is an investment in a business by an investor from

Source: Reserve Bank of India