1502-Financial Mkt&Inst [BBA S3-DSC-8 CC4] Cover Jan25.

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FINANCIAL MARKETS AND INSTITUTIONS

Editorial Board
Dr. Kumar Bijoy
Associate Director, Campus of Open Learning,
University of Delhi
Prof. Yogieta S. Mehra
Professor, Deen Dayal Upadhyaya College,
University of Delhi

Content Writers
Prof. Yogieta S. Mehra, CA. Vishal Goel, Ms. Chandni Jain,
Ms. Manisha Yadav, Ms. Jasmit Kaur, Imaran Ahmad,
Mr. Ravi Yadav, Dr. Sharif Mohd., CS Monika Saini,
Dr. Neerza, Mr. Gurdeep Singh
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Deekshant Awasthi

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 FINANCIAL MARKETS AND INSTITUTIONS
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© Department of Distance & Continuing Education, Campus of Open Learning,

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© Department of Distance & Continuing Education, Campus of Open Learning,

School of Open Learning, University of Delhi
 Contents

PAGE

Lesson 1 : An Overview of the Indian Financial System 1-40

Lesson 2 : Introduction to Financial Intermediation 41-62

Lesson 3 : Depository Institution of Banking 63-91

Lesson 4 : Banking 92-142

Lesson 5 : Financial Markets 143-168

Lesson 6 : Types of Mutual Fund Schemes 169-186

Lesson 7 : Capital Market 187-211

Lesson 8 : Trading Mechanism on Exchanges 212-234

Lesson 9 : Money Market and Debt Market 235-259

Lesson 10 : Other Markets 260-285

Lesson 11 : External Market 286-305

Glossary 307-314

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L E S S O N

1
An Overview of the Indian
Financial System
Prof. Yogieta S Mehra
Deptt. of Management Studies
Deen Dayal Upadhyaya College
University of Delhi
Email-Id: yogieta@[Link]

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 The Indian Financial System
1.4 Insolvency and Bankruptcy Code (IBC)
1.5 Payment Banks
1.6 Goods and Services Tax (GST)
1.7 Innovative Remittance Services
1.8 Regulatory Institutions in India
1.9 Answers to In-Text Questions
1.10 Self-Assessment Questions
1.11 References/Suggested Readings

1.1 Learning Objectives

u Understand the fundamental components and functions of the Indian financial system.
u Explain the key features and implications of the Insolvency and Bankruptcy Code in
the Indian financial system.
u Analyze the impact of the Goods and Services Tax (GST) on the Indian economy
and various stakeholders.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes u Discuss the concept and role of payment banks in the Indian financial
system.
u Explore innovative remittance practices and their significance in
facilitating efficient financial transactions.
u Examine the functions, role, and regulatory framework of the Reserve
Bank of India (RBI).
u Understand the role and responsibilities of the Securities and Exchange
Board of India (SEBI) in regulating the Indian securities market.
u Discuss the objectives and functions of the Insurance Regulatory and
Development Authority (IRDA) in regulating the insurance sector
in India.
u Explore the role and functions of the Pension Fund Regulatory and
Development Authority (PFRDA) in regulating pension funds and
schemes in India.
u Summarize the key points covered in the lesson to consolidate
understanding of the Indian financial system and its various components.

1.2 Introduction
An Overview of the Indian Financial System
Allocating a country’s limited cash and resources to productive endeavours
is largely dependent on the effectiveness of its financial system. It is
crucial to an economy’s development that it operate smoothly. The key to
a healthy economy is a structure that promotes savings, investment, and
the efficient distribution of funds. A nation’s economic growth may be
hastened or sped up depending on the quality of its financial infrastructure.
India has one of the world’s biggest economies, ranking fifth in terms
of nominal GDP. The Indian financial system is a crucial pillar of the
Indian economy, helping to sustain the country’s rapid development and
its abundant wealth. Consistent economic growth in the nation may be
attributed in large part to this factor.
Structure of Indian Financial System
The Indian economy may be broken down into two distinct categories: the
official, or organized, financial system, and the informal, or unorganized,
financial system.

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 An Overview of the Indian Financial System

Formal or Organised Financial System Notes

This is the preferred financial system since it is bound by rules and
regulations. It is a transparent system which is very systematic in nature
and works towards the development and growth of the economy. The
main constituents of the Formal Financial System are:
(i) Financial Institutions
(ii) Financial Markets
(iii) Financial Instruments and
(iv) Financial Services
Informal or Unorganized Financial System
People like chit fund businesses, money brokers, and local bankers are
all part of the informal financial system. These firms are not governed
by the law of the state. They operate on a very informal level and fleece
the users on many occasions. Many people have lost huge sums of money
due to promises by some fraudulent operators. However, they are still
popular due to their informal nature with minimal paperwork and ease
of transactions.

1.3 The Indian Financial System

Components of Indian Financial System
u Financial Institutions: They play a significant role in the Indian financial
system by collecting deposits from the general population and disbursing
those funds to borrowers with legitimate financial needs. The financial
institutions are an integral part of economic and financial development
of the country due to the numerous services provided by them.
There are further classified into two types:
(i) Banking Institutions
(ii) Non-Banking Institutions.
Banking Institutions
The financial system of each nation relies heavily on its banking institutions.
They make sure the people’s savings are put to good use by lending it to
responsible borrowers. There are two types of banks in India: scheduled
and nonscheduled.

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Notes u The Reserve Bank of India (RBI) Act, 1934 designates some banks
as “scheduled” under its second schedule. Scheduled banks need
at least 5 Lakh in paid-up capital and total assets before they may
be considered. Banks that receive loans from the RBI at the bank
rate are qualified to join the RBI’s clearing house.
u Banks that are not included in the second schedule of the RBI Act of
1934 are referred to as “Non-Scheduled Banks.” The total amount
of monies raised and invested is less than INR 5 Lakh. They don’t
have to use the Reserve Bank of India’s loan program.
Commercial Banks
Scheduled and non-scheduled commercial banks are both subject to
the Banking Regulation Act of 1949. These financial institutions take
deposits from customers and lend money to individuals, companies, and
governments. The most common forms of commercial banking are:
u Public Sector Banks: In India, the government or “nationalized”
banks control more than 75% of the market. The government of
India is a key player in this market.
u Private Sector Banks: Investors, rather than the Reserve Bank of
India or the government of India, make up the vast majority of
Private Sector Banks’ shareholders. However, the RBI has strict
rules that these institutions must follow.
u Foreign Banks: Banks with overseas headquarters that do business
in India do so independently under the name of an Indian company.
They act in accordance with both domestic and international law.
u Regional Rural Banks: These are commercial banks with specialized
services for low-income clients, such as subsistence farmers,
farmhands, and small companies. The Central Government owns
50%, the State Government owns 15%, and a Commercial Bank
owns the remaining 35%. RRBs are regional financial institutions
that provide agricultural and the rural sector with subsidized loans
and other financial services like debit cards, bank lockers, free
insurance, etc.
Small Finance Banks
Small finance banks, which are authorized under Section 22 of the
Banking Regulation Act, 1949, focus on customers who are underserved

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 An Overview of the Indian Financial System

by larger financial institutions. They cater to the needs of micro- and Notes
cottage-based enterprises. These financial institutions provide loans and
other forms of aid to those in the informal economy, including small
businesses and farmers. The country’s central bank sets the rules for
these financial institutions.
Local Area Banks
They are set up by private companies with profit maximization in mind.
The year 1996 saw its debut in India. Currently, in South India, just four
Local Area Banks exist.
Specialized Banks
They have been established with a specific role to aid in the financial
development of the country. Some of the specialized banks in India are:
u SIDBI: A loan for a modestly sized business may be obtained
through the Small Industries Development Bank of India (SIDBI).
This financial institution lends money to small companies so that
they may set up innovative production units and contribute to the
growth of the economy.
u EXIM Bank: The acronym “EXIM Bank” refers to the Export and
Import Bank. This kind of bank is a preferred option for companies
who need loans or other forms of financial aid to facilitate their
exports and imports.
u NABARD: NABARD is a resource for anyone seeking funding for
rural, handicraft, village, or agricultural projects.
u Payments Banks : Payment Banks are relatively new form of banking.
The Reserve Bank of India mandates that these banks may only
accept deposits up to INR 1 Lakh per user. They provide debit and
ATM cards and offer a full suite of electronic banking services.
Payments bank account holders are restricted to making deposits
of up to Rs. 1,00,000 and are not eligible for loans or credit cards.
u Co-operative Banks : These institutions are chartered as cooperatives
under the Cooperative Societies Act of 1912. Financial products and
services are provided to corporations, enterprises, and startups. These
are put in place to protect the members’ best interests. They take
deposits and provide loans to eligible members on a cooperative
basis.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes Non-banking Institutions

NBFIs, or non-banking financial institutions, are businesses that provide
financial services like banking, but are not subject to the same regulations
as banks. The purpose of non-banking financial organizations is to lend
money to businesses and individuals without the involvement of a bank.
Two broad categories of non-banking financial entities exist: the organized
and the unstructured. These are examples of some of India’s many
non-banking institutions:
u Insurance companies: Insurance policies are sold by these firms to
both consumers and businesses. Life insurance, along with other
types of insurance including those for vehicles, health care, and
property, are all available via these plans.
u Investment banks: To obtain capital, these institutions facilitate
the issuance and sale of securities by corporations. In addition to
trading stocks and bonds and advising on M&A, they also offer other
services. They play a mediating role in the IPO funding process.
u Pension funds: Workers may rely on this money when they reach
retirement age. The funds are put into various investments such as
equities and bonds.
u Mutual funds: Investors’ money is pooled in these funds and invested
across a variety of asset classes, including stocks, bonds, and other
securities.
u Hedge funds: Private investment partnerships like this utilize a wide
range of investing methods to generate profits for its investors.
u Private equity firms: These corporations make growth investments
in privately held businesses. In addition, they might steer the firm
toward becoming public.
u Venture capital firms: These corporations support promising startups
in their formative years.
All of these non-banking financial organizations are geared toward the
same end—providing capital to firms and individuals—but they do it in
their own unique ways.

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 An Overview of the Indian Financial System

Difference Between Non-Banking Financial Institutions and Banks? Notes

Non-banking financial entities are distinct from banks in many important
respects:
u The rules and regulations that apply to banks do not apply to non-
banking financial firms.
u Money is raised by non-banking financial entities via the sale of
securities or the issuance of debt; they do not accept consumer
deposits.
u Financial entities that are not banks are not subject to the same
reserve ratio requirements. A bank’s required reserve ratio is the
fraction of customer deposits it sets aside for withdrawals.
u Capital requirements for financial firms that are not banks are different.
This implies they are exempt from having a “reserve” of a certain
amount of money set aside in case of a loss.
u Last but not least, unlike banks, non-bank financial organizations
are not required to adhere to the same lending regulations. This
implies that they are not restricted by government regulations and
may provide loans to anybody they like.
Financial Markets
The term “financial markets” is used to describe any marketplace where
stocks, bonds, currencies, and other financial products are traded between
buyers and sellers. The growth of a country’s economy may be boosted
exponentially by healthy financial markets. They may make saving and
investing more efficient and boost capital creation.
Financial Market players include private investors, banks, FIIs, corporations,
and governments. These organizations engage in market activity either
alone or with the assistance of intermediaries. By facilitating the transfer
of capital between savers and investors, progressive financial markets
serve as an important link in the financial system.
u Classification of Financial Markets: One may broadly divide India’s
financial markets into “unorganized” and “organized” sectors.
u Unorganized Financial Markets: Local money lenders, indigenous
bankers, dealers, etc., who lend money to the public from their own
finances, make up the bulk of India’s unorganized financial markets.

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Notes Their interest rates tend to be sky-high, but they need nothing in
the way of documentation. They operate outside of the purview
of the Reserve Bank of India and any other applicable governing
bodies.
u Organized Financial Markets: The laws and regulations of organizations
like SEBI, RBI, etc. apply to this sector of the financial markets.
There are two subsets of the structured financial markets: the capital
market and the money market.
u Capital Markets: The capital market is a regulated exchange where
investors and savers meet to pool their resources in order to finance
economic activity. The financial assets traded on the capital market
often have a very long or infinite lifespan. The long-term securities
market goes under other names as well. It’s a formal system set up
for borrowing and lending over a longer time frame.
u Money Market: In place of physical currency, the money market
deals in short-term debt instruments having maturities of less than
a year, such as trade bills and promissory notes. The ability to
quickly and inexpensively convert money market instruments into
cash with no loss or no transaction costs is their most attractive
feature. In order to provide liquidity, this market is comprised of
financial institutions and money or credit dealers. So, the money
market is the place to buy and sell treasury bills, commercial papers,
CDs, and other short-term liabilities.
The rapid and simple availability of capital is made possible by the
financial market. With the use of demat accounts and other forms of
online storage, financial markets have made it possible to convert assets
(security holdings) into cash quickly and easily.
Financial Instruments/Assets
The financial asset is the primary output of every economic system.
Financial assets and securities are other names for financial products.
Value is created in financial assets because of contractual agreements:
u A claim on the repayment of principle or the periodic payment of
interest or dividends is represented by a financial asset or instrument.
Securities such as stocks, bonds, and debentures are all instances
of equity.

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 An Overview of the Indian Financial System

u Deposits in banks, corporations, and post offices, insurance policies, Notes

the National Savings and Investment Account, provident funds, and
pension funds are all examples of non-tradable financial assets.
Shares of stock, debentures, and government and corporate bonds
may all be traded on the stock market.
u The many types of financial instruments include:
(i) Money Market instruments
(ii) Capital Market instruments
Money market products are utilized for short-term financing needs,
often less than a year. Treasury bills, commercial paper, call money,
short notice money, CDs, commercial bills, and money market
mutual funds are all examples of money market instruments.
Financial instruments traded on the capital market are issued with
maturities of more than one year, sometimes even perpetuity. Equity
shares, preference shares, warrants, debentures, and bonds are all
types of equity instruments.
Equity and debt characteristics are combined in hybrid products.
Convertible debentures, securitized assets, mortgage warrants
denominated in a foreign currency, etc.
Financial Services
Loans, insurance, credit cards, investment possibilities, and personal
financial management are all examples of financial services provided
by banks, credit unions, and other financial organizations. The phrase
“financial intermediation” may be used to describe these services.
Mobilizing excess funds and providing them to different needy groups
(industries, firms, businesspeople, individuals, etc.) is another definition
of financial intermediation.
Important Types of Financial Services: Banking, Foreign Exchange,
Investment, and Insurance Services are the Four Most Important Financial
Services Offered by Different Institutions. In addition to traditional banking
services, alternative options exist, such as private equity, venture capital,
angel investing, etc. The financial services may be broken down into two
categories: those that are fund-based and those that are fee-based.
u Fund Based Services: Services involving the management of money
or other assets, often in exchange for a fee or a rate of interest, are

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes known as “fund-based” or “asset-based” financial services. Leasing,

Factoring, Bills Discounting, Venture Capital, Loans, Mortgages,
and Hire Purchase are all examples of services that involve the
movement of money from one location or person to another.
u Fee Based Services: Transferring money from one party to another
is not required for fee-based services. They are offered for a certain
sum of money, whether it is a flat rate or a percentage. Services
such as issue management, portfolio management, loan syndication,
corporate counseling, and international collaboration often come
with a price tag attached to them.

Objectives: The objectives of a sound, stable and growing financial

system are:
1. Accelerate growth of country’s economic development by serving
as a catalyst to country’s industrialisation.
2. Act as an agent to provide the gamut of financial services to every
nook and corner of the country.
3. Accelerate rural development by developing a network of all services
and institutions in their close vicinity.
4. Provide timely financial support to industry leading to economic
growth.
5. Help those in far-flung places get houses and small businesses off
the ground by financing their development.

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 An Overview of the Indian Financial System

1.4 Insolvency and Bankruptcy Code (IBC) Notes

The Indian Financial System has grown at a massive scale in the last
decade. Government has introduced some reforms to create an efficient
financial market arena which can comfortably compete with International
financial institutions. Some of the products of their reforms are:
(i) Insolvency and Bankruptcy Code (IBC)
(ii) Payment Banks
(iii) Goods and Services Tax (GST)
(iv) Innovative Remittance Services
Insolvency and Bankruptcy Code (IBC)
India’s 2016 Insolvency and Bankruptcy Code (IBC) is a sweeping piece
of legislation with the dual goals of streamlining the insolvency and
bankruptcy process and enhancing the country’s economic climate. The
Insolvency and Bankruptcy Code sets deadlines for closing bankruptcies.
When a debtor fails to make timely payments, the creditors are in a position
of bankruptcy and must take the debtor’s assets. IBC allows either the
debtor or the creditor to start “recovery” actions. India had the longest
average time to settle a bankruptcy case at 4.3 years, far longer than the
United Kingdom at 1 year and the United States at 1.5 years. This time
must be decreased in to make big-ticket loan account settlement easier.
The Working of Insolvency and Bankruptcy Code: IBC applies to
corporations, partnerships, and sole proprietors. It’s a limited-duration process
for getting out of debt. When a debtor fails to make timely payments,
creditors assume control of their assets and must make difficult decisions
regarding the best way to handle the debtor’s bankruptcy. “Recovery”
actions may be started by either the debtor or the creditor under IBC.
Timeframe: Businesses filing for insolvency under IBC have 180 days
to do so. The deadline may be pushed back if there is no pushback from
the creditors. For companies, including startups, with annual revenues of
up to Rs. 1 crore, the insolvency procedure must be completed within
90 days, with a 45-day extension possible. Liquidation will occur if debt
forgiveness is not granted.
Regulator of IBC: The Insolvency and Bankruptcy Board of India has
been designated to supervise these procedures. The Reserve Bank of

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Notes India and the Finance and Law Ministries each have two members on
the board of IBBI. A licenced expert oversees the settlement process,
manages the debtor’s assets, and gives creditors information to help them
make decisions.
Adjudicator of the Proceedings: The National Companies Law Tribunal
(NCLT), which hears cases involving corporations, and the Debt Recovery
Tribunal (DRT), which hears cases involving people, decides on the
resolution process’s proceedings. By authorizing the appointment of the
insolvency professional and the final decision made by the creditors,
the courts allow the resolution process to begin. The Insolvency and
Bankruptcy Board is responsible for regulating insolvency practitioners,
insolvency professional organizations, and information utilities formed
under the Code.
Procedure of Resolving Bankruptcy: When a default occurs, the process
of settlement may be initiated by either the debtor or the creditor. The
insolvency professional is in charge of the process. The expert oversees
the debtor’s assets and gives the creditor with data gleaned from various
sources. Any legal action against the debtor is barred for the 180 days
while this process lasts.
Role of Committee of Creditors: The insolvency professional establishes
a committee made up of the lenders of funds to the debtor. The creditors’
committee will determine what will happen to their unpaid debt. It’s
possible they’ll try to resuscitate the debt owed to them by renegotiating
the repayment terms or liquidating the debtor’s assets. If a decision is
not reached within 180 days, the debtor’s assets will be sold.
Process after Liquidation: If the debtor declares bankruptcy, the liquidation
procedure is managed by an insolvency specialist. The profits from the
sale of the debtor’s property are allocated as follows. First, there are
expenses related to insolvency resolution, such as the compensation of
the insolvency professional; second, there are secured creditors, whose
loans are secured by collateral; third, there are employee dues; and fourth,
there are unsecured creditors.
Key Features of the IBC: The IBC has several key features that make
it a comprehensive and effective legal framework for insolvency and
bankruptcy in India. Some of the significant features are:

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 An Overview of the Indian Financial System

1. A Single, Unified Law: Both the Recovery of Debts Due to Banks Notes
and Financial Institutions Act and the Sick Industrial Companies
Act have been rendered obsolete by the IBC. The Indian Bankruptcy
Code (IBC) is a single, comprehensive statute that establishes a
uniform and open legal framework for insolvency and bankruptcy
in India.
2. Insolvency Resolution Process: The IBC establishes a time-bound
insolvency resolution process with a 180-day goal for the resolution
of insolvency cases. A committee of creditors that decides on the
resolution plan is appointed together with an insolvency specialist
who assumes control of the company’s administration.
3. Liquidation Process: The IBC stipulates a time-limited liquidation
process in the event that the resolution process is unsuccessful. The
liquidation procedure aims to sell the company’s assets and fairly
and openly distribute the proceeds to the creditors.
4. Cross-Border Insolvency: The IBC establishes a framework for cross-
border insolvency, allowing Indian courts to engage with foreign
courts to resolve insolvency matters involving overseas businesses
and people.
5. Employee Protection: The IBC offers protection to employees of a
company going through the insolvency procedure. The insolvency
professional is responsible for making sure the employees are treated
properly throughout the procedure, and they are entitled to collect
their salary for up to 24 months.
Benefits of the IBC: The Indian economy and business climate will
gain in a number of ways from the adoption of the IBC. Significant
advantages include:
1. Insolvency cases are resolved more swiftly thanks to the IBC’s
introduction of a time-bound insolvency resolution process, which
guarantees that bankruptcy cases are handled effectively and promptly.
This lessens the financial load on the creditors and makes it possible
for them to rapidly recover their money.
2. Higher Recovery Rates: The IBC establishes a clear and uniform
legal framework for insolvency and bankruptcy, which raises the
likelihood that creditors will be paid back. This encourages financial

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Notes organisations and banks to lend money to companies and people,

which supports economic growth.
3. Ease of Doing Business: By streamlining the bankruptcy and
insolvency procedures, the IBC fosters a climate that is favourable
for enterprises to operate in India. Since the IBC’s introduction,
doing business in India has become simpler.
4. Efficient Use of Resources: The IBC makes sure that a firm going
through the insolvency process sells its assets in a fair and open
way, ensuring that resources are used effectively. All the entities
including Creditors, workers, and the economy as a whole gain
from this.
Challenges for the IBC: The implementation of the IBC has also faced
several challenges. Some of the significant challenges are:
1. Legal Framework: Implementing the Insolvency and Bankruptcy
Code (IBC) in India has faced challenges due to complexities in
the legal framework. The IBC requires coordination among multiple
stakeholders, including debtors, creditors, insolvency professionals,
and adjudicating authorities.
2. Institutional Capacity: India’s insolvency resolution ecosystem faced
capacity constraints initially, with a limited number of insolvency
professionals and infrastructure. Building a robust institutional
framework and enhancing the capacity of key institutions such as
the National Company Law Tribunal (NCLT) and Insolvency and
Bankruptcy Board of India (IBBI) has been a challenge.
3. Lengthy Resolution Process: The IBC aims to expedite the
resolution process, but it has faced criticism for lengthy proceedings.
The time-bound resolution mandated by the IBC has not always
been achieved, leading to delays and increased costs.
4. Operational Issues: The effective implementation of IBC requires
smooth coordination and cooperation among various stakeholders.
However, operational issues such as the availability of information,
conflicts of interest, and coordination challenges among lenders and
creditors have posed challenges to the successful implementation
of the code.

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 An Overview of the Indian Financial System

5. Cultural and Mindset Change: The IBC represents a significant shift Notes
in the insolvency and bankruptcy landscape in India. Encouraging
a cultural and mindset change among stakeholders, particularly
debtors and creditors, towards a more proactive approach to resolving
insolvency cases has been a challenge.
Addressing these challenges requires continuous efforts, including legislative
amendments, capacity building, awareness campaigns, and improved
coordination among stakeholders, to ensure the effective implementation
of the IBC in India.

IN-TEXT QUESTIONS
1. What is the different type of Commercial Banks in India:
(a) Public and private sector Banks
(b) Foreign Banks
(c) Regional Rural Banks
(d) All of these
2. SIDBI and EXIM Bank are examples of:
(a) Specialised Banks
(b) Local Area Banks
(c) Small Finance Banks
(d) Co-operative Banks

1.5 Payment Banks

Payment institutions are a new kind of institution in the Indian banking
system introduced by the Reserve Bank of India (RBI). They were
developed to serve the credit and remittance requirements of micro
businesses, low-income individuals, and the informal economy. They do
the majority of banking tasks, although they are not allowed to make
loans or dispense credit cards.
According to data from the RBI, the banking industry still does not serve
about 60% of the country’s population. Additionally, it primarily consists
of rural residents with lower incomes who migrate to urban regions in
search of jobs in the unorganised sector. Therefore, payment banks strive

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Notes to broaden the availability of financial services and payments to those

with limited means, small businesses, and migratory workers. It is said
to be conducted safely and using cutting-edge equipment.
The Background
Reserve Bank of India appointed Dr. Nachiket Mor to head a group that
would look at “Comprehensive financial services for small businesses
and low-income households” in September 2013. Payment banks, which
the committee recommended be established in order to help those with
lower incomes and small businesses, first opened for business in January
of 2014.
Objectives of Setting up Payment Banks
u Provide banking and payment services to small businesses, low-income
households, and migratory workers in a safe, technology-driven
environment.
u Increase the extent to which financial services are accessed in rural
areas of the nation.
Features of Payment Banks
u The Reserve Bank of India grants both universal and specialized
bank licenses to financial institutions. Payments banks are subject
to separate banking regulations since they cannot compete on a
level playing field with traditional commercial banks. In particular,
a payments bank is unable to provide credit.
u Payment banks are permitted to open both savings and current
accounts for their clients.
u They are allowed to give customers ATM or debit cards, but not
credit cards.
u They are permitted to collect remittances from across borders and
make personal payments on current accounts.
u Like Commercial Banks, they must deposit the appropriate CRR
(Cash Reserve Ratio) amount with the Reserve Bank of India. At
least 75% of their demand deposits must be placed in short-term
government assets like treasury bills with maturities of a year or less.
In addition, no more than 25% of their total deposits may be held
in operational current and fixed deposits with any one commercial
bank.

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u The Customers of payment banks can pay their utility bills online. Notes
u These banks are prohibited from establishing subsidiaries to engage
in any non-banking financial services-related activity.
u In order to distinguish themselves from other banks, Payments Banks
must have the word “Payments Bank” in their names.
u Payments banks can only collaborate with other commercial banks as
partners and sell goods like mutual funds, insurance, and pensions
after requesting permission from the RBI.

Activities permitted to payment Banks Activities not permitted

Deposits to payment banks are limited to The RBI grants payment banks a
Rs. 2,000,000. Demand deposits in the form “differentiated” bank licence, which
of savings and current accounts are acceptable. prevents them from making loans.
75% of the money received in the form of Cannot issue credit cards.
deposits can be invested in secure government
securities in the form of Statutory Liquidity
Ratio (SLR). The remaining 25% has to be
placed, as time deposits with other scheduled
commercial banks.
Transfer money domestically and internationally Payment Banks are not permitted to
on current accounts. They can also provide accept time deposits as well as NRI
remittance services deposits.
Issue Debit Cards. Cannot set up subsidiaries to undertake
non-banking financial activities
Perform the role of a Business Correspondent Cannot grant loans to any entity.
(BC) of another bank (subject to RBI guidelines)
Advantages of Payment Banks
u Ease of operations and digital mode of operations has enhanced rural
banking and financial inclusion in far flung areas.
u Easy access to payment banks has widened the entire formal financial
system.
u Payment banks have become a viable substitute for commercial banks.
u Payment Banks are able to manage high volume, low value transactions
effectively.
u Payment Banks provide access to diversified services.

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Notes Challenges Ahead for Payment Banks

u Lack of public awareness on availability of services of payment
banks.
u Incentives for the agents to participate in these activities are minimal.
u Infrastructure hurdles and technological difficulties in effective usage
of Payment Banks.
Eligible Promoters
In India, payments banks may only be established by the following
individuals and/or organizations:
u Mobile telephone firms and supermarket chains are eligible for
payment bank license.
u Present non-bank Expert issuers of Prepaid Payment Instruments
(PPI) have worked in this field for at least ten years.
u Individuals with “fit and proper” qualifications in the banking industry,
the financial sector, the NBFCs, or the Micro Finance Industry.
u NBFCs (Non-Banking Financial Companies) that get things done.
u Businesses owned and operated by locals; Businesses owned and
operated by non-locals; Governmental organizations.
u Joint venture between a promoter or group of promoters with an
established, chartered commercial bank.
u Equity investments in payments banks are permissible for scheduled
commercial banks to the degree allowed by the Banking Regulation
Act, 1949.
Around 11 applicants have received “in - principle” clearance from the
RBI to launch payments banks in the nation. Only 6 of them are now
in use, as shown below:
u Fino Payments Bank Limited
u NSDL Payments Bank Limited
u India Post Payment Bank Limited
u Airtel Payment Bank Limited
u Paytm Payment Bank Limited
u JIO Payment Bank Limited

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1.6 Goods and Services Tax (GST) Notes

Several additional indirect taxes in India have been replaced by the Goods
and Services Tax (GST). The GST is applicable across the whole supply
chain, from manufacturing to retail to final consumer. The adoption of
GST in India is a significant move toward the unification of the market
and the simplification of the indirect tax structure.
History of GST in India: In his 2007 budget address, Shri Arun Jaitly
proposed a federal Goods and Services Tax (GST). The GST Act was
enacted by Parliament on March 29, 2017, after being supported by a
number of Finance Ministers. After years of debate and discussion between
the Central and State Governments, Industry and Trade Associations, and
other stakeholders, India finally introduced the GST on July 1, 2017,
under the tagline “One Nation, One Tax.”
The Working of GST: A product goes through a number of phases on
its way to the consumer, starting with the purchase of raw materials,
followed by manufacture, storage, sales to wholesalers and retailers,
and then sales to the final customer. It is a multi-stage tax since the
Goods and Services Tax is charged at each of these steps. GST works
on the principle of Value Addition. Fabric, thread, and other materials
are purchased by a producer of shirts. When the fabric, thread, elastic,
buttons, etc. are stitched together to create a shirt, the value of the inputs
rises. The warehousing agent packs and labels the shirts once the maker
sells them to him or her. This gives the shirts yet another layer of value.
The warehouse representative then sells it to the store.
The store is investing on advertising and special packaging for these shirts
to boost their sales. GST applies to the sum of all value additions made
along the supply chain prior to final sale to the end customer.
Destination-Based: In the above example, if the goods are manufactured
in Gujarat and delivered to a buyer in Madhya Pradesh, the Goods and
Service tax will be collected at the point of consumption i.e., Madhya
Pradesh. So, Madhya Pradesh, will receive the full tax income.
Salient Features of GST
(i) GST is applied on the “supply” of products or services rather than
the “production,” “sale,” or “provision” of the same items.

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Notes (ii) The GST is based on the theory of destination-based consumption

taxes, as opposed to the traditional concept of taxing at the point
of origin.
(iii) Every value addition is subject to this comprehensive, multistage,
destination-based tax from the point of manufacture till the consumer’s
final transaction.
Value Addition: Value Addition:
GST Structure: The Central and State Governments of India both contribute
to the GST that is charged on goods and services in the country. The
GST framework consists of the following four parts:
1. The GST collected by the federal government is called Central
Goods and Services Tax (CGST).
2. Intrastate sales are subject to the State Goods and Services Tax
(SGST), which is collected by the State government.
3. The Central Government now collects a single tax on all sales of
goods and services made between states called the Integrated Goods
and Services Tax (IGST).
4. Union Territory Goods and Services Tax (UTGST): The Union
Territory Government levies this tax on intra-state sales of goods
and services.
Advantages of GST: There are several ways in which the Indian economy
has profited from the implementation of GST. Among the many advantages
are:
1. The Goods and Services Tax (GST) is a consumption tax collected
in lieu of a variety of other indirect taxes (such as the excise tax,
the service tax, the value-added tax, and others) in all states. The
GST has decreased the overall tax burden on consumers.
2. Development of a Unified Market: The GST has facilitated the free
flow of goods and services across all state borders.
3. Economic Growth: The GST has increased tax system transparency,
which has helped the economy. Additionally, it has broadened the
revenue base and improved tax compliance. Tax administration is
simplified since the federal government determines tax rates and
establishes rules. People are more likely to file their taxes on time

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now that they don’t have to juggle as many different returns types. Notes
The Goods and Services Tax (GST) has helped streamline corporate
processes and drawn more companies into the formal sector.
4. The cascading impact of taxes is no longer an issue since taxpayers
may now use tax credits from one indirect tax to offset the costs
of another. By solely taxing the incremental value created at each
level of the supply chain, GST prevents additional taxes from being
levied on top of existing ones.
5. Tax Evasion is Reduced: The GST system restricts taxpayers from
claiming input tax credits on fake invoices by requiring them to
use actual supplier invoices. The use of electronic invoices has
bolstered this objective. Since GST uses a centralized monitoring
system, it is significantly easier and faster to punish lawbreakers.
Because to GST, both tax fraud and evasion have decreased.
6. To Encourage Low Prices and More Consumption: Revenues
from both direct and indirect taxes have risen since the GST was
introduced. The generalization of GST rates has contributed to
the competitiveness of the Indian market. As a result, demand has
climbed and revenue has grown, helping to accomplish yet another
important objective.
Challenges of GST: Although the GST has brought significant advantages,
it also faces some challenges. Some of the major challenges are:
1. GST compliance requirements are quite complex, and many businesses
encounter difficulties adhering to them.
2. Technology Challenges: The GST is a technology-driven tax system,
and many small businesses find it challenging to adopt the new
technology.
3. Rate Rationalization: The GST rates are still high for some goods
and services, which has resulted in inflation.
4. Administrative Problems: Many administrative problems have arisen
during the GST introduction, confusing taxpayers.
5. Problems with Input Tax Credits (ITC): In a number of cases,
taxpayers have been refused ITCs, which has led to higher costs.

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Notes GST Rates:

The GST Council has classified goods and services under various tax
slabs, ranging from 0% to 28%. The tax rates are as follows:
1. 0% Tax Rate: The goods and services that come under this category
are essential commodities like rice, wheat, milk, curd, salt, and
books.
2. 5% Tax Rate: The goods and services that come under this category
are items like edible oils, tea, coffee, sugar, and medicines.
3. 12% Tax Rate: The goods and services that come under this category
are items like mobile phones, computers, and processed foods. Goods
and services that fall under this category include air conditioners,
refrigerators, and footwear.
4. 28% Tax Rate: The goods and services that come under this category
are luxury items like high-end cars, yachts, and cigarettes.
The Road Ahead: The future of GST in India looks promising. Further,
the government is taken several measures to improve taxation. Some of
the significant future developments of GST are:
1. Simplification and Rationalization of Tax Structure: The GST
Council regularly reviews and revises the tax structure to simplify
and rationalize it. This includes reducing the number of tax slabs
and bringing more items under a uniform tax rate.
2. Inclusion of Petroleum and Alcohol Products: Currently, separate
state-level taxes are levied on Petroleum and Alcohol Product. In
the future, these products may be included under the GST regime,
which would bring greater uniformity in taxation.
3. Introduction of E-Invoicing and Real-Time Reporting: The
implementation of e-invoicing and real-time reporting is expected
to improve tax compliance and transparency. The government may
continue to enhance and expand the scope of these digital initiatives
to ensure a smooth flow of information and minimize tax evasion.
4. Integration of GSTN with Other Systems: The Goods and Services
Tax Network (GSTN) acts as the IT backbone for GST implementation.
Government may integrate GSTN with other government systems

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like income tax, customs, and other regulatory bodies, enabling Notes
better data sharing and analysis.
5. International Collaboration: The government may actively engage
in international collaboration and best practice sharing with other
countries that have implemented GST or similar tax reforms. This
would facilitate learning and adoption of global best practices in
GST administration and compliance.
In future, it is expected that the government’s focus will be on fine-
tuning the GST framework to achieve its objectives of simplifying the
tax structure, increasing compliance, and promoting economic growth.

1.7 Innovative Remittance Services

Remittance is defined as the transfer of money from one nation to some
other. Since millions of Indians live abroad, they send money for their
families back in India. This makes India largest receiver of remittances all
over the world. The remittance industry in India has withstood significant
changes through the years, with all the advent of new technologies and
services that are innovative. Over a period of time, these remittance
services have also evolved so as to make the process easy and convenient
both from sender and receiver’s viewpoint.
Traditional Remittance Services: Traditionally, people have been using
bank transfers, money sales, and cable transfers as the most popular
means of sending money. These services were reliable but expensive and
time-consuming. Moreover, the time taken to complete the transfer also
extends to many days. Furthermore, this process of remittance requires
both the transmitter and receiver to have a bank-account.
Innovative Remittance Services: The advent of the latest technologies
has led to the growth of innovative remittance services in India. These
services are fast, affordable, and convenient. Some of the important
remittance services available in India are:
1. Mobile Wallets: Mobile wallets like Paytm, PhonePe, and Google
Pay have become very popular in India in the past few years.
These wallets enable users to receive and send money instantly. The
charges of these services are considerably lower than conventional
remittance solutions. Additionally, these Mobile wallets can also be

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Notes used to pay bills, recharge their cell phones, make online purchases,
making them a versatile remittance option.
2. Remittance Companies: Several remittance companies like Western
Union, MoneyGram, and Ria Money Transfer operate in India. These
companies offer fast remittance services that is affordable and also
have a vast network of agents around the world. The fees of these
ongoing services usually are lower than conventional bank transfers.
3. Cryptocurrency: Cryptocurrency like Bitcoin and Ethereum are also
gaining popularity in India. Cryptocurrency permits users to transfer
money immediately at considerably lower charges as compared to
traditional bank transfers. However, usage of cryptocurrency as a
means for remittance is still testing waters in India. Since there are
issues about its legality and safety, cryptocurrency is an avoidable
option.
4. Prepaid Cards: Prepaid cards like Visa and Mastercard are also
becoming popular as a remittance option in India. These cards can
be loaded with cash and utilized to withdraw cash from ATMs or
make purchases at stores that accept credit or debit cards. Prepaid
cards are a convenient remittance option, since they do not require
the transmitter or receiver to have a bank-account.
5. Peer-to-Peer (P2P) Services: Peer-to-peer solutions like Transfer-wise
and Instarem enable users to move cash with other users in different
nations. These services use the mid-market exchange rate, which
is usually better than the rates offered by traditional remittance
services. P2P solutions also offer a quick and affordable option.
Challenges of Innovative Remittance Services: While innovative remittance
services offer many benefits over their traditional peers, they face several
challenges too. Some of the significant challenges are:
1. Limited Network: Some remittance services like cryptocurrency
and P2P are innovative in nature but have a very limited network,
rendering it difficult for users to find recipients in certain countries.
2. Lack of Regulation: The use of cryptocurrency for remittance
continues to be mostly unregulated in India, and also has issues
about its security and legality.

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3. Fraud: Fraud is really a concern that is significant in the remittance Notes

industry, and users must be careful when utilizing innovative
remittance services.
4. Exchange Rate Fluctuations: The exchange rate can fluctuate
quickly, and users have to be conscious of current exchange rate
before using innovative remittance services.
Conclusion: Innovative remittance services have revolutionized the
remittance industry in India. The solutions provided by these services
are fast, affordable, and convenient making them a popular choice over
their traditional counterpart.

1.8 Regulatory Institutions in India

Reserve Bank of India (RBI): It is the Central and Apex Bank of
India. Indian currency is issued and managed by the Reserve Bank of
India (RBI). On April 1, 1935, it opened for business as required by the
Reserve Bank of India Act, 1934. The Reserve Bank of India provides
funding for the government and commercial banks in India. It’s in charge
of keeping the Indian banking industry in check.
Various Functions of RBI Under the RBI Act, 1934 are as Follows:
Banker to the Government: The RBI serves as the government’s lender,
agent, and advisor. The fund raising for both Central and state governments
is taken care of by RBI. RBI raises money for the government by issuing
bonds, treasury bills.
Banker to Banks: The Reserve Bank of India (RBI) acts as a “Banker
to Banks,” providing short-term loans and advances to certain banks as
required to encourage lending to specific sectors and purposes. Banks
provide these loans in return for promissory notes and other security.
Lender of Last Resort: The RBI serves as lender of last resort to Bankers
in this capacity. When no one else is willing to give credit to that bank,
it can save a bank that is solvent but is experiencing short-term liquidity
issues by providing it with much-needed liquidity.
The RBI offers this facility to safeguard the interests of the bank’s
depositors and prevent potential bank failure, which might have a negative
effect on financial stability and, consequently, the economy.

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Notes Management of Currencies and Foreign Exchange: The RBI is in

charge of creating and overseeing the Indian Rupee. The Indian foreign
exchange market is governed by the RBI as well.
Monetary Policy: The RBI is responsible for developing and implementing
India’s monetary policy. It is effectively implemented and periodically
reviewed by the Central Bank to manage inflation, encourage economic
expansion, and preserve financial stability.
Functions of Public Debt: The RBI’s debt management strategy aims
to reduce borrowing costs, rollover and other risks, smooth the maturity
structure of debt, and enhance the depth and liquidity of the markets for
Government Securities by creating an active secondary market.
Regulation & Supervision of Banks and Co-operative Banks: The RBI
in its capacity as the Central Bank of India regulates and supervises banks
to ensure that they are safe, sound and adhere to good banking practises.
The RBI is authorized by law to conduct periodic inspections of financial
institutions and to obtain reports and other data from them. The standards
for Indian banking have improved greatly thanks to the RBI’s oversight
responsibilities. The RBI has extensive jurisdiction over commercial and
cooperative banks, including their licensing and establishments, branch
development, asset liquidity, management and working practices, merger,
reconstruction, and liquidation.
Regulation and Supervision of NBFCs: The RBI shall use all of the
aforementioned powers in the public interest, to regulate the nation’s
financial system to its advantage, or to prevent any NBFC from conducting
its business in a way that is harmful to depositor interests or adverse to
the NBFC’s own interests.
Financial Stability: The RBI is in charge of preserving the country’s
financial stability. In order to avert systemic risk, the RBI monitors the
financial system and takes appropriate action.
Promotional Role of RBI:
Additionally, the RBI promotes the Indian economy. The RBI accomplishes
this by aiding the public and private sectors financially, encouraging
financial inclusion, and expanding the Indian financial markets. The
Reserve Bank of India (RBI) is a vital part of the Indian economy. It
is crucial for the formulation and implementation of monetary policy,
banking sector oversight, and currency management.

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Some of the Promotional Roles of RBI are: Notes

u Providing Financial Assistance to the Government: The RBI provides
financial assistance to the government by buying government bonds
and treasury bills. This helps the government to finance its budget
deficit.
u Promoting Financial Inclusion: The RBI promotes financial inclusion
by encouraging banks to open branches in rural areas and by providing
financial products and services to low-income households.
u Developing the Financial Markets: The RBI develops the financial
markets in India by providing liquidity to the markets and by
promoting the development of new financial products and services.
The RBI plays a very important role in the promotion of the Indian
economy. It helps to ensure that the financial system is stable and that
it provides access to financial services to all segments of the population.
This helps to promote economic growth and development.
Securities and Exchange Board of India (SEBI):
The Securities and Exchange Board of India (SEBI) is the regulatory
body for India’s securities market. It began operations in 1988 and has
its headquarters in Mumbai. The Securities and Exchange Board of India
(SEBI) has two primary objectives: investor protection and the development
of the securities market. In this part, we’ll talk about the Securities and
Exchange Board of India (SEBI) and its role as an Indian regulator.
Role of SEBI as a Regulator:
1. Securities Market Regulation: SEBI is in charge of overseeing the
Indian securities market. The operation of stock exchanges, brokers,
depositories, and other market intermediaries are under its control.
New product approval, market infrastructure regulation, and the
establishment of securities trading regulations are all within the
purview of SEBI.
2. Investor Protection: SEBI safeguards the interests of investors by
promoting fair and open trading in securities, all businesses that
want to seek money from the public must follow SEBI’s Disclosure
and Investor Protection (DIP) guidelines. SEBI has framed these
guidelines so that retail investors make an educated decision. The

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Notes DIP set of standards requires that corporates disclose to investors

all pertinent information, including financial statements, board
resolutions, and related party activities:
u Investor Education: SEBI runs many programmes to educate
investors on the dangers associated with purchasing securities.
u Promoting Financial Literacy : SEBI makes many efforts works
to increase investor’s financial literacy. This helps investors
in understanding the benefits and hazards of making securities
investments.
u Redressal of Investor Complaints: SEBI has a very effective
procedure in place to address all types of investor complaints.
3. Regulation of Market Intermediaries: SEBI oversees the operations
of market intermediaries like brokers, investment consultants, and
portfolio managers. All of these middlemen are required to register
with SEBI. All intermediaries must complete a thorough registration
process to demonstrate that they are qualified and capable of serving
investors. In order to ensure that all SEBI regulations are rigorously
obeyed, SEBI has established a rigid code of conduct for them.
4. Enforcement: SEBI has the authority to impose sanctions on
businesses, market intermediaries, and individuals that disobey its
rules. It has the authority to impose sanctions, impose legal action,
or even suspend or revoke a market intermediary’s registration.
5. International Cooperation: SEBI collaborates with other regulators
and organizations globally to share information and best practices.
It has signed MoUs with regulators in various countries to facilitate
cooperation and exchange of information.
Benefits of SEBI as a Regulator:
1. Investor Protection: SEBI’s regulations and guidelines help protect
the interests of investors by ensuring fair and transparent trading
in securities. This has helped to increase investor confidence and
attract more investment into the securities market in India.
2. Efficient Market: SEBI’s regulatory framework has helped in creating
a more efficient and transparent securities market in India. This has
facilitated the smooth functioning of the market and reduced the
risk of market abuse.

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3. Innovation in Products: SEBI has encouraged the introduction Notes

of new products in the securities market, such as derivatives and
ETFs. This has provided investors with more options to diversify
their portfolios and has contributed to the growth of the securities
market.
4. International Recognition: SEBI’s regulatory framework has gained
recognition globally, which has helped in attracting foreign investment
into the securities market in India. This has contributed to the
growth of the Indian economy.
Challenges for SEBI as a Regulator:
1. Market Complexity: SEBI, as the regulator of securities markets
in India, faces the challenge of regulating a complex and dynamic
market environment. The rapid advancements in technology, the
emergence of new financial instruments, and the evolving market
practices require SEBI to stay vigilant and adapt its regulations to
ensure investor protection and market integrity.
2. Enforcement and Surveillance: Effectively enforcing regulations
and conducting surveillance activities to detect market manipulation,
insider trading, and other malpractices are significant challenges
for SEBI. With a large number of participants and vast amounts of
trading data, ensuring timely and effective enforcement actions can
be resource-intensive and require advanced technological capabilities.
3. Investor Education and Awareness: Promoting investor education
and awareness is crucial for the functioning of a healthy securities
market. SEBI faces the challenge of reaching out to a diverse
investor base, especially retail investors, and equipping them with
the necessary knowledge and skills to make informed investment
decisions. Enhancing financial literacy and investor protection
remains an ongoing challenge.
4. Technological Disruptions: The rapid advancement of technology in
the financial sector poses both opportunities and challenges for SEBI.
While technology has facilitated market efficiency and innovation,
it also brings risks such as cybersecurity threats, algorithmic trading
complexities, and the emergence of new business models that may
require regulatory adaptation and oversight.

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Notes 5. Coordination with Other Regulators: SEBI operates in conjunction

with other regulators in the financial ecosystem, such as the Reserve
Bank of India (RBI) and the Insurance Regulatory and Development
Authority (IRDA). Ensuring effective coordination and cooperation
among these regulators to address systemic risks and maintain overall
financial stability can be challenging, requiring ongoing dialogue
and information-sharing mechanisms.
SEBI’s ability to navigate these challenges requires a proactive approach,
continuous monitoring of market developments, capacity building, and
the adoption of advanced technologies. By addressing these challenges,
SEBI can enhance market integrity, investor confidence, and the overall
stability of the Indian securities markets.
IRDAI
The Government of India formed the independent IRDA, or Insurance
Regulatory and Development Authority of India, in 1999 to oversee
and advance the insurance industry. The insurance industry in India is
supervised and governed by this supreme organisation. The main goals of
the IRDA are to protect policyholder interests and promote the expansion
of insurance in the nation. All the Life Insurance and General Insurance
Companies operating in India are governed by IRDA.
Evolution of IRDAI
On the advice of the Malhotra Committee report, the Insurance Regulatory
and Development Authority (IRDA) was established as an independent
agency in 1999 to oversee and advance the insurance sector. In April
2000, the IRDA became a formal organisation. The IRDA’s main goals
include fostering competition to raise customer satisfaction by increasing
consumer choice and lowering premiums, all the while preserving the
insurance market’s financial stability.
The IRDA’s constitution, which permitted foreign businesses to own
up to 26% of the company, opened the market in August. According
to Section 114A of the Insurance Act of 1938, the Authority is able to
create regulations, and since 2000, it has done so with a variety of rules
covering everything from the registration of businesses engaged in the
insurance industry to the protection of policyholders’ interests.

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The General Insurance Corporation of India’s subsidiaries underwent Notes

an independent company restructuring in December 2000, and GIC was
simultaneously transformed into a national re-insurer.
The enormous insurance industry is expanding quickly, at a pace of 15-20%.
Insurance services together with banking services boost the nation’s GDP
by roughly 7%. A thriving and advanced insurance industry is beneficial
for economic growth as it increases the nation’s capacity to take risks
while providing long-term funding for infrastructure development.
Objectives of IRDA
The primary objective of IRDA is to ensure that all the insurance
companies follow provisions given in The Insurance Act. As per the
mission statement of IRDA, its main objectives are:
u Help India’s insurance industry expand.
u Safeguard policyholders’ interests and guarantee equitable resolution
of disputes.
u Ensure the financial soundness of insurance companies.
u Promote fair competition in the insurance sector.
u Regulate the insurance sector in a transparent and efficient manner.
u Review the regulations on a regular basis to eliminate any doubt
with respect to insurance rules.
IRDA has succeeded in attaining a number of its goals. Since the creation
of the IRDA, India’s insurance industry has experienced substantial
growth. At the end of March 2022, India had 67 active insurers, of
which 24 were life insurers, 26 were general insurers, 5 were stand-alone
health insurers, and 12 were re-insurers, including branches of overseas
reinsurers. Eight of the 67 insurers that are now in business are in the
public sector, and 59 are in the private sector. Ensuring the financial
stability of insurance businesses and defending the rights of policyholders
are other accomplishments of IRDA. In India, one of the main industries
for investment and employment is insurance. IRDA is trying to make
sure that the insurance industry is viable and that it offers policyholders
a reliable source of financial protection.

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Notes The insurance sector in India is governed by the Indian Insurance

Regulatory and Development Authority (IRDA), which does so in a
variety of ways, including:
u Issuing regulations and guidelines;
u Conducting inspections of insurance companies;
u Tracking the financial performance of insurance companies;
u Taking enforcement action against insurance companies that violate
regulations; and
u Raising public awareness of insurance.
Key Achievements of IRDA
u The insurance sector in India has grown significantly since the
establishment of IRDA. The Gross Written Premium (GWP) of
the insurance sector increased from Rs. 28,000 crore in 1999-2000
to Rs. 4,51,000 crore in 2020-21 while the number of insurance
companies operating in India has increased from 24 in 1999-2000
to 67 in 2021-22.
u Promoting Insurance Penetration: The Insurance Regulatory and
Development Authority of India (IRDA) has played a crucial role
in promoting insurance penetration in the country. By implementing
various initiatives and regulatory measures, IRDA has facilitated
the growth of the insurance sector, leading to increased insurance
coverage and financial protection for individuals and businesses.
u Enhancing Consumer Protection: IRDA has prioritized consumer
protection by implementing robust regulatory frameworks and
guidelines. It has mandated fair and transparent practices by insurance
companies, ensuring that policyholders are well-informed about
the terms and conditions of insurance policies. IRDA’s initiatives
have contributed to enhancing consumer trust and confidence in the
insurance industry.
u Strengthening Insurance Regulation: IRDA has been instrumental
in establishing and enforcing prudential norms and regulations for
insurance companies. It has set stringent capital adequacy requirements,
solvency ratios, and investment norms to ensure the financial
soundness and stability of insurance companies. By continuously

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monitoring and supervising insurers, IRDA has strengthened the Notes

regulatory framework of the insurance sector.
u Promoting Innovation and Market Development: IRDA has
encouraged innovation and market development within the insurance
sector. It has introduced regulations to facilitate the introduction of
new insurance products and services, including micro insurance and
customized policies. IRDA’s initiatives have promoted competition,
product diversity, and the expansion of insurance offerings to cater
to the evolving needs of consumers.
u Implementing Digital Transformation: Recognizing the importance
of technology in the insurance industry, IRDA has focused on
promoting digital transformation. It has facilitated the adoption
of digital processes, including online policy issuance, premium
payments, and claims settlement. This has not only improved
operational efficiency for insurers but also enhanced convenience
and accessibility for policyholders.
u Facilitating Reinsurance and Risk Management: IRDA has facilitated
the development of the reinsurance market in India. It has established
guidelines for reinsurance operations and encouraged the participation
of international reinsurers in the Indian market. By promoting
effective risk management practices, IRDA has contributed to the
stability and resilience of the insurance industry.
u Strengthening Corporate Governance: IRDA has emphasized the
importance of good corporate governance practices in the insurance
sector. It has implemented guidelines related to board composition,
disclosure requirements, and risk management frameworks for
insurers. By promoting sound corporate governance practices, IRDA
has enhanced transparency, accountability, and ethical conduct within
the industry.
Through these achievements, IRDA has played a vital role in nurturing a
robust and inclusive insurance sector in India. Its efforts have resulted in
increased insurance penetration, enhanced consumer protection, strengthened
regulation, market development, and the promotion of innovation and
digitalization in the insurance industry.

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Notes However, going forward, IRDA also faces many challenges in its quest to
promote insurance and protect consumer’s interest in the Indian Economy.
Some of the key challenges are:
1. Increasing Insurance Penetration: Despite the progress made, one
of the key challenges for the Insurance Regulatory and Development
Authority of India (IRDA) is to further increase insurance penetration
in the country IRDA needs to promote awareness, affordability, and
distribution channels to reach a wider customer base.
2. Addressing Underinsurance and Low Awareness: Many individuals
in India remain underinsured or lack awareness about the importance
of insurance. IRDA faces the challenge of educating the public
about the benefits and relevance of insurance, particularly in areas
such as health, life, and property insurance. Efforts to enhance
financial literacy and consumer education are crucial to overcome
this challenge.
3. Enhancing Consumer Protection: While IRDA has taken steps to
protect consumers’ interests, ensuring effective implementation and
enforcement of consumer protection regulations remains a challenge.
IRDA needs to continuously monitor insurance companies’ practices,
address issues related to mis-selling, improve the grievance redressal
mechanism, and empower consumers with timely and accurate
information to make informed decisions.
4. Managing Technological Disruptions: The insurance sector is
witnessing significant technological disruptions, including the rise
of insurtech, digital platforms, and advanced analytics. IRDA must
adapt to these changes and establish a regulatory framework that
balances innovation and consumer protection. It needs to address
challenges related to data privacy, cybersecurity, and the ethical use
of technology in insurance operations.
5. Strengthening Risk Management and Solvency: IRDA faces the
challenge of ensuring the financial stability of insurance companies
and safeguarding policyholders’ interests. It needs to continuously
monitor insurers’ risk management practices, solvency levels, and
investment strategies. Enhancing risk-based supervision and stress
testing frameworks will be essential to address potential risks and
vulnerabilities in the insurance sector.

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6. Promoting Long-Term Savings and Retirement Planning: Encouraging Notes

long-term savings and retirement planning is a significant challenge
for IRDA. It needs to develop policies and regulations that incentivize
individuals to invest in retirement products and annuities. Promoting
pension and annuity options, along with creating awareness about
their benefits, will be crucial for addressing the challenges associated
with an aging population and the need for long-term financial
security.
7. Coordinating with Other Regulators: Collaborating and coordinating
with other regulators, such as the Reserve Bank of India (RBI) and
the Securities and Exchange Board of India (SEBI), is essential for
IRDA. Addressing regulatory overlaps, harmonizing guidelines, and
ensuring seamless coordination among regulators is vital to maintain
stability and avoid regulatory arbitrage within the financial system.
Meeting these challenges requires IRDA to adopt a proactive approach,
engage in continuous dialogue with stakeholders, monitor global trends, and
update regulations to keep pace with market developments. By effectively
addressing these challenges, IRDA can foster a resilient and inclusive
insurance sector that meets the evolving needs of Indian consumers.
IRDA is working to address these challenges and is committed to ensuring
the continued growth and development of the insurance sector in India.
PFRDA
The Government of India established the Pension Regulatory and Development
Authority (PFRDA) in 2003 in accordance with the PFRDA Act 2013.
The PFRDA was established with the goals of promoting, regulating, and
developing the pension sector in India. All citizens of India, NRIs, and
independent contractors are eligible for PFRDA services. PFRDA has a
national office in New Delhi and regional offices all across the nation.
Objectives of PFRDA:
1. Development of Pension Sector: PFRDA aims to develop the pension
sector in India by creating a conducive environment for the growth
of pension funds and schemes. It collaborates with other stakeholders
to create a conducive environment for the growth of pension funds
and schemes.

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Notes 2. Protection of Subscriber Interests: PFRDA aims to protect the

interests of subscribers of pension funds by ensuring transparency
and accountability in the operations of pension funds.
3. Promoting Pension Coverage: PFRDA aims to promote pension
coverage in India by increasing the reach of pension funds and
schemes to more people.
4. Regulating Pension Funds: PFRDA aims to regulate the operations
of pension funds by setting standards for their conduct and ensuring
compliance with the regulatory framework.
PFRDA introduced the National Pension System, a voluntary defined
contribution retirement savings scheme. PFRDA administers and manages
the NPS, which provides individuals with a platform to accumulate
savings for their retirement years. The PFRDA also works to defend the
interests of pension savers by ensuring that the pension system is fair and
transparent. PFRDA is a strong organisation with several different duties.
As a regulator, PFRDA plays the following roles:
1. Registration and Regulation of Pension Funds: PFRDA is responsible
for registering and regulating pension funds in India. It sets standards
for the conduct of pension funds and ensures compliance with the
regulatory framework. PFRDA regulates the pension sector to ensure
that it is fair, transparent, and efficient. PFRDA has the power to
investigate and prosecute violations of pension regulations.
2. Approval of Pension Products: It is mandatory for all the pension
products and schemes offered by pension funds in India to be
approved by PFRDA. It ensures that these products and schemes
are in compliance with the regulatory framework and are suitable
for subscribers.
3. Promotion of Pension Awareness: PFRDA promotes awareness
about pensions and retirement planning among the general public.
It conducts pension awareness campaigns to provide information
about pension funds and schemes.
Monitoring of Pension Fund Managers: PFRDA grants licenses and
regulates Pension Fund Managers (PFMs) who manage the investments
of NPS subscribers. PFRDA monitors the operations of pension funds in
India to ensure compliance with the regulatory framework. It conducts

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inspections and audits of pension funds to detect any irregularities Notes

or misconduct. These PFMs are responsible for providing investment
options, managing the pension funds, and delivering returns based on
the subscribers’ chosen investment schemes:
1. Regulation and Oversight: PFRDA is responsible for regulating and
overseeing various entities involved in the pension system, including
pension fund managers, custodians, and central recordkeeping
agencies. It formulates and enforces regulations, guidelines, and
investment norms to ensure transparency, integrity, and safety in
the pension industry.
2. National Pension System (NPS): PFRDA introduced the National
Pension System, a voluntary retirement savings scheme, which
allows individuals to accumulate savings for their post-retirement
period. PFRDA administers and manages the NPS, including the
registration and enrollment of subscribers, as well as ensuring proper
investment and fund management.
3. Licensing and Supervision: PFRDA licenses and regulates Pension
Fund Managers (PFMs) who manage the investments of NPS
subscribers. It sets eligibility criteria, monitors their performance,
and takes necessary actions to protect the interests of subscribers.
PFRDA also supervises other service providers involved in the NPS,
such as custodians and recordkeeping agencies.
4. Technology Adoption: PFRDA adopts technology-driven solutions to
enhance the efficiency and accessibility of pension-related services.
It implements e-governance systems, online interfaces, and mobile
applications to facilitate easy enrolment.
5. Protecting the Interests of Pension Savers: PFRDA protects the
interests of pension savers by ensuring that pension funds are
sound, fair and transparent. It has also set up an effective grievance
redressal mechanism for subscribers.
6. Market Development and Awareness: PFRDA focuses on developing
and expanding the pension market in India. It undertakes initiatives to
increase awareness about the benefits of pension planning, conducts
promotional campaigns, and collaborates with various stakeholders
to encourage more individuals to participate in the NPS.

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Notes 7. International Collaboration: PFRDA collaborates with international

pension regulators and organizations to share best practices, learn
from global experiences, and benchmark India’s pension system
against international standards. This collaboration helps PFRDA in
adopting global best practices and improving the efficiency of the
Indian pension sector.
Through its regulatory oversight, market development initiatives, and
focus on subscriber welfare, PFRDA plays a vital role in fostering a
sustainable and inclusive pension system in India. Its efforts aim to
provide individuals with the means to secure their financial well-being
during retirement.
Functions of PFRDA:
u The primary goal of the PFRDA is to enhance long-term financial
security. This is done by creating and regulating pension funds,
safeguarding programme participants in pension fund schemes,
growing pension funds, and identifying issues with them.
u PFRDA is in charge of overseeing and managing the National Pension
System’s Tiers 1 and 2. In order to meet the income expectations
of workers upon retirement, PFRDA assists in the promotion and
encouragement of both mandatory and voluntary pension systems.
u PFRDA uses a number of middlemen, such as Central Record Keeping
Agency and Pension Fund Managers, to manage its operations.
u The PFRDA also underlines the importance of pensions and increases
public and stakeholder awareness of it.
u The PFRDA also trains intermediaries who are responsible for
educating society’s citizens about the value and relevance of pensions.
u Issues that develop between intermediaries, such as banks, customers,
and intermediaries, are also addressed and resolved by the PFRDA.
Benefits of PFRDA as a Regulator:
1. Protection of Subscriber Interests: PFRDA’s regulatory framework
ensures the protection of subscriber interests by setting standards
for transparency and accountability in the operations of pension
funds.

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2. Development of Pension Sector: PFRDA’s efforts have contributed Notes

to the development of the pension sector in India. It has created a
conducive environment for the growth of pension funds and schemes,
which has increased pension coverage in India.
3. Promoting Pension Awareness: PFRDA’s pension awareness campaigns
have helped in promoting awareness about pensions and retirement
planning among the general public. This has encouraged more people
to invest in pension funds and schemes.
4. Regulating Pension Funds: PFRDA’s regulatory framework ensures
compliance with the regulatory standards set for the conduct of pension
funds. This has reduced the risk of misconduct and irregularities in
the operations of pension funds.
Challenges for PFRDA as a Regulator:
1. Limited Pension Coverage: Despite PFRDA’s efforts, the pension
coverage in India remains low. Many people in the unorganized
sector still do not have access to pension funds and schemes.
2. Lack of Awareness: The lack of awareness about pensions and
retirement planning among the general public is still a challenge
for PFRDA. It needs to increase its efforts to promote awareness
about pensions.
3. Enforcement: PFRDA faces challenges in enforcing its regulatory
framework. It needs to have more resources and better enforcement
mechanisms to ensure compliance with the regulatory.

1.9 Answers to In-Text Questions

1. (d) All of these

2. (a) Specialised Banks

1.10 Self-Assessment Questions

1. What is the role of Reserve Bank of India in the Indian economy.
2. What is the difference between Payment Banks and Scheduled
Commercial Banks.

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Notes 3. IRDA is the regulator of Insurance sector in India. Elaborate on the

challenges faced by insurance sector in India.
4. The New Pension Scheme is a good option for Government employees.
However, we are yet to develop an effective Pension scheme for
the private sector employees. Comment.
5. Goods and Services Tax is a landmark reform in the Indian economy.
List the key advantages of GST over the previous indirect tax
regime.
6. Innovative Remittance Services have provided the much-needed relief
to Indians settled abroad in easing the process of sending funds to
India. Explain the innovative remittance instruments.

1.11 References/Suggested Readings

u Pathak, B. Indian Financial System (5th ed). Pearson Publication.
u Saunders, A. & Cornett, M.M. Financial Markets and Institutions
(3rd Ed). Tata McGraw Hill.
u Bhole L.M. and Mahakud J., Financial Institutions and Markets:
Structure, Growth, and Innovations (6th Edition). McGraw Hill
Education, Chennai, India.
u Jeff Madura, Financial Institutions and Markets, Cengage Learning
EMEA, 2008.
u Khan, M.Y. Financial Services (8th ed). McGraw Hill Education.

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L E S S O N

2
Introduction to Financial
Intermediation
CA. Vishal Goel
(CA, CFA, PGDBA, M. Com, CS, UGC-NET)
Sr. Mentor & Professor - IMS Proschool Pvt. Ltd.
Ex-adjunct Faculty Amity University
Ex-Associate Professor- IILM University
Email-Id: cavishalgoel7@[Link]

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Concept of Intermediation and Disintermediation
2.4 Merits and Demerits of Intermediation and Disintermediation
2.5 Kinds of Intermediaries
2.6 Flow-of-Funds in Indian Economy
2.7 Taxonomy of Financial Markets and Institutions
2.8 Regulatory Framework and Super-Regulation
2.9 Financial Sector Reforms and Contemporary Issues
2.10 Summary
2.11 Answers to In-Text Questions
2.12 Self-Assessment Questions
2.13 Suggested Readings

2.1 Learning Objectives

u Concept of Intermediation.
u Concept of Disintermediation.

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Notes u Difference between Intermediation and disintermediation.

u Kinds of Intermediation.
u Sources of Flow-of-Funds in Indian Economy.
u Taxonomy of Financial Markets and Institutions.
u Regulatory Framework and Super-regulation in Indian Financial
Markets.
u Financial Sector Reforms and Contemporary issues in Indian Financial
markets.

2.2 Introduction
Indian Financial Markets & Institutions
The history of Indian financial markets dates back to the early 19th century
when the British established the country’s first bank, the Bank of Bengal,
in 1806. In the following years, few other banks were established, and
the financial sector in India began to grow.
Reserve Bank of India (RBI) was established in 1935 to regulate the
banking system in the country. After independence in 1947, the government
of India initiated various measures to develop the financial sector in the
country. During 1960s and 1970s, the government nationalized major banks
to ensure that credit was available to priority sectors like agriculture and
small-scale industries.
Realising the importance of participation of general Public in the whole
financial system through investment in companies, the Indian capital market
was established in the mid-19th century and Bombay Stock Exchange
(BSE) was set up in 1875. The BSE is the oldest stock exchange in Asia
and the first in India. It was followed by the National Stock Exchange
(NSE), which was established in 1992.
In the 1990s, the Indian government introduced economic reforms to
liberalize the economy and promote private investment. These reforms
led to the emergence of new financial institutions, including Non-Banking
Financial Companies (NBFCs) and mutual funds. The government also
introduced new financial products like equity derivatives and interest
rate futures.

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In recent years, the Indian financial sector has witnessed significant Notes
growth, driven by factors like a growing middle class, increasing financial
literacy, and the rapid growth of the Indian economy. A fairly regulated
financial market is what drives public to financial system and help to
financial inclusion to a large extent.
India’s financial market has come of Ages and is consists of various
institutions that facilitate the transfer of funds between savers and borrowers.
All these institutions are largely regulated by the Reserve Bank of India
(RBI) and Securities and Exchange Board of India (SEBI).
Some of the major financial markets and institutions in India are:
Stock Market: The stock market in India is regulated by SEBI. As
mentioned above, The Bombay Stock Exchange (BSE) and National Stock
Exchange (NSE) are the two major stock exchanges in India. They provide
a platform for trading in equities, derivatives, options and other securities.
Debt Market: The debt market in India comprises of government securities,
corporate bonds, and other debt instruments. Various debt instruments
are, bonds, government securities and debentures.
Money Market: The money market in India deals with short-term financial
instruments like treasury bills, commercial papers, and certificates of
deposit. It is regulated by the RBI.
Mutual Funds: Mutual funds in India are regulated by SEBI and provide
an investment avenue for individuals to invest indirectly in equities, debt
instruments, and other securities.
Insurance: The insurance industry in India is regulated by the Insurance
Regulatory and Development Authority (IRDAI). The industry provides
various insurance products like life insurance, health insurance, and
general insurance.
Banking: The banking sector in India is regulated by the RBI and provides
various financial services like deposits, loans, and remittances. There are
various types of banks in India, including commercial banks, cooperative
banks, and regional rural banks.
Non-Banking Financial Companies (NBFCs): NBFCs in India are
regulated by the RBI and provide various financial services like loans,
leasing, and hire-purchase. They do not accept deposits like banks.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes These are some of the major financial markets and institutions in India.
The government of India has taken several measures to promote financial
inclusion and to increase the penetration of financial services in the
country increase the confidence of investors. We will discuss that in
further sections of this lesson.

2.3 Concept of Intermediation and Disintermediation

Intermediation and Disintermediation:
These two terms are commonly used in the financial sector to describe
the process of connecting buyers and sellers of financial products and
services and building layers or removing layers between them. Let’s
discuss them one by one.
Intermediation:
It refers to the process of introducing one or more intermediaries or
middlemen between buyers and sellers of financial products, such as
banks, brokers, or financial advisors, who facilitate the buying and selling
of financial products and services between two or more parties. For
example, a bank acts as an intermediary between a borrower and a lender
by providing loans to the borrower and taking deposits from the lender.
In a country like India where people used to have their savings kept at
home only, intermediation has played a crucial role in the financial sector,
particularly in banking and capital markets. The Indian banking system
comprises various intermediaries such as commercial banks, co-operative
banks, regional rural banks, and Non-Banking Financial Companies
(NBFCs). These intermediaries mobilize savings from households and
provide credit to businesses, thereby contributing to the growth of the
economy.
Earlier to this both borrowers and lenders were facing problems, For e.g.
Those who had money were unaware about the avenues to invest money
safely, so they used to park their funds either at home only or to private
individuals where the risk of default is very high. Similarly, those who
need money don’t know whom to approach and were largely dependent
on private money lenders who exploit them by charging heavy interest
and providing funds to them on terms and conditions which were not at
all favourable to them.

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Here are a Few Examples of Functions Intermediaries Provide: Notes

u An intermediary provides a place for clients to store money and
assets
u They provide a place where clients can store excess money
u They give counsel and advice on how and where to invest money
u They convert savings into investments
u They provide both long- and short-term loans to help finance
investments and assets
Disintermediation:
It refers to the process of bypassing intermediaries and connecting
buyers and sellers directly. This has been made possible with the rise of
technology. Ironically the intermediaries which were introduced to help
buyers and sellers of financial product were regarded as barriers by many
now, as the new generation want control in their hands at click of button
and don’t want to go through long process of documentation and visit any
intermediary physically at their location. The penetration of internet to
every corner of the country has led to the growth of disintermediation in
many industries, including finance. In the Indian context, disintermediation
has been enabled by various fintech platforms that allow consumers to
access financial products and services directly, at the click of a button
without the need for intermediaries.
For example, Peer-to-Peer (P2P) lending platforms in India enable borrowers
to connect directly with lenders, bypassing traditional intermediaries such
as banks. Similarly, digital payment platforms such as Paytm and PhonePe
allow consumers to make payments directly to merchants, without the
need for intermediaries such as banks or credit card companies.
In conclusion, both intermediation and disintermediation are required
depending on requirements and profile of borrowers and lenders and both
have their advantages and disadvantages. On one hand if intermediation
has been a key driver of financial inclusion and economic growth then on
the other hand disintermediation has the potential to increase efficiency,
speed up the process, reduce costs, and improve access to financial products
and services to every nook and corner of the country. One section of
population who is not very tech savvy still prefer intermediaries to guide
them even if they have to pay a little cost as commission to intermediary.

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Notes On the other hand, the section of population which has smart phones and
are tech savvy prefer quick direct access to financial products at low cost.

2.4 Merits and Demerits of Intermediation and Disinter-

mediation
Intermediation and disintermediation are two sides of the same coin, and
both have their merits and demerits in the Indian context.
Merits of Intermediation:
1. Specialised Services: Intermediaries bring their exclusive experience
along with the products and services they offer on the table, which
can be beneficial for consumers who may not have the same level
of knowledge or experience.
2. Financial Inclusion: Intermediaries such as banks and NBFCs have
played a crucial role in bringing financial services to untouched
corners of country and yet unserved populations in India.
3. Risk Management: Intermediaries help to minimise risks associated
with financial transactions by conducting due diligence and credit
analysis. So, on one side investor knows that his/her money is
in safe hands and on other hand borrower knows he will not be
unnecessarily exploited.
4. Economies of Scale: When borrower borrows money through
intermediary rather than a private individual, normally rate of
interest charged is much less. The cost of transaction is lower as
compared to transactions between 2 individuals like these days
buying Gold ETF through banks is more economical than physical
gold via jeweller if it’s for investment. All this is made possible
by economies of scale.
5. Liquidity: This is one very important benefit of intermediary and stock
exchanges are best example of this. One can liquidate investment of
lacs of Rupees by just giving instructions to the respective broker.
Based on current regulations, money will be credited in your account
in 2-3 days.
6. Timing: Intermediaries have access to vast market knowledge so
they can time the returns in much better manner than individuals.

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In this manner, they are able to reap higher monetary benefits for Notes
all the participants.
Demerits of Intermediation:
1. High Costs: Sometimes Intermediaries like banks add significant
costs to financial transactions in the name of commissions and
finance charges. This can be a burden for low-income consumers
and small businesses as compared to funds borrowed locally that
might be cheaper.
2. Low Degree of Penetration: Intermediaries still do not have 100%
penetration in the country. Some intermediaries may not serve certain
populations or geographies, which can limit access to financial
services for some people.
3. Different Goals: Sometimes intermediaries like stockbrokers or
mutual fund managers have different goals than the actual investor
and their personal biases may lead to different than expected results.
4. Too Much Documentation: Intermediaries may require client to
agree on too many terms and conditions to mitigate their own
risks. Most of the time clients don’t even know the real purpose
and content of so many documents that they sign.
Merits of Disintermediation:
1. Lower Costs: If we compare transactions done via intermediary and
transactions done after disintermediation then the latter one has lower
costs for financial transactions, as there are fewer intermediaries
involved.
2. Speed & Efficiency Through Automation: Disintermediation eliminates
the need for intermediaries to verify the documents and approve
transactions thereby reducing the time to process transaction with
minimal or no human interaction at all.
3. Innovation: Disintermediation can spur up the innovation in financial
products and services, as new players enter the market and compete
with traditional intermediaries.
4. Customised Products: With the introduction of technology, clients
especially lower- and middle-income groups can choose products
and customise as per their requirements at click of button, for e.g.,
Customer can choose tenure for EMI, amount of EMI etc.

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Notes 5. Large Reach: Disintermediation has led to high degree of penetration

in market so financial products and services are available to even
those who do not have access to financial institutions including
banks.
Demerits of Disintermediation:
1. Security Risks: Disintermediation expose consumers to security
risks, as they may be required to provide personal information to
third-party platforms. Many clients may not be very comfortable
for the same.
2. Lack of Regulation: Disintermediation can lead to a lack of regulation,
as new players enter the market and may not be subject to the same
level of control by the regulators as traditional intermediaries. We
have seen this in case of many On-the go loan apps available as
mobile apps. Many apps used to offer short-term loans instantly
to the public, but due to data privacy concerns, regulators later
prohibited several such apps.
3. Limited Access: Disintermediation may not be accessible to all
consumers, especially those who do not have access to technology
or who are not very comfortable conducting financial transactions
online.
To summarize, intermediation and disintermediation have both advantages
and disadvantages, and which option to choose depends on the particular
requirements and circumstances of each consumer or business. Finding a
balance between intermediation and disintermediation is crucial to ensure
that all consumers have access to cost-effective and secure financial
services.

2.5 Kinds of Intermediaries

So, from the above discussion it is quite evident that despites some of
its limitations, intermediaries play a critical role in financial markets by
facilitating transactions, managing risks, and providing valuable information
and advice to investors and borrowers.

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 Introduction to Financial Intermediation

There can be many categories of intermediaries depending upon basis of Notes

classification. Let us concentrate on more common kinds of intermediation
that exist in Indian financial markets.
The list includes but not limited to:
1. Banks: Banks are the most popular financial intermediaries in the
world. Banks act as intermediaries by accepting deposits from
customers and lending the funds to borrowers. They play a crucial
role in the financial system by facilitating transactions and managing
risk. They offer services in multiple specialties that include saving,
investing, lending, and many more. Now a days, one can buy
mutual funds, insurance as well as gold ETFs from bank.
2. Non-Bank Financial Intermediaries: These intermediaries include
insurance companies, pension funds, mutual funds, and other financial
institutions that pool funds from investors and invest them in various
assets. They offer almost all services just like banks except that they
do not perform retail banking functions and do not offer savings
or current accounts for customers.
3. Stock Market & Brokers: Once buying corporate stocks was a
long and tedious process. In order to simplify it, stock exchanges
were invented. Stock exchanges serve as vast platforms where
individuals can submit orders to buy or sell securities of specific
companies, among many others. In these exchanges, individuals
looking to sell their securities can find interested buyers, and vice
versa. By acting as intermediaries, stock exchanges facilitate these
transactions and, in exchange for minimal fees, provide valuable
assistance to both parties involved. Stock exchange also serves as
a platform for companies to raise funds through IPO or FPO. Stock
exchange further take help from brokerage firms, Depositaries and
Custodians to smoothen the whole process.
4. Investment Bankers: Investment bankers assist companies in raising
capital by underwriting new securities offerings, such as IPOs. They
also provide advice on mergers and acquisitions and other strategic
transactions.
5. Lead Managers: The role of lead managers, also known as book
runners, is crucial in the process of issuing securities, particularly in

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Notes Initial Public Offerings (IPOs) and other large-scale offerings. Lead
managers are typically investment banks or financial institutions
that assist the issuer in navigating the complexities of the issuance
process and ensure its successful execution. Lead managers serve as
trusted advisors and facilitators throughout the securities issuance
process.
6. Book Builders: Book builders play a crucial role in the process of
pricing and allocating securities in an offering, particularly in the
context of Initial Public Offerings (IPOs) or follow-on offerings.
Book building refers to the process of generating and managing
the order book for the securities being offered. Book builders are
typically investment banks or financial institutions that facilitate
this process.
7. Market Makers: Market makers facilitate trading in financial markets
by buying and selling securities, providing liquidity to the market.
8. Credit Rating Agencies: Credit rating agencies provide information
on the creditworthiness of borrowers, helping investors to assess
the risks associated with investing in certain securities.

2.6 Flow-of-Funds in Indian Economy

The Flow-of-Funds in the Indian economy refers to the movement of
funds between various sectors, institutions, and agents in the economy. In
India, the Reserve Bank of India (RBI) is responsible for compiling and
publishing the flow-of-funds statement. This statement tracks the sources
and uses of funds in the economy and provides valuable insights into
the financial behaviour and health of different institutions and sectors.
It includes financial transactions of various sectors such as households,
businesses, government, and the external sector, and highlights sources
and uses of funds such as domestic savings, foreign savings, investment,
lending, borrowing, and capital flows.
Policymakers, investors, and analysts rely on the flow-of-funds statement
to understand the financial position of different institutions and sectors in
the economy. It also helps identify potential imbalances and vulnerabilities
that may require policy interventions. Based on this, both Ministry of

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finance and RBI made their policies to support particular weak sectors Notes
of the economy by prioritising loans disbursal to such sectors.
So, to conclude the statement of flow-of-funds in the Indian economy
provides a comprehensive understanding of the financial transactions and
positions of various institutions and sectors, which is crucial for informed
decision-making and policy formulation.

2.7 Taxonomy of Financial Markets and Institutions

By now we know that the financial market is a marketplace where
the creation and trading of financial assets, including shares, bonds,
debentures, commodities, etc., is done. Financial markets can also be
described as intermediaries between those who need funds (generally
businesses, government, etc.) and those who have funds (typically investors,
households, etc.). It mobilizes funds between them, helping allocate the
country’s limited resources.
The financial markets can be classified into four categories:
1. By Nature of Claim
2. By Maturity of Claim
3. By the Timing of Delivery
4. By Organizational Structure
Let’s delve into each category in detail:
1. Based on Nature of Claim
Markets can be classified by the type of claim investors have on the
entity’s assets they’ve invested in. There are two types of claims:
fixed and residual. Consequently, two markets exist:
(a) Debt Market
The debt market involves the trading of debt instruments like
debentures and bonds, which have fixed claims on the entity’s
assets up to a certain amount. Additionally, these instruments
generally carry a fixed coupon rate, commonly known as
interest, for a specific period. These instruments generally
do not have any right to participate in management of entity
issuing them.

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Notes (b) Equity Market

Equity instruments are traded in this market. Equity represents
the owner’s capital in the business and has a residual claim.
After paying off the fixed liabilities, whatever remains in the
business belongs to equity shareholders, regardless of the face
value of their shares. These instruments generally have any
right to participate in management of entity issuing them.
2. Based on Maturity of Claim
The maturity period of an investment affects the amount and risk
profile of the investor. There are two markets based on the maturity
of the claim:
(a) Money Market
Investors who want to invest for no longer than a year
enter the money market, where short-term funds are traded.
This market deals with monetary assets like treasury bills,
commercial paper, and certificates of deposit, and all these
instruments have a maturity period of not more than a year.
These instruments carry low risk and offer a reasonable rate
of return for investors, usually in form of interest.
(b) Capital Market
The capital market trades instruments with medium- and long-
term maturity. It is the market where maximum interchange of
money occurs, and it helps companies access money through
equity capital and preference share capital. Investors can invest
in the company’s equity share capital and be a party to the
profits earned by the company. The capital market further has
two verticals:
(i) Primary Market: Where a company lists security for the
first time, or an already listed company issues fresh
security.
(ii) Secondary Market: Once a company lists the security, it
becomes available for trading over the exchange between
investors.

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3. Based on Timing of Delivery Notes

The timing of delivery of the security is another factor that
distinguishes markets into two parts, mainly in the secondary market
or stock market:
(a) Cash Market
In this market, transactions are settled in real-time, requiring
investors to pay the total investment amount through their
funds or borrowed capital, known as margin.
(b) Futures Market
The delivery or settlement of security or commodity occurs
later in this market. Therefore, transactions in such markets are
generally cash-settled, and a margin up to a certain percentage
of the asset amount is sufficient to trade in the asset.
4. Based on Organizational Structure
Markets can also be classified based on their organizational structure,
i.e., how transactions are conducted:
(a) Exchange-Traded Market
A centralized market that works on pre-established and
standardized procedures, the exchange-traded market, involves
transactions entered with the help of intermediaries, who ensure
the settlement of transactions between buyers and sellers.
Standard products are traded in this market, so customized
products are not required.
(b) Over-the-Counter Market
This decentralized market allows customers to trade customized
products based on their requirements. In this market, buyers
and sellers interact with each other, and transactions usually
involve hedging foreign currency exposure and exposure to
commodities. These transactions occur over the counter as
different companies have different maturity dates for debt,
which generally does not coincide with the settlement dates
of exchange-traded contracts.

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Notes Over time, financial markets have gained importance in fulfilling capital
requirements for companies and providing investment avenues to investors
in the country. Financial markets offer transparent pricing, high liquidity,
and investor protection from frauds and malpractices.
Apart from these Popular types of financial markets there are other
important financial institutions which play important role in development
of an economy and maintaining flow of funds which we have discussed
under the section intermediaries. Some of them are:
Banks: Banks accept deposits from customers and lend the funds to
borrowers, earning interest on the loans.
NBFC’s: Non-bank financial institutions include insurance companies,
pension funds, mutual funds, and other financial institutions that pool
funds from investors and invest them in various assets.
Investment Banks: Investment banks assist companies in raising capital
by underwriting new securities offerings, providing advice on mergers
and acquisitions, and other strategic transactions.
Brokerage Houses: firms facilitate trades between buyers and sellers in
financial markets and earn commissions on the transactions they execute
on behalf of their clients.
CRA’s: Credit rating agencies provide information on the creditworthiness
of borrowers, helping investors assess the risks associated with investing
in certain securities.

2.8 Regulatory Framework and Super-Regulation

For any financial market to grow and remain relevant on a global scale, it
is imperative to have a dependable and standardized regulatory framework
in place. Indian financial market has also come of ages and in the process
of making it globally competitive lot of regulatory frameworks were
developed and implemented which were much appreciated by even global
counterparts. The regulatory framework in Indian financial markets refers
to the set of rules, regulations, and guidelines that govern the functioning
of financial market participants. The regulatory framework is designed to
ensure that financial markets operate in a fair, transparent, and efficient

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manner, and that investors are protected from fraudulent activities and Notes
market manipulation.
The regulatory framework for Indian financial markets is overseen by
multiple regulatory bodies such as the Reserve Bank of India (RBI),
Securities and Exchange Board of India (SEBI), Insurance Regulatory
and Development Authority of India (IRDAI), and Pension Fund
Regulatory and Development Authority (PFRDA), among others. Each
regulatory body has a specific area of focus, and together they work to
create a comprehensive regulatory framework for the Indian financial
markets:
1. The Reserve Bank of India (RBI) is the apex monetary institution
in India. RBI is India’s central bank, established under the RBI
Act of 1934 and is responsible for numerous functions under the
Banking Regulation Act of 1949.
2. The Securities and Exchange Board of India (SEBI) protects the
interest of investors in securities and also promotes the development
and regulates the securities market. It was established in 1992 under
the Securities and Exchange Board of India Act, 1992.
3. The Insurance Regulatory and Development Authority of India
(IRDAI) is the authority that regulates insurance in India. It was
established under the Insurance Regulatory and Development
Authority Act of 1999.
4. The Pension Fund Regulatory and Development Authority (PFRDA)
regulates the pension scheme in India. It regulates the National
Pension Scheme (NPS) and Atal Pension Yojana (APY). It was
established under the PFRDA Act, 2013.
Furthermore, in Indian financial markets, there exists the concept of
super-regulation, which involves a single entity or regulator overseeing
multiple regulators. The primary goal of super-regulation is to prevent
regulatory overlap and ensure efficient coordination within the regulatory
framework. The idea was initially introduced by the Financial Sector
Legislative Reforms Commission (FSLRC) in 2013, which proposed the
creation of a unified financial regulator known as the Indian Financial
Code. This regulator would streamline the regulatory framework and
oversee all financial market regulators.

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Notes The Financial Sector Legislative Reforms Commission (FSLRC) made

several key recommendations to improve the regulatory framework in
the Indian financial markets. These included the need for a uniform
legal process for financial sector regulators that emphasized the rule of
law, along with the creation of independent regulators with clear goals,
powers, and accountability.
Another important recommendation was to ensure that every entity operating
in the financial space was under the oversight of a financial regulator. The
FSLRC also emphasized the importance of consumer protection, which it
saw as the ultimate objective of financial sector regulation. This included
focusing on prevention and cure of consumer grievances, with financial
regulators responsible for the former and a proposed Financial Redressal
Agency (FRA) responsible for the latter. The FRA would span across the
financial sector and provide a feedback loop to regulators to help them
address consumer grievances with appropriate regulations.
Finally, the FSLRC recommended the creation of a resolution mechanism
to address the failure of financial firms and to protect consumers. This
mechanism would also manage the deposit insurance scheme.
However, the proposal has yet to be implemented fully, and the current
regulatory framework remains under the supervision of multiple regulatory
bodies. Nevertheless, efforts are being made to strengthen the regulatory
framework and promote greater coordination among regulators to ensure
the stability and growth of Indian financial markets.

2.9 Financial Sector Reforms and Contemporary Issues

Financial sector reforms in India refer to the measures taken by the Indian
government to develop and strengthen the financial sector of the country.
These reforms were initiated in 1991 with the objective of liberalizing and
deregulating the financial sector, making it more efficient and competitive,
and integrating it with the global economy.
The major financial sector reforms introduced in India since 1991 include
the establishment of new institutions as discussed in previous section,
like the Securities and Exchange Board of India (SEBI), the Insurance
Regulatory and Development Authority (IRDA), and the Pension Fund
Regulatory and Development Authority (PFRDA), liberalization of foreign

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investment, deregulation of interest rates, and the introduction of new Notes

financial instruments like derivatives and securitization.
The reforms have led to significant changes in the Indian financial sector,
with increased competition, improved efficiency, and greater access to
financial services. They have also contributed to the growth of the Indian
economy and its integration with the global economy.
Then in last 10 years various financial sector reforms sometimes referred
as JAM (Jan Dhan Bank Accounts, Aadhaar linking and Mobile banking
and other financial services available on mobiles). All this was aimed at
financial inclusion of the large section of population which up to now
don’t have access to financial products and services.
However, there are still several challenges that need to be addressed in
the Indian financial sector, such as improving financial inclusion, ensuring
financial stability, and addressing issues related to Non-Performing Assets
(NPAs) and corporate governance. The Indian government and regulatory
authorities continue to work towards addressing these challenges and
further developing the financial sector.
Here are a few contemporary issues faced by Indian Financial Sector:
u Non-Performing Assets (NPAs): The Indian banking system has been
grappling with high levels of Non-Performing Assets (NPAs) or bad
loans. This has been a persistent problem in the Indian banking
sector and has had a negative impact on the health of banks and
the overall economy.
u Corporate Governance: Corporate governance has become a
significant issue in the Indian financial markets, especially in the
wake of a number of corporate scams and failures. The need for
greater transparency and accountability in corporate governance
practices has become increasingly important.
u Digital Transformation: The Indian financial markets have been
undergoing a significant digital transformation, with the rapid
adoption of new technologies and the emergence of new players
in the fintech space. This has led to new challenges related to
cybersecurity, data privacy, and regulatory oversight.
u Financial Inclusion: Despite significant progress in recent years,
financial inclusion remains a key challenge in the Indian financial

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Notes markets. A large portion of the population, especially in rural areas,

still lacks access to basic financial services and products.
u Challenges in Capital Markets: The Indian capital markets have
been facing several challenges related to liquidity, volatility, and
the overall investment climate. There is a need for greater investor
confidence and participation in the capital markets to support the
growth of the economy.

IN-TEXT QUESTIONS
1. The secondary market is a platform in which:
(a) Only earlier allotted securities are being traded among
investors
(b) Investors trade in new securities
(c) Individually cannot participate
(d) None of these
2. The capital market is organized in India by?
(a) RBI
(b) NABARD
(c) SEBI
(d) IRDA
3. Which of the below mentioned is not the objective of SEBI?
(a) To regulate the securities market
(b) To protect the interests of inventors
(c) To promote individual businesses
(d) To promote the development of the market

2.10 Summary
Intermediation and Disintermediation:
These two terms are commonly used in the financial sector to describe
the process of connecting buyers and sellers of financial products and
services and building layers or removing layers between them. Let’s
discuss them one by one.

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Intermediation: Notes
It refers to the process of introducing one or more intermediaries or
middlemen between buyers and sellers of financial products, such as
banks, brokers, or financial advisors,
Disintermediation:
It refers to the process of bypassing intermediaries and connecting buyers
and sellers directly. This has been made possible with the rise of technology.
Merits of Intermediation:
1. Specialised services
2. Financial inclusion
3. Risk management
4. Economies of scale
5. Liquidity
6. Timing
Demerits of Intermediation:
1. High cost
2. Low degree of penetration
3. Different Goals
4. Too much documentation
Merits of Disintermediation:
1. Lower costs
2. Speed & Efficiency through automation
3. Innovation
4. Customised products
5. Large reach
Demerits of Disintermediation:
1. Security risks
2. Lack of regulation
3. Limited access

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Notes The List of Intermediaries Includes but not Limited to:

1. Banks
2. Non-bank financial intermediaries
3. Stock Market & Brokers
4. Investment bankers
5. Market makers
6. Credit rating agencies
The Flow-of-Funds in the Indian economy refers to the movement of
funds between various sectors, institutions, and agents in the economy. In
India, the Reserve Bank of India (RBI) is responsible for compiling and
publishing the flow-of-funds statement. This statement tracks the sources
and uses of funds in the economy and provides valuable insights into
the financial behaviour and health of different institutions and sectors.
The financial markets can be classified into four categories: –
By Nature of Claim
u Debt Market
u Equity Market
By Maturity of Claim
u Money Market
u Capital Market
By the Timing of Delivery
u Cash Market
u Futures Market
By Organizational Structure
u Exchange-Traded Market
u Over-the-Counter Market
Regulatory Framework of Indian Financial Market
The regulatory framework for Indian financial markets is overseen by
multiple regulatory bodies such as the Reserve Bank of India (RBI),
Securities and Exchange Board of India (SEBI), Insurance Regulatory and
Development Authority of India (IRDAI), and Pension Fund Regulatory

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and Development Authority (PFRDA), among others. Each regulatory Notes

body has a specific area of focus, and together they work to create a
comprehensive regulatory framework for the Indian financial markets.
Reserve Bank of India (RBI)
Financial Sector Reforms
Financial sector reforms in India refer to the measures taken by the Indian
government to develop and strengthen the financial sector of the country.
These reforms were initiated in 1991 with the objective of liberalizing and
deregulating the financial sector, making it more efficient and competitive,
and integrating it with the global economy.
Contemporary Issues Faced by Indian Financial Sector:
1. Non-Performing Assets (NPAs)
2. Corporate Governance
3. Digital Transformation
4. Financial Inclusion
5. Challenges in Capital Markets

2.11 Answers to In-Text Questions

1. (a) Only earlier allotted securities are being traded among investors
2. (c) SEBI
3. (c) to promote individual businesses

2.12 Self-Assessment Questions

1. What are the main objective of introducing intermediaries in the
financial markets?
2. What are the advantages and disadvantages of disintermediation?
3. Briefly describe any 5 intermediaries in Indian financial Markets.
4. What are various regulators in Indian Financial markets? Also briefly
discuss concept of super regulator.

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Notes 5. Discuss briefly any 5 contemporary issues faced by Indian financial

markets. Also discuss various recent reforms in Indian financial
markets

2.13 Suggested Readings

u Bharti. V. Pathak Indian Financial System, 5e, Pearsons
u Frederic S. Mishkin, Stanley Eakins - Financial Markets and Institutions,
8/e, Pearsons
u I. M Bhole, Jitendra Mahakud - Financial Institutions and Markets:
Structure, Growth & Innovation|6th Edition, McGraw Hill Education.

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L E S S O N

3
Depository Institution
of Banking
Chandni Jain
Assistant Professor
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 Overview of Banking
3.4 Principles of Lending and Credit Creation
3.5 Products and Services Offered by Banks
3.6 Banking Regulations
3.7 Role of Market Regulator
3.8 Key Players in Market
3.9 Evaluation of Banking Sector in India
3.10 Summary
3.11 Answers to In-Text Questions
3.12 Self-Assessment Questions
3.13 References/Suggested Readings

3.1 Learning Objectives

u Get an overview of banking.
u Know the types of products & services offered by banks.
u Understand banking regulations and role of market regulator.

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Notes u Know the key market players.

u Evaluate the banking sector in India.

3.2 Introduction
A depository is a place where something is kept for protection or stor-
age. Therefore, a depository can be an organisation, a structure, or a
warehouse where people and companies deposit any important item for
safekeeping. The money stored in a depository is utilised for lending to
other persons and businesses as well as investing in other assets, thereby
supplying liquidity to the exchange market.

SAVERS BORROWERS
(Having excess Depository (Facing fund
funds) Institutions deficit)

A depository can thus be defined as follows:

“A depository is a financial institution or organisation that facilitates the
purchase and sale of financial products, such as stocks and bonds, and
takes deposits from both corporations and people. To avoid the risk of
holding them, the public can park their precious assets with such finan-
cial institutions.”
Types of Depository Institutions
The following are the three main categories of depository institutions:
Banks
A bank is a type of financial institution authorised to accept deposits
and grant loans for checking and savings accounts. Individual Retirement
Accounts (IRAs), Certificates of Deposit (CDs), currency exchange,
and safe deposit boxes are other services that banks offer. Retail banks,
commercial banks and investment banks are different types of banks. We
mainly talk about commercial banks here. Commercial banks are for-profit
businesses that are typically owned by individual investors. The size
of the commercial banks affects the range of services offered by them.

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For instance, the smaller banks only provide banking for consumers, Notes
mortgages and loans, deposits, banking for small businesses and other
services. On the other hand, bigger banks and international banks provide
a wide range of services like money management, investment banking and
services linked to foreign currency. Larger, international banks may also
provide services to other banks and corporations. Among all depository
institutions, the large banks’ service offerings are the most varied.
Credit unions
As financial cooperatives, credit unions mean that the owners of these
depository organisations are people who belong to a certain group. Either
the members receive dividends from the union’s earnings or the money
is put back into the business. Credit union members are the ones with
accounts in the organisation. As a result, depositors are paid dividends
and are part owners as well. Credit unions are non-profit organisations,
thus they do not pay taxes. As a result, credit unions charge lower interest
rates on loans while paying higher rates on deposits.
Thrift institutions/Savings Institutions
Savings institutions are the local community banks and lending insti-
tutions. Local people deposit money in the banks and the banks offer
those deposits as loans for small enterprises, credit cards, mortgages
and consumer loans in return. Savings banks are occasionally set up as
companies or organised as financial cooperatives, giving their depositors
a stake in the business.
Depository institutions offer the following four crucial services to the
economy:
u Safekeeping services
u Cheque and e-transfer payment system
u Pooling the savings of many savers for loans to individuals and
businesses &
u Investing in securities.

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Notes 3.3 Overview of Banking

3.3.1 Meaning of Bank

Financial institutions differ from one country to other depending on the

overall economic structure of the respective nation. One of the most sig-
nificant financial organisations in the economy and the main providers
of credit are banks. A bank is typically thought of as an institution that
deals with accepting deposits and loaning money. It is more than just
a location for money depositing and lending. It also takes care of the
financial issues that its clients face.
A bank is a type of financial institution that deals with loans, deposits
and other services. It accepts deposits from people who wish to save
money and lends money to people who need it. The gap between savers
and borrowers is closed by it. Banks typically set themselves apart from
other kinds of financial companies through the offering of deposit and
loan products. Deposit products release funds at request or with advance
notice. For banks, deposits are liabilities that must be handled if they
are to operate profitably.

3.3.2 Meaning of Banking

Banking is the commercial activity of receiving, securing and then lending

out money that belongs to other people or entities in order to make a
profit. Banking is defined as the accepting, for the purpose of lending,
or investment of deposits, money from the public, repayable on demand
or otherwise and withdrawable by cheque, draft or order.
Simply stated, Bank is an organization or a company and Banking is the
business activity of a bank.

3.3.3 Features of banking

The fundamental traits of banking are:

(i) Dealing with money: Banks receive public deposits and lend the
same amount as loans to those in need. Deposits might be made into

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many sorts of accounts, including current account, fixed account, Notes

savings account, etc. The terms and conditions under which deposits
are accepted vary.
(ii) Deposits must be withdrawable: The public’s deposits (aside from
fixed deposits) may be withdrawable by cheques, drafts or other
means. In other words, the bank may issue and pay cheques. Most
deposits allow for immediate withdrawal.
(iii) Creation of credit: The only institutions capable of creating credit
or extra money, for lending, are banks. As a result, “creation of
credit” is a distinctive feature of banking.
(iv) Commercial in nature: All banking operations are conducted with the
intention of generating profit. So, banks are viewed as commercial
in nature.
(v) Agency nature: In addition to performing the fundamental role of
accepting deposits and disbursing funds in the form of loans, banks
also have the characteristics of an agent because of the range of
agency services they offer.

3.3.4 How do banks work?

Banks receive deposits from their customers. These deposits are liability
for banks as the money originally belongs to customers. Banks pay inter-
est on these deposits to the customers. These deposits are used by banks
to give out loans and advances to customers. The banks charge interest
on these loans given by them. The interest charged on loans is higher
than the interest paid on deposits. This is how banks earn. For instance,
a bank might charge mortgage customers an annual interest rate of 6%
while offering savings account customers an annual interest rate of 4%.

Deposits Loans
Customers Banks Customers
Interest paid Interest
received

Service fees and levies are another revenue source for banks. Account
fees (monthly maintenance fees, minimum balance fees, overdraft fees

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Notes and non-sufficient funds [NSF] penalties), safe deposit box fees, and late
fees are some examples of these charges, which vary depending on the
products. In addition to interest fees, many loan packages also include
other charges or fees.
IN-TEXT QUESTIONS
1. Bank is a type of depository institution. (True/False)
2. Interest earned by banks is greater than interest paid.
(True/False)
3. Bank is an organisation whereas banking is the business activity
of bank. (True/False)

3.4 Principles of Lending and Credit Creation

u Principle of safety
The most crucial rule of responsible lending is “safety first”. A
banker must be confident, before making a loan. It must be made
sure that the advance is secure, meaning that the money will surely
be repaid. The advance would be at risk, for instance, if the borrower
used the funds for a speculative or unprofitable endeavour or if he
or she was dishonest. Similarly, it could be challenging to collect
the money if the borrower experiences losses in his firm as a result
of his incompetence. The banker should make sure that the money
advanced as loan goes to the right kind of borrower and is used
in a way that ensures its safety (not only at the time of lending
but also throughout) and is repaid with interest after serving a
useful purpose in the trade or industry where it was employed.
A commercial bank receives consumer deposits and invests them.
But because it is using the investors’/depositors’ funds to give out
loans, it puts the security of the funds first.
u Principle of liquidity
A commercial bank provides two different kinds of deposits:
Demand deposits, which the bank must repay immediately on customers’
demand, similar to a savings account and time deposits, which the
bank must repay when a predetermined time period is over.

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Additionally, clients withdraw and deposit cash every day. Therefore, Notes
to satisfy consumer demand for cash, all commercial banks are
required to maintain a specific amount of cash in their possession.
It is not enough that the money will return; it also needs to do
so immediately upon request or in accordance with the payback
terms that have been established. When a repayment demand is
made, the borrower must be able to pay back the debt in a timely
manner. This is only conceivable if the borrower uses the funds
for short term needs and does not tie them up in the purchase of
fixed assets or in long-term investment schemes. Additionally, the
source of repayment must be specified. Bankers value ‘liquidity’
as highly as they value the safety of their funds because most of
their deposits are repaid quickly or on demand.
Despite the safety of the advances, the banker’s capacity to meet
requests would be severely hampered if sizable amount of capital is
lent to borrowers from whom repayment would come in gradually.
An advance of Rs. 50 lakhs, for instance, will be quite safe if it
is secured by a valid mortgage on a bungalow with a market value
of Rs. 100 lakhs. However, it can take several years to retrieve the
mortgage money if a legal procedure is required. Although safe,
the loan is not liquid.
u Principle of profitability
The idea of “profitability” is also crucial in bank advances since,
like other commercial institutions, banks need to turn a profit. First
of all, they must pay interest on the deposits they have received.
They must pay for their facility, their rent, their office supplies, etc.
They must account for both the depreciation of their fixed assets
and any potentially bad loans. A reasonable profit must be earned
after covering all of these expenses that are included in a bank’s
operating costs; otherwise, it won’t be possible to add anything to
the reserve or distribute dividends to shareholders.
A bank determines its loan rate after taking all of these considerations
into account. Sometimes a particular transaction might not seem
profitable in itself. But there might be some ancillary business of
the borrower and such deposits from the borrower’s other businesses
might be very lucrative. This might make the transaction beneficial for

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Notes the bank as a whole. However, it should be emphasised that lending

rates are influenced by the Bank Rate, interbank competition, and,
if applicable, Central Bank directives (such as those of the Reserve
Bank of India). The rates may also vary according to the borrower’s
credit, the security’s kind, the method of charge, the form and type
of advance, such as a cash advance or some another type.
u Principle of diversification of risks
The diversity of advances is a key component of sound lending.
No matter how solid a loan may seem, there is always a certain
amount of risk involved. Actually, taking measured risks is at the
heart of the banking industry and a successful banker is skilled at
doing so. He is interested in distributing the risks associated with
lending among a large number of borrowers, industries and geographic
regions as well as across various assets. For instance, if someone
has bet too much of his money on a single class of securities, he
runs a significant risk if that class of securities sharply declines in
value.
The bank receives a wide range of securities against the advances if
it has several branches dispersed throughout the nation. The theory
behind diversification is that not all industries and businesses are
affected by a downturn at once.
u Principle of purpose
The goal should be productive so that the funds remain safe and
have a reliable source of repayment. Additionally, the goal should
be short-term to guarantee liquidity. Banks prohibit customers from
using loans for speculative or stockpiling purposes. Apart from the
fact that such transactions are anti-social, there are obvious risks
associated with them. The banker must carefully examine the need
for the funds and make every effort to guarantee that the borrower
uses the funds in accordance with the purpose for which they were
borrowed.
u Principle of security
Banks have a policy of not lending unless security is provided. Security
is viewed as an insurance policy or a safety not to rely on, in an
emergency. For the banker, it allows for an unforeseen circumstance

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change that could have an impact on the loan’s safety and liquidity. Notes
The banker simply takes security in order to protect himself from
such occurrences. Should the well-planned and almost assured source
of repayment unexpectedly falter, he will be able to realise it and
reimburse himself. A loan proposal should not be evaluated just in
terms of security. A good banker will only approve a loan if it is
warranted, which means that they will consider its safety, likely use
and other factors as well as the borrower’s character, capacity and
capital in addition to the security’s quality. In addition to acting
as a safety valve in case of an emergency, taking security makes
it very challenging, if not impossible, for the borrower to obtain a
secured advance from another source against the same security.
u Principle of national interest and suitability
Even if an advance/loan complies with all of the aforementioned
rules, it may still not be appropriate. The advance might not be in
the country’s best interests. The Reserve Bank of India, for example,
may have issued a regulation forbidding banks from allowing a
specific sort of advance. The borrower’s business location may not
be in an environment that is conducive to law and order. There
might be additional similar-natured reasons why the bank shouldn’t
approve the advance. In the evolving idea of banking, purposes of
advances, proposals’ feasibility and national interests are taking
on greater importance than security, particularly in advances to
agriculture, small businesses, small borrowers and other industries.
u Principle of solvency
Commercial banks need to be stable financially. Additionally, they
must continue to have the necessary funds on hand to manage the
bank.
u Principle of providing services
Typically, commercial banks are service-oriented institutions. And
good service guarantees a better reputation and thus, profits.
u Principle of secrecy
Commercial banks make sure to maintain the confidentiality of their
clients’ accounts. Also, only authorised individuals are permitted
access to the accounts.

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Notes u Principle of specialisation

In addition to modernisation, we also live in a time of super-
specialization. Commercial banks divide their entire operation into
smaller sections and they assign staff based on their productivity.
u Principle of modernisation

Modernization and technology coexist in the era we live in. Commercial

banks, therefore, need to utilise cutting-edge technical services
like internet banking, mobile banking, etc. to keep up with global
innovations.
IN-TEXT QUESTIONS
4. Which is the first and foremost principle of lending?
(a) Principle of Purpose
(b) Principle of diversification
(c) Principle of Security
(d) Principle of Safety
5. “The goal should be productive so that the funds remain safe
and have a reliable source of repayment.” Which principle of
lending is referred to?
(a) Principle of Purpose
(b) Principle of diversification
(c) Principle of Security
(d) Principle of Safety
6. ______________ talks about distributing the risks associated
with lending among a large number of borrowers.

3.5 Products and Services Offered by Banks

Before we talk about the products and services offered by banks, we
need to understand that banking can be of two types:
Retail banking and Wholesale banking.
Retail banking means catering to the needs of individual customers
whereas wholesale banking involves catering to clients like corporations
or institutions.
Products and services offered by retail banks.

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Asset based products Notes

Asset products represent assets of the bank (loans given by banks). Asset
products earn interest for the bank which is paid by the borrower. Various
types of loans offered to retail customers:
u Credit Cards
u Education loans (loan for further education)
u Auto loans (for purchase of new/used four and two wheelers)
u Home loans (for purchase of land & construction of residential
house/purchase of ready built house/for repairs and renovation of
an existing house)
u Consumer loans (for purchasing household goods like air conditioner,
fridge etc.)
u Personal loans (for miscellaneous purposes like holiday, medical
treatments etc.)
Liability based products
Liability based products represent liabilities of the bank (deposits ac-
cepted by banks). Bank liability products are useful to consumers since
they provide a safe place to keep their funds and an opportunity to earn
interest on idle cash. List of such products provided by the banks are:
u Deposit accounts like savings banks accounts, current accounts, fixed
deposit accounts, recurring deposit accounts, etc.
u Foreign Currency Accounts (FCAs)

u NRE accounts for Indian citizens settled abroad

u Zero Balance account for salaried class people

u Senior Citizen Deposit accounts

Fee based products

u Insurance

u Mutual Fund

u Investment Advisory Services

u Wealth Management

u Debit Card

Valued added services

u Safe Deposit lockers

u Depository services

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Notes u Insurance Products

u Automated Teller Machine
Miscellaneous services
u Issue of Drafts
u Offering electronic remittances facilities to customers (NEFT and
RTGS)
u Collecting Cheques (local and outstation) of customers from other
banks
u Renting out Lockers

u Safe Custody Services

u Collection of Taxes from customers on behalf of the Central Bank

u Purchasing/selling of shares/bonds in the Stock Market on behalf of

its customers
u Offering net banking/mobile banking/phone banking facilities to
customers
u Offering standing instructions’ facilities to customers for periodical
payment of insurance premium on behalf of its customers
u Purchasing/selling of foreign currencies from/to customer when they
return from/go abroad
u Offering Third Party Products like insurance and mutual funds to
customers
Products and services by wholesale banks
u Cash Management services: A special product offered by banks
to handle the work of collecting monies with the least delay. This
leads to efficient management of finances of corporates. The quicker
the monies are realised, the better it is for the functioning of the
company.
u Immediate Payments Products like NEFT (National Electronic Funds
Transfer) and
RTGS (Real Time Gross Settlement)
u Short term (Working Capital Finance repayable within a year): Loan
given for managing the smooth running day to day operations of a
corporate
u Long Term (Term Loans repayable after a year, may be in 5-7 years):
These loans for buying assets which will be used for a long time
(greater than one year)

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u Project Finance/Leveraged Lending/Syndicated lending: Project Notes

Finance refers to finance given to corporates to start new Projects.
Finances repaid from cash flows from the Project in future. Leveraged
Lending means giving finance to buy assets, treating those assets
as security for the loans. Syndicated Lending means many banks
joining together to give huge amounts of loans to corporates. (No
single bank can/should give too much loan to a single co.
u Issuing Letters of Credits/Guarantees
u Extending Foreign Currency Transactions
u Trade Finance
u Equipment leasing
u Merchant banking

IN-TEXT QUESTIONS
7. Deposits received by banks are asset based products?
(True/False)
8. RTGS stands for?
(a) Right Time Gross Settlement
(b) Real Time Gross Settlement
(c) Real Term Gross Settlement
(d) Right Term Gross Settlement
9. “A special product offered by banks to handle the work of
collecting monies with the least delay.” Name the product or
service.
(a) Cash Management Services
(b) Issuing Letters of Credits/Guarantees
(c) Merchant Banking
(d) e-transfer Services

3.6 Banking Regulations

The Reserve Bank of India Act, 1934
The Reserve Bank of India (RBI) has the authority to establish rules,
regulations, instructions, and guidelines on a variety of topics relevant

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Notes to banking and the financial sector under the Reserve Bank of India Act,
1934 (the “RBI Act”). The RBI is the country’s central bank and the
main body in charge of banking regulations.
The Reserve Bank of India was established by the Reserve Bank of India
Act, 1934 with the following goals:
(a) to regulate the issuance of bank notes
(b) to maintain reserves to ensure monetary system stability
(c) to efficiently run the country’s currency and credit system.
The Reserve Bank of India’s powers, functions and constitution are all
covered by the RBI Act. With the exception of a few sections (such as
Sec. 42, which deals with banks’ maintenance of CRR, and Sec. 18, which
addresses the direct discounting of bills of exchange and promissory notes
as part of rediscounting facilities to control credit to the banking system),
the act does not directly address the regulation of the banking system.
The RBI Act covers
u The establishment, funding, administration and operations of the RBI.
u The RBI’s duties, such as issuing bank notes, managing the currency,
serving as a banker to both the national and State Governments and
banks, serving as a lender of last resort and other duties.
u General guidelines for reserve funds, credit funds, audits and accounts.
u Giving instructions and penalising people who violate the Act’s rules.
Since the RBI Act does not directly address the regulation of the banking
system, it is the Banking Regulation Act, 1949 which does this and it
is discussed below.
Banking Regulation Act, 1949
The Banking Regulation Act, 1949 primarily governs how banks and
other financial organisations are regulated in India. The Banking Regu-
lation Act of 1949 governs financial institutions from conception to final
dissolution. If a bank needs to open for business, it cannot do so unless
it has secured a licence in accordance with the terms of the Banking
Regulation Act, 1949, and if it needs to close, its operations will be
wound down in accordance with the same rules. The Banking Regulation
Act, 1949 empowers the Reserve Bank of India to inspect and supervise

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commercial banks. These powers are exercised through on-site inspection Notes
and off site surveillance.
This act was enacted as the Banking Companies Act of 1949 and went
into force on March 16, 1949. Additionally, beginning of March 1, 1966,
the act’s name was modified to the Banking Regulation Act.
The term banking is defined as per Sec. 5(i)(b), as “acceptance of deposits
of money from the public for the purpose of lending and/or investment.
Such deposits can be repayable on demand or otherwise and withdraw-
able by means of cheque, drafts, order or otherwise.”
The following are some of the crucial clauses of the Banking Regula-
tions Act:
Section 6: This section of the Banking Regulations Act lists the permitted
activities of a banking company as lending, borrowing money, issuing
bonds and conducting any type of guarantee and indemnity business, while
Section 8 of the same Act forbids it from directly or indirectly partici-
pating in any contract involving the purchase, sale or exchange of goods.
Section 9: According to Section 9, banks are only permitted to keep
assets for a maximum of 7 years in order to settle debts or commitments
and RBI has the authority to extend this time limit.
Section 14: Section 14 states that a banking company cannot create
a floating charge on the undertaking or any property of the company
without the Reserve Bank of India’s prior approval. Section 14 further
prohibits a banking company from creating a charge upon any unpaid
capital of the company.
Section 15: A bank cannot announce dividend until all capitalised costs
have been completely written down in accordance with Section 15.
Sections 17 and 18: These sections mandate that each banking company
create a reserve fund from its earnings after taxes and interest. At least
3% of the total demand and time obligations shall be retained as a cash
reserve with the Reserve Bank of India. Every second fortnight of each
month, on the last Friday, this amount should be deposited or maintained.
The return, which must include the specifics of the amount deposited
with the Reserve Bank of India, must be deposited by the twentieth day
of every month.

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Notes Section 19: Section 19 provides clarification on the shareholding of a

banking company. No banking firm may own shares in any company for
a sum greater than 30% of its own paid-up share capital plus reserves
(or 30% of that company’s paid-up share capital, whichever is less)
Section 24: This section outlines the necessity to maintain Statutory
Liquidity Ratio (SLR) as a percentage of the bank’s demand and time
liabilities in the form of cash, gold and unencumbered securities. This
is advised by Reserve Bank of India from time to time.
Section 29: The profit and loss account and balance sheet are outlined
in Section 29 and must be completed on the last working day of each
accounting year in the formats provided in the third schedule. Where there
are more than three directors, at least three must sign the accounts. All
directors must sign the accounts if the number of directors is less than
three. Accounts must be signed by a principal officer of the company in
India in the case of a banking company that was incorporated outside
of the country.
Section 30: Section 30 outlines the requirements for auditing banking
companies. This work must be performed by an auditor who is legally
qualified to perform his job and who can only be fired with RBI consent.
If it is not satisfied, it may order a special audit to be conducted at the
bank’s expense.
Section 35: The RBI is authorised to conduct bank inspections under
Section 35.
By regulating branch opening and bank location, this comprehensive
piece of law reduced fierce rivalry and also secured a minimum capital
requirement to prevent collapse of banks. Thus, the Banking Regulation
Act has aided in balanced development and operation of Indian banks.
It has made sure that depositors’ interests are protected.
Foreign Exchange Management Act, 1999
The Foreign Exchange Management Act of 1999 regulates international
trade and related activities. This stipulates, among other things, the li-
censing of specific banking and other institutions as authorised dealers in
foreign exchange. All financial transactions concerning foreign securities
or exchange cannot be carried out without the approval of FEMA.

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It is a set of regulations that empowers the Reserve Bank of India to pass Notes
regulations and enables the Government of India to pass rules relating
to foreign exchange in tune with the foreign trade policy of India. All
transactions must be carried out through “Authorised Persons.” This act
empowers RBI to place restrictions on transactions from capital account of
Balance of Payments even if it is carried out via an authorized individual.

IN-TEXT QUESTIONS
10. RBI was established under which Act?
(a) RBI Act, 1934
(b) Companies Act, 2013
(c) Securities Act, 1933
(d) None of these
11. __________ act which deals in licensing of specific banking
and other institutions as authorised dealers in foreign exchange.
12. The __________ governs financial institution of banks from
conception to final dissolution.

3.7 Role of Market Regulator

The RBI was established in 1935 under the RBI Act, 1934 to oversee
and regulate the banking industry. Its objectives include safeguarding
the rights of depositors, guaranteeing smooth banking operations and
maintaining the stability of the financial system as a whole.
It serves as the primary operational hub for the Indian monetary system.
Mumbai serves as the headquarters of the Reserve Bank of India. The
Indian Ministry of Finance oversees all aspects of RBI operation. The
RBI oversees all of the policies and operations carried out on behalf of
all Indian banks. Therefore, the RBI is India’s largest banking regulatory
organisation.
It executes the requirements of the RBI Act, BR Act, and FEMA in
addition to formulating rules and guidelines for banking activities. It is
permitted to check and probe the affairs of banks and to impose penalties
in the event of non-compliance. The RBI periodically provides directives
to ensure adherence to the banking regulations and address any non-com-

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Notes pliance that may occur. The RBI may impose a number of penalties for
regulatory violations, issue orders to suspend a bank’s operations and
cancel any bank’s banking licence.
The RBI’s role as a regulator in preserving the nation’s financial stability
is presented as follows:
u Setting up of new banks: Reserve Bank of India provides the licence
to the banks. After this licence, they have the authority to set up
their bank in India.
u Capital adequacy and provisioning requirements: RBI grants
clearance for a variety of actions, including the creation of policies,
the implementation of Basel II and III frameworks, the validation
of quantitative credit models and so on.
u Managing all problems involving Indian banks, for example, Anti-
Money Laundering, Combating Financing of Terrorism, Customer
Service Policy difficulties and other difficulties pertaining to the
dissolution of banking companies.
u The salary packages of Whole-Time Directors and Part-Time
Chairpersons of Private Sector Banks and Chief Executive Officers
of Foreign Banks operating in India are also decided by RBI.
u The RBI is in charge of choosing the chairman, other directors and
extra directors of Indian banks.
u The RBI oversees the establishment of payments banks and small
finance banks.
u Through its ‘Know Your Customer’ standards, which must be
followed at any point someone opens an account with a bank, the
RBI makes sure banks maintain transparency in reporting any fees
they impose on their clients and that money laundering is prevented.
u Based on “CAMELS”, which stands for Capital adequacy, Asset
quality, Management, Earning, Liquidity, System and Control, the
RBI has its own monitoring technique and system for audit and
inspection.
Other Regulators:
RBI frequently works closely with other regulatory authorities as needed,
to regulate banking activities that relate with other financial activity.

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Other regulatory authorities in India are: Notes

u The Securities Exchange Board of India (“SEBI”), which is in
charge of overseeing the Indian securities market.
u The Insurance Regulatory and Development Authority of India
(“IRDAI”) is in charge of overseeing the insurance industry.
u The Insolvency and Bankruptcy Board of India (“IBBI”), which
oversees how insolvency procedures under the Insolvency and
Bankruptcy Code (“IBC”) are conducted.
The CENTRAL GOVERNMENT, specifically the Ministry of Finance,
also regulates and monitors how banks and other financial organisations
operate. Its role can be elucidated as follows:
u Overseeing banking operations through the Department of Financial
Services.
u Establishing standards for the management and operation of public
sector banks.
u Examining judicial and legislative methods for recovering bank loans,
as well as legislative solutions.

IN-TEXT QUESTIONS
13. Who is the main regulator of banking industry in India?
(a) SEBI
(b) IRDA
(c) RBI
(d) ICAI
14. Does central government play a role in regulating banks?
(Yes/No)
15. RBI makes sure banks maintain transparency in reporting any
fees they impose on their clients. Through which service is this
made possible?
(a) KYC (Know Your Customer)
(b) Aadhaar
(c) e-banking
(d) None of these

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Notes 3.8 Key Players in Market

Key factors in the banking industry include the Reserve Bank of India
(RBI), commercial banks, cooperative banks, and development banks.
Reserve Bank of India
It is the apex bank of India. It’s various functions with their objectives
can be explained as follows:
u It is the monetary authority which develops, executes, and oversees
the monetary policy. There are several tools for monetary control
like CRR, SLR and LAF.
Objective: Maintaining price stability and ensuring adequate flow
of credit to productive sectors.
u As a regulator and overseer of the financial system, RBI sets
broad guidelines for banking activities that the nation’s banking
and financial system must follow.
Objective: Protect depositors’ interest and provide cost-effective
banking services to the public.
u As a manager of foreign exchange, manages the foreign exchange
market in India.
Objective: To encourage the orderly growth and maintenance of
India’s foreign exchange market as well as to enable external trade
and payment.
u As an issuer of currency, issues and exchanges or destroys currency
and coins not fit for circulation.
Objective: To provide the general people with sufficient quantities
of high-quality cash in both quantity and quality.
u Performs a variety of promotional tasks to promote governmental
goals.
u As a government banker, serves as the Central and State Governments’
merchant banker and serves as both entities’ banker.
u Maintains the accounts of all the scheduled banks as a banker to
banks.
u Payment and Settlement networks: It is now widely acknowledged
that central banks have a fundamental duty to regulate and monitor
payment networks.

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Commercial banks Notes

Commercial banks generate revenue through making loans, including
mortgages, vehicle loans, business loans, and personal loans, and charging
interest on those loans. The money needed to fund these loans is provided
by deposits made by customers in banks.
Commercial banks perform the following functions:
u Primary functions
n Accepting deposits
n Giving loans and advances
u Secondary functions
n Agency functions
Payment and collection of cheques, discounting of bills and
promissory notes, execution of standing instructions’, acting
as a trustee, executor or attorney
n General utility functions
Safe custody, safe deposit vaults, remittances of deposits,
pension payments, acting as a dealer in foreign exchange
Cooperative banks
u It is an organisation founded on a cooperative basis to handle routine
banking operations. In order to start a cooperative bank, money is
raised through the sale of shares, along with deposits and loans.
They are cooperative credit societies where members come together
to offer loans to one another on advantageous terms.
u They are registered under the Multi-State Cooperative Societies Act
of 2002 or the Cooperative Societies Act of the relevant State.
u Members of cooperative banks are both the bank’s customers and
its owners.
u Democratic Member Control: The members of these banks own
and manage the institutions, electing the board of directors in
a democratic manner. According to the “one person, one vote”
cooperative principle, members typically have equal voting rights.
u Profit Allocation: A sizeable portion of the annual profit, benefits,
or surplus is typically set aside as reserves, and some of this profit

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Notes may also be paid to the cooperative’s members within the bounds
of the law and applicable statues.
Development banks
u These banks are specialised financial institutions that carry out the
dual tasks of providing medium- and long-term financing to private
business owners and acting as catalysts for the nation’s economic
growth.
u The development banks are in charge of giving both the industrial and
agricultural sectors medium- and long-term financing. Additionally,
they support both the public and private sectors.
u The Industrial Finance Corporation of India (IFCI), the Small
Industries Development Bank of India (SIDBI), the Export-Import
(EXIM) Bank of India, and others are some of the most well-known
development banks in India.

3.9 Evaluation of Banking Sector in India

In the centre of every expanding economy are banks. The economy and
the banks both grow as bank lending increases. It’s a partnership that
benefits both parties. So, the issue is how well have Indian banks done
in this situation. The answer to this question is discussed in the para-
graphs that follow.
Performance of Indian banking sector in terms of credit, deposits and
other aspects in recent years is summarised as follows:
u In addition to cooperative credit institutions, the Indian banking
system includes 12 public sector banks, 22 private sector banks,
46 foreign banks, 56 regional rural banks, 1485 urban cooperative
banks, and 96,000 rural cooperative banks.
u As of September 2021, there were 213,145 ATMs in India, with
47.5% of them located in rural and semi-urban areas.
u Bank assets increased in every sector in 2020–2022. In 2022, the total
assets of the banking industry (including both public and private
sector banks) rose to US$ 2.67 trillion.
u Bank credit grew at a CAGR of 0.62% from FY 16 to FY 22. Total
credit extensions reached US$ 1,532.31 billion as of FY 22.

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u Deposits increased at a CAGR of 10.92% from FY 16 to FY 22, Notes

reaching US$ 2.12 trillion by FY 22. As of November 4, 2022,
bank deposits totalled Rs. 173.70 trillion (2.12 trillion USD).
u According to the RBI’s statement on Sectoral Deployment of Bank
Credit, non-food bank credit increased by 17.6% in November,
2022 compared to a growth of 7.1% a year earlier, driven by strong
credit demand from sectors including services, industry, personal,
and agriculture and allied activities.
The positive trends and challenges in recent years are also discussed below.
Positive trends
u Retail Winning
Bank lending to industry was a key focus for many years, but that
has been changing. Bank lending to industry reached a peak of
22.4% of the GDP at the end of March, 2013. Since then, it has
decreased and as of September, 2022, it was 12.5%. Bank financing
to the industry has only increased in absolute terms by 4% annually
over this time.
In contrast, retail loans from banks increased from 9% in March,
2013 to 14.3% of the GDP as of September, 2022. The total amount
of outstanding retail loans increased by 16.1% annually between
March, 2013 and September, 2022, measured in absolute terms.
It is obvious that banks prefer to offer more consumer loans than
business loans. The primary cause of this was the excessive lending
of industrial loans by public sector banks in the 2000s and early
2010s. As a result, there was a significant build-up of sub-prime
industrial loans, which has made them cautious.
u Private upswing
Another significant development that has occurred with banks is
privatisation. Public sector banks that are primarily held by the
government have not yet been privatised, but the industry as a whole
is being steadily privatised. Public sector banks held 74.2% of the
deposits and 75.1% of the outstanding bank loans as of March,
2010. But since then, they have been losing market share. Public
sector banks had 59.7% of the deposits as of September, 2022 and
54.5% of the loans.

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Notes Private banks’ percentage of total lending increased from 17.5%

to 37.3%. Their percentage of deposits increased from 17.7% in
March, 2010 to 31.4% in September, 2022. Once more, the public
sector banks’ enormous accumulation of bad loans—which peaked
at around $9 trillion as of March, 2018—has been a major factor
in their declining market share and sluggish lending activity.
u Loan clean up
Bad loans have been declining. They reached a high of 10.4 trillion
in March 2018 before dropping to 7.4 trillion in March, 2022. Bad
loans are often those that have gone unpaid for 90 days or more.
An increase in bad loans being written off is the main cause of this
decrease. Over the past five fiscal years, bad loans totalling more
than 10 trillion have been written off. In actuality, the majority of
bank loan write-offs are an accounting occurrence. The amount of
bad loans can be decreased by removing, from the balance sheet,
loans that have been 100% provisioned for and have been bad for
four years. Despite the appalling recovery rate, efforts to collect
bad debts that have been written off continue.
u Financial inclusion
Innovative banking formats like payments banks and small finance
banks have recently been introduced in the Indian banking sector.
India has recently concentrated on expanding the scope of its
banking sector through a number of initiatives like the Pradhan
Mantri Jan Dhan Yojana and Post Payment Banks. These types of
programmes, together with significant banking sector reforms like
digital payments, neo-banking, the growth of Indian NBFCs, and
fintech, have greatly increased financial inclusion in India and
fueled the country’s credit cycle.
u Digital payment system
With the advent of new technology in the banking industry, customers
are rapidly migrating away from the established branch banking
system in favour of the comfort and convenience of remote electronic
banking services. India’s Immediate Payment Service (IMPS) has
seen the most advancement in it’s digital payment infrastructure
among the 25 countries studied. Real-time payments have been

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revolutionised by India’s Unified Payments Interface (UPI), which Notes

has recently worked to expand it’s worldwide reach.
u Innovation in services
Recent technological advancements have significantly increased
efficiency, productivity, quality, inclusivity and competitiveness in
the expansion of financial services, particularly in the area of online
lending.
u Business fundamentals
The use of digital payment methods has increased dramatically in
recent years. As a result, traditional paper-based instruments like
cheques and demand drafts now account for a very small portion
of payments, both in terms of volume and value.
Challenges
The key challenges are as follows:
u Stagnating banks
The entire amount of outstanding loans held by Indian banks as of
the end of March, 2001 were 5.1 trillion rupees, or 23.9% of the
GDP of the nation at the time. The amount increased to $130.4
trillion by September, 2022, or 50.3% of GDP. As of the end of
March 2001, total bank deposits were 9.6 trillion, or 45% of GDP;
today, they are 175.4 trillion, or 67.6% of GDP. By expressing credit
and deposits in terms of GDP, we can also take into consideration
how quickly the economy is growing.
Even while the expansion seems rapid, it’s interesting to note that
Indian banking has been stagnant for more than a decade. Since
March 2009, bank lending has remained between 50 and 53 per
cent of the GDP (with the exception of 2020 and 2021 owing to
COVID-19), and bank deposits have stayed between 67 and 80 per
cent.
u Basel III implementation
By March 31, 2019, Indian banks had to adhere to Basel III Capital
Regulations (Basel Regulations) in full. Due to the greater capital
requirements, the majority of public-sector banks required additional
capital infusions, which in turn decreased the return on equity. Due

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Notes to the need for government assistance, the government’s financial

position came under a lot of strain. The Basel III standards have
not yet been fully implemented.
u Specialised banking
Quite a few finance bank licences and payments bank licences have
been given by the RBI. Although the RBI has established the
framework for their use, it appears that the services offered do not
adequately serve the unbanked sectors, which include rural areas and
other underdeveloped and unorganised industries. Given the larger
goal of financial inclusion, additional reorientation of regulatory
and supervisory resources will likely be required to increase access
to these systems.
u Asset quality
The amount of Indian banks’ net Non-Performing Assets (NPAs) has
been sharply rising. The RBI has implemented major structural and
regulatory efforts to address this issue over many years. However, the
rise in NPAs continues to be one of the most important challenges
to the banking industry.
u Priority sector lending and NPAs
The RBI establishes goals mandates that banks extend loans to
specific underserved groups of society. Banks previously had
difficulty achieving these goals. These priority sectors or industries
frequently produce poor earnings, which negatively affects the
profitability of banks. Separately, there are a lot of NPAs in the
agriculture industry, which is one of the key priority lending sectors.
Agricultural NPAs are not taken into account by the new steps the
RBI has implemented to reduce stressed assets.
u Challenges from cashless economy
The transition to a cashless economy has brought with it a unique
set of problems, many of which centre on access. The RBI has taken
coordinated action, including establishing an e-wallet connected to
the AADHAAR system for unique identity numbers and encouraging
stores and other local companies to offer discounts and cash-back
programmes for adopting electronic payment methods. Most of the
nation’s infrastructure, from a working internet connection to the

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sophistication of its users, is woefully inadequate for such payment Notes

systems to be used frequently. Concerns about privacy and related
legal issues have recently come up. While these problems are
currently being addressed, India still has a long way to go before
it becomes a cashless economy.
u Enforcement of the new insolvency regime
Since the IBC (Insolvency and Bankruptcy Code) went into force in
December 2016, there has been a noticeable change in how the RBI
and creditors have taken legal action against defaulters. Judgments
from the National Company Law Tribunal and the National Company
Law Appellate Tribunal have helped to clarify some issues that the
IBC itself left ambiguous. The Ministry of Finance has been quick
to recognise the difficulties and update the IBC with regulations
intended to speed up the process. It would be interesting to watch
if the IBC procedure can keep up with the rising NPAs and raise
banks’ standing as creditors in the Indian financial system.
The Reserve Bank of India (RBI) claims that the banking industry
in India is adequately funded and well-regulated. The nation has
significantly better financial and economic circumstances than any
other nation in the world. Studies on credit, market, and liquidity
risk indicate that Indian banks are generally robust and have fared
well during the global recession.

3.10 Summary
In this chapter, discussion has been done on the depository institution of
banking. Bank is a financial institution which accepts deposits and lends
loan to borrowers. In this process of lending, banks create credit. There
are certain principles to be kept in mind while following the process of
credit creation. Safety is foremost, followed by liquidity, profitability,
security, national interest and suitability among many other principles.
There are various kinds of services offered by the banks apart from deposit
and loans. Deposits are the loan based products and loans are asset based
products. Banks offer various fee based services, value added services
and other miscellaneous services as well. RBI is the central bank which
is vested with powers via regulations of banking like Banking Regulation

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Notes Act, 1949, RBI Act, 1934 and FEMA Act, 1999. Apart from RBI, the
key market players are commercial banks and development banks. The
Reserve Bank of India (RBI) claims that the banking industry in India is
adequately funded and well-regulated. The nation has significantly better
financial and economic circumstances than any other nation in the world.
Studies on credit, market, and liquidity risk indicate that Indian banks
are generally robust and have fared well during the global recession.

3.11 Answers to In-Text Questions

1. True
2. True
3. True
4. (a) Principle of Purpose
5. (d) Principle of Safety
6. Principle of risk diversification
7. False
8. (b) Real Time Gross Settlement
9. (a) Cash Management Services
10. (a) RBI Act, 1934
11. FEMA
12. Banking Regulation Act, 1949
13. (c) RBI
14. Yes.
15. (a) KYC (Know Your Customer)

3.12 Self-Assessment Questions

1. What do you mean by Bank?
2. Define the term “Banking”.
3. Explain the fundamental principles of banking.
4. Explain the principle of safety, liquidity and profitability.

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5. What are the recent positive trends in Indian banking sector today? Notes
Elucidate.
6. Is there any scope of improvement in Indian banking sector? Explain.
7. Explain the various products and services offered by banks.
8. What is the role of RBI as a regulator of banking in India?

3.13 References/Suggested Readings

u Brand Equity Report. (2013).
u BG Maniar. (2011). Legal Regulations of Banking: Saurashtra
University Publication.
u BSE Institute Ltd. (2015). Banking.
u Dr. A.P. Faure. 2013. Banking: An Introduction. Quoin Institute (Pty)
Limited.
u Dr. Babasaheb Sangale. Dr. T. N. Salve. Dr. M. U. Mulani. Fundamentals
of Banking. University of Pune.
u ICSI. (2014). Banking Law and Practice. Delhi.
u India Brand Equity Foundation. (2023). Banking Industry Report.
u Laksmi Ramamurthy. (2012). The Banking Sector: Centre for Public
Policy Research.
u M. Buckle, E. Beccalli. (2011). Principles of Banking and Finance.
London: University of London.

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L E S S O N

4
Banking
Ms. Manisha Yadav
Dept. of Financial Studies
School of Open Learning
University of Delhi
Email-Id: manishayadav@[Link]

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Role of Banks
4.4 Importance of Banks in Financial Markets
4.5 Types of Banks
4.6 Non-Performing Assets (NPA)
4.7 Reasons for NPA Accumulation
4.8 Impact of NPA on Banks and the Economy
4.9 NPA Management and Resolution
4.10 Risk Management in Banks
4.11 Risk Management Framework
4.12 Credit Risk Management
4.13 Market Risk Management
4.14 Operational Risk Management
4.15 Universal Banking
4.16 Benefits and Challenges of Universal Banking
4.17 Universal Banking in India
4.18 Core Banking Solutions (CBS)
4.19 Features and Benefits of CBS
4.20 Implementation and Challenges of CBS

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4.21 NBFCs and its Types Notes

4.22 Comparison Between Banks and NBFCs
4.23 Summary
4.24 Answers to In-Text Questions
4.25 Self-Assessment Questions
4.26 Suggested Readings

4.1 Learning Objectives

u Understand the role of banks in facilitating economic growth and
stability.
u Define and analyze the concept of Non-Performing Assets (NPA),
including its causes, implications, and impact on banks and the
economy.
u Comprehend the principles and practices of risk management in
banks, including risk identification, assessment, and mitigation.
u Discuss the need for and importance of universal banking, its
benefits, challenges, and its role in shaping the financial sector and
contributing to economic growth.
u Gain insights into credit risk management, including credit appraisal,
monitoring, and recovery processes, to ensure sound lending practices
and minimize default risks.
By achieving these learning objectives, students will develop a comprehensive
understanding of financial markets, institutions, and the various aspects
of risk management and banking operations. They will be equipped with
knowledge and skills that are essential for effective decision-making, risk
assessment, and strategic planning in the financial industry.

4.2 Introduction
Welcome to the lesson on “Commercial Banking.” In this comprehensive
lesson, we will dive into the intricate world of financial markets and
institutions, focusing on the crucial role played by banks in the economy.

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Notes We will examine topics such as Non-Performing Assets (NPA), Risk

Management in Banks, the need for and importance of Universal Banking,
and Core Banking Solutions (CBS), and compare banks with Non-Banking
Financial Companies (NBFCs).
Financial markets and institutions are the backbones of any economy,
serving as the channels through which funds flow between savers and
borrowers. They are crucial for efficient resource allocation, mobilization of
savings, credit creation, and overall economic growth. Among the various
financial institutions, banks occupy a central position, performing critical
functions that impact the stability and development of the financial system.
In this lesson, we will begin by understanding the fundamental concepts
of financial markets and institutions and exploring their significance in
the broader economic landscape. We will then delve into the multifaceted
role of banks, uncovering how they act as intermediaries, mobilize savings,
create credit, facilitate payment systems, and contribute to economic growth.
Non-Performing Assets (NPAs) pose significant challenges to banks,
affecting their financial health and stability. We will explore the causes,
consequences, and resolution mechanisms related to NPAs, recognizing
their impact on both banks and the overall economy.
Risk management is a crucial aspect of banking operations. We will delve
into the various types of risks faced by banks, the frameworks employed
to manage these risks, and the tools and techniques utilized for effective
risk mitigation.
Universal banking has gained prominence in recent years, and we will
examine its need, importance, advantages, and disadvantages. We will also
discuss the concept of Core Banking Solutions (CBS), its components,
benefits, and implementation challenges, and its impact on enhancing
banking operations.
Furthermore, we will explore the landscape of Non-Banking Financial
Companies (NBFCs) and understand their role in the financial ecosystem.
We will examine the different types of NBFCs and draw a comparison
between banks and NBFCs, highlighting their unique characteristics and
regulatory frameworks.
By the end of this lesson, you will have gained a comprehensive
understanding of the role of banks in the financial markets and their impact

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on the economy. You will also be equipped with insights into NPAs, risk Notes
management practices, the concept of universal banking, the significance
of Core Banking Solutions, and the distinctive features of NBFCs.
So, let us embark on this enlightening journey into the world of Financial
Markets & Institutions, uncovering the intricate workings of banks and
exploring the dynamic landscape of financial services.

4.3 Role of Banks

4.3.1 Definition and Functions of Banks

Banks are financial institutions that facilitate the flow of funds in an

economy. They act as intermediaries between depositors and borrowers,
collecting funds from individuals and institutions with surplus funds and
channeling them towards those needing funds for various purposes.
As per the Sec. 5(b) in Banking Regulation Act, 1949 “banking means the
accepting, for the purpose of lending or investment, of deposits of money
from the public, repayable on demand or otherwise, and withdrawal by
cheque, draft, order or otherwise”.
1. Functions of Commercial Banks:
(i) Accepting Deposits: Banks provide a safe and secure platform
for individuals and businesses to deposit their surplus funds.
This includes savings accounts, current accounts, fixed deposits,
and recurring deposits.
(ii) Granting Loans and Advances: Banks lend money to individuals
and businesses for various purposes, such as working capital,
investment in fixed assets, education, housing, and more.
(iii) Payment and Settlement Services: Banks facilitate the transfer
of funds domestically and internationally through various
channels like checks, demand drafts, electronic fund transfers,
and online banking platforms.
(iv) Credit Creation: Banks play a crucial role in the creation
of credit in an economy by utilizing the deposits received
to extend loans and advances, thereby stimulating economic
activity.

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Notes (v) Providing Trade Finance Services: Banks offer services like
letters of credit, bank guarantees, and export-import financing
to facilitate domestic and international trade.
(vi) Investment and Wealth Management: Banks provide investment
advisory services, mutual funds, insurance products, and
wealth management solutions to cater to the financial needs
of customers.
(vii) Foreign Exchange Services: Banks facilitate foreign exchange
transactions, currency conversion, and hedging instruments to
manage foreign exchange risk.

4.3.2 Importance of Banks in Financial Markets

1. Banks as Intermediaries: Banks act as intermediaries by bringing

together depositors and borrowers, thereby mobilizing savings, and
allocating funds efficiently to productive sectors of the economy.
2. Mobilization and Allocation of Funds: Banks mobilize funds
from various sources and allocate them to individuals, businesses,
and government entities to finance investments and expenditures,
stimulating economic growth.
3. Facilitating Economic Growth and Development: Banks provide
crucial financial resources for economic activities, supporting entre-
preneurship, investment, infrastructure development, and employment
generation.

4.4 Importance of Banks in Financial Markets

Banks play a pivotal role in financial markets and contribute significantly
to the overall functioning and stability of the economy. Here are the key
aspects that highlight the importance of banks in financial markets:
1. Intermediation of Funds: Banks act as intermediaries between
depositors and borrowers. They mobilize funds from individuals,
businesses, and institutions with surplus funds and channel them
toward those in need of funds for various purposes. By pooling
deposits, banks can provide a substantial amount of credit to
borrowers, thereby facilitating economic activities and promoting
investment.

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2. Efficient Allocation of Capital: Banks play a critical role in Notes

allocating capital to productive sectors of the economy. They assess
the creditworthiness of borrowers, analyse investment proposals, and
allocate funds based on risk assessment and return expectations.
This process ensures that capital is channelled to viable projects
with the potential to generate economic growth, job creation, and
innovation.
3. Facilitating Payments and Settlements: Banks provide essential
payment and settlement services, which are crucial for the smooth
functioning of financial markets. Through mechanisms such as
checks, demand drafts, electronic funds transfers, and online banking
platforms, banks enable the seamless transfer of funds between
individuals, businesses, and institutions. These services facilitate
the exchange of goods and services, enhance liquidity, and reduce
transaction costs.
4. Credit Creation and Money Supply: Banks have the unique ability
to create credit, which contributes to the expansion of the money
supply in the economy. When banks receive deposits, they are
legally allowed to lend out a significant portion of those funds while
keeping a fraction as reserves. This process, known as fractional
reserve banking, enables banks to create new loans and increase
the overall money supply, thereby fuelling economic growth.
5. Risk Management and Financial Stability: Banks play a crucial
role in managing risks in the financial system. They employ risk
management practices to assess, monitor, and mitigate various
types of risks, including credit risk, market risk, liquidity risk, and
operational risk. Effective risk management by banks contributes
to financial stability, as it helps prevent excessive risk-taking and
minimizes the impact of adverse events on the banking system and
the broader economy.
6. Stimulating Economic Growth: Banks provide the necessary financial
resources for economic activities, acting as a catalyst for growth
and development. By offering loans and credit facilities, banks
enable individuals and businesses to invest in productive ventures,
expand operations, create employment opportunities, and contribute
to overall economic expansion.

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Notes 7. Financial Inclusion: Banks play a vital role in promoting financial

inclusion by extending banking services to individuals and businesses
across different socio-economic strata. Through the provision of basic
banking services, such as savings accounts, payment facilities, and
small loans, banks enable individuals to participate in the formal
financial system, build savings, access credit, and improve their
financial well-being.
In summary, the importance of banks in financial markets cannot be
overstated. They serve as intermediaries, allocate capital efficiently,
facilitate payments and settlements, create credit, manage risks, stimulate
economic growth, and promote financial inclusion. Banks act as key
drivers of economic activity and play a crucial role in fostering financial
stability and development.

4.5 Types of Banks

There are different types of banks that cater to specific financial needs
and perform distinct functions within the banking system. Here is an
elaboration on the types of banks:
1. Commercial Banks: Commercial banks are the most common and
widely recognized type of banks. They provide a comprehensive
range of financial services to individuals, businesses, and government
entities. The primary functions of commercial banks include accepting
deposits, granting loans and advances, facilitating payments and
settlements, offering trade finance services, providing investment
and wealth management solutions, and engaging in foreign exchange
transactions. Commercial banks serve as the backbone of the banking
system and play a vital role in mobilizing funds and supporting
economic activities.
2. Investment Banks: Investment banks primarily focus on capital
market activities, particularly in the field of investment banking.
They specialize in providing financial advisory services, underwriting
securities issuances (such as initial public offerings and bond
offerings), facilitating mergers and acquisitions, and assisting in
corporate restructuring. Investment banks also engage in trading
activities, including buying, and selling stocks, bonds, derivatives,

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and other financial instruments on behalf of their clients. Unlike Notes

commercial banks, investment banks typically do not accept deposits
from the general public.
3. Central Banks: Central banks are the apex monetary authorities
responsible for formulating and implementing monetary policies to
maintain price stability and promote sustainable economic growth.
They act as the regulators and supervisors of the banking system,
overseeing the functioning and stability of financial markets. Central
banks are the sole issuers of a country’s currency and manage the
nation’s foreign exchange reserves. They play a critical role in
maintaining financial stability, controlling inflation, managing interest
rates, and providing lender-of-last-resort facilities to banks during
times of financial stress. Reserve Bank of India is the Central Bank
of India.
4. Cooperative Banks: Cooperative banks are financial institutions
that operate on cooperative principles, serving the banking needs
of specific groups or communities. They are owned and governed
by their members, who are typically individuals or small businesses
sharing a common bond, such as geographic location, profession,
or industry. Cooperative banks provide various banking services,
including deposits, loans, and payment services, tailored to the
specific needs of their members. These banks prioritize the welfare
of their members and often focus on promoting financial inclusion
and community development. Cooperative banks in India are
registered under the Cooperative Societies Act, and their functioning
is regulated by the Reserve Bank of India (RBI).
5. Development Banks: Development banks, also known as specialized
banks or term-lending institutions, are established with the primary
objective of financing, and promoting economic development
projects. They typically provide long-term financing for infrastructure
development, industrial projects, and sectors that require specialized
funding. Development banks support economic growth by filling
gaps in the availability of long-term capital, providing technical
assistance, and promoting investment in strategic sectors. These
banks often operate under the guidance and support of government
authorities. Examples: SIDBI, NABARD, NHB, LIC.

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Notes 6. Regional Rural Banks (RRB): These are special types of commercial
Banks that provide concessional credit to agriculture and the rural
sector. RRBs were established in 1975 and are registered under the
Regional Rural Bank Act, 1976. RRBs are joint ventures between
the Central government (50%), the State government (15%), and
a Commercial Bank (35%). 196 RRBs have been established from
1987 to 2005. From 2005 onwards government started the merger of
RRBs, thus reducing the number of RRBs to 82. One RRB cannot
open its branches in more than 3 geographically connected districts.
7. Local Area Banks (LAB): Introduced in India in the year 1996.
These are organized by the private sector. Earning profit is the main
objective of Local Area Banks. Local Area Banks are registered
under the Companies Act, 1956. At present, there are only 4 Local
Area Banks all of which are located in South India.
8. Specialized Banks: Certain banks are introduced for specific purposes
only. Such banks are called specialized banks. These include:
u Small Industries Development Bank of India (SIDBI): Loan
for a small-scale industry or business can be taken from
SIDBI. Financing small industries with modern technology
and equipments is done with the help of this bank.
u EXIM Bank: EXIM Bank stands for Export and Import Bank.
To get loans or other financial assistance with exporting or
importing goods by foreign countries can be done through
this type of bank.
u National Bank for Agricultural & Rural Development
(NABARD): To get any kind of financial assistance for rural,
handicraft, village, and agricultural development, people can
turn to NABARD.
There are various other specialized banks, and each possesses a
different role in helping develop the country financially.
9. Payments Banks: A newly introduced form of banking, the payments
bank have been conceptualized by the Reserve Bank of India. People
with an account in the payments bank can only deposit an amount
of up to Rs. 1,00,000/- and cannot apply for loans or credit cards
under this account. Options for online banking, mobile banking, the

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issue of ATM, and debit card can be done through payments banks. Notes
Given below is a list of the few payments bank in our country:
u Airtel Payments Bank
u India Post Payments Bank
u Fino Payments Bank
u Jio Payments Bank
u Paytm Payments Bank
u NSDL Payments Bank
10. Islamic Banks: Islamic banks operate in accordance with Islamic
principles and adhere to Shariah law. They offer banking services
that comply with Islamic finance principles, which prohibit the
collection or payment of interest (riba) and the involvement of
prohibited activities such as gambling and speculation. Islamic banks
use alternative financing methods, such as profit-sharing arrangements
(Mudarabah), cost-plus financing (Murabaha), and leasing (Ijarah), to
provide funding while adhering to Islamic principles. They cater to
customers seeking Shariah-compliant banking products and services.
It is essential to understand the different types of banks to recognize their
distinct roles, functions, and regulatory frameworks. Each type of bank
contributes to the overall stability, efficiency, and development of the
financial system, serving specific needs and segments within the economy.

4.6 Non-Performing Assets (NPA)

Non-Performing Assets (NPA) refer to loans and advances that have
stopped generating income for banks and financial institutions. These
assets are considered to be in default or have become delinquent in terms
of interest and principal repayments. NPAs have significant implications
for banks, borrowers, and the overall stability of the financial system.
Here is an elaboration on Non-Performing Assets:

4.6.1 Definition and Classification of NPAs

1. Understanding NPA and its Significance: Non-Performing Assets

are loans or advances that have stopped generating income for the

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Notes bank, typically due to non-payment of interest or principal for a

specified period (90 days in India). NPAs indicate the credit quality
of a bank’s loan portfolio and reflect the potential risks faced by
the financial institution.
2. Classification of NPAs Based on RBI Guidelines: The Reserve
Bank of India (RBI) provides guidelines for the classification and
identification of NPAs. These guidelines establish specific criteria
for determining the status of loans. NPAs are categorized into three
stages:
(a) Substandard Assets: Assets that have remained NPAs for a
period of 12 months or less.
(b) Doubtful Assets: Assets that have been classified as Substandard
for a period exceeding 12 months.
(c) Loss Assets: Assets that are considered uncollectible and have
been identified as such by the bank, internal auditors, or the
RBI.

4.7 Reasons for NPA Accumulation

NPA accumulation can occur due to various reasons, encompassing
economic factors, borrower-specific issues, and internal bank-related
factors. Understanding these reasons is crucial for banks and financial
institutions to develop effective risk management strategies and mitigate
the impact of NPAs. Here are the key reasons for NPA accumulation:
1. Economic Downturns and Business Cycles: Economic recessions,
industry-specific downturns, and fluctuations in business cycles
can significantly impact borrowers’ ability to repay loans. During
periods of economic contraction, businesses may experience reduced
sales, declining profitability, and cash flow problems, leading to
difficulties in servicing their debt obligations. Unfavourable economic
conditions increase the risk of loan defaults and NPA formation.
2. Inadequate Cash Flows and Financial Distress of Borrowers:
Borrowers may face financial distress due to a variety of reasons,
such as poor business performance, mismanagement, increased
competition, or adverse market conditions. Insufficient cash flows

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can hinder their ability to make timely interest and principal Notes
payments, resulting in NPAs. Inadequate cash flows can be a result
of low profitability, high debt burden, overleveraging, or liquidity
mismatches.
3. Weak Credit Appraisal and Risk Assessment Practices: Inadequate
credit appraisal and risk assessment processes by banks can contribute
to NPA accumulation. Weak evaluation of borrowers’ creditworthiness,
inadequate due diligence, and inaccurate assessment of repayment
capacity can result in loans being extended to borrowers with high
default risks. Failure to identify and mitigate risks upfront increases
the likelihood of NPAs.
4. Ineffective Monitoring and Follow-up of Loan Accounts: Inadequate
monitoring and follow-up of loan accounts by banks can lead to
NPA formation. Banks need to regularly track borrowers’ financial
performance, conduct site visits, review financial statements, and
ensure compliance with loan covenants. Lack of timely identification
of potential repayment issues and delayed remedial actions can
result in NPAs.
5. Diversion of Funds by Borrowers for Unauthorized Purposes:
Some borrowers divert loan funds for purposes other than what
the loan was intended for. They may misuse the funds for personal
expenses, speculative activities, or investments unrelated to the
approved project. Such diversion of funds reduces the borrower’s
ability to generate income from the intended project, leading to
cash flow problems and NPA formation.
6. Industry-Specific Factors Impacting Borrower Repayments:
Certain industries may face sector-specific challenges that affect
the repayment capacity of borrowers. Factors such as technological
disruptions, regulatory changes, market saturation, or shifts in
consumer preferences can impact the profitability and sustainability
of businesses. Industries facing significant headwinds may struggle
to generate adequate cash flows, increasing the likelihood of NPAs.
It is important for banks and financial institutions to assess and monitor
these factors to mitigate the risks associated with NPA accumulation.
Implementing robust credit appraisal processes, conducting regular borrower

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Notes monitoring, and staying attuned to macroeconomic and industry-specific

trends are essential for effective NPA management.

4.8 Impact of NPA on Banks and the Economy

The impact of Non-Performing Assets (NPAs) on banks and the economy
is significant, as NPAs can adversely affect the profitability, liquidity, and
stability of banks and have broader implications for the overall economic
environment. Here is an elaboration on the impact of NPAs:
1. Profitability of Banks: NPAs have a direct impact on the profitability
of banks. When loans turn into NPAs, interest income is not realized,
and banks may have to make provisions for potential loan losses.
Provisions for NPAs reduce banks’ profitability as they are set aside
from the bank’s earnings, impacting the net profit. As the level of
NPAs increases, banks may need to allocate more funds towards
provisions, which further affects their profitability and returns to
shareholders.
2. Liquidity of Banks: NPAs can also impact the liquidity position
of banks. When loans become NPAs, borrowers may default on
interest and principal repayments, leading to a reduction in the
cash inflows for banks. This reduction in cash inflows affects the
liquidity available for banks to meet their obligations, including
depositor withdrawals and payment obligations. High level of
NPAs can strain the liquidity position of banks, potentially leading
to liquidity shortages and difficulties in fulfilling their financial
commitments.
3. Capital Adequacy: NPAs have implications for the capital adequacy
of banks. As NPAs increase, the quality of a bank’s loan portfolio
deteriorates, and the risk-weighted assets may increase. This can
result in a decline in the Capital Adequacy Ratio (CAR), which is
an important measure of a bank’s financial strength and ability to
absorb losses. Inadequate capital levels can limit a bank’s lending
capacity and ability to meet regulatory requirements, potentially
leading to restrictions on growth and raising capital from the market.
4. Credit Availability: High levels of NPAs can impact credit availability
in the economy. When banks accumulate a significant amount

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of NPAs, they become cautious about extending new loans. The Notes
risk aversion amongst banks increases, leading to tighter lending
standards and reduced credit supply. This can affect businesses
and individuals seeking loans for productive purposes, hindering
investment, expansion, and economic growth.
5. Systemic Risks: The accumulation of NPAs poses systemic risks
to the financial system and the broader economy. If a substantial
number of banks face a high level of NPAs simultaneously, it can
lead to a systemic crisis. It can erode investor confidence, impact
the stability of the banking sector, and potentially lead to bank
failures. The spillover effects of banking distress can have severe
consequences on the overall economy, such as reduced investment,
job losses, and decreased consumer spending.
6. Interest Rates and Borrowing Costs: NPAs can impact interest
rates and borrowing costs in the economy. When banks face higher
levels of NPAs, they may increase lending rates to compensate for
the potential losses. Higher interest rates make borrowing more
expensive for businesses and individuals, reducing their ability to
access credit for productive purposes. This can have a dampening
effect on economic activity, including investment and consumption.
7. Reputation and Investor Confidence: The presence of a large
number of NPAs can negatively impact the reputation and investor
confidence in banks and the financial system. Investors may lose
trust in banks’ ability to manage risks and protect their investments.
Decreased investor confidence can result in capital outflows, reduced
access to funding, and volatility in financial markets.
To mitigate the impact of NPAs, banks employ various strategies such
as NPA resolution mechanisms, loan restructuring, and strengthened risk
management practices. Effective NPA management is crucial for maintaining
the stability of banks, promoting lending activity, and supporting sustainable
economic growth.

4.9 NPA Management and Resolution

NPA management and resolution are critical aspects for banks and financial
institutions to mitigate the impact of Non-Performing Assets (NPAs) on

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Notes their balance sheets and enhance their overall financial health. Effective
management and resolution strategies are aimed at minimizing losses,
recovering dues, and restoring the health of loan portfolios. Here is an
elaboration on NPA management and resolution:
1. Loan Restructuring: Loan restructuring involves modifying the terms
and conditions of the loan to provide relief to borrowers facing
financial difficulties. This can include extending the loan tenure,
reducing interest rates, or granting a moratorium on repayments.
Loan restructuring aims to improve the borrower’s cash flow and
increase the chances of loan repayment. It is typically done on a
case-by-case basis after careful evaluation of the borrower’s financial
situation and repayment capacity.
2. Asset Classification and Provisioning: Banks classify their assets
into different categories based on the severity of default. Proper
asset classification helps in assessing the risk profile of the loan
portfolio accurately. As per regulatory guidelines, banks need to
make provisions for potential losses on NPAs. Higher provisions
are set aside for loans classified as substandard, doubtful, or loss
assets. Adequate provisioning ensures that banks have adequate
buffers to absorb potential losses arising from NPAs.
3. Recovery Mechanisms: Banks employ various mechanisms to recover
dues from NPAs. These include:
(a) Legal Measures: Banks can initiate legal proceedings to recover
dues by filing lawsuits, obtaining court orders, or attaching
the borrower’s assets.
(b) Debt Recovery Tribunals (DRTs): DRTs provide a specialized
forum for banks to recover dues from defaulting borrowers.
They have the power to seize and sell the borrower’s assets
to recover the outstanding debt.
(c) Securitization and Asset Reconstruction: Banks can transfer
NPAs to Asset Reconstruction Companies (ARCs) through
securitization or sell them to ARCs at a discounted price.
ARCs specialize in recovering and resolving distressed assets.
(d) One-Time Settlement (OTS): Banks may negotiate with borrowers
for a one-time settlement, wherein the borrower agrees to pay
a reduced amount to settle the outstanding dues.

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(e) Debt Recovery Agents: Banks may engage debt recovery agents Notes
who specialize in tracing defaulting borrowers, negotiating
settlements, and facilitating the recovery process.
4. Strengthened Credit Appraisal and Risk Management: To prevent
future NPAs, banks need to strengthen their credit appraisal processes
and risk management frameworks. This includes robust evaluation of
borrowers’ creditworthiness, thorough assessment of the borrower’s
financials, collateral valuation, and periodic monitoring of loan
accounts. Banks should also implement effective early warning
systems to identify signs of potential default and take timely
corrective measures.
5. Loan Sale and Securitization: Banks can opt for loan sale and
securitization to transfer NPAs off their balance sheets. This
involves selling NPAs to other financial institutions or investors at
a discounted price. Loan sale and securitization help banks improve
their liquidity position and reduce exposure to NPAs. However, this
approach requires thorough due diligence and proper valuation to
ensure a fair price is obtained.
6. Strengthening Recovery and Collection Processes: Banks can enhance
their recovery and collection processes by establishing specialized
recovery units, deploying trained recovery agents, and leveraging
technology-driven solutions. Improved recovery processes facilitate
the timely identification of defaulting accounts, proactive follow-
ups with borrowers, and efficient tracking of recovery progress.
7. Recapitalization and Capital Infusion: In cases where banks face
a substantial burden of NPAs, recapitalization and capital infusion
may be necessary. This involves raising additional capital through
various means, such as government support, equity dilution, or
attracting investments from stakeholders. Recapitalization strengthens
the capital base of banks, enabling them to absorb losses, sustain
lending activities, and meet regulatory capital requirements. Capital
infusion provides banks with the necessary resources to resolve
NPAs and restore financial stability.
8. Improved Governance and Risk Culture: Banks need to focus on
strengthening their governance structures and fostering a robust

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Notes risk management culture. This includes having independent risk

management departments, clear risk policies and frameworks, and
effective internal controls. Strong governance and risk management
practices help in the early identification and mitigation of risks,
reducing the chances of NPAs.
9. Enhancing Credit Monitoring and Early Warning Systems: Banks
should establish robust credit monitoring mechanisms and early
warning systems to identify signs of potential default at an early
stage. This involves setting up early warning indicators, regular
monitoring of the financial performance of borrowers, and timely
actions to address emerging risks. Early intervention can help banks
take proactive measures to prevent loans from becoming NPAs.
10. Regulatory and Government Support: Regulators and governments
play a crucial role in facilitating NPA management and resolution.
They can introduce policies, guidelines, and frameworks to address
the challenges associated with NPAs. Measures such as setting up
dedicated debt recovery tribunals, creating asset reconstruction
companies, and implementing bankruptcy and insolvency frameworks
provide a supportive environment for banks to resolve NPAs
effectively.
It is important to note that NPA management and resolution require a
comprehensive and holistic approach. Banks need to strike a balance
between recovering dues and supporting borrowers in financial distress. By
implementing effective strategies and frameworks, banks can minimize the
impact of NPAs, restore the health of their loan portfolios, and contribute
to the stability of the financial system.

IN-TEXT QUESTIONS
1. What does NPA stand for in the context of banking?
(a) Non-Performing Account
(b) Non-Profit Asset
(c) Non-Performing Asset
(d) Non-Participating Agreement

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2. Which of the following is NOT a cause of Non-Performing Notes

Assets?
(a) Defaulted loan repayments
(b) Economic downturn
(c) Poor credit appraisal and
(d) Prompt interest monitoring payments
3. What are the implications of high levels of NPAs for banks?
(a) Increased profitability
(b) Enhanced credit worthiness
(c) Potential capital erosion
(d) Higher customer satisfaction
4. Which regulatory body in India oversees the resolution of NPAs
in banks?
(a) Reserve Bank of India (RBI)
(b) Securities and Exchange Board of India (SEBI)
(c) Insurance Regulatory and Development Authority of India
(IRDAI)
(d) Ministry of Finance
5. Which of the following is a common resolution strategy for
NPAs?
(a) Loan forgiveness
(b) Asset Reconstruction Company (ARC)
(c) Debt issuance
(d) Increasing interest rates

4.10 Risk Management in Banks

Risk management is a crucial aspect of the banking industry as banks are
exposed to various types of risks that can impact their financial stability
and performance. Effective risk management helps banks identify, assess,
monitor, and mitigate risks to protect their assets, maintain profitability,

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Notes and ensure the safety and soundness of the financial system. Here is an
elaboration on risk management in banks:
1. Risk Identification: The first step in risk management is the
identification of various types of risks faced by banks. These risks
include credit risk, market risk, liquidity risk, operational risk, and
strategic risk. Credit risk refers to the potential losses arising from
borrowers’ inability to repay their loans. Market risk encompasses
the potential losses arising from adverse movements in interest rates,
exchange rates, and market prices of financial instruments. Liquidity
risk is the risk of insufficient funds to meet obligations. Operational
risk involves the risk of losses due to internal processes, systems,
or external events. Strategic risk pertains to risks associated with
the bank’s strategic decisions and business model.
2. Risk Assessment and Measurement: After identifying risks, banks
assess and measure the potential impact and likelihood of those
risks. This involves quantitative analysis, stress testing, scenario
analysis, and the use of risk models and methodologies. Credit risk
assessment includes evaluating borrowers’ creditworthiness, analyzing
collateral, and assigning credit ratings. Market risk assessment involves
measuring potential losses from market fluctuations. Liquidity risk
assessment focuses on analyzing the adequacy of funding sources
and the ability to meet cash flow obligations. Operational risk
assessment involves identifying vulnerabilities in internal processes,
systems, and controls.
3. Risk Monitoring and Reporting: Banks implement robust systems to
monitor risks on an ongoing basis. This includes regular monitoring of
credit portfolios, market positions, liquidity positions, and operational
processes. Risk monitoring involves the use of risk indicators, key
risk metrics, and early warning systems to detect deviations from
risk appetite and trigger appropriate actions. Banks also establish
reporting mechanisms to provide timely and accurate information
on risk exposures to management, board of directors, regulators,
and stakeholders.
4. Risk Mitigation and Control: Banks employ various strategies to
mitigate risks and establish controls to minimize the likelihood
and impact of risks. Credit risk mitigation techniques include

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diversification of loan portfolios, collateral requirements, credit risk Notes

transfer through loan securitization or credit derivatives, and the use
of loan guarantees. Market risk can be managed through hedging
strategies, portfolio diversification, and the use of derivatives.
Liquidity risk can be mitigated through maintaining adequate liquidity
buffers, diversifying funding sources, and establishing contingency
funding plans. Operational risk can be controlled through robust
internal controls, process automation, employee training, and business
continuity plans.
5. Risk Governance and Framework: Effective risk management
requires a strong risk governance framework within banks. This
involves establishing clear risk management policies, risk appetite
statements, and risk management committees. Banks need to ensure
that there is a clear segregation of duties, effective risk culture, and
a risk-aware mindset across the organization. Risk governance also
involves assigning responsibilities for risk management, regular risk
assessments, and independent risk oversight.
6. Regulatory Compliance: Banks operate within a regulatory framework
that sets guidelines and standards for risk management. Compliance
with regulatory requirements is essential for ensuring the stability
and integrity of the banking system. Banks need to adhere to capital
adequacy regulations, risk-based capital requirements, reporting
obligations, and stress testing requirements imposed by regulatory
authorities. Compliance with regulations helps banks maintain
financial stability and enhances market confidence.
7. Technology and Data Analytics: Advancements in technology and
data analytics have transformed risk management in banks. Banks
now rely on sophisticated risk management systems, data analytics
tools, and artificial intelligence to enhance risk identification,
assessment, and monitoring. These technologies enable banks to
analyze large volumes of data, identify patterns, and make informed
risk management decisions. They also facilitate real-time risk
monitoring, scenario analysis, and stress testing. The use of technology
and data analytics improves the efficiency and effectiveness of risk
management processes in banks.

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Notes 8. Risk Culture and Training: Developing a strong risk culture within
the organization is crucial for effective risk management. Banks
need to foster a risk-aware culture where risk management is
embedded in the decision-making process at all levels. This involves
promoting risk consciousness, providing training and awareness
programs on risk management, and incentivizing risk-conscious
behaviour. Employees should be equipped with the necessary skills
and knowledge to understand and manage risks effectively.
9. Contingency Planning and Stress Testing: Banks should develop
comprehensive contingency plans to address potential risks and
adverse scenarios. Contingency planning involves identifying potential
stress events, assessing their impact, and developing strategies to
mitigate the effects. Stress testing is an important tool to evaluate
the resilience of banks against adverse scenarios and assess their
ability to withstand shocks. Banks conduct regular stress tests to
identify vulnerabilities and take proactive measures to strengthen
their risk management frameworks.
10. Continuous Improvement and Adaptation: Risk management is an
ongoing process that requires continuous improvement and adaptation
to changing market conditions and regulatory requirements. Banks
should regularly review and update their risk management frameworks,
policies, and procedures to address emerging risks and best practices.
They should stay updated with industry developments, regulatory
changes, and evolving risk landscapes to ensure the effectiveness
of their risk management practices.
Effective risk management is essential for banks to navigate uncertainties,
protect their financial health, and maintain the confidence of stakeholders.
By implementing robust risk management frameworks, banks can enhance
their resilience, optimize risk-return trade-offs, and contribute to the
stability and soundness of the financial system.

4.11 Risk Management Framework

1. Risk Identification, Measurement and Assessment: Risk identification
is the process of identifying and understanding various types of
risks that a bank may face. This involves identifying both internal

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and external risks that can affect the bank’s operations, financial Notes
position, and reputation. Internal risks include credit risk, market risk,
liquidity risk, operational risk and compliance risk. External risks
encompass macroeconomic factors, regulatory changes, geopolitical
events, and technological advancements. Once risks are identified,
banks need to measure and assess the potential impact and likelihood
of those risks. This involves using quantitative and qualitative
methods to quantify risks and evaluate their potential consequences.
Quantitative methods include statistical models, scenario analysis,
and stress testing. Qualitative methods involve expert judgment and
risk assessment frameworks. The assessment helps prioritize risks
and allocate resources for risk mitigation.
2. Risk Mitigation and Control Strategies: Risk mitigation and control
strategies aim to reduce the likelihood and impact of identified
risks. These strategies involve establishing policies, procedures, and
controls to manage risks within acceptable levels. Risk mitigation
strategies may include:
(a) Diversification: Banks can diversify their portfolios to reduce
concentration risk. This involves spreading investments across
different sectors, geographical areas, and asset classes to
minimize the impact of adverse events in specific areas.
(b) Risk Transfer: Banks can transfer risk through various
mechanisms such as insurance, reinsurance, and securitization.
Risk transfer allows banks to protect themselves against
potential losses by transferring the risk to external parties.
(c) Risk Avoidance: In certain cases, banks may choose to avoid or
limit exposure to high-risk activities or clients. This involves
setting risk appetite limits and avoiding transactions or business
activities that exceed these limits.
(d) Risk Monitoring and Controls: Banks establish robust risk
monitoring systems and controls to track risk exposures and
deviations from established risk limits. This includes regular
reporting, exception monitoring, and internal audit processes
to ensure compliance with risk management policies and
procedures.

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Notes (e) Contingency Planning: Banks develop contingency plans to

address potential risks and adverse scenarios. Contingency
planning involves identifying potential stress events, assessing
their impact, and developing strategies to mitigate the effects.
This ensures that banks have appropriate measures in place
to respond effectively to unexpected events.
3. Basel Accords and their Impact on Risk Management: The Basel
Accords are international regulatory frameworks developed by the
Basel Committee on Banking Supervision (BCBS) to enhance the
stability and soundness of the global banking system. The accords
provide guidelines and standards for risk management, capital
adequacy, and regulatory supervision. The most significant accords
are Basel I, Basel II, and Basel III.
Basel I, implemented in 1988, introduced minimum capital requirements
based on credit risk. It categorized assets into different risk weights, with
higher-risk assets requiring higher capital reserves.
Basel II, implemented in 2004, expanded the risk categories to include
operational risk and introduced more sophisticated risk measurement and
management techniques. It emphasized the use of internal risk models
and introduced the concept of economic capital.
Basel III, implemented in response to the global financial crisis of 2008,
introduced stricter capital requirements, liquidity standards, and leverage
ratios. It emphasized the importance of risk management and stress testing,
requiring banks to hold higher-quality capital and maintain sufficient
liquidity buffers.
The Basel Accords have had a significant impact on risk management in
banks. They have led to improvements in risk identification, measurement,
and management practices. Banks have had to strengthen their risk
governance structures, enhance risk measurement models, and allocate
sufficient capital for risk-bearing activities. The accords have also increased
the focus on liquidity risk management and prompted banks to establish
robust liquidity risk management frameworks.
Basel III has particularly emphasized the importance of risk management
in banks’ day-to-day operations. It has placed greater emphasis on risk
disclosure, stress testing, and capital adequacy. Banks are required to

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enhance their risk management capabilities and demonstrate their ability Notes
to withstand adverse economic conditions. Basel III has also introduced
requirements for the measurement and management of interest rate risk
in the banking book and operational risk.
Furthermore, the Basel Accords have influenced risk culture within
banks, promoting a greater focus on risk awareness, accountability,
and transparency. Banks have had to strengthen their risk governance
structures, establish clear roles and responsibilities for risk management,
and enhance risk reporting and communication practices.
The implementation of the Basel Accords has not been without challenges.
The increased regulatory requirements have placed additional compliance
burdens on banks, requiring them to invest in advanced risk management
systems, data infrastructure, and skilled personnel. Compliance with
the accords has also led to increased capital requirements, potentially
impacting banks’ profitability and lending capacity.
Nevertheless, the Basel Accords have contributed to the overall improvement
of risk management practices in banks. They have fostered a more
comprehensive and sophisticated approach to risk identification, measurement,
and mitigation. Banks have become more resilient and better equipped to
manage risks, enhancing the stability of the financial system.
In conclusion, the Basel Accords have had a significant impact on risk
management in banks. The accords have prompted banks to strengthen their
risk management frameworks, enhance risk identification and measurement
processes, and establish robust risk mitigation strategies. The focus on
capital adequacy, liquidity management, and risk disclosure has led to
more resilient and transparent banking practices. While compliance with
the accords poses challenges for banks, the overall effect has been a more
robust and well-regulated banking industry.

4.12 Credit Risk Management

1. Overview of Credit Risk and Its Sources: Credit risk refers to the
potential loss that a bank may incur if borrowers or counterparties
fail to fulfil their contractual obligations. It is the risk of default
on a loan or the deterioration in the creditworthiness of a borrower.
Credit risk can arise from various sources, including:

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Notes (a) Borrower Risk: This includes the ability and willingness of
borrowers to repay their loans. Factors such as financial
stability, repayment history, industry conditions, and economic
factors contribute to borrower risk.
(b) Counterparty Risk: Counterparty risk arises from transactions
with other financial institutions or counterparties. It includes
the risk of default or non-performance by the counterparty in
derivative transactions, securities lending, and other financial
arrangements.
(c) Concentration Risk: Concentration risk refers to excessive
exposure to a particular borrower, industry, sector, or geographic
region. Overexposure to a single entity or sector can amplify
the impact of adverse events and increase the risk of loss.
(d) Collateral Risk: Collateral risk is associated with the quality
and valuation of collateral pledged by borrowers. The value of
the collateral may fluctuate, and if it is insufficient to cover
the loan amount, the bank faces a potential loss.
(e) Country Risk: Country risk arises from lending to borrowers
in foreign countries. Factors such as political stability, legal
frameworks, economic conditions, and exchange rate volatility
can impact the ability of borrowers in foreign jurisdictions to
repay their obligations.
2. Credit Appraisal, Monitoring and Recovery: Effective credit risk
management involves a comprehensive approach to credit appraisal,
monitoring, and recovery. This ensures that banks make informed
lending decisions, continuously monitor the creditworthiness of
borrowers, and take timely actions to mitigate potential losses. The
key elements of credit risk management include:
(a) Credit Appraisal: Credit appraisal involves evaluating the
creditworthiness of borrowers before granting loans. This
process includes assessing the financial position of borrowers,
their repayment capacity, business viability, industry analysis,
and collateral valuation. It also involves analyzing qualitative
factors such as management quality, market reputation, and
regulatory compliance. The appraisal process helps banks

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determine the terms and conditions of loans and establish Notes

appropriate credit limits.
(b) Credit Monitoring: Once a loan is disbursed, banks need to
monitor the creditworthiness of borrowers on an ongoing
basis. This includes tracking repayment behaviour, financial
performance, and any changes in borrower circumstances that
may impact their ability to repay. Early warning indicators,
such as financial ratios, credit scores, and industry trends,
are used to detect signs of potential default. Effective credit
monitoring allows banks to take proactive measures to address
deteriorating credit quality and minimize potential losses.
(c) Risk Mitigation: Banks employ various risk mitigation strategies
to minimize credit risk. These strategies include collateral
requirements, credit enhancement mechanisms, and loan
covenants. Collateral helps reduce credit risk by providing
an additional source of repayment in case of default. Credit
enhancements such as guarantees, letters of credit, or insurance
can also mitigate credit risk. Loan covenants set conditions
that borrowers must meet, such as maintaining certain financial
ratios or providing periodic financial statements.
(d) Credit Recovery: In cases where borrowers default on their loan
obligations, banks need to initiate credit recovery measures. This
involves establishing dedicated recovery units or departments
to negotiate with defaulting borrowers, explore restructuring
options, or initiate legal action. Banks may also engage
external agencies or debt recovery mechanisms to recover
outstanding dues. The objective is to minimize losses and
maximize recovery from Non-Performing Assets (NPAs).
(e) Credit Risk Policies and Procedures: Banks should have
well-defined credit risk policies and procedures that outline
the criteria for credit appraisal, risk acceptance levels, risk
grading frameworks, and loan classification and provisioning
guidelines.

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Notes 4.13 Market Risk Management

1. Market Risk Types and Measurement Techniques: Market risk
refers to the potential loss that a bank may face due to adverse
changes in market conditions, including fluctuations in interest rates,
exchange rates, commodity prices, and equity prices. It is the risk
of losses arising from changes in market prices or rates. Market
risk can be categorized into various types:
(a) Interest Rate Risk: This risk arises from changes in interest rates
and affects the bank’s net interest income and the value of its
interest-sensitive assets and liabilities. Banks use techniques
such as duration analysis, repricing gap analysis, and scenario
analysis to measure and manage interest rate risk.
(b) Currency Risk: Currency risk arises from exposure to foreign
exchange rate fluctuations. Banks with international operations or
foreign currency-denominated assets and liabilities are exposed
to this risk. Techniques such as value-at-risk (VaR) models,
stress testing, and scenario analysis are used to measure and
manage currency risk.
(c) Commodity Price Risk: Banks involved in commodity trading
or financing are exposed to commodity price risk. Fluctuations
in commodity prices can impact the value of collateral, loan
repayments, and the profitability of trading activities. Techniques
such as historical simulation, option pricing models, and stress
testing are used to measure and manage commodity price risk.
(d) Equity Price Risk: Equity price risk arises from changes in
stock prices and affects banks with equity investments or
trading activities. The value of equity holdings and trading
positions can be affected by market fluctuations. Techniques
such as sensitivity analysis, VaR models, and stress testing
are used to measure and manage equity price risk.
(e) Volatility Risk: Volatility risk refers to the risk associated with
changes in market volatility. Higher volatility can lead to
larger price movements and increased market risk exposure.
Techniques such as volatility modelling, GARCH models,
and option pricing models are used to measure and manage
volatility risk.

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2. Hedging Strategies and Derivative Products: Banks employ various Notes

hedging strategies and derivative products to manage market risk
exposures. Hedging involves taking offsetting positions in financial
instruments to mitigate the impact of adverse market movements.
Some common hedging strategies and derivative products used for
market risk management include:
(a) Interest Rate Hedging: Banks use interest rate swaps, futures,
options, and interest rate caps and floors to hedge against
interest rate risk. These instruments allow banks to manage
their exposure to changes in interest rates and protect their
net interest income.
(b) Currency Hedging: Banks use currency forwards, options, and
currency swaps to hedge against currency risk. These instruments
help banks reduce the impact of exchange rate fluctuations
on their foreign currency positions and transactions.
(c) Commodity Hedging: Banks involved in commodity trading
or financing use commodity futures, options, and swaps to
hedge against commodity price risk. These instruments allow
banks to mitigate the impact of price fluctuations on their
commodity-related activities.
(d) Equity Hedging: Banks use equity futures, options, and swaps
to hedge against equity price risk. These instruments enable
banks to protect their equity investments or trading positions
from adverse movements in stock prices.
(e) Options and Futures: Banks use options and futures contracts
to hedge various market risk exposures. These instruments
provide flexibility in managing risk and allow banks to protect
their positions or portfolios from adverse market movements.
(f) Structured Products: Banks may create or invest in structured
products that provide customized risk management solutions.
These products combine various derivatives and underlying
assets to offer specific risk profiles and returns.
Hedging strategies and derivative products provide banks with tools to
manage market risk exposures effectively. However, it is important to
note that derivatives also introduce counterparty credit risk, and banks

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Notes need to carefully evaluate the creditworthiness of counterparties and

monitor their exposures to avoid excessive risk concentration. Additionally,
banks need to establish robust risk management policies and procedures
governing the use of hedging strategies and derivatives. This includes
setting clear guidelines for risk limits, counterparty risk assessment,
collateral management, and valuation methodologies.
Furthermore, market risk management should be integrated into the
bank’s overall risk management framework. This involves coordination
and communication between different risk management functions, such
as credit risk, liquidity risk, and operational risk. The aim is to have
a holistic view of the bank’s risk profile and ensure that market risk
management aligns with the bank’s overall risk management strategy.
Market risk measurement techniques should be periodically reviewed
and updated to incorporate changes in market conditions, regulatory
requirements, and industry best practices. Banks should stay abreast of
advancements in risk modelling methodologies and use appropriate tools
to capture and assess market risk exposures accurately.
Overall, effective market risk management requires a proactive and
comprehensive approach. Banks should have a well-defined risk management
framework, appropriate hedging strategies, and a thorough understanding
of the derivative products used for risk mitigation. Regular monitoring,
review, and adaptation of risk management practices are crucial to ensure
that banks can effectively navigate the dynamic and evolving market
conditions while safeguarding their financial stability and profitability.

4.14 Operational Risk Management

1. Identifying Operational Risks in Banking: Operational risk refers to
the risk of loss resulting from inadequate or failed internal processes,
people, and systems or from external events. It encompasses a wide
range of risks associated with day-to-day operations in a bank.
Identifying operational risks involves recognizing potential sources
of risk and assessing their potential impact. Common sources of
operational risks in banking include:

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(a) Internal Fraud: This includes fraudulent activities committed Notes

by employees, such as embezzlement, unauthorized trading,
or misuse of customer funds.
(b) External Fraud: External fraud involves fraudulent activities
perpetrated by individuals or entities outside the bank, such
as identity theft, hacking, or phishing attacks.
(c) Legal and Regulatory Compliance: Non-compliance with
laws, regulations, and industry standards can expose banks to
operational risks, including fines, legal actions, and reputational
damage.
(d) Cybersecurity and Information Technology Risks: Banks face
operational risks related to data breaches, system failures,
cyber-attacks, and disruptions to IT infrastructure. These risks
can lead to financial losses, customer data compromise, and
reputational damage.
(e) Business Continuity and Disaster Recovery: Operational risks
arise from disruptions to business operations due to natural
disasters, power outages, or other unforeseen events. Failure
to have robust business continuity and disaster recovery plans
can result in significant financial and operational losses.
(f) Human Resources: Risks associated with human resources
include inadequate staffing levels, lack of training, poor
performance management, and employee misconduct.
(g) Outsourcing and Third-Party Risks: Banks that outsource
certain functions or rely on third-party providers are exposed
to operational risks arising from the performance or failure
of those entities.
(h) Process and System Failures: Inefficient or inadequate internal
processes, inadequate internal controls, and system failures
can lead to errors, delays, and financial losses.
Identifying operational risks involves conducting risk assessments,
internal control evaluations, and scenario analyses to identify potential
vulnerabilities and gaps in operational processes.
2. Operational Risk Measurement and Control: Operational risk
measurement involves quantifying the potential impact of operational

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Notes risks and determining their likelihood of occurrence. While operational

risks are challenging to measure precisely, banks use various
techniques to assess and control operational risks, including:
(a) Key Risk Indicators (KRIs): KRIs are quantitative or qualitative
metrics that provide early warning signals of potential operational
risks. Examples of KRIs include the number of cybersecurity
incidents, customer complaints, transaction errors, or employee
turnover rates. Monitoring KRIs enables banks to identify
emerging risks and take proactive measures to mitigate them.
(b) Loss Data Collection and Analysis: Banks collect and analyze
loss data from internal incidents and external events to identify
patterns, trends, and root causes of operational losses. This
data helps banks assess the potential frequency and severity
of operational risks and allocate resources accordingly.
(c) Risk and Control Self-Assessment (RCSA): RCSA involves a
systematic evaluation of operational risks and the effectiveness
of internal controls. It includes self-assessment questionnaires,
interviews, and workshops with key stakeholders to identify
control weaknesses, gaps, and areas for improvement.
(d) Scenario Analysis and Stress Testing: Scenario analysis involves
assessing the impact of hypothetical events or extreme scenarios
on the bank’s operations. Stress testing involves subjecting
the bank’s operations to severe but plausible scenarios to
evaluate their resilience. These techniques help banks identify
vulnerabilities, evaluate their risk appetite, and enhance their
operational resilience.
(e) Risk Mitigation and Control Strategies: Banks implement
control measures and risk mitigation strategies to manage
operational risks. These may include segregation of duties,
access controls, fraud detection systems, cybersecurity measures,
disaster recovery plans, and robust internal audit functions.
The aim is to prevent, detect, and mitigate operational risks,
as well as to minimize the potential impact of operational
failures.

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(f) Operational Risk Insurance: Banks may transfer a portion of Notes

their operational risk through insurance coverage. Operational
risk insurance policies provide financial protection against
losses arising from operational failures, fraud, and other related
risks.
(g) Governance and Compliance: Effective governance structures
and compliance frameworks are crucial for managing operational
risks. Banks should establish clear roles and responsibilities,
robust risk management policies and procedures, and strong
internal controls. Compliance with applicable laws, regulations,
and industry standards helps mitigate operational risks associated
with legal and regulatory non-compliance.
(h) Training and Awareness: Banks should provide regular training
and awareness programs to employees to enhance their
understanding of operational risks, internal controls, and risk
management practices. Educating employees about operational
risk management promotes a risk-aware culture and helps in
the early identification and reporting of potential risks.
(i) Continuous Monitoring and Reporting: Banks should establish a
framework for ongoing monitoring and reporting of operational
risks. This includes regular assessments of control effectiveness,
incident reporting and analysis, and periodic risk reporting
to senior management and the board of directors. Effective
monitoring and reporting mechanisms ensure the timely
identification of emerging risks and enable proactive risk
management actions.
Operational risk management is an essential component of overall risk
management in banks. By identifying, measuring, and controlling operational
risks, banks can enhance their resilience, protect their reputation, and
minimize financial losses. A robust operational risk management framework,
supported by appropriate policies, processes, and control measures, helps
banks navigate the complex operational landscape and ensure the stability
and efficiency of their operations.

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Notes 4.15 Universal Banking

A. Definition and Evolution of Universal Banking
1. Understanding Universal Banking Concept: Universal banking
refers to a banking model where financial institutions offer a
comprehensive range of financial services, including commercial
banking, investment banking, and other financial activities, all under
one roof. It allows banks to engage in a diverse set of activities,
such as deposit-taking, lending, underwriting, securities trading,
asset management, and advisory services. Universal banks provide a
wide array of financial products and services to cater to the diverse
needs of their clients, including individuals, corporations, and
institutional investors. The concept of universal banking contrasts
with the traditional separation of banking activities based on the
Glass-Steagall Act in the United States, which enforced a strict
segregation between commercial banking and investment banking
activities. Universal banking models have gained prominence in
various countries worldwide, allowing banks to offer integrated
financial solutions and leverage synergies across different business
lines.
2. Historical Development and Global Trends: The evolution of
universal banking can be traced back to the 19th century, particularly
in Europe. In countries like Germany and Switzerland, universal
banks emerged as financial institutions that combined commercial
banking with investment banking activities. These banks provided a
range of services, including corporate lending, securities underwriting,
and investment advisory, thus catering to the financial needs of both
businesses and individuals.
The global trends in universal banking have varied across countries
and regions. Some key observations include:
(a) Europe: European countries have a long history of universal
banking. In addition to Germany and Switzerland, countries like
France and the United Kingdom have embraced the concept
of universal banking, allowing banks to operate across various
financial sectors. European universal banks have played a
significant role in financing large corporations, facilitating

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mergers and acquisitions, and providing comprehensive financial Notes

services to individuals and businesses.
(b) United States: In the United States, the Glass-Steagall Act,
enacted in 1933, mandated the separation of commercial
banking and investment banking activities. However, this
regulatory framework was gradually dismantled over time.
The repeal of certain provisions of the Glass-Steagall Act
through the Gramm-Leach-Bliley Act in 1999 paved the way
for the emergence of financial conglomerates that engage in
both commercial and investment banking activities. This led
to the reintegration of banking activities and the adoption of
a more universal banking approach.
(c) Asia-Pacific Region: The Asia-Pacific region has witnessed
a growing trend towards universal banking. Countries like
Japan, Singapore, and Hong Kong have embraced this model,
allowing banks to offer a wide range of financial services.
Universal banks in the region have expanded their operations
and established a strong presence in multiple financial sectors,
including commercial banking, investment banking, wealth
management, and insurance.
The need for universal banking arises from various factors. Some key
reasons for the importance of universal banking include:
(a) Integrated Financial Solutions: Universal banks are well-positioned
to offer integrated financial solutions by combining commercial
banking, investment banking, and other financial services. This allows
them to provide a comprehensive suite of products and services
tailored to the diverse needs of their clients. Customers can access
a wide range of financial services under one roof, simplifying their
financial transactions and relationship management.
(b) Synergies and Cross-Selling Opportunities: Universal banks can
leverage synergies across different business lines. For example, a
universal bank can cross-sell products and services to its existing
customer base, leading to enhanced customer loyalty and increased
revenue streams. The integration of banking activities allows for
a more holistic approach to financial services, fostering stronger
customer relationships and promoting long-term business growth.

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Notes (c) Risk Diversification: Universal banks can diversify their risk exposure
by operating in multiple financial sectors. Diversification across
different lines of business and geographic regions can help mitigate
risks associated with economic fluctuations, market volatility, and
sector-specific challenges. Universal banks can balance the potential
risks and returns of different activities, reducing their vulnerability
to any single sector or market segment.
(d) Efficiency and Cost Savings: Universal banks can achieve economies
of scale and scope by integrating various financial activities.
Consolidating operations, systems, and resources can lead to cost
savings and operational efficiencies. For example, sharing infrastructure,
technology platforms, and back-office functions across different
business lines can reduce redundancies and streamline processes,
resulting in improved cost-effectiveness.
(e) Enhanced Financial Stability: Universal banks, through their
diversified business activities and revenue streams, can enhance
financial stability. While individual sectors or markets may experience
volatility or downturns, the overall resilience of the bank may be
strengthened by the combination of different activities. This can
contribute to the stability of the banking system as a whole, reducing
systemic risks and promoting sustainable growth.
(f) Global Competitiveness: Universal banks, with their broad range of
financial services and capabilities, are better equipped to compete
in the global marketplace. They can cater to the diverse needs
of international clients, provide cross-border financing, facilitate
international trade, and support multinational corporations. Universal
banks can leverage their extensive networks and expertise to expand
their reach and compete effectively in the global financial landscape.
In summary, universal banking offers a comprehensive and integrated
approach to financial services. It enables banks to provide a wide range
of products and solutions, leverage synergies, diversify risks, achieve cost
efficiencies, enhance stability, and compete in the global marketplace.
The historical development and global trends have shaped the concept of
universal banking, and its importance continues to grow in the modern
financial industry.

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4.16 Benefits and Challenges of Universal Banking Notes

1. Synergies and Diversification Advantages: One of the primary

benefits of universal banking is the potential for synergies and
diversification advantages. By offering a wide range of financial
services under one roof, universal banks can leverage synergies across
different business lines. This allows for cross-selling opportunities,
where customers can access multiple products and services from a
single provider. Cross-selling enhances customer loyalty, improves
customer retention, and increases revenue streams for the bank.
Diversification is another advantage of universal banking. Operating
in multiple financial sectors allows banks to diversify their risk
exposure. Economic fluctuations, market volatility, and sector-
specific challenges can be mitigated through diversification. If one
sector or market segment experiences a downturn, the bank can
offset potential losses with gains from other sectors, contributing
to overall financial stability.
2. Regulatory and Operational Challenges: Despite the benefits,
universal banking also presents certain challenges, particularly in
the areas of regulation and operations.
(a) Regulatory Challenges: Universal banks face complex regulatory
frameworks due to the breadth of their activities. Regulators
need to strike a balance between promoting integrated financial
services and ensuring financial stability. Managing regulatory
compliance across various sectors and jurisdictions requires
significant resources and expertise. Universal banks must stay
updated with evolving regulatory requirements, demonstrate
robust risk management practices, and maintain adequate
capital and liquidity buffers.
(b) Operational Challenges: The operational complexity of universal
banking can pose challenges. Integrating diverse business lines,
systems, and processes requires effective coordination and
management. Operational risks, such as technology failures,
cyber threats, and human errors, increase with the expansion
of activities. Universal banks need robust operational risk
management frameworks, adequate internal controls, and
ongoing monitoring to mitigate operational risks effectively.

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Notes (c) Information and Data Management: Universal banks handle

vast amounts of data across multiple business lines. Managing
and integrating data from different sources can be a significant
challenge. Effective information and data management systems
are essential to ensure accurate reporting, risk assessment, and
decision-making.
(d) Concentration and Systemic Risks: The concentration of
financial services within a single institution can lead to
potential systemic risks. A failure or distress in one area of
the universal bank could have a cascading effect on other
operations, leading to financial instability. Regulators closely
monitor the interconnectedness and concentration of risk within
universal banks to mitigate systemic risks.
(e) Cultural and Organizational Challenges: Universal banks
often bring together different cultures, practices, and expertise
from various financial sectors. Integrating diverse teams and
aligning organizational cultures can be a significant challenge.
Harmonizing business strategies, risk appetite, and corporate
governance across different divisions require effective leadership
and change management processes.
Addressing these challenges requires proactive risk management, robust
compliance frameworks, investment in technology and infrastructure, and
continuous monitoring and adaptation to regulatory changes.
In summary, universal banking offers synergies, diversification advantages,
and integrated financial solutions. However, the regulatory and operational
challenges should not be overlooked. Universal banks must navigate complex
regulatory environments, manage operational risks effectively, ensure sound
information and data management, mitigate systemic risks, and address
cultural and organizational challenges. By effectively addressing these
challenges, universal banks can harness the benefits of diversification and
integration, contributing to their long-term success in the financial industry.

4.17 Universal Banking in India

1. Evolution of Universal Banking in India: The concept of universal
banking in India has evolved over time, driven by regulatory reforms

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and changing market dynamics. Historically, the Indian banking Notes

system was characterized by a clear separation between commercial
banking and investment banking activities. However, with the aim
of promoting a more integrated and competitive financial sector,
India embarked on a gradual transition towards universal banking.
The process of liberalization and deregulation, which began in the
early 1990s, played a significant role in shaping the evolution of
universal banking in India. The establishment of the Securities and
Exchange Board of India (SEBI) and the introduction of the Capital
Market Reforms Act in 1992 allowed banks to participate in capital
market activities. This marked the beginning of banks expanding
their services beyond traditional lending and deposit-taking activities.
Subsequently, the Narasimham Committee Reports in 1991 and 1998
recommended measures to enhance the efficiency and competitiveness
of the Indian banking sector. These reports emphasized the need for
universal banking to promote integration, diversification, and risk
management in the financial system. The recommendations included
the removal of barriers between commercial and investment banking,
the introduction of new banking licenses, and the strengthening of
prudential regulations.
The introduction of new banking licenses and the subsequent entry
of private sector banks further facilitated the growth of universal
banking in India. Private sector banks, such as HDFC Bank, ICICI
Bank, and Axis Bank, emerged as universal banks, offering a wide
range of financial services beyond traditional banking.
The Reserve Bank of India (RBI), as the central banking authority,
has played a crucial role in regulating and supervising universal
banks. The RBI has implemented prudential norms, capital adequacy
requirements, and risk management guidelines to ensure the stability
and soundness of universal banks in India.
2. Impact on the Indian Financial Sector: The advent of universal
banking in India has had a significant impact on the Indian financial
sector. Some key impacts include:
(a) Integrated Financial Services: Universal banks in India have
expanded their services to include investment banking, wealth
management, insurance, and other financial activities. This
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Notes integration has allowed banks to offer a comprehensive suite

of financial products and services to cater to the diverse needs
of individuals, businesses, and institutional clients. Customers
can access a wide range of services under one roof, simplifying
their financial transactions and relationship management.
(b) Enhanced Competition and Innovation: Universal banking has
intensified competition in the Indian financial sector. The entry
of private sector banks with universal banking capabilities
has spurred innovation, improved customer service, and led
to the development of new financial products and solutions.
The competition has also prompted traditional banks to adapt
and diversify their offerings to remain competitive.
(c) Financial Inclusion: Universal banks in India have played a
crucial role in promoting financial inclusion. By offering a
broad range of services, including basic banking facilities,
loans, and insurance, universal banks have expanded access
to financial services for individuals and businesses in both
urban and rural areas. This has contributed to the government’s
agenda of fostering inclusive growth and reducing the financial
exclusion gap.
(d) Risk Management and Governance: Universal banking has
brought greater focus on risk management and governance in
the Indian financial sector. With a wider range of activities
and increased interconnectedness, universal banks are required
to implement robust risk management frameworks, strengthen
internal controls, and enhance corporate governance practices.
This has led to a greater emphasis on risk assessment,
monitoring, and reporting, promoting a more resilient and
stable financial system.
(e) Cross-Selling and Revenue Streams: Universal banks in India
have leveraged cross-selling opportunities to enhance their
revenue streams. By offering multiple financial services, banks
can cross-sell products and solutions to their existing customer
base. This not only strengthens customer relationships but
also generates additional revenue for the banks. For example,
a universal bank can offer loans, credit cards, investment

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products, and insurance policies to its customers, increasing Notes

the overall profitability of the institution.
(f) Regulatory Challenges and Governance: The emergence of
universal banking in India has posed regulatory challenges for
the authorities. Regulators, such as the RBI and SEBI, have
had to adapt their regulatory frameworks to address the risks
associated with universal banks. Striking a balance between
promoting integrated financial services and ensuring financial
stability has been a key focus. Regulatory guidelines and
prudential norms have been put in place to ensure adequate
capital adequacy, risk management practices, and corporate
governance standards for universal banks.
(g) Systemic Risk Considerations: The expansion of universal
banking in India has raised concerns about systemic risks.
The interconnectedness of different financial activities within
a single institution can amplify risks and vulnerabilities. The
RBI and other regulators closely monitor the concentration
of risk within universal banks to mitigate potential systemic
risks and safeguard the stability of the financial system.
(h) Employment and Economic Growth: The growth of universal
banking in India has contributed to employment generation and
economic growth. As universal banks expand their operations,
they create job opportunities in various sectors, including banking,
finance, and allied services. The availability of diverse financial
services and the efficient allocation of capital through universal
banking can also facilitate economic growth by supporting
investment, entrepreneurship, and business expansion.
In conclusion, the evolution of universal banking in India has transformed
the financial landscape, promoting integrated financial services, enhancing
competition, and contributing to financial inclusion. Universal banks offer
a wide range of services, diversify revenue streams, and drive innovation
in the sector. However, regulators face challenges in maintaining financial
stability, ensuring effective risk management, and addressing systemic
risks associated with universal banking. The ongoing monitoring and
adaptation of regulatory frameworks are crucial to harnessing the benefits
of universal banking while mitigating potential risks.

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Notes
4.18 Core Banking Solutions (CBS)
1. Definition and Concept of CBS: Core Banking Solutions (CBS) refer
to a comprehensive and integrated banking software system that
allows banks to manage their core operations and services centrally.
It provides a common platform for various banking functions,
including account management, deposits, loans, customer relationship
management, payments, and other financial transactions. CBS acts
as the backbone of a bank’s operations, facilitating real-time data
processing, efficient customer service, and seamless integration of
multiple delivery channels.
CBS streamlines and automates banking processes, enabling banks
to offer enhanced services to their customers. It eliminates the need
for separate systems for different banking functions and ensures the
availability of up-to-date and accurate information across all branches
and channels. With CBS, customers can access their accounts and
perform transactions from any branch, ATM, internet banking, or
mobile banking platform, providing convenience and flexibility.
2. Evolution and Adoption of CBS in Banks: The evolution of CBS
can be traced back to the late 20th century when banks started
recognizing the need for centralized and integrated banking systems.
Prior to CBS, banks operated on disparate legacy systems, where
each branch had its own independent systems and databases. This
fragmented approach resulted in inefficiencies, data inconsistencies,
and limited access to customer information.
The adoption of CBS gained momentum in the 1990s with the
advancement of technology and the increasing competition in the
banking sector. Banks realized the importance of consolidating their
operations, standardizing processes, and leveraging technology to
improve efficiency and customer service.
The implementation of CBS typically involves the integration
of various modules, such as core banking, customer relationship
management, treasury management, risk management, and reporting.
The core banking module forms the foundation of CBS, handling
key functions like account opening, transaction processing, balance
management, and interest calculations. Other modules enhance the

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functionality of CBS by incorporating features like customer data Notes

management, analytics, and regulatory compliance.
Banks started adopting CBS in phases, beginning with the migration
of individual branches or specific functions to the centralized
system. Over time, the adoption expanded to cover the entire
network of branches, enabling seamless operations and a unified
customer experience. Today, CBS has become the standard banking
infrastructure for most modern banks, supporting their day-to-day
operations, customer interactions, and overall business growth.
The benefits of CBS adoption include improved operational efficiency,
better risk management, enhanced customer service, streamlined
reporting and compliance, and cost savings through economies of
scale. CBS enables banks to respond rapidly to market changes,
launch new products and services, and adapt to evolving customer
expectations. It also facilitates accurate and timely data analysis,
helping banks make informed decisions and develop targeted
strategies.
The advancement of technology, particularly cloud computing, artificial
intelligence, and data analytics, is further shaping the evolution
of CBS. Banks are leveraging these technologies to enhance the
capabilities of CBS, such as personalization, predictive analytics,
and digital engagement.
In summary, Core Banking Solutions (CBS) revolutionized the way banks
operate by providing a centralized and integrated banking system. CBS
improves operational efficiency, customer service, and risk management
for banks. It has evolved as the standard infrastructure in the banking
sector, enabling seamless operations, centralized data management, and
efficient delivery of banking services.

IN-TEXT QUESTIONS
6. What is the primary characteristic of universal banking?
(a) Offering a wide range of financial services under one roof
(b) Focusing exclusively on retail banking services
(c) Operating in multiple countries simultaneously
(d) Specializing in investment banking activities

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Notes 7. Which of the following is a benefit associated with universal

banking?
(a) Limited risk exposure due to diversification
(b) Specialization in a specific financial service area
(c) Reduced regulatory oversight
(d) Lower operational costs
8. Core Banking Solutions (CBS) refers to:
(a) Integration of various banking systems into a centralized
platform
(b) Offering only basic banking services to customers
(c) Non-performing assets management strategy
(d) Exclusive use of digital banking channels
9. What is the role of Core Banking Solutions (CBS) in banking
operations?
(a) Streamlining and automating various banking processes
(b) Enhancing customer convenience through mobile banking
apps
(c) Facilitating international money transfers
(d) Providing financial advice and investment services
10. Which of the following is a challenge associated with the
implementation of Core Banking Solutions (CBS)?
(a) Limited availability of digital banking channels
(b) Higher cost of technology infrastructure
(c) Decreased operational efficiency
(d) Reduced customer satisfaction

4.19 Features and Benefits of CBS

1. Integrated Banking Operations: CBS offers integration of various
banking functions, including account management, deposits, loans,
payments, and customer relationship management. It provides a
centralized platform where all customer data and transactions are

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stored and managed. This integration allows banks to streamline Notes

their operations, eliminate data redundancies, and ensure consistency
across all branches and channels. It enables real-time data processing,
immediate updates to account balances and seamless transfer of
funds between accounts. Integrated banking operations through CBS
enhance operational efficiency, reduce manual errors, and improve
overall productivity.
2. Customer-Centric Services and Convenience: CBS enables banks
to offer customer-centric services and enhanced convenience to
their customers. With CBS, customers can access their accounts
and perform transactions from any branch, ATM, internet banking,
or mobile banking platform. They can view their account balances,
transaction history, and statements in real time. CBS also enables
personalized services, such as customized account preferences,
targeted product offerings, and tailored communication. By leveraging
customer data available through CBS, banks can provide proactive
customer support, timely notifications, and personalized banking
experiences. The convenience and flexibility offered by CBS enhance
customer satisfaction and loyalty.

4.20 Implementation and Challenges of CBS

1. Steps Involved in CBS Implementation: The implementation of
CBS typically involves the following steps:
(a) Requirement Analysis: Banks need to assess their existing
systems, identify their operational needs and goals, and define
the scope of CBS implementation.
(b) System Selection: Banks evaluate different CBS software
solutions available in the market and select the one that aligns
with their requirements and future growth plans.
(c) Data Migration: Banks need to migrate their existing data
from legacy systems to the new CBS platform. This process
involves data extraction, cleansing, transformation, and loading
into the CBS database.
(d) Customization and Configuration: Banks customize and
configure the CBS software to align with their specific

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Notes workflows, products, and services. This includes defining

parameters, workflows, access controls, and integrating with
external systems, if required.
(e) Testing and Training: Banks conduct extensive testing to
ensure the accuracy and reliability of the CBS system. They
also provide training to their staff to familiarize them with
the new system and its functionalities.
(f) Go-Live and Post-Implementation Support: Once the CBS
system is ready, banks switch to the new system and start
operating on the CBS platform. Post-implementation support
is provided to address any issues, optimize performance, and
ensure a smooth transition.
2. Challenges and Risks in CBS Adoption: CBS adoption poses certain
challenges and risks that banks need to address:
(a) Technological Challenges: Implementing CBS requires robust
IT infrastructure, including hardware, software, and network
capabilities. Banks need to ensure that their systems can
handle the increased data processing and transaction volumes.
Upgrading existing infrastructure and ensuring compatibility
with the CBS software can be a significant challenge.
(b) Data Security and Privacy: CBS involves the centralized
storage and management of sensitive customer data. Banks
must implement stringent security measures to protect customer
information from unauthorized access, data breaches, and
cyber threats. Compliance with data privacy regulations, such
as GDPR (General Data Protection Regulation), is crucial.
(c) Change Management: CBS implementation brings significant
changes to the bank’s operations, processes, and workflows.
Managing change, training staff, and ensuring their readiness to
adapt to the new system is essential. Resistance to change and
inadequate training can hinder the successful implementation
of CBS.
(d) Cost and Return on Investment: CBS implementation involves
substantial financial investments, including software licenses,
hardware upgrades, data migration, training, and ongoing

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maintenance costs. Banks need to carefully evaluate the costs Notes

and expected benefits to ensure a positive return on investment.
(e) Operational Disruptions: During the transition to CBS, there
is a risk of operational disruptions. Banks need to carefully
plan the migration process to minimize disruptions to customer
services. This includes ensuring smooth data migration,
conducting thorough testing, and providing sufficient training
to staff members.
(f) Regulatory Compliance: CBS implementation requires banks to
adhere to regulatory guidelines and compliance requirements.
Banks must ensure that the CBS system meets regulatory
standards, such as Anti-Money Laundering (AML) and Know-
Your-Customer (KYC) regulations. Failure to comply with these
regulations can result in penalties and reputational damage.
(g) Vendor Selection and Management: Choosing the right CBS
vendor is crucial for successful implementation. Banks need to
assess the vendor’s track record, reputation, support services,
and scalability of the software. Additionally, effective vendor
management is essential throughout the implementation and
post-implementation phases.
Despite these challenges, the benefits of CBS adoption outweigh the
risks. CBS streamlines banking operations, improves customer service,
enables real-time information access, and enhances overall efficiency. It
allows banks to offer a wide range of services through multiple channels,
providing convenience to customers. Successful CBS implementation
requires careful planning, collaboration with stakeholders, effective
change management, and ongoing monitoring and maintenance to ensure
its seamless operation and maximize its benefits.

4.21 NBFCs and its Types

Non-Banking Financial Companies (NBFCs) are financial institutions that
offer various banking services and financial products, similar to traditional
banks, but they do not hold a banking license. NBFCs play a crucial role
in the financial system by providing credit, investment opportunities, and
other financial services to individuals and businesses.

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Notes There are several types of NBFCs, each catering to specific financial
needs and activities.
Here are some common types of NBFCs:
1. Asset Financing NBFCs: These NBFCs primarily engage in
financing assets such as vehicles, machinery, equipment, or other
tangible assets. They provide loans for the purchase of these assets
and offer lease financing options as well.
2. Loan Companies: Loan companies focus on providing loans and
credit facilities to individuals and businesses. They offer various
types of loans, including personal loans, business loans, consumer
loans, and housing loans.
3. Investment Companies: Investment companies deal with investing
in various financial assets such as stocks, bonds, mutual funds,
and other securities. They pool funds from investors and manage
portfolios to generate returns.
4. Infrastructure Finance Companies (IFCs): IFCs specialize in
financing infrastructure projects such as roads, bridges, power plants,
telecommunications, and other similar ventures. They play a vital
role in supporting the development of infrastructure in the country.
5. Microfinance Institutions (MFIs): MFIs focus on providing financial
services to low-income individuals and small businesses who
typically do not have access to traditional banking services. They
offer microloans, micro insurance, and other financial products
tailored to the needs of the economically disadvantaged.

4.22 Comparison Between Banks and NBFCs

While both banks and NBFCs operate in the financial sector and offer
financial services, there are several key differences between them. Here’s
a comparison between banks and NBFCs:
1. Regulatory Framework: Banks are regulated by the central bank or
the banking authority of the country, such as the Reserve Bank of
India (RBI). They are subject to stringent regulatory requirements,
including capital adequacy norms, reserve requirements, and liquidity

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ratios. NBFCs, on the other hand, are regulated by the RBI but with Notes
a more flexible regulatory framework compared to banks.
2. Deposit-Taking: Banks have the authority to accept deposits from
the public, which is a core function of banking. They offer savings
accounts, current accounts, fixed deposits, and other deposit products.
NBFCs, in general, are not allowed to accept demand deposits from
the public. However, certain types of NBFCs, known as Deposit-
taking NBFCs (NBFC-Ds), are authorized to accept deposits subject
to specific conditions.
3. Credit Creation: Banks have the unique ability to create credit by
accepting deposits and providing loans. They can create money
through the process of fractional reserve banking. NBFCs, on the
other hand, do not have the authority to create credit. They raise
funds from various sources, including banks, financial institutions,
debenture holders, and the public, and then lend those funds to
borrowers.
4. Access to Central Bank Facilities: Banks have direct access to
central bank facilities, such as borrowing from the central bank’s
discount window or availing themselves of liquidity support during
financial crises. NBFCs, on the other hand, do not have direct access
to such facilities and rely on interbank borrowing or alternative
sources of liquidity.
5. Services Offered: Banks provide a wide range of services, including
deposits, loans, credit cards, trade finance, foreign exchange services,
wealth management, and investment banking. NBFCs specialize in
specific financial activities, such as lending, leasing, hire purchase,
investment, or asset management. They focus on niche areas and
cater to specific customer segments or industries.
It’s important to note that while NBFCs and banks differ in certain
aspects, both play important roles in the financial ecosystem. Here
are a few additional points of comparison:
6. Capital Requirements: Banks have higher capital requirements
compared to NBFCs. This ensures that banks have a strong financial
base to support their operations and absorb potential losses. NBFCs,
while subject to capital adequacy norms, generally have lower capital

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Notes requirements, allowing them to be more nimble in terms of their

operations and risk appetite.
7. Risk Management: Banks are required to have comprehensive risk
management frameworks in place, including credit risk, market
risk, liquidity risk, and operational risk. They are also subjected
to regular stress tests and assessments to ensure their stability and
ability to withstand adverse economic conditions. NBFCs have risk
management systems as well, but the regulatory requirements are
often less stringent compared to banks.
8. Public Trust: Banks, being heavily regulated and having a long-
standing presence, often enjoy a higher level of public trust and
confidence. Customers tend to perceive banks as more secure
and reliable due to the deposit insurance provided by regulatory
authorities. NBFCs, on the other hand, may face challenges in
establishing and maintaining public trust, particularly those that do
not accept deposits.
9. Branch Network: Banks typically have a wide network of branches,
providing physical access to customers in various locations. This
allows for personal interaction and a range of banking services
at multiple locations. NBFCs generally have a smaller branch
network or may operate through a centralized office, relying more
on technology-driven platforms and digital channels for service
delivery.
10. Lending Flexibility: NBFCs often have more flexibility in terms of
lending practices compared to banks. They can design customized
loan products, offer quicker loan approvals, and cater to specific
customer segments that may not meet the stringent criteria of banks.
This flexibility allows NBFCs to fill gaps in the credit market and
meet the diverse financing needs of individuals and businesses.
In summary, while banks and NBFCs share similarities in offering financial
services, their differences lie in regulatory frameworks, deposit-taking
abilities, credit creation, access to central bank facilities, and the range
of services provided. Understanding these distinctions is crucial for
individuals and businesses to make informed decisions regarding their
financial needs and preferences. Both banks and NBFCs contribute to

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the overall growth and stability of the financial system, complementing Notes
each other’s roles in serving the diverse requirements of the economy.

4.23 Summary
In this lesson, we will delve into the subject of Financial Markets &
Institutions, focusing on the crucial role of banks in the economy. We
explored topics such as Non-Performing Assets (NPA), Risk Management
in Banks, the need for and importance of Universal Banking, Core
Banking Solutions (CBS) and compared banks with Non-Banking Financial
Companies (NBFCs).

4.24 Answers to In-Text Questions

1. (c) Non-Performing Asset

2. (d) Prompt interest monitoring payments
3. (c) Potential capital erosion
4. (a) Reserve Bank of India (RBI)
5. (b) Asset Reconstruction Company (ARC)
6. (a) Offering a wide range of financial services under one roof
7. (a) Limited risk exposure due to diversification
8. (a) Integration of various banking systems into a centralized platform
9. (a) Streamlining and automating various banking processes
10. (b) Higher cost of technology infrastructure

4.25 Self-Assessment Questions

1. Explain the role of banks in the financial market and discuss their
importance in facilitating economic growth and stability. Provide
examples to support your answer.
2. Discuss the concept of Non-Performing Assets (NPA) in banks.
Identify and analyze the main reasons for the accumulation of NPAs
and explain their impact on banks and the broader economy.

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Notes 3. Compare and contrast the functions and operations of commercial

banks, development banks, and cooperative banks. Highlight their
target customers and the specific services they provide. Provide
real-world examples to illustrate your points.
4. Describe the principles and practices of risk management in banks.
Discuss the components of a risk management framework and
explain their significance in ensuring the stability and resilience of
banking institutions. Provide examples of risk mitigation strategies
used by banks.
5. Explore the concept of universal banking and its historical development.
Discuss the benefits and challenges associated with universal banking,
including synergies, diversification advantages, and regulatory
considerations. Provide insights into the impact of universal banking
on the Indian financial sector.

4.26 Suggested Readings

u Pathak, B. Indian Financial System (5th ed). Pearson Publication.
u Saunders, A. & Cornett, M.M. Financial Markets and Institutions
(3rd Ed). Tata McGraw Hill.
u Bhole L.M. and Mahakud J., Financial Institutions and Markets:
Structure, Growth, and Innovations (6th Edition). McGraw Hill
Education, Chennai, India.
u Jeff Madura, Financial Institutions and Markets, Cengage Learning
EMEA, 2008.
u Khan, M.Y. Financial Services (8th ed). McGraw Hill Education.

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L E S S O N

5
Financial Markets
Ms. Jasmit Kaur
Sri Guru Gobind Singh College of Commerce
University of Delhi
Email-Id: jasmitkaur@[Link]

STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 Role and Importance of Financial Markets
5.4 Types of Financial Markets
5.5 Linkages Between Economy and Financial Markets
5.6 Integration of Indian Financial Markets with Global Financial Markets
5.7 Primary Market Instruments
5.8 Merchant Bank: Roles and Functions
5.9 Listing and Delisting of Corporate Stocks
5.10 Introduction to Foreign Exchange Market
5.11 Summary
5.12 Answers to In-Text Questions
5.13 Self-Assessment Questions
5.14 Suggested Readings

5.1 Learning Objectives

u Aims to develop understanding of basics of financial markets and its types.
u Give a fundamental knowledge on various ways of raising money from the primary
markets.
u Demonstrate knowledge and understanding of corporate listing and delisting process.

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Notes u Provide an introduction to the foreign exchange markets and how it

works.

5.2 Introduction
Financial Markets is a place which provides a platform for sale and purchase
of financial assets such as shares, bonds, derivatives, etc. Financial Markets
serve as a link between the savers/investors/lenders and borrowers that
meet short-term and long-term financial requirements of household and
corporate sector through efficient mobilization and allocation of money.
Financial Markets facilitate transfer of money from surplus units to
deficit units to make it productive and hence, generate more capital for
the economy. Here investors are surplus units and business enterprises
are deficit units. Business enterprises need money/capital to grow and to
expand their production thus, financial market plays an important role in
building the capital and production of goods and services in the economy.

5.3 Role and Importance of Financial Markets

The role and importance of financial markets are not limited to just
providing an avenue for the sale and purchase of financial instruments.
The Financial markets play a prominent role in capital formation and the
effective allocation/utilization of money in the economy.
List of functions performed by financial markets are as follows:
Price Determination: Demand and supply factors of the financial asset
help to determine their price. When a financial security is available in
the financial market, it gets traded by buyers and sellers. Investors are
the supplier of the capital, while business enterprises are in need of the
funds. Thus, the interaction between these two participants and market
factors provides a mechanism for determining the price of the security.
Mobilization of savings: For an economy to be developing it is important
that money should not sit idle and directing towards its most effective use.
An Economy doesn’t grow if the savings are not put to its productive use.
Financial markets help to mobilize these savings from being idle with
households, institutions, and banks to business enterprises and corporate
industry requiring capital/funds for investment in their various projects.

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Ensures Liquidity: Financial markets provide an easy platform where Notes

one can buy or sell financial assets easily at any point in time. Financial
assets that buyers and sellers trade in the financial markets have high
liquidity. Investors can easily sell financial assets at any time and convert
them into cash whenever they require money.
Saves Time and Money: Financial markets serve as an easy platform for
buyers and sellers where they can find each other with no effort or waste
of time. Also, financial markets provide complete information regarding
financial assets about their price, cost of transaction, availability etc.
This results in lower transaction costs and fees. Moreover, investors and
companies do not need to spend money for getting any information.

5.4 Types of Financial Markets

Figure 5.1: Types of Financial Markets

Money Markets
The money market is the market to trade in money market instruments.
Money market instruments are short term instruments. Money markets
facilitate constant flow of cash between governments, corporations, banks
and financial institutions. Borrowing and lending in this market is for
a term as short as overnight and no longer than a year. These markets
support industries to accomplish their working capital requirements by
circulating short-term funds in the economy. In India, money markets
serve an essential objective of providing liquid cash to borrowers and fund
providers for a small period of time, while keeping a balance between
the demand and supply of short-term funds. The important money market

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Notes instruments in India are call money, commercial papers, certificates of

deposit, treasury bills etc.
Features of Money Market:
u It is a market for short-term funds.
u The maturity period is up to one year.
u It trades with assets/instruments that can be transformed into cash
easily.
u The main participants of the money market are the Commercial
Banks, Non-banking financial companies and Central Bank, etc.
u Most popular Money Banking instruments are Treasury Bills,
Commercial Bills, Certificates of Deposit and Commercial Paper.
Capital Markets
Capital markets are the markets in which securities with maturities of
greater than one year are traded. The most common capital market securities
include stocks, bonds etc. The funds are used for productive purposes
and to create wealth in the economy in the long-term. Therefore, capital
market deals in financial instruments that are long term securities. In this
market, the buyers use funds for longer-term investment. The nature of the
capital market is risky, and it connects the surplus units with the deficit
units. A capital market is an organized market in which both individuals
and business entities buy and sell equity and debt securities.
Features of Capital Markets
u It is designed to be an efficient way to enter into purchase and sale
transactions.
u It unites entrepreneurial borrowers and savers.
u It deals with long-term investments.
u Agents are required in these markets.
u It is controlled by government rules and regulations.
u The Capital Market instrument involves both the auction market
(primary market) and dealer market (secondary market).

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Base Money Market Capital Market Notes

Concept It is a market for trade in short It is a market for trade in long term
term securities securities.
Market Nature Both unorganized and organized Capital markets are usually organized
in nature.
Instruments Call money, treasury bills, Bonds, Debentures, Shares etc.
involved certificate of deposits,
commercial paper etc.
Participants Banks, government, corporations Banks, government, corporations,
etc. stock exchange, brokers, retail
investors, foreign investors, insurance
companies etc.
Market Liquidity Highly liquid Less liquid
Risk Low Risk High Risk
Maturity of Instruments mature within a year Instruments take longer time to
Instruments attain maturity
Objective To achieve short term credit To achieve long term credit
requirements of the trade requirements of the trade.
Purpose Increasing liquidity of funds Stabilizes economy by increase in
in the economy savings.
Return on Low in money markets High in capital markets
investment
Primary Markets and Secondary Markets
The primary market is the part of the capital market that deals with the
issuance and sale of equity-backed securities to investors directly by the
issuer. Investors buy securities that were never traded before. Primary
markets create long-term instruments through which corporate entities
raise funds from the capital market. It is also known as the New Issue
Market (NIM). Since the securities are issued directly by the company
to its investors, the company receives the money and issues new security
certificates to the investors. The primary market plays the crucial function
of facilitating the capital formation within the economy. The securities
issued at the primary market can be issued in face value, premium value,
and at par value. Once issued, the securities typically trade on a secondary
market i.e., stock exchange.
The secondary market, also called the aftermarket and follow-on public
offering. It is the financial market in which previously issued financial
instruments such as shares, bonds etc are bought and sold. The term

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Notes “secondary market” is also used to refer to the market for any used stock
or assets, or an alternative use for an existing product or asset where the
customer base is the second market. The secondary market for a variety
of assets can vary from loans to stocks, from fragmented to centralized,
and from illiquid to very liquid. The major stock exchanges are the most
visible example of liquid secondary markets of publicly traded companies.
Exchanges such as Bombay Stock Exchange, National stock exchange
provide a centralized, liquid secondary market for investors who own
stocks that trade on these exchanges. Most bonds and loans are traded
over the counter (OTC) or by phoning the broker or dealer.
Base Primary Market Secondary Market
Concept It is market for new It is market for trading of
securities issued securities
Another Name New Issue Market (NIM) After market
Type of Purchasing Direct Indirect
Financing It provides funds to corporate for It does not provide funding
expansion and diversification. to the enterprises
Number of times a Only once Multiple times
security can be sold
Buying and selling Buying and selling is between Buying and selling is only
company and investors between the investors
Profit on the sale of Companies issuing the Investors gets the profit on
shares securities makes profit the sale of shares
Intermediary Underwriters Brokers
Price Fixed Fluctuating

IN-TEXT QUESTIONS
1. _______ is a link between savers & borrowers, helps to establish
a link between savers & investors:
(a) Marketing
(b) Financial market
(c) Money market
(d) None of these
2. Which of the following is the function of financial market?
(a) Mobilization of savings
(b) Price fixation

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(c) Provide liquidity to financial assets Notes

(d) All of the above

3. _________ is the organisations, institutions that provide long
term funds.
(a) Capital market
(b) Money market
(c) Primary market
(d) Secondary market

5.5 Linkages Between Economy and Financial Markets

There is a strong positive association between financial markets and
economy of the nation because financial sector is an important determinant
for economic growth and development. Efficient and sound financial
system channels funds to its most productive use which are beneficial for
sustainable development. Financial markets direct the flow of savings and
investment funds in the economy in an efficient way which facilitate the
accumulation of capital and production of various goods and services. The
combination of well-developed financial markets, financial institutions,
financial products and instruments suits the needs of borrowers and lenders
and therefore the overall economy.
Exploring a link between financial markets and economic growth has been
the focus of academics, researchers and policy makers. It is particularly
important for developing countries to design appropriate economic
policies. There seems to be a consensus on the roles and contribution
of financial markets in promoting economic growth. Financial markets
facilitate the mobilization of savings and allocation of funds to productive
investment opportunities by helping investors find financing needs. But
the opposite view also exists which means that financial development
follows economic growth. Lack of financial institutions and financial
markets in the underdeveloped countries indicates a lack of sufficient
demand for products and services. As economy grows the demand for
goods and services increases and as a result the role of financial market
also expands to facilitate the same. A stable economic framework promotes

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Notes positive relationship between financial markets and economic growth,

thus reduces vulnerability to financial crisis.

5.6 Integration of Indian Financial Markets with Global

Financial Markets
In integrated financial markets, domestic investors can buy foreign
financial assets and foreign investors can buy domestic financial assets.
The economies that are fully integrated into world financial markets,
financial assets with identical risk should command the same expected
return, regardless of location. A large number of Indian companies are
getting involved in exporting their products to global markets, also
raising funds by listing on foreign stock exchange (NYSE, London Stock
exchange and NASDAQ etc). Therefore, share price movements of these
companies are more likely to be affected by the growth and development
in the world economy.
Financial Markets across the world are showing a lot of short-term
volatility (frequent rise or fall in stock prices) mainly driven by news
and events in the global financial markets. For example, news or rumours
related to economic recession in USA, soft/hard landing and estimation
of losses due to collapse of banks in USA, rise in global commodities
prices, fluctuation in global crude oil prices etc. Whenever any negative
news triggered from the US financial markets it triggers a tsunami in
global financial markets especially in short term.
There are some fundamental reasons why global financial markets,
especially the Indian stock market behave in a volatile manner based on
developments in global financial markets. Indian economy is increasingly
exposed to global financial markets post liberalization in the 1990s.
India is seeing fast economic growth in last few years and large capital
inflows into Indian financial market from across the world. Investment
decisions of these funds are driven and depend on the development/
events in foreign financial markets, or their own domestic markets. As
a result, Indian financial markets are getting more and more integrated
with movement in global financial markets. Market analysts track and
talk about these global developmental events and global financial market
movements very closely.

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Rapid development in technology (especially in the last one decade) is Notes

another major reason of linking the various financial markets across the
world. Internet has enabled the investors to virtually trade/invest in any
financial market across the world.

5.7 Primary Market Instruments

Public Issue or Initial Public Offer (IPO): Under this method, company
issues a prospectus to the public inviting offers for subscription. The
investors who are interested in the securities apply for the securities
they are willing to buy, and advertisements are issued in the leading
newspapers. Companies typically go public to raise huge amount of
capital in exchange for securities. Once a private company is convinced
about the need to become a public company, it kick-starts the process of
IPO. Companies which want to go public follow a process that exchanges
adhere to. The IPO process is quite complicated and entire IPO process
is regulated by the ‘Securities and Exchange Board of India (SEBI)’.
This is to check the likelihood of a scam and protect the interest of the
investors. Procedure for raising capital through an IPO is as follows:
Hire an Investment Bank: A company seeks guidance from a team
of under-writers or investment banks to start the process of IPO. More
often than not, they take services from more than one bank. The team
will study the company’s current financial situation, work with their
assets and liabilities, and then they plan to cater to the needs of funds.
An underwriting agreement is signed which will have all the details of
the deal, the fund amount that will be raised, and the securities that will
be issued.
Register with SEBI: The Company and the under-writers file the
registration statement, which comprises of all the financial data and
business plans of the company. The company also have to declare how
the Company is going to utilise the funds it will raise from the IPO and
about the securities of public investment. If the registration statement is
compliant with the stringent guidelines set by the SEBI and ensures that
the company has disclosed every detail a potential investor should know,
then it gets a green signal.

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Notes Draft the Red Herring Document: The directors of the company need to
file an initial prospectus which includes the details of the price estimate
of the shares and other details regarding the IPO. It is known as the
Red Herring Prospectus because it contains the warning that it is not
the final prospectus.
Go on a Road Show: Before the IPO goes public, this happens over an
action-packed two weeks. The mangers of the Company travel around
the country marketing the upcoming IPO to the potential investors. The
agenda of the marketing includes presentation of facts and figures, which
creates the most positive interest.
Pricing the IPO: Based on whether Company wants to float a Fixed
Price IPO or Book Building Issue, the price or price band is fixed. A
fixed price IPO will have a fixed price in the order document, and the
book building issue will have a price band within which an investor
can bid. The number of shares offer for sale is decided. The Company
should also decide the stock exchange to list their shares. The Company
asks the SEBI to announce the registration statement so that purchases
can be made.
Available to Public: After the IPO price is finalized, the stakeholders
and under-writers work together to decide how many shares every
investor will receive. Investors will usually get full securities unless it
is oversubscribed. The shares are credited to their demat account and
refund is given if the shares are oversubscribed. Once the securities are
allotted, the stock market will start trading the Company’s IPO.
Kind of Intermediaries Involved:
Merchant Banker: Merchant Bankers are the most crucial intermediaries
among all. From drafting a prospectus to listing the company’s securities
at the recognized stock exchange, they assist a company throughout.
Merchant Bankers checks and verifies all the information provided in
the prospectus, by carrying out due diligence for all the details that the
prospectus provides. After that, they issue a certificate to the SEBI.
Underwriters: Underwriters are required to subscribe to the unsubscribed
shares of a company. Therefore, underwriters come into play when there
is a situation of under subscription of shares.

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Registrar and Share Transfer Agent: The Registrar and the Share Notes
Transfer Agent decide the basis for allotment to the share application
received from the public. Underwriters are required to subscribe to the
unsubscribed shares of a company. Therefore, underwriters come into
play when there is a situation of under subscription of shares.
Stockbrokers and Sub Brokers: The Stockbrokers and Sub Brokers
receive a commission from the Issuer Company for inviting the public
to subscribe to the shares offered by it.
Depositories: Depositories hold securities in dematerialized (DEMAT)
form for the shareholders. In India, there are two main depositories, CDSL
(Central Depository Securities Limited) and NDSL (National Securities
Depository Limited).
Book Building Process: When a company wants to raise money, it plans
to offer its stock to the public. Companies all over the world use either
fixed pricing or book building as a mechanism to price their shares.
Over the period of time, the fixed price mechanism has become obsolete
and book building has become the de-facto mechanism used in pricing
shares while conducting an Initial Public Offer (IPO). Book Building is
basically a process used in Initial Public Offer (IPO) for efficient price
discovery. If the company is not sure about the exact price at which to
market its shares, it can decide a price range instead of an exact figure.
During the period for which the IPO is open, bids are collected from
investors at various prices, which are above or equal to the floor price.
The offer price is determined after the bid closing date. This process of
discovering the price by providing the investors with a price range and
then asking them to bid on it is called the book building process.
It is considered to be one of the most efficient mechanisms of pricing
securities in the primary market. This is the preferred method which is
recommended by all major stock exchanges and as a result is followed
in all major developed countries in the world. The introduction of book-
building in India was done in 1995 following the recommendations of an
expert committee appointed by SEBI. The committee recommended and
SEBI accepted in November 1995 that the book-building route should
be open to issuer companies, subject to certain terms and conditions. In
January 2000, SEBI came out with a compendium of guidelines, circulars
and instructions to merchant bankers relating to issue of capital.

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Notes In this method, the company does not fix up a particular price for the
shares, but instead gives a price range, e.g., Rs. 80 to 100. When bidding
for the shares, investors have to decide at which price they would like
to bid for the shares, e.g., Rs. 80, Rs. 90 or Rs. 100. They can bid for
the shares at any price within this range. Based on demand and supply
of the shares, the final price is fixed. The lowest price (Rs. 80) is known
as the floor price and the highest price (Rs. 100) is known as cap price.
The price at which the shares are allotted is known as cut off price.
The entire process begins with the selection of the lead manager, an
investment banker whose job is to bring the issue to the public. The lead
manager and the issuing company fix the price range and the issue size.
Next, syndicate members are hired to obtain bids from the investors. The
issue is kept open for 5 days. Once the offer period is over, the lead
manager and issuing company fix the price at which the shares are sold
to the investors.
Q. DEF Ltd. wants to raise Rs. 700 crores by issuing shares of the face
value of Rs. 10 each. The company appointed a Merchant Banker
who has approached the investing public to help him in the book
building process in a price band of Rs. 100-120 per share. Assuming
there are only five investors applying for the Company’s share and
following are the quotes.
Investor Price Quoted Amount of Investment (Rs. in Crores)
A 100 320
B 105 370
C 110 160
D 115 280
E 120 330
Calculate: (i) The price at which merchant banker will issue the
shares of the company to investors. (ii) The allotment value (in Rs.)
of each investor.
Solution:
Investor Price quoted (P) Weight (W) WxP
A 100 320 32,000
B 105 370 38,850
C 110 160 17,600

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Investor Price quoted (P) Weight (W) WxP Notes

D 115 280 32,200
E 120 330 39,600
TW = 1460 Total WP = 1,60,250

Total WP
The weightage average shall be =
Total W

1,60,250
= = 109.760
1,460
The price at which merchant banker will issue the shares =
Rs. 109.76
Allotment will be as follows:
Investor Allotment Value (in Crores)
A NIL
B NIL
C (17,600/89,400) × 700 = 138
D (32,200/89,400) × 700 = 252
E (39,600/89,400) × 700 = 310
Offer for Sale: An Offer for Sale is a mechanism where promoters in
a listed company sell their shares directly to the public in a transparent
manner. This mechanism was first introduced in the market by SEBI in
2012. Through this process, promoters in public companies can sell their
shares and reduce their holdings from publicly listed companies. This is a
simpler way for public companies to sell shares and get capital compared
to other options such as IPO. The promoters are the sellers and bidders
can include market participants such as individuals, companies, qualified
institutional buyers and foreign institutional investors. The option benefits
issuers by reducing the time taken to raise funds as they otherwise have
to follow a long procedure that includes issuing a draft prospectus and
an application process involving a lot of formalities.
Private Placement: It is a non-public offering and a funding round of
securities which are sold not through a public offering, but rather through
a private offering, mostly to a small number of chosen investors. There are
minimal regulatory requirements for a private placement as compared to an
IPO. It is an alternative to an Initial Public Offering (IPO) for a company
seeking to raise capital for expansion. Investors invited to participate in

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Notes private placement programs include wealthy individual investors, banks

and other financial institutions, mutual funds, insurance companies, and
pension funds. The firm does not have to provide a prospectus to potential
investors as detailed financial information may not be disclosed. The
private placement of companies can be done under two sub-categories
(i) preferential allotment/issue (ii) qualified institutional placement.
Preferential Issue: This is the fastest way for a company to raise capital.
A preferential issue is an issue of shares or convertible securities by listed
or unlisted companies to a select group of investors on a preferential
basis. It is neither a rights issue nor a public issue. When an unlisted
company goes for preferential allotment the rules of the Companies Act,
2013 will apply. In preferential issue, allotment of shares is made to some
other persons who are given “preference” over existing members. The
offer can be made to any person whether they are equity shareholders and
employees of the company or not. Whereas in case of private placement,
offer is made to specified investors to invest their funds. They are not
the members of the company.
Qualified Institutional Placement: (QIP) is a capital-raising tool, primarily
used in India and other parts of southern Asia, whereby a listed company
can issue securities to a Qualified Institutional Buyer (QIB). Apart from
preferential allotment, this is the only other speedy method of private
placement whereby a listed company can issue securities to a select
group of persons. QIP scores over other methods because the issuing firm
does not have to undergo elaborate procedural requirements to raise this
capital. The Securities and Exchange Board of India (SEBI) introduced
the QIP process through a circular issued on May 8, 2006, to prevent
listed companies in India from developing an excessive dependence on
foreign capital. The placement document is placed on the websites of the
stock exchanges and the issuer, with appropriate disclaimer to the effect
that the placement is meant only QIBs on private placement basis and
is not an offer to the public. QIBs are those institutional investors who
are generally perceived to possess expertise and the financial muscle to
evaluate and invest in the capital markets.
Rights Issue: Cash-strapped companies can turn to rights issues to raise
money when they really need it. In these rights offerings, companies grant
shareholders the right, but not the obligation, to buy new shares at a
discount to the current trading price. The discounted price will stand for

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a specified time frame, after which it is returned to normal. A company Notes

would offer a rights issue in order to raise capital. Troubled companies
typically use rights issues to pay down debt, especially when they are
unable to borrow more money. However, not all companies that pursue
rights offerings are in financial trouble. Even companies with clean
balance sheets may use rights issues. These issues might be a way to
raise extra capital to fund expenditures designed to expand the company’s
business, such as acquisitions or opening new facilities for manufacturing
or sales. If the company is using the extra capital to fund expansion, it
can eventually lead to increased capital gains for shareholders.
Private Equity: Private Equity (PE) refers to capital investment made into
companies that are not publicly traded. A source of investment capital,
Private Equity (PE) comes from High-Net-Worth Individuals (HNWI)
and firms that purchase stakes in private companies or acquire control of
public companies with plans to take them private and delist them from
stock exchanges. A private-equity investment will generally be made by a
private-equity firm, a venture capital firm or an angel investor. A private
equity fund is a collective investment scheme used for making investments
in various equities and debt instruments. They are usually managed by a
firm or a limited liability partnership. The tenure (Investment horizon) of
such funds can be anywhere between 5-10 years with an option of annual
extension. One key feature of private equity funds is that the money
which is pooled in for the purpose of fund investment is not traded in
the stock market and is not open to every individual for subscription.
Since private equity funds are not available to everyone, the money is
usually raised from institutional investors (HNIs & Investment Banks)
who can afford to invest large sums of money for longer time periods.
A team of investment professionals from a particular private equity firm
raise and manage the funds, where they utilise this money for raising new
capital, future acquisitions, funding startups or new technology, investing
in other private companies or making the existing fund stronger. Private
equity funds represent an excellent opportunity for a high rate of return.
Employee Stock Option: Employee stock options are commonly viewed
as an internal agreement providing the possibility to participate in the
share capital of a company, granted by the company to an employee as
part of the employee’s remuneration package. Regulators and economists

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Notes have since specified that ESOs are compensation contracts. Most of the
companies use employee stock options plans to retain, reward, and attract
employees, the objective being to give employees an incentive to behave
in ways that will boost the company’s stock price. The employee could
exercise the option, pay the exercise price and would be issued with
ordinary shares in the company. As a result, the employee would experience
a direct financial benefit of the difference between the market and the
exercise prices. Employee Stock Options in India has gained immense
popularity in the recent time. Infosys, one of the earliest companies to
offer ESOPs, created millionaires of employees such as drivers, are very
well known.
Venture Capital (VC): It is a form of private equity financing that
is provided by venture capital firms or funds to startups, early-stage,
and emerging companies that have been deemed to have high growth
potential or which have demonstrated high growth (in terms of number
of employees, annual revenue, scale of operations, etc). Venture Capital
is a financing tool for companies and an investment vehicle for wealthy
individuals and institutional investors. Wealthy investors like to invest
their capital in startups with a long-term growth perspective. This capital
is called venture capital and the investors are called venture capitalists.
It is a way for companies to receive money in the short term and for
investors to grow wealth in the long term. Venture Capitals tend to
focus on emerging companies and such investments are risky as they
are illiquid, but also have the potential to provide impressive returns if
invested in the right venture. A venture capital firm can finance a company
by equity participation and capital gains, participating in debentures and
also extending conditional loans to the firms.
Disinvestment: Divestment or disinvestment means selling a stake in a
company, subsidiary or other investments. Businesses and governments
resort to divestment generally as a way to pare losses from a non-
performing asset, exit a particular industry, or raise money. Governments
often sell stakes in public sector companies to raise revenues. In recent
times, the central government has used this route to exit loss-making
ventures and increase non-tax revenues. The Indian government started
divesting its stake in public-sector companies in the wake of a change
of stance in economic policy in the early 1990s — commonly known as

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‘Liberalisation, Privatisation, Globalisation’. This has helped the Centre Notes

pare its fiscal deficits. 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.
In relation to the capital employed, the levels of profits were too low. Of
the various factors responsible for low profits in the PSUs, the following
were identified as particularly important:
Price policy of public sector undertakings
Under–Utilisation of capacity
Problems related to planning and construction of projects
Problems of labour, personnel and management

5.8 Merchant Bank: Roles and Functions

Merchant banks offer financial services to wealthy individuals and
corporations. They underwrite securities and raise funds. They do not
provide basic banking services and the focus is on providing financial
services and advice to the corporates, therefore earn from the fee paid
for advisory services. Merchant banking can be defined as a skill-oriented
professional service provided to fulfil financial needs in lieu of adequate
consideration in the form of fee for their services. Role and functions
performed by merchant banks are:
1. Provide Funds to Companies: This includes loans and funds for
startup companies. They decide how much money a company requires
for their business proposals. They also help their clients raise funds
through the stock exchange and other activities. Merchant banks act
as a foundation for small scale companies in terms of their finances.
2. Underwriting: Banks agree to provide money to their clients in case
the issue is not fully subscribed. This is very important for clients
to ensure that the bank/NBFC will help them raise money. In case
they would incur losses, the bank will pay them for the losses.

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Notes 3. Manage their Portfolios: The bank look into the company’s financial
assets and do the computation of credits and debits to ensure not
to incur any losses. They also provide services to check on the
liquidation of assets to track the income made by these companies
and study how they can make it better.
4. Offering Corporate Advisory: They offer expert advises related to
allocation and utilization of funds to starting companies to expand
further. This advice involves financial aid to ensure that the company
will be successful and will not have any problems along the way.
5. Managing Corporate Issues: They help companies to incorporate
securities management and serve as an intermediary bank in
transferring capitals and funds.

5.9 Listing and Delisting of Corporate Stocks

Listing of Companies denotes permission granted by a stock exchange to
a company to trade its particular securities (e.g., equity shares, debentures
etc.) on the stock exchange. Whereas, delisting of corporate stocks refers
to the removal of a company’s shares from listing on the stock exchanges,
either voluntarily or involuntarily.
Listing means the admission of securities of a company to trading on a
stock exchange. It becomes necessary when a Public Limited Company
wants to issue shares or debentures to the public. When securities are listed
on a stock exchange, the company has to comply with the requirements
of the exchange.
Advantages of Corporate Listing for the Company are:
(1) The company enjoys concessions under direct tax laws as such
companies are known as companies in which public are substantially
interested resulting in lower rate of income-tax payable by them.
(2) The company gains national and international importance by its
share value quoted on the stock exchanges.
(3) Financial institutions and banks extend term loan facilities in the
form of rupee currency and foreign currency loan.
(4) It helps the company to mobilize resources from the shareholders
through ‘Rights Issue’ for programs of expansion and modernization

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without depending on the financial institutions in line with the Notes

Government policies.
(5) It ensures wide distributions of shareholding thus avoiding fears of
easy takeover of the organization by others.
Advantages of Corporate Listing to Investors:
(1) Since the securities are officially traded, liquidity of investment by
the investors is well ensured.
(2) Rights entitlement in respect of further issues can be disposed of in
the market.
(3) Listed securities are well preferred by bankers for extending loan
facility.
(4) Official quotations of the securities on the stock exchanges corroborate
the valuation taken by the investors for purposes of tax assessments
under Income-tax Act, Wealth-tax Act etc.
(5) Since securities are quoted, there is no secrecy of the price realization
of securities sold by the investors.
(6) The rules of the stock exchange protect the interest of the investors
in respect of their holdings.
(7) Listed companies are obliged to furnish unaudited financial results
on the quarterly basis. The said details enable the investing public
to appreciate the financial results of the company in between the
financial periods.
(8) Takeover offers concerning the listed companies are to be announced
to the public. This will enable the investing public to exercise their
discretion on such matters.
Delisting of Corporate Stocks:
Delisting involves removal of listed securities of a company from a stock
exchange where it is traded on a permanent basis. Delisting curbs the
securities of the delisted company from being traded on the stock exchange.
It can be done either on voluntary decision of the company or forcibly
done by SEBI on account of some wrongdoing by the company. In order
to list securities on the stock exchange, there are certain guidelines laid
out by the market regulator SEBI that a company is required to follow.
In case the company fails to do so, then SEBI takes the action which

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Notes generally leads to delisting of the company from the stock exchange.
Delisting can be broadly classified into two types:
Voluntary Delisting: It occurs when the listed company decides to delist
its securities from the stock exchange. The reason for such an action
can be the below-par performances of the securities on the exchange or
a merger/acquisition of the listed company with another. Delisted shares
refer to the shares of a listed company that has been removed from
stock exchange permanently for buying and selling purposes. That means
delisted shares will no longer be traded on the stock exchanges – National
Stock Exchange (NSE) and Bombay Stock Exchange (BSE). The process
of delisting of securities for any company is governed by the Securities
and Exchange Board of India (SEBI).
Compulsory Delisting: As per the Securities Contract Regulation Act and
the Securities Contract (Regulation) Rules, 1957, a company’s securities
will be mandatorily delisted if:
(1) The company’s director has been convicted for non-compliance
with the rules and regulations of the Depositories Act and SEBI
Act. Also, the company should have incurred a loss of Rs. 1 crore
or more.
(2) The company’s shares are being traded irregularly for the previous
three years.
(3) The company’s trading activities have been halted for more than
six months.
(4) The company has been experiencing losses for three straight years,
and the company’s liabilities are exceeding its assets and the
stakeholders’ equity combined.
In financial sense, each type of delisting of shares – voluntary or
involuntary delisting - will impact the investor who owns these shares.

5.10 Introduction to Foreign Exchange Market

The foreign exchange market is a global decentralized or over the counter
(OTC) market for the trading of currencies. It is also called forex or
currency market. This market determines foreign exchange rates for
every currency. It includes all aspects of buying, selling and exchanging

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currencies at current or determined prices. It is the largest market in Notes

terms of trading volume in the world. The participants in the market
are the international banks. The foreign exchange market works through
financial institutions and operates on several levels and involves in large
quantities of foreign exchange trading. Most foreign exchange dealers
are banks and sometimes it is called the “interbank market”. The foreign
exchange market assists international trade and investments by enabling
currency conversion.
The value of one currency is determined by its comparison to another
currency via the exchange rate. The major currencies traded most often
in the foreign exchange market are the euro (EUR), United States dollar
(USD), Japanese yen (JPY), British pound (GBP) and the Swiss franc
(CHF) etc. The foreign exchange market has a huge trading volume
representing the largest asset class in the world leading to high liquidity.
Foreign currency trading is conducted without a central exchange, but
instead is traded over the counter (OTC). Unlike other markets, this
decentralization allows traders to choose from a large number of different
dealers or brokers and the means to compare prices buying or selling.
Types of Foreign Exchange Markets:
There are three types of forex markets: the spot forex market, the forward
forex market, and the futures forex market.
Spot Forex Market: The spot market is the immediate exchange of
currencies at the current exchange rate and on the spot. This is the
largest portion of the forex market and involves buyers and sellers from
the corporates and individuals exchanging currencies.
Forward Forex Market: The forward market is an agreement between
the buyer and the seller to exchange currencies at an agreed-upon price
at a predetermined date in the future. No exchange of actual currencies
takes place at present. The forward market is often used for hedging
purposes by the corporates and individuals.
Futures Forex Market: The future market is similar to the forward market
that there is an agreed price at an agreed date. The primary difference is
that the futures market is regulated and happens on an exchange. Futures
are also used for hedging.

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Notes Features:
u There are fewer rules than in other markets and investors need not
to follow the strict standards or regulations found in other markets.
u There are no clearing houses and no central bodies to oversee the
forex market.
u Most investors need not to pay the traditional fees or commissions
as compared to other markets.
u The market is open 24 hours a day, one can trade at any time of
day to participate in the market.
u There are no set limits on leverage and one can help magnify losses
and profits.
IN-TEXT QUESTIONS
4. When securities are allotted to institutional investors & some
selected individuals is referred to as _________.
(a) Initial public offer
(b) Offer through prospectus
(c) Private placement
(d) Offer for sale
5. A company can raise capital through the primary market in the
form of
(a) Equity shares
(b) Preference shares
(c) Debentures
(d) All of the above
6. Under this method of floatation in primary market, a subscription
is invited from general public to invest in the securities of a
company through the issue of advertisement.
(a) Private placement
(b) Offer through prospectus
(c) Offer for sale
(d) All of the above

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7. Jaykant is holding hundred shares of a company. He has been Notes

given a privilege offer to subscribe to a new issue of shares of
the same company in proportion of 2:1 to the number of shares
already possessed by him. Identify the method of floatation
being described in the above case.
(a) Offer through prospectus
(b) Offer for sale
(c) Rights issue
(d) Private placement

5.11 Summary
Financial Markets facilitate transfer of money from surplus units to deficit
units to make it productive and hence, generates more capital for the
economy. The role and importance of financial markets are not limited to
just providing an avenue for the sale and purchase of financial instruments.
Price determination, mobilization of savings, ensures liquidity are some
of the functions of the financial markets. There are broadly four types
of financial markets: money markets, capital markets, debt markets and
currency markets. The money market is the market to trade in short term
instruments and support the industries to accomplish their working capital
requirements by circulating short-term funds in the economy. Capital
markets are the markets for long-term securities and the funds will be
used for productive purposes and to create wealth in the economy. There
is a strong positive association between financial markets and economy
of the nation. Efficient and sound financial system channels funds to its
most productive use which are beneficial for sustainable development.
There are many ways by which money can be raised in the primary
markets. The primary markets instruments include initial public offer,
private placement, private equity, rights issue, bonus issue, disinvestment
and venture capital. Merchant banks offer financial services to wealthy
individuals, corporations and underwrite securities, raise funds etc.
Listing of Companies denotes permission granted by a stock exchange
to a company to trade its particular securities on the stock exchange. It
helps the company to mobilize resources from the shareholders through

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Notes for programs of expansion and modernization without depending on the

financial institutions in line with the Government policies. In order to
list securities on the stock exchange, there are certain guidelines laid
out by the market regulator SEBI that a company is required to follow.
In case the company fails to do so, then SEBI takes the action which
generally leads to delisting of the company from the stock exchange.
Delisting can be broadly classified into two types: compulsory delisting
and voluntary delisting.

5.12 Answers to In-Text Questions

1. (b) Financial market

2. (d) All of the above
3. (a) Capital market
4. (c) Private placement
5. (d) All of the above
6. (b) Offer through prospectus
7. (c) Rights issue

5.13 Self-Assessment Questions

1. What are financial markets? What functions do they perform? How
would an economy be worse off without them?
2. Discuss the importance of financial intermediation in the financial
system.
3. Explain why the money market is so important in the economy.
4. Discuss the differences between the Money and Capital Markets, and
the types of securities trade in those markets. Give examples.
5. What does primary markets mean? How does the company raise
fund in the primary market?
6. What do you mean by capital markets? Also, explain its types with
examples.
7. What do you mean by corporate listing? What advantages do the
company get by listing its shares on the stock exchange.

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8. Explain the concept and advantages of initial public offer. Notes

9. Explain the concept and process of venture capital with examples.
10. Why do companies have to delist its share from the stock market?
What are its implications?
11. Explain the types of delisting of corporate stocks from the stock
market in detail.
12. Explain the concept and process of issue of shares through a book
building process with example.
13. Write a short note on the following:
(i) Disinvestment
(ii) ESOPs
(iii) Rights Issue
(iv) FOREX
(v) Offer for Sale
14. Distinguish between:
(i) Venture capital and private equity
(ii) Money markets and capital markets
(iii) Primary markets and secondary markets
(iv) Private placement and preferential allotment
(v) Corporate listing and delisting of corporate stocks.
(vi) Direct quote and indirect quote
(vii) Futures and forward contracts

5.14 Suggested Readings

u Pathak, B. Indian Financial System (5th ed). Pearson Publication
u Saunders, A. & Cornett, M.M. Financial Markets and Institutions
(3rd Ed). Tata McGraw Hill.
u Bhole L.M. and Mahakud J., Financial Institutions and Markets:
Structure, Growth, and Innovations (6th Edition). McGraw Hill
Education, Chennai, India
u [Link]

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Notes u Jeff Madura, Financial Institutions and Markets, Cengage Learning

EMEA, 2008
u [Link]
factors
u [Link]
u Khan, M.Y. Financial Services (8th ed). McGraw Hill Education.

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L E S S O N

6
Types of Mutual Fund
Schemes
Imaran Ahmad
Associate Professor
University of Delhi
Email-Id: Ahmad.imran367@[Link]

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Types of Mutual Fund Schemes
6.4 Gold Exchange Traded Funds
6.5 Summary
6.6 Answers to In-Text Questions
6.7 Self-Assessment Questions
6.8 References
6.9 Suggested Readings

6.1 Learning Objectives

u Understand the classification of mutual funds on the basis of operations, investment
objectives and others.
u Identify main features related to various mutual fund schemes.
u Differentiate between open-ended, close-ended and interval funds.
u Understand the concept of entry load and exit load and evaluate its impact on the
return of investors.
u Discuss the money market mutual funds and capital market mutual funds.
u Illustrate the benefits of Systematic Investment Plan (SIP).

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Notes 6.2 Introduction

Mutual funds provide better return to investors at minimum risk. Mutual
funds issue units to the investors in proportion to the funds contributed
by the investors. These mutual funds offer different types of schemes
on the basis of investment, operations and type of income distribution.
Mutual fund schemes are of different types and invest in a wide range
of securities. Some invest in short term debt instruments while others in
long term investments. Some invest in equities only while others invest
in combination of debt and equities.
The various Mutual fund schemes provide following benefits:
1. Regular return
2. Capital appreciation
3. Tax benefits
4. Steady flow of income

6.3 Types of Mutual Fund Schemes

The schemes floated by mutual funds can be grouped into three broad
categories based on their operations, investment objectives and others.
Fig 8.1 depicts the detailed classifications of mutual funds in India.
Classification of Mutual Funds
Classification By 1. Open-ended Funds
Operation 2. Close-ended Funds
3. Interval Funds
Classification 1. Growth Fund
By Investment 2. Balanced Fund
Objectives
3. Income Fund
4. Money market Fund
5. Gilt Funds
6. Floating Rate Funds
7. Treasury management Funds
8. High yield Debt Funds

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9. Fixed Maturity Plan Notes

10. Monthly Income Plan
11. Sector Funds
Others 1. Index Fund
2. Tax Saving Fund
3. Exchange Traded Fund
4. Gold ETF
5. Fund of Funds (FoF)
6. Quantitative Fund
7. Assured Return Scheme
8. Arbitrage Fund
9. Load/Unload Fund
10. Lifestyle Fund
Figure 6.1: Classifications of Mutual Funds in India
Some of these schemes have been explained below:

6.3.1 Open-ended, Close-ended and Interval Funds

Open Ended Funds: Open-ended funds are available for subscription and
repurchase on a continuous basis. There is no fixed maturity. It does not
specify any period of redemption. Investors have the option to buy and
sell units at pre-determined price i.e., Net Assets Value (NAV) which is
declared on a daily basis. The NAV changes daily based on the prices of
stocks in the market. There is no limit on maximum amount the investor
can invest in these funds. The essential feature of open-ended scheme is
the liquidity. They increase liquidity of the investors as the units can be
bought and sold continuously. The fund’s past performance is available
in the case of open-ended funds.
Open-ended funds do not have to be listed on the stock exchange and
can also offer repurchase soon after allotment. Investors can enter and
exit the scheme any time during the life of the fund. The corpus of fund
increases or decreases, depending on the purchase or redemption of units
by investors.

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Notes Close-ended Funds: Close-ended fund is the fund where investment is

locked in for a specified period only. Investors can subscribe only during
the New Fund Offer (NFO) and redemption can take place only after the
lock in period is over. After initial offering, subsequent sale and purchase
take place only in secondary market. The market prices of these funds
are determined by the market forces of demand and supply.
Close-ended schemes have a fixed corpus and a stipulated maturity period
ranging between two to three years. The NAV of close ended schemes
are disclosed generally on weekly basis.
Basis Open-ended Close-ended
Buy-in-period Investors can buy in or buy out Investors can buy in only during a
at any time limited period
Investment These are perpetual funds with The investment tenure is between
tenure no fixed maturity 3 to 5 years
Listing These are not listed on any stock They are listed on recognized stock
exchange exchange
Trading The fund houses manage the The units are traded on the stock
trading of the units exchanges they are listed on
No of shares No limit Limited and fixed
issued
Interval Funds: Interval funds provide the perfect mix of both close-
ended funds and open-ended funds. These funds can be listed on stock
exchanges or various fund houses may allow redemption during specified
time period at on-going NAV.

6.3.2 Domestic Funds and Off-Shore Funds

Domestic Funds: These Funds are available for subscription by investors

of the country of origin only. They mobilise funds from a particular
geographical locality like a country or region. The market is limited and
confined to the boundaries of a nation in which the fund operates. They
invest only in the securities which are issued and traded in the domestic
financial markets.
Off-shore Funds: These Funds are to be subscribed abroad and provides
forex to the capital market. It is based in an offshore location. It provides
investment exposure to the international markets. They also provide
some tax benefits as well. They attract foreign capital for investment

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in the country of the issuing company. Such mutual funds can invest in Notes
securities of foreign companies. They open domestic capital market to
international investors.
CASE STUDY
Raghav is 31, newly married and a successful director in the Indian
film industry. Right from his struggling days, Raghav always saved a
part of his income and invested in safe instruments like fixed deposits.
However, during the internet boom in early 2000, he successfully
invested in equities and mutual funds. Raghav thought that he was
always well-diversified but when the internet stock bubble burst in
2002, he lost the majority of his stock portfolio. A major mistake
he made was that even though he was diversified, he invested only
in tech stocks. Currently, Raghav suffers from the asthma and thus
he is not willing to participate in the equity market at all. He now
misses the high return that his portfolio had earned during the internet
boom days. He has come to you to seek your suggestions to help his
portfolio generate higher returns.

6.3.3 Growth Funds, Income Funds and Balanced Funds

These Funds mainly focuses on capital appreciation and also provide

dividend benefits to the investors. It is suitable for investors having
medium to long term investment opportunities. The large proportion of
the fund is invested in equity and equity linked instruments. They invest
most of the corpus in equity shares with significant growth potential and
offer higher return to investors in the long run. There is no assurance or
guarantee of returns. These schemes are usually close ended and listed
on stock exchanges.
Income Funds: The funds which provide regular income in the form of
dividends to the investors is known as Income Funds. It usually invests
in fixed income investments such as bonds, debentures, government
securities and commercial paper etc. These funds are less risky whereas
capital growth is less. The aim of income funds is to provide safety of
instruments and regular income to investors. The return as well as the
risk are lower in income funds as compared to growth funds.

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Notes Balanced Funds: These kinds of funds invest in both equity and debt.
They provide both capital appreciation and regular income. They divide
their investment between equity shares and fixed bearing instruments in
such a proportion that the portfolio is balanced. Their exposure to risk
is moderate and they offer a decent rate of return. The portfolio usually
comprises companies with good profit and dividend track records. The
NAVs of such funds are likely to be less volatile compared to pure equity
funds.

6.3.4 Equity Funds Schemes

Under these schemes, funds are invested in equity shares only. Equity
securities represent ownership claims on a company’s assets. The degree
of risk under these schemes are high. However, these funds diversify the
investments in different shares of companies to reduce the risk. Since
risk is high, equity funds schemes may give high returns. These schemes
may be income schemes or growth schemes.
Equity funds are riskier compared to debt funds and they can be further
classified on the basis of their investment strategy as diversified, aggressive,
growth, value and sector funds. Example of equity funds are index funds,
diversified funds, arbitrage funds, large cap funds, small cap funds, midcap
funds, sector funds and equity linked saving schemes.
Diversified Equity Funds: These funds invest in equity shares and
hold a diversified equity portfolio. Their performance is linked to the
performance of the stock market. The various categories of Diversified
Equity Funds are:
(a) Large cap funds: They make investments in share of big companies
with market capitalization of more than Rs. 1000 crore.
(b) Mid cap funds: They make investments in share of companies that
have a market capitalization between Rs. 500 crore and Rs. 1000
crore. They have huge potential to grow big.
(c) Small cap funds: They invest in small companies with a market
capitalisation of up to Rs. 500 crore. They have ability to grow
faster and potential of providing high returns.

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6.3.5 Debt Funds Schemes Notes

Under these schemes the funds are invested in debt securities. Debt
securities are financial assets that entitle the security holder to a regular
interest payment. Debt schemes are generally income scheme. Debt
funds are characterized as low risk and high liquidity investments.
Debt fund schemes may be in the form of government securities wherein
the funds are invested in government securities only. Debt funds invest
in government securities, money market instruments, corporate debt
instruments and floating rate bonds. Examples of debt funds are liquid/
money market funds, income funds, gilt funds, fixed maturity plans and
floating rate funds. Debt fund schemes can be of short term or long-term
period, depending on investment horizon.
Short Term Debt Funds: These funds provide a high degree of liquidity
and reasonable returns. They invest in short term debt and money market
instruments. They are primarily made up of corporate bonds.
Long Term Debt Funds: They invest in long term government dated
securities and corporate bonds.

6.3.6 Gift Funds

Under these schemes, the funds are invested in government securities

only. These funds have low return and low risk. Risk averse investors
prefer to invest in these schemes. Government securities include central
government dated securities, state government securities and treasury
bills. These schemes give better returns than direct investments in these
securities through investing in various government securities yielding
differentiated returns.
SBI Magnum Gilt Fund, ICICI Prudential Gilt Fund, Axis Gilt Fund,
Nippon India Gilt Securities Fund and Edelweiss Government Securities
Fund are some of the gilt funds in India.

6.3.7 Money Market Mutual Funds (MMMFs)

Under these schemes, the funds are invested in highly liquid investment
instruments such as treasury bills, certificate of deposits, commercial
papers and interbank call money. They are set up with the objective of

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Notes investing in money market instruments. These fund schemes are part of
short-term pooling arrangement of funds. Low risk and moderate income
are the main features of these schemes. They do not carry either interest
rate risk or entry or exit loads. It is favourable for those who want to
invest their surplus funds for shorter periods. Corporates invest in these
funds to park their short-term surplus funds.
UTI Money Market fund, Tata Money Market funding India Liquid Fund
etc are some of the examples of these funds.

6.3.8 Tax Saving or Equity Linked Saving Schemes (ELSS)

These schemes are designed to avail tax exemptions to investors. They

help individual investor in their tax planning. They are entitled to tax
benefit under Section 80C of the Income tax Act. These are diversified
schemes investing in shares of blue-chip companies. Returns are linked to
the returns of the stock market. Investment in these schemes carry a lock
in period of 3 years before the end of which funds cannot be withdrawn.
They fall in high risk and high return category. Due to fixed tenure, these
funds are free from the pressure of redemption and performance during a
short time. It facilitates an opportunity to make investments in schemes
that is market linked.
Bank of India Tax Advantage Fund, Kotak Tax Saver Fund, DSP tax
Saver Fund, Mirae Asset Tax Saver Fund etc are some of the major tax
saving funds in India.

6.3.9 Index Funds

These funds replicate the performance of a stock market index or a

particular segment of the stock market. The funds collected are invested
in the shares forming the Stock exchange Index. They do not actively
traded stocks throughout the year. They offer many benefits to the
investors. The investor is indirectly able to invest in a portfolio of a
blue-chip stock that constitutes the index. The funds are allocated on the
basis of proportionate weight of different shares in the underlying Index.
They offer diversification across a various sector. There is low cost of
management. These schemes provide moderate risk, moderate return and
well diversified portfolio. It is favourable for long term investors.

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In India, an index fund reflects the major market index like NIFTY or Notes
SENSEX by investing all the stocks that comprise in proportions equal
to the weightage of those stocks in the index.
The S&P 500 index, the Russell 2000 Index and the Wilshire 5000 Total
market Index are few examples of market indexes that index funds may
seek to track.
Nippon India Index S&P BSE Sensex, HDFC Index S&P BSE Sensex
fund, IDFC Nifty 50 Index, Tata Nifty 50 Index Fund, Motilal Oswal
Nifty Midcap 150 Index Fund, UTI Nifty 200 Momentum 30 index Fund
are some of the examples of index fund in India.

6.3.10 Sectoral Funds

They invest their funds to a specified segment or sector of the economy

such as energy, real estate, banking, Information technology, healthcare,
FMCG etc. These funds allocate capital in a specified particular industry.
They generate high returns if the particular sector performs well. They
focus on only one sector of the economy. They limit diversification. As
these funds do not allow diversification, the risk is more in comparison to
other well diversified portfolio. These funds are also known as Thematic
Funds. It is favourable for investors who have already decided to invest
in a particular sector.
IDFC Infrastructure Fund, SBI magnum COMMA Fund, Nippon India
Power and Infra Fund, Mirae Asset great Consumer Fund, Franklin Build
India Fund are some of the examples of Sectoral fund in India.

6.3.11 Ethical Funds

Ethics is a branch of philosophy that involves systematic study of human

actions from the point of view of its rightfulness or wrongfulness. Values,
norms, principles, and beliefs are some of the tools used to showcase
ethical actions.
Ethical funds restrict their investment activity to companies operating
ethically. It focuses on issues like labour treatment, employee’s relation,
animal welfare, environmental issues, manufacturing weapons etc. It
caters to the investors who want to behave in a socially responsible way.

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Notes 6.3.12 Load and No-load Funds

A load fund is the one that levies a fixed percentage of NAV as entry or
exit fees. A fee is charged by the fund to meet the various expenses such
as administrative, advertisement etc. A No load fund is one which does
not charge any fee during entry or exit. All transactions are done at NAV.
Entry Load is a sales charge that the investors pay when they buy some
units of a mutual fund scheme. This charge reduces the amount of their
investment in fund. It is also called as Front-end Load or Sales Load.
Schemes that do not charge a load are called ‘No Load’ schemes.
Exit Load is the amount of money that the investor needs to pay to the
mutual fund companies when intend to exit from a scheme. It is calculated
as a percentage of NAV rather than the amount invested by investors. It
is also called as ‘Repurchase’ or ‘Back-end’ Load.

6.3.13 Fund of Funds

Fund of funds invests in other mutual funds and offers return to investors.
It enables diversification at two stages. The first stage is achieved by the
Mutual funds which invest in various securities and second stage results
when FoFs invests in various MFs. This enables the investors to obtain
diversity in risk allocation.
A Fund of Funds (FOF) scheme invests in a combination of equity and debt
mutual fund schemes available in the market. The fund manager changes
the percentage of equity and debt allocation based on the market view.
FOF becomes useful for those who want to invest in different MFs but
do not have time or inclination to track their performance. There can be
sectoral FOFs which focus on industry or geographic sector investments.

6.3.14 Systematic Investment Plan (SIP)

A SIP is an easy and convenient way to invest money in mutual funds.

An investor is required to invest a certain pre-determined amount at a
regular interval. The investor can invest smaller amounts in instalments
rather than at once. Based on the market value of investment the mutual
fund will allocate a certain number of units. The additional units are

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purchased at the market rate i.e., prevailing NAV and added to the unit Notes
holder’s account. Cost averaging and Compounding are the two benefits
of investing in SIP. It is suitable for an investor who is willing to invest
regularly. It is the method of investing in a mutual fund.
SIP is the flexible method allowing investors to invest in a disciplined
manner over long term. SIP has following benefits:
(a) Cost Averaging: The NAV of the mutual fund schemes is volatile.
The units available to the investor over a longer period would be
based on the average NAV. If NAV falls, an investor will get more
units at lower rates and in case of increase in prices, an investor
will get lesser units. Thus, SIP may bring down the average unit
price in long run. SIP helps reducing the average cost per unit
and helps an investor to take advantage of market fluctuations and
thereby reduces the risk.
(b) Compounding: An investor can invest regularly at fixed interval in
small amount, or he can accumulate these small savings and invest
at yearly interval. For example: He may invest 1000 every month
or 1200 at the end of the year. He continues this process for 5
years at the rate of 10% interest. In the first case he will get more
interest as compared to the second one.
Thus, SIP is the disciplined and easy mode of investment that have the
potential to deliver attractive returns over a long term.

6.3.15 Systematic Withdrawal Plan (SWP)

It is a facility provided by a fund house to its unitholders to withdraw

from the scheme on a regular interval. It is suitable for those who wants
a regular income from their investments. It allows investors to meet their
short-term goals and access their money to meet expenses. It is available
in two options:
(a) Fixed Withdrawal: Fixed amount is withdrawn on monthly or
quarterly basis.
(b) Appreciation Withdrawal: Certain fixed proportion of the appreciated
amount is withdrawn on monthly or quarterly basis.

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Notes 6.3.16 Systematic Transfer Plan (STP)

If the investor desires to transfer money from one scheme to another,

then the plan available is known as STP. It enables an investor to switch
or transfer a fixed amount of money at regular intervals from his fixed
income scheme investments to designated equity and balanced schemes.
It is similar to SIP, except that in a SIP the investment flows from a
bank account into the fund and here it flows from one scheme to another.

6.3.17 Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) is a basket of securities that are tradeable

at a stock exchange. They are listed on a stock exchange and are traded
as any other listed security. They are organised as unit trusts and are
similar to index mutual funds but are traded more like a stock. ETF
provides investors a fund that closely tracks the performance of the index
with the ability to buy and sell on an intra-day basis. A security firm
creates an ETF by depositing a portfolio of shares in line with an Index
selected. The security firm creates units against this portfolio of shares.
These units are sold to the retail investors.
ETFs are a hybrid of open-ended mutual funds and listed individual
stocks. They do not sell their shares directly to investors for cash. The
shares are offered to investors over the stock exchange.
The ETF portfolio once created does not change. In case of mutual
funds, the portfolio may change. The market value of the units of ETF
changes in line with the Index automatically. The ETFs have all the
benefits of indexing such as diversification, low cost and transparency.
As the funds are listed on the exchange, costs of distribution are much
lower, and the reach is wider. They are passive index funds and due to
passive fund management, these funds charge lesser fees as compared
to other funds.
ETFs offer following advantages:
1. ETFs bring the trading and real time pricing advantages of individual
stocks to mutual funds.

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2. ETFs are simple to understand and hence they can attract small Notes
investors.
3. ETFs can be used to arbitrate effectively between index futures and
spot index.
4. ETFs provide the benefits of diversified index funds.
5. ETFs is passively managed and hence have higher NAV against an
index fund of the same portfolio.
6. Financial institutions can use ETFs for utilising idle cash, managing
redemptions, modifying sector allocations and hedging market
exposure.
ACTIVITY
Make the comparison of Exchange Traded Fund (ETF) with Open-
ended Fund (OEF) and Close-ended Fund (CEF) on the basis of
following parameters:
1. Fund Size
2. NAV
3. Liquidity provider
4. Sale Price
5. Availability
6. Portfolio Disclosure

6.4 Gold Exchange Traded Funds

Gold Exchange Traded Funds track closely the price of physical gold.
These are a listed security backed by allocated gold held in a custody of
a bank on behalf of investors. Investing in Gold ETF provides the benefit
of liquidity and marketability. There are no physical gold transactions,
hence the owners of these funds do not bear any carrying cost. A gold
ETF has an underlying asset as a specific quantity of gold. The market
price of gold ETF unit moves in tandem with the price of the actual
gold.

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Notes IN-TEXT QUESTIONS

1. SIP is a:
(a) Method of regular investment
(b) Name of a mutual fund
(c) Brand of a tea stock
(d) Method of one-time investment
2. SIP stands for:
(a) Systematic Investment Plan
(b) Simple Investment Plan
(c) Simplified Investment Programme
(d) Single Investment Plan
3. The ________ is the market value of the securities that mutual
funds have purchased minus any liabilities per unit.
(a) Net Asset Value
(b) Book Value
(c) Gross Asset value
(d) Net Worth Value
4. What is an open-ended mutual fund?
(a) It is the one that has an option to invest in any kind of
security
(b) It has units available for sale and repurchase at all times
(c) It has an upper limit on its NAV
(d) It has a fixed fund size
5. In funds, the money is invested primarily in short term or very
short-term instruments e.g., T-Bills, CPs etc.
(a) Growth Funds
(b) Income Funds
(c) Liquid Funds
(d) Tax-Saving Funds (ELSS)

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6. __________ ended fund are highly liquid. Notes

(a) Close
(b) Open
(c) Old
(d) New
7. Which of the following is a risk associated with debt fund?
(a) Less volatile
(b) Unsafe Investment
(c) Fixed Return
(d) Tax Efficient
8. Which of the following is not true for Index Funds?
(a) These funds invest in the shares that constitute a specific
index
(b) The investment in shares is in the same proportion as in
the index
(c) These funds take only the overall market risk
(d) These funds are not diversified
9. In which of the following do debt funds not invest?
(a) Government debt instruments
(b) Corporate Paper
(c) Financial Institutions bonds
(d) Equity of private companies
10. Investment in ___________ is best suited for investors with
moderate risk appetite.
(a) Large-cap funds
(b) Mid cap funds
(c) Small cap funds
(d) Multi cap funds

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Notes 6.5 Summary

1. Open ended schemes are those schemes where investors can redeem
and buy new units all throughout the year as per their convenience
at NAV-related prices.
2. Close ended schemes are open for subscription only for a specified
period and have a fixed corpus.
3. Equity linked saving schemes are diversified tax saving schemes
with a lock-in period of 3 years.
4. Index fund scheme means a mutual fund scheme that invests in
securities in the same proportion as an index of securities.
5. Index funds replicate the portfolio of a particular index such as the
BSE Sensex or the S&P CNX Nifty.
6. A Fund of funds scheme invests in schemes of the same mutual
fund of other mutual funds.
7. Gilt funds invest exclusively in government securities.
8. Schemes that charge a load (a percentage of NAV for entry or exit)
are known as Load Fund.
9. Exchange Traded Funds are index funds listed and traded on stock
exchange.
10. Gold Exchange Traded Fund is a listed security backed by allocated
gold held in a custody of a bank on behalf of investors.
11. An investor may put in a fixed sum of money each month, over a
period of time regardless of the mutual fund’s unit price. This mode
of investment is known as Systematic Investment Plans (SIPs).
12. A Systematic Withdrawal Plan (SWP) enables an investor to take
out money of a fund account in a regular interval, without getting
exposed to timing risk.
13. If an investor transfers a fixed amount of money or appreciation
on the unit value in one scheme to another at regular intervals for
profit booking or exposure to a new asset class, it is known as
Systematic Transfer Plan.

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6.6 Answers to In-Text Questions Notes

1. (a) Method of regular investment

2. (a) Systematic Investment Plan
3. (a) Net Asset Value
4. (b) It has units available for sale and repurchase at all times
5. (c) Liquid Funds
6. (b) Open
7. (c) Fixed Return
8. (c) These funds take only the overall market risk
9. (c) Financial Institutions bonds
10. (c) Small cap funds

6.7 Self-Assessment Questions

1. Briefly explain the different types of mutual funds classified based
on their operations and investment objectives.
2. What are the types of mutual fund schemes prevalent in India?
Give details.
3. What is the Systematic Investment Plan (SIP) and what are the
benefits of SIP?
4. What do you mean by entry load and exit load? How do these
affect the return to investors?
5. Distinguish between:
(a) Income and Growth funds
(b) Open-ended and Close-ended funds
(c) Load and No-load funds
(d) Money market and capital market funds
6. What do you mean by close-ended mutual fund? How it can be
converted into an open-ended fund?
7. Explain ETF. What are the pros and cons of ETF as compared to an
open-ended mutual fund?

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Notes 8. Write short notes on the following:

(a) Exchange Traded Fund
(b) Net Asset value
(c) Load Fund
(d) ELSS
(e) Ethical Fund

6.8 References
u As per APA style (APA Manual 6th Edition to be referred).
u Marek, M. W., Chew, C. S., & Wu, W. C. V. (2021). Teacher experiences
in converting classes to distance learning in the COVID-19 pandemic.
International Journal of Distance Education Technologies (IJDET),
19(1), 89-109.

6.9 Suggested Readings

u As per APA style (APA Manual 6th Edition to be referred).
u Marek, M. W., Chew, C. S., & Wu, W. C. V. (2021). Teacher experiences
in converting classes to distance learning in the COVID-19 pandemic.
International Journal of Distance Education Technologies (IJDET),
19(1), 89-109.

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L E S S O N

7
Capital Market
Ravi Yadav
Assistant Professor
Shaheed Bhagat Singh College
University of Delhi
Email-Id: ryadav782ry@[Link]

STRUCTURE
7.1 Learning Objectives
7.2 Overview of Capital Market
7.3 Security Market Regulations and Role of the Market Regulator
7.4 Capital Market Instruments and Services
7.5 Evaluation of Capital Market
7.6 Regional and Modern Stock Exchanges
7.7 International Stock Exchanges
7.8 Demutualization of Exchanges
7.9 Indian Stock Indices and their Construction
7.10 Major Instruments Traded in Stock Markets
7.11 Summary
7.12 Answers to In-Text Questions
7.13 Self-Assessment Questions
7.14 References/Suggested Readings

7.1 Learning Objectives

u Understand the overview of the Capital Market.
u Compare between Primary and Secondary Markets.
u Illustrate the importance of security market regulations.
u Analyze the evolution of India’s capital markets.

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Notes u Acquaint with specific regional stock exchanges in India and

international stock exchanges.
u Describe the development of Indian Stock Indices.
u Appraise the benefits and impact of demutualization.
u Evaluate the major instruments traded in stock markets.

7.2 Overview of Capital Market

Capital markets are financial markets where investors and businesses trade
long-term debt and equity instruments. These markets offer a platform
for investors to profit from their investments and for businesses to raise
funds through the sale of securities.
The primary and secondary markets are the two main parts of the
capital markets. While existing assets are traded among investors on the
secondary market, new securities are first issued and sold to investors
on the primary market.
Debt securities, like bonds, indicate a loan to a corporation, whereas equity
securities, like stocks, represent ownership in a company. These securities
are bought by investors who want to profit from their investments through
capital growth, dividends, or interest payments.
Capital markets play a pivotal role in the global economy by enabling
businesses to secure vital capital, thereby driving economic growth and
fostering job creation. Additionally, they offer a variety of investment
options to investors, ranging from less risky fixed-income securities to
riskier shares and alternative assets.
In general, capital markets play a crucial role in the economy by facilitating
the transfer of capital between investors and businesses and fostering the
expansion and advancement of the world economy.

7.2.1 Primary Market

New securities are first issued and sold on the primary market. The new
issue market is another name for businesses raising capital by offering
their securities to retail or institutional investors. The primary market is

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essential to the economy because it makes it easier for corporations to Notes

raise capital for things like business growth and investments:
The primary market plays several significant responsibilities:
1. Capital Formation: Through the sale of new securities to the general
public or institutional investors, businesses can raise money in the
primary market. The money raised can be put to other uses, such
as research and development or corporate expansion.
2. Price Discovery: Based on market supply and demand, corporations
can determine the price of their securities on the primary market.
Companies can identify the best price for their assets with the use
of the price discovery process.
3. Investor protection: The primary market provides regulatory
monitoring to make sure that the securities provided by businesses
are disclosed correctly and that customers have access to the
information they need to make informed investment decisions.
4. Liquidity: By issuing fresh securities that can be exchanged on the
secondary market, the primary market adds liquidity to the securities
market.
5. Economic growth: By providing capital for businesses to expand
and add jobs, the primary market is essential to economic growth.
In general, the primary market plays a crucial role in the operation of
the capital markets and the economy. It promotes economic expansion
and development by giving businesses access to cash while safeguarding
investors and promoting a fair and open market. Here are some common
primary market instruments:
1. Initial Public Offering (IPO): An IPO is the first sale of shares
by a private company to the public. It allows the company to raise
funds and become publicly traded. Investors can purchase shares at
the initial offering price.
2. Follow-on Public Offering (FPO): A follow-on public offering
occurs when a publicly traded company issues additional shares to
raise capital. It enables the company to raise funds from the public
by issuing new shares.

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Notes 3. Rights Issue: A rights issue is an offering of new shares to existing

shareholders of a company. It provides them with the right to
purchase additional shares at a discounted price. Companies use
rights issues to raise capital from their current shareholders.
4. Private Placement: Private placement involves the sale of securities to
a specific group of investors, such as institutional investors, private
equity firms, or high-net-worth individuals. It allows companies to
raise capital without going through the public offering process.
5. Debt Issuance: Companies and governments issue debt securities in
the primary market to raise funds. Debt instruments include bonds,
debentures, and notes. Investors who purchase these securities become
creditors of the issuer and receive periodic interest payments and
the repayment of principal at maturity.
6. Preference Shares: Preference shares, also known as preferred stock,
are equity securities that provide preferential treatment to shareholders
in terms of dividend payments and asset distribution. Companies
issue preference shares to raise capital from investors who prefer
a fixed dividend payout and priority in case of liquidation.
These primary market instruments serve as avenues for companies and
governments to raise capital, and investors can participate in these offerings
to acquire shares or debt securities at the initial offering price.

7.2.2 Secondary Market

The secondary market, commonly referred to as the stock market or the

stock exchange, is an area of the capital market where investors can buy
and sell existing assets. The secondary market engages in the trading of
previously issued securities, such as stocks and bonds, as opposed to the
primary market, which entails the sale of fresh securities.
The secondary market fulfils several crucial functions:
1. Liquidity: By providing a platform for investors where they may
readily purchase and sell securities, the secondary market offers
liquidity to investors. This makes it possible for investors to easily
and rapidly turn their assets into cash.

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2. Price Discovery: Based on market demand and supply, investors Notes

can set the price of assets on the secondary market. This ensures
that investors can purchase and sell assets at a fair price and aids
in the establishment of fair pricing for securities.
3. Investment Possibilities: A variety of investment possibilities are
available to investors on the secondary market. Stocks, bonds, and
mutual funds are just a few examples of the many assets available
to investors, each of which offers a distinct level of risk and reward.
4. Capital Efficiency: By enabling investors to transfer assets from one
owner to another, the secondary market encourages capital efficiency.
This lessens the need for businesses to issue brand-new securities
to obtain capital, which may be expensive and time-consuming.
5. Corporate Governance: By enabling investors to cast ballots on
significant issues including the election of directors and the approval
of significant corporate activities, the secondary market plays a
crucial role in corporate governance.
Overall, the secondary market is a crucial part of capital markets because
it gives investors a place to purchase and sell securities and makes it
possible for capital to be allocated effectively. Additionally, it encourages
responsibility and transparency in corporate governance, assisting in
ensuring that businesses are answerable to their shareholders.
The Indian capital market, which comprises stock exchanges, brokers,
traders, and investors that buy and sell shares in India, includes the
secondary market as a significant component. The National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE), which are overseen by
the Securities and Exchange Board of India (SEBI), are the two primary
stock exchanges in India.
Recent years have seen a tremendous expansion of the Indian secondary
market, making it a desirable location for investors interested in the
Indian economy. The following are some significant aspects of the Indian
secondary market:
1. Diverse Investment Opportunities: Investors can invest in a variety
of securities, including mutual funds, equities, and bonds, in the
Indian secondary market. Investors have a wide range of options,
including those in the technology, healthcare, energy, and financial
services sectors.

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Notes 2. Enhanced Transparency: The SEBI has put in place several

regulations, such as the need that brokers and businesses to disclose
certain information, to enhance transparency in the Indian secondary
market. This has enhanced the market’s overall integrity and increased
investor trust.
3. Strong Regulatory Framework: As the main regulator of the Indian
secondary market, the SEBI has put in place several safeguards
to safeguard investors and guarantee honest business practices.
Additionally, the SEBI has put laws and regulations in place to
stop fraud, insider trading, and other illicit actions.
4. Participation of Retail Investors Growing: In recent years, the
participation of retail investors has grown significantly in the Indian
secondary market. The availability of inexpensive investment options,
enhanced investor education, and increasing awareness are a few
reasons for this.
5. Growing Importance of Technology: With the emergence of mobile
applications and online trading platforms, the Indian secondary
market has embraced technology. Investors now find it simpler to
access the market and transact in securities as a result.
Overall, the secondary market is a crucial part of capital markets because
it gives investors a place to purchase and sell securities and makes it
possible for capital to be allocated effectively. Additionally, it encourages
responsibility and transparency in corporate governance, assisting in
ensuring that businesses are answerable to their shareholders.

7.3 Security Market Regulations and Role of the Market

Regulator

7.3.1 Introduction

The securities market is a crucial component of the global financial system,

facilitating the buying and selling of various financial instruments such as
stocks, bonds, derivatives, and commodities. To ensure fair and efficient
operations, the securities market is subject to regulations overseen by
market regulators. In India, the securities market is regulated by several

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regulatory bodies, primarily the Securities and Exchange Board of India Notes
(SEBI).
I. Importance of Security Market Regulations:
Security market regulations serve several essential purposes, including:
1. Investor Protection: Regulations aim to safeguard the interests of
investors by ensuring they have access to accurate information,
preventing fraud and manipulation, and promoting fair trading
practices. By establishing disclosure requirements, enforcing insider
trading laws, and prohibiting market abuse, regulations create a level
playing field for investors and instill confidence in the market.
2. Market Integrity: Regulations are designed to maintain market integrity
by preventing illegal activities and maintaining fair and transparent
trading practices. They establish rules for market participants, such
as brokers, exchanges, and listed companies, to prevent market
manipulation, insider trading, and other fraudulent practices. By
maintaining integrity, regulations help foster trust and credibility
in the market.
3. Market Stability: Regulations play a vital role in ensuring the stability
of security markets. They establish mechanisms to manage systemic
risks, monitor market activities, and prevent excessive volatility.
Through measures such as circuit breakers, margin requirements,
and position limits, regulators aim to mitigate risks and maintain
market stability, thereby protecting the broader financial system.
II. The Role of Market Regulator:
A market regulator is an independent government or non-governmental
organization tasked with overseeing and enforcing security market
regulations. The specific roles and responsibilities of market regulators
may vary across jurisdictions, but they generally include the following:
Objectives of SEBI:
SEBI has the following key objectives:
(a) Protecting the interests of investors in securities.
(b) Promoting the development and regulation of the securities market.
(c) Regulating and supervising market intermediaries.

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Notes (d) Preventing fraudulent and unfair trade practices in the securities
market.
(e) Promoting investor education and awareness.
Key Functions of SEBI:
SEBI performs various functions to achieve its objectives. These functions
include:
(a) Regulation and Supervision: SEBI formulate regulations and guidelines
to regulate various segments of the securities market, such as stocks,
bonds, derivatives, and mutual funds. It also supervises market
intermediaries, including stockbrokers, depositories, and credit rating
agencies.
(b) Investor Protection: SEBI strives to protect the interests of investors
by implementing measures to prevent fraud, insider trading, and
market manipulation. It ensures that investors receive accurate and
timely information to make informed investment decisions.
(c) Market Development: SEBI undertakes initiatives to develop and
promote the securities market by introducing new products, encouraging
innovation, and attracting domestic and foreign investments. It also
facilitates the listing and trading of securities on stock exchanges.
(d) Enforcement and Adjudication: SEBI have the authority to investigate
and take action against entities involved in market misconduct or
violation of regulations. It can impose penalties, issue warnings,
and initiate legal proceedings to safeguard market integrity.
(e) Investor Education and Awareness: SEBI aims to enhance investor
knowledge and awareness through educational initiatives, seminars,
workshops, and awareness campaigns. It promotes financial literacy
and encourages investors to make informed investment decisions.
Other Regulatory Bodies:
Apart from SEBI, other regulatory bodies play a significant role in regulating
specific segments of the securities market in India. These include:
(a) Reserve Bank of India (RBI): Regulates the bond market, money
market instruments, and foreign exchange transactions.

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(b) Insurance Regulatory and Development Authority (IRDA): Regulates Notes

the insurance sector, including insurance companies’ investments in
securities.
(c) Pension Fund Regulatory and Development Authority (PFRDA):
Regulates the pension sector, including investments made by pension
funds.

7.4 Capital Market Instruments and Services

Financial goods and services that are exchanged on the capital market
are referred to as capital market instruments and services. Businesses and
governments can raise long-term cash on the capital market by selling
securities to investors. Stocks, bonds, and derivatives are the three basic
categories of capital market instruments. Investors can purchase and sell
stocks, which represent ownership in a firm, on the stock market. In
contrast, bonds are a type of debt issued by governments or businesses to
raise money. Financial products known as derivatives derive their value
from an underlying asset or security.
Asset management, investment banking, and brokerage are all examples
of capital market services. While investment banking services assist
corporations in raising money by underwriting securities and providing
financial advice, brokerage services make it easier for clients to acquire
and sell securities on their behalf. Asset management services include
managing client investment portfolios to maximize returns and lower
risks. By giving governments and companies a way to raise long-term
capital and enabling individuals to invest their savings in a variety of
financial instruments, the capital market plays a critical role in promoting
economic growth.

7.4.1 Key Market Players

The capital market is a complicated and fiercely competitive financial market

comprising several participants, each crucial to the market’s operation.
Issuers, investors, intermediaries, and regulators make up the majority of
market participants in the capital market. Key participants in the capital
market include stock exchanges, banks, investment banks, brokerage houses,

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Notes asset management organizations, and insurance companies. Companies can

list their securities and enable trading on stock exchanges. By advising
on financial matters and underwriting securities, banks and investment
banks assist businesses in raising financing. Brokerage businesses aid
in the purchasing and selling of securities by acting as a middleman
between buyers and sellers. Companies that manage assets for customers
provide portfolio management services to maximize returns. Investors
can obtain risk management services from insurance providers. Investor
interests are protected by regulators like the Securities and Exchange
Board of India (SEBI), which keep an eye on how the capital market
operates and ensure fair and transparent trading practices. The major
market participants cooperate to ensure that the capital market operates
effectively and efficiently, giving companies and governments a way to
raise long-term money and enabling investors to make investments.

7.5 Evaluation of Capital Market

Since gaining independence in 1947, India has witnessed significant
evolution and growth in its capital markets. The journey of India’s capital
markets can be divided into several phases, each marked by key reforms,
regulatory changes, and market developments. Here’s an overview of the
evolution of India’s capital markets since independence:
1. Initial Years (1947-1980):
u The Bombay Stock Exchange (BSE) was established in 1875
and continued to play a crucial role in India’s capital market
post-independence.
u In the early years, the capital markets were relatively
underdeveloped, with limited participation and regulatory
oversight.
u The Industrial Policy Resolution of 1956 emphasized state
control and regulated the corporate sector, which impacted
the growth of private enterprises and capital markets.
u The Controller of Capital Issues (CCI) was established in
1947 to regulate the issuance of securities and determine their
pricing.

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2. Economic Liberalization and Structural Reforms (1980s-1990s): Notes

u In the 1980s, India embarked on a path of economic liberalization
and initiated structural reforms to open up the capital markets.
u The Securities and Exchange Board of India (SEBI) was
established in 1988 as the regulatory authority for the securities
market, bringing transparency and investor protection.
u The process of computerization and electronic trading began
in the early 1990s, replacing the open outcry system.
u The National Stock Exchange (NSE) was established in 1992,
introducing screen-based trading and fostering competition in
the market.
u The introduction of the Depository system in 1996 facilitated
the electronic settlement of trades, replacing the cumbersome
physical share certificates.
3. Foreign Investment and Market Integration (2000s):
u India gradually opened its capital markets to foreign investment,
attracting Foreign Institutional Investors (FIIs) and promoting
capital inflows.
u The introduction of Foreign Institutional Investor (FII) and
Qualified Foreign Investor (QFI) routes allowed foreign
investors to participate in the Indian markets.
u The integration of Indian markets with global exchanges gained
momentum with the listing of Indian companies as American
Depository Receipts (ADRs) and Global Depository Receipts
(GDRs).
u The introduction of the Derivatives segment in 2000 expanded
the product offerings and provided risk management tools to
market participants.
4. Strengthening Regulatory Framework and Investor Protection
(the 2010s onwards):
u SEBI implemented several reforms to strengthen the regulatory
framework, enhance transparency, and protect investor interests.

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Notes u The introduction of Real Estate Investment Trusts (REITs)

and Infrastructure Investment Trusts (InvITs) in 2014 provided
avenues for investment in the real estate and infrastructure
sectors.
u The launch of the Unified Payments Interface (UPI) in 2016
revolutionized digital payments and facilitated seamless
transactions in the capital markets.
u SEBI introduced initiatives like Direct Market Access (DMA),
algorithmic trading regulations, and tightened insider trading
norms to promote fair and efficient markets.
5. Technology and Innovation (ongoing):
u The advent of technology and digitalization has transformed
India’s capital markets, with online trading platforms and
mobile applications making investing accessible to a wider
audience.
u Fintech innovations, such as robo-advisory services, peer-to-
peer lending platforms, and crowd funding, are emerging as
alternative investment avenues.
u The growth of startups and the emergence of the Indian unicorn
ecosystem have also attracted investor attention, leading to
increased venture capital and private equity investments.
IN-TEXT QUESTIONS
1. Which regulatory body oversees the stock exchanges in India?
(a) National Stock Exchange (NSE)
(b) Bombay Stock Exchange (BSE)
(c) Securities and Exchange Board of India (SEBI)
(d) Reserve Bank of India (RBI)
2. Which regulatory body in India is responsible for regulating
the insurance sector?
(a) SEBI
(b) RBI
(c) IRDA
(d) PFRDA

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3. Which of the following is an example of a primary market Notes

instrument?
(a) Stock exchange
(b) Mutual fund
(c) Initial Public Offering (IPO)
(d) Derivatives contract

7.6 Regional and Modern Stock Exchanges

Regional stock exchanges in India play a significant role in facilitating
securities trading at a local level and contribute to the overall development
of the Indian stock market.
Regional stock exchanges are stock trading platforms that operate at a
local or regional level within specific geographical areas in India. Their
primary purpose is to enable securities trading, including stocks, bonds,
and other financial instruments, within their designated regions.
Key Characteristics:
(a) Local Focus: Regional exchanges concentrate on serving investors and
companies within their specific regions, fostering local participation
and economic growth.
(b) Listing Requirements: They often have relaxed listing norms compared
to national exchanges, making it easier for Small and Medium-sized
Enterprises (SMEs) to get listed.
(c) Trading Mechanisms: Regional exchanges employ various trading
mechanisms, including electronic trading platforms, traditional outcry
systems, or a combination of both.
Examples of Regional Stock Exchanges in India:
Calcutta Stock Exchange (CSE):
(a) Established in 1908, the CSE is one of the oldest stock exchanges
in India.
(b) Located in Kolkata, West Bengal, it serves as a crucial trading
platform for businesses and investors in Eastern India.
(c) CSE has played a pivotal role in promoting SME listings and fostering
regional capital formation.

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Notes Madras Stock Exchange (MSE):

(a) Founded in 1937, the MSE is another prominent regional stock
exchange.
(b) Based in Chennai, Tamil Nadu, it serves as a vital financial market
for investors and companies in South India.
(c) The MSE has historically focused on facilitating trading for small-
scale and mid-scale enterprises.
Cochin Stock Exchange (CSE):
(a) Founded in 1978, the CSE operates in Kochi, Kerala, serving as a
major stock exchange in the region.
(b) It has contributed significantly to the growth of the local capital
market, particularly for businesses in Kerala.
Market Size and Significance:
Regional Exchange Market Share:
(a) While regional exchanges have witnessed a decline in recent years,
they continue to provide liquidity and trading opportunities to local
investors.
(b) Their market share is relatively smaller compared to national
exchanges such as the Bombay Stock Exchange (BSE) and the
National Stock Exchange (NSE).
Impact on Regional Economies:
(a) Regional exchanges play a vital role in supporting the economic
development of their respective regions by providing capital access
to local businesses.
(b) They help generate employment, foster entrepreneurship, and
contribute to the growth of small and medium-sized enterprises.
Regulatory Changes and Challenges:
(a) In recent years, regulatory changes have aimed to streamline the
operations and governance of regional stock exchanges.
(b) Challenges such as low trading volumes, competition from national
exchanges, and technological advancements have prompted the
consolidation and restructuring of some regional exchanges.

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7.7 International Stock Exchanges Notes

International stock exchanges play a vital role in the global financial

landscape, providing platforms for trading securities from various countries
and facilitating cross-border investment opportunities.
International stock exchanges are platforms that facilitate the trading of
securities from different countries, allowing investors to access a wide
range of international investment opportunities. These exchanges enable
the listing and trading of stocks, bonds, and other financial instruments
from companies located outside their domestic jurisdiction.
Key Characteristics:
(a) Global Reach: International exchanges attract listings from companies
across multiple countries, promoting global diversification for
investors.
(b) Regulatory Framework: They operate under the regulatory jurisdiction
of the countries where they are located and often have stringent
listing requirements to ensure investor protection and market integrity.
(c) Trading Mechanisms: International exchanges utilize electronic
trading systems, allowing seamless trading across different time
zones and facilitating efficient price discovery.
Examples of International Stock Exchanges:
New York Stock Exchange (NYSE):
(a) Established in 1792, the NYSE is the largest and most prestigious
stock exchange globally.
(b) Located in New York City, United States, it serves as a primary
platform for trading U.S. and international stocks.
(c) The NYSE operates under the oversight of the U.S. Securities and
Exchange Commission (SEC).
London Stock Exchange (LSE):
(a) Founded in 1801, the LSE is one of the oldest and most influential
stock exchanges worldwide.
(b) Situated in London, United Kingdom, it is known for its diverse
range of listings, including companies from various sectors and
countries.

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Notes (c) The LSE operates under the regulatory framework of the UK
Financial Conduct Authority (FCA).
Tokyo Stock Exchange (TSE):
(a) Established in 1878, the TSE is the primary stock exchange in Japan
and one of the largest in Asia.
(b) Located in Tokyo, it serves as a major platform for trading Japanese
and international stocks.
(c) The TSE operates under the supervision of the Japan Financial
Services Agency (FSA).
IN-TEXT QUESTIONS
4. What is the role of stock exchanges in the capital market?
(a) Underwriting securities for corporations
(b) Managing client investment portfolios
(c) Facilitating the buying and selling of securities
(d) Providing financial advice to investors
5. Which stock exchange played a crucial role in India’s capital
market post-independence?
(a) National Stock Exchange (NSE)
(b) Bombay Stock Exchange (BSE)
(c) Controller of Capital Issues (CCI)
(d) Securities and Exchange Board of India (SEBI)

7.8 Demutualization of Exchanges

Introduction:
Demutualization refers to the transformation of a traditional member-owned
stock exchange into a corporate entity owned by shareholders. This shift
from a member-owned structure to a shareholder-owned model brought
forth a new era of efficiency and transparency in India’s capital markets.
The need for demutualization:
Up till 1990, Indian stock exchanges functioned under a system where trading
rights were restricted to members or brokers who owned and operated the

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exchange. This traditional structure faced inherent limitations as a result Notes

of the control over the capital markets which was concentrated in a few
hands. The need to enhance competitiveness, improve governance, and align
with global standards necessitated a transformation. The demutualization of
stock exchanges served as a step towards this transformation, encouraging
reforms and modernization across the entire ecosystem. By separating
ownership and trading rights, the demutualization process removed conflicts
of interest and paved the way for independent decision-making, stronger
regulatory oversight, and enhanced accountability.
Impact:
Demutualization fostered investor confidence and attracted domestic and
foreign investments. The transition to a shareholder-owned structure led
to technological advancements, leading to the emergence of electronic
trading platforms and algorithmic trading. These developments not only
improved liquidity but also boosted market efficiency and price discovery.
From a governance standpoint- the stock exchanges implemented transparent
rules and regulations, along with increased disclosure requirements and
enhanced investor protection. As a result, retail investors gained access
to better information as well as a level playing field, enabling them to
make informed investment decisions.
Simultaneously, the introduction of new trading instruments, such as futures
and options, facilitated risk management and provided investors with a
broader array of investment opportunities. Additionally, the demutualization
process encouraged the establishment of specialized exchanges, such as
commodity exchanges and currency exchanges, broadening the scope
and depth of India’s financial markets. In addition, the integration of
trading platforms, information sharing, and joint initiatives fostered cross-
border investments and enhanced liquidity. Indian stock exchanges gained
recognition and attracted international investors, further solidifying the
country’s position as a global financial hub.
Conclusion:
The demutualization of stock exchanges in India marked a turning point
in the evolution of the country’s capital markets. This transformation has
successfully led to a new era of growth, efficiency, and transparency. The
stock exchanges, now owned by shareholders, have become key drivers

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Notes of economic development, providing a platform for capital formation,

fostering investor confidence, and facilitating efficient price discovery.

7.9 Indian Stock Indices and their Construction

To monitor the performance of the stock market in India, several stock
indices are employed. The BSE Sensex and the NSE Nifty are the two
indices that are most often watched.
The oldest stock market index in India is the BSE Sensex, commonly
referred to as the Bombay Stock Exchange Sensitive Index. It was established
in 1986 and monitors the market capitalization-based performance of the
top 30 companies listed on the Bombay Stock Exchange. Only shares
that are available for trading on the market are taken into account when
calculating the index because it uses the free-float market capitalization
methodology. The index’s base year is 1978–1979, and its base value is
100.
The top 50 businesses listed on the National Stock Exchange based on
market capitalization are tracked by the NSE Nifty, sometimes referred
to as the National Stock Exchange Fifty, which was introduced in 1996.
Nifty likewise uses the free-float market capitalization approach for
calculation, just like the BSE Sensex. The index’s base year is 1995, and
its base value is one thousand.
In addition to these two indices, India has several other indices that
monitor the performance of various industries and market sectors. The
BSE Bankex, BSE Auto Index, BSE Healthcare Index, Nifty IT Index,
and Nifty Bank Index are a few of these indices.
These indices are calculated using a similar technique as the BSE Sensex
and NSE Nifty, which bases their calculations on the market capitalization
of the stocks that make up the index. However, depending on the index,
different stocks may meet different particular criteria for inclusion and
exclusion.
Full Market Capitalization
The number of outstanding shares is multiplied by the market price of the
company’s shares in this method to obtain the weighted index scripts. The
index’s weightage would be higher, and its influence would be greatest for

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the share with the highest market capitalization. Market capitalization for Notes
all companies will be totaled at the end, giving the index its final value.
The entire number of shares currently held by the company’s shareholders,
including shares held by institutional investors and restricted shares owned
by the company’s executives and insiders, is referred to as the number
of shares outstanding. This approach is used by the S&P 500 index in
the USA.
Total Market Capitalization = Number of Shares Outstanding × Share
Market Price
Free Float Market Capitalization
The proportion of shares that are accessible for trading on the market
is known as free float. It does not include shares that are limited under
employee stock option plans, shares that are held by company officers and
insiders, or shares that the government holds as a strategic investment.
Based on the percentage of shares that are in free float, companies
included in the index are given free float factors. From 0.05 to 1.0 is
the free float range. The following steps are used to compute the value
of the index using this method:
The formula for Float-free market capitalization is = the total number of
free float shares × share market price × free float factor.
Add the Market value of every company in the index as determined by
step 1’s calculations.
Use the formula below to determine the index value.
Index Value is calculated as follows: Base Index Value × (Current Free
Float Market Capitalization of Index/Base Free Float Market Capitalization
of Index)
Both the BSE and NSE adopt the free float market capitalization method.
% Free Float Free-Float % Free Float Free-Float
Factor Factor
>0-5% 0.05 >50-55% 0.55
>5-10% 0.1 >55-60% 0.6
>10-15% 0.15 >60-65% 0.65
>15-20% 0.2 >65-70% 0.7

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Notes % Free Float Free-Float % Free Float Free-Float

Factor Factor
>20-25% 0.25 >70-75% 0.75
>25-30% 0.3 >75-80% 0.8
>30-35% 0.35 >80-85% 0.85
>35-40% 0.4 >85-90% 0.9
>40-45% 0.45 >90-95% 0.95
>45-50% 0.5 >95-100% 1
Source: [Link]
Price Weighted Index
Each stock has an impact on the index according to its share price when
an index is calculated using a price-weighted technique. By summing
the values of each stock in the index and dividing them by the total
number of stocks, one can determine the index’s value. Stocks with higher
prices are given more weight, which has a bigger impact on the index’s
performance. This approach is used by the Dow Jones Industrial Average.
Equal Weighted Index
Using this approach will result in an equal % weighting for each stock
in the index. Therefore, each stock has an equal impact on the overall
value of the index. This approach is utilized by the Kansas City Board
of Trade (KCBT).

7.10 Major Instruments Traded in Stock Markets

1. Stocks (Equities): Stocks represent ownership in a company and
are traded on stock exchanges. Investors can buy and sell shares of
publicly listed companies. Examples include shares of companies
such as Reliance Industries, State Bank of India, etc.
2. Derivatives: Derivatives are financial contracts whose value derives
from an underlying asset. The derivatives segment on Indian exchanges
includes futures and options contracts. Examples include Nifty 50
futures and options, stock futures, etc.
3. Commodities: The Multi Commodity Exchange (MCX) of India,
National Commodity and Derivate Exchange Limited (NCDEX)

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facilitates trading in commodities such as precious metals, agricultural Notes

harvest, crude oil, commodity derivatives, etc.
4. Currencies: Indian exchanges offer trading in currency derivatives,
allows investors to trade and speculate on foreign exchange rates.
Currency futures and options in India are available in INR/X pairs
where “X” are major currencies of the world such as USD, EUR,
etc.
5. Exchange Traded Funds (ETFs): Exchange-Traded Funds (ETFs)
are investment funds that are traded on stock exchanges, similar
to individual stocks. Exchange-Traded Funds (ETFs) are widely
available in India and have become popular investment options
among investors. The Securities and Exchange Board of India
(SEBI) regulates ETFs, which are traded on major stock exchanges
such as the National Stock Exchange (NSE) and the Bombay Stock
Exchange (BSE). Examples include NIFTYBEES (a mutual fund
that follows the Nifty 50 Index), GOLDBEES (a fund that holds
various gold instruments and tracks the price of gold)
Before investing in an Exchange-Traded Fund (ETF), it is crucial to
consider the following factors:
Investment Objective: Clarify your investment goals and determine

how the ETF aligns with those objectives. Decide whether you seek
long-term growth, income generation, diversification, or exposure
to a specific sector or asset class:
 ETF Strategy and Index: Evaluate the ETF’s investment
strategy and the index it aims to track. Understand the
index’s composition, methodology, and how closely the ETF
replicates its performance. Ensure that the index aligns with
your investment approach and risk tolerance.
 Expense Ratio: Review the ETF’s expense ratio, which reflects
the annual cost of owning the fund. Lower expense ratios are
generally preferred as they can have a significant impact on
long-term returns.
 Liquidity: Assess the liquidity of the ETF by examining its
average trading volume and bid-ask spreads. Sufficient liquidity

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes ensures that you can buy or sell shares without significantly
affecting prices. Higher liquidity enhances trading convenience.
 Tracking Error: Understand the ETF’s historical tracking error,
which measures its deviation from the index it aims to track.
Lower tracking error indicates a closer correlation with the
index’s performance.
 Diversification: Consider the level of diversification provided by
the ETF. Evaluate the number of holdings and the concentration
of assets within the fund. A well-diversified ETF can help
mitigate risks associated with individual securities.
 Performance and Historical Data: Review the ETF’s historical
performance across various periods. However, remember that
past performance does not guarantee future results. Consider
historical data alongside other factors.
 Risk Factors: Assess the risks associated with the ETF, such
as market volatility, sector-specific risks, interest rate risks
(applicable to bond ETFs), or geopolitical risks. Understand
the potential downsides and evaluate how they align with your
risk tolerance.
 Tax Implications: Consider the tax implications of investing
in the ETF. Understand how dividends, capital gains, and
distributions are treated for tax purposes. Some ETFs may
offer more tax-efficient structures than others.
 Prospectus and Fund Documents: Thoroughly read the ETF’s
prospectus and other fund documents to gain a comprehensive
understanding of its objectives, risks, expenses, and other
pertinent information. This information will facilitate an
informed investment decision.
6. Government Securities: Certain government securities such as
Sovereign Gold Bonds (SGBs) and long-term government bonds, as
well as treasury bills (T-bills), can be bought and sold on exchanges.
7. Corporate Debt: Companies can issue debt to the public in the form
of debentures and can be traded on exchanges.

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 Capital Market

IN-TEXT QUESTIONS Notes

6. Which market participant is responsible for managing client

investment portfolios?
(a) Stock exchanges
(b) Banks
(c) Asset management organizations
(d) Insurance companies
7. An investor can sell their ETF shares:
(a) Only at the end of regular market hours
(b) Only through direct negotiation with the ETF issuer
(c) Only through a redemption process with other investors
(d) At any time during market hours like a stock
8. ETFs have much lower expense ratio than traditional mutual
funds.(True/False)

7.11 Summary
The text provides an overview of various aspects related to the capital
market and securities market in India. It begins by introducing the Securities
and Exchange Board of India (SEBI) as the principal regulatory agency
governing the Indian securities market. SEBI’s goals include safeguarding
investor interests, promoting market growth, regulating intermediaries,
preventing fraud, and enhancing investor education. The concept of the
capital market is then explained, highlighting the trading of long-term
debt and equity instruments between investors and businesses. Primary
markets are described as the issuance of new securities to raise capital,
while secondary markets facilitate the trading of existing securities.
Debt securities, such as bonds, and equity securities, such as stocks, are
explained in terms of loans to corporations and ownership in companies,
respectively. The importance of capital markets in capital formation,
economic growth, and providing investment options is emphasized. The
text further explores primary and secondary markets, noting their roles
in capital formation, price discovery, investor protection, liquidity, and
economic growth. Common primary market instruments are outlined,

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes including IPOs, FPOs, rights issues, private placements, debt issuances, and
preference shares. Secondary markets, represented by stock exchanges, are
highlighted for providing liquidity, price discovery, investment opportunities,
and contributing to corporate governance. The Indian secondary market is
characterized by diverse investment opportunities, transparency, a strong
regulatory framework, retail investor participation, and technological
advancements. The text concludes by explaining the types of instruments
traded on Indian exchanges, such as stocks, derivatives, commodities,
currencies, and ETFs, which offer diversification and liquidity.

7.12 Answers to In-Text Questions

1. (c) SEBI
2. (c) IRDA
3. (c) Initial Public Offering (IPO)
4. (c) Facilitating the buying and selling of securities
5. (b) Bombay Stock Exchange (BSE)
6. (c) Asset management organizations
7. (d) At any time during market hours like a stock
8. True

7.13 Self-Assessment Questions

1. What is a capital market? How does it aid economic growth? What
are the functions of the capital market?
2. Compare and contrast the primary market and the secondary market
in terms of their purpose, participants, and activities.
3. Discuss the key participants in the secondary market and their roles,
including investors, brokers, market makers, and regulatory bodies.
4. What are the services provided by a stock exchange? What are the
distinctive features of stock markets in India?
5. What is the concept of demutualization in the context of stock
exchanges? Explain the transition from a mutual organization to a
demutualized exchange.

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Capital Market

6. Describe the role and significance of international stock exchanges Notes

in the global financial system.
7. Discuss how international stock exchanges facilitate cross-border
capital flows and enhance global market integration.
8. Compare and contrast the market capitalization-weighted index
methodology with other alternative weighting schemes, such as
price-weighted indices and equal-weighted indices. Analyze the
advantages and limitations of each approach.

7.14 References/Suggested Readings

u Pathak, B. Indian Financial System (5th ed). Pearson Publication
u Saunders, A. & Cornett, M.M. Financial Markets and Institutions
(3rd Ed). Tata McGraw Hill.
u Bhole L.M. and Mahakud J., Financial Institutions and Markets:
Structure, Growth, and Innovations (6th Edition). McGraw Hill
Education, Chennai, India
u [Link]
u Jeff Madura, Financial Institutions and Markets, Cengage Learning
EMEA, 2008
u [Link]
factors
u [Link]
u Khan, M.Y. Financial Services (8th ed). McGraw Hill Education.

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L E S S O N

8
Trading Mechanism on
Exchanges
Dr. Sharif Mohd.
Assistant Professor
Shivaji College
University of Delhi
Email-Id: smohd2991@[Link]

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Trading Mechanism on the Stock Exchanges
8.4 Dematerialisation of Securities
8.5 Clearing and Settlement Procedure in the Stock Exchange
8.6 Value at Risk Margin
8.7 NSE: Trading and Settlement
8.8 Stock Market Index: Concept and Index Construction Methodology
8.9 Summary
8.10 Answers to In-Text Questions
8.11 Self-Assessment Questions
8.12 References
8.13 Suggested Readings

8.1 Learning Objectives

u Stock exchanges are used as an indicator of a country’s economic health. It is the
capital market’s most active and well-organized segment, especially in developing
nations like India.
u The students will be able to comprehend various stock exchange, stock exchange
operations, trading and settlement at the NSE, clearing mechanisms, and settlement
of equities after completing this lesson.

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 Trading Mechanism on Exchanges

Notes
8.2 Introduction
The markets where the buying and selling of securities takes place are
called stock exchanges. A secondary market is one where securities are
exchanged that have already undergone an Initial Public Offering (IPO) in
the primary market and were made available to the public. These securities
must be listed there in order to be traded on the stock exchange. Most
trading takes place on the secondary market. Both the debt and equity
markets make up the secondary market. The secondary market offers the
average investor an effective platform for trading his assets. Investors are
given the chance to sell their shares whenever they need to.
The Board of Directors or Council of Management, which is made up
of elected brokers and government and public representatives selected
by SEBI, supervises the operation of the stock exchanges. The boards
of stock exchanges have the authority to enact and uphold rules, bylaws,
and regulations that apply to all of its participants. People who are
financially stable and have the necessary experience or knowledge in
the stock market are typically granted membership in stock exchanges.
They must pay an annual fee to SEBI, who controls and regulates their
membership enrolment. A “broker” is a stock exchange participant who
is authorised to act both on behalf of and in his own name. Only through
members may a non-member transact in securities. A broker may also use
a sub-broker, whom he may designate as part of the registration process.

8.3 Trading Mechanism on the Stock Exchanges

The stock exchanges are important institutions that facilitate the issuance
and selling of various securities. Every area of the capital market activity
revolves on it. People with savings would be unlikely to invest in
corporate securities without the stock exchange because there wouldn’t
be any liquidity for them (buying and selling facility). As a result, public
corporate investments would have been less.
Thus, stock exchanges serve as a marketplace for the purchase and
sale of securities while also providing their liquidity for the benefit of
investors. The stock markets serve as the capital market’s hub and are a
good indicator of how the country’s economy is doing overall.

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Notes In the stock market, investors and traders use their brokers to connect to
the exchanges and place buy or sell orders there. Based on their company’s
position, market value, and significance, a group of 50 NSE stocks and
30 BSE stocks are chosen to be included in a weighted formula that
calculates the index’s “worth.” The National Stock Exchange, or NSE,
is India’s top stock exchange. The world’s fourth largest, it (based on
equity trading volume). It was the first stock exchange in India to offer
a screen-based trading system, and it is situated in Mumbai. The NSE
was originally created with the intention of bringing transparency to the
Indian market system and it ultimately succeeded in meeting its objectives
pretty successfully. The NSE successfully provides services including
trading, clearing, and the settlement in debt and stocks to domestic and
foreign investors with the assistance of the government. Compared to
the NSE, the Bombay Stock Exchange is much older. Asia’s first stock
exchange was there. The BSE is the fastest stock exchange in the world,
with trades being completed in under 6 microseconds.
In the stock market, securities are traded using the settlement basis, spot
basis, and cash basis methods.
“Cash” shares or “B” category shares are the names given to shares of
companies that aren’t on the spot list. They can only be traded on a cash
basis or a delivery basis; settlement basis is not an option. In the case
of cash basis trading, the actual delivery of securities and payment must
be made on or before the specified settlement date.
For spot trading, the actual delivery of the securities to the buying broker
must occur within 48 hours after the contract. On receipt of the securities,
the buyer is anticipated to pay the seller promptly. Any security may be
traded on a spot basis or a cash basis, regardless of whether it is on the
specified list or the cash list.

8.3.1 Types of Securities

Securities that are traded on stock exchanges can be categorised as follows:

(1) Listed cleared Securities: Also known as securities that have been
played by the Board on the list of cleared securities and have been
permitted for trading on the exchange after meeting all listing
conditions.
(2) Authorized Securities: When the stock exchanges where they are
not listed permit them to be traded, the securities listed on certain
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 Trading Mechanism on Exchanges

of the recognised stock exchanges are referred to as permitted Notes

securities. If appropriate clauses are present in the stock exchanges’
regulations, this licence will be granted.
ACTIVITY
Due to the large number of companies listed on stock exchanges,
it is quite difficult to monitor every stock and evaluate the market
performance simultaneously. As a result, stock exchange indexes
are useful in determining the worth of a particular sector of the
stock exchange. Majorly Sensex, also called BSE 30 and NSE Nifty
or NIFTY 50 are the market indexes where well-established and
financially sound companies are listed, you’re needed. You must
visit the BSE and NSE websites and review their performance over
the previous ten years.

8.3.2 Types of Delivery

Spot delivery, hand delivery, and special delivery are some types of
deliveries at stock exchanges. When securities must be delivered and
paid for on the same day or the following day, the delivery is referred
to as spot delivery. If the delivery and payment are to be made on the
delivery date established by the stock exchange authorities, the delivery
is considered to have been done by hand.
A special delivery is one that must take place after the time frame set
by the stock exchange authorities for delivery.

8.3.3 Margin and Margin Trading

A margin is a portion of the value of a stock transaction that is paid in

advance. How much credit a broker or lender gives a consumer to buy
stocks.
In order to reduce speculative trading in shares that causes price volatility
in securities, SEBI established margin trading.
In this sense, “initial margin” refers to the minimal sum that the client
must deposit with the broker prior to making the actual purchase. It is
computed as a percentage of the transaction value. The balance money may
be advanced by the broker in order to fulfil all settlement requirements.

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Notes The term “maintenance margin” refers to the minimal sum that a client
must have on deposit with the broker and is determined as a percentage of
the market value of the assets based on the closing price of the previous
trading day.
The broker must initiate margin calls right away if the amount deposit
in the client’s margin account is less than the necessary maintenance
margin. However, the client cannot be given any further exposure based
on a rise in the market value of the securities.
If the client doesn’t deposit the checks the day after the day the margin
call was issued, doesn’t satisfy the margin calls the broker has made,
or if the check has been returned unpaid, the broker may liquidate the
securities.
The brokers may also sell the securities if, during the time between making
the margin call and receiving payment from the client, the customer’s
deposit in the margin account (after subtracting mark-to-market losses)
is 30% or less of the securities’ most recent market value. On or before
12 Noon the following day, the broker must provide the stock exchange
with information regarding gross exposure, including the name of the
client, unique identification number, name of the scrip, and if the broker
has borrowed money in order to provide margin trading facilities, the
name of the lender and the amount borrowed.
The market is informed by stock exchanges of the scripwise gross
outstanding in margin accounts with all brokers. Next the close of business
the following day, the website will make these disclosures about margin
trading conducted on any given day accessible.
Margin trading therefore serves as a check on clients’ propensity to
manipulate markets by placing orders with brokers without having enough
funds or securities to support the transactions transaction. Trading on
margin will also put a stop to short sales and short purchases. The decrease
in the aforementioned consumer tendencies lowers price volatility on the
stock exchange and gives regular investors stability.

8.3.4 Book Closure and Record Date

Book closure is the routine closing of the company’s membership register

and transfer books in order to keep track of the shareholders’ entitlement
to dividends, bonuses, right shares, and other share-related rights. Record

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 Trading Mechanism on Exchanges

date refers to the day that a company’s books are closed in order to Notes
identify the stockholders who should receive dividends, proxies, etc.
Book closure is required in order to pay dividends and create rights or
bonus issues. At least seven days before to the start of the book closure,
the registered company must publish a notice of it in a newspaper. The
participants whose names are listed in the registry members as of the
final day of book closure are eligible to receive dividend, right, or bonus
share benefits, as appropriate.

8.3.5 Trend Line and Trading Volume

A price line is regarded as established when share prices move consistently

in one direction over an extended period of time. The trend is referred
to as BULLISH when it moves upward and BEARISH when it moves
downward. A bear market is a weak or declining market where sellers
predominate. In contrast, a bull market is a market that is rising with
lots of buyers and few sellers.
Reactions are secondary movements that momentarily revert the upward
trend. Rallies are movements that momentarily revert the downward
trend. It is referred to as a trend reversal when an upward trend shifts
downward.
Trading volume determines whether a price increase or decrease is in
line with the general trend. In the same way that high trading volume
is based on rising prices, it is also associated with falling prices. They
represent, respectively, BULLISH and BEARISH trends.
The amount of BULLISH interest in various scrips is indicated by their
net turnover and outstanding positions, which are combined with trading
volume to determine the intensity of the phase, whether BULLISH or
BEARISH. The daily turnover of important stocks will significantly
increase during BULL phases, whereas BEAR phases will see the
opposite.

8.4 Dematerialisation of Securities

An electronic book entry system for holding and transferring stocks has been
established to address issues such as theft, fraud, delays, and bureaucracy

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes associated with physical certificates. Investors can keep securities in either
physical or Dematerialized form. SEBI has required mandatory demat
settlement for certain scrips to speed up the dematerialization process.
Securities issued via an IPO can only be settled in dematerialized form.
All future Initial Public Offerings (IPOs) will be dematerialized. Two
depositories—the National Securities Depository Limited (NSDL) and
the Central Depository Service Limited (CDSL)—offer trading facility
in the dematerialised form.
Dematerialisation is the process of converting physical share certificates
into digital form.
The process of dematerialization is as follows:
1. Open a Demat Account with depository participant.
2. Once Demat account is opened and unique ID is generated, one must
surrender share certificates with the DP.
3. DP shall share the same to registrar of issuer.
4. After certificate and document verification, certificates are registered
with NSDL or CDSL.
5. The DP then credits the given number of shares to shareholders
demat account.
IN-TEXT QUESTIONS
1. Which of these is a stock exchanges function?
(a) The function of an economic barometer
(b) Securities valuation
(c) Promoting savings and investments
(d) All of the above
2. What quantity of companies make up the Sensex (Stock Exchange
Sensitive Index)?
(a) 20
(b) 30
(c) 50
(d) 100

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 Trading Mechanism on Exchanges

3. With margin trading, you can purchase securities with _____ Notes
money.
(a) Lending
(b) Borrowing
(c) Spending
(d) Avoiding the situation
4. Based on what? NIFTY and SENSEX are calculated:
(a) Free-Float capitalization
(b) Market capitalization
(c) Authorised share Capital
(d) Paid-up capital
5. The exchange rate between two currencies _____ is known as
the spot exchange rate.
(a) For delivery later
(b) For delivery in the future at a specific location
(c) For prompt delivery
(d) None of the preceding

8.5 Clearing and Settlement Procedure in the Stock

Exchange
There are always buyers and sellers in the stock market. Thus, another
trader sells the shares when someone purchases a certain number of them.
Only after the buyer receives the shares and the seller receives payment
is this transaction considered settled. A secondary market transaction
happens in three stages:
Let’s examine the procedure in greater detail.

8.5.1 Trading

Shares in a specific company are purchased and sold during stock trading.
There are numerous trades going on at once in the stock market. An
electronic order matching system is used by the stock exchanges to match
“buy” and “sell” orders from various traders. Each trade is carried out in

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 FINANCIAL MARKETS AND INSTITUTIONS

Financial Markets and Institutions

Notes this way. Take stock “X” as an example, which is trading on the stock
exchange. For this stock, the buy and sell orders are as follows:

Financial Markets and Institutions

Figure 8.2: Buy and sell matching system in stock exchanges (source: Author Complied)
Figure 8.2: Buy and sell matching system in stock exchanges
Here, the priciest buy prices are compared
(Source: to the
Author cheapest sell prices that are currently
Complied)
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priciest buyprices
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Figurethat
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available matching system
both buys andinsells.
stock exchanges (source: Author Complied)
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Figure 8.3: The procedure for trading in stock exchanges (source: Author Complied)
 Creating a Demat account: A demat account needs to be opened by the investor.
Because the securities will be kept in the demat account, this will happen.
Figure
Figure 8.3: 8.3: The for
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exchanges (source:exchanges
Author Complied)
(Source: Author Complied) 197 | P a g e
 Creating a Demat account: A demat account needs to be opened by the investor.
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kept in the Education, Campus
demat account, of Open
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happen.
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 Trading Mechanism on Exchanges

u Creating a Demat Account: A demat account needs to be opened Notes

by the investor. Because the securities will be kept in the demat
account, this will happen.
u Choice of Broker: Only authorised brokers may be used by investors
to purchase or sell securities. The broker through whom the trades
will be placed must be chosen by the investor.
u Obtaining a Special Client Number: Each investor has a special
ID. Through this ID, the trades are tracked. The depository provides
this client ID.
u Entering the Scrip’s ISIN: Each security has a distinct 12-digit
ISIN of its own. It serves as the security’s identification number.
When placing the trade, the investor must include the ISIN of the
security.
u Placing of the Order: Investors must confirm their orders for the
securities they wish to purchase or sell.
u Finishing the Contract Note: The broker sends the client a contract
notes for each trade.
u Trading Transaction Settlement: The settlement process involves
both parties. In a purchase transaction, money is paid, and the
security is obtained; in a sale transaction, the opposite occurs. The
BSE and NSE settlement occur on T+2 days, or two working days
following the transaction days.

8.5.2 Clearing

The clearing procedure starts after a trade is executed and two orders match.
Identification of the security that belongs to the buyer and the amount
that belongs to the seller is known as clearing. ‘Clearing houses’ oversee
the entire process. These are separate organisations. But in the actual
market environment, traders frequently engage in multiple transactions.
The clearing house thus recognises all transactions and determines the
net sum or net securities owed to the trader.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes 8.5.3 Settlement

The importance of acting is to satisfy the financial commitments noted

in the clearing step. This includes settling the transaction for the buyers
and sellers. Therefore, the transaction is complete once the buyer receives
the security, and the seller receives the money. You will encounter two
different types of settlements when investing in equity, and they are as
follows:
u Spot Settling: The rolling settlement principle of T+2 is immediately
followed by this type of settlement.
u In-front Settlement: When you agree to settle the trade at a later
time—which could be T+5 or T+7—this settlement is applicable.

8.5.4 Rolling Settlement

In a rolling settlement, the trade is settled over the course of several days.
With this type of settlement, trades are concluded after the second working
day after being settled in T+2 days. This period does not include Sunday,
Saturday, bank holidays, or exchange holidays. A trade will therefore be
closed on a Thursday if it is made on a Tuesday. Similar to this, if you
purchase shares of stock on Friday, you must pay the broker on that day,
but the shares will be credited to your account the following Tuesday. On
the day your trades are settled, you are regarded as the shareholder of
record. The equity settlement day is crucial for dividend-seeking investors.
If the purchaser desires to collect a profit before the record date in order
to settle the trade and receive a dividend from the company.
All intervening holidays, such as bank holidays, exchange holidays,
Saturdays, and Sundays, are disregarded when calculating the settlement
day. Trades made on Monday are typically settled on Wednesday, those
made on Tuesday are typically settled on Thursday, and so forth. All open
positions at the end of the day must automatically result in payment or
delivery ‘n’ days later under rolling settlement. Rolling settlement trades
are currently settled on a T+2 basis, where T is the trade day. For instance,
a trade made on Monday must be settled by Wednesday (considering two
working days from the trade day).

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 Trading Mechanism on Exchanges

There is no difference for intraday traders due to rolling settlement. There Notes
would be no change for institutional investors, who are already prohibited
from competing. For small-scale investors who take leveraged positions
over the course of one night or more that roll over settlement. T+2 days
are used for the pay-in and pay-out of funds and securities.
The day that sellers deliver sold securities to the exchange and buyers
make funds for purchased securities available to the exchange is known
as pay-in day. On pay-out day, the exchange delivers the securities
purchased to the buyers and gives the sellers the money for the securities
sold. Currently, the pay-in and pay-out occur on the second working day
following the execution of the trade on the exchange, or T+2 rolling
settlement.
When a business announces a record date or book closure, for that
security, the exchange establishes a no-delivery period. Only trading in
the security is allowed during this time. These trades, however, are only
finalised after the no-delivery period has passed. To make sure that the
investor’s entitlement to the corporate benefit is identified clearly, this
is done.
The exchange puts securities up for auction when a trading member fails
to deliver securities on the pay-in day. This guarantees that the securities
are received by the buying trading member. The Exchange gives the
purchasing trading member the necessary quantity that it has purchased
in the auction market.
Table 8.1: Settlement Cycle for Rolling Settlement
(Source: [Link])
Trading Rolling settlement T
Clearing Custodial confirmation and delivery T+1 working days
generation
Settlement Securities and funds pay-in and pay-out T+2 working days
Post settlement Auction T+3 working days
Bad delivery reporting T+4 working days
Auction settlement T+5 working days
Rectified bad delivery pay-in and pay-out T+6 working days
Re-bad delivery reporting and pick up T+8 working days

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes CASE STUDY

Impact of Index Futures Trading on Spot Market: A case study of
India Sathya Swaroop Debasish conducted study on the effect of
futures trading on the underlying Indian stock market’s volatility and
operational efficiency in 2009 using a sample of specially selected
individual stocks. The study specifically investigates whether trading
in Indian index futures has significantly changed the spot price
volatility of the underlying stocks and how trading in Indian index
futures has impacted market/trading efficiency. An extensive time
frame from June 1995 to May 2009 is used to examine the impact
of the introduction of futures trading. In order to determine whether
the introduction of index futures trading has significantly changed
the volatility and efficiency of stock returns, this study employed
an event study methodology. The research contrasts before and after
futures trading are implemented in the stock indices, spot price
volatility varies. He found an association between reduction spot
price volatility and decreased trading efficiency in the underlying
stock market following the introduction of Nifty index futures trading
in India. The findings of his study appear to suggest that, at least in
the short term, there is a trade-off between the benefits and expenses
related to the introduction of derivatives trading. For the purpose of
market stabilisation, the market would have to pay a certain price,
such as a reduction in market efficiency. He goes on to say that an
ideal derivatives market policy would be one that would maintain
market stability without impairing market efficiency in the underlying
spot market.

IN-TEXT QUESTIONS
6. Which of the following could cause a stock market to suddenly
lose value?
(a) Terrorist attack
(b) Major corporation declaring bankruptcy worldwide recession
(c) Major shareholder selling
(d) All of the above

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 Trading Mechanism on Exchanges

7. Which system is used to settle cash market transactions in the Notes

current environment?
(a) T day
(b) T+1
(c) T+5
(d) T+2
8. Who handles stock market securities transfers electronically?
(a) RBI
(b) Depositories
(c) Clearing Agencies
(d) SEBI
9. The phrase “Bulls and Bears” is related to
(a) Speculator
(b) Import and Export
(c) Banking
(d) Marketing
10. Which of the following is the mode of settlement of securities
where in the transfer of securities and funds happen simultaneously?
(a) Delivery versus Payment (DvP)
(b) Clearing Corporation of India Ltd. (CCIL)
(c) None of the listed options
(d) All of the above

8.6 Value at Risk Margin

Value at risk, or VaR, is the largest expected loss that one could have
over a certain time period, based on a certain confidence range. Value
at Risk, or VaR, is a way to figure out what the biggest loses might be
over a certain period. Volatility in the past tells us how the price of an
investment changed over time. VaR tells that “How much is a security
or portfolio is likely to change in the next day?”
VaR is a way to figure out how likely it is that security will lose value. There
are three parts to a VaR statistic: a period, a confidence level, and a loss.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes Remember these three parts and find them in this is an example: “With 99%
certainty, what is the most an asset could be worth & might lose the next day?
This “VaR question” has three parts, as you can see: a fairly high level of
99% confidence, a time frame (one day), and an estimate of the loss
(which can be written in terms of dollars or percentages).
Analysts want to make a statement about when they use the value-at-risk
measure: It’s a sure thing that no more than “V amount of dollars” may
be lost in the next N days. The value of V is the portfolio’s value at
risk. It’s the amount of money that could be lost over the next N days
that has a (100 - X) % chance of happening. If N days is the time frame
and X% is the level of confidence, then VaR is the amount of money
that could be lost that is one hundredth of the way that the portfolio’s
value goes up over the next N days. The parametric method, which is
also called the variance-covariance method, says that the returns are likely
to follow a normal distribution. It uses two things to figure out the VaR:
the expected returns and the standard deviation. However, this method
doesn’t work for small sample sizes, which is its main flaw.
Let’s say you oversee an investment portfolio worth Rs 1,00,00,000 and
you want to find the VaR with 95% confidence over a one-day horizon.
This means you want to find the biggest loss that your portfolio could
have over the next day with 95% confidence (z-score of about 1.645).
To find VaR, you need to know how your portfolio or the appropriate
market index has done in the past. For example, let’s say that the standard
deviation of the portfolio’s daily returns is 2% based on past data. The
formula for VaR is:
VaR = Portfolio Value *z * Std Dev
VaR = 10,000,000 * 1.645 * 0.02
= 32,900 rupees

8.7 NSE: Trading and Settlement

Fully automated screen-based trading was made available by NSE for the
first time in India. It employs a cutting-edge, fully computerised trading
system created to provide investors with a secure and convenient way to
invest across the country. The National Exchange for Automated Trading
(NEAT) system used by the NSE is a fully automated screen-based trading
system that adheres to the idea of an order-driven market.

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 Trading Mechanism on Exchanges

The National Securities Clearing Corporation Limited (NSCCL), a wholly Notes

owned subsidiary of the National Stock Exchange of India Limited, is
responsible for clearing and settling trades made on the NSE’s capital
market platform. This company promptly completes the settlement without
postponement or delay. It functions on behalf of the clearing participants
from and to Mumbai’s central clearing centres and regional clearing centres. MBA
Through the automated system of the clearing corporation, it was the first
organisation to begin pre-delivery verification to find bad papers like
trades made on the NSE's capital market platform. This company promptly completes the
fake or forged certificates or lost and stolen share certificates. A facility
settlement without postponement or delay. It functions. on behalf of the clearing participants
is offered to lend/borrow securities and money at market-determined
from and to Mumbai's central clearing centres and regional clearing centres. Through the
rates,system
automated allowing for clearing
of the the efficient and on-time
corporation, delivery
it was the of securities.
first organisation This pre-
to begin
corporation
delivery verificationprovides clearing
to find bad papers and settlement
like fake services
or forged for or
certificates other
lost exchanges
and stolen share
in addition to Index Futures. It is affiliated with National
certificates. A facility is offered to lend/borrow securities and money at market- Securities
determined
rates, Depository
allowing for Limited (NSDL)
the efficient and delivery
and on-time Central ofDepositories Services
securities. This (India)
corporation provides
Limited (CDSL).
clearing and settlement services for other exchanges in addition to Index Futures. It is
affiliated
On awith National
netted basis,Securities
rolling Depository Limitedare(NSDL)
segment trades clearedandand
Central Depositories
settled. The
Services (India) Limited (CDSL).
Exchange/Clearing Corporation occasionally specifies trading and settlement
On a times. At therolling
netted basis, conclusion
segment of eacharetrading
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and settled. deals that were
Exchange/Clearing
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Corporation are netted,
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specifies the settlement obligations
and settlement forthe
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conclusion of each
period
trading arethecalculated.
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deals that were completedtoare
usenetted,
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and the settlement obligations for
to calculate
that settlement theare
period netcalculated.
settlementIt isobligations.
decided to use a multilateral netting procedure to
calculate
In athe net settlement
rolling obligations.
settlement, each trading day is regarded as a separate trading
period,settlement,
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trading to regarded
day is determine
as a the day’s
separate net period,
trading obligations.
and trades
Settlement obligations result from every deal, including trade-for-tradeevery
are netted to determine the day's net obligations. Settlement obligations result from
deal, and limited
including physical market
trade-for-trade transactions,
and limited which
physical market are settled
transactions, on aaretrade-
which settled on
a trade-for-trade basis.
for-trade basis.

Figure 8.4: Trading

Figureand8.4:
settlement
Tradingprocess on NSE (Source:
and settlement [Link]
process on NSE
(Source: [Link]
 1: Trading information from Exchange to NSCCL (real-time and end of day trade
file).
PAGE 227
 2: The NSCCL notifies the
© Department clearing &
of Distance members/custodians who Campus
Continuing Education, have returned theLearning,
of Open form
of the details of the completed
School oftrade. NSCCL applies
Open Learning, multilateral
University of Delhi netting and
establishes obligations based on the affirmation.

202 | P a g e

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes u Trading information from Exchange to NSCCL (real-time and end

of day trade file).
u The NSCCL notifies the clearing members/custodians who have
returned the form of the details of the completed trade. NSCCL
applies multilateral netting and establishes obligations based on the
affirmation.
u Downloading of the obligation and payment-in advice of funds/assets.
u Directing clearing banks to release funds by the pay-in deadline.
u Directing depository institutions to make securities available through
pay-in- time.
u Pay-in of securities (NSCCL advises depository to credit its account
and debit the pool account of custodians/CMs and depository follows
this advice).
u Funds are paid in (NSCCL advises clearing banks to credit their
accounts and debit the custodians’/CMs’ accounts).
u Security payout (NSCCL suggests depository join credit pool) debit
its account and the depository does it on behalf of custodians/CMs).
u Funds are paid out (NSCCL advises clearing banks to credit custodians’/
CMs’ accounts and debit their accounts.
u Through DPs, the Depository notifies the Custodians/CMs.
u Custodians/CMs are informed by clearing banks.

8.7.1 Settlement & Clearing of Equities

According to the settlement cycles of various sub-segments in the Equities

segment, NSCCL performs clearing and settlement duties. The clearing
corporation’s clearing function aims to determine what counter parties owe
and what on the settlement date, counter parties are expected to receive.
Settlement is a two-way process in which title to funds, securities, or
other assets is legally transferred on the settlement date.
Additionally, NSCCL has developed a system to deal with a number of
exceptional circumstances, such as security gaps, problematic deliveries,
business objections, and auction outcomes. Eight clearing banks have been
appointed by NSCCL to offer banking services to trading members, and

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 Trading Mechanism on Exchanges

connectivity with both depositories has been established for electronic Notes
settlement of securities. The clearing process of determining obligations,
followed by settlement to discharge those obligations.
Trading members and custodians are the two different types of clearing
members in the NSCCL. If the custodians confirm the obligation to
NSCCL, the trading members may transfer it to them. All trades whose
obligations the trading member proposes to transfer to the custodian are
sent, for confirmation, to the custodian by NSCCL. The custodian must
confirm these trades on a basis of T + 1 days.
When the aforementioned tasks are finished, NSCCL begins performing
its clearing function. The obligations of counter parties are determined
using the multilateral netting concept. A clearing member would therefore
have separate pay-in and pay-out obligations for funds and securities. In
order for members to fulfil their obligations on the settlement day (T+2),
their pay-in and pay-out obligations for funds and securities are therefore
determined at the latest by T + 1 day and forwarded to them.
The following sub-segments of the Equities segment are served by NSCCL
for the clearing and settlement of trades:
 All trades carried out in the Rolling/Book entry segment.
 Each and every transaction made in the Limited Physical Market
segment.
IN-TEXT QUESTIONS
11. Which of the following factors causes changes in the Sensex?
(a) Fiscal policy
(b) Monetary policy
(c) Instability in politics
(d) All of the above
12. The main responsibilities of NSCCL are risk management and
trade clearing and settlement.
(a) False
(b) True
13. Who settles trades made on the NSE?
(a) NSDL

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes (b) Members clearing

(c) SEBI
(d) NSCCL
14. Who transfers the securities that are available in the members’
accounts to the NSCCL?
(a) Clearing banks
(b) Custodians
(c) cleaning members
(d) Depositories
15. What entity coordinates the funds settlement between Clearing
Members and NSCCL?
(a) Clearing banks
(b) Depositories
(c) Cleaning members
(d) NSE

8.8 Stock Market Index: Concept and Index Construction

Methodology
The stock market index is hypothetical portfolio of stocks that tracks
the price movement in the stocks. Stock market index measures market
sentiment by analysing a representative sample of stocks. The stock market
index is a reflection of market activity. It reflects market direction and
shows day-to-day fluctuations in stock prices. The market index reflects
expectations about the economy’s overall performance. A stock index
helps investors understand the market’s average share price. A well-
constructed index accurately reflects market behaviour and the return of
a typical portfolio investment.
There are many indices listed on NSE and BSE. Some reflect movement
in blue chip stocks while some reflect movement in mid cap or small
cap stocks. Then there are sector specific indices monitoring and tracking
the movement of stocks in particular sector. The index on a given day is
determined as a percentage of the aggregate market value of the scrips
included in the index compared to the average market value throughout

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 Trading Mechanism on Exchanges

the base period. For example, the BSE Sensex is a weighted average of Notes
the prices of 30 select firms, while the S&P CNX Nifty is a collection
of 50 handpicked equities.
Index is constructed based on its objective. The objective will dictate the
screening criteria. Once the securities are screen in, for index construction,
their weight is computed. There are various index construction methodologies
as elaborated below:
1. Full float market capitalization method: The number of shares
outstanding multiplied by market price per share reflects their
weight.
To understand how an index value is arrived at in this method, let’s
assume that security A and B have been chosen to form part of
index. On the day index is listed, following information is available:
Total no. shares outstanding
Current market price Market
Capitalisation
A 100000 150 1,50,00,000
B 200000 200 4,00,00,000
Total market capitalisation = 5,50,00,000
Now a divisor may be selected to make the index number simpler
to understand and analyse. Let’s say the divisor chosen is 55000.
Index Value = Full float market capitalisation/index divisor =
1000
This value will change as the market capitalisation of underlying
securities change.
Let’s suppose on day 2, the market capitalisation of both the stock
is as follows:
Total no. shares outstanding
Current market price Market
Capitalisation
A 100000 155 1,55,00,000
B 200000 190 3,80,00,000
Index value will equate 5,35,00,000/55000 = 973
2. Free float market capitalization method: The methodology is based
on the idea that a company’s true market value is best represented

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes by its free-float market capitalization, which only considers shares

that are available for trading on the stock exchange. So the stock
held by directors, employees, strategic partners, government, cross
holding by affiliates, locked in shares are excluded. The free-float
market capitalization reflects the investable market capitalization,
which may be significantly lower than the full float market. Hence
while arriving at index value, free float market capitalization value
is used in place of full float market capitalization.
3. Price weighted index: This method involves adding up the prices of
each stock in the index to determine the index’s initial value. The
Laspeyre’s Price Index, which evaluates price movements against
a fixed base period quantity weight, is employed with an arbitrary
base date.

8.9 Summary
The stock exchange is a vital institution that makes it easier to issue
and sell different kinds of securities. Every aspect of the capital market
activity revolves around it. People with savings would be unlikely to
invest in corporate securities without the stock exchange because there
wouldn’t be any liquidity for them (buying and selling facility). As a
result, public corporate investments would have been less. There are two
types of securities traded on stock exchanges: listed cleared securities
and permitted securities. Settlement is the process of netting transactions,
actual delivery of securities and transfer deeds, and payments of the agreed
upon amount. The National Stock Exchange of India Limited’s wholly
owned subsidiary, National Securities Clearing Corporation Limited, was
established to carries out clearing and settlement of trades made on the
National Stock Exchange’s capital market. The BOLT and NEAT systems
are now used by the member-brokers at BSE & NSE to enter orders to
buy or sell securities from Trader Work Stations (TWSs). Thus, stock
exchanges serve as a marketplace for the purchase and sale of securities
while also ensuring their liquidity for the benefit of investors.

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Notes
8.10 Answers to In-Text Questions

1. (d) All of the above

2. (b) 30
3. (b) Borrowing
4. (a) Free-Float capitalization
5. (c) For prompt delivery
6. (d) All of the above
7. (d) T + 2
8. (b) Depositories
9. (a) Speculator
10. (a) Delivery versus Payment (DvP)
11. (d) All of the above
12. (b) True
13. (d) NSCCL
14. (d) Depositories
15. (a) Clearing Banks

8.11 Self-Assessment Questions

1. Which organisations participate in clearing and settlement? List the
steps taken in the settlement process and explain any two.
2. How do transaction cycles work? Explain with the help of a diagram,
3. Discuss the rolling settlement process for the settlement of securities.
4. Discuss the framework for borrowing and lending securities.
5. What is rolling settlement? How are trades cleared and settled in
the stock market?

8.12 References
u H. R. Machiraju (2009). The Working of Stock Exchanges in India
(3rd ed.). New Delhi New Age International.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes u Dhankar, R.S. (2019). Clearance and Settlement Process in Capital

Markets and Investment Decision Making., New Delhi, Springer,
Retrieved from, [Link] 3748-8_2.
u ICSI (2017). Capital Markets and Securities Laws, Retrieved from,
[Link].

8.13 Suggested Readings

u H. R. Machiraju (2009). The Working of Stock Exchanges in India
(3rd ed.) New Delhi, New Age International.
u Vanita Tripathi and Neeti Panwar (2019) Investing In Stock Markets
(4th ed.). New Delhi, Taxmann Publications.
u Rustagi, R.P. (2021). Investment Management: Theory & Practice.
New Delhi, Sultan Chand & Sons.

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L E S S O N

9
Money Market and
Debt Market
Monika Saini
Assistant Professor
P.G.D.A.V. College (M)
Email-Id: monikasaini@[Link]

STRUCTURE
9.1 Learning Objectives
9.2 Introduction
9.3 Money Market: Meaning, Role and Participants in Money Markets
9.4 Segments of Money Markets
9.5 Call Money Market
9.6 Repo and Reverse Repo
9.7 Treasury Bills Market
9.8 Certificate of Deposit
9.9 Commercial Paper
9.10 Debt Market: Introduction and Meaning
9.11 Primary Market for Corporate Securities in India
9.12 Issue of Corporate Securities
9.13 Secondary Market for Government/Debt Securities (NDS-OM)
9.14 Auction Process
9.15 Corporate Bonds and Government Bonds
9.16 Retail Participation in Money and Debt Market-RBI Retail Direct
9.17 Evaluation of Debt Market in India
9.18 Summary
9.19 Answers to In-Text Questions

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes 9.20 Self-Assessment Questions

9.21 References
9.22 Suggested Readings

9.1 Learning Objectives

u Understand the concept of money market.
u Develop the understanding of different segments and participants in
the money market.
u Evaluate the importance of various instruments of money market.
u Enhance the knowledge of debt market.
u Understand primary and secondary markets for corporate, government
and debt securities.
u Differentiate between government and corporate bonds.
u Analyse the importance of retail participation in Money and Debt
Market.

9.2 Introduction
Financial system also known as financial sector is very crucial for the
economic development of any economy. The financial sector of a country
includes financial institutions, financial markets, financial instruments, and
financial services. The financial system or financial sector also consists of
the procedures and practices adopted in the financial markets. Financial
markets can be organised or unorganised. Financial market is a platform
or a marketplace where sale and purchase of assets like, bonds, stocks,
derivatives, commodities, and foreign exchange take places. Broadly, we
can categorise these markets in following types:
 Stock Market
 Bond or Debt Market
 Commodities Market
 Derivatives Market

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 Money Market and Debt Market

In recent years, financial markets are growingly impacted by financial Notes

innovations, modern technologies, Fintech, expansion of domestic markets
in global world and steps taken by regulators to make financial markets
work in transparent and efficient manner.
The most important role of any financial system is to mobilise the savings
of corporates, individuals, or government in the form of monetary funds or
assets and invest them in productive channels. These financial transactions
are facilitated by financial intermediaries. These intermediaries can be
Capital Market intermediaries and Money Market intermediaries.
People with excess available Funds People with Shortage

Facilitates
Transfer of
Funds

Figure 9.1: Role of Financial Markets

9.3 Money Market: Meaning, Role and Participants

in Money Markets
Money Market and Capital Market are the two categories of financial
markets. Both these markets help in transfer of monetary assets to
businessmen and producers. The main difference between these markets is
based on period of instruments used. Capital market is a market of long-
term instruments, as it deals in long term claims i.e., maturity period of
more than one year. Money market is a market of short-term instruments
which deals in short term claims of maturity period of less than one year.
According to Shri Deepak Mohanty, Executive Director, RBI (2012),
“Money Market can be defined as a market for short term funds with
maturities ranging from overnight to one year and includes financial
instruments that are considered to be close substitutes of money.”
The primary role of the money market is to provide a source of short-
term funding to banks, corporations, and governments. Participants in
the money market include banks, corporations, governments, and other
financial institutions. They use the money market to borrow or lend funds

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes for a short period, usually less than one year, to meet their short-term
funding needs.
Banks are the most active participants in the money market as they use
it to manage their daily liquidity requirements. Governments use the
money market to fund their short-term deficits and manage their cash
flow needs. Corporations use the money market to finance their short-
term working capital needs or to invest excess funds. Other financial
institutions like mutual funds, insurance companies, and pension funds
also participate in the money market to earn short-term returns on their
investments.

9.3.1 Meaning of Money Market

The money market refers to a financial market where short-term financial

instruments with high liquidity are traded. These instruments include
treasury bills, commercial papers, certificates of deposit, and other
securities with maturities of one year or less. The money market plays
a crucial role in the overall financial system as it provides a platform
for short-term borrowing and lending. It helps in maintaining liquidity
in the financial system and promotes efficient allocation of funds. The
interest rates in the money market are used as a benchmark for other
short-term interest rates, which influences the cost of borrowing and
lending in the broader economy. Two important segments of Money
Market are: Organised sector and unorganised sector. In unorganised
market, the transactions are more informal and less structured. They are
outside the ambit of regulatory framework. These transactions do not
take place at well- structured exchanges. On the other hand, organised
market’s transactions include inter-bank transactions and transactions
between organised and structured institutes like insurance companies,
mutual funds etc.

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 Money Market and Debt Market

Notes

Figure 9.2: Structure of Indian Money Market

Before the setup of Reserve Bank of India, Indian Money market was
mainly unorganised and undeveloped. Large part of the money market
was controlled by the government. Reserve bank of India and Securities
and Exchange Board of India are the important regulators in the Indian
Money Market. Some of the major reforms in the money market includes,
borrowing of the government at prevailing market rates, pegging of interest
rates to Bank Rate. For the development of money market, Reserve Bank
of India formulated a working group, chaired by Shri Narayanan Vaghul
in September 1986. The group recommended—
 Introduction of new negotiable instruments.
 Rates and Prices to be decided by market forces and not administered.
 Increase the participants in the money market.
 Setting up of autonomous public limited company, which would deal
in money market instruments.
Following table highlights the major developments in the money market
in India.
Table 9.1: Major Developments in Money Market since the 1990s
Year Development
April, 1997 Ad hoc treasury bills were abolished
June, 2000 Adoption of Full-fledged LAF (Liquidity Adjustment Facility)

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes Year Development

2003 Introduction of CBLO (Collateralized Borrowing and
Lending Obligation) for corporate and non-bank participants
October, Minimum maturity period of CP (Commercial Papers) was
2004 shortened
April, 2005 Prudential limits on exposure of banks and PDs to call/
notice market and maturity of CD (Certificates of Deposit)
was gradually shortened
August, 2005 Call money market was transformed into pure inter-bank
market
April, 2007 State Government securities were made eligible for LAF
operations
March, 2010 Repo allowed in Corporate Bonds
July, 2010 Reporting platform for secondary market transactions in
CPs and CDs were operationalized
November, Screen based negotiated system for dealing in call/notice
2012 and term money markets was operationalized in 2006
and reporting of such transactions were made compulsory
through NDS-CALL in November 2012
(Source: Reserve Bank of India)

9.3.2 Role of Money Market

The money market plays a crucial role in the overall financial system.
Some of the important roles of the money market are:
1. Source of Short-term Funding: Money market is a market for short
term funds. The money market provides a source of short-term
funding to banks, corporations, and governments. It allows them
to borrow funds for a short period, usually less than one year, to
meet their short-term funding needs.
2. Maintaining Liquidity: The financial instruments in money market
can be easily converted into cash. The money market helps in
maintaining liquidity in the financial system. Participants can easily
buy or sell short-term securities in the money market to meet their

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 Money Market and Debt Market

cash flow needs. This promotes efficient allocation of funds and Notes
helps in stabilizing the financial system.
3. Benchmark for Interest Rates: The interest rates in the money
market are used as a benchmark for other short-term interest rates. It
influences the cost of borrowing and lending in the broader economy.
Therefore, the money market plays a critical role in setting interest
rates in the economy.
4. Risk Management: The money market provides participants with
an opportunity to manage their short-term cash positions and risk.
By investing in short-term securities with low credit and market
risk, participants can manage their risk and earn a return on their
investments.
5. Investment Opportunities: The money market provides an opportunity
for investors to earn short-term returns on their investments.
Participants can invest in low-risk and liquid securities like treasury
bills, commercial papers, and certificates of deposit to earn short-
term returns.

9.3.3 Participants in Money Markets

The participants in the money market are diverse, and they include banks,
corporations, governments, other financial institutions, non-financial
institutions, and individuals. They use the market to manage their short-
term funding needs, invest excess funds, earn short-term returns, and
manage risk:
1. Banks: Banks are the most active participants in the money market.
They use the market to borrow funds for a short-term period to
manage their daily liquidity needs.
2. Corporations: Corporations participate in the money market to
finance their short-term working capital needs or to invest excess
funds.
3. Governments: Governments use the money market to fund their
short-term deficits and manage their cash flow needs.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes 4. Other Financial Institutions: Other financial institutions like mutual

funds, insurance companies, and pension funds also participate in
the money market to earn short-term returns on their investments.
5. Non-financial Institutions: Non-financial institutions like companies,
municipalities, and state governments also participate in the money
market to borrow or lend funds for a short-term period.
6. Individuals: High net worth individuals can also participate in the
money market by investing in money market funds, which are
mutual funds that invest in short-term securities.

9.4 Segments of Money Markets

Money Market in India can be divided into two parts:
1. Organised Segment
2. Unorganised Segment
Organised Segment: The organised segment consists of commercial and
other banks, non-banking financial institutions and cooperative societies.
Inter-Bank Loan Market is also a part of organised segment of money
market. These intermediaries have extended their operations in rural India
as well to help and facilitate agricultural activities.
Characteristics of organised money market are:
1. Commercial banks dominate the organised money market. Their
operations are regulated by the Reserve Bank of India.
2. It is governed by complex rules and rigid procedures which may
lead to non-fulfilment of requirements of borrowers.
3. Due to low rate of interest on deposits, there is shortage of loanable
funds.
Unorganised Segment: The unorganised segment of money market
includes money lenders, Nidhis, Chit Funds and Indigenous bankers. They
lent money to those borrowers who cannot borrow from the organised
segment of money market. This market is characterised by informal terms
and conditions, high interest rates for borrowers and flexible procedures.
The size of unorganised sector is not easy to estimate due to lack of data

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 Money Market and Debt Market

and proper reporting. This segment is unstructured segment and over a Notes
period, the need of this sector is decreasing.
IN-TEXT QUESTIONS
1. The ____________ market refers to the market where short-
term debt securities are issued and traded.
2. Commercial paper is an example of a ____________ term debt
instrument.

9.5 Call Money Market

Call Money Market is a segment of the money market where funds are
borrowed or lent on an overnight basis, meaning for duration of one
day. The call money market is an interbank market where banks borrow
and lend funds to each other to manage their short-term liquidity needs.
In the call money market, banks can borrow or lend funds for a period of
one day, but the transaction can be rolled over if required. The interest
rate in the call money market is generally low and fluctuates based on
the demand and supply of funds.
The call money market is an important component of the money market
as it allows banks to manage their daily liquidity needs efficiently. Banks
may need to borrow funds on an overnight basis to meet their daily cash
reserve requirements or to fund unexpected payment obligations. On the
other hand, banks with excess cash can lend their funds on an overnight
basis to earn a small return on their investment.
The Reserve Bank of India (RBI) plays a crucial role in regulating the
call money market in India. The RBI sets the liquidity framework and
interest rates in the market to maintain stability and ensure the smooth
functioning of the financial system.

9.6 Repo and Reverse Repo

Repurchase agreements (Repos) and Reverse Repurchase agreements
(Reverse Repos) are financial instruments that are commonly used in
the money market.

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes A Repo is an agreement between two parties where one party sells a
security to the other party with an agreement to repurchase the security
at a specified price and date in the future. In other words, it is a short-
term borrowing arrangement where the seller of the security agrees to
buy it back later, usually within a few days to a few weeks. The buyer
of the security provides funds to the seller in exchange for the security,
and the funds are typically invested in other short-term instruments.
Reverse Repo is the opposite of a Repo. In a Reverse Repo, one party
purchases a security from another party with an agreement to sell it
back at a specified price and date in the future. In this case, the buyer
of the security provides funds to the seller, and the seller provides the
security as collateral. The seller agrees to buy back the security later,
usually within a few days to a few weeks, and the buyer earns interest
on the funds provided.
Repos and Reverse Repos are used by banks, corporations, and governments
to manage their short-term liquidity needs. For example, a bank may use
a Repo to borrow funds to meet its daily liquidity requirements, while a
corporation may use a Reverse Repo to earn interest on its excess funds.
The interest rates in the Repo and Reverse Repo markets are influenced
by factors such as the demand and supply of funds and the prevailing
interest rates in the broader economy. The rates in the Repo and Reverse
Repo markets also serve as a benchmark for other short-term interest
rates in the economy.
Repo and Reverse Repo transactions are commonly used in money markets
to manage short-term liquidity needs and are often used by central banks
to implement monetary policy.

9.7 Treasury Bills Market

Treasury Bills (T-bills) are short-term debt securities issued by the
government to finance its short-term borrowing needs. T-bills are sold at
a discount to their face value, and the difference between the purchase
price and the face value represents the interest earned by the investor.
The Treasury bill market is a segment of the money market where T-bills
are traded between investors, including banks, corporations, and individuals.

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 Money Market and Debt Market

T-bills are issued with maturities ranging from a few days to 52 weeks, Notes
and investors can buy them in denominations as low as Rs.1000.
The T-bill market is highly liquid, and investors can buy or sell T-bills
on any business day. The price of T-bills is determined by demand and
supply of funds in the market, and the interest rates in the T-bill market
are closely watched by investors as they reflect the prevailing short-term
interest rates in the economy.
The Reserve Bank of India (RBI) conducts regular auctions of T-bills to
raise funds on behalf of the government. The RBI sets the minimum price
at which it is willing to sell T-bills and investors bid for the T-bills at a
discount to the face value. The bids with the lowest yield are accepted,
and investors receive the T-bills at the discounted price.
Investors in the T-bill market include banks, mutual funds, insurance
companies, and individuals. Banks and other financial institutions use
T-bills to manage their short-term liquidity needs, while individuals and
corporations use T-bills as a safe and secure investment option with low
credit risk.
14 days T-Bills are issued at discount,
and we can calculate yield on these DO YOU KNOW?
bills with the help of following What are the various websites
formula: that give information on G-Secs?

Y =  FV − P  × 365 × 100 RBI financial market watch

 P  m - [Link]
[Link]
where;
This website offers links to
Y = Yield on T-Bill
information about G-Sec pricing
FV = Face Value of the Bill on the NDS-OM, money market,
P = Purchase Price and other G-Sec information like
m = Maturity period. outstanding shares, etc.

Following can participate in auctions of 14 days and 91 days TBs

on non-competitive basis:
1. Any person
2. Firm

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes 3. Company or Corporate Body

4. Institutions
5. State Governments
6. Non-Government Provident funds which are regulated by PF
Act, 1925 and Miscellaneous Provisions Act, 1952

9.8 Certificate of Deposit

A Certificate of Deposit is a time deposit issued by banks, financial
institutions, and other authorized dealers. It is a promissory note issued
at a discount to face value and has a fixed maturity date, usually ranging
from 1 month to 1 year. CDs are considered a safe and low-risk investment
option as they are insured by the Deposit Insurance and Credit Guarantee
Corporation of India (DICGC) up to Rs. 5 lakhs per depositor per bank.
For example, if a bank issues a 6-month CD with a face value of Rs. 1
lakh and an interest rate of 6%. An investor can purchase this CD at a
discounted price of Rs. 97,000, and at maturity, the investor will receive
Rs. 1 lakh, earning an interest of Rs. 3,000.

9.9 Commercial Paper

Commercial Paper, on the other hand, is an unsecured promissory note
issued by corporations to raise short-term funds from the money market.
CPs have a maturity period ranging from 7 days to 1 year and are
usually issued by high credit-rated companies. The interest rate on CPs
is determined by market conditions and the creditworthiness of the issuer.
For example, let’s say a company issues a 90-day CP with a face value
of Rs. 10 lakhs and an interest rate of 6%. An investor can purchase this
CP at face value and at maturity, the investor will receive Rs. 10 lakhs,
earning an interest of Rs. 15,000.
CDs and CPs are both considered low-risk investment options as they are
issued by credit-worthy institutions, have short-term maturities, and are
highly liquid. They are often used by investors, including banks, mutual
funds, and corporations, to park their short-term funds and earn a relatively
higher interest rate than traditional savings accounts or fixed deposits.

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 Money Market and Debt Market

Note: Click on the link to see Do’s and Don’ts for dealing in G-Securities: Notes
[Link]

9.10 Debt Market: Introduction and Meaning

The debt market refers to the market where debt securities are bought
and sold. Debt securities are financial instruments that represent a loan
made by an investor to a borrower, such as a government or a corporation.
These securities include bonds, notes, and bills, and they typically have
a fixed interest rate and a maturity date. The debt market is an important
source of financing for governments and corporations, and it provides
investors with a way to earn a fixed income.
Two categories of Indian Debt Market can be:
1. Government Securities Market
2. Bond Market

9.11 Primary Market for Corporate Securities in India

The primary market for corporate securities in India is where companies
issue new securities to raise funds from investors for the first time. The
primary market is an important source of capital for companies and allows
them to expand their business, undertake new projects, and meet their
working capital requirements.
In India, the primary market for corporate securities is regulated by
the Securities and Exchange Board of India (SEBI) and the Companies
Act, 2013. Companies can raise funds from the primary market through
Initial Public Offerings (IPOs), Follow-on Public Offerings (FPOs), and
Rights Issues.
The primary market for corporate securities in India is the market where
new securities are issued by companies to raise capital. The primary
market is an important source of funding for companies and provides
investors with an opportunity to invest in new securities. The Securities
and Exchange Board of India (SEBI) regulates the primary market and
ensures that companies comply with the rules and regulations related to
the issuance of securities. The types of securities that can be issued in

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes the primary market include equity shares, preference shares, debentures,
and bonds. The primary market is also known as the new issue market.
IPOs are the most common way for companies to raise funds from the
primary market. In an IPO, the company issues new shares to the public
and raises capital for the first time. The shares are offered at a price
determined through a book building process or through a fixed-price
mechanism.
Follow-on Public Offerings (FPOs) are similar to IPOs, except that they
are offered by companies that are already listed on the stock exchange.
FPOs allow companies to raise additional capital from the market by
issuing new shares to the public.
Rights Issues are another way for companies to raise funds from the
primary market. In a Rights Issue, the company offers existing shareholders
the right to purchase additional shares at a discounted price. This allows
companies to raise funds without diluting the ownership of existing
shareholders.
Investors in the primary market include institutional investors such as
mutual funds, insurance companies, and banks, as well as retail investors.
Retail investors can apply for shares in an IPO or FPO through the book-
building process or through the online application process provided by
brokers.

9.12 Issue of Corporate Securities

The issue of corporate securities refers to the process by which companies
raise funds from the market by issuing securities such as equity shares,
preference shares, debentures, and bonds. The issue of corporate securities
is an important source of funding for companies and allows them to raise
capital for various purposes such as expansion, acquisition, and debt
refinancing. Investors can participate in the issue of corporate securities
through the primary market and earn returns by investing in securities
that have the potential to appreciate over time.
The process of issuing securities involves several steps and is regulated
by securities market regulators such as the Securities and Exchange Board
of India (SEBI) in India.

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 Money Market and Debt Market

The process of issuing corporate securities typically involves the following Notes
steps:
1. Appointment of Intermediaries: Companies appoint intermediaries
such as investment bankers, underwriters, and lead managers to
manage the issue and ensure compliance with regulations.
2. Due Diligence: The intermediaries conduct due diligence to ensure
that all legal and regulatory requirements are met and that the
financial statements and disclosures are accurate and complete.
3. Pricing: The intermediaries determine the pricing of the securities
based on market conditions, demand, and supply. The pricing can
be determined through a book building process or a fixed price
mechanism.
4. Registration with Regulators: The Company registers the securities
with regulators such as SEBI and files a prospectus or offer document
with the Registrar of Companies (RoC) for public disclosure.
5. Public Offer: The securities are offered to the public through an
Initial Public Offering (IPO), Follow-on Public Offering (FPO), or
Rights Issue.
6. Allotment and Listing: The securities are allotted to investors who
have applied for them and are then listed on the stock exchange
for trading.

9.13 Secondary Market for Government/Debt Securities

(NDS-OM)
The secondary market for government/debt securities in India is regulated
by the Reserve Bank of India (RBI) and operates through a platform called
the Negotiated Dealing System-Order Matching (NDS-OM). The NDS-
OM is an electronic platform that facilitates the trading of government
securities, treasury bills, and other debt securities issued by government
and corporate entities.
The secondary market for government/debt securities plays an important
role in the economy as it allows investors to buy and sell securities after
they have been issued in the primary market. This provides investors

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 Financial Markets and Institutions FINANCIAL MARKETS AND INSTITUTIONS

Notes withof liquidity

trading and securities,
government enables them to manage
treasury theirother
bills, and portfolios by buyingissued
debt securities and by
sellingand
government securities
corporateasentities.
per their investment strategy.
The NDS-OM
The secondary marketplatform operates onsecurities
for government/debt a quote-driven system, where
plays an important role in market
the economy
as it participants such
allows investors as banks,
to buy and sellprimary
securitiesdealers,
after theyand institutional
have been issued investors
in the primary
canThis
market. place bids investors
provides and offers
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liquidity The them
and enables system matches
to manage bids
their and by
portfolios
buying and selling
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on the price theirquantity
investment strategy.
and execute trades automatically.
The NDS-OM platform
The secondary operates
market forongovernment/debt
a quote-driven system, wherealso
securities market participants
allows investorssuch as
banks,
to trade in derivatives such as interest rate swaps, forwards, and options. The
primary dealers, and institutional investors can place bids and offers for securities.
system matches
These bids andallow
derivatives offersinvestors
based onto the price their
manage and quantity
interest and
rate execute
risk andtrades
automatically.
hedge against adverse market movements.
The secondary market for government/debt securities also allows investors to trade in
The RBI regulates the secondary market for government/debt securities
derivatives such as interest rate swaps, forwards, and options. These derivatives allow
through various measures such as setting the policy rates, conducting open
investors to manage their interest rate risk and hedge against adverse market movements.
market operations, and regulating the participation of market participants.
The RBI regulates the secondary market for government/debt securities through various
The RBI also issues guidelines for the settlement of trades, which is done
measures such as setting the policy rates, conducting open market operations, and regulating
through the Clearing Corporation of India Ltd. (CCIL).
the participation of market participants. The RBI also issues guidelines for the settlement of
The
trades, secondary
which marketthefor
is done through government/debt
Clearing Corporation ofsecurities in India operates
India Ltd. (CCIL).
through the NDS-OM platform, which facilitates the trading of government
The secondary market for government/debt securities in India operates through the NDS-OM
securities,
platform, treasury the
which facilitates bills, and of
trading other debt securities
government securities,issued bybills,
treasury government
and other debt
and corporate entities. The market provides investors with liquidity
securities issued by government and corporate entities. The market provides investors and with
enables
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and enables manage
them theirtheir
to manage portfolios.
[Link]
The RBI regulatesthethemarket
RBI regulates market
through
through various measures to ensure
various measures to ensure its smooth functioning. its smooth functioning.

Figure 9.3: National Stock Exchange’s Negotiated Trade Reporting Platform

Figure 9.3: National Stock Exchange’s Negotiated Trade Reporting
221 | P a g e
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
250 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 Money Market and Debt Market

9.14 Auction Process Notes

Auctions are an important mechanism used by the government and corporate

entities to issue securities in the primary market. The auction process
involves the issuance of securities through a competitive bidding process,
where investors submit their bids for a specified quantity of securities at
a certain price. Let’s take an example of a treasury bill auction in India
to understand the process in detail.
The Treasury bills auction in India is conducted by the Reserve Bank of
India (RBI) on behalf of the Government of India. The auction process
for treasury bills involves the following steps:
1. Announcement of Auction: The RBI announces the auction date
and the details of the treasury bills to be issued. This includes the
maturity date, the auction date, the minimum amount to be bid, and
the cut-off yield.
2. Submission of Bids: The eligible participants such as banks, primary
dealers, and institutional investors submit their bids electronically
through the RBI’s electronic platform called the E-Kuber.
3. Review of Bids: The RBI reviews the bids and determines the cut-off
yield, which is the highest yield at which all the bids are accepted.
4. Allotment of Securities: The RBI allots the securities to the
successful bidders at the cut-off yield. Bidders who bid at a higher
yield than the cut-off yield do not receive any allotment.
Let’s take an example to illustrate the auction process. Suppose the
Government of India wants to issue a 91-day treasury bill worth
Rs. 10,000 crores. The RBI announces the auction date, and the details
of the treasury bill as follows:
u Auction date: 1st May 2023
u Maturity date: 1st August 2023
u Minimum amount to be bid: Rs. 1 crore
u Cut-off yield: 4.50%
On the auction date, eligible participants submit their bids electronically
through the E-Kuber platform. The RBI reviews the bids and determines
the cut-off yield to be 4.50%. The securities are then allotted to the

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes successful bidders at the cut-off yield. Suppose the total bids received
for the treasury bill are Rs. 20,000 crores. The RBI would allot the
securities to the successful bidders at the cut-off yield of 4.50%, up to
the amount of Rs. 10,000 crores. Bidders who bid at a higher yield than
4.50% would not receive any allotment.
IN-TEXT QUESTIONS
3. Treasury bills are issued by the ____________.
4. The interest rate charged by banks for short-term loans to each
other is known as the ____________ rate.

9.15 Corporate Bonds and Government Bonds

Corporate bonds and government bonds are both types of debt securities
issued by companies and governments in India to raise funds. However,
there are some key differences between these two types of bonds.
Government bonds, also known as sovereign bonds, are issued by the
central and state governments in India to fund their operations and various
developmental projects. These bonds are less risky than corporate bonds
because they are backed by the full faith and credit of the government.
As a result, government bonds typically offer lower yields than corporate
bonds.
Corporate bonds, on the other hand, are issued by companies in India
to finance their operations, expand their businesses, or undertake other
investment activities. These bonds are generally considered to be riskier
than government bonds because they are not guaranteed by the government
and are subject to the creditworthiness of the issuing company. As a result,
corporate bonds typically offer higher yields than government bonds to
compensate for the additional risk.
In India, both government and corporate bonds can be traded on the stock
exchange and purchased by investors. The Reserve Bank of India (RBI)
regulates the issuance and trading of both types of bonds.
Investors in India can choose to invest in government bonds or corporate
bonds depending on their investment objectives, risk tolerance, and
financial goals. Government bonds are generally considered to be safer
investments, while corporate bonds offer the potential for higher returns

252 PAGE
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 Money Market and Debt Market

but come with higher risks. It’s important for investors to carefully Notes
evaluate their options and assess the risk-reward trade-off before investing
in either type of bond.

9.16 Retail Participation in Money and Debt Market-RBI MBA

Retail Direct
9.16 RETaIL
The PaRTICIPaTION
RBI Retail Direct platform isINanMONEy
initiativeaND DEbT
by the MaRkET-
Reserve Bank of
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India DIRECT
(RBI) to encourage retail participation in the government securities
The RBIand Retail
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platform The platform
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January
(RBI) to
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encourage retail participation in the government securities and money market instruments.
bonds, and
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eliminates the needinvestors to invest
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allows investors to invest securities at the
directly in government
prevailing
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at the prevailing market prices.

Fig9.4:
Figure 9.4: RBI
RBI Retail
RetailDirect Platform
Direct Platform
To invest in government
To invest securities
in government throughthrough
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Retail
RBIDirect
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registered, investors can place their bids for government securities and
The minimum investment
money market amount onthrough
instruments the platform is Rs. 10,000, and investors can invest in
the platform.
multiples of Rs. 1,000 thereafter. The platform also provides investors with the flexibility to
invest in government securities with different maturities, ranging from 91 days to 40 years.
Retail participation in the money and debt market through the RBI Retail Direct platform is
expected to increase as it provides a transparent and efficient mechanism for retail investors PAGE 253
© Department
to invest in government of Distance
securities. & Continuing
The platform Education,
also provides Campus
investors with of
anOpen Learning,
opportunity
School of Open Learning, University of Delhi
to diversify their investment portfolio and earn competitive returns.
224 | P a g e

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes The minimum investment amount on the platform is Rs. 10,000, and
investors can invest in multiples of Rs. 1,000 thereafter. The platform also
provides investors with the flexibility to invest in government securities
with different maturities, ranging from 91 days to 40 years.
Retail participation in the money and debt market through the RBI Retail
Direct platform is expected to increase as it provides a transparent and
efficient mechanism for retail investors to invest in government securities.
The platform also provides investors with an opportunity to diversify
their investment portfolio and earn competitive returns.
The Reserve Bank of India (RBI) has introduced the RBI Retail Direct
platform to enable retail investors to invest in government securities
(G-Secs) and treasury bills (T-bills) directly. This platform is a part of
the RBI’s efforts to deepen the bond market in India and promote retail
participation in the debt market.
The RBI Retail Direct platform is an online platform that allows retail
investors to invest in government securities and treasury bills in a convenient
and hassle-free manner. Retail investors can access the platform through
the RBI’s website and invest in G-Secs and T-bills using their savings
bank account.
Some key features of the RBI Retail Direct platform are:
1. Minimum Investment: Retail investors can invest in G-Secs and
T-bills with a minimum investment of Rs.10,000.
2. Online Access: The platform is available online, and investors can
invest and manage their investments from the comfort of their
homes.
3. Competitive Yields: The RBI offers competitive yields on G-Secs
and T-bills, providing investors with a safe and attractive investment
option.
4. Direct Investment: The platform allows retail investors to invest
directly in G-Secs and T-bills, eliminating the need for intermediaries
such as brokers and mutual funds.
5. Secure and Transparent: The platform is secure and transparent,
with all transactions being recorded and tracked on the platform.

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 Money Market and Debt Market

Notes
9.17 Evaluation of Debt Market in India
The debt market in India has seen significant growth and development
in recent years. Here are some key points to evaluate the debt market
in India:
1. Size and Growth: The size of the debt market in India has grown
significantly over the years, with the outstanding amount of corporate
bonds and government securities standing at around Rs. 90 trillion
as of 2021. The debt market has also seen a growth in the number
of issuers and investors.
2. Diversification: The debt market in India is diverse, offering various
instruments such as government securities, corporate bonds, commercial
papers, certificates of deposits, and more. This diversification
has attracted a wide range of investors, from retail investors to
institutional investors.
3. Regulatory Framework: The regulatory framework for the debt
market in India has been strengthened over the years, with the
Securities and Exchange Board of India (SEBI) and the Reserve Bank
of India (RBI) playing an important role in regulating the market.
This has improved investor confidence and brought transparency to
the market.
4. Liquidity: The liquidity in the debt market in India has improved,
with the introduction of electronic trading platforms such as NDS-
OM and the National Stock Exchange (NSE). This has made it easier
for investors to buy and sell debt instruments and has improved the
market’s efficiency.
5. Credit Rating: The credit rating system in India has improved, with
agencies such as CRISIL, ICRA, and CARE providing investors
with reliable credit ratings of issuers. This has helped investors
make informed investment decisions and has reduced the credit risk
associated with investing in debt instruments.

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 introduction of electronic trading platforms such as NDS-OM and the National Stock
Exchange (NSE). This has made it easier for investors to buy and sell debt
instruments and has improved the market's efficiency.
5. Credit rating: The credit rating system in India has improved, with agencies such as
CRISIL, ICRA, and CARE providing investors with reliable credit ratings of issuers.
This has helped investors make informed investment decisions and has reduced the
FINANCIAL MARKETS AND INSTITUTIONS
credit risk associated with investing in debt instruments.
IN-TEXT QUESTIONS
Notes IN-TEXT QUESTIONS
True/False
5. Money market securities have longer maturities compared to
5. Money market securities have longer maturities compared to debt market
debt market securities. (True/False)
securities.
6. Money market instruments are highly liquid and have low default
6. Money market instruments are highly liquid and have low default risk.
risk.(True/False)
7. Treasury bonds are examples of money market instruments.
7. Treasury bonds are examples of money market instruments.
(True/False)

226 | P a g e

9.18 Summary
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
A bond is a type of financial instrument in which an investor lends
money to a borrower, generally a corporation or government, who then
borrows the money for a certain length of time at a fixed or variable
interest rate. Companies, communities, states, and sovereign governments
can raise money by selling bonds to support a range of initiatives and
endeavours. Owners of bonds are the issuer’s creditors or debt holders.
The Indian money and debt market plays a crucial role in the country’s
financial system, providing a platform for various participants to borrow,
lend, and invest in short-term and long-term debt instruments. It encompasses
a wide range of financial instruments and serves as a vital component of
India’s overall capital market.

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 Money Market and Debt Market

The money market in India consists of both organized and unorganized Notes
sectors. The organized sector comprises various institutions such as the
Reserve Bank of India (RBI), commercial banks, Non-Banking Financial
Companies (NBFCs), and primary dealers. These institutions facilitate
the borrowing and lending of funds for short periods, typically up to
one year. Prominent money market instruments include Treasury Bills
(T-Bills), commercial paper, certificates of deposit, and repurchase
agreements (repos).
Treasury Bills, issued by the Government of India, are short-term debt
instruments with maturities ranging from 91 days to 364 days. They are
highly liquid and serve as a means for the government to manage its
short-term borrowing requirements. Commercial paper is another widely
used money market instrument that enables corporations to raise short-term
funds directly from investors. Certificates of Deposit (CDs) are issued
by banks and financial institutions to raise funds from individuals and
corporate investors for specified periods.
On the other hand, the Indian debt market focuses on long-term debt
instruments and government securities. It provides a platform for
companies, financial institutions, and the government to raise funds for
longer durations. The debt market includes corporate bonds, government
bonds, debentures, and other fixed-income instruments. These instruments
are traded in the primary market and the secondary market, allowing
investors to buy, sell, or hold them based on their investment objectives.
The Indian debt market has witnessed significant growth in recent years,
driven by various reforms and initiatives by regulatory bodies like the
Securities and Exchange Board of India (SEBI) and the RBI. Efforts to
deepen the debt market, improve market infrastructure, enhance transparency,
and promote investor participation have led to increased liquidity and
efficiency in the market.
Investors in the Indian money and debt market include institutional
investors, such as banks, insurance companies, mutual funds, and pension
funds, as well as individual retail investors. These participants engage
in the market to earn returns on their investments, manage liquidity, and
diversify their portfolios.
Overall, the Indian money and debt market is a dynamic and evolving
ecosystem that plays a vital role in channeling funds between borrowers

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 FINANCIAL MARKETS AND INSTITUTIONS

Notes and lenders, facilitating efficient capital allocation, and contributing to

the overall economic growth of the country. Continuous efforts to develop
and strengthen this market are crucial to ensure its effectiveness, liquidity,
and stability, benefiting both market participants and the broader economy.

9.19 Answers to In-Text Questions

1. Money
2. Short
3. Government
4. Interbank
5. False
6. True
7. False

9.20 Self-Assessment Questions

1. An investor is interested in investing in Indian government securities.
What are the different types of government securities available in the
Indian debt market, and what factors should the investor consider
while making an investment decision?
2. For its working capital needs, a business organisation must raise
short-term financing. Describe the procedure and alternatives the
organisation must raise money through the Indian money market.
3. A bank wants to engage in the Indian money market since it has
extra liquidity. Identify the many money market instruments that
are accessible to the bank and the variables that it should consider
when choosing the best instrument for investment.
4. A government treasury department wants to manage its short-term
cash flows efficiently. Outline the role of Treasury Bills (T-Bills)
in the Indian money market and how they can be used for liquidity
management by the government.
5. An individual wants to invest in fixed income securities with regular
income and low risk. Compare the features and benefits of investing

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Money Market and Debt Market

Notes
in bank fixed deposits, post office schemes, and government securities
in the Indian context.

9.21 References
 Association, A. S. (July 2017). India’s Debt Market: The way
forward.
 India, T. C. (2023). CCIL Debt Market Quarterly.
 India, T. I. (n.d.). Money Market Operations.
 Natarajan, E. G. (2016). Financial Markets and Services. Mumbai:
Himalaya Publishing House Pvt. Ltd.
 Schou-Zibell, S. W. (2008). India’s Bond Market—Developments
and Challenges Ahead. WORKING PAPER SERIES ON REGIONAL
ECONOMIC INTEGRATION NO. 22.

9.22 Suggested Readings

 Financial Markets and Institutions - L. M. Bhole
 The Economics of Money, Banking and Financial Markets- Frederic
S. Mishkin and Apostolos serletis
 Module on Debt Markets by BSE, Source: BSE [Link].
com
 Modules by ICSI and ICAI
 RBI reports and CCIL website.

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L E S S O N

10
Other Markets
Dr. Neerza
Assistant Professor
Department of Commerce
PGDAV College (Morning)
University of Delhi
Email-Id: neerza@[Link]

STRUCTURE
10.1 Learning Objectives
10.2 Introduction
10.3 Fund-Based and Fee-Based Markets
10.4 Regulatory Issues in Such Markets
10.5 Market Regulators
10.6 Alternative Financial Instruments and Services
10.7 Evaluation of Financial Markets in India
10.8 Key Market Players
10.9 Summary
10.10 Answers to In-Text Questions
10.11 Self-Assessment Questions
10.12 References

10.1 Learning Objectives

 To develop basic understanding of fee-based and fund-based services.
 To know about regulatory issues and the importance of market regulators.
 To learn about various alternative financial instruments and services.
 To evaluate various financial markets and learn about the key market players.

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Notes
10.2 Introduction
Financial services sector is the primary driver of economic growth in
a country. India has witnessed a growing demand for financial services
across different income groups. Rising household incomes, approval of
100% FDI for insurance intermediaries, significant penetration in rural
areas, growth in the wealth management sector, rapid expansion in fintechs,
forthcoming initiatives like digital rupee, digital gold investment options,
etc. may be the driving force behind such significant evolution of financial
services industry. With advances in the digital finance, millions of people
in India can now settle payments and transfer funds with just few taps
on their smartphones. Covid-19 further accelerated this trend of usage
of contactless digital payment systems across the country. Commercial
banks, insurance companies, Non-Banking Financial Companies (NBFCs),
co-operatives, pension funds, mutual funds, real estate brokers and other
financial entities comprises the diversified financial services sector in
India. With robust banking and insurance sector, India’s financial services
industry is expected to maintain the growth momentum in the coming
years.
According to International Monetary Fund (IMF), a financial service
may be described as a process to acquire a financial good. For instance,
taking a mortgaged loan to buy a house. Financial sector consists of
diverse financial service providers. Financial services may also be known
as financial intermediation where the purpose is to mobilize money from
savers and provide to those who are in need of it. However, a bank or
an NBFC may offer two different types of products/services: fund-based
and fee-based. Loans are categorised as fund-based products whereas
selling a mutual fund or an insurance policy are classified as fee-based
products. A financial intermediary/institution may provide one or both
types of services.
1. Fund-Based: Fund-based markets include traditional services such
as loans, mortgages and investment in stocks, bonds, derivatives,
commodities and real estate markets. Therefore, any revenue generated
through lending or investing money and earning interest, dividend
or capital gain, is fund-based revenue. So, fund-based revenue is the
revenue earned by charging interest/fee on the funds lent/invested.

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Notes 2. Fee-Based: Fee-based markets include industries like financial advisory,

wealth management, legal services, accounting, consulting, and asset
management. Instead of deploying funds or making investments,
revenue is generated in the form of fees/commission charged for
providing professional expertise or some specific services.
Fee-based and fund-based market in India offer individuals, businesses and
institutional investors a wide range of financial services and investment
alternatives to raise capital. Various market participants including financial
institutions, investors, advisors and regulatory bodies contribute to the
growth and advancement of these markets while complying with the rules/
regulations and ensuring investor protection.

10.3 Fund-Based and Fee-Based Markets

10.3.1 Fund-Based Markets

In India, fund-based markets consist of activities related to lending and

borrowing of funds which facilitate the flow of capital from among lenders
and borrowers. The following are the key segments in fund-based markets:
 Money Market: In this market, short-term funds are lent and borrowed
for a period of up to one year. It deals in instruments like treasury
bills, commercial papers, certificates of deposit and other short-term
government securities. This market provides a platform for banks,
corporations/businesses and various financial institutions to manage
their short-term funding requirements.
 Capital Market: Capital market looks after the long-term borrowing
and lending of funds/capital. It consists of primary and secondary
markets. In primary markets, securities are issued for the first time
whereas follow-on issues are made in secondary markets. While in
primary markets, companies and government raise funds by issuing
shares, bonds, debentures, etc. Buying and selling already issued
securities take place in the secondary markets. National Stock
Exchange (NSE) and Bombay Stock Exchange (BSE) are the two
most popular secondary markets in India.

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 Debt Market: Corporate bonds, government securities, debentures, Notes

and other fixed-income securities are the various debt instruments
issued and traded in the debt market in India. Borrowers are able
to raise funds using debt securities and investors are able to earn
fixed income through such instruments.
 Foreign Exchange Market: Trading of different currencies takes place
in the foreign exchange market. Individuals, businesses/corporate
houses, banks and financial institutions convert one currency into
another for the purpose of trade, investment, speculation, etc.
 Mutual Funds: Such institutions invest the money pooled from
variety of investors in a diversified professionally managed portfolio
of securities. They offer various investment schemes like equity-
based, debt-based, hybrid funds and thematic funds.
 Venture Capital and Private Equity: Venture capitalists and Private
Equity funds invest in companies (public or private) that are in
early or late stage or established firms. They provide capital in
exchange for acquiring a controlling stake in the target company.
Often the companies receiving funding are innovative, technology
oriented and/or looking for growth/expansion opportunities.
 Real Estate Investment Trusts (REITs): REIT is a kind of investment
vehicle through which individuals can invest in real estate assets
without directly owning or managing them. REITs invest the
money pooled from several investors in a portfolio of real estate
properties such as residential and commercial buildings, hotels,
various infrastructural projects, etc. Their primary source of income
is rental income from properties.
Sometimes banks and financial institutions also lend and borrow funds
from each other in order to meet their liquidity and statutory requirements.
Such borrowing and lending forms part of interbank market. All the above
fund-based markets play a significant role in growth and development of
the economy by way of facilitating flow of funds, providing investment
capital formation opportunities.

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Notes 10.3.2 Fee-Based Markets

In India, fee-based market provides goods or services in exchange for a

charge in the form of fee or commission or payment. Some key segments
of the fee-based market in India may include:
 Advisory Services: Experts and advisors provide professional
services to individuals and businesses helping them make informed
decisions. For instance, management consultants offer assistance
in optimising the businesses processes, enhancing the operational
efficiency, developing effective strategies for growth, improving
performance and implementing change in the organisation. Advisory
services may include assistance in regulatory compliance, mergers
and acquisitions, income tax, estate tax planning, cybersecurity, and
software implementation. It may also involve guidance on business
strategy formulation, market research, organisational restructuring,
risk management, investment management, etc. Investment related
advisory services are provided to investors by individual advisors,
wealth management companies, financial institutions, etc. It helps
investors to assess their needs and make suitable investment choices.
Insurance related advisory services include making people aware
about the various insurance products and helping them buy suitable
policies as per their needs.
 Financial Planning: It involves assessing the existing financial
position, setting financial goals/objectives, formulating a budget,
building funds for contingencies, adopting strategies to save and
invest efficiently, insurance and retirement planning, and reviews the
financial plans while incorporating necessary changes over time. In
financial planning, professionals and/or companies help individuals
and corporates by providing expert guidance and customized solutions.
 Wealth Management: Personalized services such as investment/
portfolio management, estate and tax planning, retirement planning,
risk management, wealth transfer and other customised services are
provided to individuals/families with high-net-worth. It is usually
offered by financial institutions like banks, investment firms and
wealth management companies. A specialised wealth manger or

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a team of experts/professionals work closely with the clients and Notes

support them in their wealth management decisions.
 Investment Banking: Investment banks play a significant role in
the growth of the economy. They act as intermediary between those
who are in need of capital and those who are looking to deploy
their capital in anticipation of returns. Investment banks provide
advisory services to businesses, governments, and other entities.
They help companies in raising capital by issuing stocks, bonds and
debentures. They assist businesses in identifying potential targets/
buyers, carrying out the due diligence, negotiating deal terms,
valuation and completing the merger and acquisition process. In
addition, investment banks act as underwriters; provide financial
advice to clients on financial restructuring and corporate finance;
producing research reports and analysis on market trends, industry,
companies, etc. Lastly, they provide risk management advice to
clients helping them mitigate/manage financial risks by protecting
them against adverse movements in the market.
Above segments are of great relevance in the context of financial sector in
the economy. However, in general, the fee-based market may also include
services from important non-financial sectors like education and training,
healthcare, professional services, government services, telecommunications,
software, entertainment, and so on. Sometimes services are also provided
free of charge or at subsidized rates by the government, especially in the
public education and healthcare.

10.4 Regulatory Issues in Such Markets

In India, fee-based and fund-based markets experience various regulatory
issues required to be addressed by market regulators for smooth, fair
and transparent working of the financial system. Focussing on these
regulatory concerns protects the interest of investors and brings market
integrity into the system. Some of the major regulatory issues in such
markets are mentioned below:
 Disclosure and Transparency: Market regulators often want financial
intermediaries and service providers in fee-based markets to share
relevant information with clients, regarding fees, commissions, any

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Notes potential conflicts of interest, risks associated with the investment

products, etc. Likewise, in fund-based markets, issuers are required
to disclose accurate and timely information to the investors, leading
to transparency.
 Investor Protection: In order to protect the interest of investors,
market regulators establish various rules and regulations to safeguard
investors from any kind of fraudulent activities, misrepresentation,
or market manipulation. In this regard, market regulators emphasis
on fair dealing practices, and setting up mechanisms for investors
for resolving their disputes.
 Licensing and Registration: The market regulators have made it
mandatory for intermediaries, like brokers, investment advisors, and
asset managers, to obtain appropriate licenses and/or registrations
to operate in fund-based and fee-based markets. Such licenses often
accompany certain regulatory obligations and demand compliance
from the intermediaries. This leads to investor protection and
efficiency in the markets.
 Reserve Bank of India (RBI) Regulations: RBI sets the guidelines,
rules and regulations for various fee-based and fund-based services
including Know Your Customer (KYC), Capital Adequacy Norms
and Fair Practices Codes. RBI requires that financial institutions
should verify the identity and address of their customers before
providing financial services. This prevents or minimises money
laundering and fraud. RBI requires that banks and NBFCs must
maintain capital adequacy ratios to avoid the possibility of becoming
insolvent. Lastly, as per the fair practices code, banks and NBFCs
ensure transparency and fairness in their dealings with customers.
 Consumer Protection Regulations: As per the Consumer Protection
Act, 2019 consumers are empowered to seek remedies for any
deficiencies in the financial services provided, unfair practices
adopted or for any misrepresentation or misleading information in
advertisements.
 Insurance Regulatory and Development Authority of India (IRDAI):
IRDAI sets guidelines and regulations with respect to licensing,
solvency, customer protection, distribution practices, etc. for the
insurance intermediaries, companies and other entities.

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 Securities and Exchange Board of India (SEBI) Regulations: SEBI Notes

has laid down stringent regulations for investment advisers, mutual
fund managers and others, related to registration requirements, code
of conduct, and disclosure norms. These guidelines aim to protect
customers and ensure that they received quality investment advice.
 Anti-Money Laundering (AML) and Counter-Terrorism Financing
(CTF): Regulators levy strict AML and CTF regulations to prevent
illegal activities and any acts of money laundering in fee-based and
fund-based markets. Regulators require that financial institutions must
build robust customer due diligence system, report any suspicious
transactions/activities, and follow/comply with Know-Your-Customer
(KYC) regulations.
Additionally, market regulators prevent insider trading, market manipulation
and ensure a level playing field for all market participants. Indian financial
markets are diverse, deep and wide. Regulatory concerns discussed above
may not represent the all the issues in the fee-based and fund-based
markets. However, the regulatory landscape is continuously evolving, and
it becomes imperative for financial institutions and investors to remain
updated with the new regulations and comply with them.
IN-TEXT QUESTION
1. Market regulators ensure___.
(a) Disclosure and transparency of information to investors
(b) Attainment of licensing and registration of market participants
(c) Existence of grievance redressal mechanism to resolve
disputes
(d) All of the above

10.5 Market Regulators

Fee-based and fund-based services in India are primarily regulated by
the following market regulators:
 Securities and Exchange Board of India (SEBI): SEBI oversees
and maintains integrity, stability, and transparency in the securities

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Notes market in India. It regulates and supervises stock exchanges,

brokers, mutual funds, investment advisors, portfolio managers,
etc. and vested with the authority to take any legal action against
violations of laws and regulations in such markets. It operates
under Ministry of Finance, India. The primary objectives of SEBI
are investor protection, building investor confidence, promoting a
fair, transparent and efficient markets, regulating intermediaries
(stockbrokers, merchant bankers, portfolio managers, etc.), preventing
insider trading, and promoting investor education and awareness.
 Reserve Bank of India (RBI): RBI is the central bank of India
responsible for regulation and supervision of financial system of
the country. RBI has important roles and responsibilities such
as formulation and implementation of the monetary policy, issue
and management of currency notes, granting licenses to banks,
setting prudential norms and ensuring compliance, managing and
regulating foreign exchange reserves, banker to the government,
promoting financial inclusion, overseeing banking activities and so
on. For instance, RBI regulates Non-Banking Financial Companies
(NBFCs) engaged in fee-based and fund-based activities, like asset
management, wealth management, and financial advisory services.
 Insurance Regulatory and Development Authority of India (IRDAI):
IRDAI is the regulatory body which regulates and oversees the
insurance sector. It supervises the activities of insurance intermediaries,
companies and other entities in the sector. It lays down the regulations
and guidelines for insurance companies and intermediaries engaged
in fee-based and fund-based insurance products, like Unit-Linked
Insurance Plans (ULIPs) and other investment-linked insurance
products. IRDAI is also responsible for formulation of policies
and entire regulatory framework for the various market participants
in the insurance industry. It undertakes various efforts to approve
insurance products/services, ensure customer protection, promote
growth, ensure stability in the insurance sector, curb fraudulent
practices, and maintaining stability.
 Pension Fund Regulatory Development Authority (PFRDA): It
is the regulatory body for pension funds and the National Pension

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 Other Markets

System (NPS) in our country. PFRDA lays down the investment Notes
guidelines/regulations; and monitors the activities various market
participants including pension fund managers, custodians, and others
in the fee-based and fund-based pension market. It has established a
grievance redressal mechanism to protect the interest of the pension
subscribers.
 Forward Markets Commission (FMC): Multi Commodity Exchange
(MCX) and National Commodity and Derivatives Exchange (NCDEX)
are the facilitators trading in commodity futures and options in
India. FMC was the regulatory body for these commodity exchanges.
However, it was merged with SEBI in 2015. Therefore, SEBI
regulates the commodity derivative market in India since then.
Existence of these regulatory bodies makes the Indian financial system
robust, transparent and stable. They issue regulations, monitor/supervise
the market activities, ensure compliance of laws and protect the interest
of investors/customers in the fee-based and fund-based markets. They
are pillars of integrity, fairness and efficient financial ecosystem of the
country.

10.6 Alternative Financial Instruments and Services

In India, alternative financial instruments and services market is experiencing
exponential growth, offering diverse investment opportunities beyond the
traditional avenues. Alternative investments are assets that do not fall
in the category of conventional investment classes like stocks, bonds or
cash. The following are the examples of alternative financial instruments
and services in India:
 Mutual Funds: Mutual funds are defined as the investment vehicles
that allow pooling of money from multiple investors to invest in
a well-diversified portfolio of multiple securities such as stocks,
bonds, or money market instruments. They provide the investors an
opportunity to invest in a variety of asset classes and while gaining
the benefits of professional management.
 Exchange-Traded Funds (ETFs): ETFs are investment funds traded
on stock exchanges, representing a basket of securities that represent

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Notes and replicate an index, sector, commodity, or other assets. ETFs

enable both diversification as well as liquidity, and thus allow the
investors to have exposure to specific markets or investment themes.
 Real Estate Investment Trusts (REITs): REITs are the investment
vehicles that enable investors to invest in real estate properties
that generate income. They provide an option to the investors to
participate in the real estate market without directly owning these
properties. REITs are listed and traded on stock exchanges.
 Peer-to-Peer Lending (P2P): P2P lending platforms connect the
borrowers to the lenders, bypassing traditional financial institutions.
Individuals or businesses seeking loans can access funds from
multiple lenders, while the investors can earn interest on the money
they lend.
 Alternate Investment Funds (AIFs): AIFs are privately pooled
investment vehicles that invest in diverse assets, including private
equity, venture capital, real estate, infrastructure, and hedge funds.
AIFs are regulated by SEBI and provide investors access to alternative
asset classes.
 Crowd Funding: Crowd funding platforms allow individuals or
businesses to raise funds from a large number of people. This is
done typically through online platforms. Crowd funding can have
multiple ends uses, including start-up ventures, social or creative
projects, and charitable/philanthropic activities.
 Microfinance Institutions (MFIs): MFIs provide financial services,
such as small loans, savings/Deposits, and insurance, to the individuals
or small businesses who do not have access to traditional banking
services. MFIs support entrepreneurship and promote financial
inclusion at the grassroots level.
 Robo-Advisory Services: These highly automated platforms leverage
technology and algorithms to provide investment advice and portfolio
management services to their customers. They typically offer low-
cost and easy to use investment solutions, making investing more
accessible to the retail investors.
 Online Trading Platforms: Online trading platforms (websites
and mobile apps) provide individuals with easy access to various

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constituents of financial markets i.e., stocks, commodities, and Notes

currencies. These platforms offer real-time market data, research
tools, and enable execution of trades from anywhere.
 Digital Wallets and Payment Apps: Digital wallets and payment
apps enable individuals to make cashless transactions, transfer funds,
and make payments for goods and services electronically.
These alternative financial instruments and services provide investors and
consumers with a wide range of choices to meet their investment goals,
access capital, and diversify their portfolios. However, the regulations as
well as the accessibility to these instruments and services vary widely.

10.7 Evaluation of Financial Markets in India

Our country has a diverse and vibrant financial market landscape offering
investment avenues for individuals and businesses. The following are the
key financial markets in India:
 Stock Market: Over the years, the Indian stock market has transformed
tremendously having positive implications for traders, investors,
companies, and stock exchanges. Stock market enables corporates to
raise capital for their businesses through public issue. Stock market
also facilitates mobilization of funds from investors who have them
lying idle (investors) to others who need funds i.e., corporates. In
a recent panel discussion at Mint India Investment Summit 2023,
various experts vouched for expensive valuations of the Indian
stock market in comparison to other markets in the last five years.
There are 23 stock exchanges in India, however, the Indian stock
market is primarily represented by the Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE). Shares, derivatives,
commodities, currencies and Exchange Traded Funds (ETFs) are
various instruments traded on these stock markets. BSE is one of
the oldest stock exchanges in Asia. BSE is known for its benchmark
indices, the most popular is Sensex. It is regulated by Securities
and Exchange Board of India (SEBI) and operates on an electronic
trading system-BOLT. It provides a liquidity, transparency and a
regulated environment for all the market participants. NSE is one
of the leading stock exchanges in our country and known for its

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Notes benchmark index, Nifty50. NSE’s electronic trading platform National

Exchange for Automated Trading (NEAT) facilitates efficient and
transparent trading.
Various factors affect the working of stock markets in India. The
overall health of the country’s economy indicated by GDP, interest
rates, government policies and reforms affect the general investor
sentiment and market performance. Financial performance in terms
of revenue growth, profitability, etc. may drive the stock prices of
listed companies. Positive/negative sentiment and market psychology
in general affect the stock market movements. In addition, industry
trends, regulatory environment, market valuations, international trade
policies, etc. significantly drive the stock market movements. Stock
market is always subject to volatility and investing in it is usually
risky. However, with the help of financial advisors, professionals
and in-depth research, one can exploit profitable opportunities with
an acceptable level of risk.
 Debt Market: India’s debt market encompasses various types of
debt securities-both government and corporate debt instruments.
Debt market is also called the bond/fixed-income market where
debt securities are traded. A debt security indicates a loan made
by investor to government, corporations or some other entity, in
exchange for regular interest payment and principal repayment at
the time of maturity. Government debt market involves trading of
bonds and other debt instruments issued by government. They are
low-risk investment and play a crucial role in financial government
expenditures and management of fiscal policies. Corporate debt
market involves trading of bonds and other debt instruments issued
by corporations such as corporate bonds and debentures. It helps
companies to raise funds for expansion, meeting working capital
needs, debt refinancing, etc. Both SEBI as well as RBI regulate
the debt market in India.
Debt market is affected by various factors including interest rates, credit
rating, government policies and regulations, market infrastructure,
economic factors, global factors and so on. For instance, changes in
the interest rates such as policy rates determined by the RBI affect
the pricing of and yield on debt securities. Investors often rely on

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the ratings given to debt issuers by the rating agencies, to weigh Notes
the creditworthiness and risk involved in the debt instrument. Fiscal
measures taken by the government, taxation policies, borrowing
programs all have significant impact on the pricing of government
bonds and other debt securities. Strong economic fundamental,
market liquidity, transparency in the trading/settlement systems,
international interest rates and geopolitical events, etc. are other
important factors shaping the growth and development of debt
markets.
 Commodity Market: Indian commodity market in India provides
a platform for trading in essential goods and raw material. Here,
investors trade in various commodities like gold, silver, crude oil,
agricultural products and base metals. Multi Commodity Exchange
(MCX), National Commodity and Derivatives Exchange (NCDEX)
and Indian Commodity Exchange (ICEX) are the major commodity
exchanges in India. Commodity trading provides protection against
price fluctuations and also facilitate speculative trading. Commodity
market contributes significantly towards the country’s GDP. Commodity
exchanges provide a well-regulated platform for trading, ensures fair
pricing, facilitate spot and derivative trading, and offers opportunities
for efficient risk management. This market is regulated by SEBI in
India thereby maintaining integrity, investor protection and confidence.
Volatility in the commodities affect the price movements in this
market, however, government has implemented various initiatives
to support it. This is evident from increased participation of various
stakeholders, over the years, in the commodity market.
 Currency Market: In India, currency market also known as foreign
exchange market, is an important part of the country’s financial
system. The currency market facilitates trading of currencies and
is regulated by RBI. The central bank actively participates in
the currency market through buying/selling of foreign exchange
reserves. This way RBI ensures stability in the exchange rate
which facilitates international trade, attracts foreign investments
and brings macroeconomic stability. In the currency market, Indian
rupee mainly trades against the US dollar, influenced by interest
rate differences, inflation, geopolitical events, global industry/

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Notes economic trends, etc. Retail traders, commercial and foreign banks,
institutional investors, and various corporate entities are the major
market participants in this segment. The currency market is essential
for facilitating remittances from Indian citizens working abroad,
impacts the country’s foreign exchange reserves, liquidity, and
meeting various obligations. Lastly, volatile international currency
markets, global uncertainties and various macroeconomic conditions
affect our country’s currency market.
 Mutual Funds: A mutual fund manager invest the pooled money of
different investors in a portfolio of securities generating lucrative
returns which are passed back to the investors. Investing in mutual
funds provide benefits such as diversification, professional management,
return potential, flexibility and liquidity, variety of investment
alternatives, option of Systematic Investment Plan (SIP), affordability,
transparency and so on. The mutual fund industry has witnessed
significant growth over the years on account of increase participation
from investors, availability of various fund options, robust regulatory
environment and strong & significant performance by some mutual
funds. Mutual funds offer various types of schemes including equity,
debt, hybrid and others.
 Insurance Market: Insurance market in India has evolved significantly
over the years. More information and awareness, rising incomes
and favourable government policies, all have contributed to the
expansion of this sector. Intense competition among domestic and
foreign insurance companies has resulted in availability of wide/
diverse range of insurance products including life insurance, health
insurance, property insurance, travel insurance and others. In India,
Insurance Regulatory and Development Authority of India (IRDA)
regulates the insurance market. IRDA plays a crucial role in ensuring
consumer protection, maintaining stability and integrity, and promoting
transparency in the insurance market. Insurance penetration in India
is still on the lower side, therefore, efforts are made to create more
awareness about the importance of insurance for individuals and
corporations in the country. Now customers can purchase and manage
insurance policies on various online platforms or using mobile
applications. Multiple distribution channels for insurance products

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provide customers with options and convenience. Pradhan Mantri Notes

Jeevan Jyoti Bima Yojana (PMJJBY), Pradhan Mantri Suraksha Bima
Yojana (PMSBY), Pradhan Mantri Fasal Bima Yojana (PMFBY),
Ayushman Bharat (Pradhan Mantri Jan Arogya Yojana) (AB PMJAY)
are among various other government flagship initiatives providing
life, personal accident, crop insurance, hospitalization care coverage
to individuals at affordable premiums. Consistent efforts are being
made to expand the reach of insurance market in rural areas also
where customised insurance products are issued to people from
low-income groups. To conclude, the insurance market in India is
experiencing significant upward growth becoming the sixth-largest
insurance market, posing many challenges as well as opportunities
for further development.
 Alternative Investment Market: Alternative investment market in
India includes Private Equity (PE) funds, Venture Capital (VC)
funds, angel investors, seed funding, crowd funding, Real Estate
Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs)
and other alternative investment funds. Alternative investment
market provides opportunities to raise capital for small and medium
sized companies. Depending on the investor’s risk-return profile,
the alternative assets are given 10 to 33% weightage in the overall
portfolio. Initially, the investment base in alternative assets was
narrow as investments were made primarily in real estate and
private equity. However, the base has become broader now with
the emergence of pooling vehicles such as Real Estate Investment
Trusts (REITs), Infrastructure Investment Trusts (InvITs), etc. Also,
markets such as the US, Singapore, UK, etc. have many investment
options for liquid alternatives, whereas India has relatively few
options. The VC space in India is witnessing more interest from
investors as today’s customer is moving to online purchase from
offline spending. This is leading to significant growth in new-age
businesses. Alternative investment segment is one of the fastest
growing industry in India because of various reasons: alternative
investments have no direct correlation with stock market, they allow
investors to invest passively leveraging the expertise of experienced
fund professionals, provide options which can generate 8-10% cash

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Notes return annually, they are less volatile, not only provide investment
options to HNWIs but also to people from average salary group,
and with rising disposable incomes people are ready to explore
new segments for investment offering better returns. Merchant debt/
factoring (businesses loans provided to established companies),
private equity healthcare investment, artificial intelligence, real
estate, etc. are the top alternative segments in the industry. This
market is regulated by SEBI.
Investors should do extensive research, take calculated risks, seek
professional advice before investing in these markets. Various regulatory
bodies such as SEBI, RBI, IRDAI, etc. also exist to facilitate investor
protection, maintaining market integrity and ensuring fair practices in
these markets.
IN-TEXT QUESTIONS
2. In India, stock markets ___.
(a) Comprise of BSE and NSE
(b) Trading of shares, derivatives, commodities, currencies
and ETFs
(c) Provides a liquidity, transparency and a regulated environment
(d) All of these
3. Alternative investment market includes____.
(a) Private Equity and Venture Capital
(b) Angel investors and Seed Funding
(c) REITs and InvITs
(d) All of these

10.8 Key Market Players

In India, the financial markets involve a wide range of key players:
regulatory bodies, various exchanges, financial intermediaries/institutions
and others. The following are some of the key market players participating
in different financial markets:

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 Stock Market Notes

n Stock Exchanges: There are 23 stock exchanges in India,
however, the Indian stock market is primarily represented
by the Bombay Stock Exchange (BSE) and National Stock
Exchange (NSE). BSE and NSE are the oldest and largest
stock exchanges, respectively. Shares, derivatives, commodities,
currencies and Exchange Traded Funds (ETFs) are various
instruments traded on these stock markets.
n Stockbrokers: They are professional individual or financial
institutions, and brokerage firms facilitate buying and selling
of securities on behalf of investors. They are the intermediaries
between the buyers and the sellers while executing the
transactions. Stockbrokers provide investment advice, offer
portfolio management services, conduct/analyse company
financials, industry trends and market performance, comply
strictly with the rules and regulations of the regulatory bodies
and government, and build relationships with their clients
while keeping them informed and updated.
n Depositories: Depositories facilitate holding, transfer and
settlement of securities. There are two depositories in India:
National Securities Depository Limited (NSDL) and Central
Depository Services Limited (CDSL). NSDL is the first and
largest depository offers electronic holding and transaction
services for various types of securities. CDSL is the second-
largest depository provides electronic custody and transfer
services for a wide range of securities.
 Debt Market
n Bond Issuers: They are the entities that issue bonds of different
types with the purpose of raising funds for financing their
current or potential projects and meeting working capital
needs. Bond issuers are mostly government (central and state),
banks, and corporations.
n Underwriters: Underwriters include investment bankers,
brokerage firms, online bond platforms, and other firms that
help issuers sell bonds in primary and secondary markets.

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Notes n Bond Purchasers: They are the ones who buy the debt in the
market, known as the bond holders. When they purchase a
bond, they become a creditor/lender to the issuer.
n Reserve Bank of India (RBI): RBI formulates the monetary
policies and regulates the debt market in India. Primarily the
regulations are in the areas of money market instruments,
NBFCs and private placement.
n Securities and Exchange Board of India (SEBI): SEBI regulates
all corporate bonds, both public sector undertakings and private
sector as well as those listed on the stock exchange issued
either by government or financial institutions. SEBI ensures
transparency and investor protection in the debt market.
n Primary Dealers (PDs): They are the financial institutions
that are authorized by the RBI to participate in auction of
government securities and also facilitate trading in the secondary
market.
n Credit Rating Agencies: Credit rating agencies evaluate the
creditworthiness of the bond issuers as well as the various
debt instruments issued by them. It helps in determining the
probability of debt repayment. Credit Rating Information
Services of India Limited (CRISIL), ICRA Limited (formerly
Investment Information and Credit Rating Agency of India
Limited), CARE Ratings Limited (formerly Credit Analysis and
Research Limited), India Ratings and Research Private Limited
(a subsidiary of Fitch Ratings), Brickwork Ratings India Private
Limited and SME Rating Agency of India Limited (SMERA)
are various credit rating agencies in India. The credit ratings
provided by various agencies help the investors, lenders, and
other market participants to make informed decisions.
 Commodity Market
n Commodity and Derivative Exchanges: Multi Commodity
Exchange (MCX) is the country’s leading and largest commodity
futures exchange. It facilitates online trading of commodity
derivatives under the regulations of SEBI. National Commodity
and Derivatives Exchange (NCDEX) is an online commodity

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Other Markets

exchange that specializes in agricultural commodities. Life Notes

Insurance Corp. of India (LIC), NSE, and the National Bank
for Agriculture and Rural Development (NABARD) have
stakes in NCDEX. Barley, wheat, and soybeans are among
the leading agricultural commodities that are traded on these
stock exchanges.
n Producers and Consumers of Physical Commodities: In the
commodity derivatives market, they are the largest participants.
These participants use futures and options contracts to hedge
against price fluctuations/risks related to their physical
commodities. While producers use such contracts to lock in
a selling price, consumers use these contracts to lock in a
buying price for the raw materials.
n Speculators: They are individuals or organisational investors
who engage in the trading of futures and options contracts.
They invest solely for the purpose of making profit from
price movements and do not have any direct interest in the
underlying commodities.
n Intermediaries: They are banks, brokers and other entities
registered with SEBI acting as intermediaries and facilitating
commodity trading for investors. As intermediaries they
provide market related information, help participants enter
into contracts, and carry out the settlement process while
delivering the contracts to buyers.
n Warehousing Companies: Warehousing entities offer storage
facilities for the commodities while meeting quality and
delivery standards.
 Currency or Foreign Exchange Market
n Commercial banks and investment banks are the major players
in the currency markets in India. It is important to note that
the greatest volume of currency is traded in the interbank
market. In interbank market all sizes of banks electronically
trade currency with each other. Banks either engage in forex
transaction on behalf of their clients or carry out speculative
trades themselves to profit from currency fluctuations.

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Notes n Central bank is another important participant in the currency

market. It affects the currency rates through their interest rate
policies and conduct of open market operations. It manages
and stabilize competitiveness of the country’s economy.
n Hedge funds and investment managers are another group of
participants in the currency market. They trade currency on
behalf of their clients such as pension fund houses. They may
also engage in speculative trading.
n Exporters, Importers and Corporations: These market participants
are often involved in foreign trade, sending receiving foreign
currencies, hedging currency risks, etc.
 Mutual Funds
n Sponsor: The mutual fund company’s promoter is called
the sponsor. The sponsor establishes a mutual fund either
independently or in collaboration with another company. The
main purpose of establishing a mutual fund is to earn money
through fund management. The company managing the fund
(investment manager) and offering investment products to
investors is known as Asset Management Company (AMC).
n Trustees: Trustees are independent entities which act as guardians
to investors. They ensure compliance with due diligence and
authorise all the mutual funds floated in the market.
n AMC: It manages funds and charges a small fee for that. It is
responsible for planning and launching/floating various mutual
fund schemes. AMCs arrange the initial amount and manages
the funds for investors.
n Custodian: All the securities purchased by AMC, in the name
of Trust, are kept safely with a custodian in dematerialised
form.
n Registrar & Transfer Agent: Registrar & Transfer agent is
someone who has the responsibility of maintaining investor
records, processing transactions, and providing investor services,
removing units when redemption is requested, processing
dividend payments and so on.

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 Other Markets

n Distributors and Financial Advisors: They are the intermediaries Notes

which facilitate distribution mutual fund products and giving
investment advice/guidance to the mutual fund investors.
 Insurance Market
n Insurance Companies: They are the primary participants in
the insurance market offering various types of life insurance,
health insurance, motor insurance, etc. LIC, ICICI Prudential,
HDFC Life, New India Assurance, SBI Life, and private sector
insurers like Bajaj Allianz, Tata AIG, and ICICI Lombard are
the major insurance companies in India.
n Insurance Agents and Brokers: They act as intermediary
between customers and the insurance companies. They help
customers in identifying their insurance needs, suggesting and
help them choose the suitable insurance policies, and facilitate
the documentation and premium payment/collection process.
Marsh India, Aon India, and Willis Towers Watson are some
of the insurance agents in India.
n Insurance Aggregators: It refers to the online platforms that
allow people to compare and purchase different insurance
policies. Policy bazaar, Acko, Insurance dekho are examples of
insurance aggregators in India. They help customers evaluate
various policies and make informed decisions.
n Reinsurance Companies: They provide insurance coverage to
the insurance companies. Insurance companies transfer some of
their financial risk assumed to reinsurance companies against
premium payments. Reinsurance companies help insurance
companies to reduce/manage their risks, thereby ensuring
stability and financial strength in the insurance sector.
n Third-party Administrators: Such entities manage the claims
and provide administration services on behalf of insurance
companies. TPAs look after the documentation, settlement, and
management of insurance claims, thereby ensuring a smooth
process for both insurers as well as policyholders.
All the above market players contribute significantly towards the proper
functioning and growth of the financial sector in India. Presence of these

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Notes players in the industry ensures that all the market participants, even the
investors are well-aware of their roles and responsibilities.
IN-TEXT QUESTION
4. Key player(s) in the insurance market is/are ___
(a) Asset Management Company (AMC)
(b) LIC and New India Assurance
(c) Hedge Funds
(d) Multi Commodity Exchange (MCX)

10.9 Summary
u Fee-based markets include industries like financial advisory, wealth
management, legal services, accounting, consulting, and asset
management.
u Fund-based markets include activities of traditional banking services
such as loans, mortgages and investment in stocks, bonds, derivatives,
commodities and real estate markets.
u Fee-based and fund-based markets experience various regulatory issues
like disclosure and transparency, investors protection, licensing and
registration, RBI regulations, Consumer Protection Regulations,
SEBI Regulations, and Anti Money Laundering (AML) and Counter-
Terrorism Financing (CTF) regulations.
u Fee-based and fund-based services in India are primarily regulated
by Securities and Exchange Board of India (SEBI), Reserve Bank
of India (RBI), Insurance Regulatory and Development Authority of
India (IRDAI), and Pension Fund Regulatory Development Authority
(PFRDA).
u India has a diverse range of alternative financial instruments and
services including Mutual Funds, Exchange-Traded Funds, Real
Estate Investment Trusts (REITs), Peer-to-Peer Lending (P2P),
Alternate Investment Funds (AIFs), Crowd funding, Microfinance
Institutions (MFIs), Social Impact Bonds, Infrastructure Investment
Trusts (InvITs) and Robo-Advisory Services.

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Other Markets

u The key financial markets in India are stock market, debt market, Notes
commodity market, currency market (or foreign exchange market),
mutual funds, insurance market and alternative investment market.
u In India, the financial markets involve a wide range of key players:
regulatory bodies, various exchanges, financial intermediaries/
institutions and others.

10.10 Answers to In-Text Questions

1. (d) All of the above

2. (d) All of these
3. (d) All of these
4. (b) LIC and New India Assurance

10.11 Self-Assessment Questions

1. What do you understand by fee-based and fund-based markets?
Discuss its components.
2. Describe the role of fee-based and fund-based services in the Indian
financial markets.
3. Discuss the common regulatory concerns that regulators and authorities
on in fee-based and fund-based markets in India.
4. Identify the primary market regulators in fee-based and fund-based
markets.
5. Alternative investment market offers diverse range of financial
instruments and services to investors and consumers. Please elaborate.
6. Discuss and evaluate the major financial markets in India.
7. Every segment of the Indian financial market has key market
participants. Please explain in detail.

10.12 References
u [Link]
u [Link]

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Notes u [Link]
to-know-about-fee-and-fund-based-products/articleshow/47840937.
cms?from=mdr
u [Link]
[Link]
u [Link]
indian-stock-market/20404
u [Link]
u [Link]
[Link]
u [Link]
[Link]
u [Link]
u [Link]
invest-strategically-in-alternative-funds-in-india/articleshow/97094503.
cms#
u [Link]
are-attracted-towards-alternative-investment-options/2932967/
u [Link]
u [Link]
u [Link]
top-five-alternative-investment-sectors-in-2023/?sh=5f4ac47b400f
u [Link]
these-are-4-key-players-in-the-bond-market/articleshow/93314522.
cms?from=mdr
u [Link]
u [Link]
participants-in-commodity-derivatives-market#:~:text=The%20
participants%20in%20the%20commodity,stability%20of%20the%20
commodity%20markets.
u [Link]
trading-work-in-india#:~:text=Commercial%20and%20Investment%20
banks%20are,traded%20in%20the%20interbank%20market

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u [Link] Notes
of-mutual-funds-in-india
u [Link]
u [Link]
u [Link]
u [Link]
u [Link]

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L E S S O N

11
External Market
Gurdeep Singh
Assistant Professor
Department of Finance and Business Economics
University of Delhi
Email-Id: [Link]@[Link]

STRUCTURE
11.1 Learning Objectives
11.2 Introduction
11.3 Overview of External Financial Market
11.4 International Capital Flows
11.5 Capital Account Convertibility
11.6 International Financial Instruments
11.7 International Financial Centres
11.8 Selection of Sources and Forms of Funds
11.9 Summary
11.10 Answers to In-Text Questions
11.11 Self-Assessment Questions
11.12 Suggested Readings

11.1 Learning Objectives

u Understand the external financial market.
u Explain the role of international financial centres.
u Understand the need of studying international capital flows.
u Describe the concept of capital account convertibility.

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11.2 Introduction Notes

The origins of today’s international markets may be traced back to the

1960s, when rich Europeans as well as other people sought high-quality
dollar-denominated bonds in order to hold their assets outside of their own
nations. Avoiding taxes in their home countries and protecting themselves
from the depreciating value of domestic currencies were the two driving
forces behind these investors. Withholding tax was levied on the bonds
that were then available for purchase. Furthermore, the ownership of the
bonds had to be registered. Eurobonds denominated in US dollars were
created to deal with these concerns. Because these were issued in bearer
forms, no record of ownership was kept, and no tax was withheld.
Additionally, prior to 1970, the International Capital Market was primarily
concerned with debt financing, with companies primarily raising equity
funding through domestic markets. This resulted from the restrictions on
foreign equity investments that were in place in a number of countries at
the time. Investors preferred to participate in domestic issues of shares
due to potential risks associated with foreign equity issues, either due to
foreign currency exposure or due to regulatory limits on such investments.
India has made a small but noticeable presence in international financial
markets. Since 1991-1992, there has been a complete shift in market
sentiment. Bank borrowings, syndicated loans, floating rate notes, bonds,
and lines of credit have been the conventional methods of financing funds
abroad. Although there were a few instances of private businesses, access
to the foreign capital markets was primarily through debt instruments
and was primarily restricted to financial institutions and public sector
entities. Since March 1992, when the government initially permitted a
small number of Indian companies to enter the global equity market,
numerous Indian businesses have been successful in following the equity
or equity-related route.

11.3 Overview of External Financial Market

A multinational corporation must decide on a specific source of funding
for the investment project, or a combination of sources, before finalizing
the project for foreign investment. In this case, it should be pointed out
that a multinational company places itself in a better position than a

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Notes domestic firm in terms of obtaining funding. A domestic company typically

receives funding from domestic sources. It can get funding from the global
financial market, but it is not as easy as it is for a multinational company.
External financial markets intermediate by moving savings from investors
and lenders to those wanting to invest in assets that they believe will
deliver future returns. Assets are exchanged across national borders
between citizens of several financial centres in international financial
transactions. Regardless of where the savings are generated, international
financial market act as reservoirs of savings and channel them to the most
effective use. Financial markets perform three crucial tasks. The price of
the traded assets is determined by the process of price discovery. The first
task begins with interactions between buyers and sellers in the markets
for price discovery. Giving investors a way to sell financial assets is the
second method the financial markets ensure liquidity. Lastly, the financial
markets lower the cost of information and transaction. International
financial markets can be split into money and capital markets, just like
domestic financial markets. Assets issued or sold in the money markets
often have a relatively short maturity, say less than a year. Instruments
with a maturity of more than one year or those without a clear maturity
are dealt with in capital markets. There is a symbiotic relationship between
both primary and secondary markets in domestic as well as international
financial markets. International financial markets have been divided into
five markets owing to the development and quick growth of swaps and
the globalization of equity markets: lending by financial institutions,
the foreign currency market, the issuance and trading of tradable debt
instruments, the issuance and trading of tradable equity securities, and
internationally arranged swaps. In order to protect against the risk of loss
resulting from fluctuations in both foreign exchange and interest rates,
derivative instruments are exchanged in both organized exchanges and
over-the-counter marketplaces. With the exception of interest rate swaps,
the majority of derivatives are short-term in nature.

11.4 International Capital Flows

The movement of financial assets for investments, management of
businesses, or commercial trade is referred to as capital flows. Individual
investors put their money to work by investing it in a variety of securities,

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such as mutual funds, stocks, and bonds. Investment capital, operational Notes
expenditures, and research and development spending are all examples of
internal cash flow movements. On a larger scale, a government controls the
flow of funds by allocating tax revenue to various projects and activities
and by trading goods and services for other nations’ currencies and goods.
The financial aspect of global trade is referred to as international capital
flows. When a good is imported, a physical good enters the importing
nation and money enters the nation that exported the good. If foreign
investors choose to purchase assets there, money may be able to flow
back into the importing nation. The concept of international capital flow
is based on the movement of financial capital across borders. Capital is
moving nearly everywhere one looks, from individuals to enterprises to
national governments.
Budgets for capital investment are evaluated at the company level as part
of the monitoring process for growth objectives. In the meantime, federal
budgets are based on spending plans.
Commercial real estate is frequently considered by businesses as part of
their ordinary business operations to provide a site for manufacturing
activities. Furthermore, many people regard the purchase of real estate
as an investment that may create cash through rental services.
International capital movements have numerous advantages. The capacity
to transfer financial resources across borders creates a fantastic potential
for economies to thrive. Global money flows enable startups to launch their
products and existing businesses to develop and invest in new ventures.
Increased aggregate demand is one of the benefits of foreign capital flows.
As more loanable funds become available in the economy as a result of
capital inflows, interest rates will fall.
Borrowing would be cheaper as a result, allowing investors to borrow
money and invest in new ventures. Increasing aggregate demand raises
the economy’s potential output and reduces unemployment. Another
significant benefit of foreign money flows is that it promotes technical
advancement.
Capital flows are financial asset transfers between multinational entities.
Bank deposits, equity securities, loans, debt securities, and other financial
assets may be included. Capital outflows are usually caused by economic

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Notes uncertainty in a country, whereas high capital inflows imply a strengthening

economy. Many governments place limits on the cross-border movement of
financial capital. Capital controls is the term given to such restrictions. For
example, sanctions can be imposed that prohibit investment in a foreign
business. Tariffs, taxes, and volume restrictions are some examples. Capital
controls can be imposed to prevent foreign investment in the country or
to ban domestic investors from investing in specific countries. Economic
welfare is reduced as a result of the constraints.
Increased global capital flows are mostly positive for enhanced international
capital, credit, and risk allocation, but this process is not without threats
to global financial stability.
Increased international capital flows are advantageous as long as they
contribute to more effective credit and capital allocation.
IN-TEXT QUESTIONS
1. What are the three crucial tasks performed by financial markets?
(a) Price discovery, providing liquidity, and lowering the cost
of information and transaction
(b) Protecting assets, issuing financial instruments, and managing
businesses
(c) Providing liquidity, lowering taxes, and Protecting assets
(d) None of the above
2. What are capital flows?
(a) The movement of physical goods across borders
(b) The movement of political power across borders
(c) The movement of financial assets for investments, management
of businesses or commercial trade
(d) The movement of people across borders
3. Why derivative instruments used for in international financial
markets?
(a) To increase the risk of loss resulting from fluctuations in
foreign exchange and interest rates
(b) To fund government projects

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(c) To protect against the risk of loss resulting from fluctuations Notes
in foreign exchange and interest rates
(d) None of the above

11.5 Capital Account Convertibility

The current and capital accounts make up the balance of payments account,
which is a list of all transactions that take place between a nation and
the rest of the world. While the capital account is largely concerned with
the cross-border movement of capital through investments and loans, the
current account is primarily concerned with the import and export of
goods and services. The capacity to freely exchange rupees into other
internationally recognized currencies and vice versa, whenever one makes
payments, is referred to as current account convertibility. Similarly, capital
account convertibility denotes the ability to perform investment transactions
without constraint. It is also known as capital asset liberation. In layman’s
words, full capital account convertibility allows for the exchange of local
currency for foreign currency with no limit on the amount. This is done
so that local businesses can readily do transnational commerce without
having to exchange foreign money for small transactions. Capital account
convertibility is primarily used to govern changes in ownership of foreign
or domestic financial assets and liabilities.
Normally, this would imply that there are no limitations on the number of
rupees that an Indian resident may change into foreign currency in order
to purchase any foreign asset. The same goes for the NRI relative who
wants to buy a property in India and is free to bring in any amount of
dollars. In the past three decades, India has made significant progress in
allowing capital account transactions, and it now enjoys partial convertibility.
The term “Capital Account Convertibility” (CAC) refers to the removal
of all restrictions on the transfer of capital from India to other nations
throughout the world:
u It leads to a fair distribution of income levels in India.
u It facilitates the unrestricted conversion of foreign currency into
Indian currency.

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Notes u It permits unrestricted capital movement from foreign investors into

a nation.
u It facilitates easy access to hawala money.
u It aids to control the foreign exchange market’s volatility.
u It enables investment in foreign markets easily.
u It makes it easier to access the large funds that are available through
the global financial market.
The Fully Accessible Route (FAR), which allows non-residents to invest
in specific government securities without any restrictions, was recently
introduced. Along with other recent actions the end-user restrictions have
been loosened, and the foreign portfolio investment limits in the Indian
debt markets have been raised in an effort to further streamline the
external commercial borrowing framework. India’s decision to open its
capital account with prudence was hailed after the currency crisis in East
Asian nations in 1997 showed the difficulties brought on by the potent
combination of massive current account deficits, reliance on short-term
capital flows, and the fluctuating pattern of these flows. Even nations
with ostensibly stable fiscal situations have had currency crises and swift
exchange rate decline when the economic environment changes, according
to a report on fuller capital account convertibility published by the SS
Tarapore group in 2006. The majority of currency crises, according to the
report, are caused by sustained exchange rate overvaluation, which results
in unmanageable current account deficits. The current account deficit
widens as a result of excessive exchange rate appreciation, which renders
exporting industries unprofitable and greatly increases the competitiveness
of imports. As a result, it indicates that clear fiscal consolidation is
required to lessen the likelihood of a currency crisis. The freedom with
which a country’s currency is converted into any other foreign currency
such as the US dollar, British pound, or Euro, and back again is referred
to as capital account convertibility.
It refers to the ability to swap domestic financial assets for international
financial assets at market exchange rates. The unrestricted capital movement
would eventually emerge from full capital account convertibility. Due to
the unfavourable current account situation—India had a sizable current
account deficit—the Indian rupee was not granted complete capital

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account convertibility. The government wanted to make sure that imports Notes
of essential goods and commodities could be made with foreign currency
at a lower cost.

IN-TEXT QUESTIONS
4. Which of the following is a primary goal in choosing funding
sources for multinational companies?
(a) Using more short-term capital
(b) Minimize the effective cost of funds
(c) Increasing the debt-equity ratio
(d) None of the above
5. What is a key consideration for multinational companies when
raising funds for fluctuating and permanent current assets?
(a) Using more long-term capital
(b) Using more Short-term capital
(c) Balance Short-term and long-term liabilities
(d) None of the above
6. What is a key factor that impacts the choice of funding sources
for multinational companies?
(a) The company’s location
(b) Interest rates and currency fluctuations
(c) The company’s industry
(d) None of the above
7. Recommend funding source for fluctuating current assets in
multinational companies:
(a) Short-term capital
(b) Long-term capital
(c) Equity financing
(d) None of the above
8. What is the difference in the approach of conservative and
aggressive finance managers in choosing funding sources for
multinational companies?

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Notes (a) Conservative finance managers prefer more Euro notes,

while aggressive finance managers prefer more international
bonds
(b) Conservative finance managers prefer more long-term
capital, while aggressive finance managers prefer more
short-term capital
(c) Conservative finance managers prefer more host country
norms, while aggressive finance managers prefer more
parent company norms
(d) None of the above

11.6 International Financial Instruments

Instruments Available in Global Financial Markets
International funding can be divided into two basic groups, just like
domestic capital structuring. There are two types of financing:
 Equity Financing
 Debt Financing
Equity, straight debt, and hybrid instruments are among the numerous
types used to raise finance abroad.
Debt Instruments
The practice of issuing bonds to fund international capital movements
has been around for over 150 years. Foreign bond issuers, mostly
governments and railway corporations, made use of the London market
to raise financing in the nineteenth century.
International bonds are generally classified into two types.
Foreign Bonds: Non-resident entities issue bonds in the domestic market
denominated in domestic currency. Yankee Bonds are bonds issued by
non-US entities in domestic markets of the US and are denominated in
dollars, Samurai Bonds are bonds denominated in yen and issued by
non-Japanese entities in the domestic market of Japan. In a similar way
currency sectors in other foreign bond markets have unique names, such
as the Matador Spanish Peseta, the Rambrand Dutch Guilder, etc.

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Eurobonds: When the United States was aiding European countries in Notes
recovering from the wreckage of World War II through the Marshall
Plan, the term “Euro” first surfaced in the fifties. Eurodollars were the
name given to dollars used outside of the US. In this sense, a currency
that is not issued by its home country is referred to as a Euro. Thus,
‘Eurobonds’ refer to bonds issued and sold outside of the currency’s home
country. A bond issued in the United Kingdom that is denominated in
dollars is known as a Euro (dollar) bond and a Yen-denominated bond
issued in the United States is a Euro (Yen) bond. Companies who want
to issue securities with shorter maturities have the option of doing so
in the European Markets. Medium-Term Notes (MTNs), Note Issuance
Facilities (NIF), and Commercial Paper (CP) are the three most significant
varieties. When Euro-Commercial Paper is issued, it is unsecured, has
a maximum maturity of one year, and is not underwritten. NIFs (Note
Issuance Facilities) are underwritten and have a maximum maturity of one
year. The Multiple Component Facility (MCF), a version of NIF, allows
a borrower to access money in several ways as part of the larger NIF
program. These choices, which include the ability to select the maturity,
currency, and interest rate basis, are known as banker’s acceptances and
short-term advances. On the contrary, Medium-Term Notes are issued for
maturities of more than a year with a range of tranches dependent on the
preferred maturities and are not underwritten. Under comparable conditions,
a usual CP program permits a number of note issues in accordance with the
maturity of the overall program. Euro Loans, which serve as borrowings
in the international capital markets, which are essentially bank loans to
businesses in need of long- and medium-term financing. Club loans and
syndicated loans are essentially the two unique methods of arranging
syndicated credits that have evolved in Euromarkets. A private agreement
between lending banks and a borrower is the Club Loan. The term “club
loan” refers to a loan that is advanced by a group of lending institutions
when the borrower and lender are well-known to one another, and the
loan amounts are small. However, a full-fledged public mechanism for
coordinating a loan transaction exists in Syndicated Euro Credit. With
a vast network of institutions taking part in the transaction around the
world, it is recognized as an essential component of the financial market
process. Syndicated loans typically have maturities of seven years, with
shorter-term deals having maturities of three to five years.

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Notes Equity Instruments

International Capital Markets until the end of the 1970s relied on debt
financing, while corporate entities raised equity primarily in domestic
markets. This was brought on by the restrictions on international equity
investments that many nations had up until that point. Due to potential
risks associated with overseas equity offerings, such as those related
to exposure to foreign currencies or concerns about national regulatory
constraints on such investments, inventors also opted to invest in domestic
equity issues. Many domestic economies underwent liberalization and
globalization in the early 1980s. Through the issuance of an intermediate
instrument known as a “Depository Receipt,” issuers from developing
nations that do not allow the issuance of equity shares denominated in
dollars or other foreign currencies can now access international equity
markets. The beneficial interest in shares issued by a firm is represented
by a Depository Receipt (DR), which is a negotiable certificate issued by
a depository bank. These shares are deposited with a local “custodian”
that the depository has designated; the custodian then issues receipts for
the deposit of the shares.
Depository Receipts are referred to as a Global Depository Receipt
(GDR), an American Depository Receipt (ADR), and an International
Depository Receipt (IDR) depending on the placements planned. The
number of shares represented by each Depository Receipt in the domestic
markets is stated. The GDRs and domestic shares are often convertible
or may be redeemed in nations with capital account convertibility. This
suggests that a shareholder in an equity company may deposit the required
amount of shares in order to receive a GDR, and vice versa. There is no
foreign exchange risk for the corporation up until the Global Depository
Receipts (GDRs), American Depository Receipts (ADRs), and International
Depository Receipts (IDRs) are converted, also the holder cannot exercise
any voting rights. These kinds of instruments are perfect for companies
that desire to have a sizable shareholder base and a global presence. The
company will list on the designated stock exchange, ensuring that the
instrument has liquidity.
Quasi-Instruments
After a certain period of time, these instruments are converted into equity
at the investor’s or the company’s discretion and cease to be regarded as

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debt instruments. These include warrants, Foreign Currency Convertible Notes

Bonds (FCCBs), etc. Warrants are typically offered in conjunction with
other debt instruments as a sweetener. FCCBs are legally obligated to
make payments at a predetermined coupon rate. With the opportunity to
convert into shares at the investor’s discretion, it has more flexibility.
The conversion price for FCCB is very similar to the share’s trading
price on the stock exchange. Additionally, the business may include a call
option at the issuer’s discretion to acquire FCCBs before to maturity. For
investment in Europe, there is an issue of a Euro Convertible Bond. It is
an outside-of-the-domestic market quasi-equity issue that allows the holder
the opportunity to convert the instrument from debt to equity. The ability
to convert Euro Convertible Bonds into GDR is a modern feature. The
issuing company often favours a GDR even though the investor would
prefer the convertible bond as an instrument for investment. Interest is
paid in US dollars up until conversion, and bond redemption is likewise
completed in US dollars. During the convertible life, the conversion option
may be used by the investor at any time or at predefined intervals. A
stipulated number of shares are issued to the investor upon conversion
of the convertible bond.
IN-TEXT QUESTION
9. Consider the following statements in relation to Capital Account
Convertibility (CAC):
(1) It alludes to the removal of restrictions on the transfer of
capital from India to other nations around the world
(2) It results in an equitable distribution of income levels in
India
(3) It aids in the effective distribution or appropriation of
foreign capital in India
Pick the correct response from the statements given above:
(a) 1 & 2
(b) 2 & 3
(c) 1 & 3
(d) 1, 2 & 3

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Notes
11.7 International Financial Centres
IFC stands for International Financial Centre. The IMF defines these large
full-service international centres as having sophisticated settlement and
payment systems that support significant domestic economies, deep market
liquidity, a variety of funding sources and uses, and legal and regulatory
frameworks that are sufficient to protect the integrity of principal-agent
relationships and supervisory functions. IFCs typically lend long-term to
non-residents and borrow short-term from non-residents. The IMF cited
New York City, London, and Tokyo as examples.
A Financial Centre, also known as a financial hub, is a site where there
is a concentration of people involved in banking, asset management,
insurance, or the financial markets, along with venues and supporting
services. Financial intermediaries like brokers and banks, institutional
investors (like investment managers, insurers, pension funds, and hedge
funds), and issuers (like governments and businesses) are all examples
of potential participants. Even though many transactions happen over
the counter (OTC), or directly between participants, trading activity can
occur on sites like exchanges and involve clearing houses. Companies
that provide a wide range of financial services, such as those connected
to mergers and acquisitions, corporate actions, or public offerings, or that
participate in other fields of finance, such as hedge funds, private equity,
and reinsurance, usually operate in financial centres.
Rating agencies and the supply of allied professional services, particularly
legal counsel and accounting services, are examples of ancillary financial
services. The largest International Financial Centre (IFC) and fintech hub
in the world is located in Lower Manhattan, New York City’s Financial
District, which includes Wall Street. One of the oldest financial centres
was the City of London also known as the Square Mile. One of the biggest
international financial centres in the globe is London. The majority of
Regional Financial Centres and International Financial Centres are full-
service financial centres having direct access to sizable capital pools and
are located in major worldwide cities. Offshore Financial Centres, as well
as some Regional Financial Centres, concentrate on tax-driven services
such as tax-neutral vehicles, corporate tax planning tools, and shadow
banking or securitisation, and can include smaller areas.

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11.8 Selection of Sources and Forms of Funds Notes

In order to accomplish its goals, a corporation selects a particular source

or kind of finance. Among the primary goals are minimizing the effective
cost of capital, aligning the obtained capital to the desired debt-to-equity
and current obligations to long-term liabilities ratios, and avoiding onerous
legal and administrative formalities.
Minimisation of Cost of Funds: The choice of funding sources is taken
with the goal of minimizing the cost of capital. The interest rate and
fluctuations in the value of the borrowed currency or the exchange rate
are two further factors that affect how much the funds really cost.
Kbf = (1 + rf) (1 + Ef) - 1 represents the effective cost of borrowing
in a foreign market, whereas Ef is the change in the exchange rate, the
foreign market interest rate is expressed as rf and Kbf is the effective
cost of borrowing in a foreign market. For instance, if interest rates are
14% in New York and 12% in London, respectively, and the value of
growth in the pound sterling is expected to be 4%, then.
The effective cost of borrowing in pounds would be:
= (1 + 12/100) (1 + 4/100) - 1
= (1.12 × 1.04) - 1
= 0.1648 or 16.48% (0.1648 × 100)
A company with global operations will borrow in this case from the New
York money market even if London’s money market offers a cheaper
interest rate. The weighted average of the effective borrowing costs across
several currencies is determined if the company borrows from numerous
financial markets. If the movement of the values of many currencies has
a negative correlation, the effective cost of overall borrowing is going to
be lower. The cost may rise if the correlation coefficient is positive. In
order to lower the effective cost of total borrowing, the firm takes into
account both the projected change in currency value and the correlation
coefficient of the anticipated fluctuations in currency value of several
currencies.
Borrowing in Compliance with Norms for Capital Structure: Another
funding issue is largely about minimizing the cost of capital, not by picking
the currency of borrowing, but by adhering to capital structure norms. The

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Notes weighted average cost of capital will go down when the debt-equity ratio
in the capital structure increases, according to the net income approach.
The cost of debt is lower than the cost of equity since it is tax deductible.
The overall cost of capital decreases with the proportion of the less
expensive form of capital in the capital structure. Miller and Modigliani,
on the other hand, believe that regardless of changes in the debt-equity
ratio, the weighted average cost of capital stays the same because as the
debt ratio rises, the risk that equity investors must bear also rises. Due
to the significant differences between these two methods, a third method
has been developed, according to which the weighted average cost of
capital tends to rise after the debt-to-equity ratio reaches a specific level
(sharan, 1991). Every time a multinational company has to raise money,
it does so by combining debt and equity in a way that lowers the cost
of capital. However, because of its highly diversified cash flow across
numerous nations, the multinational corporation is better positioned than a
domestic firm to support a greater debt ratio. The capital structure norms
of 677 companies across 9 industries and 23 countries are examined in
the study by Sekely and Collins (1988), which reveals that the debt ratio
can vary depending on economic, social, cultural, and political factors.
Because of these differences, different countries have different capital
structure norms. The debate over whether affiliates of a company with
global operations should adhere to host country norms or parent company
principles is a crucial one. If the norms in the home nation and the host
country are the same, there is no issue; but, if they are not, it becomes
a matter of vital importance. Capital structure requirements are in line
with the host government’s monetary and financial policy if they abide
by local norms in the host country. They help assess the return on equity
investment in relation to regional rivals in a particular industry. However,
when it comes to adhering to the worldwide target debt ratio adhered to
by the parent firm, the rules are more suited to maximizing total profit.
Identifying an Ideal Maturity: A company with global operations prefers
to raise money from the international financial market while maintaining
a healthy balance between short-term and long-term obligations. There
is no uncertainty surrounding the financing of fixed assets because it is
done so using long-term capital. The ideal balance between long-term
capital and short-term capital is crucial when it comes to the financing
of current assets. According to the widely accepted practice, short-term

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capital should be used to fund the variable element of current assets while Notes
long-term capital should be used to fund the assets that are permanent.
Profitability and liquidity are truly being traded off here. Long-term capital
is less profitable even though it is more liquid. On the other side, short-
term capital is less liquid yet does not significantly reduce profitability.
However, a conservative finance manager will use more long-term capital.
If he/she is aggressive the usage of short-term capital is significant. As
a result, whenever a multinational company seeks funding, it considers
the ideal trade-off between short-term capital and long-term capital.
Avoidance of Legal and Procedural Formalities: Any business seeking
funding does not want to go through too many procedural formalities.
International bond issues are far more intricate than Euro note issues.
The borrowing strategy may only be established within the constraints
of applicable county laws and regulations. The borrower cannot issue an
instrument even though it is economically viable when the government
forbids it. For instance, before to 1992, the Indian Government had
forbidden Indian companies from issuing Euro Convertible bonds or Euro
equities securities.
IN-TEXT QUESTIONS
10. Which of the following does not constitute a benefit of full
capital account convertibility?
(a) Encourages import
(b) Easy access to forex
(c) Boosts exports
(d) Promotes international commerce and capital flows between
nations
11. A net flow of capital, into one’s country, in the form of increased
purchases of domestic assets by foreigners and/or decreased
holdings of foreign assets by domestic residents is known as:
(a) Financial inflow
(b) Financial transaction
(c) Financial outflow
(d) None of the above

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Notes 12. According to Miller and Modigliani’s theory, what remains the
same regardless of changes in the debt-equity ratio?
(a) The cost of equity
(b) The weighted average cost of capital
(c) The cost of debt
(d) None of the above
13. What is a potential risk associated with full capital account
convertibility?
(a) It can reduce unemployment in India
(b) It can promote technical advancement in India
(c) It can carry a significant risk of capital outflows and
exchange rate volatility
(d) It can lead to a fair distribution of income levels in India

11.9 Summary
External financial markets intermediate by moving savings from investors
and lenders to those wanting to invest in assets that they believe will
deliver future returns. Assets are exchanged across national borders
between citizens of several financial centres in international financial
transactions. There is a symbiotic relationship between both primary
and secondary markets in domestic as well as international financial
markets. International capital movements have numerous advantages. The
capacity to transfer financial resources across borders creates a fantastic
potential for economies to thrive. Global money flows enable startups
to launch their products and existing businesses to develop and invest
in new ventures. Increased aggregate demand is one of the benefits of
foreign capital flows. As more loanable funds become available in the
economy as a result of capital inflows, interest rates will fall. Borrowing
would be cheaper as a result, allowing investors to borrow money and
invest in new ventures. Increasing aggregate demand raises the economy’s
potential output and reduces unemployment. Another significant benefit of
foreign money flows is that it promotes technical advancement. Capital
account convertibility is a feature of a country’s financial regime that

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focuses on the capacity to freely or at market-determined exchange rates Notes

conduct transfers of local financial assets into foreign financial assets. It
is also known as capital asset liberation. In layman’s words, full capital
account convertibility allows for the exchange of local currency for
foreign currency with no limit on the amount. The IMF defines these
large full-service international centres as having sophisticated settlement
and payment systems that support significant domestic economies, deep
market liquidity, a variety of funding sources and uses, and legal and
regulatory frameworks that are sufficient to protect the integrity of
principal-agent relationships and supervisory functions. The full-service
financial hubs that comprise International Financial Centres, as well as
a number of Regional Financial Centres, are situated in large worldwide
cities and have direct access to sizeable capital pools.
IN-TEXT QUESTIONS
14. What is the difference between full and partial Capital Account
Convertibility (CAC)?
(a) Partial CAC only allows for limited capital movement,
while full CAC has no restrictions
(b) Partial CAC is only granted to countries with a current
account surplus, while full CAC has no such requirement
(c) Partial CAC is only allowed under certain situations, while
full CAC has no restrictions
(d) Partial CAC allows for unlimited capital movement, while
full CAC has restrictions
15. Which of the following is a potential risk associated with full
capital account convertibility?
(a) Increased capital inflows
(b) Increased capital outflows
(c) Reduced exchange rate volatility
(d) None of the above

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Notes
11.10 Answers to In-Text Questions

1. (a) Price discovery, providing liquidity, and lowering the cost of

information and transaction
2. (c) The movement of financial assets for investments, management
of businesses or commercial trade
3. (c) To protect against the risk of loss resulting from fluctuations
in foreign exchange and interest rates
4. (b) Minimize the effective cost of funds
5. (c) Balance Short-term and long-term liabilities
6. (b) Interest rates and currency fluctuations
7. (a) Short-term capital
8. (b) Conservative finance managers prefer more long-term capital,
while aggressive finance managers prefer more short-term capital
9. (a) 1 & 2
10. (a) Encourages import
11. (a) Financial inflow
12. (b) The weighted average cost of capital
13. (c) It can carry a significant risk of capital outflows and exchange
rate volatility
14. (a) Partial CAC only allows for limited capital movement, while
full CAC has no restrictions
15. (b) Increased capital outflows

11.11 Self-Assessment Questions

1. What is the essence of the external financial market.
2. What is the meaning of international capital flows?
3. What are the International financial centres and also explain its
role.
4. What is meant by capital account convertibility?

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Notes
11.12 Suggested Readings
 Khan, M. Y. (2018). Indian Financial System. Chennai: McGraw-Hill
Education
 Vij, M., & Dhawan, S. (2017). Merchant Banking and Financial
Services. Delhi: McGraw-Hill Education
 Madura, J. (2016). Financial Markets and Institutions. USA: Cengage
Learning
 Fabozzi, F. J., Modigliani, F. P., & Jones, F. J. (2010). Capital
Markets – Institutions and Instruments. Delhi: PHI Learning.

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 Glossary
AB PMJAY: Ayushman Bharat Pradhan Mantri Jan Arogya Yojana.
AIFs: Alternative Investment Funds.
Algorithmic Trading: With the increasing trend amongst capital market players of generating
orders through automated execution logic.
AMC: Asset Management Company.
AML: Anti-Money Laundering
Bank: Bank is an institution that accepts deposits from public and lends money to the
people who need it.
Banking: Banking consists of various activities that can be done through financial
institutions that will accept deposits from individuals and other entities. These financial
institutions will then utilize this money to offer loans and invest it for a profit.
Bear Market: A weak or falling market characterized by the dominance of sellers.
BOLT: Bombay Online Trading System.
Bond: A loan security (instrument) issued by Government or a private sector company to
raise funds. It is redeemable at maturity.
BSE: Bombay Stock Exchange.
Bull Market: A rising market with abundance of buyers and relatively few sellers.
Business Enterprises: An enterprise in a business organization or a corporation engaged
in commercial, industrial and professional activities.
Capital Market: The capital market trades instruments with medium-and long-term
maturity. Investors can invest in the company’s equity share capital and be a party to the
profits earned by the company.
CARE: Credit Analysis and Research Limited.
Cash Market: In this market, transactions are settled in real-time, requiring investors to
pay the total investment amount through their funds or borrowed capital, known as margin.
CDSL: Central Depository Services Limited.
Clearing: Settlement or clearance of accounts, for a fixed period in a Stock Exchange.
Commercial Banks: Commercial banks are those banks that help in the flow of money
in an economy by providing deposit and credit facilities.

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Notes Commercial Paper: A type of money market instrument. It represents

unsecured promissory notes of large and financially sound companies.
Credit Rating Agencies: Independent agencies that assess the creditworthiness
of debt issuers and assign ratings based on their analysis. These ratings
provide an indication of the issuer’s ability to meet its financial obligations
and help investors in making investment decisions.
CRISIL: Credit Rating Information Services of India Limited.
CTF: Counter-Terrorism Financing.
Daily Margin: The amount that has to be deposited at the Stock Exchange
on a daily basis for the purchase or sale of a security. This amount is
decided by the stock exchange.
Debenture: A bond that may or may not be secured by specific property.
It is written acknowledgement of a debt.
Debt Market: The debt market is the one where the trading of debt
instruments is executed like debentures and bonds, which have fixed
claims on the entity’s assets up to a certain amount.
Demutualization of Exchanges: The transformation of a traditional member-
owned stock exchange into a corporate entity owned by shareholders.
Deposits: Deposits received by a bank from its customers are a liability
from the banks point of view. They are of different types like current
account deposit, savings account deposit, fixed deposit and recurring
deposits.
Derivatives: Derivatives are financial contracts whose value derives from
an underlying asset.
Disintermediation: It refers to the process of bypassing intermediaries
and connecting buyers and sellers directly. This has been made possible
with the rise of technology.
Diversification: The process of adding securities to a portfolio in order
to reduce the portfolio’s unique risk and thereby, the portfolio’s total risk.
Dividend: Cash payments made to stockholders by the company.
E-Kuber: E-Kuber is an electronic platform introduced by the Reserve
Bank of India (RBI) for the centralized accounting and settlement of
government securities. It is an online system that facilitates the issuance,

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auction, settlement, and management of government securities in India. Notes

E-Kuber provides a secure and efficient platform for various participants,
including the RBI, commercial banks, primary dealers, and institutional
investors, to conduct transactions and maintain records related to government
securities. It aims to streamline the process of government debt management
and enhance transparency and efficiency in the Indian debt market.
Economy: A system of inter-related production and consumption activities
that determine the allocation of resources within a group.
Equity: Refers to equity shareholders’ wealth- equity share capital plus
reserves and surplus.
Equity Market: Equity instruments are traded in this market. Equity
represents the owner’s capital in the business and has a residual claim.
After paying off the fixed liabilities, whatever remains in the business
belongs to equity shareholders, regardless of the face value of their shares.
Equity Share Capital: It is capital other than preference share capital.
ETFs: Exchange-Traded Funds.
Exchange-Traded Market: A centralized market that works on pre-
established and standardized procedures, the exchange-traded market,
involves transactions entered with the help of intermediaries, who ensure
the settlement of transactions between buyers and sellers. Standard products
are traded in this market.
Exchange Traded Funds (ETFs): Exchange Traded Funds (ETFs) are
investment funds that are traded on stock exchanges, similar to individual
stocks.
FDI: Foreign Direct Investment
Financial Assets: An asset which gets its value from a contractual right
or ownership claim for example Cash, stocks, bonds, mutual funds, and
bank deposits etc.
Financial Institutions: Business entities that provide services as
intermediaries for different types of financial monetary transactions.
FMC: Forward Markets Commission.
Free Float Market Capitalization: The proportion of shares that are
accessible for trading on the market is known as free float.

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Notes Futures Market: The delivery or settlement of security or commodity

occurs later in this market. Therefore, transactions in such markets are
generally cash-settled, and a margin up to a certain percentage of the
asset amount is sufficient to trade in the asset.
GDP: Gross Domestic Product.
Gilt or Gilt Edged: Refers to government securities. These are considered
to be risk free and have low yield.
HNWIs: High-Net Worth Individuals.
ICEX: Indian Commodity Exchange.
ICRA: Investment Information and Credit Rating Agency.
IMF: International Monetary Funds.
Insolvency and Bankruptcy Code (IBC): Insolvency and Bankruptcy
Code (IBC) sets deadlines for closing bankruptcies. When a debtor fails
to make timely payments, the creditors are in a position of bankruptcy
and must take the debtor’s assets. IBC allows either the debtor or the
creditor to start “recovery” actions.
Intermediation: It refers to the process of introducing one or more
intermediaries or middlemen between buyers and sellers of financial
products, such as banks, brokers, or financial advisors, who facilitate
the buying and selling of financial products and services between two
or more parties.
Investor: A person or organization that puts money into financial schemes,
property, etc. with the expectation of achieving a profit.
InvIT: Infrastructure Investment Trusts.
IRDA: Insurance Regulatory and Development Authority of India, was
established to oversee and advance the insurance industry. It aims to
protect policyholder interests and promote the expansion of insurance
in the nation. All the Life Insurance and General Insurance Companies
operating in India are governed by IRDA.
IRDAI: Insurance Regulatory and Development Authority of India.
Jobber: Member brokers of a stock exchange who specialize, by giving
two-way quotations, in buying and selling of securities from and to
fellow members. Jobbers do not have any direct contact with the public,
but they serve the useful function of imparting liquidity to the market.

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KYC: Know Your Customer. Notes

LIC: Life Insurance Corporation of India.
Liquidity (or Marketability): The ability of investors to convert securities
to cash at a price similar to the price of the previous trade in the security.
Listed Security: A security that is traded on an organised security exchange.
Loans: Money received in form of deposits from customers by a bank
are lent out in form of loans. They are an asset for a bank.
Margin: A margin is a portion of the value of a stock transaction that
is paid in advance.
Market Risk (or Systematic Risk): The portion of a security’s total
risk that is related to moves in the market portfolio and hence cannot
be diversified away.
MCX: Multi Commodity Exchange of India Limited.
MFIs: Microfinance Institutions.
Money Market: This market deals with monetary assets like treasury bills,
commercial paper, and certificates of deposit, and all these instruments
have a maturity period of not more than a year.
NABARD: National Bank for Agriculture and Rural Development.
NBFCs: Non-Banking Finance Companies.
NCDEX: National Commodity and Derivatives Exchange Limited.
NEAT: National Exchange for Automated Trading.
Net Asset Value: The market value of an investment company’s assets
less any liabilities divided by the number of shares outstanding.
Non-Banking Financial Institutions: Businesses that provide financial
services like banking but are not subject to the same regulations as banks.
They lend money to businesses and individuals without the involvement
of a bank.
NPS: National Pension System.
NSDL: National Securities Depository Limited.
NSE: National Stock Exchange.
Optimal Portfolio: The feasible portfolio that offers an investor the
maximum level of satisfaction.

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Notes Over-the-Counter Market: This decentralized market allows customers to

trade customized products based on their requirements. These transactions
occur over the counter as different companies have different maturity
dates for debt, which generally does not coincide with the settlement
dates of exchange-traded contracts.
P2P: Peer-to-Peer Lending.
Payments Banks: Payment Banks are relatively new form of banking.
They accept deposits up to INR 1 Lakh per user. They provide debit and
ATM cards and account holders are restricted to making deposits of up
to Rs. 1,00,000/- and are not eligible for loans or credit cards.
PE: Private Equity.
PFRDA: The Pension Fund Regulatory and Development Authority was
established with the goals of promoting, regulating, and developing the
pension sector in India.
PMFBY: Pradhan Mantri Fasal Bima Yojana.
PMJJBY: Pradhan Mantri Jeevan Jyoti Bima Yojana.
PMSBY: Pradhan Mantri Suraksha Bima Yojana.
Primary Dealers: Financial institutions authorized by the RBI to participate
in the primary market for government securities. Primary dealers act as
market makers, helping in the distribution and underwriting of government
securities.
Primary Market: Where a company lists security for the first time, or
an already listed company issues fresh security.
Principle of Liquidity: Liquidity refers to the capacity of an institution
to obtain sufficient cash or its equivalent in a timely manner to meet its
commitments as they fall due.
Principle of Safety: Safety means that the borrower should be able to
repay the loan and interest in time at regular intervals without default.
Prospectus: A document published by a company provides details about
an investment offering to the public.
RBI: Reserve Bank of India is the Central Bank of India and is the
regulator for all types of banks in India. It also serves as Banker to the
Government of India.

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RBI Retail Direct Scheme: Retail Direct Scheme is a one-stop solution Notes
to facilitate investment in Government Securities by individual investors.
Under this scheme individual retail investors can open a Gilt Securities
Account – “Retail Direct Gilt (RDG)” account with RBI. Using this
account, retail investors can buy and sell government securities through
the online portal – [Link]
REITs: Real Estate Investment Trusts
Reserve Bank of India: The central bank of India. The apex institution.
The RBI acts as a regulator and supervisor of the overall financial system.
Risk: The uncertainty associated with the end of period value of an
investment.
SEBI: The Securities and Exchange Board of India (SEBI) is the
regulatory body for India’s securities market. It began operations in 1988
and has its headquarters in Mumbai. The Securities and Exchange Board
of India (SEBI) has two primary objectives: investor protection and the
development of the securities market.
Secondary Market: Once a company lists the security, it becomes
available for trading over the exchange between investors.
Settlement: To fulfil the financial obligations identified in the clearing
step. This involves the transaction settlement for the buyers and sellers.
Share: the smallest part of the total share capital of a company. It has
a distinctive number and a par value.
SIBs: Social Impact Bonds.
SIP: Systematic Investment Plan.
Small Finance Banks: Small finance banks focus on customers who are
underserved by larger financial institutions. They cater to the needs of
micro- and cottage-based enterprises.
SMERA: SME Rating Agency of India Limited.
SMEs: Small and Medium Enterprises.
Spot Delivery: If the delivery of and payment for securities are to be
made on the same day or the next day.
STRIPS: Separate Trading of Registered Interest and Principal of
Securities, refers to securities that are formed by separating the cash flows

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Notes associated with a conventional G-Sec. These cash flows include the semi-
annual coupon payments and the final principal payment received from
the issuer. Essentially, STRIPS are Zero Coupon Bonds (ZCBs) but are
created by dividing existing securities. It’s important to note that STRIPS
differ from other securities in that they are not issued through auctions.
Trend Line: when share prices move consistently in one direction over
an extended period of time.
VC: Venture Capital.

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