Content Module 1 Overview of the Indian Financial System 1 Financial Systems 1 2 Indicators Of Financial Development 18 3 Financial Sector Reforms 25 Module 2 Financial Institutions 4 Central Bank and Monetary Policy 31 5 Commercial Banking 48 6 Non-Performing Assets and Capital Adequacy Norms (CAN) 60 7 Non Banking Financial Companies (NBFCS) 70 Module 3 Financial Markets 8 Money Market 93 9 Capital Market 106 10 Secondary Market And Foreign Exchange Market 127 Module 4 Financial Instruments 11 Traditional Financial Instruments 164 12 New Financial Instruments 181 Module 5 13 The Derivatives Market In India 188 Module 6 Financial services and regulation 14 Financial Instruments Services 200 15 Regulation of Financial System 212 T.Y.B.A Economics Paper VI INDIAN FINANCIAL SYSTEM Preamble: The post globalised period has brought about remarkable changes in the financial sector The purpose of this paper is to acquaint students with the working of the system and the recent changes that have taken place. The operations of both the Central Bank and commercial banks .in an open economy, had to be reassessed. The opening of the financial markets and the evolution of new instruments should also be an important constituent of the paper. It was also necessary that financial services be discussed separately as a topic. 1. OVERVIEW OF THE INDIAN FINANCIAL SYSTEM (15 lectures) Definition and Meaning of the Financial System - Components of the financial System: Institutions, Instruments, Markets, and Services; Functions and Role of financial system; Financial System and Economic Development - Indicators of Financial Development: FR, FIR, NIR and IR; Financial Sector Reforms: Narasimham Committee Report 1991 and 1998. 2. FINANCIAL INSTITUTIONS (15 lectures) Central Banking: Functions - traditional and promotional - Monetary Policy of the RBI - Transmission Channels of Monetary policy - interest rate channel, exchange rate channel and asset price channel. Commercial banking: Growth of Commercial banking since independence, nationalization of commercial banks and their performance assessment till 1992 and developments thereafter - Classification of assets (with respect to BalanceSheet of Commercial Banks.) and the Issue of non-performing assets and their management; Capital Adequacy Norms- Basel Accord 1 and 2; Risk management in Indian banks. Overview of Development Banking in India - Non Banking Finance Companies:Meaning, Types, Growth and Regulation. 3. FINANCIAL MARKETS (15 lectures) Money Market: Meaning - Constituents of organized money market and reforms; Features of Indian Money Market. Capital Market: Overview of History of Indian Capital; Phases of Growth of Indian Capital Market since 1947; Primary Market: Free pricing regime, book-building, green-shoe option, on-line IPOs; Secondary Market: organization, management and membership of stock exchanges, listing, trading and settlement systems; Overview of Debt Market in India - Interlink between Money Market and Capital Market. Foreign Exchange Market: Constituents/ players in the market - Growth since 1991- Rate of Exchange and its influence on financial flows. 4. FINANCIAL INSTRUMENTS (10 lectures) Traditional Instruments: Equities, Debentures and Bonds; New Instruments: Floating Rate Bonds, Zero interest bonds, Deep Discount bonds,Auction rated debentures, securitized papers, collateralized debt obligations, Inverse float bonds. 5. THE DERIVATIVES MARKET IN INDIA (10 lectures) Meaning of derivatives and their significance -need for financial derivatives -types of financial derivatives; pricing of derivatives; Derivatives trading in India. 6.FINANCIAL SERVICES & REGULATION (10 lectures) Classification, Importance and working of financial services - insurance, mutual funds, leasing, venture financing, credit rating, merchant banking, e - banking, factoring and forfeiting - Micro finance and financial inclusion. Regulation of the financial system: RBI, SEBI, and IRDA. REFERENCES 1) Pathak Bharati (2008): The Indian Financial System -Markets, Institutions, and Services, Second Edition.Pearson education 2) Bhole L. M. (2008): Financial Institutions and Markets, Growth and Innovation, Tata McGraw-Hill, New Delhi. 3) Bodie, Z. et. el. (2009), Financial Economics, Pearson Education, New Delhi. 4) Paul J. and P. Suresh (2008), Management of Banking and Financial Services, Pearson Education, Delhi. 5) Khan, M.Y.(2007): Financial Services, Tata McGraw Hill, New Delhi. 6) Hull John (2002): Introduction to Futures and Options Market, Prentice Hall of India, New Delhi. 7) World Bank (2001): Developing Government Bond Market-A Handbook 8) Reserve Bank of India (various issues) Report on Currency and Finance, RBI, Mumbai. 9) Reserve Bank of India (1997) )Occasional Papers, Vol. 18, Nos. 2&3,RBI,Mumbai. 1 1 Module 1 Overview of the Indian Financial System FINANCIAL SYSTEM Unit structure 1.0 Objectives 1.1 Introduction 1.2 Meaning a Financial System. 1.3 Structure of a Financial System. 1.4 Constituents and Role of Indian Financial System 1.5 Role of Financial System 1.6 Functions of Financial System 1.7 Summary 1.8 Questions 1. 0 Objectives 1. To understand the meaning and structure of a financial system. 2. To study the functions of a financial system 3. To examine the role of financial system in an economic system. 1.1 Introduction An economy can attain welfare of the people through production and proper distribution of goods and services. The basic economic activities like production and distribution of goods and services require funds or finance. The financial system consist of the ways and means whereby it can render service to the real sectors for their operations and growth. The financial system consist of the institutions, markets and services. It ranges from credit societies, money lenders, banks, insurance companies, investment trusts to stock exchanges. Its instruments ranges from coins, currency notes, cheques, bills, bonds, stocks to futures and swaps. Market for these instruments may be organized or unorganized consisting of money market, capital market and others. 2 A financial system also provide services which are essential for the economic development of the country. Therefore it is said that money, credit and finance are the life blood of an economic system. Given the resources, a well developed financial system can contribute of fast development of an economy. 1.2 Meaning of Financial System “The financial system consists of a variety of institutions, markets and instruments related in a systematic manner and provide the principal means by which savings are transferred into investments” (by Prof. Prasanna Chandra). Financial system of any country is made up of specialized and non-specialised financial institutions. It also consists of organized and unorganized money markets, which provide services and facilitate transfer of funds with the help of financial instruments. According to S.B. Gupta, “Financial system is a set of institutional arrangements through which financial surpluses available in the economy are mobilized.” The above definitions draws our attention to the following points. (i) Constituents of financial system. (ii) Structure and aspects of financial system, and (iii) Functions of financial system 1.3 Structure of Financial System (Inter-relations) Structure of financial system consists of parts and sub-parts of the system is simple and narrow in scope. In modern economy, the structure of the financial system gets complex in terms of its broad network and instruments. Structure of financial system has organized and unorganized components. The organized component consists of diverse institutions providing wide choice to savers to lend their funds. The financial assets in organized system are bank deposits, P.O. deposits, corporate deposits, shares, debentures, insurance policies, units of UTI, etc. Inter-relationships: The structure of financial system helps to understand inter-relationships within the system. For instance, commercial banks which are ‘core’ institutions operate in both money market as well as capital market. As such, there exists close inter-relationship between interest rate of funds for different time period. Similarly, there are close 3 Financial System Savers House holds Lenders Foreign Sectors Investors Corporate Sector Unorganised Borrowers Govt. Sector Sector Economy Chart 1 Interrelation between the Financial System and the Economy market (stock exchange). So also there is interdependence of financial assets i.e. suppliers have wide choice among bank deposits, insurance policy, P.O. deposits, company deposits, shares, etc. The financial system also induces people (savers) to convert their surplus into financial assets. For example people holding unproductive assets may convert them into physical assets like housing, land, etc. Banks play an important role in credit creation monitored or controlled by the RBI. The structure of Financial System: The structure of financial system consists of following : (a) Financial Institutions (FIs). (b) Financial Markets (FMs) (c) Financial Instruments and Services: Financial institutions are also called as intermediaries. Such institutions are called : institutions and non-banking institutions. 4 Financial System Financial Financial Financial Financial Institutions Markets Instruments Services Banking Non-Banking Primary Secondary Institutions Institutions Organised Un-organised Market Market OR Primary Secondary Capital Money Short medium Long Market Market Term Term Term Chart 2 : Structure of