(Indian Financial System)
Full Marks: 80
The figures in the margin indicate full marks for the questions.
1. (a) Discuss briefly the structure of Indian financial system. (16)
-> The services that are provided to a person by the various Financial Institutions including banks, insurance companies, pensions, funds, etc. constitute the financial system.
Given below are the features of the Indian Financial system:
· It plays a vital role in the economic development of the country as it encourages both savings and investment
· It helps in mobilizing and allocating one’s savings
· It facilitates the expansion of financial institutions and markets
· Plays a key role in capital formation
· It helps form a link between the investor and the one saving
· It is also concerned with the Provision of funds
· The financial system of a country mainly aims at managing and governing the mechanism of production, distribution, exchange and holding of financial assets or instruments of all kinds.
Components of Indian Financial System
There are four main components of the Indian Financial System. This includes:
1. Financial Institutions
2. Financial Assets
3. Financial Services
4. Financial Markets
Let’s discuss each component of the system in detail.
1. Financial Institutions
The Financial Institutions act as a mediator between the investor and the borrower. The investor’s savings are mobilized either directly or indirectly via the Financial Markets.
The main functions of the Financial Institutions are as follows:
· A short term liability can be converted into a long term investment
· It helps in conversion of a risky investment into a risk-free investment
· Also acts as a medium of convenience denomination, which means, it can match a small deposit with large loans and a large deposit with small loans
The best example of a Financial Institution is a Bank. People with surplus amounts of money make savings in their accounts, and people in dire need of money take loans. The bank acts as an intermediate between the two.
The financial institutions can further be divided into two types:
- Banking Institutions or Depository Institutions – This includes banks and other credit unions which collect money from the public against interest provided on the deposits made and lend that money to the ones in need
- Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds and brokerage companies fall under this category. They cannot ask for monetary deposits but sell financial products to their customers.
Further, Financial Institutions can be classified into three categories:
- Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.
- Intermediates – Commercial banks which provide loans and other financial assistance such as SBI, BOB, PNB, etc.
- Non Intermediates – Institutions that provide financial aid to corporate customers. It includes NABARD, SIBDI, etc.
2. Financial Assets
The products which are traded in the Financial Markets are called Financial Assets. Based on the different requirements and needs of the credit seeker, the securities in the market also differ from each other.
Some important Financial Assets have been discussed briefly below:
- Call Money – When a loan is granted for one day and is repaid on the second day, it is called call money. No collateral securities are required for this kind of transaction.
- Notice Money – When a loan is granted for more than a day and for less than 14 days, it is called notice money. No collateral securities are required for this kind of transaction.
- Term Money – When the maturity period of a deposit is beyond 14 days, it is called term money.
- Treasury Bills – Also known as T-Bills, these are Government bonds or debt securities with maturity of less than a year. Buying a T-Bill means lending money to the Government.
- Certificate of Deposits – It is a dematerialized form (Electronically generated) for funds deposited in the bank for a specific period of time.
- Commercial Paper – It is an unsecured short-term debt instrument issued by corporations.
3. Financial Services
Services provided by Asset Management and Liability Management Companies. They help to get the required funds and also make sure that they are efficiently invested.
The financial services in India include:
- Banking Services – Any small or big service provided by banks like granting a loan, depositing money, issuing debit/credit cards, opening accounts, etc.
- Insurance Services – Services like issuing of insurance, selling policies, insurance undertaking and brokerages, etc. are all a part of the Insurance services
- Investment Services – It mostly includes asset management
- Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of the Foreign exchange services
The main aim of the financial services is to assist a person with selling, borrowing or purchasing securities, allowing payments and settlements and lending and investing.
4. Financial Markets
The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds, shares and other assets is called a financial market.
The financial market can be further divided into four types:
- Capital Market – Designed to finance the long term investment, the Capital market deals with transactions which are taking place in the market for over a year. The capital market can further be divided into three types:
(a) Corporate Securities Market
(b) Government Securities Market
(c) Long Term Loan Market
- Money Market – Mostly dominated by Government, Banks and other Large Institutions, the type of market is authorized for small-term investments only. It is a wholesale debt market which works on low-risk and highly liquid instruments. The money market can further be divided into two types:
(a) Organized Money Market
(b) Unorganized Money Market
- Foreign exchange Market – One of the most developed markets across the world, the Foreign exchange market, deals with the requirements related to multi-currency. The transfer of funds in this market takes place based on the foreign currency rate.
- Credit Market – A market where short-term and long-term loans are granted to individuals or Organizations by various banks and Financial and Non-Financial Institutions is called Credit Market.
2. (a) What are the money market organization in India? Write elaborately on investment pattern of Money Market Mutual Funds. (8+8=16)
-> Money market is a market for short-term funds. We define the short-term as a period of 364 days or less. In other words, the borrowing and repayment take place in 364 days or less. The manufacturers need two types of finance: finance to meet daily expenses like purchase of raw material, payment of wages, excise duty, electricity charges etc., and finance to meet capital expenditure like purchase of machinery, installation of pollution control equipment etc.
The first category of finance is invested in the production process for a short-period of time. The market where such short-time finance is borrowed and lent is called ‘money market’. Almost every concern in the financial system, be it a financial institution, business firm, a corporation or a government body, has a recurring problem of liquidity management, mainly because the timing of the expenditures rarely synchronize with that of the receipts.
The most important function of the money market is to bridge this liquidity gap. Thus, business and finance firms can tide over the mismatches of cash receipts and cash expenditures by purchasing (or selling) the shortfall (or surplus) of funds in the money market.
In simple words, the money market is an avenue for borrowing and lending for the short-term. While on one hand the money market helps in shifting vast sums of money between banks, on the other hand, it provides a means by which the surplus of funds of the cash rich corporations and other institutions can be used (at a cost) by banks, corporations and other institutions which need short-term money.
A supplier of funds to the money market can be virtually anyone with a temporary excess of funds. The government bonds, corporate bonds and bonds issued by banks are examples of money market instruments, where the instrument has a ready market like the equity shares of a listed company. The money markets refer to the market for short-term securities (one year or less in original maturity) such as treasury bills, certificates of deposits, commercial paper etc. Money market instruments are more liquid in nature.
The money market is a market where money and highly liquid marketable securities are bought and sold. It is not a place like the stock market but an activity and all the trading is done through telephones. One of the important features of the money market is honor of commitment and creditworthiness.
Features and Objectives of Money Market:
Following are the features of money market:
1. Money market has no geographical constraints as that of a stock exchange. The financial institutions dealing in monetary assets may be spread over a wide geographical area.
2. Even though there are various centers of money market such as Mumbai, Calcutta, Chennai, etc., they are not separate independent markets but are inter-linked and interrelated.
3. It relates to all dealings in money or monetary assets.
4. It is a market purely for short-term funds.
5. It is not a single homogeneous market. There are various sub-markets such as Call money market, Bill market, etc.
6. Money market establishes a link between RBI and banks and provides information of monetary policy and management.
7. Transactions can be conducted without the help of brokers.
8. Variety of instruments is traded in money market.
Structure of Indian Money Market:
(i) Broadly speaking, the money market in India comprises two sectors- (a) Organised sector, and (b) Unorganized sector.
(ii) The organized sector consists of the Reserve Bank of India, the State Bank of India with its seven associates, twenty nationalized commercial banks, other scheduled and non-scheduled commercial banks, foreign banks, and Regional Rural Banks. It is called organized because its part is systematically coordinated by the RBI.
(iii) Non-bank financial institutions such as the LIC, the GIC and subsidiaries, the UTI also operate in this market, but only indirectly through banks, and not directly.
(iv) Quasi-government bodies and large companies also make their short-term surplus funds available to the organized market through banks.
(v) Cooperative credit institutions occupy the intermediary position between organized and unorganized parts of the Indian money market. These institutions have a three-tier structure. At the top, there are state cooperative banks. At the local level, there are primary credit societies and urban cooperative banks. Considering the size, methods of operations, and dealings with the RBI and commercial banks, only state and central, cooperative banks should be included in the organized sector. The cooperative societies at the local level are loosely linked with it.
(vi) The unorganized sector consists of indigenous banks and money lenders. It is unorganized because activities of its parts are not systematically coordinated by the RBI.
(vii) The money lenders operate throughout the country, but without any link among themselves.
(viii) Indigenous banks are somewhat better organized because they enjoy rediscount facilities from the commercial banks which, in turn, have link with the RBI. But this type of organization represents only a loose link with the RBI.
Money market mutual funds (MMF) invest in short-term debt instruments, cash, and cash equivalents that are rated high quality. It is for this reason that money market mutual funds are considered safe or investment with minimal to low risk. As these funds invest in high-quality instruments, they offer a predictable risk-free return rate.
Money market mutual funds (MMMF) are used to manage short-term cash needs. These funds are open-ended in the debt fund category and deal only in cash or cash equivalents. Money market securities have an average maturity of one-year; that is why these are termed as money market instruments.
The fund manager invests in high-quality liquid instruments such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit. Money market funds mainly target earning interest for the unitholders. The primary aim of money market funds is to minimize the fluctuation of the Net Asset Value (NAV) of the fund.
Types of Money Market Instruments
Following are the most popular money market instruments:
Certificate of Deposit (CD)
These are time deposits such as fixed deposits that are offered by scheduled commercial banks. The only difference between FD and CD is that investors are not allowed to withdraw CD until maturity.
Commercial Paper (CPs)
These are issued by companies and financial institutions which have a high credit rating. Commercial papers are also known as promissory notes, commercial papers are unsecured instruments, which are issued at the discounted rate and redeemed at face value.
Treasury Bills (T-bills)
T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. Treasury bills are considered one of the safest instruments as the government backs these. The rate of return, also known as the risk-free rate, is low on T-bills as compared to all other instruments.
Repurchase Agreements (Repos)
It is an agreement under which RBI lends money to commercial banks. It involves the sale and purchase of agreement at the same time.
A money market fund tries to offer the highest short-term income by maintaining a well-diversified portfolio of money market instruments. Investors having a short investment horizon of up to one year may invest in these funds.
Those individuals with low-risk appetite having their surplus cash parked in a savings bank account can invest in money market funds. These funds have the potential to offer higher returns than a regular savings bank account. The investors could be corporate as well as retail investors.
If you have a medium to long-term investment horizon, then money market fund won’t be an ideal option. Instead, you may go for dynamic bond funds or balanced funds, which are capable of providing relatively higher returns.
Things to Consider as an Investor
Money market funds face interest rate risk, credit risk, and reinvestment risk. In interest rate risk, the prices of the underlying asset increases as interest rates decline and decrease as interest rates rise. The fund manager may invest in risky securities which have a higher probability of default.
Money market funds have the potential to offer higher returns than a regular savings bank account. However, the returns are not guaranteed. The Net asset value (NAV) fluctuates with changes in the overall interest rate regime. A fall in interest rates may increase the prices of an underlying asset and deliver good returns.
Expense ratio refers to the fee charged by fund houses to manage your investment. SEBI has capped the expense ratio at 1.05%. As the assets under management (AUM) increases, the scheme tends to reduce the cost of operations.
Money market funds are suitable for very short-term to short-term investment horizons, i.e. three months to one year. For medium-term horizons, you may invest in other debt funds like dynamic bond funds.
If you have to make EMI payments or invest extra cash while maintaining liquidity, then you can use money market funds. A small portion of your portfolio can be invested in these for diversification.
Tax on Gains
Investing in debt funds provides you with taxable capital gains. The tax rate depends on the holding period, i.e. for how long you stayed invested in the fund. You make a Short-term Capital Gain (STCG) when you stay invested for a period of fewer than three years.
Long-term Capital Gains (LTCG) are made when you stay invested for over three years. STCG from money market funds are added to your income and taxed according to your income slab. LTCG from money market funds is taxed at the flat rate of 20% after indexation.
(b) What is secondary market of stocks? What is the necessity of secondary market in a financial system? Explain with suitable examples. (8+8=16)
-> A secondary market is a platform wherein the shares of companies are traded among investors. It means that investors can freely buy and sell shares without the intervention of the issuing company. In these transactions among investors, the issuing company does not participate in income generation, and share valuation is rather based on its performance in the market. Income in this market is thus generated via the sale of the shares from one investor to another.
Some of the entities that are functional in a secondary market include –
- Retail investors.
· Advisory service providers and brokers comprising commission brokers and security dealers, among others.
· Financial intermediaries including non-banking financial companies, insurance companies, banks and mutual funds.
Different Instruments in the Secondary Market
The instruments traded in a secondary market consist of fixed income instruments, variable income instruments, and hybrid instruments.
- Fixed income instruments
Fixed income instruments are primarily debt instruments ensuring a regular form of payment such as interests, and the principal is repaid on maturity. Examples of fixed income securities are – debentures, bonds, and preference shares.
Debentures are unsecured debt instruments, i.e., not secured by collateral. Returns generated from debentures are thus dependent on the issuer’s credibility.
As for bonds, they are essentially a contract between two parties, whereby a government or company issues these financial instruments. As investors buy these bonds, it allows the issuing entity to secure a large amount of funds this way. Investors are paid interests at fixed intervals, and the principal is repaid on maturity.
Individuals owning preference shares in a company receive dividends before payment to equity shareholders. If a company faces bankruptcy, preference shareholders have the right to be paid before other shareholders.
- Variable income instruments
Investment in variable income instruments generates an effective rate of return to the investor, and various market factors determine the quantum of such return. These securities expose investors to higher risks as well as higher rewards. Examples of variable income instruments are – equity and derivatives.
Equity shares are instruments that allow a company to raise finance. Also, investors holding equity shares have a claim over net profits of a company along with its assets if it goes into liquidation.
As for derivatives, they are a contractual obligation between two different parties involving pay-off for stipulated performance.
- Hybrid instruments
Two or more different financial instruments are combined to form hybrid instruments. Convertible debentures serve as an example of hybrid instruments.
Convertible debentures are available as a loan or debt securities which may be converted into equity shares after a predetermined period.
Functions of Secondary Market
- A stock exchange provides a platform to investors to enter into a trading transaction of bonds, shares, debentures and such other financial instruments.
· Transactions can be entered into at any time, and the market allows for active trading so that there can be immediate purchase or selling with little variation in price among different transactions. Also, there is continuity in trading, which increases the liquidity of assets that are traded in this market.
· Investors find a proper platform, such as an organised exchange to liquidate the holdings. The securities that they hold can be sold in various stock exchanges.
· A secondary market acts as a medium of determining the pricing of assets in a transaction consistent with the demand and supply. The information about transactions price is within the public domain that enables investors to decide accordingly.
· It is indicative of a nation’s economy as well, and also serves as a link between savings and investment. As in, savings are mobilized via investments by way of securities.
Types of Secondary Market
Secondary markets are primarily of two types – Stock exchanges and over-the-counter markets.
- Stock exchange
Stock exchanges are centralized platforms where securities trading take place, sans any contact between the buyer and the seller. National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are examples of such platforms.
Transactions in stock exchanges are subjected to stringent regulations in securities trading. A stock exchange itself acts as a guarantor, and the counterparty risk is almost non-existent. Such a safety net is obtained via a higher transaction cost being levied on investments in the form of commission and exchange fees.
- Over-the-counter (OTC) market
Over-the-counter markets are decentralized, comprising participants engaging in trading among themselves. OTC markets retain higher counterparty risks in the absence of regulatory oversight, with the parties directly dealing with each other. Foreign exchange market (FOREX) is an example of an over-the-counter market.
In an OTC market, there exists tremendous competition in acquiring higher volume. Due to this factor, the securities’ price differs from one seller to another.
Apart from the stock exchange and OTC market, other types of secondary market include auction market and dealer market.
The former is essentially a platform for buyers and sellers to arrive at an understanding of the rate at which the securities are to be traded. The information related to pricing is put out in the public domain, including the bidding price of the offer.
Dealer market is another type of secondary market in which various dealers indicate prices of specific securities for a transaction. Foreign exchange trade and bonds are traded primarily in a dealer market.
Examples of Secondary Market Transactions
Secondary market transactions provide liquidity to all kinds of investors. Due to high volume transactions, their costs are substantially reduced. Few secondary market examples related to transactions of securities are as follows.
In a secondary market, investors enter into a transaction of securities with other investors, and not the issuer. If an investor wants to buy Larsen & Toubro stocks , it will have to be purchased from another investor who owns such shares and not from L&T directly. The company will thus not be involved in the transaction.
Individual and corporate investors, along with investment banks, engage in the buying and selling of bonds and mutual funds in a secondary market.
Advantages of Secondary Market
· Investors can ease their liquidity problems in a secondary market conveniently. Like, an investor in need of liquid cash can sell the shares held quite easily as a large number of buyers are present in the secondary market.
· The secondary market indicates a benchmark for fair valuation of a particular company.
· Price adjustments of securities in a secondary market takes place within a short span in tune with the availability of new information about the company.
· Investor’s funds remain relatively safe due to heavy regulations governing a secondary stock market. The regulations are stringent as the market is a source of liquidity and capital formation for both investors and companies.
· Mobilisation of savings becomes easier as investors’ money is held in the form of securities.
Disadvantages of Secondary Market
· Prices of securities in a secondary market are subject to high volatility, and such price fluctuation may lead to sudden and unpredictable loss to investors.
· Before buying or selling in a secondary market, investors have to duly complete the procedures involved, which are usually a time-consuming process.
· Investors’ profit margin may experience a dent due to brokerage commissions levied on each transaction of buying or selling of securities.
- Investments in a secondary capital market are subject to high risk due to the influence of multiple external factors, and the existing valuation may alter within a span of a few minutes.
3. (a) Explain briefly the functions of a Merchant Banker in India. (16)
-> In modern terms, a merchant bank is a firm or financial institution that invests equity capital directly in businesses and often provides those businesses with advisory services. A merchant bank offers the same services as an investment bank ; however, it typically services smaller clients and makes direct equity investments in them.
Merchant banks mainly work with small-scale enterprises that are unable to raise funds through an initial public offering (IPO) by providing mezzanine financing , bridge financing, equity financing, and corporate credit products. They also issue and sell securities on behalf of corporations through private placements to refined investors who require less regulatory disclosure.
Large merchant banks place equity privately with other financial institutions by acquiring a considerable share of ownership from companies with a significant potential for high growth rate to seal the gap between venture capital and public stock.
The functions of merchant banking are listed as follows:
1. Raising Finance for Clients: Merchant Banking helps its clients to raise finance through issue of shares, debentures, bank loans, etc. It helps its clients to raise finance from the domestic and international market. This finance is used for starting a new business or project or for modernization or expansion of the business.
2. Broker in Stock Exchange: Merchant bankers act as brokers in the stock exchange. They buy and sell shares on behalf of their clients. They conduct research on equity shares. They also advise their clients about which shares to buy, when to buy, how much to buy and when to sell. Large brokers, Mutual Funds , Venture capital companies and Investment Banks offer merchant banking services.
3. Project Management : Merchant bankers help their clients in the many ways. For e.g. advising about location of a project, preparing a project report, conducting feasibility studies, making a plan for financing the project, finding out sources of finance, advising about concessions and incentives from the government.
4. Advice on Expansion and Modernization: Merchant bankers give advice for expansion and modernization of the business units. They give expert advice on mergers and amalgamations, acquisition and takeovers, diversification of business, foreign collaborations and joint-ventures, technology up-gradation, etc.
5. Managing Public Issue of Companies: Merchant bank advice and manage the public issue of companies. They provide following services:
a. Advise on the timing of the public issue.
b. Advise on the size and price of the issue.
c. Acting as manager to the issue, and helping in accepting applications and allotment of securities.
d. Help in appointing underwriters and brokers to the issue.
e. Listing of shares on the stock exchange, etc.
6. Handling Government Consent for Industrial Projects: A businessman has to get government permission for starting of the project. Similarly, a company requires permission for expansion or modernization activities. For this, many formalities have to be completed. Merchant banks do all this work for their clients.
7. Special Assistance to Small Companies and Entrepreneurs: Merchant banks advise small companies about business opportunities, government policies, incentives and concessions available. It also helps them to take advantage of these opportunities, concessions, etc.
8. Services to Public Sector Units: Merchant banks offer many services to public sector units and public utilities. They help in raising long-term capital, marketing of securities, foreign collaborations and arranging long-term finance from term lending institutions.
9. Revival of Sick Industrial Units: Merchant banks help to revive (cure) sick industrial units. It negotiates with different agencies like banks, term lending institutions, and BIFR (Board for Industrial and Financial Reconstruction). It also plans and executes the full revival package.
10. Portfolio Management : A merchant bank manages the portfolios (investments) of its clients. This makes investments safe, liquid and profitable for the client. It offers expert guidance to its clients for taking investment decisions.
11. Corporate Restructuring: It includes mergers or acquisitions of existing business units, sale of existing unit or disinvestment. This requires proper negotiations, preparation of documents and completion of legal formalities. Merchant bankers offer all these services to their clients.
12. Money Market Operation: Merchant bankers deal with and underwrite short-term money market instruments, such as:
a. Government Bonds.
b. Certificate of deposit issued by banks and financial institutions.
c. Commercial paper issued by large corporate firms.
d. Treasury bills issued by the Government (Here in India by RBI).
13. Leasing Services: Merchant bankers also help in leasing services. Lease is a contract between the lessor and lessee, whereby the lessor allows the use of his specific asset such as equipment by the lessee for a certain period. The lessor charges a fee called rentals.
14. Management of Interest and Dividend: Merchant bankers help their clients in the management of interest on debentures / loans, and dividend on shares. They also advise their client about the timing (interim / yearly) and rate of dividend.
(b) What is a development bank in Indian context? Explain the role of development banks in economic development of India. (8+8=16)
-> A development bank may, thus, be defined as a financial institution concerned with providing all types of financial assistance (medium as well as long-term) to business units, in the form of loans, underwriting, investment and guarantee operations, and promotional activities-economic development in general, and industrial development , in particular. In short, a development bank is a development-oriented bank;
Features of Development Banks:
Following are the main characteristics or features of development banks:
· It is a specialized financial institution, provides medium and long-term finance to business units.
- Unlike commercial banks , it does not accept deposits from the public; It is not just a term-lending institution. It’s a multi-purpose financial institution.
· It is essentially a development-oriented bank. Its primary objective is to promote economic development by promoting investment and entrepreneurial activity in a developing economy. It encourages new and small entrepreneurs and seeks balanced regional growth.
· They provide financial assistance not only to the private sector but also to the public sector undertakings, It aims at promoting the saving and investment habit in the community.
· It does not compete with the normal channels of finance, i.e., finance already made available by the banks and other conventional financial institutions. Its major role is of a gap-filler, i. e., to fill up the deficiencies of the existing financial facilities.
· Its motive is to serve the public interest rather than to make profits. It works in the general interest of the nation.
The Few important functions of development banks in India are as follows:
- They promote and develop small-scale industries (SSI) in India.
- To finance the development of the housing sector in India.
· To facilitate the development of large-scale industries (LSI) in India.
· They help in the development of the agricultural sector and rural India.
- To enhance the foreign trade of India.
- They help to review (cure) sick industrial units.
- To encourage the development of Indian entrepreneurs.
- To promote economic activities in backward regions of the country.
- They contribute to the growth of capital markets.
Now let’s discuss each important function of development banks one by one.
Small Scale Industries (SSI):
Development banks play an important role in the promotion and development of the small-scale sector. The government of India (GOI) started the Small Industries Development Bank of India (SIDBI) to provide medium and long-term loans to Small Scale Industries (SSI) units. SIDBI provides direct project finance and equipment finance to SSI units. It also refinances banks and financial institutions that provide seed capital, equipment finance, etc., to SSI units.
Development of Housing Sector:
Development banks provide finance for the development of the housing sector. GOI started the National Housing Bank (NHB) in 1988.
NHB promotes the housing sector in the following ways:
- It promotes and develops housing and financial institutions.
· It refinances banks and financial institutions that provide credit to the housing sector.
Large Scale Industries (LSI):
The development bank promotes and develops large-scale industries (LSI). Development financial institutions like IDBI, IFCI, etc., provide medium and long-term finance to the corporate sector. They provide merchant banking services , such as preparing project reports, doing feasibility studies, advising on the location of a project, and so on.
Agriculture and Rural Development:
Development banks like the National Bank for Agriculture & Rural Development (NABARD) helps in the development of agriculture. NABARD started in 1982 to provide refinance to banks, which provide credit to the agriculture sector and also for rural development activities. It coordinates the working of all financial institutions that provide credit to agriculture and rural development. It also provides training to agricultural banks and helps to conduct agricultural research.
Enhance Foreign Trade:
Development banks help to promote foreign trade. The government of India started the Export-Import Bank of India (EXIM Bank) in 1982 to provide medium and long-term loans to exporters and importers from India. It provides Overseas Buyers Credit to buy Indian capital goods. Also, encourages abroad banks to provide finance to the buyers in their country to buy capital goods from India.
Review of Sick Units:
Development banks help to revive (cure) sick-units. The government of India (GOI) started the Industrial Investment Bank of India (IIBI) to help sick units. IIBI is the main credit and reconstruction institution for a revival of sick units. It facilitates modernization, restructuring, and diversification of sick-units by providing credit and other services.
Many development banks facilitate entrepreneurship development. NABARD, State Industrial Development Banks, and State Finance Corporations provide training to entrepreneurs in developing leadership and business management skills. They conduct seminars and workshops for the benefit of entrepreneurs.
The development bank facilitates rural and regional development. They provide finance for starting companies in backward areas. Also, they help companies in project management in such less-developed areas.
Contribution to Capital Markets:
The development bank contributes to the growth of capital markets. They invest in equity shares and debentures of various companies listed in India. Also, invest in mutual funds and facilitate the growth of capital markets in India.
4. (a) Write a note on financial instruments in place in Indian financial market. What are the instruments do not have much popularity in Indian financial market? (8+8=16)
-> Money market instruments are short-term financing instruments aiming to increase the financial liquidity of businesses. The main characteristic of these kinds of securities is that they can be converted to cash with ease, thereby preserving the cash requirements of an investor.
The money market and its instruments are usually traded over the counter, and therefore, cannot be done by standalone individual investors themselves. It has to be done through certified brokers, or a money market mutual fund .
There are multiple types of money market instruments available, each of them aiming to boost the total productive capacity and hence, the GDP of the country. It also provides secure returns to the investors looking for low-risk investment opportunities for a short tenure.
The list of money market instruments traded in the money market are:
- Certificate of Deposit
Lending substantial financial resources to an organization can be done against a certificate of deposit. The operating procedure is similar to that of a fixed deposit, except the higher negotiating capacity, as well as lower liquidity of the former.
- Commercial Paper
This type of money market instrument serves as a promissory note generated by a company to raise short term funds. It is unsecured, and thereby can only be used by large-cap companies with renowned market reputation.
The maturity period of these debt instruments lies anywhere between 7 days to one year, and thus, attracts a lower interest rate than equivalent securities sold in the capital market.
- Treasury Bills
These are only issued by the central government of a country when it requires funds to meet its short term obligations.
These securities do not generate interest but allow an investor to make capital gains as it is sold at a discounted rate while the entire face value is paid at the time of maturity.
Treasury bills are an optimal investment tool for novice investors looking for options having minimal risk associated with it. Since treasury bills are backed by the government, the default risk is negligible, thus serving as an optimal investment tool for risk-averse investors.
- Repurchase Agreements
Commonly known as Repo, is a short term borrowing tool where the issuer availing the funds guarantees to repay (repurchase) it in the future.
Repurchase agreements generally involve the trading of government securities. They are subject to market interest rates and are backed by the government.
- Bankers Acceptance
One of the most common money market instruments traded in the financial sector, a banker’s acceptance signifies a loan extended to the stipulated bank, with a signed guarantee of repayment in the future .
Since money market instruments are traded wholesale over the counter, it cannot be purchased in standard units by an individual investor.
However, you can choose to invest in money market instruments through a money market mutual fund.
These are interest-earning open-ended funds and bear significantly low risks due to their short maturity period, and the collateral guarantee of the central government, in most cases.
Money market investments should ideally be undertaken when the stock market poses a great degree of volatility. During this time, investing in equity and debt instruments in the capital market has high risk associated with it, as the chances of underperforming are immense.
The government generally tries to enhance the money circulation in the country to minimize market fluctuations. Thus, government-backed instruments offer higher returns in these circumstances to boost the demand for the same.
(b) Explain the role and functions of NBFCs in India. (16)
-> NBFCs (Non Banking Financial Companies) play an important role in promoting inclusive growth in the country, by catering to the diverse financial needs of bank excluded customers. Further, NBFCs often take lead role in providing innovative financial services to Micro, Small, and Medium Enterprises (MSMEs) most suitable to their business requirements. NBFCs do play a critical role in participating in the development of an economy by providing a fillip to transportation, employment generation, and wealth creation, bank credit in rural segments and to support financially weaker sections of the society. Emergency services like financial assistance and guidance is also provided to the customers in the matters pertaining to insurance.
NBFCs are financial intermediaries engaged in the business of accepting deposits delivering credit and play an important role in channelizing the scarce financial resources to capital formation. They supplement the role of the banking sector in meeting the increasing financial needs of the corporate sector, delivering credit to the unorganized sector and to small local borrowers. However, they do not include services related to agriculture activity, industrial activity, sale, purchase or construction of immovable property. In India, despite being different from banks, NBFC are bound by the Indian banking industry rules and regulations.
NBFC focuses on business related to loans and advances, acquisition of shares, stock, bonds, debentures, securities issued by government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business.
The banking sector would always be the most important sector in the field of business because of its credibility in supporting manufacturing, infrastructural development and even being the backbone for the common man’s money. But despite this, the role of NBFCs is critical and their presence in a country would only boost the economy in the right direction.
Functions Of NBFC
Hire Purchase Services
A hire purchase service is a way through which the seller delivers the goods to the buyer without transferring the ownership of the goods. The payment of the goods is made in instalments. Once the buyer pays all the installments of the goods, the ownership of the good is automatically transferred to the buyer.
Companies that Provides short term funds for Loans against shares, gold, property, primarily for consumption purposes.
Companies dealing in Dealer/distributor finance so that they can for working capital requirements, vendor finance, and other business loans.
This is the largest section where major NBFCs deal in. A lot portion of this segment alone makes up a major portion of funds lent, amongst the different segments. This majority includes Real Estate, railways or Metros, flyovers, ports, airports, etc.
Asset Management Company
Asset managment companies are those companies that consist of fund managers (who invest in equity shares to gain handsome gains) who invest the funds pooled by small investors and actively manage it.
The companies that deal in leasing or for a better understanding of this word we can understand it in such a way that the way we rent a property or flat for living similarly these companies provide property to small businesses or sometimes even larger ones who cannot afford it for whatsoever reason. The only difference between renting and leasing is that leasing contracts are made for a fixed period of time.
Venture Capital Services
The companies that invest in small businesses are at their initial stage but their success rate is high and is promising enough of sufficient return in the coming time.
Micro Small Medium Enterprise (MSME) Financing
MSME is one of the roots of our economy and millions of livelihood depends on this sector that is why the government announced such luring schemes for the MSME sector to promote its growth.
5. (a) What are “put options” and “call options”? Explain with clear examples. (8+8=16)
(b) What is foreign direct investment? How this is very vital for the economic development of a country like India. 8+8=16
-> Foreign direct investment (FDI) occurs when an individual or business owns at least 10% of a foreign company. When investors own less than 10%, the International Monetary Fund (IMF) defines it simply as part of a stock portfolio. Whereas a 10% ownership in a company doesn’t give an individual investor a controlling interest in a foreign company, it does allow influence over the company’s management, operations, and overall policies.
FDI is critical for developing and emerging market countries. Companies in developing countries need multinational funding and expertise to expand, give structure, and guide their international sales. These foreign companies need private investments in infrastructure, energy, and water in order to increase jobs and salaries.
There are various levels of FDI which range based on the type of companies involved and the reasons for the investments. An FDI investor might purchase a company in the targeted country by means of a merger or acquisition, setting up a new venture, or expanding the operations of an existing one. Other forms of FDI include the acquisition of shares in an associated enterprise, the incorporation of a wholly-owned company, and participation in an equity joint venture across international boundaries.
Investors who are planning to engage in any type of FDI might be wise to weigh the investment’s advantages and disadvantages.
Advantages of foreign direct investment:
- Economic growth
The creation of jobs is the most obvious advantage of FDI, one of the most important reasons why a nation (especially a developing one) will look to attract foreign direct investment. FDI boosts the manufacturing and services sector which results in the creation of jobs and helps to reduce unemployment rates in the country. Increased employment translates to higher incomes and equips the population with more buying powers, boosting the overall economy of a country.
- Human capital development
Human capital involved the knowledge and competence of a workforce. Skills that employees gain through training and experience can boost the education and human capital of a specific country. Through a ripple effect, it can train human resources in other sectors and companies.
Targeted countries and businesses receive access to the latest financing tools, technologies, and operational practices from all across the world. The introduction of newer and enhanced technologies results in company’s distribution into the local economy, resulting in enhanced efficiency and effectiveness of the industry.
- Increase in exports
Many goods produced by FDI have global markets, not solely domestic consumption. The creation of 100% export oriented units help to assist FDI investors in boosting exports from other countries.
- Exchange rate stability
The flow of FDI into a country translates into a continuous flow of foreign exchange, helping a country’s Central Bank maintain a prosperous reserve of foreign exchange which results in stable exchange rates.
- Improved Capital Flow
Inflow of capital is particularly beneficial for countries with limited domestic resources, as well as for nations with restricted opportunities to raise funds in global capital markets.
- Creation of a Competitive Market
By facilitating the entry of foreign organizations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies. A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation. Consumers also gain access to a wider range of competitively priced products.
The United Nations has also promoted the use of FDI around the globe to help combat climate change
Disadvantages of foreign direct investment:
- Hindrance of domestic investment
Sometimes FDI can hinder domestic investment. Because of FDI, countries’ local companies start losing interest to invest in their domestic products.
- The risk from political changes
Other countries’ political movements can be changed constantly which could hamper the investors.
- Negative exchange rates
Foreign direct investments can sometimes affect exchange rates to the advantage of one country and the detriment of another.
- Higher costs
When investors invest in foreign counties, they might notice that it is more expensive than when goods are exported. Often times, more money is invested into machinery and intellectual property than in wages for local employees.
- Economic non-viability
Considering that foreign direct investments may be capital-intensive from the point of view of the investor, it can sometimes be very risky or economically non-viable.
Constant political changes can lead to expropriation. In this case, those countries’ governments will have control over investors’ property and assets.
- Modern-day economic colonialism
Many third-world countries, or at least those with history of colonialism, worry that foreign direct investment would result in some kind of modern-day economic colonialism, which exposes host countries and leave them vulnerable to foreign companies’ exploitation.
- Poor performance
Multinationals have been criticized for poor working conditions in foreign factories.
FDI plays an important role in the economic development of a country. The capital inflow of foreign investors allows strengthening infrastructure, increasing productivity and creating employment opportunities in India. Additionally, FDI acts as a medium to acquire advanced technology and mobilize foreign exchange resources. Availability of foreign exchange reserves in the country allows RBI (the central banking institution of India) to intervene in the foreign exchange market and control any adverse movement in order to stabilize the foreign exchange rates. As a result, it provides a more favorable economic environment for the development of Indian economy.
There are various factors that signify the importance of FDI in India some of which are listed below:
1) Helps in Balancing International Payments:
FDI is the major source of foreign exchange inflow in the country. It offers a supreme benefit to country’s external borrowings as the government needs to repay the international debt with the interest over a particular period of time. The inflow of foreign currency in the economy allows the government to generate adequate resources which help to stabilize the BOP (Balance of Payment).
2) FDI boosts development in various fields:
For the development of an economy, it is important to have new technology, proper management and new skills. FDI allows bridging of the technology gap between foreign and domestic firms to boost the scale of production which is beneficial for the betterment of Indian economy. Thus, FDI is also considered an asset to the economy.
3) FDI & Employment:
FDI allows foreign enterprises to establish their business in India. The establishment of these enterprises in the country generates employment opportunities for the people of India. Thus, the government facilitates foreign companies to set up their business entities in the country to empower Indian youth with new and improved skills.
4) FDI encourages export from host country:
Foreign companies carry a broad international marketing network and marketing information which helps in promoting domestic products across the globe. Hence, FDI promotes the export-oriented activities that improve export performance of the country.
Apart from these advantages, FDI helps in creating a competitive environment in the country which leads to higher efficiency and superior products and services.
Government Initiates to Promote FDI
The Indian government has initiated steps to promote FDI as they set an investor-friendly policy where most of the sectors are open for FDI under the automatic route (meaning no need to take prior approval for investment by the Government or the Reserve Bank of India). The FDI policy is reviewed on a continuous basis with the purpose that India remains an investor-friendly and attractive FDI destination. FDI covers various sectors such as Defense, Pharmaceuticals, Asset Reconstruction Companies, Broadcasting, Trading, Civil Aviation, Construction and Retail, etc.
In the Union Budget 2018, the cabinet approved 100% FDI under the automatic route for single-brand retail trading. Under this change, the non-resident entity is permitted to commence retail trading of ‘single brand’ product in India for a particular brand. Additionally, the Indian government has also permitted 100% FDI for construction sector under the automatic route. Foreign airlines are permitted to invest up to 49% under the approval route in Air India.
The main purpose of these relaxations in foreign investment by the government is to bring international best practices and employee the latest technologies which propel manufacturing sector and employment generation in India. To boost manufacturing sector with a focus on ‘Make in India’ initiative, the government has allowed manufacturers to sell their products through the medium of wholesale and retail, including e-commerce under the automatic route.