2017
COMMERCE
Paper: 205
(Indian Financial System)
Full Marks: 80
The figures in the margin indicate full marks for the questions.
1(a) Explain the meaning of Financial System. Discuss the components of a formal financial system. (6+10=16)
-> The financial system consisting of a variety of institution, markets, and the instruments which are related in a systematic manner and provide the principal means by which savings are transformed into instruments.
Significance of the Financial System:
1. To attain economic development, financial systems are important since they induce people to save by offering attractive interest rates. These savings are then channelized by lending to various business concerns which are involved in production and distribution.
2. It helps in monitor corporate performance
3. It links savers and investors. This process is known as capital formation
4. It helps in lowering the transaction cost and increase returns which will motivate people to save more
5. It helps the government in deciding monetary policy
Five Basic Components of Financial System
- Financial Institutions
- Financial Markets
· Financial Instruments (Assets or Securities)
- Financial Services
- Money
Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and borrowers meet. They mobilize the savings of investors either directly or indirectly via financial markets, by making use of different financial instruments as well as in the process using the services of numerous financial services providers.
They could be categorized into Regulatory, Intermediaries, Non-intermediaries and Others. They offer services to organizations looking for advises on different problems including restructuring to diversification strategies. They offer complete array of services to the organizations who want to raise funds from the markets and take care of financial assets for example deposits, securities, loans, etc.
Financial Markets
A financial market is the place where financial assets are created or transferred. It can be broadly categorized into money markets and capital markets. Money market handles short-term financial assets (less than a year) whereas capital markets take care of those financial assets that have maturity period of more than a year. The key functions are:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
One more classification is possible: primary markets and secondary markets. Primary markets handle new issue of securities in contrast secondary markets take care of securities that are presently available in the stock market.
Financial markets catch the attention of investors and make it possible for companies to finance their operations and attain growth. Money markets make it possible for businesses to gain access to funds on a short term basis, while capital markets allow businesses to gain long-term funding to aid expansion. Without financial markets, borrowers would have problems finding lenders. Intermediaries like banks assist in this procedure. Banks take deposits from investors and lend money from this pool of deposited money to people who need loan. Banks commonly provide money in the form of loans.
Financial Instruments
This is an important component of financial system. The products which are traded in a financial market are financial assets, securities or other type of financial instruments. There is a wide range of securities in the markets since the needs of investors and credit seekers are different. They indicate a claim on the settlement of principal down the road or payment of a regular amount by means of interest or dividend. Equity shares, debentures, bonds, etc are some examples.
Financial Services
Financial services consist of services provided by Asset Management and Liability Management Companies. They help to get the necessary funds and also make sure that they are efficiently deployed. They assist to determine the financing combination and extend their professional services upto the stage of servicing of lenders. They help with borrowing, selling and purchasing securities, lending and investing, making and allowing payments and settlements and taking care of risk exposures in financial markets. These range from the leasing companies, mutual fund houses, merchant bankers, portfolio managers, bill discounting and acceptance houses.
The financial services sector offers a number of professional services like credit rating, venture capital financing, mutual funds, merchant banking, depository services, book building, etc. Financial institutions and financial markets help in the working of the financial system by means of financial instruments. To be able to carry out the jobs given, they need several services of financial nature. Therefore, financial services are considered as the 4th major component of the financial system.
Money
Money is understood to be anything that is accepted for payment of products and services or for the repayment of debt. It is a medium of exchange and acts as a store of value.
(b) How the financial system of a country can contribute to the economic development of a country? Briefly explain.
-> Roles Performed by Financial Institution
Financial institutions play a pivotal role in every economy. They are regulated by a central government organization for banking and non-banking financial institutions. These institutions help in bridging the gap between idle savings and investment and its borrowers, i.e., from net savers to net borrowers.
Following are the list of roles performed by Financial Institutions –
1. Regulation of Monetary Supply
2. Banking Services
3. Insurance Services
4. Capital Formation
5. Investment Advice
6. Brokerage services
7. Pension Fund Services
8. Trust Fund Services
9. Financing the Small and Medium Scale Enterprises
10. Act as A Government Agent for Economic Growth
Let us discuss each one of them in detail –
1 – Regulation of Monetary Supply
Financial institutions like the central bank help in regulating the money supply in the economy. They do it to maintain stability and control inflation. The central bank applies various measures like increasing or decreasing repo rate, cash reserve ratio , open market operations , i.e., buying and selling government securities to regulate liquidity in the economy.
2 – Banking Services
Financial institutions, like commercial banks , help their customers by providing savings and deposit services. They provide credit facilities like overdraft facilities to the customers for catering to the need for short-term funds. Commercial banks also extend several kinds of loans like personal loans, education loans, mortgage or home loans to their customers.
3 – Insurance Services
Financial institutions, like insurance companies, help to mobilize savings and investment in productive activities. In return, they provide assurance to investors against their life or some particular asset at the time of need. In other words, they transfer their customer’s risk of loss to themselves.
4 – Capital Formation
Financial institutions help in capital formation, i.e., increase in capital stock like the plant, machinery, tools and equipment, buildings, means of transport and communication, etc. They do so by mobilizing the idle savings from individuals in the economy to the investor through various monetary services.
5 – Investment Advice
There are a number of investment options available at the disposal of individuals as well as businesses. But in the current swift changing environment, it is very difficult to choose the best option. Almost all financial institutions (banking or non-banking) have an investment advisory desk that helps customers, investors, businesses to choose the best investment option available in the market according to their risk appetite and other factors.
6 – Brokerage services
These institutions provide their investors access to a number of investment options available in the market that ranges from stock, bonds (common investment alternative) to hedge funds , and private equity investment (lesser-known alternative).
7 – Pension Fund Services
Financial institutions, through their various kinds of investment plans, help the individual in planning their retirement. One such investment options is a pension fund, where the individual contributes to the pool of investment set up by employers, banks, or other organizations and get the lump sum or monthly income after retirement.
8 – Trust Fund Services
Some financial organization provides trust fund services to their clients. They manage the client’s assets, invest them in the best option available in the market, and take care of its safekeeping as well.
9 – Financing the Small and Medium Scale Enterprises
Financial institutions help small and medium scale enterprises set up themselves in their initial days of business. They provide long-term as well as short-term funds to these companies. The long-term fund helps them in the formation of capital, and short-term funds fulfill their day to day needs of working capital.
10 – Act as a Government Agent for Economic Growth
Financial institutions are regulated by the government on a national level. They act as a government agent and help in the growth of the nation’s economy as a whole. For example, to help out an ailing sector, financial institutions, as per the guidelines from the government, issue selective credit line with lower interest rates to help the sector overcome the issues it is facing.
2(a) Discuss the characteristics and functions of Indian Money Market. (8+8=16)
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.
Functions of the Money Market
The money market contributes to the economic stability and development of a country by providing short-term liquidity to governments, commercial banks, and other large organizations. Investors with excess money that they do not need can invest it in the money market and earn interest.
Here are the main functions of the money market:
1. Financing Trade
The money market provides financing to local and international traders who are in urgent need of short-term funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services.
International traders benefit from the acceptance houses and discount markets. The money market also makes funds available for other units of the economy, such as agriculture and small-scale industries.
2. Central Bank Policies
The central bank is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform its policy-making function efficiently.
For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Also, the integrated money markets help the central bank to influence the sub-markets and implement its monetary policy objectives.
3. Growth of Industries
The money market provides an easy avenue where businesses can obtain short-term loans to finance their working capital needs. Due to the large volume of transactions, businesses may experience cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses.
Through commercial paper and finance bills, they can easily borrow money on a short-term basis. Although money markets do not provide long-term loans, it influences the capital market and can also help businesses obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market.
4. Commercial Banks Self-Sufficiency
The money market provides commercial banks with a ready market where they can invest their excess reserves and earn interest while maintaining liquidity. Short-term investments, such as bills of exchange, can easily be converted to cash to support customer withdrawals.
Also, when faced with liquidity problems, they can borrow from the money market on a short-term basis as an alternative to borrowing from the central bank. The advantage of this is that the money market may charge lower interest rates on short-term loans than the central bank typically does.
(b) What is Primary Capital Market? Discuss the reform measures undertaken in regard to the Primary Capital Market in India. (6+10=16)
-> When a company publicly sells new stocks and bonds for the first time, it does so in the primary capital market. This market is also called the new issues market. In many cases, the new issue takes the form of an initial public offering (IPO). When investors purchase securities on the primary capital market, the company that offers the securities hires an underwriting firm to review it and create a prospectus outlining the price and other details of the securities to be issued.
All issues on the primary market are subject to strict regulation. Companies must file statements with the Securities and Exchange Commission (SEC) and other securities agencies and must wait until their filings are approved before they can go public.
Companies that issue securities through the primary capital market may hire investment bankers to obtain commitments from large institutional investors to purchase the securities when first offered. Small investors are often unable to buy securities at this point because the company and its investment bankers want to sell all of the available securities in a short period of time to meet the required volume, and they must focus on marketing the sale to large investors who can buy more securities at once. Marketing the sale to investors can often include a road show or dog and pony show , in which investment bankers and the company’s leadership travel to meet with potential investors and convince them of the value of the security being issued.
Prices are often volatile in the primary market because demand is often hard to predict when a security is first issued. That’s why a lot of IPOs are set at low prices.
A company can raise more equity in the primary market after entering the secondary market through a rights offering. The company will offer prorated rights based on shares investors already own. Another option is a private placement, where a company may sell directly to a large investor, such as a hedge fund or a bank. In this case, the shares are not made public.
In a primary market, companies, governments or public sector institutions can raise funds through bond issues and corporations can raise capital through the sale of new stock through an initial public offering (IPO). This is often done through an investment bank or finance syndicate of securities dealers. The process of selling new shares to investors is called underwriting . Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus . [1]
IPOs are not the only way new shares are issued. Publicly traded companies can issue new shares in what is called a primary issue of debt or stock, which involves the issue by a corporation of its own debt or new stock directly to institutional investors like pension funds , or to private investors and shareholders. [3] [4]
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 play 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 such as a stock exchange , bond market or derivatives exchange . [1]
Raising Funds
Corporate entities raise funds from the primary market in three ways: [2]
1. Public Issue – a stock exchange lists the securities and the corporation raises funds through initial public offering (IPO).
2. Rights Issue – existing shareholders are offered more shares at a discounted price and on a pro-rata basis.
3. Preferential Allotment – corporate issues shares at a price which may or may not be related to the current market price of the same security.
The five measures are: (1) Establishment of SEBI, (2) Setting up of Private Mutual Funds, (3) Opening up to Foreign Capital, (4) Access to International Capital Markets, and (5) Banks and Capital Markets.
1. Establishment of SEBI:
An important measure regarding capital market reforms is the setting up of Securities and Exchange Board of India (SEBI) as the regulator of equity market in India.
2. Setting up of Private Mutual Funds:
Another important reform is the permission granted to the private sector firms to start Mutual Funds. Many private sector companies such as Tata, Reliance, Birla have set up their mutual funds through which they raise money from the public. In this way monopoly position of UTI in Mutual Fund business has come to end. Mutual Funds raise money by selling units to the public and the funds so raised are invested in a number of equities and debentures of companies.
A mutual fund may be entirely equity-based or debt-based or a balanced one having a particular combination of investment in equities and debentures of a number of companies. Investment in mutual funds enables the investors to reduce risk. Mutual funds have also been allowed to open offshore funds to invest in equities abroad. UTI has also been brought within the regulatory framework of SEBI.
3. Opening up to Foreign Capital:
A significant reform has been that Indian capital market has been opened up for foreign institutional institutions (FII). That is, FII can now buy shares and debentures of private Indian companies in the Indian stock market and can also invest in government securities. This has been done to attract foreign capital. Foreign Institutional Investors (FII) have been permitted full capital convertibility
4. Access to International Capital Markets:
The Indian corporate sector has been allowed to raise funds in the international capital markets through American Depository Receipts (ADRs), Global Depository Receipts (GDR), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs). Similarly, Overseas Corporate Bodies (OCBs) and Non-resident Indians have been allowed to invest in the equity capital of the Indian companies. FIIs have been allowed to invest in equities of private corporate Indian companies as well as in Government securities.
5. Banks and Capital Markets:
Another important step to strengthen the Indian capital market is that banks have been allowed to lend against various capital market instruments such as corporate shares and debentures to individuals, investment companies, trusts and endowment share and stock brokers, industrial and corporate buyers and SEBI-approved market makers.
Lending by banks against various capital market instruments to individuals, share and stock brokers, and market makers is made in accordance with certain norms regarding purpose, capital adequacy, transparent transactions, maximum possible amount or ceiling, or duration of the loan. Bank lending against shares and debentures, according to C. Rangarajan, will “enable partial liquidity to scrip’s, to help reduce volatility in price movement, encourage the presence of market makers so as to reduce market concentration and help in widening and deepening of trading in the secondary market.”
3(a) Discuss in brief about banking sector reforms in India during the economic liberalization. (16)
-> Banking is an ancient business in India with some of oldest
references in the writings of Manu. Bankers played an important role during
the Mogul period. During the early part of the East India Company era,
agency houses were involved in banking. Modern banking (i.e. in the form of
joint-stock companies) may be said to have had its beginnings in India as
far back as in 1786, with the establishment of the General Bank of India.
Three Presidency Banks were established in Bengal, Bombay and Madras in the
early 19th century. These banks functioned independently for about a
century before they were merged into the newly formed Imperial Bank of
India in 1921. The Imperial Bank was the forerunner of the present State
Bank of India. The latter was established under the State Bank of India Act
of 1955 and took over the Imperial Bank.
The Swadeshi movement witnessed the birth of several indigenous banks
including the Punjab National Bank, Bank of Baroda and Canara Bank. In
1935, the Reserve Bank of India was
established under the Reserve Bank of India Act as the central bank of
India. In spite of all these developments, independent India inherited a
rather weak banking and financial system marked by a multitude of small and
unstable private banks whose failures frequently robbed their middle-class
depositors of their life’s savings. After independence, the Reserve Bank of
India was nationalized in 1949 and given wide powers in the area of bank
supervision through the Banking Companies Act (later renamed Banking
Regulations Act). The nationalization of the Imperial bank through the
formation of the State Bank of India and the subsequent acquisition of the
state owned banks in eight princely states by the State Bank of India in
1959 made the government the dominant player in the banking industry. In
keeping with the increasingly socialistic leanings of the Indian
government, 14 major private banks, each with deposits exceeding Rs. 50
crores, were nationalized in 1969. This raised the proportion of scheduled
bank branches in government control from 31% to about 84%. In 1980, six
more private banks each with deposits exceeding Rs 200 crores , were
privatized further raising the proportion of government controlled bank
branches to about 90%. As in other areas of economic policy-making, the
emphasis on government control began to weaken and even reverse in the
mid-80s and liberalization set in firmly in the early 90’s. The poor
performance of the public sector banks, which accounted for about 90% of
all commercial banking, was rapidly becoming an area of concern. The
continuous escalation in non-performing assets (NPAs) in the portfolio of
banks posed a significant threat to the very stability of the financial
system. Banking reforms, therefore, became an integral part of the
liberalization agenda.
The first Narasimham Committee set the stage for financial and bank reforms
in India. Interest rates, previously fixed by the Reserve Bank of India,
were liberalized in the 90’s and directed lending through the use of
instruments of the Statutory Liquidity Ratio was reduced. While several
committees have looked into the ailments of commercial banking in India,
but major work has been done according to the Narsimham committee reports.
– the Narasimham committee I (1992) and II (1998)
Liberalization
Liberalization (or liberalization) refers to a relaxation of previous
government restrictions, usually in areas of social or economic policy. In
some contexts this process or concept is often, but not always, referred to
as deregulation. In the arena of social policy it may refer to a relaxation
of laws restricting. Most often, the term is used to refer to economic
liberalization, especially trade liberalization or capital market
liberalization.
Liberalization in Indian Banking Sector-
Liberalization in Indian banking sector was begun since 1992, following the
Narsimham Committee Report (December 1991). The 1991 report of the
Narasimham Committee served as the basis for the initial banking sector
reforms .In the following years, reforms covered the areas of interest rate
deregulation, directed credit rules, statutory pre-emptions and entry
deregulation for both domestic and foreign banks. The objective of banking
sector reforms was in line with the overall goals of the 1991 economic
reforms of opening the economy, giving a greater role to markets in setting
prices and allocating resources, and increasing the role of the private
sector. The Narsimhan Committee was first set up in 1991 under the
chairmanship of Mr. M. Narasimham who was 13th governor of RBI. Only a few
of its recommendations became banking reforms of India and others were not
at all considered. Because of this a second committee was again set up in
1998.As far as recommendations regarding bank restructuring, management
freedom, strengthening the regulation are concerned, the RBI has to play a
major role. If the major recommendations of this committee are accepted, it
will prove to be fruitful in making Indian banks more profitable and
efficient.
Problems Identified By the Narasimham Committee
1. Directed Investment Program: The committee objected to
the system of maintaining high liquid assets by commercial banks in the
form of cash, gold and unencumbered government securities. It is also known
as the Statutory Liquidity Ratio (SLR). In those days, in India, the SLR
was as high as 38.5 percent. According to the M. Narasimham’s Committee it
was one of the reasons for the poor profitability of banks. Similarly, the
Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks
needed to maintain 53.5 percent of their resources idle with the RBI.
2. Directed Credit Program : Since nationalization the
government has encouraged the lending to agriculture and small-scale
industries at a confessional rate of interest. It is known as the directed
credit programme. The committee opined that these sectors have matured and
thus do not need such financial support. This directed credit programme was
successful from the government’s point of view but it affected commercial
banks in a bad manner. Basically it deteriorated the quality of loan,
resulted in a shift from the security oriented loan to purpose oriented.
Banks were given a huge target of priority sector lending, etc. ultimately
leading to profit erosion of banks.
3. Interest Rate Structure: The committee found that the
interest rate structure and rate of interest in India are highly regulated
and controlled by the government. They also found that government used bank
funds at a cheap rate under the SLR. At the same time the government
advocated the philosophy of subsidized lending to certain sectors. The
committee felt that there was no need for interest subsidy. It made banks
handicapped in terms of building main strength and expanding credit supply.
4. Additional Suggestions: Committee also suggested that
the determination of interest rate should be on grounds of market forces.
It further suggested minimizing the slabs of interest.
Along with these major problem areas M. Narasimham’s Committee also found
various inconsistencies regarding the banking system in India.
Narasimham Committee Report I – 1991
The Narsimham Committee was set up in order to study the problems of the
Indian financial system and to suggest some recommendations for improvement
in the efficiency and productivity of the financial institution.
The committee has given the following major recommendations:-
1.
Reduction in the SLR (Statutory Liquidity Ratio) and CRR (Cash Reserve
Ratio)
: The committee recommended the reduction of the higher proportion of the
Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR). Both of
these ratios were very high at that time. The SLR then was 38.5% and CRR
was 15%. This high amount of SLR and CRR meant locking the bank resources
for government uses. It was hindrance in the productivity of the bank thus
the committee recommended their gradual reduction. SLR was recommended to
reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.
2. Phasing out Directed Credit Programme: In India, since
nationalization, directed credit programmes were adopted by the government.
The committee recommended phasing out of this programme. This programme
compelled banks to earmark then financial resources for the needy and poor
sectors at confessional rates of interest. It was reducing the
profitability of banks and thus the committee recommended the stopping of
this programme.
3. Interest Rate Determination: The committee felt that
the interest rates in India are regulated and controlled by the
authorities. The determination of the interest rate should be on the
grounds of market forces such as the demand for and the supply of fund.
Hence the committee recommended eliminating government controls on interest
rate and phasing out the concessional interest rates for the priority
sector.
4. Structural Reorganizations of the Banking sector: The
committee recommended that the actual numbers of public sector banks need
to be reduced. Three to four big banks including SBI should be developed as
International banks. Eight to Ten Banks having nationwide presence should
concentrate on the national and universal banking services. Local banks
should concentrate on region specific banking. Regarding the RRBs (Regional
Rural Banks), it recommended that they should focus on agriculture and
rural financing. They recommended that the government should assure that
henceforth there won’t be any nationalization and private and foreign banks
should be allowed liberal entry in India.
5. Establishment of the ARF Tribunal: The proportion of
bad debts and Non-performing asset (NPA) of the public sector Banks and
Development Financial Institute was very alarming in those days. The
committee recommended the establishment of an Asset Reconstruction Fund
(ARF). This fund will take over the proportion of the bad and doubtful
debts from the banks and financial institutes. It would help banks to get
rid of bad debts.
6. Removal of Dual control: Those days banks were under
the dual control of the Reserve Bank of India (RBI) and the Banking
Division of the Ministry of Finance (Government of India). The committee
recommended the stepping of this system. It considered and recommended that
the RBI should be the only main agency to regulate banking in India.
7. Banking Autonomy: The committee recommended that the
public sector banks should be free and autonomous. In order to pursue
competitiveness and efficiency, banks must enjoy autonomy so that they can
reform the work culture and banking technology upgradation will thus be
easy.
Some of these recommendations were later accepted by the Government of
India and became banking reforms.
Narasimham Committee Report II – 1998
In 1998 the government appointed yet another committee under the
chairmanship of Mr. Narsimham. It is better known as the Banking Sector
Committee. It was told to review the banking reform progress and design a
programme for further strengthening the financial system of India. The
committee focused on various areas such as capital adequacy, bank mergers,
bank legislation, etc.
It submitted its report to the Government in April 1998 with the following
recommendations.
1. Strengthening Banks in India: The committee considered
the stronger banking system in the context of the Current Account
Convertibility (CAC). It thought that Indian banks must be capable of
handling problems regarding domestic liquidity and exchange rate management
in the light of CAC. Thus, it recommended the merger of strong banks which
will have ‘multiplier effect’ on the industry.
2. Narrow Banking: Those days many public sector banks
were facing a problem of the Non-performing assets (NPAs). Some of them had
NPAs were as high as 20 percent of their assets. Thus for successful
rehabilitation of these banks it recommended ‘Narrow Banking Concept’ where
weak banks will be allowed to place their funds only in short term and risk
free assets.
3. Capital Adequacy Ratio: In order to improve the
inherent strength of the Indian banking system the committee recommended
that the Government should raise the prescribed capital adequacy norms.
This will further improve their absorption capacity also. Currently the
capital adequacy ration for Indian banks is at 9 percent.
4. Bank ownership: As it had earlier mentioned the freedom
for banks in its working and bank autonomy, it felt that the government
control over the banks in the form of management and ownership and bank
autonomy does not go hand in hand and thus it recommended a review of
functions of boards and enabled them to adopt professional corporate
strategy.
5. Review of banking laws: The committee considered that
there was an urgent need for reviewing and amending main laws governing
Indian Banking Industry like RBI Act, Banking Regulation Act, State Bank of
India Act, Bank Nationalisation Act, etc. This upgradation will bring them
in line with the present needs of the banking sector in India.
Apart from these major recommendations, the committee has also recommended
faster computerization, technology upgradation, training of staff,
depoliticizing of banks, professionalism in banking, reviewing bank
recruitment, etc.
Changes due to the recommendations made by the Narsimham committee are-
1. Statutory pre-emptions: The degree of financial repression in the Indian
banking sector was significantly reduced with the lowering of the CRR and
SLR, which were regarded as one of the main causes of the low profitability
and high interest rate spreads in the banking system. During the 1960s and
1970s the CRR was around 5%, but until 1991 it increased to its maximum
legal limit of 15%.The reduction of the CRR and SLR resulted in increase
flexibility for banks in determining both the volume and terms of lending.
2. Priority sector lending: Besides the high level of statutory
pre-emptions, the priority sector advances were identified as one of the
major reasons for the below average profitability of Indian banks. The
Narasimham Committee therefore recommended a reduction from 40% to 10%.
However, this recommendation has not been implemented and the targets of
40% of net bank credit for domestic banks and 32% for foreign banks have
remained the same.
3. Interest rate liberalization: Prior to the reforms, interest rates were
a tool of cross-subsidization between different sectors of the economy. To
achieve this objective, the interest rate structure had grown increasingly
complex with both lending and deposit rates set by the RBI. The
deregulation of interest rates was a major component of the banking sector
reforms that aimed at promoting financial savings and growth of the
organized financial system. The lending rate for loans in excess of Rs200,
000 that account for over 90% of total advances was abolished in October
1994. Banks were at the same time required to announce a prime lending rate
(PLR) which according to RBI guidelines had to take the cost of funds and
transaction costs into account.
4. Entry barriers: Before the start of the 1991 reforms, there was little
effective competition in the Indian banking system for at least two
reasons. First, the detailed prescriptions of the RBI concerning for
example the setting of interest rates left the banks with limited degrees
of freedom to differentiate themselves in the marketplace. Second, India
had strict entry restrictions for new banks, which effectively shielded the
incumbents from competition. Through the lowering of entry barriers,
competition has significantly increased since the beginning of the1990s.
Seven new private banks entered the market between 1994 and 2000. In
addition, over 20 foreign banks started operations in India since 1994. By
March 2004, the new private sector banks and the foreign banks had a
combined share of almost 20% of total assets. Deregulating entry
requirements and setting up new bank operations has benefited the Indian
banking system from improved technology, specialized skills, better risk
management practices and greater portfolio diversification..
5. Prudential norms: The report of the Narasimham Committee was the basis
for the strengthening of prudential norms and the supervisory framework.
Starting with the guidelines on income recognition, asset classification,
provisioning and capital adequacy the RBI issued in 1992/93, there have
been continuous efforts to enhance the transparency and accountability of
the banking sector. The improvements of the prudential and supervisory
framework were accompanied by a paradigm shift from micro-regulation of the
banking sector to a strategy of macro-management .
6. Public Sector Banks: At the end of the 1980s, operational and allocative
inefficiencies caused by the distorted market mechanism led to a
deterioration of Public Sector Banks’ profitability. Enhancing the
profitability of PSBs became necessary to ensure the stability of the
financial system. The restructuring measures for PSBs were threefold and
included recapitalization, debt recovery and partial privatization.
Despite the suggestion of the Narasimham Committee to rationalize PSBs, the
Government of India decided against liquidation, which would have involved
significant losses accruing to either the government or depositors. It
opted instead to maintain and improve operations to allow banks to create a
good starting basis before a possible privatization.
(b) What is Development Bank? Discuss the role and functions of Development Banks in India. (6+10=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.
Entrepreneurship Development:
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.
Regional Development:
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) Compare the relative advantages and disadvantages of equity shares and preference shares. Which one will you prefer for your portfolio? Give reasons. (8+8=16)
-> EQUITY SHARE-
Equity shares were earlier known as ordinary shares. The holders of these shares are the real owners of the company. They have a voting right in the meetings of holders of the company. They have a control over the working of the company. Equity shareholders are paid dividend after paying it to the preference shareholders.
The rate of dividend on these shares depends upon the profits of the company. They may be paid a higher rate of dividend or they may not get anything. These shareholders take more risk as compared to preference shareholders.
Equity capital is paid after meeting all other claims including that of preference shareholders. They take risk both regarding dividend and return of capital. Equity share capital cannot be redeemed during the life time of the company.
Advantages of Equity Shares:
1. Equity shares do not create any obligation to pay a fixed rate of dividend.
2. Equity shares can be issued without creating any charge over the assets of the company.
3. It is a permanent source of capital and the company has to repay it except under liquidation.
4. Equity shareholders are the real owners of the company who have the voting rights.
5. In case of profits, equity shareholders are the real gainers by way of increased dividends and appreciation in the value of shares.
Disadvantages of Equity Shares:
1. If only equity shares are issued, the company cannot take the advantage of trading on equity.
2. As equity capital cannot be redeemed, there is a danger of over capitalisation.
3. Equity shareholders can put obstacles for management by manipulation and organising themselves.
4. During prosperous periods higher dividends have to be paid leading to increase in the value of shares in the market and it leads to speculation.
5. Investors who desire to invest in safe securities with a fixed income have no attraction for such shares.
Preference shares are hybrid financing instruments having several benefits and disadvantages of using them as a source of capital. Benefits are in the form of an absence of a legal obligation to pay the dividend, improves borrowing capacity, saves dilution in control of existing shareholders and no charge on assets. The major disadvantage is that it is a costly source of finance and has preferential rights everywhere.
PREFERENCE SHARE-
Preference shares are used by big corporate as a long-term source of funding their projects. They are known as hybrid financing instruments because they share attributes of both equity and debt. It is important to analyze the benefits and disadvantages affixed with using preference shares as a medium of financing.
Advantages of Preference Share:-
No Legal Obligation for Dividend Payment
There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances.
Improves Borrowing Capacity
Preference shares become a part of net worth and therefore reduces debt to equity ratio . This is how the overall borrowing capacity of the company increases.
No dilution in control
Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.
No Charge on Assets
While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore, the company gets the required money and the assets also remain free of any kind of charge on them.
DISADVANTAGES OF PREFERENCE SHARES:-
Costly Source of Finance
Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on the debt is a tax-deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example, the dividend on preference share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%.
Skipping Dividend Disregard Market Image
Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk.
Preference in Claims
Preference shareholders enjoy a similar situation like that of an equity shareholder but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation .
(b) Discuss in brief about the various sources of short term services of finance available in our country. (16)
-> Short-term financing may be defined as the credit or loan facility extended to an enterprise for a period of less than one year.
It is a credit arrangement provided to an enterprise to bridge the gap between income and expenses in the short run. It helps the enterprise to manage its current liabilities, such as payment of salaries and wages to labors and procurement of raw materials and inventory.
The availability of short-term funds ensures the sufficient liquidity in the enterprise. It facilitates the smooth functioning of the enterprise’s day-to-day activities.
The various short-term sources of finance are as follows:
Source 1- Trade Credit:
Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. It occupies a very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no business. Trade credit is a spontaneous source of finance that arises in the normal business transactions without specific negotiation, (automatic source of finance).
In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice.
As such trade credit constitutes a very important source of finance, represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements.
Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit. Building confidence in suppliers is possible only when the buyer discusses his/her financial condition, future plans and payment record. Trade credit involves some benefits and costs.
The main advantages are:
(i) Easy availability when compared to other sources of finance (except financially weak companies)
(ii) Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.
(iii) Informality as stated in the above that it is an automatic finance.
Costs of Trade Credit:
The above discussion on trade credit reveals two things:
(i) Cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment.
(ii) If the company is not able to avail cash discount it should pay only at the end of the last day of credit period, even it can delay one or two days if it does not affect the credit standing.
Source 2- Accruals:
Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly base, respectively.
The amounts of salaries and wages are owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of the financial year. The longer the time lag in–payment of these expenses, the greater is the amount of funds provided by the employees. Similarly, interest and tax are accruals, as source of short-term finance. Tax will be paid on earnings.
Income-tax is paid to the government, on quarterly basis and some other taxes may be payable half- yearly or annually. Amount of taxes due as on the date of the balance sheet but not paid till then are shown as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short-term finance but shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.
But in actual terms it may not be true, since payment of salaries and wages is determined by provisions of law and industry practice. Similarly, tax payment is governed by laws and delay in payment of tax leads to penalty. Hence, a firm must note that use of accruals as a source of working capital paying may not be possible.
Source 3- Deferred Income:
Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.
Advance payment can be demanded by firms which are having monopoly power, great demand for its products and services and if the firm is manufacturing a special product on a special order.
Source 4- Commercial Papers (CPs):
Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on Money Market. CP is a source of short-term finance to only large firms with sound financial position.
1. The maturity period of CP ranges from 15 to 365 days (but in India it ranges between 91 to 180 days).
2. It is sold at a discount from its face value and redeemed at its face value.
3. Return on CP is the difference between par value and redeemable value.
4. It may be sold directly to investors or indirectly through dealers.
5. There is no developed secondary market for CP.
Source 5- Public Deposits:
Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.
Fixed deposits accepted by companies are governed by the Companies (Acceptance of Deposits) Amendment Rules, 1978.
The main features of this regulation are:
1. A firm cannot issue public deposits for more than 25 per cent of its share capital and free reserves.
2. The public deposits can be issued for a period ranging from a minimum 6 months to maximum 3 years, only for an amount up to 10% of the company’s share capital and free reserves. Maximum period of 5 years allowed for non-banking financial corporation (NBFC’s).
3. The company that has raised funds by way of issue of public deposits is required to set aside, a deposit and/or investment, by the 30th April each year an amount equal to 10 per cent of the maturity deposits by the 31st March of the next year. The amount, so set aside can be used only for repaying the amount of deposits.
4. Finally, and importantly, a company soliciting and accepting the public deposits from the public is required to disclose true, fair, vital and relevant facts in regard to its financial position and performance.
Source 6- Inter-Corporate Deposits (ICDs):
A deposit made by one firm with another firm is known as Inter-Corporate Deposit (ICD). Generally, these deposits are made for a period up to six months.
Such deposits may be of three types:
(a) Call Deposits:
These deposits are those expected to be payable on call/on just one day notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter-corporate deposits generally have 12 per cent interest per annum.
(b) Three Months Deposits:
These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for meeting short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum.
(c) Six months Deposits:
Inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to ‘A’ category borrowers only and they carry an interest rate of around 16 per cent per annum.
i. There are no legal regulations, which make an ICD transaction very convenient.
ii. Inter-corporate deposits are given and taken in secrecy.
iii. Inter-corporate deposits are given based on if the borrower is financial sound, but in practice lender lends money based on personal contacts.
Source 7- Commercial Banks:
Commercial banks are the major source of working capital finance to industries and commerce. Granting loan to business is one of their primary functions. Getting bank loan is not an easy task since the lending bank may ask a number of questions about the prospective borrower’s financial position and its plans for the future.
At the same time the bank will want to monitor borrower’s business progress. But there is a good side to this that is borrower’s share price tends to rise, because investor knows that convincing banks is very difficult.
Forms of Bank Finance:
Banks provide different types of tailor- made loans that are suitable for specific needs of a firm.
The different types or forms of loans are:
(i) Loans,
(ii) Overdrafts,
(iii) Cash credits,
(iv) Purchase or discounting of bills and
(v) Letter of Credit.
(i) Loans:
Loan is an advance lump sum given to the borrower against some security. Loan is given to the applicant in the form of cash or by credit to his/her account. In practice the loan amount is paid to the customer by crediting his/her account. Interest will be charged on the entire loan amount from the date the loan is sanctioned.
Borrower can repay the loan either in lump sum or in installments depending on conditions. If the loan is repayable in installment basis interest will be calculated on quarterly and on reduced balances. Generally, working capital loans will be granted for one-year period.
(ii) Overdrafts:
Overdraft facility is an agreement between the borrower and the banker, where the borrower is allowed to withdraw funds in excess of the balance in the firm’s current account up to a certain limit during a specified period. It is flexible from the borrower point of view because the borrower can withdraw and repay the cash whenever he/she wants within the given stipulations. Interest is charged on daily over drawn balances and not on the overdraft limit given by the bank. But bank charges some minimum charges.
(iii) Cash Credit:
It is the most popular source of working capital finance in India. A cash credit facility is an arrangement where a bank permits a borrower to withdraw money up to a sanctioned credit limit against tangible security or guarantees.
Borrower does not require to withdraw the total sanctioned credit at a time, rather, he/she can withdraw according to his/ her requirements and he/she can also repay the surplus cash in his/her cash credit account. Interest is chargeable oil actually used amount and there is no commitment charge. Cash credit is a flexible source of working capital from borrower’s point of view.
(iv) Purchasing or Discounting of Bills:
Bills receivable arise out of credit sales transaction, where the seller of goods draws the bill on the buyer. The bill may be documentary or clean bill. Once the bill is accepted by the buyer, then the drawer (seller) of the bill can go to the bank for bill discounting or sale.
The creditworthiness of the drawer (seller) is satisfactory, and then bank purchases or discounts the bill and provides funds by way of crediting to the customer’s account. The credited amount will be less than the bill amount. At the end of the maturity period of the bill bank presents the bill to the drawer (acceptor) for payment.
If the bill is discounted and it is dishonored by the drawer, then the customer (seller) is liable to pay the bill amount and any other expenses incurred by the bank. If the bill is purchased then bank takes the risk of non-payment.
(v) Letter of Credit [L/C]:
There are two non-fund based sources of working capital, viz., letter of credit (L/Cs) and Bank Guarantees (B/Gs). These are also known as quasi-document issued by the Buyer’s Banker (BB) at the request of the Buyer’s, in favour of the seller, where the Buyer’s Banker gives an undertaking to the seller, that the bank pay the obligations of its customer up to a specified amount, if the customer fails to pay the value of goods purchased.
It helps the bank’s customer to obtain credit from the seller (supplier), which is possible by assurance of the payment. Put it simply, it allows the supplier to extend credit, since the risk of non-payment is transferred to the buyer’s bank. Letter of credit facility is available from banks only for the companies that are financially sound and bank charges the customer for providing this facility.
Source 8- Factoring:
Factoring is one of the sources of working capital. Banks have been given more freedom of borrowing and lending both internally and externally and facilitated the free functioning in lending and investment operations. From 1994, banks are allowed to enter directly leasing, hire purchasing and factoring services, instead through their subsidiaries. In other words, banks are free to enter or exit in any field depending on their profitability, but subject to some RBI guidelines.
Banks provide working capital finance through financing receivables, which is known as “factoring”. A “Factor” is a financial institution, which renders services relating to the management and financing of sundry debtors that arises from credit sales.
Features of Factoring:
The following are the salient features of the factoring arrangement:
(i) Factor selects the accounts of the receivables of his client and set up a credit limit, for each account of receivables depending on safety, financial stability and creditworthiness.
(ii) The factor takes the responsibility for collecting the accounts receivables selected by it.
Factor advances to the client against selected accounts that may be not-yet, collected and not-yet- due debts. Generally, the amount of money as advance will be between 70 per cent to 80 per cent of the amount of the bills (debt). But factor charges interest on advances, that usually is equal to or slightly higher than the landing rate of commercial banks.
5(a) Explain briefly the policy and procedure being followed by Govt. of India to encourage Foreign Direct Investment in our country. (16)
(b) Write short notes on: (8*2=16)
i. External Commercial Borrowing.
-> The External Commercial Borrowings or ECBs is the financial instrument used to borrow money from the foreign sources of financing to invest in the commercial activities of the domestic country. Simply, borrowing money from the non-resident lenders and investing it in the commercial activities of India is called as external commercial borrowings.
The external commercial borrowings are considered as a source of finance to expand the existing capacity of the Indian corporate and finance new investment ventures, with an objective to have a sound economic growth.
The government of India seeks investment in the infrastructure and core sectors such as power, coal, railways, roads, telecom, etc. which are directly related to economic development of the country.
External commercial borrowings cannot be used for the investments in a stock market or any speculation business. And to keep a check on it, department of economic affairs, finance ministry, government of India and RBI monitor and regulates the policies of external commercial borrowings.
The ECBs is known as the money borrowed from the foreign sources or the non-resident lenders and include Commercial bank loans, Floating rate notes and fixed rate bonds (securitized instruments), Buyer’s and supplier’s credit, credit notes, mortgage-backed securities, etc.
Here, one thing should be made clear that such borrowing is a type of funding other than equity. This means, if the money is used to finance the core capital (equity shares, preference shares, convertible preference shares, convertible debentures, etc.) of any company, then it will be termed as a foreign direct investment and is not included under external commercial borrowings.
Advantages of ECBs
· ECBs provide opportunity to borrow large volume of funds
· The funds are available for relatively long term
· Interest rate are also lower compared to domestic funds
· ECBs are in the form of foreign currencies. Hence, they enable the corporate to have foreign currency to meet the import of machineries etc.
· Corporate can raise ECBs from internationally recognized sources such as banks, export credit agencies, international capital markets etc.
ii. Foreign Institutional Investors in India.
-> Foreign Institutional Investors is an institutional, individual or group entity seeking to invest in the economy of a country other than where the entity is headquartered. FIIs are important to emerging economies because they bring funds and capital to businesses in developing countries.
Understanding Foreign Institutional Investors
· These investors usually include hedge funds, mutual funds,insurance companies and investment banks among others. FIIs generally hold equity positions in foreign financial markets. Due to this, the companies invested in by FIIs generally have improved capital structures due to healthy inflow of funds. Thus, FIIs facilitate financial innovation and growth in capital markets.
· The entry of an FII can cause a drastic swing in domestic financial markets. It increases demand for local currency and directs inflation. Therefore, there are restrictions put by the managing authority of a country on how much stake FIIs can hold in the domestic company. This ensures that the FII’s influence on the company is limited, so as to avoid exploitation.
Factors to Consider
· Foreign Direct Investments (FDI) is a part of the investment made by Foreign Institutional Investors. However, not every FII will make an FDI in the country it is investing in.
· FIIs directly impact the stock/securitiesmarket of the country, its exchange rate and inflation.
· FIIs can invest in listed, unlisted, and to-be-listed companies on the stock markets, in both the primary and secondary markets.
· FDIs are more intentional, while FIIs are more concerned with transfer of funds and looking for capital gains in a prospective company.
· In India, FIIs tend to invest via Portfolio Investment Scheme (PIS) after registering with Securities and Exchange Board of India (SEBI).
· Foreign Institutional Investors choose to invest in developing countries because they provide greater growth potential, due to the emerging economies.
· Sometimes, FIIs invest in the securities for a short period of time. This is helpful for liquidity in the market, but they also cause instability in flow of money.
A Foreign Institutional Investor may invest only in the following:
1. Securities in the primary and secondary markets including shares, debentures and warrants of companies listed or to be listed on a recognized stock exchange in India; and
2. Units of schemes floated by domestic mutual funds including Unit Trust
of India, whether listed on a recognized stock exchange or not
3. Units of scheme floated by a collective investment scheme
4. Dated Government Securities
5. Derivatives traded on a recognized stock exchange
6. Commercial papers of Indian companies
7. Rupee denominated credit enhanced bonds
8. Security receipts
9. Indian Depository Receipt
10. Listed and unlisted non-convertible debentures/bonds issued by an
Indian company in the infrastructure sector, where ‘infrastructure’ is
defined in terms of the extant External Commercial Borrowings (ECB)
guidelines
11. Non-convertible debentures or bonds issued by Non-Banking Financial
Companies categorized as ‘Infrastructure Finance Companies’(IFCs) by the
Reserve Bank of India
12. Rupee denominated bonds or units issued by infrastructure debt funds
13. Indian depository receipts
Myths about FIIS:
There are certain myths / beliefs about FIIs which are not necessarily true.
· Myth -1: FIIs do not invest in unlisted entities. They participate only through stock exchanges.
· Myth -2: FIIs cannot invest at the time of initial allotment. Foreign investors investing in initial allotment of shares (say IPOs or when a group of entities come together to float a company) are categorized as FDIs.
· Truth on 1 and 2: As per Section 15 (1) (a) of the SEBI FII Regulations, 1995, a Foreign Institutional Investor (FII) could invest in the securities in the primary and secondary markets including shares, debentures and warrants of companies unlisted, listed or to be listed on a recognized stock exchange in India. In fact FIIs are very active in the over the counter (OTC) markets and in the IPO market in India. However, subsequent to SEBI (FPI) regulations, FIIs are allowed to invest only in listed or to-be listed entities and only through stock exchanges.
· Myth 3: FDI has more direct involvement in technology, management etc while FIIs are interested in capital gain and momentary price differences. Generally direct investment involves a lasting interest in the management of an enterprise and includes reinvestment of profits. In contrast, FIIs do not generally influence the management of the enterprise.
· Truth on 3: To some extant this notion is true and is emphasized in policy documents. For instance, consolidated FDI Policy of Department of Industrial Policy and Promotion (DIPP) states that “foreign Direct Investment, as distinguished from portfolio investment (FII), has the connotation of establishing a ‘lasting interest’ in an enterprise that is resident in an economy other than that of the investor”.
· However, of late, there have been occasions where FIIs come together to influence decisions in companies where they hold shares. The difference between FDI and FII, except for the fact that the latter necessarily has to be an institution (FDI can come from an individual also), rather lies in the registration or approval process and to some extent in the individual investment limits or lock-in conditions specified for each category.
· Globally also, the acquisition of at least ten percent of the ordinary shares or voting power in a public or private enterprise by non-resident investors makes it eligible to be categorized as FDI, rather than the purpose of the investments, as intimated or stated by the investing foreigner due to difficulty in assessing it and also for statistical consistency.
