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The financial system functions as an intermediary and facilitates the flow of funds from the areas of surplus to areas of deficit. A financial system is a composition of various institutions, markets regulations and laws, practices, money managers, analysts, transactions and claims and liabilities. The financial system helps determine both the cost and volume of credit. Primarily two functions are performed by a financial system; these are promoting Savings and furthering Investment.
A financial market can be defined as a market in which funds are borrowed or lent as per the requirements of various agents in the economy. These markets are classified as Money Market (where the instruments dealt are of short-term maturity) and Capital Market (the instruments dealt are of long-term maturity).
These markets deal with instruments that have a maturity period of less than 1 year. These are further sub-divided into following:
The Indian money market consists of two parts:
The unorganized sector consists of indigenous bankers who pursue the banking business on traditional lines and non-banking financial institutions (NBFCs).
The organized sector comprises
1. the Reserve Bank, the State Bank of India and its associate banks, the nationalized banks and other private sector banks, both Indian and foreign. Organised banking will be discussed in detail in a separate chapter.
2. It also has a number of sub-markets such as the treasury bills market, the commercial bills market etc. therefore the Indian money market is not a single homogenous market but is composed of several sub markets, each one of which deals in a particular type of short-term credit.
This market deals with instruments that have a maturity period greater than one year. It is further divided in to:
Primary Market
This is the market where new securities are issued by Companies and are purchased by the investors.
Secondary Market
This market deals with trading of outstanding securities i.e. securities that have been already issued. This market operates via the medium of Stock Exchanges.
Primary and Secondary markets have been discussed later in the chapter as well.
A well-organized money market is the basis for an effective monetary policy. A money market may be defined as the market for lending and borrowing of short-term funds. It is the market where the short-term surplus investible funds of banks and other financial institutions are demanded by borrowers comprising individuals companies and the Government. Commercial banks are both suppliers of funds in the money market and borrowers.
Call/Notice money is an amount borrowed or lent on demand for a very short period. If the period is more than one day and upto 14 days it is called 'Short Notice money' otherwise the amount is known as Call money'. Intervening holidays and/or Sundays are excluded for this purpose. No collateral security is required to cover these transactions.
It serves as an outlet for deploying funds on short-term basis to the lenders having steady inflow of funds.
The RBI encourages the use of bills by the banking system. The ‘Discount and Finance House of India Ltd.’ was set up in 1987 by RBI jointly with public sector banks and financial institutions. It deals with money market instruments like the 364 days treasury bills. It also rediscounts short-term commercial bills.
DFHI has been set up as a part of the package of reform of the money market. It fills the longstanding need of a discount house in India which will buy bills and other short term paper from banks and financial institutions. In this way, DFHI enables banks and financial institutions to invest their idle funds for short periods in bills and short dated paper. Banks can sell their short-term securities to DFHI and get funds, in case they need them, without disturbing their investments. The DFHI has been very active in the short-term money market and has effectively contributed to the over-all stability of the money market.
In the short term, the lowest risk category instruments are the treasury bills. RBI issues these at a prefixed day and a fixed amount. These are four types of treasury bills.
A considerable part of the government's borrowings happen through Treasury bills of various maturities. Based on the bids received at the auctions, RBI decides the cut off yield and accepts all bids below this yield.
After treasury bills, the next lowest risk category investment option is the certificate of deposit (CD) issued by banks and FIs. Allowed in 1989, CDs were one of RBI's measures to deregulate the cost of funds for banks and FIs. A CD is a negotiable promissory note, secure and short term (upto a year) in nature. A CD is traable in market but the issuer is not allowed to buy back/repurchase before maturity.
Commercial Paper (CP) is an 'unsecured'[1] money market instrument issued in the form of a promissory note. CP was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.
It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction.
Effectively the seller of the security borrows money for a period of time (Repo period) at a particular rate of interest mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions.
The Repo/Reverse Repo transaction can only be done at Mumbai between parties approved by RBI and in securities as approved by RBI (Treasury Bills, Central/State Govt securities).
Capital market is the market for long-term funds. It refers to all the facilities and the institutional arrangements for borrowing and lending term funds (medium-term and long-term funds). It does not deal in capital goods but is concerned with the raising of money capital for purpose of investment.
Thus, like all markets, the capital market is also composed of those who demand funds (borrowers) and those who supply funds (lenders). The rapid expansion of the corporate and public enterprises since 1951 has necessitated the development of the capital market in India.
The Indian capital market is divided into the gilt-edged market and the industrial securities market.
The Gilt-edged market refers to the market for government and semi-government securities, backed by the Reserve Bank of India. The securities traded in this market are stable in value and are much sought after by banks and other institutions.
The Industrial securities market refers to the market for shares and debentures of old and new companies. This market is further divided into the new issue market and the old capital market meaning the stock exchange. The new issue market refers to the raising of new capital in the form of shares and debentures whereas the old capital market deals with securities already issued by companies. Both markets are equally important, but often the new issue market is much more important from the point of view of economic growth. However, the functioning of the new issue market will be facilitated only when there are abundant facilities for transfer of existing securities.
The capital market is also classified into primary capital market and secondary capital market.
The primary market refers to the new issue market, which relates to the issue of shares, preference shares and debentures of non-government public limited companies, and also to the raising of fresh capital by Government companies and the issue of public sector bonds. The secondary capital market, on the other hand, is the market for old or already issued securities.
The secondary capital market is composed of industrial security market or the stock exchange in which industrial securities are bought and sold, and the gilt-edged market in which the government and semi-government securities are traded.
The capital market is an increasingly international one. In any country it is not one institution but all those institutions that canalize the supply and demand for long-term capital and claims on capita, e.g. the stock exchanges, banks and insurance companies. The canalizing of securities is an important element in the efficient working of the capital market. An organized capital market fosters rapid development in an economy.
The Indian capital market has a grown after Independence with steady improvement in the volume of saving and investment. An indicator of the growth of the capital market is the growth of joint stock companies or corporate enterprises.
Primary and secondary market can also be understood as Debt Market and Equity market. Debt Market refers to those instruments which are in the nature of loan to the agency e.g. Bond Market, whereas equity market is in the nature of share.
The debt markets in advanced countries are significantly larger and deeper than equity markets. But in India, the trend is just the opposite. The development of debt market in India has not been as remarkable as in the equity market. However, the debt markets in India have undergone considerable change in the last few years. Characterised by regulated interest rates, limited players and lack of trading earlier, the markets have become more integrated and less regulated.
The debt market in India can be divided into two categories, viz., Government securities market consisting of Central Govt and State Govt securities; and Bond market consisting of FI bonds, PSU bonds and Corporatebonds/debentures. The Government Securities segment is the most dominant category in the debt market.
The Government securities comprise dated securities issued by the Government of India and state governments. The date of maturity is specified in the securities therefore it is known as dated government securities.
The Government borrows funds through the issue of long term-dated securities, the lowest risk category instruments in the economy. These securities are issued through auctions conducted by RBI, where the central bank decides the coupon or discount rate based on the response received. Most of these securities are issued as fixed interest bearing securities, though the government sometimes issues zero coupon instruments and floating rate securities also. In one of its first moves to deregulate interest rates in the economy, RBI adopted the market driven auction method in FY 1991-92. Since then, the interest in government securities has gone up tremendously and trading in these securities has been quite active.
These include the following-
1. Financial Institutional Bonds
2. Public Sector Unit Bonds
3. Corporate Bonds/Debenture
As compared to the large size of government securities market both in terms of primary market as well as secondary market, the corporate bond market is not so big. The corporate bond market consists of issuers of three different categories- Government owned financial institutions (FIs), Government owned public sector units (PSUs) and Private corporates.
The FIs, which do not have access to retail deposits like banks, depend on bond issues for raising funds. Only the better managed PSUs approach the markets to raise the funds through issue of bonds. The PSUs are also given an advantage in terms of tax breaks for the investors on investments in specified PSU bonds. These bonds referred to as tax-free bonds, obviously get traded at lower yields. Investments in rest of PSU bonds are taxed like any other bonds. Private corporates also access the bond market to raise funds. This phenomenon has increased of late as the primary capital markets have been dull for the last two years. This has diverted a lot of corporates to issue bonds.
Subsidiaries manage and under write new issues, undertake syndication of credit, and advise corporate clients on fund raising. In India they do not perform banking functions. A few merchant banks have been set up by private financial service companies in association with foreign banking and money market institutions, or by firms in brokerage and financial advisory business. These banks are under the supervisory authority of SEBI or RBI.
Mutual funds have been set up by several public sector banks and financial institutions. These funds are sizable collections of savings by a number of investors and are managed by a team of specialists who make up for individual investors’ lack of knowledge of the market. They are marked by relative safety and optimum returns to the investor. They provide even small investors, rural or urban, easy accessibility to the investment market. Now even the private and joint sector’s can set up mutual funds, SEBI lays down guideline for mutual funds.
Venture capital companies are of special help of technocrat entrepreneurs who have technical expertise but lack venture capital. These companies give commercial support to new ideas and for adoption of new technologies. Risk is high in venture capital financing.
Other institutions like the Risk Capital and Technology Corporation Ltd. (RCTC), Credit Rating Information Services of India Ltd. (CRISIL), Stock Holding Corporation of India (SHCI), have been set up in the last decade to meet the emerging need of the capital market.
Since 1991 government has allowed Indian companies to access international capital markets through Euro equity shares. The Euro-issue proceeds were initially to be utilized for approved and use within a year of issue. There were long gestation periods of new investment, the companies were required to retain their Euro-issue proceeds abroad and repatriate only when expenditure was incurred.
The Stock exchange is the market where stocks, shares and other securities are bought and sold. It is the market where the owners may dispose of their securities as and when they like.
For the existence of the capitalist system of economy and for the smooth functioning of the corporate form of organisation, the stock exchange is, therefore, an essential institution.
The Bombay Stock Exchange goes beck to July 1875 when a few local brokers doing business in stocks and shares decided to form and association in Bombay. In 1887 the Stock Exchange was formally established. In 1894, the Ahmedabad Stock Exchange was started to facilitate dealings in the shares of textile mills there. The Calcutta Stock Exchange was started in 1908 to provide a market for shares of plantations and jute mills.
Corporates do not have adequate defence mechanisms to tackle the threat of a takeover. One such defence mechanism is the face of buyback of their own shares by managements. Such a practice is very common in most of the advanced countries but in India is not easy to do so as the present Companies Act comes in the way.
Today, there is an intense debate going on in the corporate world on the entire issue of merits or otherwise of buyback of shares.
Nevertheless, as things stand, the special resolution for capital reduction is possible only with the approval of the High court and the creditors. With all the safeguards provided under the Act, there can be misuse of the buyback facility. For instance, when a company is performing poorly, promoters may buy back their shares, reduce their holdings and may move out of the company. Moreover, in case a company has surplus cash, it could invest it in its own companies instead of in instruments elsewhere. In such a situation, buyback would mean more returns to the shareholders as earnings per share would go up. In a way, increased earnings per share and lower price to earnings ratio would make investment in the company attractive.
There is a view that buyback of shares amounts to trafficking in one’s own shares to enable a company to influence the price of its own shares on the share market. This is unfair and prejudicial to the interest of shareholders and investors at large. It would also be a negation of the SEBI (Insider Trading) Regulations of 1992 and SEBI (Substantial Acquisition of Shares and Takeovers) Regulations of 1994.
[1]Since the borrowing is unsecured, RBI has set some guidelines-The borrower should be a Limited Company registered with NSE/BSE/MCX, It should have a minimum prescribed capital of 5 crores and a minimum prescribed credit rating.
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