Introduction to Financial Markets and Institutions:

Financial markets serve six basic functions. These functions are briefly listed below:

 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing

power) from one agent to another for either investment or consumption purposes.

 Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.

 Information Aggregation and Coordination: Financial markets act as collectors and

aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.

 Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.

 Liquidity: Financial markets provide the holders of financial assets with a chance to

resell or liquidate these assets.

 Efficiency: Financial markets reduce transaction costs and information costs.

In attempting to characterize the way financial markets operate, one must consider both the
various types of financial institutions that participate in such markets and the various ways in
which these markets are structured.

Eurodollar market

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Definition

The Europeanmarketwhere USdollarscan be deposited and loaned for shortperiodsof time. In

this market,loansare made in theformofEurodollarsandproductsaredenominatedin the
UScurrency. However, becausetransactionsare typically $1 million or more, only
largeinstitutional investorsparticipate in this market. Also, because this market is largely
unregulated,bankscanlendout 100 percent of thedepositstheyreceiveand
thereforeofferextremely attractiveinterest rates.

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e Nature of the Eurodollar

Eurodollars are bank deposit liabilities denominated in U.S. dollars but not subject to U.S.
banking regulations.  Banks that offered Eurodollar deposits were located outside the United
States. However, since late 1981 non-U.S. residents have been able to conduct business, free
of U.S. banking regulations at International Banking Facilities (IBFs) in the United
States.  Eurodollar deposits may be owned by individuals, corporations, or governments from
anywhere in the world, with the exception that only non-U.S. residents can hold deposits at
IBFs.

Originally, dollar-denominated deposits, not subject to U.S. banking regulations were held
almost exclusively in Europe; hence, the name Eurodollars. Most of these deposits are still
held in Europe, but they also are held at U.S. IBFs and in such places as the Bahamas,
Bahrain, Canada, the Cayman Islands, Hong Kong, Japan, the Netherlands Antilles, Panama,
and Singapore. Regardless of where they are held, such deposits are referred to as
Eurodollars.

Banks in the Eurodollar market, including U.S. IBFs, compete with banks in the United States
to attract dollar-denominated funds. Since the Eurodollar market is relatively free of regulation,
banks in the Eurodollar market are able to operate on narrower margins or spreads between
dollar borrowing and lending rates than can banks in the United States. This gives Eurodollar
deposits an advantage relative to deposits issued by banks operating under U.S. regulations. 
The Eurodollar market has grown  largely as  means of avoiding the regulatory costs involved
in dollar-denominated financial intermediation.

Functions of Central Banks

Business

General functions of central bank are as follows:

1. Supervision of the banking system

2. Advising the government on monetary policy

3. Issue of banknotes

4. Acting as banker to other banks

5. Acting as banker to government

6. Raising money for the government

7. Controlling the nation’s currency reserves

8. Acting as “ lender of last resort”

9. Liaising with international bodies

Lets look at little brief of some of them:

1. Supervision of the banking system: Central bank supervises the banking system of the
country. Central may be responsible for banking system. They collect information from
commercial bank and take necessary decision by two ways- a) bank examine and b) bank
regulation 

2. Advising the government on monetary policy: The decision on monetary policy may

be taken by the central bank. Monetary policy refers to interest rates and money supply. The
central bank will corporate with the government on economic policy generally and will
produce advice on monetary policy and economic matters, including all the statistics. 

3. Issue of banknotes: The central bank controls the issue of banknotes and coins. Most
payment these day do not involve cash but cheques, standing order, direct debit, credit
cards and so on. Nevertheless, cash is important as bank’s cash holdings are a constraint
on creation of credit, as we have seen.

4. Acting as banker to other banks: The Central bank will act as banker to the other banks
in the country. As well as holding accounts with international bodies like IMF World bank. It
is a common habit for the central bank to insist that the other banks hold non-interest
bearing reserves with in proportion to their deposit.

5. Acting as banker to government: Normally a central bank acts as the government’s

banker. It receives revenues for Taxes and other income and pay out money for t6he
government’s expenditure. Usually, it will not lend to the government but will help the
government to borrow money by the sales of its bill and bonds. 

6. Raising money for the government: The government Treasury bill and bond markets
are covered by the central bank. While sometimes the treasury or ministry of finance handle

What is Bank rate?   Bank Rate is the rate at which central bank of the country  (in India it is
RBI)  allows finance to commercial banks. Bank Rate is a tool, which central bank   uses for
short-term purposes. Any upward revision in Bank Rate by central bank is an indication that
banks should also increase deposit rates as well as Prime Lending Rate. This any revision in
the Bank rate indicates could mean more or less interest on your deposits and also an
increase or decrease in your EMI.

What is Bank Rate ? (For Non Bankers)  : This is the rate at which central bank (RBI) 
lends money to other banks or financial institutions.   If the bank rate goes up, long-term
interest rates also tend to move up, and vice-versa. Thus, it can said that in case bank rate 
is hiked,  in all likelihood banks will hikes their own lending rates to ensure and they
continue to make a profit.

What is CRR?    The Reserve Bank of India (Amendment) Bill, 2006 has been enacted and
has come into force with its gazette notification. Consequent upon amendment to sub-Section
42(1), the Reserve Bank, having regard to the needs of securing the monetary stability in the
country, can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate
or ceiling rate.  [Before the enactment of this amendment, in terms of Section 42(1) of the RBI
Act, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20
per cent of total of their demand and time liabilities].

RBI uses CRR either to drain excess liquidity or to release funds needed for the economy from
time to time. Increase in CRR means that banks have less funds available and money is
sucked out of circulation. Thus we can say that this serves duel purposes i.e. it not only
ensures that a portion of bank deposits is totally risk-free, but also enables RBI to  
control liquidity in the system, and thereby, inflation by tying the  hands of the banks in lending
money.

What is CRR (For Non Bankers)  : CRR means Cash Reserve Ratio.  Banks in India are
required to hold a certain proportion of their deposits in the form of  cash.  However,
actually Banks  don’t hold these as cash with themselves, but deposit such case with
Reserve Bank of India (RBI) / currency chests, which is considered as  equivlanet to
holding cash with themselves.. This minimum ratio (that is the part of the total deposits   to
be held as cash) is stipulated by the RBI and is known as the CRR or  Cash Reserve
Ratio.  Thus, When a bank’s deposits increase by Rs100, and if the cash reserve ratio is
9%, the banks will have to hold additional Rs 9 with  RBI and Bank will be able to use only
Rs 91 for investments and lending / credit purpose. Therefore,  higher the  ratio (i.e. CRR),
the lower is the amount that banks will be able to  use for lending and investment.  This
power of RBI to reduce the lendable amount by increasing the CRR,  makes it an
instrument in the hands of a central bank through which it can control the amount that
banks lend.  Thus, it is a tool used by RBI to control liquidity in the banking system.

What is SLR? Every bank is required to maintain at the close of business every day, a
minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of
cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and
time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is 24%. (reduced w.e.f.
8/11/208,  from earlier 25%) RBI is empowered to increase this ratio up to 40%.  An increase
in SLR  also restrict the bank’s leverage position to pump more money into the economy.
What is SLR ? (For Non Bankers)  : SLR stands for Statutory Liquidity Ratio. This term is
used by bankers and indicates  the minimum percentage of deposits that the bank has to
maintain in form of gold, cash or other approved securities.  Thus, we can say that it is ratio
of cash and some other approved to liabilities (deposits) It regulates the credit growth in
India. 

What are Repo rate and Reverse Repo rate?

Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks.
When the repo rate increases borrowing from RBI becomes more expensive.  Therefore, we
can say that in case,  RBI wants to make it more expensive for the banks to borrow money, it
increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it
reduces the repo rate

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the
RBI.  The RBI uses this tool when it feels there is too much money floating in the banking
system.  An increase in the reverse repo rate  means that the RBI will borrow money from the
banks at a higher rate  of interest. As a result, banks would prefer to keep their money with the
RBI

6.00% (w.e.f.
Bank Rate  
29/04/2003)

Increased from 5.00%

to 5.50% wef
13/02/2010; and then
6.00% (w.e.f.
Cash Reserve Ratio (CRR) again to 5.75% wef
24/04/2010)
27/02/2010; and now
to 6.00% wef
24/04/2010

Increased from 24%

25%(w.e.f.
Statutory Liquidity Ratio (SLR) which was continuing
07/11/2009)
since. 08/11/2008

Reverse Repo Rate 4.50% Increased from 4.00%

(w.e.f. which was continuing
(27/07/2010
 ) since 02/07/2010

5.75% Increased from 5.50%

Repo Rate under LAF (w.e.f. which was continuing
27/07/2010) since 02/07/2010

UNIVERSAL  BANKING

Universal Banks refers to those banks that offer a wide range of financial services,
beyond saving accounts and loans, and includes investment banking, insurance etc.  Thus,
universal banking is a combination of commercial banking, investment banking and various
other activities including insurance.  They may sell insurance, underwrite securities, and carry
out securities transactions on behalf of others. They may own equity interest in firms, including
non-financial firms.

 Universal Bank is quit popular in European Countries as compared to North American, there
are generally more restrictions in North America as to what services financial institutions can
offer. 

Till recent times, the financial institutions were doing business on`long term' basis,  both on the
assets and liabilities sides of the balance sheet, while commercial banks catered to `short
term' businesses. This demarcation was quite visible though at times they breached this thin
line.   However, with the advent of market economy, this gap is being bridged through
`universal banking'.   The rising NPAs and dearth of avenues for resources for the financial
institutions since 1990s, in the wake of falling market sentiments have put these institutions in
red.   Some of such financial institutions are finding hard to survive in the changed
environment.  

Universal banking has certain advantages and some disadvantages. University Banking
mostly results in greater economic efficiency in the form of lower cost, higher output and better
products.   However large banks will have greater impact if they even fail. Moreover, it is also
felt that such institutions, by virtue of their sheer size, could gain monopoly power in the
market, and can result in undesirable consequences for economic efficiency.   It is also feared
that combining commercial and investment banking can gives rise to conflict of interests.  

 
Universal banking in India

Since independence, Development financial institutions (DFIs) and refinancing institutions

(RFIs)in India were created with the specific objective to meet the specific sectoral needs and
provide long-term resources at concessional terms.  On the other hand, commercial banks
were, by and large, restricted themselves to the core banking functions of accepting deposits
and providing working capital finance to industry, trade and agriculture.   However, after
introduction of liberalisation and deregulation of financial sector, the border line started
thinning and now it almost does not exist at all.

The Narasimham Committee II suggested that Development Financial Institutions (DFIs)

should convert ultimately into either commercial banks or non-bank finance companies.   In
December, 1997, Reserve Bank of India constituted a Working Group under the Chairmanship
of Shri S.H. Khan to bring about greater clarity in the respective roles of banks and financial
institutions for greater harmonisation of facilities and obligations.  The Khan Working Group
held the view that DFIS should be allowed to become banks at the earliest. The RBI released
a 'Discussion Paper' (DP) in January 1999 for wider public debate. The feedback on the
discussion paper indicated that while the universal banking is desirable from the point of view
of efficiency of resource use, there is need for caution in moving towards such a system by
banks and DFIs. Major areas requiring attention are the status of financial sector reforms, the
state of preparedness of the concerned institutions, the evolution of the regulatory regime and
above all a viable transition path for institutions which are desirous of moving in the direction of
universal banking. It is proposed to adopt the following broad approach for considering
proposals in this area: 

   The issue of universal banking came to limelight in 2000, when ICICI gave a presentation to
RBI to discuss the time frame and possible options for transforming itself into an universal
bank.  

Later on RBI asked financial institutions which are interested to convert them into a universal
bank, to submit their plans for transition to a universal bank for consideration and further
discussions.   FIs need to formulate a road map for the transition path and strategy for smooth
conversion into an universal bank over a specified time frame. The plan should specifically
provide for full compliance with prudential norms as applicable to banks over the proposed
period.

 
Thus Indian financial structure is slowly evolving towards a continuum of institutions rather
than discrete specialization.    Universal banking  is likely to assume the role of a one stop
financial supermarket.    

SECURITISATION, ASSET RECONSTRUCTION & ENFORCEMENT OF SECURITY

INTERESTS

Supreme Court's Decision

The popularly known as  Securitisation Act is really ‘three in one’ Act.   It covers three aspects,
namely :-

(a) in respect of enforcement of security interest

by secured creditor (Banks/Financial institutions) without intervention of Court.

(b) Second  aspect is transfer of the non-performing assets to asset reconstruction company,

which will then dispose of those assets and realise the proceeds.

(c) Third aspect is to provide legal framework for securitisation of assets.

All three aspects are almost independent of each other.   For example, it is possible for a
secured creditor to take possession of non performing asset (NPA) and dispose of it himself,
without handing it over to asset reconstruction company or securitisation company.     Handling
it over to asset reconstruction company or securitisation company is at the option of
Bank/FI.     

The law relating to  securitisation has almost nothing to do with provisions in respect of
enforcement of security interest.     Rather usually only a perfectly normal and performing
asset which has good credit rating is securitised.     Securitisation basically consists of
acquisition of ‘financial assets’ (mainly debts or receivables) and not the ‘assets’ themselves.
The asset continues with the owner/bank/FI as the case may be.   The provisions of ‘asset
reconstruction’ combine the features of securitisation and enforcement of security interest.
THE DIFFERENCE BETWEEN CAPITAL MARKETS AND MONEY MARKETS

In order to understand what the differences between things are you first need to understand
what each of the items is. In this case before you can understand the difference between
capital markets and money markets you are going to need to understand what capital markets
are and what money markets are. Once you understand the two items are it will be easier to
see what the difference or differences are between the two markets.

What is capital market?

Basically the capital market is a type of financial market, it includes the stocks
and bonds marketas well. But in general the capital market is the market for securities where
either companies or the government can raise long term funds. One way that the companies or
the government raise these long term funds is through issuing bonds, which is where a person
buys the bond for a set price and allows the government or company to borrow their money for
a certain time period but they are promised a higher return for allowing them to borrow the
money, the higher return is paid through interest that accrues on the money that the
government or company borrows.

The capital market actually consists of two markets. The first market is the primary market and
it is where new issues are distributed to investors, and the secondary market where existing
securities are traded. Both of these markets are regulated so that fraud does not occur and in
the United States the U.S. Securities and Exchange Commission is in charge of regulating the
capital market.

What is the money market?

Basically the money market is the global financial market for short-term borrowing and lending
and provides short term liquid funding for the global financial system. The average amount of
time that companies borrow money in a money market is about thirteen months or lower.
Some of the more common types of things used in the money market are certificates of
deposits, bankers' acceptance, repurchase agreements and commercial paper to name a few.

Basically what the money market consists of is banks that borrow and lend to each other, but
other types of finance companies are involved in the money market. What usually happens is
the finance companies fund themselves by issuing large amounts of asset backed commercial
paper that is secured by the promise of eligible assets into an asset backed commercial paper
conduit. Your most common examples of these are auto loans, mortgage loans, and credit
card receivables.

What is the difference?

Basically the difference between the capital markets and money markets is that capital
markets are for long term investments, companies are selling stocks and bonds in order to
borrow money from their investors to improve their company or to purchase assets. Whereas
money markets are more of a short term borrowing or lending market where banks borrow and
lend between each other, as well as finance companies and everything that is borrowed is
usually paid back within thirteen months.

Another difference between the two markets is what is being used to do the borrowing or
lending. In the capital markets the most common thing used is stocks and bonds, whereas with
the money markets the most common things used are commercial paper and certificates of
deposits.