FINANCIAL SYSTEMS AND SERVICES NOTES

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Unit-1

Introduction to Financial System

Level of Knowledge: Basic and Conceptual

Financial System, Financial Assets, Financial Intermediaries, Financial Markets, Classification, Components of
Financial Market, Financial Instruments, Multiplicity of Financial Instruments, Formal and Informal Financial Sectors,
Key Elements of well-functioning Financial System, New Financial Instruments. Financial Sector Reforms:
Narasimham Committee Report 1991 and 1998. Indicators of Financial Development\

Financial System​ - ​A financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges, that permit the exchange of funds​ or,

The financial​ ​system is an organized and regulated structure where an exchange of funds takes place between the lender
and the borrower

Components

Financial institutions
The Financial Institutions act as a mediator between the investor and the borrower. The investor’s savings are
mobilised either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows:

● A short term liability can be converted into a long term investment

● It helps in conversion of a risky investment into a risk-free investment
 ● Also acts as a medium of convenience denomination, which means, it can match a small deposit with large
loans and a large deposit which small loans

The financial institutions can further be divided into two types:

● Banking Institutions or Depository Institutions – ​This includes banks and other credit unions which collect
money from the public against interest provided on the deposits made and lend that money to the ones in need
● Non-Banking Institutions or Non-Depository Institutions – ​Insurance, mutual funds and brokerage
companies fall under this category. They cannot ask for monetary deposits but sell financial products to their
customers.

Further, Financial Institutions can be classified into three categories:

● Regulatory – ​Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.
● Intermediates –​ Commercial banks which provide loans and other financial assistance such as SBI, BOB,
PNB, etc.
● Non-Intermediates – ​Institutions that provide financial aid to corporate customers. It includes NABARD,
SIBDI, etc.

Financial Markets
The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds,
shares and other assets is called a financial market.

The financial market can be further divided into four types:

● Capital Market – ​Designed to finance the long term investment. It is a venue where savings and investments
are channeled between suppliers who have capital and those who are in need of capital. The capital market can
further be divided into 2 types:
1. Primary market - where the securities are floated for the first time
2. Secondary market - where the existing securities are traded among interested parties
● Money Market –​ Mostly dominated by Government, Banks and other Large Institutions, the type of market is
authorised for small-term investments only. It is a wholesale debt market which works on low-risk and highly
liquid instruments. The money market can further be divided into two types:

(a) ​Organised Money Market

(b) ​Unorganised Money Market

Financial Instruments

A​ ​financial instrument is a monetary contract between parties. We can create, trade, or modify them. We can also settle
them. A financial instrument may be evidence of ownership of part of something, as in stocks and shares. Bonds, which
are contractual rights to receive cash, are financial instruments
Derivative instruments

Derivative instruments are instruments who’s worth we derive from the value and characteristics of at least one
underlying entity. Assets, interest rates, or indexes, for example, are underlying entities.

​Cash instruments
Cash instruments are instruments that the markets value directly. Securities, which are readily transferable, for
example, are cash instruments. Deposits and loans, where both lender and borrower must agree on a transfer, are also
cash instruments.

Debt-based financial instruments​ reflect a loan the investor made to the issuing entity.

Equity-based financial instruments​ reflect ownership of the issuing entity.

Financial Services

Services provided by Asset Management and Liability Management Companies. They help to get the required funds
and also make sure that they are efficiently invested.

The financial services in India include:

● Banking Services –​ Any small or big service provided by banks like granting a loan, depositing money, issuing
debit/credit cards, opening accounts, etc.
● Insurance Services – ​Services like issuing of insurance, selling policies, insurance undertaking and brokerages,
etc. are all a part of the Insurance services
● Investment Services – ​It mostly includes asset management
● Foreign Exchange Services –​ Exchange of currency, foreign exchange, etc. are a part of the Foreign exchange
services

The main aim of the financial services is to assist a person with selling, borrowing or purchasing securities, allowing
payments and settlements and lending and investing.

Fund based services​ – services that are used to acquire assets or funds for a customer

Fee based services​ – when financial institutions operate in specialised fields to earn income in form of fees,
commissions, brokerage and likes it is called fee-based services

Formal and Informal Financial Sectors, Key Elements of well-functioning Financial System, New Financial
Instruments.
Formal and Informal Financial Sectors

The financial systems of most developing countries are characterized by coexistence and

cooperation between the formal and informal financial sectors. This coexistence of these two

sectors is commonly referred to as ‘financial dualism.’ The formal financial sector is characterized

by the presence of an organized, institutional, and regulated system which caters

to the financial needs of the modern spheres of economy; the informal financial sector is an

unorganized, non-institutional, and non-regulated system dealing with the traditional and

rural spheres of the economy.

The informal financial sector has emerged as a result of the intrinsic dualism of economic

and social structures in developing countries, and financial repression which inhibits the

certain deprived sections of society from accessing funds. The informal system is characterized

by flexibility of operations and interface relationships between the creditor and the

debtor. The advantages are: low transaction costs, minimal default risk, and transparency of

procedures. Due to these advantages, a wide range and higher rates of interest prevail in the

informal sector.

An interpenetration is found between the formal and informal systems in terms of operations,

participants, and nature of activities which, in turn, have led to their coexistence. A high

priority should be accorded to the development of an efficient formal financial system as it can

offer lower intermediation costs and services to a wide base of savers and entrepreneurs.

Informal Financial System

Advantages

• Low transaction costs

• Minimum default risk

• Transparency of procedures

Disadvantages

• Wide range of interest rates

• Higher rates of interest

• Unregulated

KEY ELEMENTS OF A WELL-FUNCTIONING FINANCIAL SYSTEM

The basic elements of a well-functioning financial system are (i) a strong legal and regulatory environment,

(ii) stable money, (iii) sound public finances and public debt management, (iv) a central

bank, (v) a sound banking system, (vi) an information system, and (vii) a well-functioning securities

market.

Since finance is based on contracts, strong legal and regulatory systems that produce and strictly

enforce laws alone can protect the rights and interests of investors. Hence, a strong legal system is the

most fundamental element of a sound financial system.

Stable money is an important constituent as it serves as a medium of exchange, a store of value

(a reserve of future purchasing power), and a standard of value (unit of account) for all the goods and

services we might wish to trade in. Large fluctuations and depreciation in the value of money lead to

financial crises and impede the growth of the economy.

Sound public finance includes setting and controlling public expenditure priorities and raising revenues

adequate to fund them efficiently. Historically, these financing needs of the governments world over

led to the creation of financial systems. Developed countries have sound public finances and public debt

management practices, which result in the development of a good financial system.

A central bank supervises and regulates the operations of the banking system. It acts as a banker to

the banks, banker to the government, manager of public debt and foreign exchange, and lender of the last

resort. The monetary policy of the central bank influences the pace of economic growth. An autonomous

central bank paves the way for the development of a sound financial system.

A good financial system must also have a variety of banks both with domestic and international operations

together with an ability to withstand adverse shocks without failing. Banks are the core financial

intermediaries in all countries. They perform diverse key functions such as operating the clearing and

payments system, and the foreign exchange market. The banking system is the main fulcrum for transmitting

the monetary policy actions. Banks also undertake credit risk analysis, assessing the expected risk
and return on the projects. The financial soundness of the banking system depends on how effectively

banks perform these diverse functions.

Another foundational element is information. All the participants in a financial system require information.

A sound financial system can develop only when proper disclosure practices and networking of

information systems are adopted.

Securities markets facilitate the issue and trading of securities, both equity and debt. Efficient securities

markets promote economic growth by mobilizing and deploying funds into productive uses, lowering

the cost of capital for firms, enhancing liquidity, and attracting foreign investment. An efficient securities

market strengthens market discipline by exerting corporate control through the threat of hostile takeovers

for underperforming firms.

Basic Elements of a Well-functioning Financial System

• A strong legal and regulatory environment

• Stable money

• Sound public finances and public debt management

• A central bank

• Sound banking system

• Information system

• Well-functioning

securities market

Financial instruments

Different types of financial instruments can be designed to suit the risk and return preferences of

different classes of investors.

Savings and investments are linked through a wide variety of complex financial instruments known

as ‘securities.’ Securities are defined in the Securities Contracts Regulation Act (SCRA), 1956 as including

shares, scrips, stocks, bonds, debentures, debenture stocks or other marketable securities of a similar

nature or of any incorporated company or body corporate, government securities, derivatives of securities,

units of collective investment scheme, security receipts, interest and rights in securities, or any other
instruments so declared by the central government.

Financial securities are financial instruments that are negotiable and tradeable. Financial securities

may be primary or secondary securities. Primary securities are also termed as direct securities as they are

directly issued by the ultimate borrowers of funds to the ultimate savers. Examples of primary or direct

securities include equity shares and debentures. Secondary securities are also referred to as indirect securities,

as they are issued by the financial intermediaries to the ultimate savers. Bank deposits, mutual fund

units, and insurance policies are secondary securities.

Financial instruments differ in terms of marketability, liquidity, reversibility, type of options,

return, risk, and transaction costs. Financial instruments help financial markets and financial intermediaries

to perform the important role of channelizing funds from lenders to borrowers. Availability

of different varieties of financial instruments helps financial intermediaries to improve their own

risk management.

Types of Financial

Securities

• Primary

• Secondary

Distinct Features

• Marketable

• Tradeable

• Tailor-made

Financial sector reforms: Narasimham Committee report 1 and 2

Banking sector reforms:

● Narasimham committee 1 [1991]

➔ Was set up by Manmohan Singh as India’s Finance minister on 14th august 1991
➔ A nine-member committee was set under the chairmanship of M.Narasimham, A former governor of
RBI
➔ The committee submitted its report to the finance minister in November 1991

The major recommendations made by this committee are:

➔ Establishment of four-tier hierarchy for the banking structure consisting of three to four large banks with SEBI
at the top
 ➔ The private sector banks should be treated equally with the public sector banks- Fair playing ground
➔ The ban on setting up new banks in the private sector should be lifted and the licensing policy in the branch
expansion must be abolished.
➔ The government should be more liberal in the expansion of foreign bank branches and also foreign operations
of Indian banks.
➔ SLR and CRR should be progressively brought down from 1991-92 levels.
➔ Priority sector should be redefined to comprise small and marginal farmers, industrial sector, small traders, and
weaker sections.
➔ The banking sector should follow ​Basel norms​ or capital adequacy within three years.

Basel norms​ - Basel is a city in Switzerland which is also the headquarters of the Bank for International
Settlement [BIS]. BIS fosters cooperation among central banks with a common goal of financial stability and
common standards of banking regulation. BIS is the world’s oldest international financial organization. It was
established in 1930 immediately after the great depression.

➔ The government should tighten the prudential norms for commercial banks.
➔ The government’s share of public sector banks should be disinvested to a certain percentage like in the case of
any other public sector units so more private players can enter the market.

● Narasimham Committee 2 [1998]

➔ The 2nd Narasimham committee was set up by Mr.P Chidambaram in 1997.
➔ Committee submitted a report to finance minister Mr. Yashwant Sinha in April 1998.
➔ It was known as the committee on banking sector reforms.
➔ Mainly focused on:
1. Capital adequacy ratio
2. Size of banks
3. Review progress and implementation of reforms.

Capital adequacy ratio [CAR]

● To improve the inherent strength of the Indian banking system, the committee recommended that the
government should raise the prescribed capital adequacy norms.
● This would improve their risk absorption capacity
● The committee targeted raising the capital adequacy ratio to 9% by 2000 and 10% by 2002.
● Recommended penal provisions for banks that fail to meet these requirements.

CAR/CRAR [Capital to risk-weighted asset ratio]

CAR = Total capital / RWA [ Risk Weighted assets] *100

Total capital = tier 1 + tier 2

Tier 1 - paid-up capital, retained earnings, general reserves, and hybrid capital

Tier 2 - ARR + provisions for doubtful debts, perpetual sub-debt, dated sub-debt.

Major recommendations by Narasimham Committee 2

➔ Strengthening banking sectors

➔ Asset quality
➔ Prudential norms and disclosure requirements
➔ Systems and methods in banks ​Financial indicators - ​are certain measures that give a signal to make decisions,
statistical indicators. The main financial/ economical indicators are
1. GDP Growth rate
 2. Interest rates
3. Inflation rates
4. Unemployment rate
5. Government debt to GDP
6. Balance of trade - a component of the balance of payments
7. Current accounts to GDP
8. Credit rating

Unit-2

Capital Market

Level of Knowledge: Basic and Conceptual

Capital markets- meaning; Classification of capital market; growth of stock exchange, stock brokers, functions of stock
exchange, Margin trading, Forward trading, Sensex, Nifty, OTCEI (over the counter exchange of India), Depositories,
SEBI as capital market regulator - Objectives, Functions, Powers, Organisation, SEBI and government, SEBI
guidelines on primary markets, secondary markets, book building, buyback of shares. Derivatives in India- Introduction
to Financial and Commodity Derivatives.

Capital market

The capital market is an important constituent of the financial system. It is a market for

long-term funds—both equity and debt—and funds raised within and outside the country.

The capital market aids economic growth by mobilizing the savings of the economic sec-

tors and directing the same towards channels of productive use.

Issue of ‘primary securities’ in the ‘primary market,’ i.e., directing cash flow from the

surplus sector to the deficit sectors such as the government and the corporate sector.

•  Issue of ‘secondary securities’ in the primary market, i.e., directing cash flow from the

surplus sector to financial intermediaries such as banking and non-banking financial

institutions.

•  ‘Secondary market’ transactions in outstanding securities which facilitate liquidity. The

liquidity of the stock market is an important factor affecting growth. Many profitable

projects require long-term finance and investment which means locking up funds for
a long period. Investors do not like to relinquish control over their savings for such a

long time. Hence, they are reluctant to invest in long gestation projects. It is the pres-

ence of the liquid secondary market that attracts investors because it ensures a quick

exit without heavy losses or costs.

growth of stock exchange

The history of stock exchange:

Security trading in India goes back to the 18th century when the East India Company began trading in loan securities.
Corporate shares started being traded in the 1830s in Bombay (now Mumbai) with the stock of Bank and Cotton
presses. The simple and informal beginnings of stock exchanges in India take one back to the 1850s when 22
stockbrokers began trading opposite the Town Hall of Bombay under a banyan tree. The tree still stands in the area
which is now known as Horniman Circle.

The venue then shifted to banyan trees at the Meadows Street junction, which is now known as Mahatma Gandhi Road,
a decade later. The shift continued taking place as the number of brokers increased, finally settling in 1874 at what is
known as Dalal Street. This as yet informal group known as the Native Share and Stockbrokers Association organized
themselves as the Bombay Stock Exchange (BSE) in 1875. The BSE is the oldest stock exchange in Asia and was the
first to be granted permanent recognition under the Securities Contract Regulation Act, 1956.

The BSE was followed by the Ahmedabad Stock Exchange in 1894 which focused on trading in shares of textile mills.
The Calcutta Stock Exchange began operations in 1908 and began trading shares of plantations and jute mills. The
Madras Stock Exchange followed, being set up in 1920.

Modern history

In the post-independence era, the BSE dominated the volume of trading. However, the low level of transparency and
undependable clearing and settlement systems, apart from other macro factors, increased the need of a financial market
regulator, and the SEBI was born in 1988 as a non-statutory body. It was made a statutory body in 1992.

After the Harshad Mehta scam in 1992, there was a pressing need for another stock exchange large enough to compete
with the BSE and bring transparency to the stock market. This gave birth to the National Stock Exchange (NSE). It was
incorporated in 1992, became recognized as a stock exchange in 1993, and trading began on it in 1994. It was the first
stock exchange on which trading took place electronically. In response to this competition, BSE also introduced an
electronic trading system known as BSE On-line Trading (BOLT) in 1995.

The BSE launched its sensitivity index, the Sensex, now known as the S&P BSE Sensex, in 1986 with 1978–79 as the
base year. This is an index of 30 companies and is a benchmark stock index, measuring the overall performance of the
exchange. The index reached the level of 1,000 in July 1990, 2,000 in January 1992, 4,000 in March 1992, 5,000 in
October 1999, and 6,000 in February 2000. The exchange introduced equity derivatives in 2000. Index options were
launched in June 2001, stock options in July 2001, and stock futures in November 2001. India’s first free-float index,
BSE Teck, was launched in July 2001.

Its competitor, NSE, launched its benchmark exchange, the CNX Nifty, now known as Nifty 50, in 1996. It comprises
of 50 stocks and functions as the performance measure of the exchange. In terms of electronic screen-based trading and
derivatives, it beat BSE by launching first of its kind products and services.
The current stock exchange scenario

BSE and NSE are not the only stock exchanges in India. After the country gained independence, 23 stock exchanges
were added not including the BSE. However, at present, there are only seven recognized stock exchanges. Apart from
the BSE and NSE, they are:

● Calcutta Stock Exchange Ltd.

● Magadh Stock Exchange Ltd.
● Metropolitan Stock Exchange of India Ltd.
● India International Exchange (India INX)
● NSE IFSC Ltd.

All other exchanges have been granted exit by SEBI.

Stock brokers

A stockbroker, also known as a broker is a financial market representative who operates in securities. Their primary job
role dictates the obtainment of purchase and sale orders and execution of the same. Market participants or investors rely
on their expertise and knowledge regarding market dynamics to invest in stocks and other investment options.

Share brokers either work individually or as part of a brokerage firm.

A broker is officiated post their registration with a recognised stock exchange such as Bombay Stock Exchange or by
working for a brokerage firm. Such brokers levy a charge in the form of commission, fee, or mark-up. This charge
widely varies from broker to broker. Some dealers charge a flat fee, whereas some levy a percentage of the securities
value traded.

The share market brokers’ foray is dominated by discount brokers. This set of brokers has mustered widespread
popularity because of their low charges which make the security market more accessible to laymen. A key distinction
between a discount broker and regular stockbroker is that the latter is required to have a profuse knowledge of the
market and has to go through arduous examination routines while these parameters are not compulsory for a discount
broker.

Types of Share Market Brokers

The different types of share brokers are listed below –

Traditional or full-time brokers​: This kind of brokers provides a vast assortment of products and services to its
customers. These services involve securities’ trading, investment advice, retirement planning, management of
investment portfolio, taxes on capital gains, etc. Full-time stockbrokers charge a hefty commission, however, given the
range of their services, such cost might justify.

As was earlier mentioned, such brokers go through rigorous training and examinations to attain the job and thus have
in-depth knowledge regarding the stock market. Therefore, they are adequately trained to make a bid on your behalf
and steer your portfolio to its maximum earning potential and minimise risks on it.

Discount brokers​: Discount or online stock brokers dominate the band of brokers. Along with their inexpensive nature,
they also offer convenience to the laymen in terms of time and place utility. Market participants do not need to
personally meet discount brokers and carry out their investment through the internet.
Investors with minimal disposable income can also start investing in the stock market through discount brokers.
However, not all discount brokers offer the same level of expertise as a traditional broker and thus are a less profitable
option for companies and individuals who can afford hefty investment corpus and costs.

There are two other subtypes of stockbrokers who operate in the stock market. These are –

Jobbers​:

These are independent brokers who trade in securities for their own sake and not on behalf of other investors. They are
not licensed to trade in someone else’s name and cannot levy commission from others. They quote two prices on
stocks, one of which is the buy price quote and the other is the sale price quote. The gap between these two prices is
their profit margin.

Arbitrageurs​:

This subset of stockbrokers is known to purchase securities from one stock exchange at a lower price and then sell the
same at a higher price in a different stock exchange.

How the Advent of the Internet has Impacted Stock Market (and where stock brokers come in all this)​?

The rise of online stock brokers and investment platforms is testimonial to the intensity of impact the internet has had
over the stock market. Earlier, only high-end individuals could transact in the stock market by paying high charges to
full-time brokers. However, after the ease in accessibility of stock market and share stockbrokers on the internet, the
stock market has percolated to a much more convenient level.

The shift of the stock market has significantly elevated the volume of transactions which took place and also forged the
way for start-ups and small-scale businesses to raise capital by releasing stocks in the market. The stockbrokers play a
crucial role in aiding investors to transact in the stock market day in and day out.

Note-

A ‘Sub-Broker’ is any person who is not a Trading Member of a Stock Exchange but who acts on behalf of a Trading
Member as an agent or otherwise for assisting investors in dealing in securities through such Trading Members.

All Sub-Brokers are required to obtain a Certificate of Registration from SEBI without which they are not permitted to
deal in securities. SEBI has directed that no Trading Member shall deal with a person who is acting as a Sub-Broker
unless he is registered with SEBI and it shall be the responsibility of the Trading Member to ensure that his clients are
not acting in the capacity of a Sub-Broker unless they are registered with SEBI as a Sub-Broker.

Functions of a stock exchange

Following are some of the most important functions that are performed by stock exchange:

Role of an Economic Barometer​: Stock exchange serves as an economic barometer that is indicative of the state of the
economy. It records all the major and minor changes in the share prices. It is rightly said to be the pulse of the economy
which reflects the state of the economy.

Valuation of Securities​: Stock market helps in the valuation of securities based on the factors of supply and demand.
The securities offered by companies that are profitable and growth-oriented tend to be valued higher. Valuation of
securities helps creditors, investors and government in performing their respective functions.
Transactional Safety​: Transactional safety is ensured as the securities that are traded in the stock exchange are listed,
and the listing of securities is done after verifying the company’s position. All companies listed have to adhere to the
rules and regulations as laid out by the governing body.

Contributor to Economic Growth​: Stock exchange offers a platform for trading of securities of the various companies.
This process of trading involves continuous disinvestment and reinvestment, which offers opportunities for capital
formation and subsequently, growth of the economy.

Making the public aware of equity investment​: Stock exchange helps in providing information about investing in equity
markets and by rolling out new issues to encourage people to invest in securities.

Offers scope for speculation​: By permitting healthy speculation of the traded securities, the stock exchange ensures
demand and supply of securities and liquidity.

Facilitates liquidity​: The most important role of the stock exchange is in ensuring a ready platform for the sale and
purchase of securities. This gives investors the confidence that the existing investments can be converted into cash, or
in other words, stock exchange offers liquidity in terms of investment.

Better Capital Allocation​: Profit-making companies will have their shares traded actively, and so such companies are
able to raise fresh capital from the equity market. Stock market helps in better allocation of capital for the investors so
that maximum profit can be earned.

Encourages investment and savings​: Stock market serves as an important source of investment in various securities
which offer greater returns. Investing in the stock market makes for a better investment option than gold and silver.

Margin Trading

Margin trading refers to the process of trading where an individual increases his/her possible returns on investment by
investing more than they can afford to. Here, investors can benefit from the facility of purchasing stocks at a marginal
price of their actual value. Such trading transactions are funded by brokers who lend investors the cash to purchase
stocks. The margin can later be settled when investors square off their position in the stock market.

However, this trading can be quite risky, and investors can earn a profit only when total profit earned is higher than the
margin.

Margin accounts can be offered only by authorised brokers, according to regulations put forth by SEBI.

Those wishing to invest through margin trading can do so by creating a Margin Trading Facility (MTF) account with
their brokers.

MTF account is a type of a brokerage account where the authorised broker will disburse funds to an investor to
purchase stocks or other such financial products.As is the norm with margin trading, the loan in MTF accounts is
availed against collateral of cash (also known as minimum margin) or securities purchased, and come with an interest
rate levied periodically.

When an investor purchases securities through the funds in the MTF accounts and the value of these securities increase
over the rate of interest charged on them, then the investor enjoys higher returns than they would have if they had
invested in securities solely with their own funds.

However, on the other hand, the broker charges interest on the funds in MTF accounts for as long as the loan remains
outstanding, thereby increasing the investor’s cost of purchasing the securities.
As a result, if the securities do not appreciate and rather decline in value, investors will suffer losses on top of having to
pay the broker interest on margin funds.

Following is a margin trading example that illustrates how the process works –

Mr Agarwal purchases a stock for Rs. 80 and while squaring-off, the price of this stock rises to Rs. 90. Had he
purchased the stock through the cash segment, and paid for it in full, Mr Agarwal would have earned a 12.5% return
from his investment.

On the other hand, if he purchases this stock through margin trading and pays only Rs. 30 in the cash segment, he will
earn a 75% return on the money he invested.

Margin trading thus makes way for investors to earn a much higher return on investment.

On the other hand, if the price of the stock falls, the investor can also incur insurmountable losses. For instance, the
value of the stock Mr Agarwal purchased falls from Rs. 80 to Rs. 40. If he had purchased this stock entirely through
cash, he would have incurred a 50% loss on his investment. But if he purchases the stock through margin trading, he
will incur a loss of more than 100%.

Functions of a Capital Market

The functions of an efficient capital market are as follows:

•  Mobilize long-term savings to finance long-term investments.

•  Provide risk capital in the form of equity or quasi-equity to entrepreneurs.

•  Encourage broader ownership of productive assets.

•  Provide liquidity with a mechanism enabling the investor to sell financial assets.

•  Lower the costs of transactions and information.

•  Improve the efficiency of capital allocation through a competitive pricing mechanism.

•  Disseminate information efficiently for enabling participants to develop an informed

opinion about investment, disinvestment, reinvestment, or holding a particular finan-

cial asset.

•  Enable quick valuation of financial instruments—both equity and debt.

•  Provide insurance against market risk or price risk through derivative trading and

default risk through investment protection fund.

•  Enable wider participation by enhancing the width of the market by encouraging par-

ticipation through networking institutions and associating individuals.

•  Provide operational efficiency through

​ simplified transaction procedures;

​ lowering settlement timings; and

​ lowering transaction costs.

•  Develop integration among

​ real and financial sectors;

​ equity and debt instruments;

​ long-term and short-term funds;

​ long-term and short-term interest costs;

​ private and government sectors; and

​ domestic and external funds.

•  Direct the flow of funds into efficient channels through investment, disinvestment, and reinvestment.

Primary Capital Market and Secondary Capital Market

The capital market comprises the primary capital market and the secondary capital market.

Primary Market This refers to the long-term flow of funds from the surplus sector to the government

and corporate sector (through primary issues) and to banks and non-bank financial intermediaries (through

secondary issues). Primary issues of the corporate sector lead to capital formation (creation of net fixed

assets and incremental change in inventories). The capital formation function enables companies to invest

the proceeds of a primary issue in creating productive capacities, increasing efficiency, and creating jobs

which, in turn, generate wealth.

The nature of fund-raising is as follows:

Domestic

Equity issues by — Corporates (primary issues)

— Financial intermediaries (secondary issues)

Debt instruments by — Government (primary issues)

— Corporates (primary issues)

— Financial intermediaries (secondary issues)

External

Equity issues through issue of — Global Depository Receipts (GDR) and American

Depository Receipts (ADR)

Debt instruments through — External Commercial Borrowings (ECB)

Other External Borrowings

Foreign Direct Investments (FDI) — in equity and debt form

Foreign Institutional Investments (FII) — in the form of portfolio investments

Non-resident Indian Deposits (NRI) — in the form of short-term and medium-term deposits

The fund-raising in the primary market can be classified as follows:

•  Public issue by prospectus

•  Private placement

•  Rights issues

•  Preferential issues

The Secondary Market​ This is a market for outstanding securities. An equity instrument, being an

eternal fund, provides an all-time market while a debt instrument, with a defined maturity period, is

traded at the secondary market till maturity. Unlike primary issues in the primary market which result in

capital formation, the secondary market facilitates only liquidity and marketability of outstanding debt

and equity instruments. The secondary market contributes to economic growth by channelizing funds into

the most efficient channel through the process of disinvestment to reinvestment. The secondary market

also provides instant valuation of securities (equity and debt instruments) made possible by changes in the

internal environment, i.e., through companywide and industrywide factors. Such a valuation facilitates

the measurement of the cost of capital and rate of return of economic entities at the micro level. Secondary

markets reduce the cost of capital by providing liquidity, price discovery and risk transfer capability.
Liquidity is the ability to buy or sell an asset readily at a low cost and without a substantial impact on

its price. Price discovery is the process whereby market participants attempt to find an equilibrium price

which, in turn, is useful in making economic decisions. Both the government and business firms use this

information to formulate future strategies. For instance, the derivatives trading reveals expected future

prices of different commodities, currencies, precious metals, securities, and interest rates. Based on this

information, both the government and business firms determine particulars like pricing commitments,

timing of issues and expansion of production facilities.

The secondary market creates a wealth effect. The bull run in the stock markets adds to the market cap-

italization which notionally accrues to all investors–government, corporates, promoters, strategic holders

of equity on listed companies, mutual funds and individual investors and it makes them feel wealthier.

Investors also feel rich when they receive frequent dividend distribution from mutual funds or corporates.

This stock market created wealth does influence consumption and growth of the economy. The wealth

effect suggests that an addition in financial wealth boosts consumer spending in the long run.

The Indian secondary market can be segregated into two.

1. The secondary market for corporates and financial intermediaries. For trading in issues of corpo-

rates and financial intermediaries, there are the following entities:

a. Recognized stock exchanges

b. The National Stock Exchange of India Limited (NSE)

c. The Over the Counter Exchange of India (OTCEI)

d. The Interconnected Stock Exchange of India (ISE).

The participants in this market are registered brokers—both individuals and institutions. They

operate through a network of sub-brokers and sub-dealers and are connected through an elec-

tronic networking system.

2. The secondary market for government securities and public sector undertaking bonds. The

trading in government securities is basically divided into the short-term money market instru-

ments such as treasury bills and long-term government bonds ranging in maturity from 5 to 20

years.
The main participants in the secondary market for government securities are entities like

primary dealers, banks, financial institutions, and mutual funds.

The secondary market transactions in government securities have been conducted through

the subsidiary general ledger (SGL) since September 1994. Both the government securities and

public sector undertaking bonds are now traded in the wholesale debt market (WDM) segment of

the NSE, the BSE, and the OTCEI.

Forward Contract and Trading

A forward contract is a customized contract between two parties where settlement takes place on a specific date in the
future at a price agreed today. They are over-the-counter traded contracts. Forward contracts are private agreements
between two financial institutions or between a financial institution and its corporate client.
In a forward contract, one party takes a long position by agreeing to buy the asset at a certain specified date for a
specified price and the other party takes a short position by agreeing to sell the asset on the same date for the same
price.
The main features of forward contracts are as follows:
•  They are bilateral contracts wherein all the contract details, such as delivery date, price, and quantity, are negotiated
bilaterally by the parties to the contract. Being bilateral in nature, they are exposed to counter-party risk.
•  Each contract is custom designed in the sense that the terms of a forward contract are individually agreed between
two counter-parties. Hence, each contract is unique in terms of contract size, expiration date, and the asset type and
quality.
•  As each contract is customized, the contract price is generally not available in public domain.
•  The contract has to be settled by delivery of the asset on the expiry date.
•  In case, the party wishes to reverse the contract, it has to compulsorily approach the same counterparty, which being
in a monopoly situation can command a high price.

Forward markets for some goods are highly developed and have standardized market features. Some forward contracts
do have liquid markets. In particular, the forward foreign exchange market and the forward market for interest rates are
highly liquid. Forward contracts’ dominance is very high for the purposes of hedging foreign exchange exposures,
particularly in Europe. Forward contracts help in hedging risks arising out of foreign exchange rate fluctuations. For
instance, an exporter who expects to receive payments in dollars three months later can sell dollars forward and an
importer who is required to make payment in dollars can buy dollars forward, thereby reducing their exposure to
exchange-rate fluctuations.
Forward markets are not free from limitations. As these contracts are customized, they are nontrade able. Moreover,
there is a possibility of default by any one party to the transaction and this gives rise to counter-party risk which is a
very serious issue worldwide.

SENSEX
Sensex, otherwise known as the S&P BSE Sensex index, is the benchmark index of India's BSE, formerly known as the
Bombay Stock Exchange.) The Sensex is comprised of 30 of the largest and most actively-traded stocks on the BSE,
providing a gauge of India's economy.
The Sensex is the oldest stock index in India. Analysts and investors use the Sensex to ​observe the overall growth,
development of particular industries, and booms
Eg: INFOSYS LTD. KOTAK MAHINDRA BANK LTD. OIL AND NATURAL GAS CORPORATION LTD.
RELIANCE INDUSTRIES LTD. TATA STEEL LTD .​etc.

NIFTY
Nifty stands for ​"N" of National Stock Exchange "ifty" of top Fifty equities. The Standard & Poor's CRISIL NSE Index
50 or S&P CNX Nifty nicknamed Nifty 50 or simply Nifty, is the leading index for large companies on the National
Stock Exchange of India. The Nifty 50 was a group of 50 stocks that were most favored by institutional investors in the
1960s and 1970s​.​ The NIFTY 50 stocks represent about 65% of the total float-adjusted market capitalization of the
National Stock Exchange (NSE).
Eg: Reliance Industries Ltd​, HDFC Bank Ltd, Hindustan Unilever, etc.

Difference between SENSEX and NIFTY

· ​National Fifty is considered as Nifty while the Sensitive Index is considered as Sensex.
· ​Nifty is related to NSE and whereas Sensex is related to BSE.
· ​SENSEX is older than Nifty.
· ​Nifty is situated in New Delhi, while SENSEX is situated in Mumbai.
· ​50 companies are indexed in nifty and 30 companies are indexed in SENSEX.
· ​Nifty was founded in 1995 and SENSEX was founded in the year 1986.

How are SENSEX 30 and NIFTY 50 stocks selected?

· ​ ​Listing History
· ​Trading Frequency
· ​Rank based on the Market Capitalization (should be among the top 100)
· ​Market capitalization weight
· ​Industry/Sector they belong
· ​Historical Record

When SENSEX and Nifty increases, it shows the economic growth of the country and vice versa.
OCTEI

The ​OTC Exchange Of India (OTCEI), also known as the Over-the-Counter Exchange of India, is based in ​Mumbai​,
Maharashtra​. It is India's first exchange for small companies, as well as the first screen-based nationwide ​stock
exchange​ in India. OTCEI was set up to access high-technology (electronic stock exchange) enterprising promoters in
raising finance for new product development in a cost-effective manner and to provide a transparent and efficient
trading system to investors.​ ​Over The ​Counter Exchange of India (OTCEI) can be defined as a stock exchange without
a proper trading floor​.

Depositories
Depository is a place where financial securities are held in dematerialized form. It is responsible for maintenance of
ownership records and facilitation of trading in dematerialized securities. ​Depository is a place where financial
securities are held in dematerialized form. It is responsible for maintenance of ownership records and facilitation of
trading in dematerialized securities. However, a Depository Participant (DP) is described as an Agent (law) of the
depository. They are the intermediaries between the depository and the investors. The relationship between the DPs and
the depository is governed by an agreement made between the two under the Depositories Act.

Demat account

You can easily buy or sell shares of different companies using your Demat account.

A Demat (Dematerialised) converts stocks and other equity-oriented investments from paper to electronic form. It

allows you to buy/sell or even view your portfolio. It’s like viewing a savings bank account online, except this one is

only for investment-related transactions. Most banks and brokerage houses offer these accounts at competitive

operating costs.

PROCEDURE TO OPEN A DEMAT ACCOUNT

· ​Step 1. First select where you want to open a Demat Account and then select the Depository Participant you want
to open demat account with. Most brokerages and financial institutions offer the service.
· Step 2.Then fill up demat account opening form and submit along with copies of the required documents and a
passport-sized photograph. You also need to have a PAN card. Also carry the original documents for verification.
· Step 3. You will be provided with a copy of the rules and regulations, the terms of the agreement and the charges
that you will incur.
· Step 4. During the process, an In-Person Verification would be carried out. A member of the DP’s staff would
contact you to check the details provided in the demat account opening form.
· Step 5. Once the application is processed, the DP will provide you with a demat account number and a client ID.
You can use the details to access your demat account online.
· Step 6. As a demat account holder, you would need to pay some fees like the annual maintenance fee levied for
maintenance of the demat account and the transaction fee -- levied for debiting securities to and from the account on a
monthly basis. These fees differ from every service provider (called a Depository Participant or DP). While some DPs
charge a flat fee per transaction, others peg the fee to the transaction value, and are subject to a minimum amount. The
fee also differs based on the kind of transaction (buying or selling). In addition to the other fees, the DP also charges a
fee for converting the shares from the physical to the electronic form or vice-versa.
· Step 7. Minimum shares: A demat account can be opened with no balance of shares. It also does not require that a
minimum balance be maintained.

​WHAT ARE THE DOCUMENTS REQUIRED TO A DEMAT ACCOUNT?

To open a demat account, you need to submit proofs of identity and address along with a passport size photograph and
the demat account opening form. Only photocopies of the documents are required for submission, but originals are also
required for verification.

SEBI

Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a non-statutory body for
regulating the securities market. It became an autonomous body in 1992 through an ordinance.

Need for SEBI

The Sixth Five Year Plan was launched (1985) when some major industrial policy changes like opening up of the
economy to the outside world and a greater role to the Private Sector were initiated.

The rampant malpractices noticed in the Stock and Capital Market stood in the way of infusing confidence in investors
which is necessary for mobilisation of larger quantities of funds from the public and help the growth of the industry.

Objective of SEBI

1. Protecting the interest of investors and to

2. promote the development of and to regulate the securities market.
3. To monitor the activities of the stock exchange.
4. To safeguard the rights of the investors
5. To curb fraudulent practices by maintaining a balance between statutory regulations and self-regulation.
6. To define the code of conduct for the brokers, underwriters, and other intermediaries.
Functions of SEBI (Issuers, Investors,Intermediaries)

1. Regulatory Functions
2. Development Functions
3. Protective Functions

Regulatory Functions of SEBI

● Registration of brokers and sub brokers and other players in the market.
● Registration of collective investment schemes and Mutual Funds.
● Regulation of stock brokers, underwriters and merchant bankers and the business in stock exchanges and any
other securities market.
● Regulation of takeover bids by companies.
● Calling for information by undertaking inspection, conducting enquiries and audits of stock exchanges and
intermediaries.
● Levying fee or other charges for carrying out the purposes of the Act.
● Performing and exercising such power under Securities Contracts (Regulation) Act 1956, as may be delegated
by the Government of India.

Development Functions:

● Training of intermediaries of the securities market.

● Conducting research and publishing information useful to all market participants.
● Undertaking measures to develop the capital markets by adapting a flexible approach.
● Educating investors to broaden their understanding.
● Permitting internet through registered stock brokers.

Protective Functions

● Prohibition of fraudulent and unfair trade practices like making misleading statements, manipulations, price
rigging etc.
● Controlling insider trading and imposing penalties for such practices.
● Undertaking steps for investor protection.
● Promotion of fair practices and code of conduct in the securities market.
● Check price rigging and check on preferential allotment.

Powers of SEBI:

● Quasi-Judicial ​(SEBI can conduct hearings and pass ruling judgements in cases of unethical and fraudulent
trade practices.)
 ● Quasi-Legislative ​(Draft rules and regulations for the protection of the interests of the investor.)
● Quasi-Executive ​(authorised to file a case against anyone who violates its rules and regulation.)

❖ Power to call periodical returns from recognised stock exchanges

❖ Power to compel listing of securities by public companies
❖ Power to levy fees or other charges for carrying out the purpose of regulation.
❖ Power to grant approval to bye-laws of recognised stock exchanges
❖ Power to control and regulate stock exchanges

ORGANISATIONAL GRID OF THE SEBI:

The Board of SEBI comprises nine members. The Board is an aggregate of the following:

1. One Chairman of the board – appointed by the Central Government of India

2. One Board member – appointed by the Central Bank, that is, the RBI
3. Two Board members – hailing from the Union Ministry of Finance
4. Five Board members – elected by the Central Government of India

1. The Chairman of SEBI, in addition to overseeing the Board, also looks over the Communications, Vigilance,
and Internal Inspection Department.
2. There are four whole-time members in the organizational structure. The whole-time members are allocated a
number of departments that they have to oversee. Each department is individually headed by an executive
director. The executive directors report to specific whole-time members.
3. The organizational structure of SEBI consists of more than 25 departments, such as Foreign Portfolio Investors
and Custodians (FPI&C), Corporation Finance Department (CFD), Information Technology Department (ITD),
Department of Economic and Policy Analysis (DEPA-I,II, & III), Investment Management Department, Legal
Affair Department, Treasury and Accounts Divisions (T&A), and National Institute of Securities Market
(NISM)

SEBI Guidelines for First Issue by New Companies in Primary Market

1. A new company which has not completed 12 months of commercial operations will not be allowed to issue shares at
a premium.

2. If an existing company with a 5-year track record of consistent profitability, is promoting a new company, then it is
allowed to price its issue.

3. A draft of the prospectus has to be given to the SEBI before public issue.
4. The shares of the new companies have to be listed either with ​OTCEI​ or any other stock exchange.

SEBI Guidelines for Secondary Market

1. All the companies entering the capital market should give a statement regarding fund utilization of previous issues.

2. Brokers are to satisfy capital adequacy norms so that the member firms maintain adequate capital in relation to
outstanding positions.

3. The stock exchange authorities have to alter their bye-laws with regard to capital adequacy norms.

4. All the brokers should submit with SEBI their audited accounts.

5. The brokers must also disclose clearly the transaction price of securities and the commission earned by them. This
will bring transparency and accountability for the brokers.

6. The brokers should issue within 24 hours of the transaction contract notes to the clients.

7. The brokers must clearly mention their accounts details of funds belonging to clients and that of their own.

8. Margin money on certain securities has to be paid by claims so that ​speculative investments​ are prevented.

9. Market makers are introduced for certain scrips by which brokers become responsible for the supply and demand of
the securities and the price of the securities is maintained.

10. A broker cannot underwrite more than 5% of the public issue.

11. All transactions in the market must be reported within 24 hours to SEBI.

12. The brokers of Bombay and Calcutta must have a capital adequacy of Rs. 5 lakhs and for Delhi and Ahmedabad it
is Rs. 2 lakhs.

13. Members who are brokers have to pay a security deposit and this is fixed by SEBI.

What is Book Building?

SEBI guidelines defines Book Building as "a process undertaken by which a demand for the securities proposed to be
issued by a body corporate is elicited and built-up and the price for such securities is assessed for the determination of
the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information
memoranda or offer document".
Book Building is basically a process used in Initial Public Offer (IPO) for efficient price discovery. It is a mechanism
where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above
or equal to the floor price. The offer price is determined after the bid closing date.

As per SEBI guidelines, an issuer company can issue securities to the public though prospectus in the following
manner:
 ● 100% of the net offer to the public through book building process
● 75% of the net offer to the public through the book building process and 25% at the price determined through
book building. The Fixed Price portion is conducted like a normal public issue after the Book Built portion,
during which the issue price is determined.
The concept of Book Building is relatively new in India. However it is a common practice in most developed countries.

Buy-back of Shares

Share or stock buyback is the practice where companies decide to purchase their own share from their existing
shareholders either through a tender offer or through an open market. In such a situation, the price of concerning shares
is higher than the prevailing market price.

When companies decide to opt for the open market mechanism to repurchase shares, they can do so through the
secondary market. On the other hand, those who choose the tender offer can avail the same by submitting or tendering a
portion of their shares within a given period. Alternatively, it can be looked at as a means to reward existing
shareholders other than offering timely dividends.

However, company owners may have several reasons for repurchasing their stocks. Individuals should make a point to
find out the underlying causes to make the most of such decisions and also to benefit from it accordingly.

● A company may buy-back its shares by any one of the following methods:

a. from the existing shareholders on a proportionate basis through the tender offer;
b. from the open market through—
i. Book building method
ii. stock exchange;
c. from odd-lot holders

If the buy back amount during a F.Y. Authority

exceeds

upto 10% of the total paid-up equity capital Board resolution

and free reserves of the company.

upto 15% of the total paid-up equity capital Special resolution of Shareholders
and free reserves of the company from
open market
 Upto 25% of the aggregate of paid-up Special resolution of Shareholders
capital and free reserves of the company

● Every buy-back shall be completed ​within a period of one year ​from the date of passing of the special
resolution at general meeting, or the resolution passed by the board of directors of the company, as the case may
be.
● Where the buy-back is from open market either through the stock exchange or through book building, the
resolution of board of directors/ shareholders resolution shall specify ​the maximum price at which the
buy-back shall be made​.
● The price for buy back of shares can also be at discount to Market Price/ Book value of shares.
● A company may undertake a buy-back of its own shares or other specified securities out of:

i. its free reserves;

ii. the securities premium account; or
iii. the proceeds of the issue of any shares or other specified securities
Provided that no such buy-back shall be made out of the proceeds of an earlier issue of the same kind of shares or
same kind of other specified securities.
● For obtaining shareholder approval through postal ballot, it may take time of 60 days for obtaining shareholder
approval.
● No insider shall deal in shares or other specified securities of the company on the basis of unpublished price
sensitive information relating to buy-back of shares or other specified securities of the company.
● No company shall directly or indirectly purchase its own shares or other specified securities:

a. through any subsidiary company including its own subsidiary companies;

b. through any investment company or group of investment companies; or

Introduction to derivatives
A derivative is a contract whose value is derived from the value of another asset, known as the underlying, which could
be a share, a stock market index, an interest rate, a commodity, or a currency. The underlying is the identification tag
for a derivative contract. When the price of this underlying changes, the value of the derivative also changes. Without
an underlying, derivatives do not have any meaning.
The Securities Contracts (Regulation) [Act SC(R)A], 1956, defines derivatives in the following manner. Derivatives
include the following:
• A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, or
contract for differences, or any other form of security.
• A contract which derives its value from the prices or index of prices of underlying securities.
Features of derivatives:-
• Highly leveraged – loss/profit can be magnified compared to the initial margin. The investor pays only a
fraction of the investment amount to take an exposure called margin. The investor can take large positions even when
he does not hold the underlying security.
For example – if the share price of a company is 1000 rs, the an investor can get the future contract of that share (for
ex. 1 future contract equals 100 shares) at 20% of its original value.
i.e, he can get the future contract that share which is worth 1000 x 100 = 1,00,000 for 20% of 1,00,00 which is 20,00
only.

• Fixed lifespan – derivatives have a fixed lifespan ranging from 1 week to 3 months. At the time of when the
contract expires, the contract has to be settled between the buyers and sellers and fresh contracts are issued on the next
day.

• Fixed quantities – derivatives are traded in fixed quantities of the underlying asset called lots. For example 1
lot future contract of reliance currently has 505 shares.

Purpose of inventing derivatives:-

There are several risks inherent in financial transactions and asset liability positions. Derivatives are risk-shifting
devices. There are 3 types of risks in financial transactions
• Market risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole
market. Market risk is also referred to as ‘systematic risk’ since it cannot be diversified away because the stock market
as a whole may go up or down from time to time.
•   Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government
securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price
of fixed income securities could fall if the interest rate shot up.
•   Exchange rate risk​: In the case of imports, exports, foreign loans or investments, foreign currency is
involved which gives rise to exchange rate risk.

Types of derivative contracts:-

• Forwards: A forward contract is a contract between two parties obligating each to exchange a particular good
or instrument at a set price on a future date. It is an over-the-counter agreement and has standardized market features.
• Futures: Futures are standardized contracts between the buyers and sellers, which fix the terms of the exchange
that will take place between them at some fixed future date.
They are traded on an organized stock exchange
They are legally binding agreements
• Options ​- Options are contracts between the option writers and buyers which obligate the former and entitles
(without obligation) the latter to sell/buy stated assets as per the provisions of contracts. The major types of options are
stock options, bond options, currency options, stock index options, futures options, and options on swaps.
•   Warrants: Warrants are long-term options with three to seven years of expiration. In contrast, stock options
have a maximum life of nine months. Warrants are issued by companies as a means of raising finance with no initial
servicing costs, such as dividend or interest. They are like a call option on the stock of the issuing firm. A warrant is a
security with a market price of its own that can be converted into a specific share at a predetermined price and date. If
warrants are exercised, the issuing firm has to create a new share which leads to a dilution of ownership. Warrants are
sweeteners attached to bonds to make these bonds more attractive to the investor. Most of the warrants are detachable
and can be traded in their own right or separately. Warrants are also available on stock indices and currencies.
•   Swaps: Swaps are generally customized arrangements between counterparts to exchange one set of financial
obligations for another as per the terms of agreement. The major types of swaps are currency swaps, and interest-rate
swaps, bond swaps, coupon swaps, debt–equity swaps.
•   Swaptions: Swaptions are options on swaps. It is an option that entitles the holder the right to enter into or
cancel a swap at a future date. Swaptions become operative at the expiry of the options. Instead of having calls and
puts, swaptions have receiver swaption (an option to receive fixed and pay floating) and a payer swaption (an option to
pay fixed and receive floating).

Derivative trading in India:-

• In India, commodity futures dates back to 1875. The government banned futures trading in many of the
commodities in the 1960s and the 1970s. Forward trading was banned in the 1960s by the government despite the fact
that India had a long tradition of forward markets. Derivatives were not referred to as options and futures but as
‘tezi-mandi.’
• In June 1998, the SEBI constituted a group under the Chairmanship of Prof. J. R. Verma to recommend
measures for risk containment in the derivatives market to be followed by all exchanges. The group submitted its report
in October 1998 and the main recommendations were accepted by the SEBI in March 1999. On March 1, 2000, the
government lifted the three-decade-old prohibition on forward trading in securities by rescinding the 1969 notification.
• The SEBI set up a technical group to lay down the broad framework for risk management of index options. The
trading in index options commenced in June 2001 and trading in options on individual securities commenced in July
2001. Trading in stock futures commenced in January 2002. New products such as interest rate futures contracts and
futures and options contracts were introduced in June 2003 and August 2003 respectively.
Types of derivatives traded in India:-
• Stock index options ​– Stock index options are options where the underlying asset is a stock Index. For example
nifty and bank nifty are traded with good volumes. In case of stock index options, an investor can exercise his option
only on the last day. These are called European-style options. Stock index options are cash settled.
• Individual stock options - Individual stock options are contracts where the underlying asset is an equity stock.
They are mostly American-style options, i.e., they can be exercised on any day during their tenure. Prices are normally
quoted in terms of premium per share although each contract is for a larger number of shares.
• Stock index futures - Stock index futures are futures contracts where the underlying asset is the index. Trading
in stock index futures means that market participants are taking a view on the way the index will move. Stock index
futures are merely a tool to guess the mood of the market over the period of the contract. The market participants buy
the entire stock market instead of individual securities by taking a position on index futures.
• Individual stock futures​ - Stock futures are futures contracts on the shares of individual companies.
Participants in derivative markets –
• Hedger - A hedge is a position taken in order to offset the risk associated with some other position. A hedger is
someone who faces risk associated with price movement of an asset and who uses derivatives as a means of reducing
that risk. A hedger is a trader who enters the futures market to reduce a pre-existing risk.
• Speculators ​- While hedgers are interested in reducing or eliminating risk, speculators buy and sell derivatives
to make profit and not to reduce risk. Speculators willingly take increased risks. Speculators wish to take a position in
the market by betting on the future price movements of an asset. Futures and options contracts can increase both the
potential gains and losses in a speculative venture. They are important to derivatives markets as they facilitate hedging,
provide liquidity, ensure accurate pricing, and help to maintain price stability. It is the speculators who keep the market
going because they bear risks which no one else is willing to bear.
• Arbitrageur - An arbitrageur is a person who simultaneously enters into transactions in two or more markets to
take advantage of the discrepancy between prices in these markets. For example, if the futures price of an asset is very
high relative to the cash price, an arbitrageur will make profit by buying the asset and simultaneously selling futures.
Hence, arbitrage involves making profits from relative mispricing. Arbitrageurs also help to make markets liquid,
ensure accurate and uniform pricing, and enhance price stability. All three types of traders and investors are required
for a healthy functioning of the derivatives market. Hedgers and investors provide economic substance to this market,
and without them the markets would become mere tools of gambling. Speculators provide liquidity and depth to the
market. Arbitrageurs help in bringing about price uniformity and price discovery. The presence of hedgers, speculators,
and arbitrageurs, not only enables the smooth functioning of the derivatives market, but also helps in increasing the
liquidity of the market.
importance of traders in derivative markets –
• They Enable smooth functioning of the market.
• They Provide liquidity and depth to the market.
• They Enable price discovery

UNIT 3

Money Market

Level of Knowledge: Basic and Conceptual

Definition, Money Market and Capital Market and their Features, Objectives, Features of a Developed Money Market,
Importance of Money Market, Composition of Money Market, Money Market Instruments, Structure of Indian Money
Market, Features of Indian Money Market , Call Money Market, Recent Developments, the role of RBI and
Commercial Banks in the Indian Money market.
Money Market

A money market is a market for short-term debt instruments (maturity below one year). It is a highly liquid market
wherein securities are bought and sold in large denominations to reduce transaction costs. Call money market,
certificates of deposit, commercial paper, and treasury bills are the major instruments/segments of the money market.

The functions of a money market are

• to serve as an equilibrating force that redistributes cash balances in accordance with the liquidity needs of the
participants;

• to form a basis for the management of liquidity and money in the economy by monetary authorities;

and

• to provide reasonable access to the users of short-term money for meeting their requirements at realistic prices.

Features of Money Market

The following are the general features of a money market:

1. It is market purely for short-term funds or financial assets called near money.

2. It deals with financial assets having a maturity period up to one year only.

3. It deals with only those assets which can be converted into cash readily without loss and with minimum
transaction cost.

4. Generally, transactions take place through phone i.e., oral communication. Relevant documents and written
communications can be exchanged subsequently. There is no formal place like stock exchange as in the case of a
capital market.
5. Transactions have to be conducted without the help of brokers.

6. The components of a money market are the Central Bank, Commercial Banks, Non-banking financial
companies, discount houses and acceptance houses. Commercial banks generally play a dominant role in this market.

Objectives of Money Market

The following are the important objectives of a money market:

1. To provide a parking place to employ short-term surplus funds.

2. To provide room for overcoming short-term deficits.

3. To enable the Central Bank to influence and regulate liquidity in the economy through its intervention in this
market.

4. To provide a reasonable access to users of Short-term funds to meet their requirements quickly, adequately and
at reasonable costs.

Capital Market

A capital market is a market for long-term securities (equity and debt). The purpose of capital market is to

• mobilize long-term savings to finance long-term investments;

• provide risk capital in the form of equity or quasi-equity to entrepreneurs;

• encourage broader ownership of productive assets;

• provide liquidity with a mechanism enabling the investor to sell financial assets;

• lower the costs of transactions and information; and

• improve the efficiency of capital allocation through a competitive pricing mechanism.

Capital market consists of two main categories,

● Primary market​: A ​primary market​ where the fresh issue of securities are offered to the public
● Secondary market​: A ​secondary market​ where issued securities are traded between the investors.

Main features of the capital market:

1. ​Dealing in long term securities: capital market deals in securities for long and medium term like shares,
debentures and bonds. It does not deal with channelising saving for less than one year.

2. ​Dealing in marketable and non-marketable securities: capital market deals in both marketable and
non-marketable securities. Marketable securities are those which can be transferred e.g. Shares, debentures etc.
Non-marketable securities are those which cannot be transferred e.g. Term deposits with banks, loans and
advances of banks and financial institutions.

3. ​Includes both individual and institutional investors: capital market comprises both individual and
institutional investors. Individual investors are general public and institutional investors include mutual funds,
pension funds, lic etc.

4. ​Includes both primary and secondary markets: primary market relates to issue of fresh securities in
the market and secondary market deals with sale and purchase of existing securities through stock exchange.

5. ​Utilizes intermediaries: operations in the capital market is conducted with the help of intermediaries like
merchant bankers, underwriters, brokers, sub-brokers, collection bankers etc.
 Money Market and Capital Market Comparison

Basis for Money Market Capital Market

comparison

Definition It is the part of financial Capital market is part of the

market where lending and financial market where lending
borrowing takes place for and borrowing takes place for the
short-term up to one year medium-term and long-term

Types of Money markets generally Capital market deals in equity

instruments deal in ​promissory notes, shares, debentures, bonds,
involved bills of exchange, preference shares, etc.
commercial paper, T bills,
call money, etc.

Institutions The money market contains It involves stockbrokers, mutual

involved/types of financial banks, the central funds, underwriters, individual
investors bank, commercial banks, investors, commercial banks,
financial companies, chit stock exchanges, Insurance
funds, etc. Companies
Nature of Market Money markets are informal Capital markets are more forma​l

Liquidity of the Money markets are liquid Capital Markets are

market comparatively less liquid

Maturity period The maturity of ​financial The maturity of capital markets

instruments is generally up instruments is longer and they do
to 1 year not have stipulated time frame

Risk factor Since the market is liquid Due to less liquid nature and long
and the maturity is less than maturity, the risk is comparatively
one year, Risk involved is high
low

Purpose The market fulfills the The capital market fulfills the
short-term credit needs of long-term credit needs of the
the business business

Functional merit The money markets increase The capital market stabilizes the
the liquidity of funds in the economy due to long-term
economy savings

Return on The return in money markets The returns in capital markets are
investment are usually low high because of higher duration

Characteristic features of a developed Money Market

1. Highly organized banking system​: The commercial banks are the nerve center of the whole money market.
They are principal suppliers of short-term funds. Their policies regarding loans and advances have impact on
the entire money market. The commercial banks serve as vital link between the central bank and the various
 segments of the highly organized banking system co-exist. In an underdeveloped money market, the
commercial banking system is not fully developed.
2. Presence Of A Central Bank​: The Central Bank acts as the banker’s bank. It keeps their cash reserves and
provides them financial accommodation in difficulties by discounting their eligible securities. In other words, it
enables the commercial banks and other institutions to convert their assets into cash in times of financial crisis.
Through its open market operations, the central bank absorbs surplus cash during off-seasons and provides
additional liquidity in the busy seasons. Thus, the central bank is the leader, guide and controller of the money
market. In an underdeveloped money market, the central bank is in its infancy and not in a position to influence
and control the money market.
3. Availability of Proper Credit Instruments​: It is necessary for the existence of a developed money market a
continuous availability of readily acceptable negotiable securities such as bills of exchange, treasury bills etc. in
the market. There should be a number of dealers in the money market to transact in these securities. Availability
of negotiable securities and the presence of dealers and brokers in large numbers to transect in these securities
are needed for the existence of a instruments as well as dealers to deal in these instruments in an
underdeveloped money market.
4. Existence of Sub-Markets​: The number of sub-markers determines the development of a money market. The
lager the number of sub-makers, the broader and more developed will be the structure of money market. The
several sub-makers together make a coherent money market. In an underdevelopment money market, the
various sub-makers, particularly the bill market, are absent. Even of sub-makers exist, there is no co-ordination
between them. Consequently, different money rates prevail in the sub-makers and they remain unconnected
with of funds.
5. Ample Resources​: There must be availability of sufficient funds to finance transactions in the sub-makers.
These funds may come from within the country and also from foreign countries.
6. Existence of Secondary Market​: There should be an active secondary market in these instruments.
7. Demand And Supply Of Funds​: There should be a large demand and supply of short-term funds. It
presupposes the existence of a large domestic and foreign trade. Besides, it should have adequate amount of
liquidity in the form of large amounts maturing within a short period.
8. Other factors​: Besides the above, other factors also contribute to the development of a money market. Rapid
industrial development leading to the emergence of stock exchange, large volume of international trade leading
to the system of bills exchange, political stability, favorable conditions for foreign investment, price
stabilization etc. are the other factors that facilitate the development of money market in the country.
Importance of Money Market
A developed money market plays an important role in the financial system of a country by supplying short-term funds
adequately and quickly to trade and industry. The money market is an integral part of a country’s economy. Therefore,
a developed money market is highly indispensable for the rapid ​development of the economy​. A developed money
market helps the smooth functioning of the ​financial system​ in any economy in the following ways:

● Development Of Trade And Industry​: Money market is an important source of financing trade and industry.
The money market, through discounting operations and ​commercial papers​, finances the short-term ​working
capital requirements of trade and industry and facilities the development of industry and trade both — national
and international.
● Development Of Capital Market​: The short-term rates of interest and the conditions that prevail in the money
market influence the long-term interest as well as the resource mobilization in capital market. Hence, the
development of capital depends upon the existence of a development of capital money market.
● Smooth Functioning of Commercial Banks​: The money market provides the ​commercial banks with facilities
for temporarily employing their surplus funds in easily realizable assets. The banks can get back the funds
quickly, in times of need, by resorting to the money market. ​The commercial banks gain immensely by
economizing on their cash balances in hand and at the same time meeting the demand for large withdrawal of
their depositors. It also enables commercial banks to meet their statutory requirements of cash reserve ratio
(CRR) and Statutory Liquidity Ratio (SLR) by utilizing the money market mechanism.
● Effective Central Bank Control​: A developed money market helps ​the effective functioning of a central bank​.
It facilities effective implementation of the ​monetary policy of a central bank. The central bank, through the
money market, pumps new money into the economy in slump and siphons off in boom. The central bank, thus,
regulates the flow of money so as to promote economic growth with stability.
● Formulation Of Suitable Monetary Policy​: Conditions prevailing in a money market serve as a true indicator
of the monetary state of an economy. Hence, it serves as a guide to the Government in formulating and revising
the monetary policy then and there depending upon the monetary conditions prevailing in the market.
● Non-Inflationary Source Of Finance To Government​: A developed money market helps the Government to
raise short-term funds through the treasury bills floated in the market. In the absence of a developed money
market, the Government would be forced to print and issue more money or borrow from the central bank. Both
ways would lead to an increase in prices and the consequent inflationary trend in the economy.
● Helps in determining interest rates: ​The short term interest rates influence long term interest rates. The
money market mobilises the resources to the capital markets by way of interest rate control.
● Helps the government to raise short term funds at ease:​ Money market instruments like T-bills, help the
government raise short term funds. Otherwise, to fund projects, the government will have to print more
 currency or take loans leading to inflation in the economy. Hence the money market is also responsible for
controlling inflation.

Components of Money Market

1. Central Bank: ​It is naturally the leader of all banks. It is the bank, which is entrusted with the task of controlling the
issue of money and funds to the market and regulates credit facilities provided by various other institutions.

2.​ ​Commercial Banks: ​They play a vital role in the money market. They make ad​vances, discount bills and lend
against the promissory notes and the like. They also take help of the market in solving their liquidity problems.

3.​ ​Discount Houses: ​Discount houses are special institutions for rediscounting the bills of exchange. They usually deal
in three kinds of bills.

(a) The domestic bills

(b) The foreign bills and

(c) The government treasury bills.

The discount houses borrow huge funds for short periods from the commercial banks and RBI and Invest them in
discounting bills. But before discounting a trade bill of ex​change, the Discount House insists that it should be accepted
by an Acceptance House.

4.​ ​Acceptance Houses: ​Acceptance Houses are institutions which specialize in accept​ing bills of exchange. Generally
they are merchant bankers. They act as second signatories on the bills of exchange. That is they guarantee the bills of a
trader whose financial stand​ing is not known, for making the bill negotiable.

They maintain correspondents in impor​tant towns of various places within and outside the country to collect
information about the creditworthiness and financial position of the customers, who seek the assistance of the
Acceptance Houses. For their service, they charge a small amount of commission but en​sure great security for the bills
discounted by the Discount Houses.

5.​ ​Bill Brokers: ​The “Bill Brokers” intimately know their customers and act as intermediaries between the sellers and
buyers of bill for a small commission. Sometimes, these bill brokers discount bills on their own account.
MONEY MARKET INSTRUMENTS

The instruments traded in the Indian money market are:

1.) ​Treasury Bills (T-bills)
Treasury bills are short-term instruments issued by the Reserve Bank on behalf of the government to tide over
short-term liquidity shortfalls. This instrument is used by the government to raise short-term funds to bridge seasonal or
temporary gaps between its receipts (revenue and capital) and expenditure. They form the most important segment of
the money market not only in India but all over the world as well. T-bills are repaid at par on maturity. The difference
between the amount paid by the tenderer at the time of purchase (which is less than the face value) and the amount
received on maturity represents the interest amount on T-bills and is known as the discount. Tax deducted at source
(TDS) is not applicable on T-bills. Features of T-Bills
•  They are negotiable securities.
•  They are highly liquid as they are of shorter tenure and there is a possibility of inter-bank repos in them.
•  There is an absence of default risk.
•  They have an assured yield, low transaction cost, and are eligible for inclusion in the securities for SLR purposes.
•  They are not issued in script form. The purchases and sales are effected through the Subsidiary General Ledger
(SGL) account.
•  At present, there are 91-day, 182-day, and 364-day T-bills in vogue. The 91-day T-bills are auctioned by the RBI
every Friday and the 364-day T-bills every alternate Wednesday, i.e., the Wednesday preceding the reporting Friday.
•  Treasury bills are available for a minimum amount of `25,000 and in multiples thereof.
2.) ​Cash Management Bills (CMBs)
Cash Management Bills (CMBs) The Reserve Bank of India on behalf of the Government of India issues a new
short-term instrument, known as Cash Management Bills (CMBs), to meet the temporary mismatches in the cash flow
of the Government. The CMBs have the generic character of T-bills but are issued for maturities less than 91 days. Like
T-bills, they are also issued at a discount and redeemed at face value at maturity. The tenure, notified amount and date
of issue of the CMBs depends upon the temporary cash requirement of the Government. The announcement of their
auction is made by the Reserve Bank of India through a Press Release which is issued one day prior to the date of
auction. The settlement of the auction is on T+1 basis. The non-competitive bidding scheme has not been extended to
the CMBs. However, these instruments are tradable and qualify for ready forward facility. Investment in CMBs is also
reckoned as an eligible investment in Government securities by banks for SLR purposes under Section 24 of the
Banking Regulation Act, 1949. First set of CMBs were issued on May 12, 2010. Cash Management bills are also issued
under market stabilization scheme for liquidity management
3.) ​Call and Notice Money Market
● Introduction The money market is a market for short-term financial assets that are close substitutes of money.
The most important feature of a money market instrument is that it is liquid and can be turned into money
quickly at low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the
 requirements of borrowers. The call/notice money market forms an important segment of the Indian money
market. Under call money market funds are transacted on an overnight basis and under notice money market
funds are transacted for a period between 2 days and 14 days.
● Participants Scheduled commercial banks (excluding RRBs), co-operative banks (other than Land
Development Banks) and Primary Dealers (PDs), are permitted to participate in the call/notice money market
both as borrowers and lenders.
● Interest Rate
(i)Eligible participants are free to decide on interest rates in the call/notice money market.
(ii)Calculation of interest payable would be based on the methodology given in the Handbook of Market
Practices brought out by the Fixed Income Money Market and Derivatives Association of India (FIMMDA).
● Dealing Session Deals in the call/notice/term money market can be done from 9:00 am to 5:00 pm on each
business day or as specified by RBI from time to time.
) Documentation Eligible participants may adopt the documentation suggested by FIMMDA from time to time.
● Trading The call/notice money transactions can be executed either on NDS-Call, a screen–based, negotiated,
quote-driven electronic trading system managed by the Clearing Corporation of India (CCIL), or Over The
Counter (OTC) through bilateral communication.

4. ​Commercial Papers (CPs)

Commercial paper is an unsecured, short period debt tool issued by a company, usually for the finance and inventories
and temporary liabilities. The maturities in this paper do not last longer than 270 days. These papers are like a
promissory note allotted at a huge cost and exchangeable between the All-India Financial Institutions (FIs) and Primary
Dealers (PDs).

Most of the commercial paper investors are from the banking sector, individuals, corporate and incorporated
companies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs), etc. However, FII can only invest
according to the limit outlined by the Securities and Exchange Board of India (SEBI)

In India, commercial paper is a short-term unsecured promissory note issued by the Primary Dealers (PDs) and the
All-India Financial Institutions (FIs) for a short period of 90 days to 364 days.

Features of commercial paper :

● It is a short-term money market tool, including a promissory note and a set maturity.
● It acts as an evidence certificate of unsecured debt.
● It is subscribed at a discount rate and can be issued in an interest-bearing application.
● The issuer guarantees the buyer to pay a fixed amount in future in terms of liquid cash and no assets.
● A company can directly issue the paper to investors, or it can be done through banks/dealer banks.
5. ​Certificates of Deposits (CDs)
Certificate of Deposit or CD is a fixed-income financial instrument governed under the Reserve Bank and India (RBI)
issued in a dematerialized form. The amount at payout is assured from the beginning. A CD can be issued by any
All-India Financial Institution or Scheduled Commercial Bank. They are issued at a discount provided on face value.
Like a fixed deposit (FD), a CD’s purpose is to denote in writing that you have deposited money in a bank for a fixed
period and that bank will pay you interest on it based on the amount and duration of your deposit.

Difference between CD and commercial paper​:

There are two glaring differences between commercial paper and a CD. The first is who can issue them. A CD is issued
by financial institutions and banks. Commercial papers are issued by primary dealers, large corporations and All-India
Financial Institutions. The second difference is the minimum amount of deposit. A certificate of deposit requires a
minimum investment of ₹1 lakh and thereafter permits multiples of it. A commercial paper, on the other hand, is issued
for investments of at least ₹5 lakhs and in multiples of ₹5 lakh, thereafter.

6. ​Commercial Bills (CBs)

Trade bills or accommodation bills are bills drawn by one business firm on another. These are common instruments
used in credit purchase and sale. These have a short term maturity period generally 90 days and can be discounted with
the bank even before the maturity period.

These are negotiable instruments and can be easily transferred. The drawee of the bill honours the bill on the due date.
A trade bill is nothing but written acknowledgement of debt where the maker or drawer instructs or directs the payee or
drawee to make payment within a fixed period of time. The drawee accepts the bill and becomes liable to make
payment on the due date.

7. ​Collateralized Borrowing and Lending Obligation (CBLO).

A collateralized borrowing and lending obligation (CBLO) is a money market instrument that represents an obligation
between a borrower and a lender concerning the terms and conditions of a loan. CBLOs allow those restricted from
using the interbank call money market in India to participate in the short-term money markets.
CBLOs are operated by the Clearing Corporation of India Ltd. (CCIL) and the Reserve Bank of India (RBI). CBLOs
allow short-term loans to be secured by financial institutions, helping to cover their transactions. To access these funds,
the institution must provide eligible securities as collateral—such as Treasury bills that are at least six months from
maturity.
Call/notice money market and treasury bills form the most important segments of the Indian money market. Treasury
bills, call money market, and certificates of deposit provide liquidity for government and banks while commercial
paper and commercial bills provide liquidity for the commercial sector and intermediaries.

Structure of Indian Money Markets

The Indian monetary market has two broad categories – the organized sector and the unorganized sector.

● Organized Sector​: This sector comprises the governments, the RBI, the other commercial banks, rural
banks, and even foreign banks. The RBI organizes and controls this sector. Other corporations like the LIC,
UTI, etc also participate in this sector but not directly. Other large companies and corporates also
participate in this sector through banks.

An organised financial system is one where all processes take place in a systematic manner. It is managed by
the RBI or SEBI. The books of account are maintained and this type of financial system requires a lot of
documentation which is why it's not preferred as much among the poorer classes. The components of the
organized financial system include

● Financial institutions

● Financial markets

● Financial instruments

● Financial services

Financial institutions are classified into banking and non banking institutions.Under banking institutions you have
commercial banks and co-operative banks. Banking institutions accept deposits whereas non banking institutions do
not. Banking institutions come under banking Regulations Act 1949 and non banking institutions fall under the
Companies Act 1956. HDFC AND ICICI banks example of the banking institutions will accept deposits and provide
loans and other services to its customers whereas mutual funds like Muthoot Finance is an example for Non banking
financial institutions.

We then have our financial markets which provide a platform for the sale and purchase of securities. Financial markets
are classified into three categories namely ;

Industrial securities market - they deal with raising funds for industrial projects or concerns alike.

Government securities market - securities were mostly dealt with in the OTCEI (Over the Counter Exchange board of
India

Long term loan markets

Industrial markets are further classified into primary and secondary markets.
Primary markets(new issues market) deal with new shares whereas in the secondary market already existing shares are
traded with. National Stock Exchange and Bombay Stock Exchange are examples of Stock Exchanges in India.

Financial instruments are assets or securities which are issued for which payments are made. These instruments are
used like tokens or receipts to get back what belongs to you. When you pay the issue value of your share, your share is
your financial instrument which you can claim to receive your dividends. Examples of these instruments are shares,
debentures, scrips, futures, index bonds, equity warrants, etc.

The last component, financial services are those services which are provided for finances like the services offered by
banks, insurance companies, mutual funds and stock exchanges. They have a wide range of services like providing
loans, life insurance, hire purchase contracts, leasing contracts.

Unorganized Sector​: These are the indigenous banks and the local money lenders and hundis etc. Their activities are
not controlled by the RBI or any other body, so they are the unorganized sector.

The main features of Indian Money Market are as follows​:

1. Dichotomy:
The Indian Money market is divided between two sectors, namely organised sector and unorganised sector. There is
very little cooperation and contact between them.Consequently the rate of interest in both the markets varies widely.

2. Seasonal Variations:
Considering the demand for funds, there are two seasons, the busy season and slack season. The busy season covers the
period from November to April when agricultural products come into the market.

There is great demand for funds during this period. The slack season covers the period between May and October. The
funds begin to be repaid and there is substantial fall in the demand for funds.

3. Inter-Call Money Market:

The core of the Indian money market is the inter-bank call money market. It is the most sensitive sector of the money
market.

4. Predominant Place of Government Securities:

In the Indian money market, the predominant place is enjoyed by government and semi government securities.

5. Absence of Acceptance and Discount Houses:

There is almost complete absence of acceptance and discount houses in the Indian money market. This is due to the
underdeveloped bill market in India.

6. Isolation from Foreign Money Market:

The Indian money market is isolated from foreign markets. There is hardly any movement of funds between Indian
Money Market and foreign markets.

7. Variety of Financial Institutions:

The Indian market is characterised by the presence of a large number of financial institutions such as non-banking
financial intermediaries, cooperative banks, Export-Import banks. They cater to the financial needs of different sectors.

Acts as a Link​: Financial markets connect the investors to the borrowers and bridge the gap between the two for
mutual benefits.

8. Easy Accessibility​: These markets are readily available anytime for both the investors and the borrowers.

9. Trades in Marketable and Non-Marketable Securities​: Financial markets initiate buying and selling of
marketable commodities. Some of these are bonds, debentures and shares along with non-marketable securities like
bank deposits, post office deposits and other loans and advances.

10. Government Rules and Regulations​: The government controls the operations of a financial market in the country
by imposing different rules and regulations.

11. Involves Financial Intermediaries​: These markets require financial intermediaries such as a bank, non-banking
financial companies, stock exchanges, mutual fund companies, insurance companies, brokers, etc. to function.

12. Deals in Long and Short-Term Investment​: For the investors, financial markets provide an opportunity of putting
in their funds into various securities or schemes for short or long-term investing benefits.

Call Money Market:

Call money, also known as "money at call," is a short-term financial loan that is payable immediately, and in full, when
the lender demands it. Unlike a term loan, which has a set maturity and payment schedule, call money does not have to
follow a fixed schedule, nor does the lender have to provide any advanced notice of repayment.

• Call money is a short-term, interest-paying loan from one to 14 days made by a financial institution to another
financial institution. if it exceeds one day (but less than 15 days) it is referred to as "Notice Money

• The interest charged on a call loan between financial institutions is referred to as the call loan rate.

• day-to-day surplus funds (mostly of banks) are traded.

• Term Money refers to Money lent for 15 days or more in the Inter Bank Market.

Banks borrow in this money market for the following purpose:

• To fill the gaps or temporary mismatches in funds

• To meet the Cash Reserve Ratio(CRR) & Statutory Liquidity Ratio(SLR) mandatory requirements as stipulated
by the RBI

• To meet sudden demand for funds arising out of large outflows.

Thus call money usually serves the role of equilibrating the short-term liquidity position of banks

Participants in the Call Money Market:

As the RBI guideline, the participants in call/notice money market currently include scheduled commercial banks
(excluding RRBs), Development Financial Institutions, Co-operative banks (other than Land Development Banks) and
Primary Dealers (PDs), both as borrowers and lenders.

Interest Rate:

Eligible participants are free to decide on interest rates in call/notice money market. Calculation of interest payable
would be based on the methodology given by the Fixed Income Money Market and Derivatives Association of India
(FIMMDA).

Advantages of call money:

• It has several special features, as an extremely short period funds management vehicle, as an easily reversible
transaction, and as a means to manage the balance sheet.

• Dealing in call money allows banks the opportunity to earn interest on surplus funds.

• The transaction cost is low, in that it is done bank-to-bank without the use of a broker.
• It helps to smooth the fluctuations and contributes to the maintenance of proper liquidity and reserves, as
required by banking regulations

• It also allows the bank to hold a higher reserve-to-deposit ratio than would otherwise be possible, allowing for
greater efficiency and profitability.

Disadvantages of call money market:

• Uneven Development: The call market in India is confined to only big industrial and commercial centers like
Mumbai, Kolkata, Chennai, Delhi, Bangalore and Ahmadabad. Generally call markets are associated with stock
exchanges. Hence the market is not evenly development.

• Lack Of Integration: The call markets in different centers are not fully integrated. Besides, a large number of
local call markets exist without any integration.

• Volatility In Call Money Rates: Another drawback is the volatile nature of the call money rates. Call rates very
to greater extant indifferent centers indifferent seasons on different days within a fortnight. The rates very between 12%
and 85%. One can not believe 85% being charged on call loans.

Role of RBI in money market:

• The money market comes within the direct purview of the Reserve Bank of India regulations.

• The Reserve Bank of India influences liquidity and interest rates through a number of operating instruments
such as CRR, Open Market Operations, repos, change in bank rates etc

Unit-4

Introduction to Financial Services

Level of Knowledge: Conceptual

Meaning-features of financial services-Classification-scope-Fund Based Activities-Non-fund based Activities-

Modern Activities -Sources of Revenue- causes of Financial Innovation – Financial Services and promotions
of Industries –New Financial Products and Services- innovative Financial Instruments- Challenges Facing
the Financial Service sector-Present Scenario. NBFC’s in India- Functions and Role.

Meaning of Financial Services

In general, all types of activities which are of financial nature may be regarded as financial services. In a broad sense,
the term financial services means mobilisation and allocation of savings. Thus, it includes all activities involved in the
transformation of savings into investment. Financial services refer to services provided by the finance industry. The
finance industry consists of a broad range of organisations that deal with the management of money. These
organisations include banks, credit card companies, insurance companies, consumer finance companies, stock brokers,
investment funds and some government sponsored enterprises. Financial services may be defined as the products and
services offered by financial institutions for the facilitation of various financial transactions and other related activities.
Financial services can also be called financial intermediation. Financial intermediation is a process by which funds are
mobilised from a large number of savers and make them available to all those who are in need of it and particularly to
corporate customers. There are various institutions which render financial services. In short, services provided by
financial intermediaries are called financial services.

Characteristics or Nature of Financial Services

From the following characteristics of financial services, we can understand their nature:

1. Intangibility: Financial services are intangible. Therefore, they cannot be standardized or reproduced in the same
form. The institutions supplying the financial services should have a better image and confidence of the customers.
Otherwise, they may not succeed. They have to focus on quality and innovation of their services. Then only they can
build credibility and gain the trust of the customers.

2. Inseparability: Both production and supply of financial services have to be performed simultaneously. Hence, there
should be perfect understanding between the financial service institutions and its customers.

3. Perishability: Like other services, financial services also require a match between demand and supply. Services
cannot be stored. They have to be supplied when customers need them..

4. Variability: In order to cater a variety of financial and related needs of different customers in different areas,
financial service organisations have to offer a wide range of products and services. This means the financial services
have to be tailor-made to the requirements of customers.

5. Dominance of the human element: Financial services are dominated by the human element. Thus, financial services
are labour intensive. It requires competent and skilled personnel to market the quality financial products.

6. Information based: Financial service industry is an information based industry. It involves creation, dissemination
and use of information. Information is an essential component in the production of financial services.

Role/Importance of Financial Services

The importance of financial services may be understood from the following points:

1. Economic growth: The financial service industry mobilises the savings of the people, and channels them into
productive investments by providing various services to people in general and corporate enterprises in particular. In
short, the economic growth of any country depends upon these savings and investments.
2. Promotion of savings: The financial service industry mobilises the savings of the people by providing transformation
services. It provides liability, asset and size transformation service by providing huge loans from small deposits
collected from a large number of people. In this way the financial service industry promotes savings.

3. Capital formation: Financial serv huice industry facilitates capital formation by rendering various capital market
intermediary services. Capital formation is the very basis for economic growth.

4. Creation of employment opportunities: The financial service industry creates and provides employment opportunities
to millions of people all over the world.

5. Contribution to GNP: Recently the contribution of financial services to GNP has been increasing year after year in
almost all countries.

6. Provision of liquidity: The financial service industry promotes liquidity in the financial system by allocating and
reallocating savings and investment into various avenues of economic activity. It facilitates easy conversion of financial
assets into liquid cash. Types of Financial Services Financial service institutions render a wide variety of services to
meet the requirements of individual users. These services may be summarized as below:

1. Provision of funds: 2. Managing investible funds: 3. Risk financing:

(a) Venture capital (a) Portfolio management (a) Project preparatory services
(b) Banking services (b) Merchant banking (b) Insurance
(c) Asset financing (c) Mutual and pension funds (c) Export credit guarantee
(d) Trade financing
(e) Credit cards
(f) Factoring and forfaiting

4. Consultancy services: 5. Market operations: 6. Research and development:

(a) Project preparatory services
(b) Project report preparation
(c) Project appraisal
(d) Rehabilitation of projects
(e) Business advisory services
(f) Valuation of investments
(g) Credit rating
(h) Merger, acquisition and
reengineering
(a) Stock market operations (a) Equity and market research
(b) Money market operations (b) Investor education
(c) Asset management (c) Training of personnel
(d) Registrar and share transfer (d) Financial information services
agencies
(e) Trusteeship
(f) Retail market operation
(g) Futures, options and derivatives

Scope of Financial Services

The scope of financial services is very wide. This is because it covers a wide range of services. The financial services
can be broadly classified into two: (a) fund based services and (b) non-fund services (or fee-based services)

I. Fund based Services II. Non-fund based Services

1. Underwriting 1. Securitisation
2. Dealing in secondary market activities 2. Merchant banking
 3. Participating in money market instruments like CPs, 3. Credit rating
CDs etc. 4. Loan syndication
4. Equipment leasing or lease financing 5. Business opportunity related services
5. Hire purchase 6. Project advisory services
6. Venture capital 7. Services to foreign companies and NRIs.
7. Bill discounting. 8. Portfolio management
8. Insurance services 9. Merger and acquisition
9. Factoring 10. Capital restructuring
10. Forfaiting 11. Debenture trusteeship
11. Housing finance 12. Custodian services
12. Mutual fund 13. Stock broking

FUND BASED SERVICES​- It refers to the services that are used to acquire assets or funds to the customer which
consist of-

1. Primary market activities

2. Secondary market activities.

3. Foreign exchange activities

4. Specialized financial services.

Important fund services include

● Leasing
● Hire purchase
● Factoring
● Forfeiting
● Mutual Funds
● Bill discounting
● Credit Financing
● Housing Finance
● Venture capital.

FEE BASED SERVICES​-When financial institutions operate in specialized fields to earn income in form of fees,
commission, brokerage, or dividend it is called a Fee based service. They include-

● Issue Management
● Portfolio Management
● Corporate counseling
● Merchant banking
● Credit rating
● Stock broking
● Capital restructuring
● Bank guarantee
● Letter of credit
● Debt Restructuring
Types of financial activities.

1. ​FUND BASED ACTIVITIES​-

● Underwriting or investment in shares, debentures, bonds etc. of new issues

● Dealing in secondary market activities
● Participating in money market instruments eg. Discounting bills, treasury bills,
certificate of deposits etc.
● Involving in equipment leasing, hire purchase, venture capitals
● Dealing on foreign exchange activities.

2. FEE BASED ACTIVITIES

● Managing the capital issue in accordance with SEBI regulations enabling promoters to their market
issue.
● Making arrangements for placement of capital and debt instruments with investment institutions
● Arrangement of funds from financial institutions for client’s project cost or working capital
● Assisting in getting all government and other clearances.

3. MODERN ACTIVITIES

● Rendering project advisory services right from the preparation of the project report till raising funds
● Planning for Memorandum and Articles of Association and assisting for their smooth carry out.
● Guiding corporate customers in capital restructuring
● Acting as trustees to debenture holders
● Recommending changes in managing structure and style
● Structuring financial collaboration/Joint ventures by identifying partners and preparing joint ventures
agreements.
● Rehabilitating and restructuring sick companies
● Hedging of risks by using swamps and other derivative products
● Managing the portfolio of large public sector corporations
● Undertaking risk management services e.g. Insurance, buy back options
● Advising clients
● Promoting credit rating agencies
● Minimizing cost of debt and determining optimum debt equity ratio.
● Undertaking capital market services
○ Clearing services
○ Registration and transfers
○ Safe custody of securities
○ Collection of income or securities

Sources of Revenue- causes of Financial Innovation

 Financial innovation refers to the process of creating new financial or investment products, services, or processes
which include updated technology, risk management, risk transfer, credit and equity generation, as well as many other
innovations. Recent financial innovations are namely crowdfunding, mobile banking technology, and remittance
technology. Financial innovation, which is the creation of new securities, markets and institutions leads to improvement
in the financial services sector and thereby accelerates economic growth. As the new products contribute to the
deepening of financial markets, this innovation in the financial sector fosters economic development.

Benefits:

• Financial innovation lowers the cost of capital, promotes greater efficiency, and facilitates the smoothing of
consumption and investment decisions with considerable benefits for households and corporations.

• As the new products contribute to the deepening of financial markets, innovation, in turn, fosters economic
development.

• Financial innovation may also help to moderate business cycle fluctuations.

• Innovations such as credit cards and home equity loans allow households to keep their consumption smooth,
even when their incomes are not. The increased availability of credit to businesses allows them to smooth their
spending across short periods when revenues do not cover costs.

Drawbacks:

• Rapid financial innovation can be a source of systemic risk as evidenced during the financial crisis. When
financial products without a track record expand rapidly in a buoyant economic environment, investors tend to
underestimate the risks that only occur in periods of economic stress.

• Investors do not obtain adequate compensation for the risks that they take because they do not understand the
risks or because the risks are invisible as innovations can conceal concentrations of risk, making the financial system
more vulnerable to a shock.

Reasons for Innovations in Financial Instruments

•  Every product needs constant re-engineering. Moreover, it has to be tailored according

to the needs of the consumers. The investment environment does not get a boost if there

are repeated offerings of the same product. Hence, new designs of financial products

are always needed.

•  The interest rates had declined and this trend forced the corporate world to think of new

financial instruments.

•  Investors also prefer not to be saddled with long-term instruments. Hence, instruments

with varying maturity periods and with various put and call options are preferred.

•  The old trend of getting finance from financial institutions has changed. Now com-

panies prefer the capital market as a source of finance. To successfully tap capital
markets, companies are compelled to offer attractive terms even on debt securities,

in order to raise funds.

● Investors have shied away from the equity market in the last few years due to various capital market

scams. Attractive financial instruments are needed to lure these investors back.

In the post-reforms period, a host of innovative instruments have been introduced in the capital mar-

ket. Most of these instruments are debt instruments. These instruments have not only been structured and

designed properly, they have also been successfully marketed at the retail level.

NEW AND INNOVATIVE FINANCIAL PRODUCTS AND SERVICES

As the markets are getting sophisticated, there is a need for development of new and innovative financial products and
services. Many banks have already started to offer a variety of new products to expand their activities in the financial
service sector. Some of them are stated below.

1. Merchant Banking - A financial institution providing the services of underwriting, portfolio management,
counselling, insurance etc. to large corporations and not the general public. Some examples are JP Morgan, Goldman
Sachs, and Kotak Mahindra Capital Company Ltd.

2. Loan Syndication - Many banks jointly form a syndicate and provide huge sum of loans to large corporate
customers or government departments.

3. Forward Contract - A contract to buy/sell an asset on a future date at a price determined today. The parties can
default if the price of the asset fluctuates. These contracts are found in commodity market.

4. Future Contract - It is similar to forward contracts, but the parties cannot withdraw from the contract. Stock
exchange acts as an intermediary in these types of contracts and it decides the quantity, price, quality, and delivery date
of the asset.

5. Securitisation - Sometimes companies raise money by converting its ill-liquid assets or selling off its
receivables by converting them into securities. These are sold at a discount to the investors.

6. Mutual Funds - A company pooling money from many people and then invests that in stocks or other assets.
Each investor in the fund will own shares of variety of companies. This reduces the risk of the investor as the failure of
one company is neutralized by the success of another company.
NEW FINANCIAL INSTRUMENTS

New financial instruments such as floating rate bonds, zero interest bonds, deep discount bonds, revolving
underwriting finance facility, auction rated debentures, secured premium notes with detachable warrants,
non-convertible debentures with detachable equity warrants, secured zero interest partly convertible debentures with
detachable and separately tradable warrants, fully convertible debentures with interest (optional), differential shares,
securitized paper, collateralized debt obligations, and inverse float bonds, perpetual bonds, and municipal bonds.

1. Floating Rate Bonds - Floating Rate Bonds are bonds wherein the interest rate is not fixed and is linked to an
anchor/benchmark rate.
2. Zero Interest Bonds -Zero interest bonds carry no periodic interest payment and are sold at a huge discount to
face value.
3. Deep Discount Bonds (DDBs) - Deep discount bonds are zero coupon bonds with high maturity.
4. Revolving Underwriting Finance Facility (RUFF) - RUFF is a 91-day debenture which is rolled over after its
maturity.
5. Differential Shares - Differential Shares are a class of shares with differential rights to voting or dividend.

And more.

CHALLENGES FACED BY FINANCIAL SERVICE SECTOR IN COVID SCENARIO

The covid-19 pandemic has had an adverse impact on the physical, psychological, socio physiological health of
the individuals. Individuals from the lower stratum of the economy are observed to be affected the most during
the lockdown as their daily earning had stopped and also, were struggling to move out of cities to their villages.
When it comes to the broader aspect, the sharp slow-down of the economy, decline in the real GDP,
non-functioning of various sectors due to the lockdown explains evidently the severe effect on the economy
whose previous fiscal year shows a slow growth. The people-centered sectors, service sectors and mainly
tourism sectors have faced serious predicament in this period. Likewise, the financial sector of our nation,
which acts as a key element of the economy. The investors started to take back their investments in different
types of financial securities. It has also increased the need for liquid forms of money. This crisis led to a global
recession this year. The covid-19 pandemic has impacted the global financial markets in the long term,
adversely.

The banks, financial institutions, investment houses and insurance companies are some of the institutions in the
financial service sector. The banking industry faced serious issues like reduced demand for loans and other
credit facilities, lower incomes in banks, shortage of staff, and hence the businesses of the banks. One main
reason which can be quoted here, with respect to problems in the banks is the low digitalization of transactions
and also less developed infrastructure of banks, which would have, otherwise helped the banks sustain in the
pandemic. The RBI gave credit waivers to many debtors who faced temporary financial difficulties. They were
exempted from paying the interest and principal amount for a fixed period of time. The banks are also instructed
to identify borrowers facing permanent financial difficulties so that they could be given more provisions. The
firms also defaulted payments of loan to the banks because of the reduced revenues. This leads to reduced
capital adequacy and liquidity. Banks also come across customers who face serious financial issues like reduced
credit ratings and credit quality. The banks are also prone to get breached by such customers with issues or
agreements which are connected to ratios like profitability ratios, debt coverage ratios etc. The banks also face a
 threat wherein the depositors may withdraw cash from the bank. This will raise the interest for borrowing
finance from banks and reduce the interest income on deposits. Hence, the net interest income, margins and
spreads are expected to have an adverse impact. The non-banking financial sectors have faced a liquidity crunch
during the pandemic as the 19 banks which are the major source of liquid money for the NBFC’s faced declined
deposits. The assets quality of the NBFC’s is at risk, one reason being inability of MSME’s in India.

Insurance companies insure their customers for any uncertain future events. During the lockdown, the
companies’ assets and liabilities in the balance sheet have an effect which might pose a threat to the continuity
of their business. These companies also need to handle large amounts of claims which deal with health, life or
other lines. Also, the insurance companies are required to report the impact of the pandemic in the financial
statements as well as cash flow statements.

The fintech sector, i.e., the financial technology provides financial services through new technological tools.
During the pandemic, it was evident that the market growth was negative and hence, the funding for the fintech
companies was also affected. The investors were not ready to invest in new capital. This crisis is expected to
continue in the upcoming quarters. The supply and demand sides of the fintech companies have declined which
has reduced the total revenue.

The global market fell to extreme lower levels which was unexpected and it is compared to the global financial
crisis of 2008. The IPO’s which were expected to be filed during the beginning of 2020 did not happen. Since
the outbreak of corona virus, the market is still under the fear of uncertainties about the business and financial
operations. The companies paused their activities, employee lay-offs increased much more than before.
Companies which dealt with tourism and hospitality were the worst hit. Their stocks dropped by more than
40%. Looking into statistics, the indices like Nifty 50 and Sensex are more concentrated upon. They both fell by
38% approximately. The lockdown began on 23rd march 2020. The following inferences are from this date. The
global market cap lost 27.31% from the beginning of the year.

From march 20th the NSE started to decline when the covid-19 outbreak claimed serious issues across the
country. On 23rd march, the Nifty 50 was found to be 7610.25, while the SENSEX was 25962.25. On 30th
April both of these indices increased to the maximum level ever since the lockdown because of the
announcement of opening of industries.

NON-BANKING FINANCIAL COMPANY

DEFINITION​:

Non-Banking Financial Companies are those companies engaged in the trading of loans and advances, money transfer
service, chit business, saving and investment plans, credit facilities, acquisition of shares, stocks and hire purchase.
These NBFC’s got registered under the Companies Act, 1956 of India. Basically NBFC’s offer similar kinds of
financial services like banks, but they are not banks and also these NBFC’s does not have banking license. In India,
even though they are different from banks but NBFC’s are bound by the Indian Banking Industry rules and regulations.

FUNCTIONS OF NBFC’S​:

● Hire Purchase Services​: Hire purchase is a way of buying goods, where the buyers makes initial
amount as down payment and pays the remaining amount in instalments plus interest. Under this system
 the ownership of merchandize is not officially transferred until all the instalments are made by the
buyer. Hire purchase agreements are usually last between 2 to 5 years and these agreements are made to
buy fixed assets or long term assets.
● Retail financing​: Retail financing is a type of credit facility for short – term loans, these loans are
provided against securities such as shares, gold and property etc. Basically these financial services are
used by retailers and real estate companies and also this can be between businesses, as in a company
obtaining finance from banks.
● Trade finance​: Trade finance makes the business transactions easier for both the importers and the
exporters through trade. Besides reducing the risk of non-payment and non-receipt of goods, trade
finance became an important tool for companies to boost their revenues and efficiency. The primary
function of trade finance is to act as a third party to remove the payment and supply risk between
importer and exporter by providing the exporter with receivables and to the importer with extended
credit.
● Infrastructural funding​: This is the major and largest section, where the non-banking financial
company’s deal in. Money lent in this function alone makes up a largest amount, amongst other
functions of NBFC’s. This infrastructural funding includes real estates, railways, metros, airports etc.

Role of NBFC’s:

● NBFC’s play a very important role in providing various financial services of bank to importers, exporters,
companies etc. but excluding customers.
● NBFC often provide innovative and suitable financial services to micro, small and medium enterprises
(MSME’s) to their business requirements.
● NBFC’s play a vital role in lifting up the economy by boosting the transportation, employment creation, wealth
creation, bank credit to rural and financially weaker segments of the society.
● Customers are given financial assistance and guidance in the matters related to insurance.
● These NBFC’s act as intermediaries engaged in business of accepting deposits and lending credit and also
channelizing scarce resources for capital formation.
● NBFC’s supplement the role of banks by providing increasing financial services to corporate sector, delivering
credit to unorganised sectors and to small local borrowers.
● Helps in development of financial markets in India and also helps in attracting foreign.

Importance NBFC’s in India:

● ​Size of the sector: The NBFC had shown a stupendous growth during the past few years in the economy,
despite of the slowdown in economy. On March 2013, this NBFC sector alone contributed 12.5% of the
country’s Gross Domestic Product (GDP). This up is from March 2006 with 8.4% and also these NBFC with
their assets counts to more than 100 crore.
 ● Growth: if we see the reports in terms of year-over-year growth rates, these NBFC’s has beaten the banks
growth rates between the year 2006 and 2013. On an average it grew 22% every year. Even though when the
country’s GDP slowed down in 2011 and 2012, these NBFC sector showed a tremendous growth of 25.7%.
This is how NBFC sector is contributing to the country’s GDP and seeing their percentage contribution we can
see their importance in our economy.
● Profitability​: NBFC are more profitable than the banking sector because NBFC’s offer loans to its customers at
a very low rates compare to banks. As a result the credit rate of the NBFC grow than the banking sectors. Credit
grew on an average of 24.3% per year for NBFC’s as against 21.4% for banks. This shows that more customers
opt for NBFC rather banks for loans.
● Infrastructural lending: Infrastructural lending is more important to a country like India, as these NBFC’s
contributes largely to economy by lending to infrastructure projects such as construction of airports, railways,
metros etc. But they require large amount of funds to lend on these infrastructural projects and they earn profits
only over a long time frame. And also these lending’s on long term projects are very risky and this discourages
banks to lending on infrastructural projects. Compare to banks, NBFC’s has contributed more to these
infrastructural projects. NBFC’s lent over one third or 35.8% over their total assets to infrastructure sector but
when compare to banking institutions banks only lent 7.6%.
● Promoting inclusive growth: NBFC’s provide a wide range of financial aid and assistance to its customers for
both who live in rural and urban areas. They finance projects of small-scale companies of sectors which is the
main growth of rural areas. They also provide possible and small affordable ticket loans for housing projects to
both rural and urban customers. And they also provide employment creation, transportation and wealth
creations for rural and financially weaker sectors of the economy.

Unit-5

Merchant Banking

Level of Knowledge: Conceptual

Definition- origin merchant banking in India-merchant banks and commercial banks –services of merchant
banks-qualities required of merchant bankers –merchant bankers as lead managers-guidelines-merchant bankers
commission –Scope of Merchant Banking in India – Prohibition of Fraudulent and Unfair Trade Practices Relating to
the Securities-Market regulation- Prohibition on Dealing /Communicating/Counselling on Matters Relating to
Insider Trading- Issue of capital and Disclosure Requirements Regulations - SEBI issue and Listing of Debt
Securities Regulation 2008

In modern terms, a merchant bank is a firm or financial institution that invests equity capital directly in businesses and
often provides those businesses with advisory services. A merchant bank offers the same services as an investment
bank; however, it typically services smaller clients and makes direct equity investments in them.

Origin.
Merchant banks mainly work with small-scale enterprises that are unable to raise funds through an initial public
offering (IPO) by providing mezzanine financing, bridge financing, equity financing, and corporate credit products.
They also issue and sell securities on behalf of corporations through private placements to refined investors who
require less regulatory disclosure.

Large merchant banks place equity privately with other financial institutions by acquiring a considerable share of
ownership from companies with a significant potential for high growth rate to seal the gap between venture capital and
public stock.

Origin in india

In India, merchant banking services were started only in 1967 by National Grindlays Bank followed by Citi Bank in
1970. The State Bank of India was the first Indian commercial bank having set up a separate merchant banking
Division in 1972. Since then, a number of other banks, financial institutions and other organisations are also engaged in
providing merchant banking services.

But merchant banks in India have been primarily operating as issue houses than full-fledged merchant banks as in other
countries.

In view of the above, we can define merchant bank as an institution or an organisation which provides a number of
services including management of securities issues, portfolio services, underwriting of capital issues, insurance, credit
syndication, financial advices and project counseling

Commercial Bank Vs Merchant Bank

1. Introduction

Commercial Bank: A financial institution that provides various banking services to the individuals and firms such as
collection of deposit, providing debit and credit cards, granting loans etc.

Merchant Bank: Financial institution that deals with international trade and serves large business firms as a financial
consultant.

2. Useful For

Commercial Bank: It is useful for individuals and small business firms

Merchant Bank: It is useful for large corporate firms engaged in international trade.
3. Risk Involved

Commercial Bank: It is less riskier than merchant bank

Merchant Bank: It involves higher degree of risk than commercial bank.

. Governed By

Commercial Bank: It is governed by the Banking Act.

Merchant Bank: It is governed and regulated by SEBL

Also Read: Difference Between Merchant Bank And Investment Bank

5. Services Offered

Commercial Bank: Collecting deposits, advancing of loan, payment of check, providing remittance service, foreign
currency exchange etc.

Merchant Bank: Underwriting, loan syndication, trade financing, portfolio management etc.

CHARACTERISTICS OF MERCHANT BANKING

High proportion of decision makers as a percentage of total staff.

Quick decision process.

High density of information.

Intense contact with the environment.

Loose organizational structure

Concentration of short and medium term engagements

Emphasis on fee and commission income.

Innovative instead of repetitive operations

Sophisticated services on a national and international level.

Low rate of profit distribution.

High liquidity ratio

QUALITIES OF A GOOD MERCHANT BANKERS

Ability to analyse

Abundant knowledge

Ability to built up relationship

Innovative approach

Integrity

Capital Market facilities

Liaisoning ability

Cooperation and friendliness

contacts

Attitude toward problem Solving

Prohibition of Fraudulent and Unfair Trade Practices Relating to the Securities-Market regulation.

Prohibition of certain dealings in securities

No person shall directly or indirectly—
(a) buy, sell or otherwise deal in securities in a fraudulent manner;
(b) use or employ, in connection with issue, purchase or sale of any security
listed or proposed to be listed in a recognized stock exchange, any
manipulative or deceptive device or contrivance in contravention of the
provisions of the Act or the rules or the regulations made thereunder;
(c) employ any device, scheme or artifice to defraud in connection with dealing
in or issue of securities which are listed or proposed to be listed on a
recognized stock exchange;
(d) engage in any act, practice, course of business which operates or would
operate as fraud or deceit upon any person in connection with any dealing in
or issue of securities which are listed or proposed to be listed on a
recognized stock exchange in contravention of the provisions of the Act or
the rules and the regulations made thereunder.

​Prohibition of manipulative, fraudulent and unfair trade practices

(1) Without prejudice to the provisions of regulation 3, no person shall indulge in
a fraudulent or an unfair trade practice in securities.
(2) Dealing in securities shall be deemed to be a fraudulent or an unfair trade
practice if it involves fraud and may include all or any of the following,
namely :—
(a) indulging in an act which creates false or misleading appearance of
trading in the securities market;
(b) dealing in a security not intended to effect transfer of beneficial
ownership but intended to operate only as a device to inflate, depress orcause fluctuations in the price of such security
for wrongful gain or
avoidance of loss;
(c) advancing or agreeing to advance any money to any person thereby
inducing any other person to offer to buy any security in any issue only
with the intention of securing the minimum subscription to such issue;
(d) paying, offering or agreeing to pay or offer, directly or indirectly, to any
person any money or money’s worth for inducing such person for
dealing in any security with the object of inflating, depressing,
maintaining or causing fluctuation in the price of such security;
(e) any act or omission amounting to manipulation of the price of a security;
(f) publishing or causing to publish or reporting or causing to report by a
person dealing in securities any information which is not true or which
he does not believe to be true prior to or in the course of dealing in
securities;
(g) entering into a transaction in securities without intention of performing it
or without intention of change of ownership of such security;
(h) selling, dealing or pledging of stolen or counterfeit security whether in
physical or dematerialized form;
(i) an intermediary promising a certain price in respect of buying or selling
of a security to a client and waiting till a discrepancy arises in the price
of such security and retaining the difference in prices as profit for
himself;
(j) an intermediary providing his clients with such information relating to a
security as cannot be verified by the clients before their dealing in such
security;
(k) an advertisement that is misleading or that contains information in a
distorted manner and which may influence the decision of the investors;
(l) an intermediary reporting trading transactions to his clients entered into
on their behalf in an inflated manner in order to increase his commission
and brokerage;
m) an intermediary not disclosing to his client transactions entered into on
his behalf including taking an option position;
(n) circular transactions in respect of a security entered into between
intermediaries in order to increase commission to provide a false
appearance of trading in such security or to inflate, depress or cause
fluctuations in the price of such security;
(o) encouraging the clients by an intermediary to deal in securities solely
with the object of enhancing his brokerage or commission;
(p) an intermediary predating or otherwise falsifying records such as
contract notes;
(q) an intermediary buying or selling securities in advance of a substantial
client order or whereby a futures or option position is taken about an
impending transaction in the same or related futures or options contract;
(r) planting false or misleading news which may induce sale or purchase of
Securities.

Merchant bankers as lead bankers:

Merchant bankers are the ones who provide financial services to the companies, institutions etc. They help them
finance their business activities, raise funds, expanding business etc.

​ ead managers are independent financial institutions appointed by the companies going public. Their main
L
responsibilities include initiating the IPO processing and other things related to the process.

As per SEBI guideline it is mandatory that all public issues should be managed by MB in the capacity of lead
managers. Only in the case of right issues not exceeding Rs 50 lakhs such as obligations is not necessary.

Public issues should be managed by MB. There should be no discrimination in the case of ethics, legal issues.

The manager should be excellent in leading the issue of securities of the company.

Duties and responsibilities of lead manager

· It is the duty of every lead manager to enter into an agreement with the issuing companies. A copy of this
agreement should be submitted to SEBI at least one month before the opening of the issuing shares

· One merchant banker cannot have association with another merchant banker who does not hold a certificate of
registration with SEBI

· Lead managers cannot undertake the work of issue management if the issuing company is its associate. Issue
company and lead manager should have independence.

· In case there is more than one lead manager to an issue the responsibility of each of item should be clearly defined
in the agreement

· A lead manager has to exercise due care and diligence in the verification of prospected or letter of offer

· In case of any suggestions or modifications given by SEBI he has to ensure they are properly incorporated in the
appropriate users

Unit-6

Venture Capital and Factoring

Level of Knowledge: Conceptual & Practical

Concept - Meaning-Features- Activities of VC Funds- Scope of Venture capital - Importance-Origin-Initiative in India
- Venture capital Guidelines - Method of Venture Financing - Factoring-Meaning - Modus operandi-Terms and
conditions-Functions-Types of factoring- Factoring vs Discounting - Cost of factoring-Benefits – Factoring in
India-International Factoring. Securitisation of Debt. Credit Rating in India. Credit rating agencies in India.

VENTURE CAPITAL

Companies at an early stage or start-ups with a potential of growth requires funds to sustain their business. Wealthy
investors, investment banks or other financial institutions may invest in these new ventures due to their exceptional
growth potential. This type of private equity that investors provide to the new or small businesses is called venture
capital and the investors are called venture capitalists. Venture capital is often referred to as ‘risk capital’ or ‘patient
capital’ as it involves risk od losing the money if the venture does not turn out to be successful as expected.

Features of Venture Capital investments

● High Risk
● Lack of Liquidity
● Long term horizon
● Equity participation and capital gains
● Venture capital investments are made in innovative projects
● Suppliers of venture capital participate in the management of the company

Methods of Venture capital financing

● Equity
● participating debentures
● conditional loan

Scope of Venture Capital

1)Development of an Idea- Seed capital:

In this initial stage capitalist provide seed capital for translating an idea into business proposition. At this stage
investigation is made in-depth which normally takes a year or more.

2) Implementation stage-start up finance:

When the firm is set up to manufacture a product or provide a service, start up finance provide by the venture capitalist.
3) Fledging stage-Additional finance:

The firm has made headway and entered the stage of manufacturing a product but faces teething problems.

4) Establishment stage-establishment finance:

At this stage the firm is established in the market and expected to expand at rapid pace.

Importance

1.​Promotes Entrepreneurs​: Just as a scientist brings out his laboratory findings to reality and makes it commercially
successful, similarly, an entrepreneur converts his technical know-how to a commercially viable project with the
assistance of venture capital institutions.

2. ​Promotes products: New products with modern technology become commercially feasible mainly due to the
financial assistance of venture capital institutions.

3. ​Encourages customers​: The financial institutions provide ​venture capital to their customers not as a mere financial
assistance but more as a package deal which includes assistance in management, marketing, technical and others.
Example: H ​ ot mail dot com. It was a project invented by an young Indian graduate from Bangalore, by name Sabir
Bhatia. This project was developed by him due to the financial assistance provided by the venture capital firms in
Silicon Valley, U.S.A. His project was later on purchased by Microsoft company, U.S.A. The Chairman of the
company, Mr. Bill Gates offered 400 Million US Dollars in hot cash.

4. ​Brings out latent talent:​ While funding entrepreneurs, the venture capital institutions give more thrust to potential
talent of the borrower which helps in the growth of the borrowing concern.

5. ​Promotes exports:​ The Venture capital institution encourages export oriented units because of which there is more
foreign exchange earnings of the country.

6. ​As Catalyst: A venture capital institution acts as more as a catalyst in improving the financial and managerial talents
of the borrowing concern. The borrowing concerns will be more keen to become self dependent and will take necessary
measures to repay the loan.

7. ​Creates more employment opportunities:​ By promoting entrepreneurship, venture capital institutions are encouraging
self employment and this will motivate more educated unemployed to take up new ventures which have not been
attempted so far.

8. ​Brings financial viability:​ Through their assistance, the venture capital institutions not only improve the borrowing
concern but create a situation whereby they can raise their own capital through the capital market. In the process they
strengthen the capital market also.

9. ​Helps technological growth​: Modern technology will be put to use in the country when financial institutions
encourage business ventures with new technology.
10. ​Helps sick companies: Many sick companies are able to turn around after getting proper nursing from the venture
capital institutions.

11. ​Helps development of Backward areas:​ By promoting industries in backward areas, venture capital institutions are
responsible for the development of the backward regions and human resources.

12. ​Helps growth of economy: By promoting new entrepreneurs and by reviving sick units, a fillip is given to the
economic growth. There will be increase in the production of ​consumer goods which improves the standard of living of
the people.

INDIAN VENTURE CAPITAL MARKET AND INVESTMENTS

Venture capitalism in India began in 1986 with the start of the economic liberalisation. In 1988, the Indian government
formalised venture capital by issuing a set of guidelines. Initially, venture capital or VC was limited to subsidiaries set
up ​IDBI​, ​ICICI​ and the IFC, and focused on large industrial concerns.

But the turning point came when the well-established start-ups by Indians in the Silicon Valley convinced foreign
investors that India had the talent and the scope for economic development and growth. Over the years, more and more
private investors from India and abroad have entered the Indian venture capital market.

In the early stages, venture capital investments were mainly in the manufacturing sector. However, with changing
trends and increased liberalisation, companies in consumer services and consumer retail space emerged as top
contenders for VC funding, attracting almost 50% of total VC investments. Other key industries included IT and
IT-related services, software development, telecommunications, electronics, biotechnology and pharmaceuticals,
banking and finance/insurance, public sector disinvestment, media and entertainment, and education.

Since 1988, ICICI has played a prominent role in promoting venture capital investments in India and currently manages
funds over $2 billion.

In fact, India recorded a 13% increase in the amount invested against the global rise of 2%. At $45.8 million, India
posted an all-time-high median value at the profitable stage in 2013, the highest value ever seen in any market across
all of the development stages since 2007.
VENTURE CAPITAL GUIDELINES

SEBI amended regulations for VCFs are:

(i) VCF is a fund established in the form of a trust/a company including a body corporate and registered with SEBI. It
has a dedicated pool of capital, raised in the specified manner and invested in VCUs in accordance with the regulations.
VCU is a domestic company whose shares are not listed on a stock exchange and is engaged in specified business
(ii) The minimum investment in a VCF from any investor would not be less than Rs. 5 lakh and the minimum corpus of
the fund before it could start activities should be at least Rs. 5 crore.
(iii) The norms of investment were modified. A VCF seeking to avail benefit under the relevant provisions of the
Income Tax Act will be required to divest from the investment within a period of one year from the listing of the VCU.
(iv) The VCF will be eligible to participate i the IPO through book building route as Qualified Institutional Buyer.
(v) The mandatory exit requirement by VCF from the investment within one year of the listing of the shares of VCUs
to seek tax pass-through was removed under the SEBI (VCF) Regulation to provide for flexibility in exit to VCFs.
(vi) The VCFs were directed to provide with the information pertaining to their venture capital activity for every
quarter starting form the quarter ending December 31, 2000.
(viii) Automatic exemption was granted from applicability of open offer requirements in case of transfer of shares form
VCFs in Foreign Venture Capital Investors (FVCIs) to promoters of a VCU.

GUIDELINES -
METHODS OF VENTURE FINANCING
Factoring

Meaning: ​ A type of financial transaction in which the business sells its account receivables to a third party at a
discounted rate. It is also called as ​accounts receivable factoring, invoice factoring, and sometimes accounts receivable
financing. The company/ agency purchasing these bonds are known as factors.

Benefits:​ This allows the company to get immediate liquid cash which may be used for other transactions or which may
be needed by the business immediately for other purposes.

MODUS OPERANDI

Meaning​: word used to describe an individual’s or a group’s habitual way of operating. This is usually used in
situations describing criminal behaviour.

Modus operandi can also be described as a specific method of operation.

Behaviour of people may also be influenced by their culture and region. This too will be described by modus operandi.

Terms and Conditions

Commissions. The factor will charge your company a percentage of the gross amount of the factored invoice as a
commission, subject to a minimum, specified dollar-per-invoice amount.

Payment of the Purchase Price of an Account. As a purchase price for each factored account, the factor will pay your
company the net amount, generally calculated by deducting customer discounts, commissions, and credits, including
merchandise returns, allowances, chargebacks, and all other charges from the gross amount of the account

Advances. The factoring agreement will provide for discretionary advances by the factor up to a specified percentage of
the purchase price of approved factored accounts (and, in some cases, the factor may also make advances against the
purchase price of non-approved accounts).

Sale and Purchase of Receivables​.​ The factoring agreement will require you to sell all of your accounts receivable to
the factor.

Credit Approvals and Withdrawals and Disputes. Prior to shipping goods to a customer, you will be submitting the
customer’s order to the factor for its approval of the creditworthiness of the customer and the terms of sale.

Types of Factoring

● Recourse Factoring: In this type of factoring, the risk of account receivables purchased from client becoming
bad is borne by client himself

● Non-Recourse Factoring: This is opposite to recourse factoring where the client is not responsible or liable for

the account receivable.

● Maturity Factoring: In this type, the money to the client is paid only after the factor receives the money from the

account receivable on maturity.

● Advance Factoring: Here, the factor will pay 75%-85% of the value of receivables are paid immediately and the
rest is paid after maturity
 ● Invoice Discounting: Factor makes prepayment to the client against the purchase of book debts and charges
interest for the period spanning the date of pre-payment to the date of collection. This arrangement is also

referred to as ​‘Confidential Factoring’ or undisclosed factoring​.

● Full Factoring: Also known as ​Conventional Factoring​, it combines the features of both non-recourse and
advance factoring arrangement.

● Bank Participation Factoring: Under this arrangement, ​a bank participates in factoring by providing an

advance to the client against the reserves maintained by the factor.

● Domestic and Cross border Factoring: In domestic factoring, three parties are involved – ​seller (client), Factor,

Buyer. ​While in cross border or export factoring, four parties are involved in transactions – ​Exporter

(Seller/client), Importer (buyer), Export Factor, Import Factor.

COST OF FACTORING

Finance charge: Finance charge is computed on the prepayment outstanding in the client’s account at
monthly intervals. Finance charges are only for financing that has been availed. These charges are

similar to the interest levied on the cash credit facilities in a bank. •

  Service fee: Service charge is a nominal charge levied at monthly intervals to cover the cost of services,
namely, collection, sales ledger management, and periodical MIS reports. Service fee is determined on the

basis of criteria such as the gross sales value, the number of customers, the number of invoices and credit

notes, and the degree of credit risk represented by the customers or the transaction. Both these charges
taken together compare very favourably with the interest rates charged by banks and financial

institutions for short-term borrowings.

Difference b/w Factoring and Discounting

 BASIS FOR BILL DISCOUNTING FACTORING
COMPARISO
N

Meaning Trading the bill before it A financial transaction in which the

becomes due for payment at a business organization sells its book
price less than its face value is debts to the financial institution at a
known as Bill Discounting. discount is known as Factoring.

Arrangement The entire bill is discounted
and paid, when the transaction
takes place.
The factor gives the maximum part of
the amount as advance when the
transaction takes place and the
remaining amount at the time of
settlement.

Parties Drawer, Drawee and Payee Factor, Debtor and Client

Type Recourse only Recourse and Non Recourse

Governing The Negotiable Instrument No such specific act.

statute Act, 1881

Financier's Discounting Charges or Financiers get interest for financial

Income interest services and commission for other
allied services.

Assignment of No Yes
Debts
Advantages of Factoring Factoring is beneficial to the client, his customers, and banks.

Benefits to the Client The benefits to the clients are as follows: • 

The client’s credit sales are immediately converted into ready cash as the factor makes a payment of around 80 per
cent of the factored invoices in advance.

This proportion of finance is higher than the bank finance against credit sales. • 

The client can offer competitive credit terms to his buyers which, in turn, enable him to increase his sales and profits.
•  The cash realised from credit sales can be used to accelerate the production cycle. • 

The client is free from the tensions of monitoring his sales ledger and can concentrate on production, marketing, and
other aspects. This results in a reduction in overhead expenses and an increase in sales and profits. •

  Factoring results in a close interaction among working capital components of the business. Efficient management of
one component can have positive impact on other component. For example, an increase in liquidity enables the firm to
avail of discounts on purchases of raw materials. •  The factor provides a comprehensive credit control system by
analyzing payment history. This helps in assessing the quality of the debtors and monitoring their financial health. • 
The client can expand his business by exploring new markets)

The benefits that the customers enjoy are as follows:

•  Factoring facilitates the credit purchases of the customers as they get adequate credit period. •  Customers save on
bank charges and expenses. •  The customer has not to furnish any documents. He has merely to acknowledge the
notification letter, that is, an undertaking to make payment of the invoices to the factor. Customers are furnished with
periodical statements of outstanding invoices by the factor. •  Factoring does not impinge on the customer’s rights
vis-a-vis the supplier’s in respect of quality of goods, contractual obligations, and so on.

Benefits to Banks Factoring​ improves liquidity of the clients and, thereby, improves the quality of advances of banks.
Factoring is not a threat to banking; it is a financial service complementary to that of the banks.

INTERNATIONAL FACTORING

International factoring facilitates international trade. It is a comprehensive range of receivables management and
financing services wherein a factor provides an exporter with at least two of the following

•  Credit management and bad debt protection.

•  Credit guarantee.

•  Finance upto 90 per cent of the invoice value on shipment to approved debtor.

•  Collection services.

•  Professional sales ledger and analysis.

International factoring eases much of the credit and collection burden created by international sales. Export receivables
that can be factored should have the following characteristics:
 •  The buyer’s country should be covered by the factor.

•  The exporter’s performance obligation should be completed at the time the exporter presents an invoice for
prepayment.

•  There should be multiple shipments or a continuous sales flow on an ongoing basis with the same buyer or buyers.
There should be assignment of the whole turnover with a buyer on a continuous basis.

•  Factoring transactions are best suited for credit periods up to 180 days and factoring facilities are typically provided
for ‘open-account’ transactions. In the absence of this, the buyers would have to open a letter of credit (LC), thereby
blocking bank limits.

Credit Rating in India. Credit rating agencies in India.

Credit Ratings are the opinions of certain entities called the Credit Rating Agencies. These ratings indicate the ability
or the willingness of an entity that includes government, business, or individuals to repay or fulfill their financial
obligations. In other words, Credit Rating Agencies give Credit Ratings to entities, particularly to those that issue
instruments and indicate whether it is capable of repaying or not.

“ Credit rating is an opinion of the relative capacity of a borrowing entity to service its debt obligations within a
specified time period and with particular reference to the debt instrument being rated.”

Rating agencies use symbols such as AAA, AA, BBB, B, C, D, to convey the safety grade to the investor. Ratings are
classified into three grades: high investment grades, investment grades and speculative grades.

Importance of Credit Rating

· Credit rating helps in the development of financial markets.

· Credit rating agencies play a key role in the infrastructure of the modern financial system.

· Credit rating enables investors to draw up the credit–risk profile and assess the adequacy or otherwise of the
risk–premium offered by the market.

· It saves the investors, time and enables them to take a quick decision and provides them better choices among
available investment opportunities based on their risk-return preferences.

· Issuers have a wider access to capital along with better pricing.

· Issuers with a high credit rating can raise funds at a cheaper rate thereby lowering their cost of capital.

· It acts as a marketing tool for the instrument, enhances the company’s reputation and recognition, and enables
even lesser known companies to raise funds from the capital market.

· Credit rating is a tool in the hands of financial intermediaries, such as banks and financial institutions that can be
effectively employed for taking decisions relating to lending and investments.

· Credit rating helps the market regulators in promoting stability and efficiency in the securities market.

· Ratings make markets more efficient and transparent.

CREDIT RATING AGENCIES IN INDIA

There are seven credit rating agencies registered with the SEBI. The RBI also has accorded accreditation to seven
rating agencies registered with market regulator SEBI. The Reserve Bank of India has decided to review and monitor
the performance of credit rating agencies, for continuation of their accreditation. The move is aimed at ensuring greater
accountability in the quality of the rating process and methodologies. The seven credit rating agencies are:

· CRISIL Limited

· ICRA Limited

· CARE Ratings

· India Ratings and Research Pvt. Ltd. (formerly Fitch Ratings India Pvt. Ltd.)

· Brickwork Ratings India Pvt. Ltd.

· SMERA Ratings Limited

· Infomerics Valuation and Rating Pvt. Ltd

Limitations of Credit Rating in India

The rating business in India grew tremendously in the 1990s. New rating agencies came into existence and
competition among them increased. There has been a significant increase in volume of rated debt. The rating
business is going strong because of mandatory rating of IPOs, roll out of Basel II norms, rating of security
receipts of public–private partnership projects, increased market access by real estate companies, rating of
urban municipal bonds, and RBI’s stipulations that companies with borrowings of `10 crore and above need to
get rated. Despite the increase in popularity of rating, the credit rating business suffers from certain limitations.
·   The credibility of rating is questionable. The institutions whose instruments were given the highest rating have
not performed well. For example, CARE gave the highest rating to CRB Capital, which failed. The CRB scam
created a panic among investors and credit agencies alike. While investors queued up to prematurely retire their
deposits with NBFCs, rating agencies started downgrading almost every company irrespective of their status.

· A frequent revision of grading by credit rating agencies, that is, sometimes upgrading and sometimes
downgrading, creates a confusion among investors questioning again the credibility of the expertise of rating
agencies.

· Around a third of the ratings done by credit rating agencies are not accepted by the clients. This has led to a
competitive relaxation of rating standards by credit rating agencies. It should be mandatory to obtain at least two
ratings as risk perception of rating agencies differ. Both the ratings should be mandatory published in the
prospectus, advertisements, and newspapers,

· The rating agencies do not perform an audit but rely solely on information provided by the issuer. If the
information provided is inaccurate and incomplete, the rating process is compromised.

· Often a credit rating agency gives a high rating to one instrument of a particular company on the one hand and on
the other, frequently downgrades the rating of another instrument of the same company. The rating exercise appears
biased and investors not only get confused but lose their investments by depending on these ratings.

· Rating agencies often fail to correctly predict a borrower’s financial health in the short-term. The latest case is the
non-convertible debenture (NCD) issue of BPL which was downgraded by CRISIL from A to D in one stroke. In
other words, CRISIL downgraded the instrument by 12 stages. The investor, who depends on these ratings, is not
given any warning by rating agencies to wind down his investment in time.

· Rating agencies offer consultancy and financial advice to the clients whose papers they rate. This leads to a
conflict of interest and compromise on their rating process to favour their clients. This has been highlighted by the
financial crisis in the US. Hence, the government is working with regulators on the new regulatory framework for
credit rating agencies.